Section 10 - Government Economic Policy Objectives

Question 1

What are the 4 main objectives for government macroeconomic policy?

Answer 1

1. Strong economic growth
2. Keeping inflation low
3. Reducing unemployment
4. Equilibrium in the balance of payments

Question 2

Main objectives for government macroeconomic policy - strong economic growth

Answer 2

1. Governments want economic growth to be high (but not too high).
2. In general, economic growth will improve the standard of living in a country.

Question 3

Main objectives for government macroeconomic policy - keeping inflation low

Answer 3

1. In the UK, the government aims for inflation of 2%.

2. The Monetary Policy Committee of the Bank of England uses monetary policy to try to achieve this target rate,

Question 4

Main objectives for government macroeconomic policy - reducing unemployment

Answer 4

1. Governments aim to reduce unemployment and move towards full employment.
2. If more people are employed then the economy will be more productive. AD will also increase as more people will have a greater income.

Question 5

Main objectives for government macroeconomic policy - equilibrium in the BoP

Answer 5

1. Governments want an equilibrium in the balance of payments, i.e. they want earnings from exports and other inward flows of money to balance the spending on imports and other outward flows of money.
2. This is more desirable than a long-term deficit or surplus in the BoP - which can cause problems.

Question 6

Additional government objectives

Answer 6

> Balance the budget
Protect the environment
Achieve greater income equality

Question 7

Economic growth - definition

Answer 7

> Economic growth is an increase in the productive potential of an economy.

Question 8

Short-run economic growth

Answer 8

> In the short-run, economic growth is measured by the percentage change in real national output (real GDP).
This is known as actual/real growth (inflation removed from growth figure).
Increase in actual growth are usually due to an increase in AD, but can also be caused by increases in AS.
Actual growth doesn’t always increase - it tends to fluctuate up and down.

Question 9

Long-run economic growth

Answer 9

> Long run growth (also known as potential growth) is caused by an increase in the capacity, or productive potential, of the economy.
This usually happens due to a rise in the quality or quantity of inputs.
Long run growth is shown by an increase in the trend growth rate.
Increases in long run growth are caused by an increase in AS.

Question 10

Trend rate of growth

Answer 10

> The trend rate of growth is the average rate of economic growth over a period of both economic slumps and booms.
It rises smoothly rather than fluctuating like actual economic growth, so the actual rate of growth often doesn’t match the trend rate.

Question 11

PPFs and showing economic growth

Answer 11

> Short run and long run economic growth can be shown on a PPF.
Short run growth is shown by a movement of a point towards the PPF, but the PPF itself remains fixed.
Long run growth occurs if there’s an increase in the capacity of the economy - this would make the PPF shift outwards.

Question 12

The Economic Cycle - phases

Answer 12

> The economic cycle has different phases.
The actual growth of an economy fluctuates over time. These fluctuations are known as the economic cycle.
Boom, recession, recovery.
Long run growth is shown by an increase in the trend rate of growth. The trend rate of growth is the average rate of economic growth over a period of both economic booms and slumps.
Also known as the trade or business cycle.

Question 13

The Economic cycle - boom

Answer 13

> A boom is when the economy is growing quickly. AD will be rising, leading to a fall in unemployment and a rise in inflation.

Question 14

The Economic cycle - recession

Answer 14

> A recession is when there’s negative economic growth for at least 2 consecutive quarters.
AD will be falling, causing unemployment to rise and a fall in price levels.

Question 15

The Economic cycle - recovery

Answer 15

> During a recovery the economy begins to grow again, going from negative economic growth to positive economic growth.
AD will be rising, so unemployment will be falling and inflation will be rising.

Question 16

Levels of investment

Answer 16

> Levels of investment tend to match the rate of change of GDP.
This means investment will be greatest when the gradient of the actual growth is steepest.

Question 17

Negative output gap

Answer 17

> A negative output gap (a.k.a recessionary gap) is the difference between the level of actual output and trend output when actual output is below trend output.
A negative output gap will occur during a recession when the economy is under-performing, as some resources will be unused or underused (including labour, so unemployment may be high).
A negative output gap also usually means downwards pressure on inflation.

Question 18

Positive output gap

Answer 18

> A positive output gap (a.k.a an inflationary gap) is the difference between the level of actual output and trend output when actual output is above trend output.
A positive output gap will occur during a boom when the economy is overheating, as resources are being fully used or overused (so unemployment may be low).
A positive output gap also usually means upwards pressure on inflation.

Question 19

What happens during a recovery?

Answer 19

> During a recovery an economy will go from having a negative output gap to having a positive output gap as actual output rises above trend output.

Question 20

Benefits of economic growth

Answer 20

1. Economic growth will increase demand for labour, leading to a fall in unemployment and higher incomes for individuals.
2. Economic growth usually means that firms are succeeding, so employees may get higher wages. This will also produce a rise in the standard of living, as long as prices don’t rise more than the increase in wages.
3. Firms are likely to earn greater profits when there’s economic growth, as consumers usually have higher incomes and spend more. Firms can use these profits to invest in better machinery, make technological advances and hire more employees - causing an increase in the economy’s productive potential.
4. As firms are likely to produce more when there’s economic growth then this can improve a country’s balance of payments because it will sell more exports.
5. Economic growth causes wages and employment to rise, which will increase the government’s tax revenue and reduce the amount it pays in unemployment benefits. The gov. can use this extra revenue to improve public services or h=the country’s infrastructure without having to raise taxes, which is good for individuals.
6. Economic growth will improve a government’s fiscal position because if it receives greater tax revenue and spends less on things like unemployment benefits then this will reduce the gov’s need to borrow money.
7. There might be some benefits to the environment brought about by economic growth, e.g. firms may have the resources to invest in cleaner and more efficient production processes.

Question 21

Costs of economic growth

Answer 21

1. It can create income inequality - low-skilled workers may find it hard to get the higher wages that other workers are benefitting from.
2. Higher wages for employees are often linked to an increase in their responsibilities at work leading to increased stressed and reduced productivity.
3. Demand-pull inflation can occur because it causes demand to increase faster than supply. It can also cause cost-push inflation as economic growth increases the demand for resources, pushing up their prices. However, the effects of inflation will be reduced if LRAS also increases.
4. A deficit in the balance of payments can be created because people on higher incomes buy more imports. Furthermore, firms may import more resources to increase their production to meet the higher levels of demand.
5. Industrial expansion created by economic growth may bring negative externalities, such as pollution of increased congestion which harm the environment and reduce people’s quality of life.
6. Beautiful scenery and habitats can be destroyed when resources are overexploited.
7. Finite resources may be used up in the creation of economic growth, which may constrain growth in the future and threaten future living standards.

Question 22

Why is a recession bad?

Answer 22

> A recession will usually see many firms close down, with many people losing their jobs. This means unemployment usually increases.
Other firms may stop hiring new employees - this means young people are often particularly badly hit.
Gov. spending tends to increase leading to increased gov. borrowing and a budget deficit.
Levels of investment fall - e.g. firms might reduce the amount they spend on R&D. This can have consequences for the long run productive potential of the economy.

Question 23

Who can benefit from a recession?

Answer 23

> Some firms can benefit at times of recession - e.g. discount retailers can often attract more customers if people are feeling less confident about their economic prospects.
Recessions can also force firms to face up to their inefficiencies. In good times, firms might be able to get away will being inefficient in some areas. But they may need to cut costs to survive a recession. This can benefit the firm in the long run if it emerges from the recession more efficient than it was before.

Question 24

Short run economic growth - how can it be created?

Answer 24

1. Rise in AD

2. Rise in SRAS

Question 25

What does the extent to which the AD curve shift depend on?

Answer 25

> People’s MPC

>How big the multiplier is.

Question 26

Creating long run economic growth

Answer 26

> Long run economic growth is the result of supply-side factors that increase the productive potential of the economy.
The productive potential of a country can be increased by raising the quantity or quality of the FoPs.
A government can also help to create long run economic growth by creating stability in a country.

Question 27

How can a country’s quality/quantity of FoPs be achieved?

Answer 27

1. Through innovation (e.g. new technology).
2. Investing in more modern machinery (i.e. improving capital stock).
3. Raising agricultural output by using GM crops.
4. Increasing spending on education and training to improve human capital.
5. Increasing the population size, e.g. by encouraging immigration, to increase the size of a country’s workforce.

Question 28

Instability in an economy

Answer 28

> It’s normal for an economy to go through regular ups and downs - this is the economic cycle.
However, if these ups and downs are particularly large or particularly frequent, this can cause problems for an economy.
Governments can try and control these ups and downs to a certain extent - but some thins are beyond their control.

Question 29

Demand and supply side shocks

Answer 29

> An economy might start to shrink or grow because it is affected by a demand-side shock (AD rises or falls) or by a supply-side shock (AS rises or falls).
These shocks can be domestic or global.

Question 30

Examples of demand-side shocks

Answer 30

> If consumer confidence is boosted, e.g. due to house prices rising, this will increase consumer spending.
If a country’s major trading partners go into a recession, this may significantly reduce demand for the country’s exports.

Question 31

Examples of supply-side shocks

Answer 31

> A poor harvest reduces the supply of food, increases its price, and reduces the economy’s capacity.
The discovery of a major new source of a raw material will greatly reduce its price and increase its supply - increasing the capacity of the economy.

Question 32

What can cause instability?

Answer 32

> External shocks.

>Animal spirits

Question 33

Instability - Animal Spirits

Answer 33

> According to classical economic theory, economic agents always act rationally.
In fact, people often seem to act very irrationally. Keynes used the term animal spirits to describe how human behaviour is often guided by instincts and emotions, rather than economic realities.
For example, the following are common danger signs for an economy - they often start to emerge during a boom but are followed shortly after by a bust, and created (at least partly) by animal spirits:
1. Excessive growth in credit and levels of debt.
2. Destabilising speculation and asset price bubbles.

Question 34

Common danger signs for an economy

Answer 34

1. Excessive growth in credit and levels of debt.

2. Destabilising speculation and asset price bubbles.

Question 35

Excessive growth in credit and levels of debt

Answer 35

> When credit is cheap and consumers are feeling confident, they often spend more and accumulate debt.
This can increase AD and lead to higher inflation. This inflation can lead to higher interest rates, which could mean firms delay investment projects and become more cautious, storing up problems for an economy.
High levels of debt also mean that it consumers lose confidence for any reason, they’re likely to greatly slow down their spending for fear of not being able to pay off their loans. It also means they’ll have less money to spend in the future, as they’ll be spending money repaying debts (including interest).

Question 36

Destabilising speculation and asset price bubbles

Answer 36

> Speculation is when people buy assets (e.g. houses, shares, etc.) and hope to sell them for a profit later.
Speculators often assume than increase in the price of an asset means that its price will continue to increase in the future - this prompts further buying of the good and further price increases, leading to further buying and further price increases, and so on. The herding effect has been used to explain why this behaviour may occur.
This behaviour can lead to asset price bubbles - where prices increase way beyond the asset’s ‘true value’.
Eventually, the bubble bursts and asset prices start to fall. When this happens, people’s optimism and confidence can disappear. If people start to fear they’ll lose money, they may start to sell the assets, leading to further price decreases, and further selling, and so on.
Property and shares are often affected by asset-price bubbles, and the effects of a sudden fall in UK house prices, for example, can be dramatic. As people feel less wealthy and less confident, they start to save instead of spend, and this can lead to a downward spiral in the economy.

Question 37

Capital stock - defintion

Answer 37

> Capital stock is the stuff that’s used to make goods.

Question 38

Speculation - definition

Answer 38

> Speculation is when people buy assets (e.g. houses, shares, etc.) and hope to sell them for a profit later.

Question 39

Herding effect

Answer 39

> Herding describes how people follow a crowd in the belief that ‘if everyone else is doing something then it must be the right thing to do.’

Question 40

Sustainable economic growth - definition

Answer 40

> Sustainable economic growth means making sure the economy keeps growing (now and in the future), without causing problems for future generations.

Question 41

What does sustainable growth rely on?

Answer 41

> Sustainable growth relies on a country’s ability to:

• expand output every year.
• find a continuous supply of raw materials, land, labour and so on, to continue production.
• find growing markets for the increased output, so it’s always being bought.
• reduce negative externalities, e.g. pollution, to an acceptable level so they don’t hamper production.
• do all of the above things at the same times as many other countries who are pursuing the same objectives.

Question 42

Achieving sustainable growth

Answer 42

> It’s very difficult to achieve sustainable growth.
To be able to achieve sustainable growth, countries need to develop renewable resources. Non-renewable resources will run out and, for growth to be sustainable, a continuous supply of raw materials is necessary.
Countries will also need to innovate to create new technologies that reduce negative externalities, such as pollution, and the degradation of resources, such as land or rivers, without stopping output from expanding.
A country that achieves sustainable growth will gain long-term benefits to society - it can easily plan ahead, since it can be more confident about its long-term economic prospects.

Question 43

UK’s recent macroeconomic performance (textbook - i.e. may be outdated) - trade cycle

Answer 43

> From 2000 to 2008 the UK enjoyed continuous GDP growth of, on average, just under 3% each year. However, in 2008 the UK went into a recession that lasted for several months and was followed by a long, slow recovery.
During the recovery the UK economy went through short bursts of growth followed by slow-downs - it almost went back into recession in 2012. From 2013 onwards, the UK has had much more consistent GDP growth and by 2014, GDP returned to the level it was just before the recession - suggesting that the recovery is complete.

Question 44

UK’s recent macroeconomic performance (textbook - i.e. may be outdated) - inflation

Answer 44

> Between 2000 and early 2015 the rate of inflation in the UK, as measured by the CPI, has been quite steady - generally inflation has been between 0.5% and 3%.
There have been some exceptions to this steady level of inflation.
On a couple of occasions, inflation rose to about 5%, well above the government’s target of 2%. This happened just at the start of the recession in 2008 and again in 2011.
Inflation then fell again and remained between 0 and 3% for some time.

Question 45

UK’s recent macroeconomic performance (textbook - i.e. may be outdated) - unemployment

Answer 45

> Unemployment in the UK remained quite low between 2000 and 2008 - between about 1.4 to 1.7 million.
It rose rapidly between 2008 and 2011, reaching about 2.7 million (8%).
Since then unemployment has fallen, but, by January 2015, it was still higher than it was at the start of 2008.

Question 46

UK’s recent macroeconomic performance (textbook - i.e. may be outdated) - extra

Answer 46

> The UK has had a current account deficit in its balance of payments for the whole period between 1984 and 2014.
The deficit was at its largest during this period towards the end of 2014.
The UK economy is currently dominated by its service sector, which accounts for approximately 77% of GDP.
Manufacturing now accounts for just around 10% of GDP.

Question 47

Full employment - definition

Answer 47

> The situation when everyone of working age who wants a job at the current wage rates can get one.

Question 48

Full employment - info

Answer 48

> Governments aim for full employment.
Full employment doesn’t mean everyone has a job - in most economies there will always be people between jobs.
Governments want full employment because this will maximise production and raise standards of living in a country.
If there’s unemployment, the economy won’t be operating at full-capacity (point within PPF curve). At full employment the economy can operate at full capacity (point on the PPF curve).
Under-employment would also mean an economy isn’t operating at full capacity.

Question 49

Under-employment

Answer 49

> Under-employment would mean an economy is not operating at full capacity, and it will be represented by a point within its PPF curve.
Under-employment is when someone has a job, but it’s not a job that utilises that persons skills, experience or availability to best effect.
E.g. someone who could only find part-time employment when they actually wanted a full-time position.

Question 50

What affect unemployment?

Answer 50

> Economic growth and the time of year.

Question 51

Unemployment - economic growth

Answer 51

> Labour is a derived demand - an employer’s demand for labour is derived from consumers’ demand for goods/services.
So when demand in the economy is low (e.g. when there’s negative economic growth), unemployment will rise. When demand is high, it will fall.
Cyclical unemployment (or demand-deficient unemployment) usually happens when the economy is in a recession - when AD falls, employment will too.
A country suffering from a negative output gap is likely to have cyclical unemployment too.
Cyclical unemployment can affect any industry.

Question 52

Unemployment - time of year

Answer 52

> Seasonal unemployment occurs because demand for labour in certain industries won’t be the same all year round.
E.g. tourism and farming industries have ‘peak’ seasons where the need for labour is much higher than at other times of year.
Retailing is also affected by seasonal unemployment (many shops will be particularly busy at Christmas).
Seasonal unemployment tends to be regular and predictable, and it only affects certain industries.

Question 53

Structural unemployment

Answer 53

> Structural unemployment is caused by a decline in a certain industry or occupation - usually due to a change in consumer preferences or technological advances, or the availability of cheaper alternatives.
It often affects regions where there’s a decline in traditional manufacturing (e.g. shipbuilding or the steel industry).
It’s made worse by labour immobility (occupational and geographical).
If a region is affected by structural unemployment then it could also suffer from the negative multiplier effect, causing further unemployment in the region due to less spending.
The problem of structural unemployment may become more common in the future.

Question 54

Why may the problem of structural unemployment may become more common in the future?

Answer 54

> Technological change in both products and production methods is accelerating quickly. This will speed up the decline of out-of-date industries and reduce the number of workers needed to make products.
Consumer spending is more likely to change as consumers are better informed (through the internet and social media) than ever before - making them more likely to switch to lower priced or higher quality goods.

Question 55

Labour immobility - types

Answer 55

> Occupational

>Geographical

Question 56

Occupational labour immobility

Answer 56

> Occupational labour immobility occurs when some occupation may decline over time, but the workers in these occupations don’t have the skills required to be able to do the jobs that are available.

Question 57

Geographical labour immobility

Answer 57

> Geographical labour immobility is where workers are unable to leave a region which has high unemployment to go to another region where there are jobs.
This might be because they can’t afford to move to a different region, or they have family ties.

Question 58

Frictional unemployment

Answer 58

> Frictional unemployment is the unemployment experienced by workers between leaving one job and starting another.
Even if an economy is at full employment, there will be some frictional unemployment. There will always be some employees changing jobs - maybe because their contract has run out or they want to earn higher wages.
The length of time people spend looking for a new job (the ‘time lag’ between jobs) depends on several things.

Question 59

What does the length of time people spend looking for a new job depend on?

Answer 59

> In a boom the number of job vacancies is much higher. So frictional unemployment is likely to be short term.
In a slump frictional unemployment could be much higher as there will be a shortage of jobs.
Generous welfare benefits will give people less incentive to look for a new job, or they can mean people can afford to take their time to look for a good job - so the time spent between jobs may increase.
The quality of information provided to people looking for jobs is important too. If people don’t know what jobs are available or what skills they need to get the job they want, then they’re likely to remain unemployed for longer.
Occupational and geographical labour immobility will also effect the time lag between jobs.

Question 60

Real wage unemployment

Answer 60

> Real wage unemployment is caused by real wages being pushed above the equilibrium level of employment (where labour D=S).
It’s usually caused by trade unions negotiating for higher wages or by the introduction of a national minimum wage.
Introducing a NMW above the equilibrium wage rate would cause unemployment due to excess supply.
However, a rise in productivity or consumer spending would increase the demand for labour (labour demand curve shifts right) and his would reduce the size of the increase in unemployment.

Question 61

Migration and unemployment

Answer 61

> Migration of workers into a country increases the supply of labour.
When the economy is strong, national income should increase as a result of migration - especially if the skills and knowledge of the migrant workers is different from the mix of skills of the country’s native population. There’s little evidence from the UK that migration during a boom increases unemployment among the native population.
During a recession, unemployment among native workers (especially low-skilled workers) may increase, especially if migration levels are particularly high. However, even these effects weaken over time.

Question 62

Costs and consequences of unemployment

Answer 62

> The unemployed will have lower incomes, which means that they’ll spend less and this could reduce firm’s profits.
Unemployment will mean less tax revenue for governments, and less consumer spending will reduce their indirect tax revenue. The gov. also have to spend more on unemployment benefits.
Areas with high unemployment can have high crime rates, and reduced incomes can cause people to have health problems.
Workers who are unemployed for a long time may find that their skills and training become outdated. This will reduce their employability and make it more likely that they’ll stay unemployed. Hysteresis.

Question 63

Types of inflation

Answer 63

> Cost-push inflation

>Demand-pull inflation

Question 64

Cost-push inflation - definition

Answer 64

> Cost-push inflation is inflation caused by rising costs of production.
Rising costs of inputs to production force producers to pass on higher costs to consumers in the form of higher prices, which causes the AS curve to shift to the left.

Question 65

Cost-push inflation examples

Answer 65

1. A rise in wages above any increase in productivity:
   - if wages make up a large proportion of a firm’s total costs then this could lead to a significant rise in prices.
   - price rises could lead to further wage demands, which in turn could lead to price increases, and so (this is a wage-price spiral).
2. A rise in the cost of imported raw materials:
   - if the world prices of inputs rise then, in the short run, producers will pay the higher cost and set higher prices. This is how price increases in world commodity markets can lead to higher domestic inflation.
   - also, if a country’s currency decreases in value then producers will have to pay more for the same imports.
3. A rise in indirect taxes:
   - if the gov. raises indirect taxes this will increase costs and in turn, prices.
   - if a good is price inelastic then more of the cost of the tax will be passed on to the consumer.

Question 66

Demand-pull inflation - definition

Answer 66

> Demand-pull inflation is inflation caused by excessive growth in AD compared to supply.
This growth in demand shifts the AD curve to the right, which allows sellers to raise prices.

Question 67

Causes of demand-pull inflation - list

Answer 67

1. High consumer spending or high demand for exports.
2. The money supply growing faster than output.
3. Bottleneck shortages.

Question 68

Causes of demand-pull inflation - high consumer spending or high demand for exports

Answer 68

> High consumer spending could be caused by high levels of confidence in consumers’ future employment prospects. Low interest rates encourage cheap borrowing and greater spending.
High foreign demand for exports could be caused by rapid economic growth in other countries.

Question 69

Causes of demand-pull inflation - the money supply growing faster than output

Answer 69

> If the amount of money in the economy is not matched by the output of goods and services (a.k.a ‘too much money chasing too few goods), this can lead to a rise in prices. This might be the case, for example, when interest rates are low and consumers are spending more.
Monetarists economists believe that excess money is the biggest cause of inflation.

Question 70

Causes of demand-pull inflation - bottleneck shortages

Answer 70

> If demand grows quickly at a time when labour and resources are already being fully used, then increasing output may lead to shortages (i.e. there may be a positive output gap). These shortages will cause prices to rise and firm’s costs to increase.
Price rises caused by shortages (e.g. a rise in wages for skilled labour) in one area of the market may be copied by other markets (e.g. higher wages for low-skilled labour), leading to more general inflation.

Question 71

Quantity of Money Theory - formula

Answer 71

> money supply x velocity of money = price level x aggregate transactions.
MV = PT.

Question 72

Quantity of Money Theory - info

Answer 72

> The quantity theory of money is based on Fisher’s equation of exchange.
On the left-side is M (= the total amount of money in the economy) and V (=the speed at which money is spent). On the right-side is P (=the price level) and T (= the total amount of transactions in the economy).
Monetarists argue that, in the short run, V and T are unlikely to change, so any increases in P, the price level, will be directly caused by an increase to M, the money supply. Both sides of the equation are assumed to be equal to each other, so any increase in the money supply (M) will create the same percentage increase in the price level (P).
To avoid inflation, monetarists believe that the money supply needs to be strictly controlled.
There’s evidence to suggest that this theory is useful for explaining high levels of inflation, but is not so good when looking at more modest inflation.

Question 73

Costs and consequences of inflation

Answer 73

1. Inflation will cause the standard of living of those on fixed, or near-fixed, incomes to fall. This will have the biggest impact on those in low income employment or on welfare benefits.
2. A country’s competitiveness will be reduced by inflation as exports will cost more to buy and imports will be cheaper. If exports fall and imports rise, then this could create a deficit in the balance of payments and increase unemployment.
3. Inflation discourages saving because the value of savings falls. This makes it more attractive to spend (creating demand-pull inflation) before prices rise further.
4. A reluctance to save creates a shortage of funds for borrowing and investment, which means that it’s harder for firms to make improvements, e.g. buy new machinery. If interest rates go up to reduce inflation, this will also reduce investment.
5. Inflation creates uncertainty for firms as rising costs will reduce investment - harming future growth.
6. Shoe-leather costs, which are the costs of the extra time and effort taken by consumers to search for up-to-date price info on goods and services they’re using, and menu costs, which are the extra costs to firms of altering the price information they provide to consumers.
7. An extreme case is hyperinflation, where inflation grows very quickly to very high levels (e.g. several hundred percent or more). It’s often as a result of governments creating too much money (e.g. because of a war or some other crisis).

Question 74

Deflation - definition

Answer 74

> When the rate of inflation falls below 0% it’s called deflation.

Question 75

Deflation - info

Answer 75

> Although there are many costs to inflation, deflation isn’t very good either.
Deflation is often a sign that the economy is doing badly, as it’s usually caused by falling AD and increased unemployment.
However, deflation can also be caused if firms’ cost fall (e.g. because of new technology) and these benefits are then passed on to consumers in the form of lower prices.
Deflation can cause big problems. For example, if consumers think that prices are falling then they may choose nor to spend in the hope that prices will fall further. However, if the economy is healthy and people feel generally confident, deflation may not cause problems.
Less spending and lower prices will also mean lower profits for firms and reduced economic growth.

Question 76

Acceptable inflation

Answer 76

> In the UK, the BoE and the government consider low and stable inflation (up to 2% per year) to be acceptable. Excessive inflation (above 2%) is undesirable and can cause the problems mentioned above.
The gov uses a combination of monetary, fiscal and supply-side policies to try to keep the rate of inflation at 2%.
However, to achieve this the gov. has to make trade-offs between their inflation target and their other three main economic objectives.
Some economists, called monetarists, believe that bringing down inflation in the short run will help the gov, in the long run to achieve the other main economic objectives.

Question 77

Balance of Payments - definition

Answer 77

> A record of a country’s international transactions, i.e. flows of money in and out of a country.

Question 78

Balance of payments - intro

Answer 78

>The BoP records all flows of money in out of a country.
>The UK BoP is made up of the:
1. Current account
2. Capital account
3. Financial account.

Question 79

Current account - sections

Answer 79

> There are 4 sections of the current account:

1. Trade in goods
2. Trade in services
3. Investment and employment income (primary income)
4. Transfers (Secondary income)

Question 80

Current Account - trade in goods

Answer 80

> Trade in goods measures imports and exports of visible goods.
The UK’s biggest goods exports include things such as machinery, mechanical appliances and pharmaceuticals.
The UK’s biggest goods imports also include machinery and mechanical appliances, along with mineral fuels (e.g. coal) and oil.

Question 81

Current account - trade in services

Answer 81

> Trade in services measures imports and exports of services such as insurance or tourism.
Some of the UK’s biggest exported services are banking and insurance.
The UK’s biggest imported services include tourism.

Question 82

Current account - investment and employment income (primary income)

Answer 82

> This covers flows of money in and out of a country resulting from employment or earlier investment - e.g:

• Deposits in foreign banks receive interest payments.
• Businesses set up overseas by a UK company will earn profits for the UK parent company.
• Shares bought in foreign firms will bring dividend payments to the UK shareholder - the shares themselves won’t appear on the current account.
• Salaries paid to UK residents working abroad.

Question 83

Current account - transfers (secondary income)

Answer 83

> Transfers are the movements of money between countries which aren’t paying for a good or service and aren’t the result of investment.
Transfers include payments made to family members abroad and aid paid to or received from foreign countries.

Question 84

Finding the balance on the current account

Answer 84

> Subtract imports from exports.
Positive balance = surplus.
Negative balance = deficit.

Question 85

UK’s recent BoP shows…

Answer 85

> A large deficit on the balance of visible trade.
A small surplus on the balance of invisible trade.
A surplus on flows of investment income.
A deficit on transfers.
As a result, the UK has a large deficit on its current account, and it has had a deficit every year since 1984.
This means that the UK’s current macroeconomic policy includes having to deal with a BoP deficit.

Question 86

Causes of a BoP deficit - list

Answer 86

1. There are high levels of consumer spending (low savings rate).
2. It’s struggling to compete internationally.
3. It has to deal with external shocks.

Question 87

Causes of a BoP deficit - high levels of consumer spending/low savings rate

Answer 87

> When there’s economic growth, consumers and firms buy more imports.
If the income elasticity of demand for imports is high then there will be a greater increase in imports.

Question 88

Causes of a BoP deficit - struggling to compete internationally

Answer 88

> Countries that can’t compete internationally will see a reduction in exports.
Some countries (especially more developed countries) may not be able to compete with low costs of production in other countries, e.g. newly industrialised nations:
-When the CoP in a country rise faster than in competitor countries, e.g. due to higher labour costs, production inefficiencies, a fall in labour productivity etc, then exports will fall and imports will rise.
-Other countries may struggle to compete with countries that have access to more advanced technology or more efficient methods of production, which can lower costs and improve the quality of the products they make.
-If the country has structural problems, e.g. labour immobility, this could be making domestic products and exports more expensive.
The UK’s large deficit in visible trade is partly caused by a lack of competitiveness in its manufacturing industries.
A rise in the value of a currency will make goods more expensive to foreign buyers, so exports will fall. At the same time, foreign goods will be cheaper to buy, so imports will rise.
If inflation rises exports will fall because they’ll become more expensive and less competitive in foreign countries. Imports will rise because it’ll become cheaper for consumers and firms to buy imports rather than domestic products.

Question 89

Causes of a BoP deficit - external shocks

Answer 89

> If there’s a rise in the world prices of imported raw materials, and the demand for these materials is relatively price inelastic, then a country will end up paying more for these imports - at least in the short run.
An economic downturn in countries to which a country exports can cause a sudden reduction in the amount of exports that are demanded.
The imposition of trade barriers on goods by a trading partner could mean a sudden reduction in the number of exports made to that country.

Question 90

Causes of a current account surplus

Answer 90

1. It’s been experiencing a recession - sometimes domestic producers will struggle to sell goods domestically, so they’ll focus their efforts on competing in international markets instead. There may be a fall in imports too as a result of an overall reduction in spending.
2. Its domestic currency has a low value - this will make exports cheaper and imports more expensive.
3. High interest rates are causing more saving and less spending.

Question 91

Consequences of a BoP deficit

Answer 91

1. Could indicate that an economy is uncompetitive.
2. A deficit isn’t always a bad thing - it might mean that people in that country are wealthy enough to be able to afford lots of imports. A deficit may also allow people to enjoy a higher standard of living, as they’re importing the things they want and need. But, a long term deficit is likely to cause problems.
3. The consequences of a deficit include a fall in the value of a currency, leading to higher import prices - at least in the short run. This can lead to an increase in inflation.
4. A BoP deficit may also lead to job losses domestically - e.g. if more goods are imported, that may mean fewer goods need to be made domestically, so unemployment may increase.

Question 92

Consequences of a BoP surplus

Answer 92

1. Surpluses can show that an economy is competitive.
2. However, if a country has a surplus for a prolonged period of time, e.g. Japan, they may experience stagnation. This means that, for example, due to low domestic demand, they’ll experience low or even negative economic growth - which also has the potential to lead to other problems such as high unemployment.
3. A large surplus is created by a country having an undervalued currency, this will create inflationary pressures - the price of imported components for use in production will rise, meaning a rise in the CoP and therefore a rise in the price level.

Question 93

How might governments correct a BoP deficit

Answer 93

> Expenditure-switching policies:
-They might use policies to reduce the price of domestic goods - this should increase exports and reduce imports. E.g. a gov. may use supply-side policies to remove structural problems.
-Gov. may impose restrictions on imports - e.g. a gov. might impose tariffs on imports to make them relatively more expensive (compared to domestic goods) for domestic consumers. This might cause inflation if demand for imports is too price inelastic.
They may devalue (fixed exchange rate systems) or depreciate (floating exchange rate systems) the currency - this will make exports cheaper and imports more expensive. For this to be successful, the Marshall-Lerner condition most hold true.
Expenditure-reducing policies:
-Gov. may use fiscal policy to reduce spending in the economy - however, as well as reducing imports it’s likely to also reduce domestic demand and harm economic growth.

Question 94

Expenditure-switching policies - definition

Answer 94

> Policies which switch consumer spending away from imports, towards domestically produced goods instead.

Question 95

Gov. correcting BoP surplus

Answer 95

> Gov. may try to correct a BoP surplus - for example, they might raise the value of their currency.
This will reduce the demand for exports and increase the demand for imports.
However, this is likely to result in a reduction in output and has the potential to cause a rise in unemployment.

Question 96

Global impact of governments of major economies trying to correct imbalances on BoP

Answer 96

> Supply-side policies to correct deficits may lead to an increase in world trade and growth.
Restrictions on imports can lead to trade wars, reducing international trade and leading to lower global efficiency. Restrictions might also break WTO rules.
If a government’s attempts to reduce its BoP deficit lead to a fall in exports from developing countries, this may have many negative consequences. For example, economic growth in those developing countries will be limited, leading to a rise in unemployment. Reduced economic growth in developing countries has the potential to hold back global improvements in efficiency.

Question 97

BoP - capital account

Answer 97

> The capital account includes transfers of non-monetary and fixed assets.
The most important part of this is the flow of non-monetary and fixed assets of immigrants and emigrants
E.g. when an immigrant comes to the UK, their assets become part of the UK’s total assets.

Question 98

BoP - financial account

Answer 98

> The financial account involves the movement of financial assets. It includes:
-FDI
-Portfolio investment
-Financial derivatives
-Reserve assets.
Income from the financial account, e.g. in the form of interest, is recorded in the current account.

Question 99

Portfolio investment - definition

Answer 99

> Investment in financial assets, such as shares in overseas companies.

Question 100

Financial derivatives - definition

Answer 100

> These are contracts whose value is based on the value of an asset, e.g. a foreign currency.

Question 101

Reserve assets - definition

Answer 101

> These are financial assets held by the Bank of England to be used as and when they are needed.

Question 102

What should the balance on the capital and financial accounts do?

Answer 102

> The current account should balance the capital and financial accounts.
However, due to errors and omissions they often don’t balance, so a balancing figure is needed.

Question 103

Capital account on the BoP - definition

Answer 103

> A part of the record of a country’s international flows of money. This includes transfers of non-monetary and fixed assets, such as through emigration and immigration.

Question 104

Financial account - definition

Answer 104

> A part of the record of a country’s international flows of money. This involves the movement of financial assets (e.g. through FDI).

Question 105

Short-term capital and financial flows

Answer 105

> Short-term flows (sometimes called ‘hot money’) are based on speculation and people/firms trying to quickly make money - e.g. by moving money from one currency to another expecting to make a profit through changes in exchange rates.

Question 106

Long-term capital and financial flows

Answer 106

> Long-term flows are due to things such as FDI and portfolio investment.
They’re usually quite predictable as, e.g., FDI is often made when a country gains comparative advantage in producing something, which tends to happen over a long period of time.

Question 107

Private vs official financial flows

Answer 107

> Private financial flows come from individuals and firms, and official financial flows go to and from governments and other official organisations.

Question 108

Interconnectedness of international economies

Answer 108

> International trade and capital flows mean that many firms and governments have interests and investments in lots of different countries.
This allows those firms and economies to grow in ways that wouldn’t otherwise be possible.
However, it also means that economies are now dependent on each other much more than ever before. E.g. a banking crisis in one country can now cause economic problems in many different countries (e.g. if foreign firms or governments have borrowed or lent money to banks that have collapsed.)
Similarly, if one country enters a recession, then this might cause problems for countries that trade with it.

Question 109

Interconnectedness of international economies - implication

Answer 109

> These connections mean that global trade imbalances carry a serious risk.
For example, the USA currently has a very large current account deficit, while China has a very large surplus. If the USA imposed tariffs to try and reduce their deficit, then other countries could retaliate with their own tariffs, harming trade and damaging economies.

Question 110

What does income depend on?

Answer 110

> In an economy, there’s a wide range of earnings. Earnings depend on a number of things, including:

1. Labour skill - training and education raises a person’s labour productivity and usually, their pay rate.
2. Market forces in the labour market - shortages or surpluses of various kinds of labour influence the wage rate.
3. Geography - in less prosperous parts of the country, earnings are lower.
4. Level of responsibility - in general, the greater the authority and responsibility of a job, then the higher the pay.

Question 111

Economic policy objectives - income distribution

Answer 111

> Governments may want to distribute income more equally to increase overall welfare or reduce poverty so there’s a better overall standard of living. Governments may also consider too much inequality in society to be unfair.
The redistribution of income can also benefit the economy. High earners tend to save more and low earners tend to spend more or all of it - so income redistribution will increase overall consumer spending, and raise AD, output and employment.
The government can redistribute income by reducing the net income of high earners and increasing the net income of people with no or low incomes - this can be done by:
-tax - especially income tax.
-welfare payments.
However, redistributing income carries a risk as some income differences are beneficial.

Question 112

Economic policy objectives - income distribution - benefits of income inequality

Answer 112

> The reward of higher wages acts as an incentive to hard work, training and risk-taking - so too little inequality would mean these incentives are lost and people will not work as hard.
Wealth creation can produce employment and income opportunities for others.
Spending by people with high incomes (e.g. on luxury goods that might not be purchased by those on lower incomes) creates jobs for others.

Question 113

Economic policy objectives - protecting the environment

Answer 113

> Environmental protection has become more important to governments.
Two of the main factors governments recognise are:
1. Damage/pollution to the environment.
2. Depletion of finite resources caused by continued economic growth.

Question 114

Economic policy objectives - protecting the environment - damage/pollution to the environment

Answer 114

> The role of the government is to:

1. Identify environmental damage caused by firms/individuals.
2. Measure the cost of this damage.
3. Use financial penalties or certain restrictions or bans to reduce environmental damage and provide incentive for firms/individuals to decrease the damage they cause. These might include:
   - Non-market policies: outright bans or limits on polluting practices.
   - Market policies: influencing the cost of polluting and therefore changing the behaviour of firms/individuals. E.g. tradable pollution permits, which put a restriction on the amount of pollution a firm can produce, but firms are allowed to buy/sell permits between themselves.

Question 115

Economic policy objectives - protecting the environment - depletion of finite resources

Answer 115

1. Some governments feel it’s necessary to use non-renewable resources more wisely to either avoid a future without, or just to make them last for longer.
2. E.g. governments might want to encourage the development and use of renewable energy resources. They might try to achieve this by giving financial incentives to firms to develop or use renewable energy.

Question 116

Economic policy objectives - economic stability - what will economic instability do?

Answer 116

> Economic growth tends to fluctuate up and down (i.e. economic cycle). This involves periods of high growth (booms) followed by periods of low or even negative growth (slumps, recessions).
If the fluctuations are frequent or particularly big then there will be economic instability. This will:
1. Discourage firms from planning any long-term investment, which harms the economy in the long run.
2. Discourage foreign firms from making investments, which means that the country misses out on extra money being brought into the economy and the creation of new jobs.

Question 117

Economic policy objectives - economic stability - government aims and actions

Answer 117

> Governments try to reduce the fluctuations in growth and avoid both slumps and booms. They try to this through a combination of fiscal and monetary policies.
Governments also try to avoid volatility in the rate of inflation, unemployment and exchange rates - big fluctuations in any of these will discourage investment and make it hard for governments and firms to plan for the future.
Economic stability will also depend on how politically stable a country is.
If governments are corrupt or can’t enforce the rule of law on their people then the country’s economy will be unstable too.

Question 118

Economic policy objectives - productivity

Answer 118

> Improving a country’s productivity will help future economic growth.
Governments don’t have much control over the productivity of private companies - but there are ways in which they can encourage improvements.
E.g. they might offer financial help to firms so they can buy more efficient equipment, or they could introduce regulations to increase competition between firms so that they’re forced to improve their productivity.
In the public sector, the government has more direct control over productivity. E.g. the UK government could improve the NHS’s productivity by introducing procedures that might be cheaper and/or more effective.
Governments can also improve productivity of society in general. E.g. the government could increase spending on schools and improve education, which will help to develop a better trained and more productive labour force.

Question 119

List of government objectives - 4 main ones + others

Answer 119

1. Strong economic growth
2. Keeping inflation low
3. Reducing unemployment
4. Maintaining an equilibrium in the BoP.
5. A more equal distribution of income and wealth.
6. Protecting the environment.
7. Maintaining economic stability.
8. Improving productivity and international competitiveness.

Question 120

Conflicts between economic objectives

Answer 120

> There are conflicts between policy objectives.
In the short run, governments decide which objective they think are most important and accept that these decisions may have an adverse effect on their other objectives - i.e. they make trade-offs between their objectives.
Governments may have to use short-term policies to correct sudden problems, such as major unemployment caused by a severe recession.
In a scenario like this the gov accepts that inflation will result from a policy designed to reduce unemployment quickly because it’s more important to get people back to work.

Question 121

Changes in AD

Answer 121

> Short run economic growth is caused by the AD curve shifting to the right.
If AD shifts right, output increase and unemployment decreases as labour is a derived demand.
If AD shifts right then there will be an increase in price level. High prices may also leaf to a lack of competitiveness internationally, meaning a decrease in exports, a rise in imports and therefore a worsening in the current account on the BoP.
So in this case an increase in AD will only help the gov. achieve 2 of its macroeconomic objectives.
However, a shift in LRAS curve will enable a government to achieve all 4 of the main macroeconomic policy objectives at the same time.
Increase in output, fall in unemployment, price level falls and this will improve a country’s competitiveness - improving the BoP.
This suggests that if the government only used demand-side policies to achieve its macroeconomic objectives then this would lead to conflict between its objectives. However, supply-side policies are more likely to help a government achieve their 4 main ones in the long run.

Question 122

List of conflicts between macroeconomic objectives

Answer 122

> These objectives are likely to conflict in the short run, but in the long run these conflicts may not occur if AS increases.

1. Inflation and unemployment.
2. Economic growth and environmental protection.
3. Economic growth and inflation.
4. Inflation and equilibrium in the BoP.
5. Economic growth and a reduction in wealth inequality.

Question 123

Macroeconomic objective conflicts - inflation and unemployment.

Answer 123

> When unemployment is reduced and the economy begins to approach full capacity, there are fewer spare workers, so demand for workers increases - especially for skilled workers. This leads to an increase in wages and the extra cost of this may be passed on by producers to consumers in the form of higher prices - causing cost-push inflation.
Low unemployment may cause consumers to spend more because they feel more confident in their long-term job prospects. This may cause prices to rise due to demand-pull inflation.
So reducing unemployment makes it more difficult to keep inflation at the preferred low rate.

Question 124

Macroeconomic objective conflicts - economic growth and environmental protection

Answer 124

>Economic growth can put a strain on the environment.
>Pollution
>Waste disposal
>Depletion of natural resources
>Damaged ecosystems

Question 125

Macroeconomic objective conflicts - economic growth and inflatioin

Answer 125

> A rapidly growing economy can cause large increases in prices, due to an increase in demand. This will cause a higher than desirable level of inflation.
Similarly, attempts to keep inflation low can restrict growth. E.g. if IRs are kept high to reduce inflation by discouraging spending this can restrict economic growth.
This can also cause conflict between growth and equilibrium in the BoP as high inflation is likely to worsen the BoP.

Question 126

Macroeconomic objective conflicts - inflation and equilibrium in the BoP

Answer 126

> Sometimes the government’s objectives for low inflation and equilibrium in the balance of payments will be compatible, other times they’ll conflict.
E.g. if inflation is low, this implies that prices are rising slowly. If prices rise more slowly than those in other countries, then exports will increase and imports decrease. Increasing a surplus on the BoP, reduce deficit.
However, low inflation is often maintained by high interest rates. High IRs encourage foreign investment, which increases demand for the domestic currency - increasing its value. Exports more expensive, imports cheaper so reduce BoP surplus and increase deficit.

Question 127

Macroeconomic objective conflicts - economic growth and a reduction in wealth inequality

Answer 127

> Economic growth can increase inequality, as not everyone benefits equally from a growing economy.
E.g. as an economy grows, highly skilled workers may become more in demand, while the demand for low-skilled workers may fall.
Governments can choose to use increased tax revenue from economic growth to decrease this inequality by:
1. Increasing welfare payments.
2. Using progressive taxes.
3. Increasing the min wage in line with increase in the average wage.
However, increasing taxes or welfare payments may damage future economic growth. E.g:
-high taxes may be a disincentive for individuals and businesses to earn and grow.
-extra welfare payments may not encourage people to work (however, some welfare benefits can help economic growth like help with childcare costs).
Supply-side policies that help people back to work and reduce geographical and occupational labour immobility would encourage growth, while reducing the welfare budget and unemployment.

Question 128

Natural rate of unemployment - definition

Answer 128

> The natural rate of unemployment (NRU) is the rate of unemployment when the labour market is in equilibrium - this is when the labour demand is equal to labour supply.

Question 129

NRU

Answer 129

> The Natural Rate of Unemployment.
When there’s equilibrium in the labour market that means there’s enough jobs for every worker in the labour force but that doesn’t mean that every worker will be in a job (because of frictional and structural unemployment).
There can be unemployment when the labour market is in equilibrium, and the rate of that unemployment is the NRU.
The NRU can be seen as corresponding to full employment, as it’s not possible for every person in the workforce to have a job. No matter how much AD is increased, frictional and structural unemployment will always exist.

Question 130

What shows the trade-off between inflation and unemployment?

Answer 130

The Short Run Phillips Curve

Question 131

The Short Run Phillips Curve

Answer 131

> The short run Phillips curve shows an apparent trade-off between inflation and unemployment.
By plotting historical inflation and unemployment data, the economist A.W. Phillips found that as inflation falls, unemployment seems to rise, and vice versa.
So it looks like if the government wants to reduce unemployment, then it can increase AD to achieve this…as long as it’s prepared to accept higher inflation.
However, not everyone agrees that it’s quite this simple.
One problem is that once inflation has gone up, people seem to expect it to remain high (adaptive expectations) and change their behaviour accordingly.

Question 132

Adaptive expectations

Answer 132

> The idea of ‘adaptive expectations’ - i.e people using the past to predict what’s going to happen in the future.
So if inflation is high today, then people will expect it to be high tomorrow as well.
This can lead to high inflation becoming ‘embedded’ in an economy, even if the government is trying to reduce it.

Question 133

Keynesian economists and the Phillips curve

Answer 133

> The Phillips curve shows the same idea as appears in the curved section of a Keynesian LRAS curve.
The horizontal part - workers will take jobs even if the wages are low and output increases with little effect on inflation.
The increasing part - as output rises (and unemployment falls), there is an increase in prices (inflation). This is the same relationship as shown in the short-run Phillips curve.

Question 134

NAIRU

Answer 134

> The Non-Accelerating Inflation Rate of Unemployment (NAIRU) is the lowest rate of unemployment that can exist in the long-run without leading to changes in the rate of inflation.
E.g. if NAIRU is 5% then unemployment below this level will lead to increases in inflation, but unemployment above this level will not.

Question 135

Phillips Curve relationship - against

Answer 135

> In the 1950s and 60s, governments used the Phillips curve to try and manage the trade-off between inflation and unemployment.
However, in the 1970s the relationship between unemployment and inflation seemed to break down as there was a period of ‘stagflation’.
It was monetarist economists who put forward an explanation for this:
-They said that the short run Phillips curve only takes into account the current rate of inflation. It doesn’t take into account the influence of the expected rate of inflation. That’s where the long run Phillips curve comes in.

Question 136

Long-run Phillips curve

Answer 136

> Assume the economy has unemployment at its natural rate (NRU).
At this point inflation is at 0% and this will influence things like worker’s wage negotiations.
However, if AD increases and this unemployment below the NRU then this will cause wage demands to go up and inflation will increase (to 3%).
At this point economic agents now expect inflation to stay at 3% and as a result, future wage negotiations will be based on inflation being at 3%.
Higher wage demands will mean firms are less willing to take on workers, so unemployment will rise back to the NRU. So the short run Phillips curve will shift right.
When the SRPC shifts right, you can see that, despite unemployment returning to the NRU, an inflation rate of 3% has become ‘embedded’ in the economy. Further increases in AD will mean that higher inflation rates can become embedded in the economy.
This shows how important it is for governments to use policies that stop inflation rising continuously. In the UK, the Bank of England is tasked with keeping inflation close to the target rate of 3% so that the expectations of economic agents are based on 2% inflation. On top of this, governments will use policies to lower unemployment and even lower the NRU.

Question 137

Monetarists - relationship between inflation and unemployment

Answer 137

> Monetarist economists say there is no trade-off between inflation and unemployment.
In the long run Phillips curve above, the increase in AD caused inflation to rise. However, there was no long-term effect on unemployment - this eventually returned to the NRU.
This idea led the monetarist economists who first suggested the idea of adaptive expectations to conclude that there was no long-term link between inflation and unemployment:
-no matter how the SRPC shifts, unemployment will always return to the NRU.
-so the LRPC will always be a vertical line coming up from the NRU.
-this means that in the long run there is no trade-off between unemployment and inflation.
In fact, many economists say the short run Phillips curve relationship (that you can trade off inflation against unemployment in the SR) doesn’t exist either.
The significance of Phillips curve isn’t clear.
Supply-side policies may mean that low unemployment and low inflation can exist at the same time. However, at times it does seem that unemployment-inflation trade-off exist. In practice, the Phillips curve is now only used in short run economic policy-making.

Question 138

Demand-side policies and unemployment - solutions

Answer 138

> Economists argue over the theory of how an economy works. Governments have to get on with the practical business of making policies.
Here’s some of the issues they face, and the solutions they can try to use:
1. To reduce unemployment, governments need to understand what type of unemployment they’re trying to tackle.
2. During a recession an economy is likely to have cyclical unemployment, so a government would need to introduce policies that boost AD. E.g. could use reflationary fiscal policies like decreasing taxes or increasing welfare payments, or expansionary monetary policies, such as lowering IRs.

Question 139

Demand-side policies and unemployment - problems

Answer 139

> There are problems.
Lack of information about the size of an economy’s output gap may mean that the government overspends when it tries to boost AD and causes the economy to ‘overshoot’ - leading to inflation. Alternatively, the government might under-spend and prolong a recession.
A lack of information about the size of the multiplier can cause problems too. E.g. if the multiplier in a country is bigger than the government expects, then an increase in government spending could cause inflation.
It’s hard for a government to use demand-side policies to fine-tune the economy - they can be quite clumsy and cause more problems.
Time lags can also mean that improvements are slow to develop - governments may think that their policies aren’t working, so they increase spending further and create inflation.

Question 140

What can reduce the NRU?

Answer 140

> Supply-side policies.

Question 141

Supply-side policies - NRU - general

Answer 141

> To reduce the NRU governments need to use supply-side policies that make the labour market more flexible, and reduce frictional and structural unemployment.
The flexibility of labour is determined by 3 important factors: 1. Labour mobility, 2. Wage flexibility, 3. Flexibility of working arrangements.
So, policies that improve labour market flexibility will focus on improving these 3 factors.
Frictional unemployment will be reduced by policies which encourage people to find a job and speed up this process.
Structural unemployment will be reduced by policies which tackle geographical and occupational immobility.

Question 142

Reducing the NRU - supply-side policies - labour market flexibility

Answer 142

> Policies that improve labour market flexibility will focus on improving labour mobility, wage flexibility and flexibility of working arrangements.
Labour mobility can be tackled by the same policies that are used to reduce structural unemployment.
Governments can improve wage flexibility by scrapping the NMW and limiting TU power.
The flexibility of working arrangements could be improved if the government passed laws that made it easier for firms to hire workers on short-term or zero-hour contracts.

Question 143

Flexibility of labour - the 3 important factors list

Answer 143

1. Labour mobility.
2. Wage flexibility.
3. Flexibility of working arrangements.

Question 144

Flexibility of labour - the 3 important factors - labour mobility

Answer 144

> Labour mobility is the ability of workers to switch jobs easily.
The more transferable skills workers have, the more easily they can switch jobs - so labour mobility will depend on how skilled workers are.
On top of that, labour mobility will also depend on the willingness of workers to move where there are jobs.

Question 145

Flexibility of labour - the 3 important factors - wage flexibility

Answer 145

> Wage flexibility is the ability of wages to change with changes to the labour market (i.e. respond to supply).
For example, during a recession, employers can lower wages to avoid having to lay off workers.

Question 146

Flexibility of labour - the 3 important factors - flexibility of working arrangements

Answer 146

> Flexibility of working arrangements is the ability of employers to hire workers in a way that suits them.
Things such as part-time work, short-term contracts (or zero-hour contracts) or shift employment make it easier and cheaper for firms to hire of fire workers and respond to changes in the market.

Question 147

Reducing the NRU - supply-side policies - frictional unemployment

Answer 147

> Frictional unemployment will be reduced by policies which encourage people to find a job and speed up this process:

1. Reducing benefits will give unemployed workers a greater incentive to find and it will help the government avoid the unemployment trap (where unemployed workers are better off than those working on low wages).
2. Income tax cuts will increase the incentive for workers to find a job, or encourage them to work longer hours.
3. Increased information about jobs will help workers find the right job for themselves more quickly.

Question 148

Reducing the NRU - supply-side policies - structural unemployment

Answer 148

> Structural unemployment will be reduced by policies which tackle geographical and occupational immobility:

1. Governments can improve occupational mobility by investing in training schemes that help workers to improve their skills, or by encouraging firms to set up their own training schemes.
2. Geographical immobility can be tackled by giving workers subsidies to move to different areas or by building affordable housing in areas that need workers. However, workers will still often be reluctant to leave their homes and families.
3. Governments can bring jobs to areas with high unemployment by providing benefits to firms that locate in certain areas. This might be combined with training schemes to give local workers the skills required for the jobs provided.

Question 149

What is used to tackle demand-pull inflation?

Answer 149

Monetary policy.

Question 150

What can be used to tackle cost-push inflation?

Answer 150

Supply-side policies

Question 151

Inflation and government policies

Answer 151

> Governments also need to use policies that deal with demand-pull and cost-push inflation.
Monetary policy is usually used to tackle demand-pull inflation.
The supply-side policies used to tackle frictional and structural unemployment are the kinds of policies often used to tackle cost-push inflation.

Question 152

Income - definition

Answer 152

> An individual’s income is the amount of money they receive over a set period of time.
Income comes from many sources, e.g. wages, interest on bank accounts, dividends from shares and rent from properties.

Question 153

Wealth - definition

Answer 153

> Wealth is the value in money of assets held - assets can include property, land, money and shares.

Question 154

Income and wealth

Answer 154

> In the UK, and most other economies, income and wealth aren’t equally distributed.
Wealth is more unevenly distributed than income.
Income and wealth are not distributed equally in a market economy.

Question 155

Factors affecting the distribution of income

Answer 155

1. People earn different wages: certain skills are more in demand than others, so workers with those skills are likely to receive higher wages.
2. Unwaged people (e.g. unemployed, pensioners) often rely on state benefits, so their incomes tend to be lower.
3. Tax and state benefits - in the UK there’s a progressive tax system. Those with higher incomes are taxed a higher percentage of their earnings over certain levels. Some of this tax is then redistributed as benefits, e.g. to the unemployed, or people with disabilities.
4. Compared to the private sector, workers in the public sector (on average) earn more per week.
5. Average full-time earnings also differ considerably between different regions. The highest are in London and the South East. In 2013, the North East and Northern Ireland were the 2 lowest paid regions.

Question 156

Why is wealth more unevenly distributed than income?

Answer 156

> Wealth often earns income - e.g. shares may increase in value and generate more income. Those who earn income from their wealth could invest that income again, which in turn will generate more income and so on. This means wealthy people become even wealthier, whereas those with low wealth don’t have much if anything to invest, so their wealth will only grow by a small amount if at all.
Assets tend to increase in value more quickly than income rises.
In the UK, income is taxed, but wealth isn’t - so it’s much easier to redistribute income than wealth.

Question 157

What shows and measures inequality?

Answer 157

> The Lorenz Curve shows the extent of inequality in the distribution of income.
The Gini Co-efficient is a measure of inequality.

Question 158

Lorenz Curve

Answer 158

> The Lorenz curve can be used to represent the distribution of income graphically.
Along the horizontal axis is the cumulative percentage of the population, and up the vertical axis is the cumulative percentage of income.
A diagonal line represents complete equality.
The further the Lorenz curve is from the diagonal, the greater the inequality in the country.
The Gini coefficient, a measure of inequality, can be found from the Lorenz curve.

Question 159

Gini coefficient

Answer 159

> The Gini coefficient, a measure of inequality, can be found from the Lorenz curve.
Formula = area A divided by (area A + area B).
A coefficient of 0 represents complete equality and 1 represents complete inequality (one person earns all the income).
Wealth and income inequality have become greater in many countries (inc. the UK) since the early 1980s with the highest incomes growing particularly quickly.
Lorenz curve and Gini can also be used to represent the distribution of wealth.
Gini Coefficient in the UK 1979 = 0.27, 2013 = 0.33.

Question 160

Equality - general

Answer 160

> Equality means that everyone is treated completely equally - they all get exactly the same things.
Equality is positive (it’s objective and deals with facts)..

Question 161

Equity vs equality

Answer 161

> Equality is positive (it’s objective and deals with facts), whereas equity is normative (it’s subjective and based on opinion.)

Question 162

Equity

Answer 162

> There are 2 types of equity:

1. Horizontal equity: people with the same circumstances are treated fairly (i.e. they are treated the same).
2. Vertical equity: people with different circumstances are treated fairly but differently.

Question 163

Positives of unequal income and wealth distribution.

Answer 163

1. Inequality provides incentives for people to work harder and earn more - so rewarding hard work increases productivity.
2. It encourages enterprise by those who have the funds available to start a business.
3. It also encourages people to work instead of claiming benefits.
4. It may create a trickle-down effect - some economists argue that if there’s inequality and greater economic growth, the rich will become even richer and spend more on goods and services, providing more income for the poor. This is known as the trickle-down effect. As a result, relative poverty may increase, but absolute poverty will decrease.

> Perfectly equal distribution could be seen as inequitable as doesn’t reward hard-work and risk-taking.

Question 164

Trickle-down economics

Answer 164

> Some economists argue that if there’s inequality and greater economic growth, the rich will become even richer and spend more on goods and services, providing more income for the poor. This is known as the trickle-down effect. As a result, relative poverty may increase, but absolute poverty will decrease.

Question 165

Negatives of unequal income and wealth distribution

Answer 165

1. Absolute and relative poverty can remain high.
2. It restricts economic growth and wastes people’s talent, because the poorest won’t have the funds to start a business.
3. As incomes rise even higher, [ep[;e generally spend more on imports so this money would leave the circular flow.
4. Crime is likely to increase because people don’t have what they need.

Question 166

Types of poverty

Answer 166

1. Relative poverty

2. Absolute poverty

Question 167

Relative poverty - definition

Answer 167

> Relative poverty is when someone has a low income relative to other incomes in their country.
E.g. people whose income is less than 50% of the average income might be classed as living in relative poverty.
So someone from a rich country might be classed as living in relative poverty, even though someone in a much poorer country with the same income might be considered wealthy.

Question 168

Absolute poverty - definition

Answer 168

> Absolute poverty is when someone can’t afford the very basics - e.g. food and shelter.
The minimum income needed for these basics is called the poverty line (e.g. the World Bank uses a poverty line of $2 per day).

Question 169

Causes of poverty

Answer 169

1. Unemployment: even in a country where the state gives unemployment benefits, the unemployed are likely to be at the bottom level of income in that country.
2. Low wages: workers most likely to receive low wages are those with few skills or qualifications.
3. State benefits rising more slowly than wages: this means the relative incomes of people relying on state benefits fall over time.

Question 170

The Poverty Trap

Answer 170

> The poverty trap can affect people who are in poverty: these may be people relying on state benefits or those on low wages and means-tested benefits.
When these people earn higher wages, they may only actually receive a small percentage of their wage increase. This is because they’ll need to pay income tax and National Insurance contributions (in the UK), and have their benefits reduced (because they are earning more money).
In some cases, this could even cause a drop in their disposable income, and this means their marginal tax rate will be high.
So the combination of income tax, NI and the benefit system can result in a disincentive for these people to find work, or to increase the number of hours they work. Governments may attempt to remove these disincentives.

Question 171

Means-tested benefits - definition

Answer 171

> Benefits based on people’s wage.

Question 172

Marginal tax rate

Answer 172

> Marginal tax rate is just the percentage (tax) that’ll be taken from the next pound you earn.

Question 173

Government policies to tackle poverty

Answer 173

> Governments often intervene to try to alleviate poverty.
Governments can use these 3 policies to redistribute income and wealth after it’s been earned:
1. Benefits
2. State provision
3. Progressive taxation.
Or these 2 policies can be used to change the amount of income people receive instead:
1. Economic growth
2. National Minimum Wage (NMW).

Question 174

Government policies to tackle poverty - benefits

Answer 174

> Benefits are used to redistribute income - tax revenue (from those with higher incomes) is used to pay for the benefits of those who need them.
However, as means-tested state benefits contribute to the poverty trap, governments might:
-Remove means-tested benefits completely. This would increase the incentive to work. However, at least in the short term, it would cause larger differences in income, and relative and absolute poverty would increase.
-Change means-tested benefits to universal benefits. But the cost of these extra benefits might mean that those on low incomes are taxed more.
-Reduce means-tested benefits more gradually as income increases.

Question 175

Government policies to tackle poverty - state provision

Answer 175

> State-provided services, such as health care and education, help to reduce inequalities caused by differences in income - e.g. someone on a low income can receive the same health care as someone on a high income.
State-provided services also redistribute income because most of the money to pay for them comes from taxing people with higher incomes. But free access reduces the incentive to work and is expensive to provide.

Question 176

Government policies to tackle poverty - progressive taxation

Answer 176

> Progressive taxation means a bigger percentage of tax is taken from workers with high incomes than those with low incomes. It helps to reduce the difference between people’s disposable incomes, reducing relative poverty.
But progressive taxation can contribute to the poverty trap. Also, if high income earners are taxed too much, some may move to a country where they’re taxed less. This will mean a loss of labour and money from the economy.

Question 177

Government policies to tackle poverty - economic growth

Answer 177

> Perhaps the most effective way of reducing poverty is through economic growth. This will mean jobs are created and unemployment will be reduced. It also tends to lead to higher wages, meaning the government will gain more tax revenue, which it can use to provide services.
However, economic growth can be difficult to achieve. It can also result in larger inequalities in income - for example, economic growth might mainly benefit the rich so that they become even richer. It can also cause problems such as the using up of finite resources, which might mean more poverty and inequality in the future.

Question 178

Government policies to tackle poverty - National minimum wage (NMW)

Answer 178

> A national minimum wage, if it’s set at a sensible level, will reduce poverty among the lowest paid workers. It will provide an incentive to work, and will help those on low incomes to afford a reasonable standard of living. A NMW can also counteract monopsony power - e.g. if an employer with monopsony power is paying low wages, resulting in workers being in relative or absolute poverty.
However, the NMW might mean some employers employ fewer people. This would mean a rise in unemployment, and therefore a rise in poverty. A NMW also doesn’t take into account that the cost of living varies depending on where someone lives, so the standard of living for people who are earning the NMW will vary depending on where they live (while anyone who’s unemployed won’t benefit from a NMW at all).