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Topic pack - Macroeconomics - introduction

Welcome to this Triple A Learning topic pack for Macroeconomics. The pack has a wide range of materials including notes, questions, activities and simulations.

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A few words about Navigation

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Higher level extension material

Some of the material in this pack relates to the higher level extension topics in the Economics guide. This material is marked by icons as follows:

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Key terms - the level of economic activity

One of the key things you need to be sure to know are the definitions of all key macroeconomics terms. In this section we give you explanations and definitions of terms relevant to the level of economic activity.

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Key terms - aggregate demand and supply

One of the key things you need to be sure to know are the definitions of all key macroeconomics terms. In this section we give you explanations and definitions of terms relevant to aggregate demand and supply.

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Key terms - macroeconomic objectives

One of the key things you need to be sure to know are the definitions of all key macroeconomics terms. In this section we give you explanations and definitions of terms relevant to macroeconomic objectives.

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Key terms - macroeconomic policy

One of the key things you need to be sure to know are the definitions of all key macroeconomics terms. In this section we give you explanations and definitions of terms relevant to macroeconomic policy.

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Aims of the economics course

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The aims of the economics course at HL and SL are to enable students to:

Assessment Objectives

Having followed the economics course at HL or SL, students will be expected to:

  1. AO1 Demonstrate knowledge and understanding of specified content
    • Demonstrate knowledge and understanding of the common SL/HL syllabus
    • Demonstrate knowledge and understanding of current economic issues and data
    • At HL only: Demonstrate knowledge and understanding of the higher level extension topics
  2. AO2 Demonstrate application and analysis of knowledge and understanding
    • Apply economic concepts and theories to real-world situations
    • Identify and interpret economic data
    • Demonstrate the extent to which economic information is used effectively in particular contexts
    • At HL only: Demonstrate application and analysis of the extension topics
  3. AO3 Demonstrate synthesis and evaluation
    • Examine economic concepts and theories
    • Use economic concepts and examples to construct and present an argument
    • Discuss and evaluate economic information and theories
    • At HL only: Demonstrate economic synthesis and evaluation of the extension topics
  4. AO4 Select, use and apply a variety of appropriate skills and techniques
    • Produce well-structured written material, using appropriate economic terminology, within specified time limits
    • Use correctly labelled diagrams to help explain economic concepts and theories
    • Select, interpret and analyse appropriate extracts from the news media
    • Interpret appropriate data sets
    • At HL only: Use quantitative techniques to identify, explain and analyse economic relationships

Section Two Structure

Unit two has four core sub-topics and one HL extension.

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Using the pack

Questions

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At the end of the section there are a number of questions you can attempt to check your understanding of the concepts involved. When attempting a question you should always be clear about what the question is actually asking you to do. A key to doing this is to look for the command term that starts the question. This command term will tell you whether the question needs an explanation, requires some analysis or expects you to offer some insights or draw conclusions of your own. In may sound obvious but always remember that the success of passing an examination or test is to ensure that the answer you give corresponds to the question that is being asked!

Pauses for thought

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Throughout the pack there will be times when you are asked to think about some issues relating to macroeconomics in a broader sense. This may involve you reflecting upon the validity of the information you have found or been given or encourage you to make connections with other areas of knowledge. You may want to talk about some of these issues with other students family members or friends as some of the ideas can be quite contentious and lead to some interesting discussions.

2.1 The level of overall economic activity (notes)

In this section, we consider the level of overall economic activity.

By the end of this section you should be able to:

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Overall economic activity - introduction

S:\triplea_resources\DP_topic_packs\business management\student_packs\articulate_interactions\images\stability_change.jpgIn this section, we consider the following sub-topics in detail:

  1. Economic activity
    1. Circular flow of income model
    2. Measures of economic activity
  2. The business cycle
    1. Short term fluctuations and long term trend

Peoples' living standards are clearly dependent upon the amount of goods and services that they are able to consume. Therefore, the production and exchange of these goods and services in the economy, the level of economic activity, will directly affect peoples' wellbeing. A major aim of governments is to improve the living standards of its citizens by increasing the amount of economic activity and the rate at which this activity grows.

To get a better understanding of the nature of economic activity, we will explore a simple model of an economic system - the circular flow of income. This will enable us to see the various elements of the economy and how they relate to each other. As will all economic models, it will be based on a number of simplifying assumptions. The use of assumptions it allows us to make some simple predictions that relate to the real world.


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Pause for thought

Economics is considered by many to be a social science. It uses models based on simplifying assumption as tools to help understand complex systems, and problems, and to make predictions about the real world. Is this approach used in other subjects you study? If not, why not?

A main aim of government is to increase the wealth of the economy by maintaining or increasing the level of economic growth. Economic growth is measured in terms of the increase in national income over a period of time. What do we understand by the term National Income and how do we measure it? In this section we look at the issues relating to national income and its measurement.

One of the other interesting things about economic activity is, that over time, it constantly changes. These changes can occur from year to year as the economy moves through a business cycle, but also over the longer term as the economy experiences growth or decline.

The circular flow of income model (1)


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Circular flow - two sector closed


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Circular flow - two sector open


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Circular flow - three sector open


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Circular flow - government

How important is the role of government in the economy?

In the 3-sector open economy circular flow of income, we could also represent the government separately in this circular flow - here's an alternative representation of the 3-sector open economy circular flow. It shows exactly the same flows, but represents them a little differently.

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Figure 1 Circular flow - 3 sector, open economy

In this diagram, why a big box in the middle for government? Just how big a player do you think the government is in the economy?


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Useful Internet sites for research are:

  1. Identify the proportion of national income represented by government expenditure in your country.
  2. Identify the proportion of national income taken up by government spending for the following countries
    1. USA
    2. Tanzania
    3. Sweden
    4. Cuba
    5. Hong Kong
  3. Considerthe differences in the proportion of national income represented by government spending in the countries above and with your country.
  4. Reflect on the reasons for these differences and remember these findings as you work your way through the macroeconomics pack.

The circular flow of income model (2)

In a centrally planned economy, where the government takes direct responsibility for planning, producing and distributing goods and services to the population, what will the circular flow look? Think about this, then click CENTRALLY PLANNED to see how our answer matches with yours.

Yes, this is an example of a 2-sector economy. The government is the same as firms, since all firms are owned by the government (state). However, the economy may still be open or closed.

Look again at the circular flow model for a three-sector economy.

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Figure 5 Circular flow: A 3 sector, open economy

Circular flow - a summary

A reminder:

The leakages (W) from the circular flow are:

The injections (J) are

An economy is in equilibrium when injections (J) match the leakages (W).

The standard codes used in this model, and in economics in general, are:

Y = National Income
C = Domestic Consumption
S = Savings
M = Imports
T = Taxation
I = Investment
X = Exports
G = Government Spending

The circular flow model of an economy is very useful within the study of economics. We will be looking at the actions and behaviour of firms and households, and how governments interact with them. We will also look at how changes in the leakages and injections affect the stability of an economy.

Some mathematics

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Economists offer try to use mathematics to simplify the analysis of the circular flow of income model. Income is passed on in the circular flow of income through consumer spending or leaked out though savings, taxation or spending on imports. The proportion of national income spent on consumption is called the average propensity to consume (APC)

The proportion of national income save is called the average propensity to save (APS)

Economists have a penchant for what happens at the margin, or when variables change in an incremental way. Anytime there is an incremental change in national income consumption, savings, taxation and imports will also change by a certain proportion. Whereas average propensity is concerned with the proportion of total national income that is passed on or leaked from the circular flow of income, marginal propensity is used to describe the proportion of an incremental change in income that is passed on or leaked from the circular flow of income, .

We can, therefore, identify the marginal propensity to consume as the proportion of a change in national income that is spent on consumption

Similarly, the proportion of a change in national income that is saved, is called the marginal propensity to save (MPS)

The proportion of a change in national income that is paid to the government in tax, is called the marginal rate of taxation (MRT)

The proportion of a change in national income that is spent on imported goods, is called the marginal propensity to import (MPM)


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Now have a go at the following questions:

  1. Assuming a two sector closed economy and that the APC = 0.6 and national income is $1000, calculate the:
    1. level of consumer spending
    2. level of savings in the economy.
  2. Assuming a three sector open economy and that the MPS and MRT and MPM are all 0.2, and national income changes by 2000, calculate the change in the level of:
    1. consumer spending
    2. tax revenue
    3. import spending
  3. Assuming a three sector open economy (however would also be the case for a two sector closed and open economy) the MPC is 0.5, and national income falls by 1500, calculate:
    1. the change in the amount of money that leaks out of the circular flow of income
    2. the change in the amount of consumer spending.


These concepts will be revisited later in later section when we look at what causes national income to change.

Measures of economic activity

In the last section, we looked at the circular flow of income and established that the total flow of income around the economy arising from economic activity is called National Income. There are three different ways of measuring this income. First let's remind ourselves of the circular flow.

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Figure 1 Circular flow of income

We can measure national income in three different ways. We could look at the total level of expenditure on goods and services being produced by firms. This would include consumer expenditure (C), investment expenditure (I), government expenditure (G) and net export spending (X-M) i.e. C + I + G + (X-M).

Alternatively, we could look at the total level of income generated. This would include all factor incomes - wages, profit, rent and interest. A final possibility is to measure the total level of output produced by firms.

All three of these are methods of calculating national income:

Each should give the same result, because each is measuring essentially the same thing; i.e. a flow of income over a period of time. The logic of this is that, for the economy as a whole, the value of all output equals what is spent on the output, and what is spent on the output becomes income to those who have produced the output. Thus NATIONAL INCOME = NATIONAL OUTPUT = NATIONAL EXPENDITURE.


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For an excellent review of the operation of the Circular Flow of Income, watch the video on YouTube by Paj Holden.

Examining the three methods of calculating national income

Theoretically a government can attempt to find out the level of economic activity by trying to measure the total amount of output produced (the output method) or the income generated from producing it (the income method), or the total expenditure on purchasing it (the expenditure method). Governments try to calculate how much output, income, and expenditure takes place within one year.


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To get a basic overview of national income accounting, and in particular the three methods used to measure national income, review the following sites:

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  1. Describe the three methods of calculating national income and explain why they should, in theory, produce the same result
  2. Identify the problems encountered when measuring national income using the three methods.
  3. Exaplain how these problems are overcome.


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To find national income account data relating to these three accounting methods for countries within the Organization for Economic Cooperation and Development (OECD), the StatExtracts site is particularly useful.. You can see the site in the web window below, or follow the previous link to open the site in a new web window.


Find the national accounts link by scrolling down the list on the left hand navigational bar and examine the different measures of national income.


However, in practice a number of difficulties arise when trying to ascribe an accurate monetary value to income, output and expenditure. These difficulties include:

What is GDP? (video)

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For a basic introduction to GDP watch the video below - What is GDP? (You can do this in the web window below or follow the previous link to open the page in a new web window)


Different national income measures

Gross National Product (GNP) and Net National Product (NNP) - gross and net measures

Just as the national assets (the capital stock) work towards creating new wealth, so some of them wear out and need to be replaced (this wearing out is called depreciation). Unless worn out capital is replaced, the national capital stock shrinks and negative economic growth could be recorded. To stop this from happening, part of national income each year must be invested to repair, replace and make good that part of the capital stock, which ceases to be adequate for use.

When we mention Gross National Product (GNP), we are referring to national income BEFORE the amount needed to replace capital has been deducted. This amount is called capital consumption (or depreciation) and, once this has been deducted, we call the figure Net National Product (NNP).

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Net National Product

Net National Product is calculated using the following formula:

NNP = GNP minus capital consumption


Increasingly gross national product (GNP) is being referred to a gross national income (GNI). So remember if you are given GNI data it is the same at GNP!

Gross Domestic product (GDP) and Gross National Product (GNP) - national and domestic

Gross Domestic Product (GDP) is similar to Gross National Product (GNP/GNI), but it only measures the flow of output produced within the country. GNP/GNI adds in property income flowing to domestic economic agents from their investments outside the country. It also includes a deduction of those sums that flow out of the country. Property income is income derived from the ownership of assets in the form of profits, interest and rent.


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Net National Product

Gross National Product is calculated using the following formula:

GNP/GNI = GDP + net property from abroad (or minus net property income paid abroad)


Although this may appear to be a rather dry, inconsequential topic, the question of property income flows is often of life and death significance for millions of people in the developing countries. While net property income is often positive for developed countries, the figure will inevitably be negative for many of the poorest countries of the world. This reflects their indebtedness to the financial institutions and governments of the industrialised countries and manifests itself in the form of large outflows of interest repayments. It often also reflects the domination of less developed countries by multinational corporations who repatriate profits made from these countries to their centre of operations, inevitably somewhere in the richer part of the world. The impact on living standards of the peoples of these countries is dramatic. These issues are discussed in more detail in section 4.5

Real v money data

One of the most crucial things to look at whenever you look at growth and GDP figures is whether they are in real terms.

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Real terms

If a variable is in real terms this means that the effects of inflation have been removed.


If they are not in real terms, then they are described as being in nominal or money terms. This means that they are valued at the same value as money was worth at the time the data was recorded.

However, just to muddle things, the data may not be described as being in real terms. The expression that is often used is that the data is at constant prices. This means that the whole series is expressed at the prices that were ruling in a particular year, e.g. at 2008 prices. If the data is expressed in nominal or money terms, then it may be described as being valued at current prices. So, remember:

Current prices - includes the impact of inflation, as output is valued at prices currently prevailing in markets.

Constant prices - the effect of inflation has been removed and the variable is in real terms.


GDP at constant and current prices - Italy

GDP at constant and current prices - Turkey

The brown line shows GDP at current prices, and this clearly grows a lot faster than GDP at constant prices. The difference between the two datasets is simply inflation. In this graph, GDP is expressed at the prices ruling in the base year of the index.

So, first thing when you look at a piece of data - is it in real or nominal terms?

Current and constant prices

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The GDP deflator is a broader index of price increases than the consumer price index. It includes the prices of capital goods as well as consumer goods. It can be used to calculate real changes in the level of GDP. We say that it is used to convert GDP at current prices to GDP at constant prices.

The following table show the GDP deflator indices for two countries, Italy and Turkey

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009
Italy 100.00 102.96 106.32 109.63 112.52 114.84 116.95 119.96 123.26 125.91
Turkey 230.07 351.67 483.28 595.74 669.62 717.05 783.96 832.73 932.61 980.65


The formula for the GDP deflator is as follows:

Hence to calculate Real GDP the formula can be rearranged as follows


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Task

  1. Calculate the increase in the overall level of price increases between 2000 and 2009 for both countries. This will give you a clue why nominal GDP has increased over the period.
  2. The table below shows the GDP figure at current prices in US $.
Country Name 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010
Italy 1,097,344,131,196 1,117,358,481,432 1,218,921,247,883 1,507,171,243,792 1,727,825,472,922 1,777,693,953,639 1,863,380,936,371 2,116,201,719,593 2,296,628,950,818 2,112,780,152,061 ..
Turkey 266,567,531,990 196,005,288,838 232,534,560,775 303,005,302,818 392,166,274,991 482,979,839,238 530,900,094,505 647,155,131,629 730,337,495,198 614,603,094,839 ..


  1. For the above nominal GDP data calculate the real GDP and add it to a spreadsheet
  2. Plot the GDP at current prices (nominal) and the GDP at constant prices (real) for both countries between 2000 and 2009. Time should be plotted along the X axis.
  3. Are there any differences between the two graphs for each country?
  4. What accounts for the difference between the two sets of data?

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Using index numbers

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Much of the data you will come across in your course is presented in the form of index numbers and index series. Let's review how index numbers work.

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009
Italy 89 91 93 96 98 100 102 104 107 108
Turkey 29 45 66 82 91 100 111 120 133 141


The following shows the consumer price index for two countries, Italy and Turkey. The consumer price index is a number calculated every year, which indicates how much on average consumer prices have risen since the previous year.

If we look at prices in Italy between 2000 and 2001 we can see that the consumer price index has increased from 89 to 91. The first point to note is that this DOES NOT MEAN that prices have gone up by 2%. That is not how index numbers work!

To calculate the increase in consumer prices we would need to find the percentage change between these two index numbers.

In the above example

We can say, therefore, that the prices have gone up by 2.3% over the two years.


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Now it's your turn

Calculate the increase in consumer prices:

    1. from 2003 and 2007 for both countries
    2. from 2001 to 2009 for both countries
    3. from 2008 to 2009 for both countries


NB The index number in 2005 for both countries is 100. This means that the index has been calculated in such a way that all prices are being compared with those that existed in 2005. 2005 is referred to as the base year. Therefore, when you use an index, it is said that you are valuing something in terms of constant prices i.e. in the case of the example, all prices are benchmarked against those that existed in 2005.

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Total and per capita

S:\triplea_resources\DP_topic_packs\economics\student_topic_packs\media_macroeconomics\images\per_capita.jpgSo far we have been talking about national income as the total amount of income earned by the economy and this is an important measure. However, if we want to compare national income between countries, we need to adjust the measure.

For example, we would expect the USA to have a higher national income than France, for example, as they have approximately five times the population and more people means the USA should be able to produce more goods and servies. However, what is more important is whether, on average, each person in the USA produces more in value more than each person in France. To calculate this figure, we divide the national income by the population to get 'national income per person' or 'per capita'. Using this measure we are in a better position to compare standards of living between countries. However, when using national income per capita to make international comparisons of welfare, there are still a number of additional factors that need to be taken into account.

Case study - rapid economic growth

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S:\triplea_resources\DP_topic_packs\business management\student_packs\articulate_interactions\images\boom_recession.jpgChina's development could be advanced considerably if the government and the people abandoned their unhealthy fixation on the rise of gross domestic product.

A recent edition of The South China Morning Post carried a feature expressing the point in a particularly enlightening fashion.

What's so great about rapid economic growth anyway?

For the princely sum of 14,500 yuan (HK$16,800), the magazine's Beijing correspondent joined 30 or so mainlanders for a gruelling 10day, five-country coach tour of Europe.

Watching cultures collide - even at second hand - is always illuminating. No doubt the speed at which the tourists swept past the architectural and artistic glories of Paris, pausing only to snap the obligatory photographic record of their presence before heading off for an orgy of handbag shopping, would have raised some supercilious French eyebrows.

But equally, for their part the visitors were taken aback by the leisurely pace of life in Europe, where the locals linger over coffee, prohibit bus drivers from working more than 12 hours a day, and even stop their cars for pedestrians.

"With a pace like that, how can their economies keep growing?" the Chinese guide asks. "Only when you have diligent, hardworking people will the nation's economy grow."

It's a theme that recurred constantly as the group tore around Europe, with the visitors marvelling at the willingness of French workers to go on strike, and at how many years the Italians take to build a new highway. "If this were China, it would be done in six months," one says. "That's the only way to keep the economy growing."

What's remarkable here is not that the Chinese tourists found Europe slow-moving - Americans have been saying the same for decades - but that their automatic assumption that fast growth is the best, indeed the only, measure of a country's economic success.

This begs the question: what's so great about rapid growth anyway?

That might sound like a dumb thing to ask, but the more you think about it, the more the question makes sense.

The growth our tourists were talking about was in gross domestic product (GDP), which measures the final value of all goods and services produced by an economy.

GDP was developed in the US during the Great Depression, and came into its own during the second world-war as a measure of how many guns, ships and planes the US economy was able to produce. It has been the standard measure of economic strength ever since.

But GDP measures quantity, not quality. In other words, although it says a great deal about how much stuff you can churn out, it tells you very little about the state of your economic development.

For example, GDP counts all investment as positive, whether or not that investment turns out to be productive in the longer run.

So if a country pours resources into building pyramids, its GDP will rise sharply while they are under construction. But considering that pyramids, once complete, add nothing to the economy (except maybe generating tourist revenues four millennia later), it is difficult to claim that their construction furthers economic progress.

This consideration is especially important for China. Although the country's leaders aren't building pyramids, they may be doing the modern equivalent: building hundreds of expensive airports, high-speed rail lines and glittering financial centres that can never hope to generate a return on the investment involved. These projects add to GDP growth in the short term but do nothing to advance economic development.

Similarly, GDP fails to account for the costs of environmental damage. All production is regarded as positive, even if the pollution it causes reduces the productive capacity of the agricultural sector and pushes up health care costs.

Again, this is important for China. A few years ago, the State Environmental Protection Administration did try to factor pollution costs into the country's GDP figures. But when it found that including environmental costs would have reduced growth by at least a third, the attempt was quickly discontinued. That shouldn't have been too surprising given that maintaining high headline GDP growth has become an obsession with China's leaders, who tout rapid growth as the justification for their authoritarian rule.

And as our travellers' comments show, their message resonates strongly with China's people, or at least those rich enough to take package tours round Europe.

But unfortunately the GDP measure by which both China's government and its travelling classes set such store is a deeply flawed measure of true economic progress.

As Simon Kuznets, the US economist who originally developed the idea of gross domestic product, warned: "Distinctions must be kept in mind between quantity and quality of growth, between its costs and return, and between the short and the long run. Goals for more growth should specify more growth of what, and for what."

It's a message China and its leaders would do well to heed.

That's not to say China should immediately embrace a European lifestyle - heaven forbid - but it does mean that the country's economic development could be advanced considerably if only its government and people were to abandon their unhealthy fixation on the rapid growth of GDP.

South China Morning Post (25 May 2011) by Tom Holland (reproduced here with permission of the author)

If you would prefer a pdf version of the original article, please follow the link below:

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  1. Summarize the arguments for slowing down the rapid growth of GDP?
  2. To what extent do you agree with these arguments?
  3. Explain the counter arguments in favour of increasing the level of a country's GDP.

Using national income data

S:\triplea_resources\DP_topic_packs\economics\student_topic_packs\media_macroeconomics\images\dollar_gdp.jpgIt is recommended that you review section 4.2 which looks at the problems of measuring development. Living standards and welfare are considered to be key concepts in economic development. In the previous section we noted that using national income data to measure living standards, and to measure how these change over time, is fraught with potential hazards. Similarly, using national income data to compare the living standards in different countries can also be problematic. In particular, governments have problems:

  1. measuringliving standards of the population
  2. measuring how living standards change over time
  3. comparing international living standards

Can you remember the issues associated with using national income data such as GDP to measure living standards?

Can you remember the issues associated with using national income data such as GDP to measure how living standards change over time?

When comparing GDP figures between countries, think about the following (Section 4.2 explores many of these issues in more detail):

Purchasing power of GDP

Allowances for differences in purchasing power when comparing welfare between countries

S:\triplea_resources\DP_topic_packs\business management\student_packs\articulate_interactions\images\information_gather.jpgWe saw in the previous section, that GDP alone is not a completely adequate measure of the standard of living, though it is often used as a proxy for it. If we do use GDP as a measure of standard of living, then we also need to take account of differences between the purchasing power of GDP. If you have travelled, you will be aware that prices of goods in other countries often appear cheaper / more expensive. This may appear the case to us, but not to the people living there.

It may be that a lower GDP per capita nevertheless gives the same standard of living, because the same level of income can buy more in a particular country. When comparing GDP between countries, we need to try to adjust for the purchasing power of the GDP. Differences in purchasing power often relate to exchange rate differentials. Although purchasing power is one factor affecting exchange rates, there are many others as well if a country's exchange rate is out of line with what is called the purchasing power parity exchange rate.

When comparing GDP levels between countries, we should try to compare GDP per capita translated at purchasing power parity rates.


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Task

  1. Visit the World Bank data site and find the most recent GDP per capita for the following countries:
  1. Search the web to identify factors causing the differences between the GDP per capita figures you have found. Present evidence to support your findings.

Alternative measures of GDP

S:\triplea_resources\DP_topic_packs\economics\student_topic_packs\media_microeconomics\images\environment_globe.jpgWe have seen already that GDP is a rather narrow measure of living standards. There are alternative measures of living standards, such as the Human Development Index of the United Nations Development Programme (UNDP). This index includes development indicators, such as life expectancy and access to education, as well as GDP. In addition, there are a number of single and composite indicators we can use as measures of development. These are explored in more detail in Section 4.2

The Green GDP

national income statistics provide a rather limited measure of living standards and wellbeing and do not take environmental concerns, such as the depletion of natural resources, into account. In response to this omission, the United Nations and the World Bank introduced the idea of Green GDP. In essence, 'Green GDP' highlights both the contribution of natural resources to economic development and the costs caused by pollution or resources degradation. By including both the use and depletion of natural resources in economic growth, this measure tells us more about the quality of the growth in terms of sustainable development.

Green GDP = GDP -Depletion of Natural Resources - Cost of Pollution


Index of Sustainable Economic Welfare (ISEW)

Another measure of development is the ISEW This provides a fuller picture of economic welfare because, like the MEW, this index adjusts the GDP figure to allow for actors ignored by GDP. These include:

After these adjustments are made, we get the ISEW figure which will be a better representation of economic welfare than GDP alone.

While GDP provides a somewhat limited measure of economic growth and living standards, it does have the advantage of being fairly easily obtained and is based on three variables only - income, expenditure and output. In contrast to this, as can be seen from the HDI, MEW and ISEW, development is a multi-dimensional, complex process which can only be judged against a variety of criteria, using composite indices. This may give rise to various problems involving subjective, value judgements on behalf of the statisticians who construct the indices. For example, how should factors such as life expectancy and literacy be weighted within an index? Which factors should be included and which should be excluded? While the HDI, for example, may provide a fairly sophisticated indicator of living standards, it omits some very important components, such as environmental quality; but to construct a development index, which is all-embracing, would be a statistically awesome task!

Case Study

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Grossly distorted picture

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Read the article Grossly distorted picture. You can do this in the web window below, or follow the previous link to open the article in a new web window.


Having read this article organize a debate about the meaning of quality of life or standard of living. You will need to think through how to word the motion. It should be somewhat contentious to give those debating something to get their teeth into. For example it could be:

"This house believes that the chief aim of a thriving economy is to raise the material living standards of its citizens."

Short term fluctuations and long term trends


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Business cycle

The business cycle, also often known as the trade cycle, is the tendency of economies to move, over time, through periods of boom and slump. In other words, the business cycle represents the fluctuations in the rate of economic growth that take place in the economy.


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What the data says (1)

  1. Visit the World Bank Data site and examine GDP data for your own country over the last 20 years. Using this data, identify the years when the economy was in periods of boom, recession, slump and recovery.
  2. Explain why governments might want to predict where a country is in its business cycle?.


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What the data says (2)

  1. Import the GDP data for your own country and three others from different continents into a spreadsheet and plot the data. Using this date, comment on whether it is possible to determine a longer term trend in economic activity. If it is possible, construct a trend line to show whether the economy is growing or declining over the longer term.
  2. Discuss whether the long term trends for all four countries are broadly the same or, whether there differences.

The business cycle in history

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The following article explores the business cycle in the UK over the last 300 years. As you read the article, reflect on whether the business cycle has changed over the centuries and consider factors that may underpin cyclical activity in the UK.


The business cycle is explored in more detail in sections 2.2 and 2.4. Specifically, we try to understand what causes the cycle, once it has started, to continue or to change direction.

2.1 The level of overall economic activity (questions)

In this section are a series of questions on the topic - the level of overall economic activity. The questions may include various types of questions. For example:





Click on the right arrow at the top or bottom of the page to work through the questions.

Self-test questions

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1

Trade cycle

In which phase of the trade cycle is inflation most likely to emerge?

a)
b)
c)
d)
Please select an answerYes, well done. A boom means rapid growth and this may cause demand-pull inflation to emerge.No, inflation is likely to fall in this phase.No, inflation is likely to remain low in this phase.No, inflation is likely to high or rising in this phase.
Check your answer

2

Trade cycle

Which of the following is not a phase of the trade cycle?

a)
b)
c)
d)
Please select an answerNo, this is a phase of the business cycle.No, this is a phase of the business cycle.No, this is a phase of the business cycle.Yes, this may happen WITHIN the boom phase of the cycle.
Check your answer

3

Trade cycle

In which phase of the business cycle is unemployment most likely to rise?

a)
b)
c)
d)
Please select an answerNo, unemployment is likely to be falling here. Higher demand for goods and services will lead to more jobs being created.Yes, well done. In a recession, demand is falling and this is likely to lead firms to lay off workers.No, unemployment may rise or it may begin to stabilise in this phase.No, unemployment is likely to be falling here.
Check your answer

Short questions

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Question 1

Distinguish between saving and investment.

Question 2

"Saving is a leakage from, and investment is an injection into, the circular flow of income." Identify:

(a) two further examples of a leakage
(b) two further examples of an injection

Question 3

Using a three sector open circular flow of income model:

(a) Explain what is meant by equilibrium
(b) Describe the conditions for the circular flow of income to be in equilibrium

Question 4

Explain what you would expect to happen to the size of the circular income flow if there was an increase in the amount of government spending into the flow.

Question 5

Explain why GDP may not always be the best measure of economic welfare.

Question 6

Analyse two possible factors that will lead to GDP understating the level of economic welfare.

Question 7

Analyse two possible factors that will lead to GDP overstating the level of economic welfare.

Question 8

Explain the main problems with using GDP as a measure of economic welfare.

Question 9

Evaluate two measures of economic welfare and compare these to GDP.

Data response (1)

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Read the article Sarkozy seeks le feel-good factor (you can do this in the web window below or follow the previous link to open the article in a new web window) and then answer the questions below.


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Question 1

Define Gross Domestic Product.

Question 2

Examine the view that GDP is a useful indicator of living standards.

Question 3

Identify, and evaluate, alternative measures to GDP as indicators of the quality of life of a country.

Question 4

Examine the problems associated with using indicators of living standards, such as GDP across national boundaries.

Data response (2)

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Read the following article written by a Ugandan coffee farmer:

And then answer the questions below.

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Question 1

Define the term 'buffer stocks.

Question 2

To what extent is Gross Domestic Product is an effective measure of the standard of living on Ugandans.

Question 3

Explain whether an annual growth rate of 5.1% in 2010 means that Ugandans livings standards have increased by an equivalent amount.

Question 4

Disuss the reasons behind the fluctuations in the Gross Domestic Product of Uganda.

Long Questions

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Question 1

(a) Explain what is meant by the circular flow of income.

(b) Using diagrams to illustrate your answers, explain the conditions necessary for the circular flow of income of a country to be in equilibrium.

Question 2

(a) Describe the methods by which Gross Domestic Product can be measured.

(b) To what extent can Gross Domestic Product be used as a reliable indicator of living standards, both nationally and internationally?

Section 2.2 Aggregate demand and supply (notes)

In the previous section we considered the level of overall economic activity.

In this section, we examine the concepts of aggregate demand and aggregate supply.

By the end of this section you should be able to:

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Aggregate demand and supply - introduction

S:\triplea_resources\DP_topic_packs\business management\student_packs\articulate_interactions\images\dollar_symbol.jpgIn this section we consider the following topics in detail:

As economists we want to be able to model what is happening in an economy - particularly in the macroeconomy. This enables us to analyse what causes changes in the economy at the macro level and to develop appropriate policies to achieve our macro goals.

In managing a country's economy, governments are usually aiming to:

There will always be trade-offs between these macroeconomic goals, because it can be difficult to maintain all of them at once; governments will, as a result, face decisions on acceptable levels for each target.

In trying to understand the various macroeconomic problems a country might face, and the policies that its government may adopt in response, it is useful to look at one of the most common theoretical frameworks for analysing the macroeconomy; those of aggregate demand and supply. These are similar to the concepts of demand and supply that we considered in Section 1, but with the addition of the word 'aggregate'. Agregate means 'the sum of', so we are now looking at total demand and supply in the whole economy, instead of demand and supply of goods and services in individual markets.

The AD/AS model

The AD/AS model is central to macro-economic analysis, because it focuses on the determination of the equilibrium level of real output and the level of prices.

Using AD and AS curves, allows us in a relatively simple way, to illustrate complex inter-relationships and linkages, that are characteristic of market economies.


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Why is the AS/AD model important for exam success?

It is relevant across a wide area of macro-economics and allows you to tackle a variety of macro-economic questions using a formalised mode of analysis, rather than relying purely on descriptive or ad hoc approaches. It is, therefore, an excellent tool for accumulating marks in HL and SL economics exams.


What are the differences between the AD/AS model and the D&S model?

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Figure 1 Demand and supply and AD/AS compared

Aggregate demand curve


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Changes in aggregate demand


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N.B. A change in the price level will simply be represented by a movement along the AD curve.

Short-run aggregate supply (SRAS)


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Changes in SRAS


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Long run aggregate supply (LRAS) - classical

The neo-classical approach


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Changes in LRAS - classical

The neo-classical approach


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Long run aggregate supply (LRAS) - Keynesian


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Aggregate supply changes

Many economists argue that the LRAS curve is vertical, which means that any increase in AD will lead to an increase in prices. They feel that a time lag exists between the level of demand increasing and the supply sector of the economy being able to expand to meet this. They argue that only through increases in LRAS will such rises in AD be met without inflationary pressures.

Supply-side policies may enable the economy to expand in a non-inflationary way, as shown in Figure 1 below.

lras_ad_right

Figure 1 Impact of supply-side policies

Full employment level of national income

As we have seen in previous sections, national income can be calculated by measuring the total level of output of the economy. Generally speaking, the more the economy produces, the more people will be needed to produce the goods and services. However, there will be a maximum level of output where everyone available is employed and no more output can be produced. This level of output is called the full employment level of national income. At this level of income, everyone who wants a job will have a job and there is no shortage of demand in the economy.

We can see the level of full employment income in Figure 1 below - Yfe.

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Figure 1 Full employment national income (Yfe) - Keynesian and Neo-classical

In practice, there may still be some unemployment at this level of income, but this would be caused by institutional factors like the level of social security payments or perhaps seasonal factors. However, at the full employment national income the economy is producing as much as it is able to in current circumstances.

Equilibrium national income


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The essentials of AD and AS

As is said in their titles, both aggregate demand and supply curves are aggregates - that is, they are the total of either all demand or supply within the economy. Aggregate demand slopes downwards as any other demand curve and shows that as the aggregate demand for real output increases, the average price level in the economy falls. This is the same relationship you studied when looking at individual demand. As with effective demand for individual products, a change in any of its components will SHIFT the AD curve to a new position. So, if a country becomes more successful in exporting its products to other countries, the AD line will shift to the right as in the diagram below (Figure 2). A similar situation will arise if the government stimulated the economy via expansionary fiscal or monetary policy.

ad_as_ad_right

Figure 2 Increased aggregate demand

The aggregate supply curve shows the total output of goods and services, which the firms or producers or suppliers will, or plan to supply, at a given price level. As we saw previously, a change in any of the determinants of AS, apart from the price level, will shift the AS curve to a new position.

If, or when, any of these change the curve can shift. In the diagram below (Figure 3), import prices have fallen and so too have the costs of production - the AS curve has therefore moved to the right (outwards).

ad_as_as_right

Figure 3 Increased aggregate supply

Have a go at shifting the AD/AS curves for each of the changes below, draw original equilibrium AD and AS curves and show how the equilibrium has changed. Once you have answers to the outlined changes, follow the links to see if your answers agree with ours.

Illustrate the effect on equilibrium of the following:

  1. The central bank is concerned about future inflation and so increases interest rates.
  2. The exchange rate depreciates, leading to a fall in export prices and an increase in import prices.
  3. Consumers are concerned about high levels of debt and so reduce spending and increase saving to try to reduce their indebtedness.

Answer 1

Answer 2

Answer 3

Changes in short-run equilibrium - summary


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Equilibrium in the long run?


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Non-inflationary growth

LRAS can be shifted through supply-side policies, and free market economists argue that, if these are used, the economy can grow in a non-inflationary way as in Figure 1 below. We will look at these policies in more detail in the next section.

lras_ad_right

Figure 1 Impact of supply-side policies

It is generally accepted that there is a relationship between output and employment and, that as output increases, so employment will rise. This seems easier to prove in the short term than it is in the long term. For example, if we make a major breakthrough in technology then output will certainly increase, but will it lead to a similar reaction in employment?

Equilibrium in the Keynesian model


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Inflationary and deflationary gaps


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Any fluctuations in growth must be caused either by changes on the demand-side or changes on the supply-side of the economy. So what can cause these demand-side or supply-side changes?

1. Demand-side shocks

These might be caused by a variety of different events, but they all cause demand to change more suddenly than had been expected. A downturn is normally the more difficult to deal with, although excessive growth may result in inflationary pressures. Such shocks might have resulted from a previous bout of inflation, or a subsequent rise in unemployment or any event that reduces consumer confidence and causes demand to fall. An example is the impact of the swine flu in a country. A demand-side shock is illustrated by shifting AD left.

2. Supply-side shocks

Supply-side shocks can be just as devastating, though, as their name suggests, they are the result of something happening on the other side of the economic equation. It could be a war, drought, natural catastrophe or anything that causes the supply chain to be adversely affected. A supply-side shock is illustrated by shifting AS left.

Remember business and economic planners like stability and certainty, so any 'surprise' event can cause calculations and confidence to be blown off course.

Other possible causes of a cyclical pattern of growth could be:

Keynes vs. Hayek (video)

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For a slightly different summary of the arguments between the Keynesian and Neo Classical economists why not watch and listen to the video clip. It presents a hip hop song imagining a debate between John Maynard Keynes and Friedrich Hayek. Try to follow the argument.


The Keynesian multiplier

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Multiplier

The multiplier refers to the phenomenon, whereby a change in an injection of expenditure (either investment, government expenditure or exports), will lead to a proportionately larger change (or multiple change) in the level of national income i.e. the eventual change in national income will be some multiple of the initial change in spending.


S:\triplea_resources\DP_topic_packs\economics\student_topic_packs\media_macroeconomics\images\multiplier.jpgWe need to be aware that changes in any of the components of AD (e.g. investment) may have a larger effect on GDP than just the value of the change. This is known as the multiplier effect. Let's look at what may happen if there was an injection of extra money into government-provided health care in an economy. Certainly, some of the money will go to doctors and nurses in the form of a salary increase or to employ new doctors and nurses, but new building and equipment will probably also be bought. This will boost sales of those making such items and so allow them to consume more. This 'first round effect' is the big boost to spending within the economy.

However, doctors eat, drink and consume just like the rest of us, and they will choose to spend some of their additional salary, known as their marginal propensity to consume (MPC) and save the rest, known as their marginal propensity to save (MPS). So, if a doctor was awarded an extra $100 in salary and chose to spend $80 of this, his or her MPC would be 0.8 and his or her MPS would be 0.2. MPC and MPS must add up to 1, since additional money can only be saved or spent.

The producers of the goods and services that the doctor now buy buy will take on more labour to cope with the extra demand and these new employees will also spend part of their additional income and so it goes on. The amount that is passed on will diminish in each successive round of spending but the overall injection into the economy will be greater than the first sum that was put into it. The size of the multiplier can be worked out by dividing the increase in national income that eventually occurs by the increase in injections that caused it.

So, for example, if an increase in government spending of $10m caused GDP to rise by $50m, this would be a multiplier of 5. This would be found by dividing $50m (the change in GDP) by $5m (the initial change in injection of expenditure).

The key determinants of the value of the multiplier are:

Overall, the value of the multiplier therefore depends on the amount of any increase in income that is spent by the people receiving it. The higher the MPC, the higher the value of the multiplier will be.


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Marginal propensity to consume (MPC)

The marginal propensity to consume is the proportion of each extra dollar of income spent by households. For example, if a person earns $1 more and consumes 70c of it, then the MPC is 0.7.


The value of the multiplier can be calculated from the following formula:

Where MPC is marginal propensity to consume and MPS is marginal propensity to save.

But, how exactly is the multiplier determined?

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Section 2.2 Aggregate demand and supply (simulations and activities)

In this section are a series of simulations and activities on the topic - aggregate demand and supply. These simulations and activities might include:





Click on the right arrow at the top or bottom of the page to move on to the next page.

Diagram toolkit

In the diagram toolkit you get given a panel showing possible curves and labels and you then drag these curves onto targets on the diagram to try to build an appropriate diagram.

There are a number of sections. Follow the links below to access the different sections or use the table of contents on the left.

Why not try the one below as some practice? Drag curves and labels onto the targets on the diagram to build a demand and supply diagram showing a market in equilibrium. Once you think the diagram is right, click 'Check answer'. To see the correct answer, click the 'Feedback' button.

Click on the right arrow to start trying out the diagram toolkit.

National income equilibrium (1)

On the diagrams below, drag curves and labels from the panel on the right to build the appropriate diagram. Once you think the diagram is right, click 'Check answer'. To see the correct answer, click the 'Feedback' button.

Number 1

Number 2

Number 3

Number 4

Click on the right arrow try some further examples.

National income equilibrium (2)

On the diagrams below, drag curves and labels from the panel on the right to build the appropriate diagram. Once you think the diagram is right, click 'Check answer'. To see the correct answer, click the 'Feedback' button.

Number 1

Number 2

Number 3

Number 4

Click on the right arrow try some further examples.

National income equilibrium (3)

On the diagrams below, drag curves and labels from the panel on the right to build the appropriate diagram. Once you think the diagram is right, click 'Check answer'. To see the correct answer, click the 'Feedback' button.

Number 1

Number 2

Number 3

Number 4

Click on the right arrow try some further examples.

National income equilibrium (4)

On the diagrams below, drag curves and labels from the panel on the right to build the appropriate diagram. Once you think the diagram is right, click 'Check answer'. To see the correct answer, click the 'Feedback' button.

Number 1

Number 2

Number 3

Number 4

DragIT - Aggregate demand and supply

The above diagram shows an aggregate demand curve and an aggregate supply curve, with equilibrium real national income (Ye) and the price level (Pe) where the two curves intersect.

First, drag the two lines in turn to show the influence of (a) increased aggregate demand and (b) increased costs on the price level and national income.

Second, click the 'Rotate AS line' button so that the AS curve becomes more elastic and then again drag the two lines in turn and note the effects on Ye and Pe.

Referring to the above diagram, are the following statements true or false? In each case assume that nothing else changes. (Try dragging the lines to check on your answer.)

1

Shifts in aggregate supply and demand

An increase in aggregate demand will cause higher inflation.

a)
b)
Yes, that's correct. The statement is true. Higher aggregate demand will shift the aggregate demand to the right (try dragging this in the above diagram) and cause the equilibrium price level to rise (inflation).No, that's not right. The statement is true. Higher aggregate demand will shift the aggregate demand to the right (try dragging this in the above diagram) and cause the equilibrium price level to rise (inflation).Your answer has been saved.
Check your answer

2

Shifts in aggregate supply and demand

An increase in costs will make the aggregate supply curve more inelastic.

a)
b)
Yes, that's correct. The statement is false. An increase in costs will shift the supply curve to the left, but will not change the elasticity.No, that's not right. The statement is false. An increase in costs will shift the supply curve to the left, but will not change the elasticity.Your answer has been saved.
Check your answer

3

Shifts in aggregate supply and demand

The less responsive is AS to a rise in AD, the more prices will rise for a given increase in AD.

a)
b)
Yes, that's correct. The statement is true. Try rotating the AS curve and then drag the AD curve and see the impact on the equilibrium price level.No, that's not right. The statement is true. Try rotating the AS curve and then drag the AD curve and see the impact on the equilibrium price level.Your answer has been saved.
Check your answer

4

Shifts in aggregate supply and demand

An increase in expenditure tax will shift both the aggregate demand and supply curves to the left.

a)
b)
Yes, that's correct. The statement is true. An increase in expenditure tax will reduce consumption (shifting aggregate demand to the left) and will also represent an increase in costs (shifting aggregate supply to the left as well).No, that's not right. The statement is true. An increase in expenditure tax will reduce consumption (shifting aggregate demand to the left) and will also represent an increase in costs (shifting aggregate supply to the left as well).Your answer has been saved.
Check your answer

5

Shifts in aggregate supply and demand

An improvement in productivity will shift both the aggregate demand and supply curves to the right.

a)
b)
Yes, that's correct. The statement is false. An improvement in productivity will mean that firms are more efficient (shifting aggregate supply to the right), but it will not shift aggregate demand. There will simply be a 'move along' the aggregate demand curve, not a shift.No, that's not right. The statement is false. An improvement in productivity will mean that firms are more efficient (shifting aggregate supply to the right), but it will not shift aggregate demand. There will simply be a 'move along' the aggregate demand curve, not a shift.Your answer has been saved.
Check your answer

2.2 Aggregate Demand and Aggregate Supply (questions)

In this section are a series of questions on the topic - aggregate demand and supply. The questions may include various types of questions. For example:





Click on the right arrow at the top or bottom of the page to work through the questions.

AD/AS - self-test questions

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1

Shifts in aggregate demand

Which of the following would NOT cause a shift in AD?

a)
b)
c)
d)
Yes, that's correct. Well done. This would not shift the aggregate demand curve, but would shift the aggregate supply curve.No, that's not right. The correct answer is D. All of the others would be a possible cause of a shift in AD.Your answer has been saved.
Check your answer

2

Shifts in aggregate demand

Choose appropriate phrases from the drop down boxes below to complete the explanation of shifts of an aggregate demand curve and movements along aggregate demand curves.

When the price level in the economy changes there will a the aggregate demand curve. If the price level increases, there will be a movement upwards and to the left on the aggregate demand curve. If there is a decrease in the price level, then there will be a movement downwards to the right. However, if factors other than the price level change then the whole aggregate demand curve will shift, either to the right or to the left. For example, if there is a reduction in income tax, then the aggregate demand curve will shift to the . If, however, the rate of income tax increases, then the demand curve will shift to the .

Your answer has been saved.Check your answer

3

Shifts in aggregate supply

Which of the following would NOT cause a SHIFT in AS?

a)
b)
c)
d)
Yes, that's correct. Well done. This would not cause a shift in the aggregate supply curve.No, that's not right. The correct answer is A as this is not normally associated with a shift in AS. The others, plus technology and factor mobility would all be possible causes of a shift in AS.Your answer has been saved.
Check your answer

4

Shifts in aggregate supply

If the price of imports rose, caused by a change in the value of the pound then the AS would shift to the:

a)
b)
c)
d)
Yes, that's correct. Well done. The aggregate supply curve would shift to the left. The price of imports has risen and this would raise firm's costs making them less willing to supply.No, that's not right. The correct answer is B. A would show an increase in AS whereas we are analysing a fall. C is not possible on the diagrams we use and D is not right as the curve will shift.Your answer has been saved.
Check your answer

5

Shifts in aggregate supply

Which of the following might have caused the shift in aggregate supply shown in the diagram below? Tick all the answers that apply.

ad_as_as_left

a)
b)
c)
d)
e)
f)
a) Yes, you have chosen the correct option. An improvement in technology will shift the aggregate supply curve to the right.a) No, you have not chosen the correct option. An improvement in technology will shift the aggregate supply curve to the right.b) Yes, you have chosen the correct option. A depreciation of the exchange rate will increase import prices and so raise firm's costs.b) No, you have not chosen the correct option. A depreciation of the exchange rate will increase import prices and so raise firm's costs.c) Yes, you have chosen the correct option. An increase in costs will shift the aggregate supply curve to the right.c) No, you have not chosen the correct option. An increase in costs will shift the aggregate supply curve to the right.d) Yes, you have chosen the correct option. A reduction in government expenditure will affect aggregate demand.d) No, you have not chosen the correct option. A reduction in government expenditure will affect aggregate demand.e) Yes, you have chosen the correct option. A cut in income tax will affect aggregate demand.e) No, you have not chosen the correct option. A cut in income tax will affect aggregate demand.f) Yes, you have chosen the correct option. An increase in wage levels will increase firm's costs and therefore shift the aggregate supply curve to the left.f) No, you have not chosen the correct option. An increase in wage levels will increase firm's costs and therefore shift the aggregate supply curve to the left.
Check your answer

6

Determinants of exports

A key determinant of exports is:

a)
b)
c)
d)
Yes, that's correct. Well done. We need to have an efficient business sector to make the products others want to buy.No, that's not right. The correct answer is A as we need to have an efficient business sector to make the products others want to buy. B might help us to produce exports but then much would depend on the productivity of the workforce. C is not normally thought to affect exports as any government promotes overseas sales. D is related to monetary policy and not exports.Your answer has been saved.
Check your answer

7

Shifts in aggregate supply and demand

Which of the following would cause the shift shown in the diagram below? Tick all the answers that apply.

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a)
b)
c)
d)
e)
f)
a) Yes, you have chosen the correct option. An increase in interest rates will reduce aggregate demand and shift the curve to the left.a) No, you have not chosen the correct option. An increase in interest rates will reduce aggregate demand and shift the curve to the left.b) Yes, you have chosen the correct option. An increase in tax-free allowances will boost disposable income and shift aggregate demand to the right.b) No, you have not chosen the correct option. An increase in tax-free allowances will boost disposable income and shift aggregate demand to the right.c) Yes, you have chosen the correct option. If the rate of VAT is increased this will reduce aggregate demand and shift the curve to the left.c) No, you have not chosen the correct option. If the rate of VAT is increased this will reduce aggregate demand and shift the curve to the left.d) Yes, you have chosen the correct option. Relaxing lending controls will boost aggregate demand and shift the curve to the right.d) No, you have not chosen the correct option. Relaxing lending controls will boost aggregate demand and shift the curve to the right.e) Yes, you have chosen the correct option. This is a supply-side policy and so will shift the aggregate supply curve.e) No, you have not chosen the correct option. This is a supply-side policy and so will shift the aggregate supply curve.f) Yes, you have chosen the correct option. A reduction in income tax will boost aggregate demand and shift the curve to the right.f) No, you have not chosen the correct option. A reduction in income tax will boost aggregate demand and shift the curve to the right.
Check your answer

8

AD/AS analysis

When using AD/AS analysis to illustrate changes within an economy, which of the following would NOT need to be considered when looking at changes to economic growth?

a)
b)
c)
d)
Yes, that's correct. Well done. This might result from greater economic growth but it is not one of its main causes. Other factors affecting economic growth could include the application of new technology and the creation of a more efficient infrastructure and utilities sector.No, that's not right. The correct answer is C as this might result from greater economic growth but it is not one of its main causes. The others are causes of economic growth. Other factors affecting economic growth could include the application of new technology and the creation of a more efficient infrastructure and utilities sector.Your answer has been saved.
Check your answer

9

Aggregate supply

Which of the following is a major influence on AS?

a)
b)
c)
d)
Yes, that's correct. Well done. The quality of the factors of production is a key determinant of the level of aggregate supply.No, that's not right. The correct answer is C. Both A and B refer to aggregate demand, whilst D is unlikely to have any real influence on AS.Your answer has been saved.
Check your answer

10

Shifts in aggregate supply

Choose appropriate phrases from the drop down boxes below to complete the explanation of an aggregate supply curve.

The short run AS curve slopes . In the , firms respond to price increases by supplying more goods but in the supply may not always respond to an increase in price levels. In the short run changes like a reduction in profits tax will shift the aggregate supply curve to the whereas a reduction in wage costs would shift the aggregate supply curve to the .

Your answer has been saved.Check your answer

11

Shifts in aggregate supply and demand

An increase in aggregate demand (given no change in aggregate supply) will cause higher inflation.

a)
b)
Yes, that's correct. The statement is true. Higher aggregate demand will shift the aggregate demand to the right and cause the equilibrium price level to rise (inflation).No, that's not right. The statement is true. Higher aggregate demand will shift the aggregate demand to the right and cause the equilibrium price level to rise (inflation).Your answer has been saved.
Check your answer

12

Shifts in aggregate supply and demand

An increase in costs will make the aggregate supply curve more inelastic.

a)
b)
Yes, that's correct. The statement is false. An increase in costs will shift the supply curve to the left, but will not change the elasticity.No, that's not right. The statement is false. An increase in costs will shift the supply curve to the left, but will not change the elasticity.Your answer has been saved.
Check your answer

13

Shifts in aggregate supply and demand

The less responsive is AS to a rise in AD, the more prices will rise for a given increase in AD.

a)
b)
Yes, that's correct. The statement is true. Try rotating the AS curve and then drag the AD curve and see the impact on the equilibrium price level.No, that's not right. The statement is true. Try rotating the AS curve and then drag the AD curve and see the impact on the equilibrium price level.Your answer has been saved.
Check your answer

14

Shifts in aggregate supply and demand

An increase in expenditure tax will shift both the aggregate demand and supply curves to the left.

a)
b)
Yes, that's correct. The statement is true. An increase in expenditure tax will reduce consumption (shifting aggregate demand to the left) and will also represent an increase in costs (shifting aggregate supply to the left as well).No, that's not right. The statement is true. An increase in expenditure tax will reduce consumption (shifting aggregate demand to the left) and will also represent an increase in costs (shifting aggregate supply to the left as well).Your answer has been saved.
Check your answer

15

Shifts in aggregate supply and demand

An improvement in productivity will shift both the aggregate demand and supply curves to the right.

a)
b)
Yes, that's correct. The statement is false. An improvement in productivity will mean that firms are more efficient (shifting aggregate supply to the right), but it will not shift aggregate demand. There will simply be a 'move along' the aggregate demand curve, not a shift.No, that's not right. The statement is false. An improvement in productivity will mean that firms are more efficient (shifting aggregate supply to the right), but it will not shift aggregate demand. There will simply be a 'move along' the aggregate demand curve, not a shift.Your answer has been saved.
Check your answer

16

Increase in AD

Which of the following is likely to result from a rapid rise in aggregate demand?

a)
b)
c)
d)
Please select an answerNo, it is more likely to fall as the extra demand will lead to an increase in the demand for labour.No, they are more likely to rise.Yes, this is likely. A rapid rise in AD is likely to cause demand-pull inflation.No, the balance of payments is more likely to move into deficit. A rapid rise in AD is likely to lead to inflation. This may cause a depreciation, which may lead to a deficit on the balance of payments.
Check your answer

Short questions

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Question 1

Explain the main aims of government macro-economic policy.

Question 2

Assess the view that the control of inflation should be the main priority of any government.

Question 3

Explain why the AD curve slope downwards.

Question 4

Describe the main determinants of consumer spending.

Question 5

Identify the factors that might cause a shift in AD.

Question 6

Identify the factors that influence long run AS.

Question 7

Define the term 'aggregate supply'.

Question 8

Use an AD/AS diagram to explain the likely effects of a general increase in raw material and wage costs in the economy.

Question 9

Which component(s) of AD is/are likely to be affected in each case (C, I, G, X - M)?

(a) An increase in the money supply
(b) An increase in income tax
(c) An increase in house prices
(d) A decrease in the rate of interest
(e) A decrease in the population
(f) Greater pessimism about the future among consumers
(g) Improved business expectations
(h) A government decision to reduce capital spending on roads
(i) A fall in incomes abroad
(j) A fall in the UK exchange rate
(k) Greater spending on imports

Question 10

Identify whether the short run aggregate supply curve (SRAS) will shift to the left, or to the right, given the following circumstances:

(a) A decrease in wage rates
(b) An increase in raw material prices
(c) A decrease in import costs
(d) An increase in indirect taxation/taxation of company profits

Question 11

Identify whether the short run aggregate supply curve (LRAS) will shift to the left, or to the right, given the following circumstances:

(a) An increase in the skills of the workforce
(b) A decrease in the labour force
(c) A decrease in net investment
(d) Improvements in health care
(e) Advances in technology

Data response (1)

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Read the article:

and then answer the questions below.

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Question 1

Explain what is meant by the multiplier principle

Question 2

Explain the reasons why there has been a shift in the thinking of many leading economists about the merits of fiscal policy.

Question 3

Using aggregate supply and demand diagrams, examine the factors that determine the size of the multiplier effect following an increase in government spending.

Question 4

Assess whether an increase in government spending and taxation by equivalent amounts will leave national income unchanged?

Data response (2)

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Read the article China's capital spending could soon be bigger than America's (you can do this in the web window below or follow the previous link to open the article in a new web window) and then answer the questions below.


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Question 1

Define the terms:

Question 2

Analyse the effect of the Chinese government increasing the amount of public sector investment on the level of aggregate demand, output, employment and income in the short run.

Question 3

Examine the effect of the increase in Chinese public sector investment on long run aggregate supply.

Question 4

Explain how the multiplier and accelerator principles are connected and influence the level of economic activity.

Long questions

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Question 1

(a) Explain why the value of the multiplier may vary over time and from country to country.

(b) Explain how the multiplier and the accelerator principles help understand the dynamics of the business or trade cycle.

Question 2

(a) Using aggregate demand and supply diagrams to aid your analysis, explain the difference between an inflationary and deflationary gap.

(b) Evaluate the policy options open to a government that wants to close a deflationary gap and reduce unemployment.

2.3 Macroeconomic objectives (notes)

In the previous section we considered the level of overall economic activity and examined the concepts of aggregate demand and aggregate supply.

In the following section we concentrate on the role of macroeconomic objectives in the development of government policies.

Macroeconomic objectives - introduction

S:\triplea_resources\DP_topic_packs\business management\student_packs\articulate_interactions\images\recession.jpgIn this section, we consider the following sub-topics in detail:

Government macroeconomic policy aims to achieve a number of macroeconomic objectives.The major objectives usually targeted by all governments include maintaining or creating:


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For an excellent review of the operation of the macroeconomic goals of government, watch the video on YouTube by Paj Holden.

Low Unemployment

By the end of this section you should be able to:

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Low Unemployment

S:\triplea_resources\DP_topic_packs\economics\student_topic_packs\media_macroeconomics\images\job.jpgThere will always be trade-offs between different macroeconomic objectives as it can be difficult to satisfy all of them at once and so governments will face decisions on acceptable levels for each target. The trade-off is particularly apparent, between reducing unemployment and achieving stable price levels.

Governments perceive high unemployment as a waste of resources; the economy is operating within its production possibility boundary and as a result could potentially produce a more goods and services. However, the government is aware that stimulating an economy to lower unemployment can cause inflation, which is undesirable because it makes a country less competitive and is destabilising. In addition, consumers do not like prices going up all the time and firms face less r and this may make the government unpopular.

We often tend to look at unemployment and inflation together because if one target is hit, the other may be missed. If economic growth is healthy, this may help keep unemployment low, but it may also add to inflationary pressures. If the government 'cools' the economy to reduce inflation using fiscal and/or monetary policy, increased unemployment may be the result.

What the data says

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Task

Investigate the levels of unemployment in your country over the last 20 years, by accessing the World Bank Catalogue through this link and then follow the steps below:

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  1. Describe the data you have plotted focusing on short term patterns, long term trends, and relationships between variables.

Repeat the exercise for two other countries from different continents.

  1. Identify similarities and differences between the three sets of unemployment data.
  2. Analyse the factors that might account for the similarities and differences you have identified. (You may want to revisit this answer once you have completed this section).

The meaning of unemployment

What is unemployment?

Since the late 1970s, full employment has not meant that everyone is employed. It now means the number of people wishing to work at the agreed wage rate is equal to the number of employees firms are willingto hire at that rate. If there are still people who want to work at the existing wage rate, and are willing and available to work, this is described as unemployment.

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Unemployment

Unemployment is where individuals are able and willing to work, but do not have a job.

Employment rate

The employment rate is the percentage of the labour force in work.

Unemployment rate

The unemployment rate is the percentage of the labour force who are out of work.

Underemployment

Underemployment refers to those people, who can only find part-time employment, although they want full-time employment..


The official definition of unemployment may differ from country to country. National definitions vary as regards age limits, reference periods, the criteria for seeking work, treatment of persons temporarily laid off and of persons seeking work for the first time. The International Labour Organisation (ILO) definition is commonly employed.

In addition, countries will often distinguish between those who are classified as unemployed, and those who claim some form of unemployment-related benefits because they have no job; the latter being referred to as the claimant count. An explanation of this difference with reference to the UK can be found on the UK government website.

Hidden Unemployment

Hidden unemployment is the unemployment, or underemployment of workers, that is not reflected in official unemployment statistics, because of the way they are compiled. Only those who have no work, but are actively looking for work, are counted as unemployed. Those who have given up looking, those who are working less than they would like, and those who work at jobs in which their skills are underutilized are not officially counted among the unemployed, though in a sense they are. These groups constitute hidden unemployment.

Source: answers.com

Getting a full picture of the rate of unemployment is difficult. In addition to the problems of underemployment and other examples of hidden unemployment, a single national unemployment rate does not take into account any regional, ethnic, age and gender disparities. All of these may be of importance to the government when considering policy measures.

Case study - regional variation

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Regional variation in unemployment in the UK

Have a look at the Economy tracker in the BBC website. You can see how unemployment in the various UK regions has changed significantly over the last 6 years. (You can do this in the web window below or follow the previous link to open the site in a new web window)


Government policy will usually aim to get rid of this unemployment as it represents a waste of resources. Those people could be producing and boosting the national income of the economy. Not only that, but they are likely to be claiming unemployment benefits or social security payments and so the government budget is taking a double hit - no tax return and social security payments being made. This is not good news for governments under pressure to deliver better and better public services.

Consequences of unemployment

S:\triplea_resources\DP_topic_packs\business management\student_packs\media_human_resources\images\unemployment.jpgThe main cost of unemployment is a personal one to those who are unemployed. However, if they suffer as individuals, then it is likely that the whole economy suffers as a consequence. Individuals may become dispirited by unemployment and lose their self-esteem and confidence. This may affect their motivation to work. The longer individuals are unemployed, the more they may lose their skills and which is bad for the economy as well. On top of that, the problems associated with unemployment may result in the unemployed being less healthy, which leads to health-related costs. Areas of high unemployment and social deprivation may also experience higher crime levels. Certainly, both the national economy, and society in general, suffers from high rates of unemployment.

As well as these microeconomic effects, there will also be macro effects. These will include:

The true impact of unemployment will depend on two factors. These are:

Normally, the longer an individual is unemployed, the more difficult it is to find work. Similarly, a large number of unemployed people cause more problems than a small number.

Unemployment has individual consequences. Some of those who are unemployed may seek a career change, whilst others may enjoy their additional leisure time! However, for the majority, there will be a fall in disposable income, since unemployment-related benefits seldom pay as much as salaried employment. Living standards will fall and some of the unemployed might be forced to extend credit and loan-financed purchases. The longer they remain unemployed, the less training and development they are receiving and the more unemployable they become.

For businesses, unemployment means lower demand for some products and employee morale may suffer. Productivity could fall, as workers fear that they are next for the unemployment pile. However, a larger pool of unemployed will exist, so some employers might find hiring new labour easier (and perhaps cheaper).

The economy might also suffer as output falls (and therefore tax revenue falls) and government expenditure on benefits increases. Opportunity cost decisions will have to be made. The distribution of income will become more uneven, but unemployment might cause downward pressure on wage levels, as workers fear pricing themselves out of a job.

When unemployment exists, it means lost output, as the economy will be working below full potential and tax revenues will be lower. As unemployment rates increase more state benefits have to be paid, which involves a further economic opportunity cost. We have also noted the potential for social difficulties.

Case study - tougher for men

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Unemployment is tougher for men

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Read the article Unemployment is tougher for men and then answer the questions below. (You can read the article in the web window below, or follow the previous link to open it in a new web window)


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  1. Identify the psychological effects of being unemployed.
  2. Explain the differences between these effects on men and women.
  3. Analyse the economic effects of having a high rate of unemployment.

Types and causes of unemployment


If you would prefer to view this interaction in a new web window, then please follow the link below:

Disequilibrium unemployment


If you would prefer to view this interaction in a new web window, then please follow the link below:

Equilibrium unemployment


If you would prefer to view this interaction in a new web window, then please follow the link below:

Policies to reduce unemployment

If unemployment is cyclical or demand-deficient, then the best policy to get rid of it will be to boost the level of aggregate demand. Sounds easy, but how can the government achieve this? actually do it? It is likely to use expansionary monetary policy and/or fiscal policy. This could mean:

These expansionary fiscal or monetary policies should increase aggregate demand and shift the aggregate demand curve to the right as in figure 1 below.

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Figure 1 Expansionary fiscal/monetary policy

This solution appears to be quite simple, but in macroeconomics things are rarely as simple as they first appear! As we already know, policy conflicts can arise, especially the possible adverse effects on inflation of higher aggregate demand. So, a mixture of monetary policy, fiscal policy and supply-side policies would normally be used. Governments hope that supply-side policies will boost the capacity of the economy and enable higher aggregate demand, but without the associated inflationary pressures.

In the long run, if there is no shortage of aggregate demand, the cause of the unemployment is likely to lie with supply-side problems, such as geographic and occupational immobility of labour, lack of appropriate skills and training or a lack of information. This type of unemployment can be tackled by application of appropriate supply-side policies, as previously identified in Section 2.6.

Low and stable inflation

By the end of this section you should be able to:

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Low and stable inflation (notes)

S:\triplea_resources\DP_topic_packs\economics\student_topic_packs\media_macroeconomics\images\inflation_word.jpgStabilising the level of prices (or reducing inflation) is another macroeconomic objective that most governments set as a priority. In some cases, a deflationary situation exists and there is downward pressure on prices and output.

In this section, the following topics will be covered:

The meaning and measurement of inflation

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Inflation

Inflation is a persistent increase in the general level of prices.


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What the data says

Identify the main inflation measure in your country by accessing the World Bank Catalogue though this link.

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  1. Describe the data you have plotted focusing on short term patterns, long term trends, and relationships between variables.

Repeat the exercise for two other countries from different continents.

  1. Identify similarities and differences between the three sets of unemployment data.
  2. Analyse the factors that might account for the similarities and differences you have identified. (You may want to revisit this answer once you have completed this section).

A consumer price index

S:\triplea_resources\DP_topic_packs\economics\student_topic_packs\media_macroeconomics\images\weighting.jpgIn most countries inflation is measured by using a weighted price index. This may be called something like the 'Consumer Prices Index'.

However, what do we mean by a weighted index and why does it need weighting? Well, prices of all goods change, but some goods are more important than others. If the price of a major food item goes up by 10% and the price of shoelaces goes up by 100%, we don't want them to have the same impact on inflation. This is because we spend a large proportion of our income on food and usually hardly any on shoelaces. We therefore weight each price change to reflect its importance in our spending. Prices of goods which we spend a lot on get higher weights. Those that are relatively less important get lower weights.

There are THREE main stages to calculating a weighted index. These are:

  1. The use of a survey to decide on the weights to be used. The survey will usually try to measure the way in which families spend their income so that the weights can reflect average spending patterns on a typical basket of consumer goods.
  2. The recording of price changes. This is often done monthly to get a figure for inflation and a number of prices may be collected for the same good. This is to reflect regional differences or differences resulting from selling it in different locations.
  3. Each price is then multiplied by its weight. This ensures that the inflation measure is appropriate for the way in which the people in the economy spend their money.

Finding out more about consumer price index weights

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Search the web or the site of the statistics office for the country where you are and see if you can find the weights for the main inflation measure.

The OECD website is a good place to start for many countries. (You can look at this site in the web window below or follow the previous link to open it in a new web window)


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  1. Identify the most important item where you are.
  2. Note down the figures for the weights and record them on your inflation spreadsheet.

Problems with measuring inflation

S:\triplea_resources\DP_topic_packs\economics\student_topic_packs\media_macroeconomics\images\3dperson_question.jpgThere are several problems when trying to measure inflation. These include:

Inflation - videos

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Watch the following video clips and reflect upon the questions following each video:

Video 1 (BBC) - the effects of inflation:


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  1. Identify the winners and losers from inflation.
  2. Explain why consumer price indices are weighted.


Video 2 - changing CPI weightings in China

Video 2 shows a news clip about attempts by the Chinese government to change the consumer price index weighting


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  1. Explain what the government of China has done to the weighting of the consumer price index.
  2. Identify the effect of this change on the reported level of inflation.
  3. Analyse the reasons why the Chinese government has made this change.


Video 3 - problems of a CPI in the US

Video 3 is a presentation considering the problems of constructing a consumer price index in USA


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  1. Summarise the main problems associated with calculating a consumer price index.

Consequences of inflation

S:\triplea_resources\DP_topic_packs\business management\student_packs\articulate_interactions\images\boom_recession.jpgThe effects of a period of inflation depend on:

Anticipated inflation

The seriousness of the costs of inflation depends mainly on whether it is anticipated (expected) or not. If people anticipate the inflation rate, then the effects will be less as they will build these expectations into their behaviour. The costs of anticipated inflation may include:

Unanticipated inflation

The costs are more serious if the inflation is unanticipated. The main costs of unanticipated inflation are:

The higher the level of inflation, the more difficult it is to predict. This will almost certainly lead to higher costs.

Hyperinflation

In some cases inflation can rise to such a level that it becomes known as hyperinflation.


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Watch the video clip about the hyperinflation in Zimbabwe and the attempts by the government to reduce it. Once you have watched the video, answer the questions below.


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  1. Find a definition for hyperinflation and record this definition in your notes.
  2. Distinguish 'hyperinflation' from 'normal' inflation.
  3. Analyse the effects of hyperinflation on the Zimbabwean economy.
  4. Explain how the Zimbabwean government attempted to reduce the level of inflation.
  5. To what extent to you think they have been successful? If not, why not?

The consequences of deflation

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Deflation

Deflation is a persistent decrease in the price level or a situation in which output and employment are falling as a result of a fall in AD.


The term deflation is often used in a broad sense to describe a process in which there is a fall in aggregate demand leading to lower levels of output, employment, investment and possibly profits and prices.

Costs of deflation

Types and causes of inflation: demand-pull inflation

Demand-pull inflation

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Demand-pull inflation

A term used in Keynesian economics to describe the scenario that occurs when price levels rise because of an increase in aggregate demand, caused by factors such as greater government expenditure and increases in the money supply. When aggregate demand in an economy strongly outweighs aggregate supply, prices will increase. Economists will often say that demand-pull inflation is a result of 'too much money chasing too few goods'.


Demand-pull inflation happens when the level of aggregate demand grows faster than the underlying level of aggregate supply. This may be easier to imagine, if you think of supply as the level of capacity. If the capacity to produce in an economy is growing at 3%, and the level of demand grows at the same rate, or slower, then the country does not have a problem, as it can produce all it needs. However, if capacity grows at 3%, but demand grows faster, then there is a problem. In effect, the country has too much demand relative to supply, and it cannot produce all that is demanded. The economic effect is that prices are forced up, causing inflation. We can see this in Figures 1 (Keynesian) and 2 (Classical) below. As the aggregate demand curve shifts to the right, the price level rises - inflation.

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Figure 1 Demand-pull inflation - Keynesian diagram

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Figure 2 Demand-pull inflation - Classical

There are a variety of possible reasons for the increase in aggregate demand, and to look at these in more detail we will look at the components of aggregate demand. Aggregate demand is made up of all spending in the economy. It is represented by the following formula:


AD = C + I + G + (X-M)
where C is consumer expenditure, I is investment, G is government expenditure, X is exports and M is imports


An increase in aggregate demand could, therefore, be because consumers are spending more, possibly because interest rates have fallen or taxes have been cut or, simply, because there is a greater level of consumer confidence. It could also be that firms are investing more in the expectation of future economic growth, or the government is boosting spending on defence, health, education. An external factor may begreater demand for exports from overseas buyers - in other words exports are rising Whatever is the cause, it will be inflationary if demand grows faster than supply.

Types and causes of inflation: cost-push inflation

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Cost-push inflation

A sustained increase in the prices of goods and services brought about by rising input costs and a decrease in aggregate supply. There are a number of factors that can contribute to cost-push inflation, including increases in:

For inflation to be cost-push in nature, increases in input prices must affect a large proportion of producers, forcing up the general price level as demand stays constant in the short-run.


Cost-push inflation

Cost-push inflation happens when costs increase independently of aggregate demand. It is important to look at why costs have increased, as quite often costs are increasing simply due to the economy booming. When costs increase for this reason it is generally just a symptom of demand-pull inflation and not cost-push inflation. For example, if wages are increasing because of a rapid expansion in demand, then they are simply reacting to market pressures. This is demand-pull inflation causing cost increases. However, if wages rise because of greater trade union power pushing through larger wage claims - this is cost-push inflation. Cost-push inflation is shown on the diagram below. The aggregate supply curve shifts left, because of the cost increase, pushing prices up.

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Figure 5 Cost-push inflation

So why might costs get pushed up, causing inflation? There are a number of possible sources of rising costs.

Wages

If trade unions gain more power, they may be able to push wages up independently of consumer demand. Firms then face higher costs and are forced to increase their prices to pay the higher claims and maintain their profitability.

Profits

If firms gain more power and are able to push up prices independently of demand to make more profit, then this is considered to be cost-push inflation. This is most likely when markets become more concentrated and move towards a monopoly or perhaps an oligopoly position.

Imported inflation

Economies operate within a global contxt and many firms import a significant proportion of their raw materials. If the cost of these increase for reasons beyond their control, then firms may increase prices to pay these higher raw material costs, although this will depend upon elasticities of demand. Highr raw material costs may happen for several reasons:

Exhaustion of natural resources

As resources run out, their price will inevitably rise. This will increase firms' costs and may push up prices until they find an alternative source of raw materials (if they can). This has happened with fish stocks. Over-fishing has put many types of fish and fish-based products under extreme pressure, forcing their price up. In many countries, equivalent problems have been caused by erosion of land as forests are cleared resulting in the land becoming unsuitable for agriculture.

Taxes

Changes in indirect taxes (taxes on expenditure) increase the cost of living and push up the prices of products in the shops.

Expectations

Another factor that can accelerate cost-push inflation is a poulation's expectation of inflation. This sounds odd, but when you consider that employees build their expectation of inflation into their wage claims, you can see that this in itself can be a cause of inflation. If employees expect inflation to be 5%, they may expect a wage rise equal to, or in excess of, this level. If employees manage to obtain that wage increase, then this may cause further cost-push inflation as firms are face higher production costs, which firms attempt to pass on to consumers by charging higher prices. The higher inflation may then raise people's expectations further causing a vicious cycle or inflation spiral. Expectations can be a bit like a self-fulfilling prophecy. Higher expectations can actually cause higher inflation.

Excess monetary growth

It is also important to look at the role of the amount of money (money supply) in the economy. Monetarist economists believe that increased growth in the money supply can cause inflation. This happens because the extra money boosts the level of demand, and so causes demand-pull inflation.

Case Study - car prices in Trinidad

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Read the article Quake pushes up Japanese car prices in Trinidad and then consider answers to the questions below. (You can read the article in the web window below, or follow the previous link to open it in a new web window).


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  1. Describe the type of inflation the tsunami and earthquake might lead to in Jamaica.
  2. Explain how the Japanese tsunami and earthquake has affected the price of cars in Jamaica.
  3. Examine the effect of imported inflation on the economy of Jamaica.

Possible relationships between unemployment and inflation

As we have seen, it is very important for a government to achieve its objectives. However, we are also now aware that these economic objectives are closely related and that, a movement in one, may cause an opposite movement in another. Such movements need not be beneficial to the economy. For example, a large balance of payments deficit might cause a fall in the exchange rate and thereby impact on the rate of inflation. So, it is very much a 'balancing act' for government, whose policies can get blown off course by events beyond their control, such as a war in another country or a natural disaster.


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Up until the recent 'credit crunch' in 2008, many economies were experiencing both low inflation and low unemployment. Improvements in technologies which have lowered costs, and globalization which lowered import prices were two factors thought to be responsible for this. However, in the 1970s the curve broke down as the economies suffered from unemployment and inflation rising together (stagflation). This caused governments many problems and economists struggled to explain the situation. One of the most well-known explanations came from Milton Friedman - a monetarist economist. He developed a variation on the original Phillips Curve called the 'long-run' or 'expectations-augmented' Phillip's Curve, which is explained in the following pages.

PlotIT - Phillips curve

In the short run, there seems to be an inverse relationship between inflation and unemployment. During the expansionary phase of the business cycle, unemployment falls but inflation rises. During the contractionary or slowdown phase, inflation falls but unemployment rises. This inverse relationship can be shown in a Phillips curve.

The period from 1987 to 1993 illustrates these effects. The UK economy was growing rapidly from 1987 to 1989, but then moved into recession. The following table shows inflation and unemployment in that period.

1987 1988 1989 1990 1991 1992 1993
Inflation (%) 4.1 4.9 7.8 9.5 5.9 3.7 1.6
Unemployment (%) 10.3 8.6 7.2 6.9 8.8 10.1 10.4


Plot the above figures on the following diagram by clicking on the diagram at the appropriate point for each part. When you have done this, click on 'Reveal' to show how a line of best fit can be plotted from this scatter of points.

Phillips curve - long-run


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Some criticisms of the Friedman analysis

Natural rate of unemployment

Monetarists believe that in the long run real output tends to an equilibrium level, because employment tends to an equilibrium level. The level of unemployment that exists in equilibrium is referred to as the natural rate of unemployment, which is the amount of structural and frictional unemployment which is left in the economy when supply and demand are in balance. For monetarists, the natural rate of unemployment is the full employment rate and would be consistent with stable wages and prices.

The monetarist view of the labour market differs from the Keynesian view in that it considers unemployment from the supply-side of the economy, rather than resulting from deficient demand.

The labour market is considered like any other market where the equilibrium price, i.e. the wage rate, is determined by demand and supply. The amount of labour demand by employers will depended on the level of real wages.

Hence the higher the real wage, the lower the demand for labour
the lower the real wage, the higher the demand for labour
the higher the real wage, the higher the supply of labour
the lower the real wage, the lower the supply of labour

The equilibrium real wage will be established where demand for labour is equal to the supply of labour.

Any unemployment remaining, when the labour market is in equilibrium, is referred to as the natural rate of unemployment.

unemp_disequil1

Figure 1 Natural rate of unemployment

With reference to figure 1, the labour market is in equilibrium at OM, with a real wage of OW. If the real wage was above the equilibrium, then excess supply of labour would result as the supply of labour is greater than the demand.

The implication from this is that unemployment is caused by real wages being too high, and that the cure for unemployment is for workers to accept lower real wages. Monetarists would say that any unemployment above OM is voluntary, and occurs because workers are not willing to work for a low enough wage. Thus any unemployment at OM is referred to as the natural rate of unemployment, and is the unemployment which remains when the labour market is in equilibrium.

What determines natural rate and how can it be reduced?

The natural rate of unemployment cannot be defined as some percentage of the labour force. It depends on a number of factors which are liable to change over time. For example:

According to monetarists it would, therefore, follow that the natural rate of unemployment could be reduced by removing 'frictions' or obstacles to supply. This could be achieved by various supply-side measures, such as:

NAIRU

S:\triplea_resources\DP_topic_packs\economics\student_topic_packs\media_macroeconomics\images\job.jpgThe concepts of the natural rate of unemployment and NAIRU are quite close and are often used interchangeably, but there is a slight difference between the two.

Economic growth

By the end of this section you should be able to:

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Economic growth (notes)

The meaning of economic growth

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Economic growth

This occurs where there is an increase in the productive potential of the economy and is best measured by the increase in a country's real level of output over a period of time, i.e. the increase in real Gross Domestic Product ('real' meaning adjusted for inflation).


As we saw in the previous section, there are various measures of national income; GDP and GNP being two of these. GDP considers all output that has been domestically produced, whereas GNP takes into account net property income from abroad or paid abroad.

Causes of economic growth

S:\triplea_resources\DP_topic_packs\economics\student_topic_packs\media_macroeconomics\images\global_growth.jpgFor economic growth to take place either, or both, of the following must happen

  1. An increase in resources (natural, human and or capital) available to a country
  2. An increase in the efficiency with which a country's resources are used in the production process.

Have a look at section 4.1 on growth and development for a more detailed view of how these increases can happen. Although this section focuses on developing countries, the factors influencing the level of economic growth will be the same. Clearly, the role of investment is essential in increasing the amount of resources available bringing about economic growth. This investment may be in:

It is usual to distinguish between actual growth and potential growth.

Economic growth and the PPF (1)

Economic growth can be shown graphically using the production possibility curve. Consider the two graphs below.


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Economic growth and the PPF (2)


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The above analysis raises two questions for governments.

  1. How do they move the economy from operating at the point inside the production possibility curve to a position on the production possibility curve?
  2. In the longer term how do they bring about a shift of the production possibility curve from curve 1 to curve 2? In other words how can a government encourage economic growth? Ultimately, it can only do so by increasing the amount of resources, or finding ways of using the resources more efficiently.

Economic growth and the business cycle

We saw in section 2.1 that economic activity measured by GDP and GDP per capita is prone to short term cyclical fluctuations. This was referred to as the of business or trade cycle. The figures below show the various stages of the trade cycle and can also be used to illustrate whether an economy is experiencing economic growth. To observe this we can look at the trend line. If the trend shows GDPincreasing over time, then the economy will be experiencing economic growth. The trend line can also slope downwards, in which case the economy is experiencing economic decline or negative economic growth.

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Economic growth - what the data says

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Identify the levels of GDP per capita in your country by accessing the World Bank Catalogue though this link.

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1. Describe the data you have plotted. Identify whether there is evidence of a business or trade cycle.

Repeat the exercise for two other countries from different continents.

2. Identify similarities and differences between the three sets of GDP data.

3. Analyse the factors that might account for the similarities and differences you have identified. (You may want to revisit this answer once you have completed this section).

Economic growth and the aggregate supply curve

Finally, we can use the aggregate demand and supply diagrams to illustrate the effect of economic growth. An increase in economic growth will cause the long run aggregate supply curve to shift to the right as in figure 1 below.

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Figure 1 - Increase in long-run aggregate supply

Consequences of economic growth

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Pause for thought

Economic growth is often seen as an economic goal to which all countries and governments should aspire. . However, economic growth can be a double-edged sword in that it can have both distinct advantages, but create problems as well. You might want to work with fellow students to consider what these pros and cons might be. Follow the links below to compare your responses.

Equity in the distribution of income

By the end of this section you should be able to:

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Equity in the distribution of income (notes)

S:\triplea_resources\DP_topic_packs\economics\student_topic_packs\media_microeconomics\images\quota.jpgIn this section, we move on to look at the distribution of income within a society. Market economies often lead to a very unequal distribution of income. The economically strong will tend to be rewarded with more income, but the economically weak may lose out - the rich get richer, the poor get poorer.

Government policy will often be aimed at reducing these disparities in income distribution, and in this section we look at the ways taxes and benefits can be used to achieve this.

Indicators of income equity


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Task

Use the web and perhaps the web site of the statistics office for the country where you live to try to find Gini coefficient data. This may be difficult and if you can't find it, try broadening the search for any other country to compare it with the sample UK data given above.

Poverty

The United Nations defines poverty as:

"a denial of choices and opportunities, a violation of human dignity. It means lack of basic capacity to participate effectively in society. It means not having enough to feed and clothe a family, not having a school or clinic to go to, not having the land on which to grow one's food or a job to earn one's living, not having access to credit. It means insecurity, powerlessness and exclusion of individuals, households and communities. It means susceptibility to violence, and it often implies living in marginal or fragile environments, without access to clean water or sanitation."

Poverty is usually expressed as either absolute or relative poverty.

The poverty line: An Indicator of Relative poverty

The poverty line used in the UK is 60 per cent of the median UK income, after housing costs have been paid. Below this amount, a household is described as living in income poverty. The poverty line is adjusted to take into account how expenditure needs differ between types of households.

UK poverty line for a range of households, 2009/10

Household type Poverty line: Household income, a week
Single person, no children 124
Couple with no children 214
Lone parent with two children (aged 5 and 14) 256
Couple with two children (aged 5 and 14) 348


Source: http://www.cpag.org.uk/povertyfacts/

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Questions for consideration

  1. Explain why the poverty line varies according to family circumstances.
  2. Find out the median income for your country. To what extent do you think 60% of this figure is an acceptable indicator of poverty?

The causes of poverty

Section 4 of the pack considers a number of issues relating to the causes of absolute poverty in developing countries.

As far as the causes of relative poverty are concerned, read the following resource provided by Child Poverty Action Group (You can read this in the web window below or follow the previous link to open the site in a new web window).


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Watch the following video clip on poverty in the USA and answer the following questions.


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  1. Identify the extent of relative poverty in the USA.
  2. Describe the main causes of relative poverty in the USA.
  3. Analyse the impact of being in relative poverty in the USA.

The role of taxation in promoting equity

By the end of this section you should be able to:

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The role of taxation in promoting equity (notes)

S:\triplea_resources\DP_topic_packs\economics\student_topic_packs\media_development\images\tax.jpgIt is argued by some economists and politicians, that one of the purposes of taxation is to help bring about a more equitable distribution of income.

Canons of taxation

The 'canons of taxation' were first developed by Adam Smith as a set of criteria, by which to judge the efficiency and equity of taxes. These canons are still widely accepted as providing a good basis for such a judgment.

Smith's four canons were:

  1. The cost of collection must be low relative to the yield
  2. The timing and amount to be paid must be certain to the payer
  3. The means and timing of payment must be convenient to the payer
  4. Taxes should be levied according to ability to pay

Modern economists added three more canons to update and extend them to reflect contemporary issues:

  1. A tax must not hinder efficiency, or should involve the least loss of efficiency
  2. A tax should be compatible with foreign tax systems
  3. Tax should automatically adjust to changes in the rate of inflation (particularly important in high inflation economies)

A good tax should meet most of these criteria, and these canons are well worth learning to provide a structure for an examination question on taxation.

Classification of taxes

Direct and indirect taxation

  1. Direct taxation - taxation on income. Direct taxation includes income tax, profits tax and wealth taxes on inheritance.
  2. Indirect taxation - taxation on expenditure. Indirect taxation includes VAT (sales tax) and customs and excise duties (tax on cigarettes, alcohol etc.).

Progressive, regressive and proportional taxes

Taxes can also be classified according to their impact on different income groups. Taxes, which redistribute from better-off to less well-off groups, are called 'progressive' taxes. Those with an opposite effect are called 'regressive' taxes.

The definitions that you need to know are:

The balance of thesetype of taxes will have a significant effect on income distribution in an economy. If a government chooses to switch the balance of taxation from progressive to regressive taxes, then the less well-off in society will be hardest hit. In general, direct taxes tend to be progressive and indirect taxes regressive.

Governments with differing objectives will aim to change the balance of direct and indirect taxes. 'Right-wing' governments may choose to shift the balance of taxation from direct to indirect. They will argue that this is more efficient as it allows people to keep more of what they earn - providing greater incentive to work hard. Taxing people on expenditure is also seen as more economically efficient. However, a switch from progressive direct taxes to regressive indirect taxes will have an adverse impact on the distribution of income.

Why does a government tax? The practical reason is that governments require income to fund their spending, not only on their own administration, but also on behalf of the society that they represent. Countries may have accumulated reserves of cash of over time, but it is unlikely that this could sustain their long-term spending plans. Governments tend to raise most of their income from those who can, in theory, afford it. Some of this tax revenue may be re-directed this to the more vulnerable members of society through benefits and/or focused social investment. Direct taxes, and in particular income tax, are normally progressive. This means that the richer members of society contribute more to government revenues and, as a consequence of government policies, help the less well-off. This is thought to be EQUITABLE, though not everyone would agree. Some economists and politicians argue that by reducing tax, particularly on wealth creators and entrepreneurs, governments will stimulate economic growth and incomes. Additional incomes will be spent within the domestic economy, through investment and higher consumption, and will set up a multiplier effect generating more incomes for those producing the goods and services that satisfy the higher demand. There is a so called 'trickle-down' effect. However, there does seem to be a tendency for the gap between rich and poor to widen when governments follow a more laissez-faire approach, suggesting that trickle down is not particular efficient.


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Reflect on the reasons why the trickle-down effect may be inefficient as a means of stimulating economic growth and average incomes.

Other methods of promoting equity

Transfer payments

Tax revenues raised governments may be spent on a huge range of items. However, two of the most significant areas for government expenditure in developed economies are:

Benefits (social security) and pensions are known as transfer payments.


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Transfer payments

A payment from a government to its citizens, for which no good or service is received in exchange. Governments use transfer payments as means of income redistribution by making payments under social welfare programmes, such as social security, old age or disability pensions and unemployment benefits. Transfer payments are excluded when calculating gross national product. A significant proportion of government expenditure is on transfer payments.


It is the combination of transfer payments and progressive taxes that has the most impact on income distribution. Transfer payments are paid to the poorest and most vulnerable members of society and so will have a significant redistribution effect.

By giving people benefits/social security payments governments are:

  1. helping the less fortunate live more financially secure lives.
  2. increasing injections into the circular flow of income which will be subject to a multiplier effect increasing aggregate demand in the economy.
  3. expecting some of the expenditure to re-enter the government funds via the taxes benefit recipients pay.

Provision of Social infrastructure

Governments spend tax revenues directly on providing social infrastructure including:

By making services, such as education and health servies, available to people on low incomes, at zero or reduced prices, poverty is reduced and a more equitable distribution of income is achieved. This will certainly be the case if public servies are funded through a progressive tax structure.

Government subsidy

Government may provide subsidies to those on low incomes to fund consumption of certain goods and services provided by the private sector, such as concessionary bus and train fares.

2.3 Macroeconomic objectives (questions)

In this section are a series of questions on the topic - macroeconomic objectives. The questions may include various types of questions. For example:





Click on the right arrow at the top or bottom of the page to work through the questions.

Macroeconomic objectives - self-test questions

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1

Demand-side unemployment

Demand-side unemployment is partly caused by:

a)
b)
c)
d)
Yes, that's correct. Well done. This is the main reason demand-side unemployment arises.No, that's not right. The correct answer is D, as this is the main reason demand-side unemployment arises. A is central to supply-side unemployment and B is also considered to be part of the supply-side theory. C is certainly a cause of unemployment, but not directly related to the demand-side theory.Your answer has been saved.
Check your answer

2

Types of unemployment

Which of the following is NOT a type of unemployment?

a)
b)
c)
d)
Yes, well done. That's correct. Demographic is not a type of unemployment.The correct answer is D, which refers to people and the population. It might have some influence on the rate of unemployment, but it is not a type. The others are all types of unemployment together with cyclical or demand deficient.Your answer has been saved.
Check your answer

3

Costs of unemployment

Which of the following is not a cost of unemployment?

a)
b)
c)
d)
Yes, that's correct. Well done. Imports have only a limited link to employment.No, that's not right. The correct answer is C as imports have only a limited link to employment. The others, together with an increase in government expenditure are all 'costs' of unemployment.Your answer has been saved.
Check your answer

4

Reducing unemployment

Which of the following might be used by government to lower unemployment?

a)
b)
c)
d)
Yes, that's correct. Well done. This should boost spending and lead to a need to employ more people to meet the increase in demand.No, that's not right. The correct answer is D as this should boost spending and lead to a need to employ more people to meet the increase in demand. A would have the opposite affect and so would B. C, which is monetary policy would also be used to slow an economy and that might increase unemployment.Your answer has been saved.
Check your answer

5

Types of unemployment

When there is unemployment caused by a lack of consumer spending, we classify this type of unemployment as?

a)
b)
c)
d)
Please select an answerYes, well done. Cyclical unemployment results from a fall in the level of demand (related to the trade cycle).No, this is caused by regions being unable to attract businesses.Not really - this is caused by the seasonal patterns of output of some industries.No, this is caused by structural issues within the economy.
Check your answer

6

Types of unemployment

When there are vacancies in the job-market, but also high levels of unemployment, then we could say that this unemployment is?

a)
b)
c)
d)
Please select an answerNo, this is caused by spending being too low.This is a type of unemployment, but there is a more appropriate answer that matches the description better.Not really. Seasonal unemployment is specific to a particular time and this is not really what the question asks.Yes, well done. Structural unemployment results from a change in the structure of industry.
Check your answer

7

Demand-pull inflation

Demand-pull inflation is said to exist when:

a)
b)
c)
d)
Yes, that's correct. Well done. For demand pull inflation to exist demand must be rising faster than supply.No, that's not right. The correct answer is B as for demand-pull inflation to exist demand must be rising faster than supply. A refers to cost-push inflation and C is import led inflation. D is a 'shock' and is not part of demand-pull inflation.Your answer has been saved.
Check your answer

8

Costs of inflation

Shoe leather costs are:

a)
b)
c)
d)
Yes, that's correct. Well done. Shoe leather costs are associated with our need to get more cash as prices rise.No, that's not right. The correct answer is A, as shoe leather costs are associated with individual's need to get more cash as prices rise. B is what is called 'menu costs'. C takes place if tax allowances do not keep pace with inflation and people pay more tax as their income increases. D is wage distortion, which is part of unanticipated inflation, whilst all the others used in this question are anticipated costs of inflation.Your answer has been saved.
Check your answer

9

Costs of inflation

Why might uncertainty arise during a period of sustained price rises?

a)
b)
c)
d)
Yes, that's correct. Well done. Inflation tends to lead to less certainty and so business becomes less likely to invest and expand.No, that's not right. The correct answer is , as inflation tends to lead to less certainty and so business becomes less likely to invest and expand. A is part of unanticipated inflation, but is not directly related to uncertainty. B also takes place during a period of unanticipated inflation and may cause serious social problems. C may also take place and may lead to increases in unemployment. It is always worth thinking about LINKS between the main parts of macroeconomics, as a change in one may well affect another.Your answer has been saved.
Check your answer

10

Inflation

Which of the following would not influence the rate of inflation?

a)
b)
c)
d)
Yes, well done. That's correct. Inflation is an increase in the general level of prices. The number of people affected by it will not have any impact on its rate.The correct answer is C, for although those affected by inflation would be rather worried by this is NOT a direct influence on the rate of consistent increases in the general level of prices. The others would all have an influence on the rate of inflation.Your answer has been saved.
Check your answer

11

Economic growth

What is economic growth?

a)
b)
c)
d)
Yes, well done. That's correct. This is the best definition of economic growth.The correct answer is B. A reflects changes in consumer spending, which is always closely watched by economists. C has nothing to directly to do with growth although government spending can increase/decrease the possibilities for growth. D is capital consumption and needs to be covered by growth before real economic expansion has been achieved.Your answer has been saved.
Check your answer

12

Increases in consumer spending

Which of the following is the least likely to occur if there is a sustained rise in consumer spending?

a)
b)
c)
d)
Please select an answerNo, this is likely to occur. The increase in consumer spending is an increase in aggregate demand and this may cause demand-pull inflation.No, this is likely to occur. Higher consumer spending will mean more demand which will lead to more jobs being created.No, this possibly could occur. Higher consumer spending will mean more demand which will lead to more jobs being created.Yes, it is likely that imports will increase not fall when consumer spending increases.
Check your answer

13

Cost-push inflation

Which of the following best defines cost-push inflation?

a)
b)
c)
d)
Please select an answerNo, this is demand-pull inflation.Yes, well done. This is a definition of cost-push inflation.No, this is monetary inflation - not seen as a major issue today.No, certainly not. Falling prices would be known as deflation.
Check your answer

Short questions

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Question 1

Distinguish between the level of unemployment and the rate of unemployment.

Question 2

Explain why a government might find the goal of full employment difficult to achieve.

Question 3

Explain how a government might tackle structural unemployment.

Question 4

Define what an economist means by the term 'inflation'.

Question 5

Examine which groups within society might be most affected by a permanent rise in prices.

Question 6

Briefly state two reasons why inflation may be considered to be an economic problem.

Question 7

Explain why deflation might be considered to be an economic problem.

Question 8

Explain the factors, which may give rise to an unequal distribution of (a) income and (b) wealth.

Question 9

Evaluate the different approaches, which a government can adopt to reduce the degree of inequality in a society.

Question 10

Statistics indicate that over the past decade the distribution of income in many countries has become more unequal. Identify two reasons why this may have occurred.

Question 11

In relation to taxation, explain the meaning of the terms (a) equity and (b) efficiency.

Data response question (1)

Read the article Families feel pinch as inflation threatens economic miracle and then answer the questions below. (You can read the article in the web window below, or follow the previous link to read the article in a new web window)


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Question 1

Distinguish between cost-push and demand-pull inflation.

Question 2

Using aggregate demand and supply diagrams, evaluate the extent to which the inflation taking place in China is of a cost-push nature.

Question 3

Explain the main policies that the Chinese government has been adopting to try to reduce the level of inflation.

Question 4

Discuss the extent to which growth in world food prices will affect the level of aggregate demand in China.

Data response question (2)

Read the article Japan sees end to deflation curse and then answer the questions below. (You can read the article in the web window below, or follow the previous link to read the article in a new web window)


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Question 1

Define the terms:

Question 2

Using aggregate supply and demand diagrams, analyse the changes currently taking place in the Japanese economy.

Question 3

It has been said that "a small amount of inflation in the system is not a bad thing". Evaluate this statement.

Long questions

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Question 1

(a) Explain the purpose of the Lorenz Curve and the Gini Coefficient

(b) Evaluate the view that greater income equality can best be achieved through the taxation system.

Question 2

(a) Describe how the Philips curve helps illustrate the relationship between unemployment and inflation.

(b) Explain how the Philips curve helps understanding of the impact of increasing aggregate demand on unemployment in the long run.

2.4 Fiscal policy (notes)

In the previous section we considered the level of overall economic activity, examined the concepts of aggregate demand and aggregate supply and looked at the role of macroeconomic objectives in the development of government policies.

In this section we examine fiscal policy.

By the end of this section you should be able to:

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Fiscal policy - introduction

S:\triplea_resources\DP_topic_packs\economics\student_topic_packs\media_macroeconomics\images\budget.jpgFiscal policy is the use of government expenditure and taxation to manage the economy. It can be employed:

The government budget

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We will approach the examination of government expenditure by looking at a case study of the UK. As we work through this, you may like to find equivalent data and information for your own country.


We will start the process by examining some terminology.

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The budget

The budget is essentially the relationship between government spending on the one hand and government income or taxation on the other hand.


Sources of government income

Source: From 2011 UK Budget http://www.hm-treasury.gov.uk/d/junebudget_complete.pdf


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Task (1) - sources of government income (UK)

The above chart shows how the UK government raises its revenue. Find out what each of these different forms of collecting revenue relate to.

Income source Brief explanation
Council tax
Business rates
VAT
Corporation tax
Excise duties
National insurance
Income tax
Capital tax
Stamp duties
Vehicle excise duties
Interest and dividends



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Task (2) - sources of government income (other country)

Build an equivalent table to that in Task (1) for your own country.

Types of government expenditure

Government spending or government expenditure is often divided into three main types:

  1. Government final consumption expenditure on goods and services for current use to directly satisfy individual or collective needs of the members of the community.
  2. Gross fixed capital formation (or government investment) - government spending on goods and services intended to create future benefits, such as infrastructure investment in road building and research spending.
  3. Transfer payments - spending that does not involve the acquisition of goods and services, but instead represent transfers of money, such as social security payments and unemployment benefit.


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Task (1) - types of government expenditure (UK)

Complete the table below with an example of each type of government spending.

Government spending types Example
Social protection
Personal social services
Health
Transport
Education
Defence
Industry Agriculture, and Employment
Housing and environment
Public order and safety
Debt interest
Recreation, culture and religion
Public sector pensions



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Task (2) - types of government expenditure (other country)

Build an equivalent table to that in Task (1) for your own country.

A Case study: Government spending in the UK

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The following diagram shows the extent of government spending in the UK, and identifies spending by individual government departments.


The following website provides a great deal on information about UK government spending. Specifically it enables you to see information about:



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  1. Identify the five main areas of government spending in the UK.
  2. Describe how the proportion of government spending on these five areas changed over the last 5 years.
  3. Plot the proportion of GDP spent by the government over the last 10 years and describe the results you have found.
  4. Use the web to find out the above data for your own country.

The budget outcome

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What does the data say?

  1. Using the World Bank website World Bank - data indicators
    Record:
    1. Total government revenue
    2. Total government expenditure
      for your country for the most recent 10 years. Put the data into a spreadsheet
  2. Plot the two data sets on the same graph over time.
  3. Describe the state of the budget for each of the years.
  4. Describe changes in the budget over the 10 years i.e. moves from surplus to deficit or vice versa?
  5. In the event of a budget deficit, identify how this was financed.

Fiscal policy and short-term demand management

Reflationary or expansionary fiscal policy

Governments may choose to employ reflationary or expansionary fiscal policy in times of recession or a general downturn in economic activity. In this situation, they will use fiscal policy to stimulate the economic activity. They may do this by lowering taxes in some form or by increasing the level of government expenditure. This should encourage people to spend more. If they lower indirect taxes then this will lower the prices of the taxed goods and encourage more demand. Alternatively, they could lower direct taxes increasing disposable incomes (take-home pay) and encouraging greater consumption. Either way the level of demand in the economy should rise and stimulate economic growth.

Reflationary fiscal policies can include:

The effect of these policies should be to boost aggregate demand and the equilibrium level of income. This can be seen in Figure 1 below.

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Figure 1 Reflationary fiscal policy

However, this policy may cause demand-pull inflation. We can see from Figure 1, that there has been an increase in the price level from P1 to P2. Keynesians would differ slightly with this view and argue that reflationary fiscal policy is appropriate where there is spare production capacity as they believe that the economy can settle at any equilibrium level of output. Their view of reflationary policy can be seen in Figure 2 below.

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Figure 2 Reflationary fiscal policy - Keynesian analysis

For Keynesians, any increase in AD on the horizontal section of the AS curve will not be inflationary. Prices will only increase when the economy approaches full employment and can only be inflationary as the AS curve becomes vertical.

Deflationary fiscal policy

euro_fiscal_pressureDeflationary fiscal policy is likely to be most appropriate in times of economic boom. If the economy is growing at above its capacity, this is likely to cause inflation and balance of payments problems. To slow the growth of the economy, the government could raise taxes in some form and/or reduce government expenditure. Either of these should reduce the level of demand in the economy and, therefore, the level of economic growth. The government may increase indirect taxes, which will result in higher prices for goods and services if firms maintain their profit margins. This should deter consumers from purchasing the same quantity of goods and services. Alternatively, the government may increase direct taxes, which will leave people with less money in their pockets and discourage spending.

Deflationary fiscal policies include:

The effect of these policies will be to shift the aggregate demand curve from AD1 to AD2, as in Figure 3 below.

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Figure 3 Deflationary fiscal policy

Impact of automatic stabilisers

"Automatic stabilisers are features of the tax and transfer systems, that tend by their design to offset fluctuations in economic activity without direct intervention by policymakers. When incomes are high, tax liabilities rise and eligibility for government benefits falls, without any change in the tax code or other legislation. Conversely, when incomes slip, tax liabilities drop and more families become eligible for government transfer programs, such as food stamps and unemployment insurance, that help buttress their income."

Source: http://www.taxpolicycenter.org/briefing-book/background/stimulus/stabilizers.cfm

S:\triplea_resources\DP_topic_packs\economics\student_topic_packs\media_macroeconomics\images\stabilisers.jpgIn section 2.1, you discovered that real GDP fluctuates over time and that these create business, or trade, cycles. Economies move through the following cycle:

Income taxation and transfer payments can act as non-discretionary fiscal policy, in that they automatically have the effect of dampening the business cycle. In other words, the government does not necessarily intend, or want, the consequences.

During times of expansion, when real GDP is growing, incomes will be increasing. If the country has a progressive tax, such as an income tax, in place an increasing proportion of those incomes will be paid to the government as incomes rise. This represents a leakage from the circular flow of income and thus is not passed on and spent on new goods and services. The effect of this is to reduce the rate of growth of GDP.

Similarly, during times of recession when real GDP is falling, incomes will fall as unemployment increases. Transfer payments, such as unemployment benefits, will start to kick in, ensuring that consumption does not slow-down in the same proportion as falling employment income. Real GDP, therefore, does not continue to fall at the same rate.

Fiscal drag

We have shown the effect of automatic stabilisers dampening down the business cycle and bringing about certain amount of stability in output, employment and income. However, automatic stabilisers can sometimes cause problems if the economy is in a depression with a great deal of unemployment. The stabilisers can reduce the upward effects of the multiplier as the governments tries to kick start a recovery by increasing government spending. Incomes will not increase as rapidly as hoped, because additional taxation causes some of the injections to be leaked from the circular flow of income. Similarly, ifgovernments want to introduce a discretionary deflationary policy to close an inflationary gap, the existence of transfer payments will not enable the desired reduction in consumer spending to happen as fast as the government may want. In both cases, the discretionary policy is being dragged back by the stabilisers, hence the term, 'fiscal drag'.

Fiscal policy and its impact on potential output

S:\triplea_resources\DP_topic_packs\economics\student_topic_packs\media_macroeconomics\images\gears_accelerator.jpgSupply-side policies are policies that aim to increase the capacity of the economy to produce. However, it is also possible for fiscal policy to act on the level of supply and government will often use fiscal policy as one of their key supply-side policy tools.

Income tax may have an effect on people's incentives to work. This will be true at most income levels. If income tax at low income levels is too high, people may choose to remain unemployed, or not to seek, employment. This is an economically rational decision, because it may be more rewarding to stay on benefits when other expenses of employment, such as transport and child-care, are factored in. This situation is often referred to as a 'poverty trap', because the unemployed cannot improve their financial position. If income tax on high levels of income is too high, people may choose not to work so hard or take risks. Ultimately, they could make the choice to leave a particular country if taxes in other countries are significantly lower This 'flight' out a country to seek lower taxes elsewhere is called a 'brain drain', when the process involves large numbers of the most talented and skilled in a population.

Supply-side fiscal policies can include:

The intended effects of these supply-side policies are known as 'microeconomic effects', although bear in mind that they may have macroeconomic effects as well. Whether, or not, supply-side policies work in the way they are intended, or whether they may are desirable, is considered in section 2.6.

Evaluation of fiscal policy

S:\triplea_resources\DP_topic_packs\economics\student_topic_packs\media_macroeconomics\images\yes_no_yes.jpgThe effectiveness of fiscal policy, as a measure to influence aggregate demand and output, is open to much debate. The argument over using fiscal policy revolves around whether:

Major arguments in favour of fiscal policy

Major arguments against fiscal policy

Fiscal policy - weaknesses

The multiplier effect & fiscal policy


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Accelerator


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Importance of the accelerator

The accelerator principle indicates how changes in the level of current income will have an accelerated impact on the level of investment and is, therefore, one explanation of economic instability and the upward and downward swings of the trade cycle.

Accelerator principle - some qualifications

Weaknesses of accelerator theory

The accelerator assumes a fixed relationship between a change in consumption and a change in investment - the bullet points above show that this is not necessarily the case. The accelerator principle also ignores the time lags, which would probably occur in reality, between a change in consumption and the implementation of any investment decisions.

Crowding out

S:\triplea_resources\DP_topic_packs\business management\student_packs\articulate_interactions\images\competition_interconnected.jpgMany economists argue that the government should aim, as a policy objective, to minimise the level of government borrowing and should not increase its spending if this means borrowing to do so. If the government borrows heavily, it will have to compete for funds with private sector firms, which want to borrow to invest themselves. This competition for funds will push up interest rates. Higher interest rates mean that firms will be less willing to invest and individuals may even be more reluctant to borrow to spend. This process is described as government expenditure 'crowding out' private borrowing. In its most extreme form, an increase in government expenditure will lead to an equivalent fall in consumption and investment (because of the higher interest rates) with the result that aggregate demand does not increase at all.

Economists debate how significant the effect of crowding out is and, as with most things, they rarely agree! (Keynesians generally argue that an increase in government spending, through the multiplier process, will crowd in private consumption and investment).

If the problem is one of unemployment, changes in taxation and particularly government spending may have a significant impact on the level of national income through the increase in aggregate demand that they cause. Fiscal policy therefore may be very effective in reducing demand-deficient unemployment. (N.B. For HL students only, the effectiveness of fiscal policy in combating unemployment may be explained through the operation of the multiplier effect. This is dealt with in the HL extension section that follows).

Fiscal policy may also succeed in shifting the LRAS curve to the right, increasing real output and reducing the rate of inflation. This may work via greater government spending on education and training and tax cuts, which improve incentives to work and invest.

As will be seen in Section 2.3, fiscal policy may be used to alter the distribution of income and wealth within an economy. Greater emphasis on direct, progressive taxes and benefits to the less well-off make the distribution more equal. The opposite effect will be achieved through a shift towards indirect, regressive taxes and cuts in benefits for the less well-off.

Section 2 of the course showed how fiscal policy can be used in a selective way, for example, to:

2.4 Fiscal policy (questions)

In this section are a series of questions on the topic - fiscal policy. The questions may include various types of questions. For example:





Click on the right arrow at the top or bottom of the page to work through the questions.

Self-test questions

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1

Progressive tax

A progressive tax is one which:

a)
b)
c)
d)
Yes, that's correct. Well done. This is the definition of a progressive tax.No, that's not right. The correct answer is B. A is the definition of a regressive tax (e.g. VAT) and C refers to a direct tax. D is what is known as an indirect tax.Your answer has been saved.
Check your answer

2

Reducing unemployment

Which of the following might be used by government to lower unemployment?

a)
b)
c)
d)
Yes, that's correct. Well done. This should boost spending and lead to a need to employ more people to meet the increase in demand.No, that's not right. The correct answer is D as this should boost spending and lead to a need to employ more people to meet the increase in demand. A would have the opposite affect and so would B. C, which is monetary policy would also be used to slow an economy and that might increase unemployment.Your answer has been saved.
Check your answer

3

Government policies

Match the examples of government policy given to the appropriate type.

a)
b)
c)
d)
e)
Yes, that's correct well done. Expansionary fiscal policy will boost the level of aggregate demand (e.g. tax cuts) while contractionary fiscal policy will have the opposite effect (e.g. tax increases). Expansionary monetary policy is a reduction in interest rates as this will boost aggregate demand. Contractionary monetary policy is the opposite. Supply-side policies are those that are aimed at boosting aggregate supply.No, that's not right. Try again. Expansionary fiscal policy will boost the level of aggregate demand (e.g. tax cuts) while contractionary fiscal policy will have the opposite effect (e.g. tax increases). Expansionary monetary policy is a reduction in interest rates as this will boost aggregate demand. Contractionary monetary policy is the opposite. Supply-side policies are those that are aimed at boosting aggregate supply.Your answer has been saved.
Check your answer

4

Government policies

Match the examples of government policy given to the appropriate type.

a)
b)
c)
d)
e)
Yes, that's correct well done. Expansionary fiscal policy will boost the level of aggregate demand (e.g. tax cuts) while contractionary fiscal policy will have the opposite effect (e.g. tax increases). Expansionary monetary policy is a reduction in interest rates as this will boost aggregate demand. Contractionary monetary policy is the opposite. Supply-side policies are those that are aimed at boosting aggregate supply.No, that's not right. Try again. Expansionary fiscal policy will boost the level of aggregate demand (e.g. tax cuts) while contractionary fiscal policy will have the opposite effect (e.g. tax increases). Expansionary monetary policy is a reduction in interest rates as this will boost aggregate demand. Contractionary monetary policy is the opposite. Supply-side policies are those that are aimed at boosting aggregate supply.Your answer has been saved.
Check your answer

Short questions

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Question 1

With reference to public expenditure and using suitable examles, distinguish between current, capital and transfer expenditure.

Question 2

A government can fund public spending through taxation and/or borrowing. Discuss the possible consequences of its decisions.

Question 3

When a government's budget deficit increases, this may lead to a worsening of the trade deficit. Explain why this might be the case.

Question 4

Explain two reasons why there may need to be controls on the growth of government spending.

Question 5

Explain why some economists consider crowding out to be important.

Question 6

Define the terms 'national income multiplier' and 'investment accelerator'.

Question 7

In a closed economy with no government sector, an increase in injections of $100 million causes the equilibrium level of national income to rise by $500 million. Calculate the marginal propensity to consume.

Question 8

An open economy with a government sector is in equilibrium. Assume the following:

Showing your method of working, calculate:

(a) the value of the multiplier
(b) by how much the equilibrium level of national income would fall, if injections in the economy are reduced by $60m.

Question 9

Explain why increasing government expenditure is likely to have a larger multiplier effect than an equivalent reduction in taxation.

Question 10

Government expenditure represents one of the injections of expenditure. Explain how an increase in government spending may have a multiplier effect on the economy.

Data response (1)

Read the article The ups and downs of flat taxes and then consider answers to the questions below. You can either read the article in the window below or you can follow the previous link to read the article in a separate window.


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Question 1

Distinguish between a progressive and a regressive tax

Question 2

Explain how a pure flat-rate tax would work in practice.

Question 3

Explain why many groups believe that a flat-rate tax will help boost economic growth.

Question 4

Explain what impact a flat-rate tax is likely to have on the level of tax revenue.

Question 5

Analyse the arguments for and against the adoption of a flat-rate tax in your country.

Data response (2)

Read the article Italy: Silvio Berlusconi pressed to make tax cuts by rightwing partner and answer the questions that follow. (You can read the article in the web window below, or follow the previous link to read the article in a new web window)


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Question 1

Distinguish between a budget deficit and national debt.

Question 2

Describe the economic circumstances that Italy finds itself in at present.

Question 3

Using aggregate demand and supply diagrams, examine the impact of cutting taxation on Italian public finances, output, income and employment.

Question 4

Analyse which policy options are most appropriate to Italy in the current economic climate.

Long questions

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Question 1

(a) Explain what is meant by a) tightening and b) loosening of fiscal policy.

(b) "Unemployment can best be reduced through the use of demand-side policies". Do you agree? Justify your answer.

Question 2

(a) Explain the difference between discretionary fiscal policy and automatic stabilisers

(b) Discuss the effectiveness of two fiscal policy options available to a country experiencing a recession.

2.5 Monetary policy (notes)

In the previous section we considered the level of overall economic activity, examined the concepts of aggregate demand and aggregate supply and looked at the role of macroeconomic objectives in the development of government policies and the operation of fiscal policy.

In this section we examine monetary policy.

By the end of this section you should be able to:

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Monetary policy - introduction

S:\triplea_resources\DP_topic_packs\economics\student_topic_packs\media_macroeconomics\images\percent_symbol.jpgIn this section we consider the following topics in detail

Monetary policy is the use of interest rates and money supply changes to manage the overall level of demand in the economy and, therefore, help achieve the economic objectives set out in previous sections. For examinations you will need to show how monetary policy is used to achieve macroeconomic objectives. So, think about how monetary policy is used to:

Interest rate determination and the role of a central bank

The responsibility for monetary policy will rest with the government and/or the central bank. Some countries (e.g. the UK and New Zealand) have made their central banks fully independent of government. The bank is then given an inflation target and they set interest rates to keep to that target. In the case of the Eurozone (all the EU countries who use the euro - the single European currency), this responsibility for monetary policy rests with the European Central Bank, which sets a single interest rate for the whole Eurozone.


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Case study - The role of a Central Bank


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Now visit the website of the Norges Bank at http://www.norges-bank.no/en/about/

  1. Identify who owns Norges Bank.
  2. Describe the main functions and responsibilities of the Norges bank and, for each function, briefly explain how Norges Bank carries out this function.
  3. Use the internet to identify who is responsible for monetary policy (setting interest rates) in your country. Is it the government or the central bank? If it is the central bank - is it independent? Find figures for how interest rates have changed in recent years.

Interest rate determination


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How can the Central Bank increase the supply of money?

This is a complicated topic, because there are many different measures of money; each differing according which assets are actually considered to be 'money'. Money in its most liquid form consists of cash and is demanded as a medium of exchange for transactionary purposes, in other words for buying things. However, other more illiquid assets, such as short-term government securities, treasury bills and long dated government securities are often considered to be money from the commercial banks point of view.

The most straightforward way for Central Banks to increase the money supply is to either:

Case study

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Read the article ECB hikes interest rates as UK rates remain at record low and then answer the questions that follow. (You can read the article in the web window below, or follow the previous link to read the article in a new web window)

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  1. Identify the reasons whythe European Central Bank is increasing its interest rates.
  2. Explain, why is the UK's Bank of England is keeping its base interest rates at a 28 month all-time low of 0.5%.
  3. Describe what is meant by the Bank of England's base rate (you might have to do some research here).
  4. Explain whythere is pressure from some quarters for the Bank of England to increase its base rate.

Monetary policy and short term demand management

Expansionary monetary policy

Governments may choose to use expansionary (loose) monetary policy in times of recession or a general downturn in economic activity. This was in widespread use by many governments following the financial crisis on 2008. In this situation, governmentsuse monetary policy to stimulate the economy. They may do this by lowering interest rates or by increasing the money supply. Following the 2008 credit crunch, periods of Quantitative Easing (Q.E.) took place where governments increased the money supply by purchasing assets of longer maturity than only short-term government bonds with the objective of lowering longer-term interest rates.

Lowering interest rates encourage firms and individuals to borrow and spend more. Increasing the money supply into the national income will similarly increase spending. Either way, the level of demand in the economy should rise and help encourage economic growth.

Reflationary monetary policies include:

Thesepolicies should boost aggregate demand and, therefore, the equilibrium level of income. This can be seen in Figure 1 below.

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Figure 1 Reflationary monetary policy

However, this policy may cause demand-pull inflation. We can see from Figure 1, that there has been an increase in the price level from P1 to P2. Keynesians would differ slightly with this view and argue that reflationary monetary policy sometime referred to as a loosening or easing of monetary policy, is appropriate where there is spare capacity, as they believe that the economy can settle at any equilibrium level of output. Their view of reflationary policy can be seen in Figure 2 below.

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Figure 2 Reflationary fiscal policy - Keynesian analysis

For Keynesians, any increase in AD on the horizontal section of the AS curve will not be inflationary. Prices will only increase when full employment is reached and the AS curve becomes vertical.

Monetarists, sometimes referred to as neo-classicalists would take a very different view. They would argue that increasing the money supply, either directly by printing more money, or indirectly by expanding commercial banks capacity to lend more, would feed through into increases in aggregate demand. They believe that the long-run supply curve (LRAS) is vertical and hence increases in aggregate demand would have no effect on output in the long run, but simply result in prices being pushed up through demand-pull inflation.

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Figure 3 Reflationary monetary policy - Classical analysis

Contractionary monetary policy

euro_fiscal_pressureContractionary (tight) montary policy is likely to be most appropriate in times of economic boom. If the economy is operating at full capacity, further increases in aggregate demand will result in inflation and potential balance of payments problems. In an attempt to slow economic growth and control inflation, the government could increase interest rates and/or reduce the money supply. Either, or both of these policies, will reduce the level of demand in the economy and the level of economic growth.

Contractionary (tight) monetary policies include:

The effect of these policies will be to shift the aggregate demand curve from AD1 to AD2, as in Figure 3 below.

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Figure 3 Deflationary fiscal policy

Both Monetarists and Keynesians maintain that raising interest rates or reducing the supply of money will lower aggregate demand and close an inflationary gap. Keynesians would argue that such actions may overshoot and cause a deflationary situation, with rising unemployment. They have traditionally argued that reducing the money supply may not always be effective. Indeed, any attempt to control the money supply may only speed up the velocity of circulation, to fund spending. In other words, the existing stock of money will simply be used more frequently and changes hands at a quickening rate.

The analogy of the balloon

To help imagine how these policies work, think of the economy as a balloon. The air in the balloon is the level of demand or economic activity. If the balloon is a little low and short of air, you want to reflate it; if it is over-expanded and in danger of bursting, then you deflate it.

This is similar to the economy. However, when an economy over-expands, instead of bursting, it suffers from other problems including higher inflation and a deteriorating balance of payments. Supply-side policies are policies that manage the capacity of the balloon: making it bigger so it can take more air or making the balloon material more 'stretchy', so it can expand further.

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Contractionary Policies (Reducing aggregate demand)

Tight Fiscal Policy

Tight Monetary Policy

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Expansionary Policies (Increasing Aggregate Demand)

Loose Fiscal Policy

Loose monetary policy

Interest rate changes & Aggregate Demand

S:\triplea_resources\DP_topic_packs\economics\student_topic_packs\media_macroeconomics\images\percent_symbol.jpgThe impact of changes in interest rate on Aggregate Demand

Interest rate changes will affect aggregate demand. For example, if interest rates rise, the impact on aggregate demand will be:

The aim of monetary policy is generally to manage the economy without causing sudden increases in either inflation or unemployment. Price stability is now central to macroeconomic policy, although following the financial crisis in 2008, and the resultant recession, some governments appear to be prepared to allow inflationary pressures to build (following cost push pressures from increase in commodity prices) and adopt expansionary fiscal and monetary policies in an attempt to avoid a recurring recessions and depressions. Many governments borrowed large amounts to finance expansionary policies in response to the credit crunch and are now having to make large cuts in their government spending in order to pay back the debts incurred.

A successful monetary policy allows for price stability and maximum employment. It should also allow supply-side policies to work. This will be covered in the next section 2.6

Monetary policy and inflation targeting

Many countries opt not to aim to achieve full employments or low levels of inflation. Rather, the decisions relating to the monetary policy of their Central Banks are guided by establishing explicit or implicit targets for inflation.

Let's revisit the Norwegian Central Bank, the Norges Bank, to consider what this means. The bank operate a system of flexible inflation targeting. Their annual report for 2010 explained it as follows

Flexible inflation targeting

Norges Bank operates a flexible inflation targeting regime, so that smoothing fluctuations, both in inflation and in output and employment, is given weight in interest rate setting. Flexible inflation targeting builds a bridge between the long-term objective of monetary policy, which is to keep inflation low and anchor inflation expectations, and the objective of smoothing developments in output. Expectations regarding future interest rates play an important role for developments in output, employment, incomes and inflation. Through its interest rate forecasts, Norges Bank influences the interest rate expectations of market participants, enterprises and households.

Interest rate forecasts should satisfy the following main criteria:

  1. The interest rate should be set with a view to stabilising inflation at target or bringing it back to target after a deviation has occurred. The relevant time horizon will depend on the type of disturbances to which the economy is exposed and their effect on the path for inflation and the real economy ahead.
  2. The interest rate path should, at the same time, provide a reasonable balance between the path for inflation and the path for overall capacity utilisation in the economy.
    In the assessment, potential effects of asset prices, such as property prices, equity prices, and the krone exchange rate on stability in output, employment and inflation are also taken into account.

Assuming the criteria above have been satisfied, the following additional criteria are useful:

  1. Interest rate adjustments should normally be gradual and consistent with the Bank's previous response pattern.
  2. Interest rate developments should result in acceptable developments in inflation and output also under alternative assumptions concerning the economic situation and the functioning of the economy. Any substantial and systematic deviations from simple, robust monetary policy rules should be explained.
  3. The interest rate forecast is an expression of Norges Bank's overall judgement and assessment based on the criteria above. Usually, the criteria cannot all be satisfied simultaneously, and the various considerations must therefore be weighed against each other. Forecasts of the key policy rate and other economic variables are based on incomplete information concerning the economic situation and the functioning of the economy. Should developments in the economy differ from assumptions or should the central bank change its view of the functioning of the economy, developments in the interest rate and other variables may deviate from the forecasts.

Source: Taken from Norges Bank Annual Report 2010 http://www.norges-bank.no/Upload/82632/activities.pdf


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Task

Visit the websites of a selection of central banks, including that of Norges Bank, and determine whether the Central Government has identified an explicit inflation target. Once you have done this, complete the following table:

Country Name of Central Bank Inflation target Interest rate
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http://www.norges-bank.no/en/price-stability/


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The websites of many of the world's Central Banks can be found here:


Evaluation of monetary policy


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Case Study - The Credit Crunch

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The late-2000s witnessed a financial crisis (often called the 'Credit Crunch' that resulted in the collapse of large financial institutions, the bailout of banks by national governments, declines in national housing markets and collapses in the institutions that financed house purchase, failures in businesses, increased unemployment, declines in consumer wealth, downturns in stock markets around the world, decline in economic activity and global recession in 2008.

Read the following article, Credit crunch: A sickness in the heart of Britain, and watch the two videos below and then consider the questions below.


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Watch the following two video clips.

Video (1) - The credit crunch explained


Video (2) - Quantitative easing


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  1. Examine the causes of the credit crunch. Specifically address the role of the US property market in the crisis.
  2. Explain why the crisis in the US property market spread to banks outside the US.
  3. Examine the factors that lead to a recessionary situation in 2008 following the bank crisis.
  4. Identify the characteristics of the recession in the UK.
  5. Describe how did the governments of affected countries reacted to the recession.
  6. To what extent do you consider that the policies introduced were effective in promoting a recovery? Identify the economic costs associated with these policies.

2.5 Monetary Policy (questions)

In this section are a series of questions on the topic - monetary policy. The questions may include various types of questions. For example:





Click on the right arrow at the top or bottom of the page to work through the questions.

Self-test questions

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1

Interest rates

Which is the most likely to occur if interest rates are increased?

a)
b)
c)
d)
Please select an answerYes, well done. An increase in interest rates will lead to an increase in demand for sterling and this will lead to an appreciation of the exchange rate.No, this normally happens if interest rates are cut.No, this rarely happens when interest rates change. A devaluation is a deliberate change in a fixed exchange rate.Unlikely, interest rates often affect the exchange rate.
Check your answer

2

Rising interest rates

If interest rates were to rise the impact on consumption would be:

a)
b)
c)
d)
Yes, that's correct. Well done. A rise in interest rates would be expected to cause incomes to fall and so consumption would drop.No, that's not right. The correct answer is C - a rise in interest rates would be expected to cause incomes to fall and so consumption would drop. A is the complete opposite and B is not what we would normally expect. D is also the opposite of what we would expect as most people would try to continue some consumption of necessities but would drop luxuries as the cost of money increased.No, that's not right. Try again. Expansionary fiscal policy will boost the level of aggregate demand (e.g. tax cuts) while contractionary fiscal policy will have the opposite effect (e.g. tax increases). Expansionary monetary policy is a reduction in interest rates as this will boost aggregate demand. Contractionary monetary policy is the opposite. Supply-side policies are those that are aimed at boosting aggregate supply.Your answer has been saved.
Check your answer

3

Rising interest rates

If interest rates were to rise the impact on consumption would be:

a)
b)
c)
d)
Yes, that's correct. Well done. A rise in interest rates would be expected to cause incomes to fall and so consumption would drop.No, that's not right. The correct answer is C - a rise in interest rates would be expected to cause incomes to fall and so consumption would drop. A is the complete opposite and B is not what we would normally expect. D is also the opposite of what we would expect as most people would try to continue some consumption of necessities but would drop luxuries as the cost of money increased.Your answer has been saved.
Check your answer

4

Government policies

Match the examples of government policy given to the appropriate type.

a)
b)
c)
d)
e)
Yes, that's correct well done. Expansionary fiscal policy will boost the level of aggregate demand (e.g. tax cuts) while contractionary fiscal policy will have the opposite effect (e.g. tax increases). Expansionary monetary policy is a reduction in interest rates as this will boost aggregate demand. Contractionary monetary policy is the opposite. Supply-side policies are those that are aimed at boosting aggregate supply.No, that's not right. Try again. Expansionary fiscal policy will boost the level of aggregate demand (e.g. tax cuts) while contractionary fiscal policy will have the opposite effect (e.g. tax increases). Expansionary monetary policy is a reduction in interest rates as this will boost aggregate demand. Contractionary monetary policy is the opposite. Supply-side policies are those that are aimed at boosting aggregate supply.Your answer has been saved.
Check your answer

5

Government policies

Match the examples of government policy given to the appropriate type.

a)
b)
c)
d)
e)
Yes, that's correct well done. Expansionary fiscal policy will boost the level of aggregate demand (e.g. tax cuts) while contractionary fiscal policy will have the opposite effect (e.g. tax increases). Expansionary monetary policy is a reduction in interest rates as this will boost aggregate demand. Contractionary monetary policy is the opposite. Supply-side policies are those that are aimed at boosting aggregate supply.No, that's not right. Try again. Expansionary fiscal policy will boost the level of aggregate demand (e.g. tax cuts) while contractionary fiscal policy will have the opposite effect (e.g. tax increases). Expansionary monetary policy is a reduction in interest rates as this will boost aggregate demand. Contractionary monetary policy is the opposite. Supply-side policies are those that are aimed at boosting aggregate supply.Your answer has been saved.
Check your answer

6

Inflation policy

Which of the following would be an acceptable policy to reduce the inflation rate?

a)
b)
c)
d)
Please select an answerYes, that's correct. This would slow down spending.No, this is more likely to increase inflation as it would boost people's disposable income and lead to an increase in demand.No, this will lead to higher inflation through costlier imports.No, this is likely to boost inflation as it leads to an increase in aggregate demand.
Check your answer

7

Inflation policy

Which policy is mainly used in the UK to control inflation?

a)
b)
c)
d)
Please select an answerYes, that's correct. Interest rates are set by the Monetary Policy Committee of the Bank of England to keep inflation within targets set by the Chancellor of the Exchequer.No, these have been used but not since the 1970s.No, although it was used for this purpose until the 1970s.No, these are mainly used to reduce unemployment and boost productivity and potential output.
Check your answer

Short questions

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Question 1

Explain the possible effects of an increase in interest rates.

Question 2

Distinguish between the nominal rate of interest and the real rate of interest.

Question 3

Distinguish between monetary and fiscal policy.

Question 4

Explain the link between an increase in the money supply lead to and an increase in interest rates.

Question 5

Distinguish between tight (contractionary) and loose (expansionary) monetary policy

Question 6

Describe the process of quantitative easing.

Question 7

Describe the role of the Central Bank.

Question 8

Explain how a government can use monetary policy to expand aggregate demand.

Data response (1)

Read the article China to raise interest rates again and then answer the questions below. (You can read the article in the web window below, or follow the previous link to read the article in a new web window)


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Question 1

Explain what is meant by monetary policy.

Question 2

Identify examples of monetary policy used by the Chinese government and explain the desired outcomes.

Question 3

Evaluate the effects of the monetary policy measures the Chinese government is using on output, employment, prices and incomes.

Data response (2)

Read the article After the flood and then consider answers to the questions below. (You can either read the article in the window below or you can follow the previous link to read the article in a separate window).


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Question 1

Explain what is meant by tight and loose monetary policy

Question 2

Identify the main features of Japanese monetary policy in recent years and explain the reasons for recent changes.

Question 3

Analyse the impact of these changes in monetary policy on the main Japanese macroeconomic targets.

Question 4

The Bank of Japan defines price stability as "a state where the change in the price index is zero". Examine the advantages and disadvantages of setting a zero target rate.

Long questions

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Question 1

(a) Distinguish between monetary and fiscal policy.

(b) Using the appropriate aggregate demand and supply diagrams, and specific examples, evaluate the effect of loosening monetary policy on the economy of a country.

Question 2

Analyse the policy options available to a government that is experiencing both moderate levels of unemployment and inflation.

Section 2.6 Supply-side policies (notes)

In the previous section we considered the level of overall economic activity, examined the concepts of aggregate demand and aggregate supply and looked at the role of macroeconomic objectives in the development of government policies and the operation of fiscal and monetary policy.

In this section we examine supply-side policies. By the end of this section you should be able to:

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Supply-side policies - introduction

S:\triplea_resources\DP_topic_packs\economics\student_topic_packs\media_macroeconomics\images\gears_accelerator_2.jpgIn this section we consider the following topics in detail:

The history of supply-side policy

From 1945 until the mid-1970s, Keynesian fiscal policy (influencing aggregate demand levels) was the major instrument of government economic policy in most countries around the world. The Phillips curve represented the observed inverse relationship between the rate of unemployment and the rate of inflation in an economy, which had been recorded historically. In other words, the lower the level of unemployment in an economy, the higher the rate of inflation (and vice-versa). This observed relationship had underpinned many governments' macroeconomic policies since the 1950s. However, while this trade off appeared to exist in the short-run, the relationship broke down in the long-run. In the early 1970s, 'stagflation', or 'slumpflation' occurred in many countries, which was the simultaneous increase in both prices and unemployment; a situation that Keynesian economists believed was not possible. As a result, the use of monetary policy to achieve macroeconomic goals became widespread, and has dominated government policies in major economies since the 1970s. The 'radical right', or monetarists, in the USA particularly (although similar moves were happening in Europe), suggested that concentration on the demand-side of the economy was untenable and that governments should focus instead on the use supply-side policies to create greater flexibility in the economy to react to changes in aggregate demand. Monetarist policies became to dominate government economic approaches in most developed economies with a growing importance placed on the use of interest rates to fine tune economic development. The debate moved away from Keynesian policies to arguments over the nature of about supply-side policies and whether these should be more or less interventionist in nature as both liberals and conservatives embraced policy measures focusing on increasing aggregate supply.

However, it should be noted that many governments reacted to the financial crisis of 2007 - 2010, by using traditional Keynesian approaches to stimulate aggregate demand, in face of opposition from Monetarists who saw these policies as inevitably inflationary in the longer-term.


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Read the following articles and reflect on the reaction of governments around the world to the financial crisis of 2007-2010, and why did so many governments revert to policies that appear to be Keynesian in nature?

The role of supply-side policies

Supply-side policies are designed to make aggregate supply (AS) more responsive to changes in national income. Supply-side policies tend to concentrate on improving efficiencies in either product markets, i.e. specific good or services such as cars, or labour markets. Supply-side policies are designed to increase competition and efficiency of production by improving the quality and quantity of labour available to firms. When combined with other macro policies, they are supposed to deliver a more competitive and efficient economy.

Supply-side policies focus on:

Supply-side policies aim to shift the LRAS curve to the right, increasing the level of real output and lowering the price level. This is shown in Figure 1 below:

lras_ad_right1

Figure 1 Supply-side policies - LRAS shifts

Supply-side policies were initially advocated only by free-market oriented economists and politicians. However, policies designed to affect the aggregate supply of goods and services are now embraced by those in favour of a more interventionist approach. It may, therefore, be better to think of supply-side policies in terms of being either market based or interventionist.

Interventionist supply-side policies


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The supply-side - case study

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Read the article:

Now read the following article taken from the UK's Daily Telegraph:

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Answer the following questions:

  1. Having read both articles, explain why the governments of South Korea and the UK are investing in the respective sectors of the economy?
  2. Explain why the private sector does not provide all the necessary investment and analyse the possible risks if it did.
  3. Examine the economic consequences of a government not investing in the technical infrastructure of the country.

Market based supply-side policies


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Market-based supply-side policies - case study (1)

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Watch the following video on the state of the Indian economy prior to the introduction of liberalization policies in the 1990s


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Read the Washington Post article Air India strike sparks debate over privatization considering the case of privatization in India. (You can read the article in the web window below, or follow the previous link to read the article in a new web window)


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Answer the following questions:

  1. Identify the areas of production highlighted by the video as important if the productive efficiency and the supply-side of the Indian economy is to be improved.
  2. Examine the problems highlighted by the article associated with government owning and controlling business.
  3. Describe the supply-side policy measures to improve efficiency advocated by some sectors of the India media. Analyse the economic arguments for, and against, such measures.

Evaluation of supply-side policy

S:\triplea_resources\DP_topic_packs\economics\student_topic_packs\media_macroeconomics\images\yes_no_yes.jpgSupply-side policies - strengths

Supply-side policies may be targeted at particular sections of the economy raising efficiency there. Successful application for the economy, as a whole, will shift the LRAS to the right, increasing the level of real output and lowering the price level.

Achievement of the major macro-economic goals of economic policy may be achieved if LRAS is shifted to the right. Such a shift:

Policies that cut the rate of income tax, in addition to increasing the incentive to work and to be entrepreneurial are considered by some economists to lead to an increase in tax revenue. As employment and incomes increase they generate more tax revenue, albeit with lower tax rates. This is demonstrated by the Laffer curve. However, there is some dispute as to the precise rate of tax which maximizes potential tax revenue.


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More interventionist supply-side policies may, in addition to increasing productive efficiencies, have the effect of injecting money into the circular flow of income and setting up a multiplier process leading to an increase in output, employment and income. The benefits, or otherwise, of this expansionary fiscal effect can be further considered by reviewing Section 2.4.

Supply-side policies - weaknesses

As we have seen, whilst some supply-side policies represent a more interventionist approach, most supply-side policies are associated with neo-classical, free market or supply-side economists. There is considerable disagreement between free market economists and economists, who favour an interventionist approach, as to how best the economy should be managed.

Some interventionist objections to particular free market oriented supply-side policies are as follows:

In particular, privatisation has been criticised on the following grounds:

2.6 Supply-side policies (questions)

In this section are a series of questions on the topic - supply-side policies. The questions may include various types of questions. For example:





Click on the right arrow at the top or bottom of the page to work through the questions.

Self-test questions

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1

Supply-side policies

Which of the following is NOT something on which supply-side policies are normally focused?

a)
b)
c)
d)
Yes, that's correct. Well done. This is not part of conventional supply-side economics.No, that's not right. The correct answer is D as this is not part of conventional supply-side economics. The rest are all part of normal supply-side targets.Your answer has been saved.
Check your answer

2

Supply-side policies

Which of the following would be considered supply-side policies? Tick all answers that are correct.

a)
b)
c)
d)
e)
f)
Yes, that's correct. Supply-side policies are policies that are aimed at boosting the level of aggregate supply in the economy.No, that's not right. Supply-side policies are policies that are aimed at boosting the level of aggregate supply in the economy. Changes in interest rates and credit controls are monetary policy.Your answer has been saved.
Check your answer

Short questions

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Question 1

Describe the aims of supply-side policies.

Question 2

Explain why has 'privatisation' become such a popular economic policy and examine the problems it may have caused.

Question 3

Outline the major supply-side policies, which could be used by a government.

Question 4

Discuss the extent to which supply-side policies have been successful in improving the performance of an economy with which you are familiar.

Question 5

Identify two possible disadvantages which might arise from the privatisation of a nationalised postal service.

Data response (1)

Read the article Kaliningrad erases stains of past and then answer the questions below. You can either read the article in the window below or you can follow the previous link to read the article in a separate window.


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Question 1

Define the term economic growth.

Question 2

Identify the main determinants of the increase in the rate of economic growth in Kaliningrad.

Question 3

Explain the policies that the government is putting in place to maintain economic growth.

Question 4

Examine whether the policies being put in place can be considered supply-side policies.

Question 5

Discuss the likely principal constraints on the long-term rate of economic growth in Kaliningrad.

Data response (2)

Read the article Protecting the silent majority - and the Royal Wedding and then answer the questions below. (You can read the article in the web window below, or follow the previous link to read the article in a new web window)


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Question 1

Explain what are meant by supply-side policies.

Question 2

Using appropriate diagrams to support your analysis, explain how supply-side policies can increase output, employment and income.

Question 3

Explain how supply-side policies that reform labour markets can increase output, employment and income.

Question 4

Discuss the potential hazards of introducing labour market supply-side policies, such as those described in the article.

Long questions

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Question 1

(a) Distinguish between market based and interventionist supply-side policies.

(b) Using specific examples and diagrams where appropriate, analyse the costs and benefits to the economy of the government implementing a market based approach to supply-side policy.

Question 2

(a) Explain why the shape of the aggregate supply curve may differ in the short and long run.

(b) Evaluate the extent to which supply-side policy attempts is effective in influencing output, employment and income in the long run.