Unit 4 - Economics

The effects of unemployment

Unemployment has very strong and undesirable effects on an economy - on consumers, workers, firms, the government and society as a whole. Here are some of the issues in the case of each of these stakeholder groups. - Consumers/workers: People who lose their jobs also lose their incomes and thus their spending power. They have to cut back on their expenditure, do without the less necessary items and substitute lower priced for higher priced items. They will probably draw on any savings they may have, especially to finance an unexpected life event such as a family wedding, and they are more likely to get into debt to enable them to maintain their lifestyle. Unemployment is especially hard for people who are already in debt. In 2009 and afterwards, many people who lost their jobs had mortgages on their homes and also had outstanding personal loans and credit card bills. In such a situation unemployment leads to people defaulting on their mortgages and having their homes repossessed, and also to high levels of bankruptcy. People who lose their jobs are no longer practising their profession or trade and the longer the period of unemployment continues, the more they become detached from their skills. This increasingly hinders their ability to find a new job. This is an example of hysteresis. -Firms: Businesses face a fall in demand for their products, especially if they are selling luxuries that people can do without such as new cars or meals in restaurants. Some people cancel life insurance policies when they become unemployed. Conversely, businesses selling lower priced substitutes do well. During the post-crisis recession, a lot of pound shops opened and budget supermarkets such as Lidl and Aldi took a considerable amount of trade away from supermarkets like Tesco and Sainsbury. When demand falls, firms have to decide whether to lay off their workers or to keep them on, perhaps on shorter hours. During the recent recession, a lot of firms did the latter so that the workers would not lose their skills and in the hope that the recession would not last too long. However, many firms found their profits falling and turning into losses and weaker firms closed down, especially smaller businesses which did not have the backing of a large company and which found it hard to extend their credit lines with their banks. -The government: Unemployment is a problem for the government in that it is part of government macroeconomic policy to keep the jobless figures low. As people lose their jobs and spend less, a snowball effect takes place because the lower spending creates less demand for other people's jobs and so the situation becomes aggravated. Unemployment affects the government's finances adversely. Since many people are not working, they are not paying income tax, and they are spending less so pay less VAT. At the same time the government has to pay out more in unemployment and related benefits. So the public sector finances are hit from both sides and government has to borrow more, making the public sector debt higher. - Society: Unemployment is a problem to society. Not only are large numbers of people having to manage on a lower income but they also suffer from not having a purpose. They can suffer physical and mental health problems, including depression. This is not only a problem for themselves and their families but it also places an increased burden on the health and social services. Some people may even turn to crime and this causes additional problems for the police. These are negative externalities and constitute a welfare loss to society. Communities suffer when large numbers of their members are out of work. People cannot afford to maintain their homes and the housing stock can deteriorate. Town centres become less vibrant, with increased numbers of charity shops and vacant shop premises. As a general conclusion, we can say that unemployment is a waste of an economy's resources as the productive potential which sits in each factor of production is idle and not being put to use. There is a huge opportunity cost in terms of lost output and of the additional cost put on the state.

Limitations of the CPI

The CPI has certain limitations as a measure of inflation. The first is that, like all other indices, it gives one monthly result to represent the rate of inflation throughout the country. For example, the official rate of CPI inflation in the UK in June 2015 was 0.0%. This means that, according to the index, prices were stable and there was no inflation. This is the figure that results from changes in prices in the 700 items chosen and in their weights, which are considered to be typical of most people. But in practice, we all have our own personal rate of inflation, depending on our spending habits. For example, a rise in the price of oil pushes up the price of petrol and this makes quite a big difference to someone who drives many miles every day between home and work. But it has less of an effect on someone who does not drive a car, although this person may still have to pay more for electricity. In 2012 and 2013 global food and oil prices rose by a large percentage and these price increases pushed up the CPI. However, the rise in the CPI was less than the rises in these particular commodities because they were not the only goods in the index and because the prices of other products were rising by only a small amount. The CPI therefore underestimated the effect of the food and oil price rises. This was especially the case for people on lower wages or on benefits, who spend a greater proportion of their incomes on basic foodstuffs and energy. The personal inflation rates of such people were much higher than the CPI suggested. Allied to the above point is the feeling expressed by many that the CPI tends to concentrate on the buying habits of urban consumers and excludes those of the rural population. There would be fuller information if separate indices were also produced for different demographic groups. The next limitation concerns the fact that the prices of different products within the same group rise at different rates. Consumers tend to shift from more expensive products and turn to cheaper substitutes. But the CPI does not allow for this and, unless there is a good reason for changing the weights, the index will assume that people are continuing to buy the same amount of all the products in the group, including the dearer ones. So the index does not take account of consumer strategies to make the most of their money. The quality and performance of many products improve over time, notably in the case of electronic products, but a price index assumes that the quality of the product group does not change. For instance, if the price of televisions rises by 5% between 2014 and 2015, this may not mean that sellers are charging 5% more for exactly the same set. The new, more expensive television may incorporate additional features and so some of the rise in price may reflect a rise in quality. Indeed, the CPI is restricted by the very fact that it must choose a limited number of products and follow only some movements in their prices. However, the nature of statistical sampling is that if it is done with a large enough group of people and products, the final result should be fairly representative.

What alteration in aggregate supply is illustrated in Figure 3.11 below?

Check notes - contraction in aggregate supply AS has contracted due to a decrease in AD.

Which change would increase aggregate supply? a) increase in consumer spending b) increase in corporation tax c) increase in the cost of production d) ncrease in the age at which people can take their state pension

d) ncrease in the age at which people can take their state pension An increase in the retirement age will increase the size of the labour force and so increase the maximum output the economy is capable of producing. (a) would increase AD. (b) and (c) would cause a decrease in AS.

Effects of inflation - continued

-Firms: Inflation affects firms by causing their raw material, wage and energy costs to rise. Individual firms will be affected differently according to the extent to which they are able to pre-empt these rises, for example, by purchasing their raw materials in the forward market, where they can set the price in advance while it is lower. The effects will also depend on the extent to which firms are able to keep their wage costs down, perhaps by good industrial relations and by promising wage rises later. In a period of inflation, no firm can put off facing a rise in its costs for long and the effect of the inflation depends on the extent to which the firm can raise its prices to cover its higher costs and still keep its markets. This in turn depends to a large extent on the degree of price elasticity of demand for its products (go back to Topic 3 in Section 1 if you are unsure of the meaning of this concept). Firms that produce necessities (products whose prices are low relative to people's incomes or products without close substitutes) are less likely to lose a lot of sales even when prices rise because the demand is relatively price inelastic. But firms that produce more expensive luxury products with many substitutes are more likely to lose markets and to earn lower profits. Firms are also affected in foreign markets. If exporters raise their prices because of inflation, they will be less competitive in international markets and especially against firms from countries where the inflation rate is lower. Second, they will be affected by changes in the exchange rate of the currency. If a country is experiencing inflation, and if this results in a fall in confidence in the country, the exchange rate of the currency may fall and this would make it relatively cheap for firms to sell their products in export markets. However, it will make it more expensive to import raw materials and services. -The government: The government is affected first and foremost by inflation because it has the job of controlling it as part of its macroeconomic policy. It takes responsibility for the problems caused by inflation and it has to devise policies to restore price stability. But the government itself is affected via its need to collect taxes and to finance public expenditure. The government collects more money in taxes as money incomes and profits increase with inflation, but the real value of every pound collected reduces. On the other hand, as inflation tends to redistribute income from the lower paid to the higher paid, the government continues to receive direct taxes from people whose real incomes have not fallen and indirect taxes from the money they continue to spend. In the end, the effects of inflation on the working and spending population will have a knock-on effect on the government's finances. The government is also a debtor as it borrows money to finance that part of its expenditure that is not covered by taxation. It has to pay interest on its debts and, assuming that interest rates rise to combat inflation, the government's debt-servicing costs will rise. But the value of the outstanding debt is reduced by the inflation. However, any new public sector projects being undertaken will cost more. Inflation also affects the country's balance of payments which is the responsibility of the government. Briefly, the balance of payments is the difference between the foreign currencies the country earns and spends. If inflation makes exports less competitive and imports more so, the balance of payments will worsen. Other things being equal, this would cause a fall in the price of the currency on the foreign exchange markets making imports more expensive, adding to inflation. Inflation causes the money supply to perform its functions less efficiently. We have seen above that there is a redistributive effect on savers and borrowers, depending on interest rates. The unit of account function does not operate so well because, as money is losing value, people lose track of the value of the monetary unit (the pound). They have to keep getting used to higher prices. Firms have to spend money regularly on rewriting their catalogue prices and accountants have to make adjustments for changes in the values of assets and liabilities. This is known as a 'menu cost'. The medium of exchange function is not affected by a mild or controlled inflation, but in the event of a very high rate of inflation (known as hyperinflation), when prices rise continuously, people desert money and turn to barter. From the above it should be clear that the overall net effect of inflation on all sectors of the economy is the result of many complex and interlocking relationships. A low and controlled rate of inflation can be seen as a sign of a growing economy and not as a problem, since the redistributive effects are limited. But a high rate of inflation, which threatens to get out of control, is a serious problem. It is a sign of greater uncertainty and that people are losing confidence in the economy and it threatens the continued operation of the money supply.

The long-run (LRAS) curve

By definition the short run lasts only while firms are able to produce more output with their existing capacity. Both the factors which cause firms to increase their supply in response to a rise in prices (and vice versa) cease to apply. - Firms cease to have the advantage of raising their prices without having to pay higher costs as workers negotiate higher wages and as fixed-term, fixed-price contracts expire and are replaced with new ones at higher prices. This can apply to suppliers' prices, rents and interest rates. Firms' profit margins are squeezed and they no longer respond by supplying more. - In the short run firms were able to expand their production by using their existing factors of production more intensively but now they reach the point of full capacity. This means that they cannot produce any more units in response to a price rise unless they increase their capacity by spending more on labour recruitment and on capital investment. So we move into the territory of the long-run aggregate supply (LRAS) curve. There are two main schools of thought on the shape of the LRAS curve and a third which combines them. -The classical LRAS: The classical economists were those writing in the eighteenth and nineteenth centuries. Many of their ideas were adopted by twentieth-century economists who became known as neo-classical economists. Their view was that a change in aggregate demand, and therefore in the price level, will not affect the level of real output. This is because the classical school believed that an economy would reach a point of full employment at which there is no spare capacity. At this point, everyone who wants a job at the existing wage rate will be able to find a job. So when aggregate demand rises (AD2), prices will rise and aggregate supply will not change. The LRAS curve is therefore perfectly inelastic and it looks like the graph in Figure 3.3 below. Since demand is higher but supply cannot respond, prices rise and the economy suffers from inflation. -The Keynesian LRAS: A view of the LRAS was developed by John Maynard Keynes. He believed that the curve is perfectly elastic in the short run because of the flexibilities discussed above. This means that firms can easily increase or decrease their supply in response to a change in the price level but only while factors of production are working below capacity. Once full capacity is reached and once short-term contracts expire, firms have to spend more money on producing more. Keynes believed that the LRAS will become perfectly inelastic at this point, as shown by point Y1 in Figure 3.4 below. So the Keynesian view is that an increase in aggregate demand results in a rise in aggregate supply up to the point where the economy is working at full employment. After this, a further rise in aggregate demand is not matched by a rise in any more supply and the result is inflation. - The modern compromise: This view brings together the classical and Keynesian approaches to the AS curve. It looks like the curve in Figure 3.5 below. It begins at low levels of GDP with the classical/Keynesian short-run aggregate supply curve where there is spare capacity and where it is possible to increase output without raising costs of production and the price level. This situation exists up to the point Y on the real GDP axis. Between Y and Y1, however, pressure begins to be placed on capacity; shortages begin to be felt in skilled labour and factory or office space and so unit costs begin to rise and the AS curve starts to slope upwards. At Y1 the full employment level of resources is reached and the AS curve becomes vertical. Y1 is the maximum real national output that the economy can produce using existing resources; after this the economy experiences inflation. - Movements along the AS curve: Movements along the AS curve are caused by changes in aggregate demand. They may be accompanied by a rise in real GDP and/or the price level. Figure 3.6 shows aggregate demand increasing from AD to AD1. As a result the price level rises from P to P1 and aggregate supply extends from Y to Y1.

Consumption

Consumption is the most significant factor in aggregate demand. It is the expenditure by households on goods and services to satisfy current wants, such as spending on food, clothes, cars and insurance. The word 'consumption' implies that these items are used up quickly and have to be replaced. This certainly applies to items such as food and electricity, but items such as clothing and electronic appliances and other consumer durables last for a period of time. Because they are used by households they are however classed as consumption, and they do lose value over time and need to be replaced. Houses are the main investment item purchased by households. The following are the main determinants of household spending. -Disposable income: A large amount of the money people spend is financed by their income (Y). So the amount of aggregate consumption is determined largely by the size of aggregate income. This is sub-divided as follows: - Total wages and salaries earned by people from their employment. - Total rents received from people who let property. - Total interest earned by people from their savings and investments. - Total profits earned by people who are self-employed and shareholders of companies. The sum of all of the above has to be reduced by the amount of tax paid by people on all of these incomes, since they cannot spend money paid in taxes. But we also have to add on the amount received by people in state benefits, since these boost their spending power. The total that then emerges is known as disposable income. Disposable income = total income - direct taxes + state benefits -Relationship between consumption and savings: As disposable income rises, the total amount of household spending also rises. However, the proportion of income spent normally falls. This is because as people get richer they can afford to save more of their income. Note that saving (S) is that part of total income that is not consumed, so all income is either consumed or saved: Y = C + S For example, someone with an income of £400 a week may have to spend it all to cover rent, heating, light, the purchase of food and other necessities, whereas someone receiving £4,000 a week may spend only 75% of their income and save the other 25%. So as the total population gets richer, the proportion of total income spent may fall as the proportion of total income saved rises. However, as people on higher incomes are able to save more than those on lower incomes, total consumption is determined not only by the size of total income but also by its distribution. The more evenly income is distributed between people, the more is likely to be spent and the less is likely to be saved. In an economy where income is very unevenly distributed, the majority of people are on low incomes and save nothing. If incomes now increase in such a way that there is a more even distribution, people on low incomes will spend most of their additional money on goods and services they wanted to buy previously but could not afford. The amount people save is determined by whether their incomes are high enough to allow them to put money aside every month, but it is also determined by how important they feel it is to save. People save up for life events such as a family wedding, for future emergencies (the 'rainy day') and also for their retirement. Because an ageing population will put a lot of pressure on future governments, people are now realising that they need to save more for their retirement years by taking out a pension plan. - Wealth: Household spending is also determined by the amount of wealth, as opposed to income. Wealth is the value of the total of assets that people own, such as shares and houses. A rise in wealth tends to encourage people to spend more. For example, if the price of houses increases, people who own their own homes feel better off and increase their spending. Before the financial crisis in 2008, house prices rose considerably, giving property owners additional 'equity', the difference between the value of the property and the amount they owed on it. The additional equity was used as security for bank loans, which financed more consumption. But the fall in house prices after 2008 led to a slowdown in the growth in consumer spending and left a lot of people with negative equity, which meant that they owed more on their property than its market value. - Cost and availability of credit: A lot of consumer spending is financed not by current income but by borrowing via credit cards, hire purchase, bank loans and other forms of credit. The easier and cheaper it is to obtain credit, the more people tend to spend. Credit increased hugely in the pre-crisis period, but since 2008 UK banks have been more reluctant to lend, especially to high-risk borrowers. Financial regulations are now in place which require lenders to take affordability into account when granting loans. The amount that people are able to borrow also depends on the level of interest rates. At the time of writing (July 2015), the level of interest rates in the UK is very low compared with previous periods. But borrowing money via credit cards and personal loans is still expensive. When interest rates rise, these forms of credit will become more expensive still and this will choke off a certain amount of consumption. - Consumer confidence: The amount of money that people spend and save depends to some extent on their confidence in the future. In particular it depends on how safe they feel their job is. In a period of recession, when unemployment is high, even those who are still in work are likely to spend less and save more in case they become unemployed. But in an economic boom, people feel more confident and are likely to spend more. - The culture of consumerism: The amount that people spend out of their income is also determined by the extent to which it is seen as normal and desirable to spend money. Nowadays there is a huge range of attractive goods and services on the market that people want to have, and developments in technology and design mean that products go out of fashion very quickly. Many people like to be seen using the latest mobile phone, driving the newest model of car and taking holidays in expensive foreign resorts. The companies that produce these goods and services use a wide range of marketing techniques to persuade people to spend their money, knowing that people like to 'follow the crowd'.

Significance of changes in rates of employment, unemployment and inactivity

Employment, unemployment and inactivity (see below for a definition of inactivity) are all important indicators of the level of economic activity. They are inter-related and they are also closely connected with the country's GDP and with its rate of growth. When employment is higher and unemployment, under-employment and inactivity are lower, incomes increase and total expenditure increases. This can take the economy from a point to the left of the production possibility frontier towards the boundary line or it can even shift the boundary line to the right (you covered this in Topic 2 in Section 1). When an economy is experiencing a boom, with high levels of activity, employment is higher and unemployment and inactivity are lower. The reverse applies during a period of recession. Since 2013, when the UK economy began to emerge from recession, employment rates have risen and unemployment and inactivity rates have fallen. It is interesting to note that there has been a significant rise in the number of people who are self-employed. Remember that employment refers to the total number of people who are employed or self-employed, although as you have seen, it does include people who are only part-time workers. So employment does include an element of under-employment. Unemployment refers to those who are not employed but who are available for and seeking work. It is important to understand that unemployment and employment do not have to move in the same direction. It is possible for both the number of people unemployed and the number of people employed to increase. This could occur if the labour force increases due to immigration or a rise in the retirement age. It is also possible for unemployment to fall without employment rising. This is because some people stop being unemployed, not because they have found a job but for some other reason. The reasons may include reaching retirement age, starting full-time education, becoming a homemaker and emigrating. Imagine a scenario where there is a rise in the number of people who decide to stop being inactive and start to look for a job (a rise in the workforce). Some will find a job immediately but others will become unemployed. If the economy now grows and more jobs are created, employment will rise as the new job vacancies are filled, but there are also more unemployed people than there were previously. In other words, those who are benefiting from the growing economy are those who were previously outside the labour market. Under the ILO definition, inactivity refers to those who are neither working nor looking for paid employment or self-employment. This does not mean they are literally inactive as they may be studying full-time, looking after families, caring for relatives or doing voluntary work. Or they may be sick, disabled or retired and therefore not able to be economically active. The higher the rate of inactivity, the fewer people there will be making themselves available to the workforce. The proportion of people who are inactive has risen since the 1990s and this is partly due to the increase in the number of young people who choose to study full time after leaving school. Although these young people are withholding their labour during their study years, they are investing in education and will join the workforce later with better qualifications and skills. Inactivity rates have also fallen because people in their fifties and sixties are working later in order to save more for their retirement. It is also because reforms to the welfare system have made it harder for people to sign on for social security benefits - people on sickness and disability benefits are now reassessed under stricter medical criteria. It is the policy of the UK Conservative government to reduce benefits and taxes to make it more attractive for people to work. Inactivity can also be due to 'immobilities'. These are factors that make it hard or even impossible for someone to move from one job to another. Geographical immobility happens where a person is unable or unwilling to move to another area of the country in search of a job. This particularly affects middle-aged and older people who are settled in their area for family and sentimental reasons. Occupational immobility happens where someone is unable or unwilling to move to another type of job. This might be because they are not qualified or skilled enough to do that job, or it might be because it is unpleasant or dangerous.

Using examples, define investment. (3 marks)

Investment is spending on capital goods. A firm's spending on delivery vehicles, photocopiers and buildings is categorised as investment.

Calculate the real GDP and then the real GDP per capita for a country for the years given. Year - 2012 Nominal GDP (£M): 50 000 Price index: 100 Population (million): 10 million

Real GDP=50 000 Real GDP per capita: 5000

The short-run (SRAS) curve

The AS curve measures the output of the economy in terms of real GDP against the price level. There are differences between what happens in the short run, when firms cannot change the level of the factors of production they employ, and the long run when they can change this level. If aggregate demand rises then prices will rise in the short run as firms cannot suddenly produce more output. But in the longer run, the higher prices will motivate firms to produce more and they will be able to do this by expanding their capacity. Aggregate supply rises and this will satisfy the additional demand. Conversely, a fall in aggregate demand will push prices down and firms will produce less. So a change in the price level will cause a movement along the aggregate supply curve in the same direction. In summary, the response of aggregate supply to a change in the price level depends on the time period we are talking about. The AS curve is different in the short run and the long run. The difference is a matter of flexibility. - Sticky prices A rise in the price level encourages firms to produce more as they prefer to sell their products for a higher price. Even though a rise in prices means that their costs will also rise, some of these costs do not rise straight away and are 'sticky' in the short run. For example, a firm that rents its premises might have a rental contract which applies for a year; even if prices have risen generally, the firm will not have to pay more rent until its contract expires and it has to agree to pay a new higher rental. This could also apply to labour contracts and wages might not rise immediately either. So within the period of such fixed contracts, the firm can benefit by raising its prices in line with the rise in the overall price level and by producing more. A firm would experience the opposite effect if prices fell. It would produce less supply in response to a fall in prices but it would still have to continue to pay the agreed prices for the duration of its contracts. - Spare capacity Firms with spare capacity are not using all their current factors of production to their fullest extent. So if prices rise, firms can increase their production without buying any more machinery or hiring more labour. Let us take the example of a factory making cakes. If it is working below capacity, it may not be using its existing production machinery continuously and its salaried workers may not be doing a full working week. If prices rise, each firm with spare capacity can produce more by employing its workers and its machinery for more hours per day. If the workers are being paid per hour, then labour costs would rise but firms would not have to spend money on recruiting more employees. If all firms in the economy have spare capacity in the short run, then a rise in the price level will motivate them to operate more intensively and to produce more goods and services. Conversely if prices fall, firms can shut down a part of their factory and employ their labour for fewer hours. This happened during the post-crisis recession, when many firms did not actually make all of their staff redundant but employed them on a shorter working day or week. However, by definition, the short-run period lasts for only a certain period of time. You will see in later what happens in the longer run. - Movements along a short-run AS curve The short-run aggregate supply (SRAS) curve has a positive slope and looks like the microeconomic supply curve, but you will notice that the axes of the graph are labelled with macroeconomic variables (Figure 3.1). The short-run period begins at the point of the rise (or fall) in prices that firms can charge, and it ends at the point of the rise (or fall) in the costs that firms have to pay. - Shifts in a short-run aggregate supply curve Just like a microeconomic supply curve, the aggregate supply curve shifts its position on the graph if some factor other than the price level changes. There are some short-term factors that can cause a shift in the SRAS curve and explain why firms may be willing and able to produce a higher or lower level of output at the same price level. Raw material and labour costs: A change in the cost of raw material inputs will cause the SRAS to shift. The costs of these inputs are determined by changes in the conditions in global markets, for example, by the demand for and supply of oil. The prices of these inputs are therefore not necessarily in tune with the general price level in our economy. If raw material costs rise, there is a decrease in aggregate supply as firms are making less profit at each level of production, other things being equal, and the SRAS curve shifts to the left. Conversely, a fall in costs allows firms to make higher profits, again other things being equal, and the SRAS curve shifts to the right (Figure 3.2). Labour costs could also increase if firms have to pay overtime rates to their workers in order to hire them to work longer hours to produce an increased number of units. Exchange rates: Changes in the exchange rate of a country's currency affect the cost of imports and therefore of the inputs of firms which rely on imported raw materials, components or services. If sterling rises against the currency of a major trading partner, such as the euro or the US dollar, imports become cheaper for UK firms to purchase and their input costs fall, with a consequent shift to the right of the SRAS curve. A fall in sterling has the opposite effect. Changes in tax rates: Changes in tax rates affect the SRAS curve. For example, in the July 2015 budget, the chancellor announced that corporation tax (the tax on company profits) will be cut from the present 20% to 19% in 2017 and 18% by 2020. This will allow companies to keep more of their profits and so it is an implied cut in costs and will shift the SRAS curve to the right.

2. Which of the following is the largest component of UK aggregate demand? a) consumption b) government expenditure c) investment d) net exports

(a) Consumption is the largest component of aggregate demand. Answers (b), (c) and (d) are the other components of aggregate demand but account for a smaller proportion of aggregate demand than consumption.

Causes of inflation

Economists have disagreed for many years over the reasons why inflation happens and they fall into three main schools of thought. Their theories are complex and you do not need to know a lot of detail on any of them, but you do need to know of their existence and to be able to give a brief definition and explanation of each. There are close links between them and you will find that, when taken together, they give a clear overall picture of what happens to a country when it is experiencing inflation. When studying these theories, remember that inflation is a situation where there is an imbalance between the quantity of goods and services and the quantity of money. -Demand-pull inflation: This theory proposes that inflation is caused by a rise in aggregate (total) demand for goods and services that cannot be immediately matched by an increase in supply. There is thus a greater scarcity of real products. This would happen when the level of unemployment is low and people's incomes and purchasing power have increased. At the same time, people have confidence in the economy and they are more likely to spend money, either by spending more of their earnings or by taking out more credit based on their higher incomes. Price theory shows us that a rise in demand, other things being equal, causes the price of a product to rise. And the same thing happens to a rise in demand for all products. As firms near the point of full capacity, they raise their prices. When prices rise, people's purchasing power falls so workers push for higher wages and people on benefits push for increases too. This puts up firms' costs and they respond by raising their prices again. -Cost-push inflation: This theory looks at the supply side of the economy and blames inflation on rises in the prices of firms' inputs (raw material costs and wages). Commodity prices for products such as oil or metals are global prices. A global rise in demand and fall in supply of oil, for example, will result in a rise in the world price of oil. The UK imports many commodities and so any price rises coming from outside the economy cannot be avoided. Firms cannot purchase less if they want to maintain their production levels so they respond by raising their prices to cover the higher costs they are facing. Rises in wages depend on the negotiating strength of employees, and especially on the ability of trade unions to carry out successful wage bargaining, and also on the state of the economy. When the economy is growing and when unemployment is low, it is easier for people to push for higher wages. Rising wages are an important part of cost inflation because they constitute a significant cost for many firms. Another aspect of wage inflation is that productivity (output per worker) could fall without workers being paid any less. This in effect raises the unit cost of production. A fall in the exchange rate of a country's currency can also cause imported inflation as more of the currency must be spent to buy the foreign currencies to allow the imports to be purchased. This additional cost is passed on to consumers via higher prices. Firms react to higher input costs by increasing the prices of their products which in turn causes workers to push for higher wages to enable them to pay the higher prices. -Growth of the money supply: This is the monetarist school and it believes that inflation is caused by an independent rise in the money supply. This would happen if the central bank makes it easier for banks to lend more money and thus create more credit. It could do that by keeping interest rates low. (Note that the majority of the money supply in an economy like the UK is in the form of bank deposits, which are created when banks lend to borrowing customers.) The central bank too can create more money by itself. When there is more money in circulation but the same volume of goods and services, prices rise. This is because the additional money supply allows people to spend more, thus increasing their demand and pushing prices up. Note that a rise in house price inflation can have a similar effect, again via bank lending. If house prices are rising fast, as has been the case in the UK over the last decade, people who already own their homes see a rise in their equity - the difference between the value of the house and the amount they owe on their mortgages. There has been a trend in recent years, and this was a big factor in the years before the financial crisis, whereby people withdrew the equity in their homes by borrowing more from their banks on the strength of the equity. This fuelled a lot of consumer demand and has therefore pushed up prices. And also note that, if interest rates are low, this pushes down the value of the pound on the foreign exchange markets, thus making imports dearer. Study hint: Note that each of the three theories outlined above stresses a different variable and starts at a different point (high aggregate demand, high costs and high money supply), but they all conclude in a situation where inflation begins to spiral - higher prices lead to higher costs and therefore to higher prices. For this spiral to continue, there must be more money in circulation. It is not necessary for you to justify any one of these theories but you should understand the interlocking relationship between higher prices, higher wages, higher costs and therefore higher money supply. -Inflation expectations: Economics describes and analyses human behaviour and so we need to know how people behave in a situation of inflation. One very central concept that determines behaviour is inflation expectations. People tend to act according to what they think is going to happen. If they expect that inflation is going to continue and that prices are going to rise even faster, then they will try to forestall the situation. Consumers will buy more products now, before their prices rise, and at the same time they will ask their employers for wage rises, again before prices rise. Firms on the other hand will try to raise their prices before wages rise. Both sides are therefore contributing to the continuation of the wage/price spiral.

Net exports

The term 'net exports' describes the value of exports sold abroad by the UK (and therefore the money received from their sale) minus the value of expenditure on imports by the UK (and therefore the money spent on them). In other words, net exports means exports minus imports (X-M). If net exports are positive (if the value of exports exceeds the value of imports), then more money is coming into the country than is leaving it and this boosts aggregate demand. The opposite is true if net exports are negative (if the value of imports exceeds the value of exports). You have already looked at the balance of payments in the previous topic; as you saw, it is influenced by a number of factors. - Real income The volume of goods and services exported and imported depends on the level of the real incomes of the people buying them. So UK demand for imports depends on the level of economic activity at home, and this fluctuates with the trade cycle. If, for example, UK employment is high, the economy is growing and incomes are rising, people will buy more imports of consumer goods and services, such as tourism, and businesses will buy more imports of raw materials, equipment and components. At the same time, exports may fall if goods and services originally intended for the export market are diverted to the buoyant home market. Conversely, the demand for UK exports depends to a large extent on employment, growth and incomes in the countries that buy them. These incomes also fluctuate with the economic cycle, which may or may not match what is happening in the UK. But foreign demand is also affected by external shocks such as war, unrest or political and economic uncertainty. For example, Iran has been subject to international sanctions for some years and especially since 2006. This has resulted in a loss of markets to UK firms that sell to Iran. The nuclear agreement signed between Iran and the US in July 2015 may lead to the dropping of these sanctions and this will be a boost to UK exporters. - Competitiveness of exports and imports: UK exporters may receive a boost if incomes abroad rise, but this is not enough for them to be sure that they will sell their products as international markets are very competitive. UK exports can be competitive in terms of price and non-price factors: - Relative prices: If the UK's goods and services are cheaper compared to the prices of other countries' goods and services, it is likely that it will sell more exports and buy fewer imports. This is more likely to happen if the UK's inflation rate is lower than the inflation rates of other countries. - Relative quality: An improvement in the quality of a country's products in comparison to the products produced by other countries is likely to lead to a rise in export revenue and a fall in expenditure on imports. This cannot happen with all products but it is very important in those industries that the country specialises in. For example, the quality of banking services, light engineering components and pharmaceuticals in the UK is high and this quality needs to be maintained and improved on in order for competitiveness not to be lost. - Reliability of delivery dates: Exporting firms need to be able to deliver their goods and services on time, or they risk losing contracts to foreign competitors. -Exchange rates An exchange rate is the price of one currency in terms of another currency. At the time of writing (July 2015), £1 = €1.42. This means that someone exchanging sterling for euro will receive €1.42 for every pound. If we turn this round by dividing 1 by 1.42, we get 0.7, which means that someone selling euro for sterling will receive £0.70 for every euro. (These values are approximate.) Exchange rates between pairs of currencies fluctuate constantly with changes in demand for and supply of the currencies on the foreign exchange markets. These fluctuations affect the price that importers have to pay for the goods and services they buy, as well as the price that exporters receive for the goods and services they sell. You need to look at the effects from a UK point of view. A rise in the exchange rate of sterling means that foreign importers have to pay more for buying sterling and so export prices become more expensive. Conversely, UK importers get more foreign currency when selling sterling and so import prices become cheaper. A fall in the exchange rate has the opposite effect and makes exports cheaper abroad and imports more expensive at home. The effects on the country's balance of payments, and on aggregate demand, depend on the extent to which people react to these price changes, that is, to the price elasticity of demand for exports and imports. A change in the exchange rate of sterling can have a different effect on the current account of the balance of payments in the short and the long run. A fall in the price of sterling may increase a current account deficit in the short run. This is because demand for exports and imports is likely to be relatively price inelastic as it will take time for traders to notice the price changes and for contracts to change or elapse. In the longer run, however, demand may become more price elastic as traders adjust to the price changes and as other competitors enter the market. -State of the world economy This is connected with what we said above about real incomes in the UK and in other countries. Different countries can have differently timed trade cycles but, because of the huge volume of international trade and the global nature of many businesses, many economic trends are repeated in many parts of the world at the same time. For example, if growth slows in China, then that country will import less from the rest of the world and growth will slow in other countries too as they are able to sell less to China. -Degree of protectionism Protectionism happens when a country puts trade barriers against other countries. It may impose import taxes or quotas on goods and services coming from certain countries that restrict the amount of trade. A country does this in order to protect its own industries and to counter what it might see as unfair competition being practised by other countries. Protectionism has the effect of reducing the volume of trade and will have a negative effect on a country that depends on its export sector. However, it may have a positive effect on a country that imports a lot more than it exports. Groups of countries around the world have formed free trade areas between them and they do not use protectionist measures between them. An example is the European Union and this means that the UK is able to export to a huge 'home market'.

Which of the following events are likely to increase investment? Explain your answer in each case. 1. A reduction in the basic rate of income tax 2. A reduction in investment subsidies 3. A forecast of an economic recession 4. A fall in the cost of capital equipment 5. A fall in corporation tax (the tax on company profits)

A reduction in income tax rates is likely to increase consumer spending and thereby stimulate investment. A fall in the cost of capital equipment would reduce the cost of investment, and a fall in corporation tax would mean that firms would have more funds to invest and a greater incentive to invest. But a reduction in investment subsidies would reduce the funds available to invest, and a forecast of an economic recession would discourage investment as firms would expect to sell less in the future. So the correct events above are 1, 4 and 5.

Gross National Product

Gross National Product (GNP), also sometimes expressed as Gross National Income (GNI), is a broader measure of a country's total output as it is the total value of all the finished goods and services produced by nationals of the country, whether they live in the country or abroad. Thus, GNP in the UK is the GDP plus net income received from abroad by UK nationals (net income means the difference between incomes received from and paid to overseas residents).

National happiness

Making comparisons using the output produced, income earned and expenditure in a country is the traditional way of measuring the wellbeing of its people. But these methods are quantitative and are based on material living standards and they ignore quality of life. This is harder to measure. For example, take a household where both adult partners work very long hours in order to maximise the family income. They and their children probably have a high material standard of living. They may own their home, have a lot of electronic equipment and smart furniture, drive two new cars and go on two foreign holidays every year. But what was the opportunity cost to the family of achieving this standard? Are the parents away from the home for long hours every day and do they bring work home? Are they tired and stressed? Do they spend any time with their children? Or have they financed their purchases by taking on debt and are they having trouble meeting the monthly repayments? Some people would argue that they prefer to earn less money but have more quality family time, giving up some of the material standard of the family described above. In other words, they may believe that it is more important to be happy and that money does not bring happiness. (Although they would probably also agree that it is miserable not to have enough money for basic necessities.) Clearly, different people have different views on this. Happiness is a subjective concept and the relationship between this and real income is a tricky one to establish. One person's satisfactory lifestyle would not suit another but, on the other hand, the culture in a country like the UK does set a benchmark that most people try to achieve. So, to the extent that most people want to have access to material possessions, real income is important. On the other hand, as indicated above, material wealth must be set against qualitative wellbeing as measured by the amount of leisure time, lack of stress and a quiet mind. The Gross National Happiness Index: Bhutan is a tiny Himalayan kingdom situated between India and China. It was cut off from the world for hundreds of years but began to open up to the outside world during the 1970s. Bhutan is ruled by its Dragon King, whose name is Jigme Khesar Namgyel Wangchuck. It was his father who, in 1972, created the concept of gross national happiness. This was an attempt to strike a balance between the traditional Buddhist spiritual values and western material development as represented by GDP. The Bhutanese Gross National Happiness Index measures people's happiness under headings that include psychological wellbeing, health, education and community vitality, as well as living standards. People are classified under these headings according to whether they are 'deeply happy, extensively happy, narrowly happy or unhappy'.

Explain the varying effects of the oil price on Mexican output.

Mexico is an oil producer and the fall in oil prices has hit the economy. Oil company profits will be lower and there will be higher unemployment among oil workers. This means that the government will be receiving less money in taxes, hence the need to cut public spending. However, since the oil sector is being opened up to private sector investment, there will be greater potential oil output in the future. Lower oil prices are beneficial to manufacturers as they result in lower costs, meaning expanded supply and lower prices.

Explain what the effects on Mexican potential output might be of the rise in the working population.

The rise in the working population means that Mexico's potential output is greater, assuming that these additional workers are employed. This addition to potential output will be smaller to the extent that the workers are unskilled. Training and education would boost potential output even further.

Illustrate how an aggregate supply curve would show the effect of an increase in potential output.

check diagram notes

1. Which of the following would cause an extension in aggregate demand? a) rise in consumption b) increase in investment c) fall in the exchange rate d) fall in the price level

(d) A fall in the price level will stimulate a rise in aggregate demand and a movement along the aggregate demand curve. Answers (a), (b) and (c) would all cause an increase in demand and hence a shift in the aggregate demand curve to the right.

Use the data in the tables to calculate GDP per capita for the countries listed below. Note that the GDP figures are in millions (000,000s) so you will have to add 6 zeros to each GDP figure given in the table. The population figures are given in full. 1. Bangladesh 2. China 3. Germany 4. Nigeria 5. United Arab Emirates

1. Bangladesh: $185,415,000,000/158,600,000 = $1,169 per capita 2. China: $10,380,380,000,000/1,370,700,000 = $7,573 per capita 3. Germany: $3,859,547,000,000/81,083,600 = $47,599 per capita 4. Nigeria: $573,652,000,000/183,523,000 = $3,125 per capita 5. United Arab Emirates: $401,647,000,000/9,577,000 = $41,938 per capita

In July 2015 Egypt opened a new section of the Suez Canal. This investment is an important upgrading in the country's infrastructure, which is expected to double the capacity of the canal by 2023. 1. Use an AS diagram to illustrate what happened to the Egyptian economy in 2015. 2. What impact would the change in investment have on aggregate demand?

1. CHECK DIAGRAM NOTES 2. Investment is a component of aggregate demand. If investment is higher than in the previous period, AD will increase.

Say which one of the following statements is true. Explain why the others are, or may be, false. 1. The CPI in June 2015 was 0.0%. This means that the UK is experiencing deflation. 2. The CPI includes the prices of all the main products bought by a typical household. 3. Inflation is caused by an increase in the money supply. 4. In a period of inflation, savers always lose and borrowers always gain. 5. A slow rate of inflation is not a problem as it is a sign of growth. Record my answers in my Blog

1. False. 0.0% inflation means that prices are stable and there is neither inflation nor deflation. Deflation is a period when prices are falling. 2. False. The CPI does not include housing costs. 3. Neither true nor false but debatable. This describes the monetarist theory of inflation but it is not proven and other economists believe in either the demand-pull or the cost-push theories. It is an example of an assertion - a statement that states a view without supporting it. 4. False. This would be true only if interest rates are ignored. But there is a discriminatory (redistributive) effect on the two groups, depending on whether interest rates are higher or lower than the rate of inflation. 5. True. A slow rate of inflation is not seen as a problem and indeed, the UK government's target is 2% CPI inflation. Low and controlled inflation means that the economy is growing to some degree. 0% inflation could be accompanied by very low growth and high unemployment.

Government spending

A significant part of aggregate demand is general government spending on public goods and services. The UK government spends around 41% of annual GDP on a wide range of goods and services. Examples are the government's current spending on the salaries of doctors and teachers and its capital spending on building hospitals and schools. However, it does not include spending on welfare benefits, also known as 'transfer payments', as this becomes income for the recipients and is spent by them. It would be double counting to include these amounts twice. The amount of money spent annually by a government does not depend directly on income but on several aspects of the relation-ship between the government and the people in the country: - Consumer demand for government-financed goods and services: In order to be elected, political parties have to promise to provide those services which are very important to people. One of these in the UK is the National Health Service. Although the Conservative government would like to cut overall public spending, it finds it hard to reduce the provision of healthcare that people expect. - Market failure: As you saw in Section 3 Topic 1, market failure is a major reason for public expenditure. Governments have to spend money on those public goods that the private sector does not make available in sufficient quantity and it also has to deal with externalities. You might need to reread the topic on market failure to make sure you understand it. - The state of the economy: This determines how much money the government has to spend on certain areas. When unemployment is high, public spending rises. Although we do not include welfare payments in the contribution of government expenditure to aggregate demand, a recession and a high level of unemployment cause people to suffer from poorer physical and mental health and also lead to more crime, so that the health and law and order services have to spend more.

Topic 2 - Aggregate demand

In Topic 1 you looked at the measurement of a country's economic performance. In this topic, and in the topics that follow in this section and Section 5, you will be studying the principles of macroeconomics that aim to explain the level of economic activity. Macroeconomics is the study of economic aggregates or totals. Instead of looking at the demand of one individual consumer or the production of one individual firm, you will look at the total demand in the economy of all consumers, the production by all firms and the income and expenditure of everyone. The aim of macroeconomic analysis is to discover the factors that determine the size of the economy and the levels of employment and unemployment, growth, inflation and the balance of payments. You will note that each economic aggregate is identified by an individual letter. For example, consumption is denoted as C. This enables us to refer to the addition and subtraction of aggregates in a brief format. You should not be put off by this as it is not mathematics as such but simply a shorthand way of referring to aggregates used by all economists.

Topic 3 - Aggregate supply

In the previous topic you examined the nature of aggregate demand. In this topic the focus shifts to the other side of the market to aggregate supply. You will explore the meaning of aggregate supply and the main influences on it, distinguishing between the short run and the long run.

Topic 1 - Measuring economic performance

In this topic you will look at the key indicators of economic performance, how they are measured and some of the limitations of the measurements used. You will discover how economic growth, inflation, unemployment and international trade are measured. You will learn the meaning of Gross Domestic Product (GDP) and the limitations of using GDP as an indicator of living standards. In addition, you will explore the types, causes and effects of inflation, unemployment and of a current account deficit on the balance of payments. Throughout the topic we will be making use of the definitions and data produced by the Office for National Statistics (ONS). This organisation is the UK's largest independent producer of official statistics and is the recognised national statistical institute for the UK.

Explain two causes of an increase in investment. (6 marks)

One cause for an increase in investment is an increased confidence. If firms expect demand and profits to be higher in the future, they may invest more now. A second cause is the fall in the rate of interest. This is because it will decrease the cost of borrowing to buy capital goods and may encourage firms to spend their profits on capital goods rather than place them in financial institutions to earn interest. In addition, firms will expect demand for their products to be higher as a lower interest rate will also encourage consumption.

Analyse two reasons why rising house prices may result in an increase in consumption. (6 marks)

One reason why rising house prices may result in an increase in consumption is that households will feel wealthier. For many people, their house is their main asset. When people feel wealthier, they tend to spend more. Another reason is that rising house prices tend to increase activity in the housing market. More houses will be bought and sold. When people move house, they buy furniture, carpets and curtains and spend money on DIY equipment.

Employment and unemployment

The Office for National Statistics uses two separate figures to measure unemployment. -The International Labour Organisation: The International Labour Organisation (ILO) definition is the internationally agreed definition of unemployment and it is used by the ONS. The ILO puts everyone over 16 into one of three classifications: - In employment: Everyone who does at least one hour's paid work per week. - Unemployed: People who are without work but available for and seeking work. - Economically inactive: This includes full-time students, people who are sick, disabled, retired, looking after a family or home and other reasons. The UK's Labour Force Survey (LFS) measures unemployment in accordance with the above ILO definition. It carries out quarterly surveys, taking a sample of around 40,000 households and 80,000 individuals living in private households and classifying them as above. It then calculates an unemployment rate as the proportion of the economically active who are unemployed - in other words, the unemployed as a proportion of the employed plus the unemployed.

The claimant count

The claimant count is an additional method of measuring unemployment that is used in the UK. It is the number of people receiving benefits for being unemployed and it consists of those claiming Jobseeker's Allowance (JSA) or National Insurance (NI) credits or, since April 2013, those receiving Universal Credit (UC) for being unemployed. It addresses the measurement from another angle - from the administrative records of people who are claiming unemployment benefits. The claimant count rate is calculated by expressing the number of people claiming unemployment benefits as a percentage of the total number of full-time and part-time jobs available, including self-employed jobs

Current account imbalances and other macroeconomic objectives

The government sees the current account of the balance of payments as a macroeconomic objective - to achieve a balance over time. It might be pleased with a small surplus but it would definitely like to avoid a deficit. The situation on the current account however links up with the other three main macroeconomic objectives as follows. In each case, the current account is affected by the objective and also affects it. Inflation: If inflation is high, and especially if it is higher than inflation in other countries, the prices of UK goods and services become uncompetitive and any current account deficit is likely to worsen as people both at home and abroad switch from UK products. The position on the current account will have an effect on inflation via the exchange rate of the currency. If sterling is strong, then the UK can buy imports more cheaply and this keeps inflation down. If sterling is weak, the UK could suffer imported inflation. Employment and growth: We will consider these together as they are closely linked. If the economy is growing and employment is high and unemployment low, aggregate expenditure will be high and there will be a big demand for imported products. This could worsen the current account, especially if UK residents are also buying large volumes of goods and services that could have been exported. The opposite is true for a period of low growth and high unemployment as people will cut their spending and will buy fewer imports. This situation will free up products for export but demand for them will depend on whether the low level of activity is also being experienced in other countries. You will see below that international trade connects economies and they can experience similar problems at the same time.

Measuring inflation with the CPI

The main measure of inflation in the UK is the Consumer Prices Index (CPI). This is also the measure used in the government's inflation target. The CPI is used for up-rating wages in some sectors and also in pensions and benefits. The CPI is used throughout the European Union and this makes it easy to make comparisons between the rates of inflation of different member countries. Like other indices, the CPI uses the idea of a large shopping basket of hundreds of the goods and services most commonly consumed by households, and it measures changes in the prices of these products on a monthly basis. The CPI measures price changes in more than 700 separate consumer items and these represent the price changes in all the goods and services covered by the index. The content of the 'basket' is changed every 12 months to reflect changes in shopping habits. Each item in the index is given a 'weight' or quantity to reflect its importance in the budget of a typical household. Information on people's spending habits is compiled by consumer surveys carried out by the ONS. In May 2015 some of the new products included in the CPI were streaming music subscriptions, e-cigarettes and sweet potatoes. Two of the products that were removed were yogurt drinks and sat navs, the latter because smartphones have apps which do the same job and because many new cars have built-in units.

In which countries is the PPP-adjusted exchange rate quite close to the official exchange rate? In which countries is there a large difference? Record my answers in my Blog

The two rates are quite close in the case of Britain and the euro area. There is a big difference in the case of China. You may have noted other differences.

Unfilled vacancies and skills shortages

To get a full picture of the labour market, it is necessary to look at the number of unfilled vacancies at any point in time. These are positions that employers want to fill but for which they have been unable to find suitable employees. It is possible for unemployment to be quite high but for there to be a high number of unfilled vacancies. One of the main reasons is that the available jobs require skills, qualifications and experience that unemployed people do not have. Another reason could be that the jobs are in the wrong geographical areas. The obvious answer to this mismatch is to train unemployed people to develop skills that will make them employable. A country like the UK, which has a large services sector and whose manufacturing industry tends to be technologically advanced, offers fewer jobs which require low or no skills and so training is very important. Nevertheless, it should be noted that the fall in unemployment and rise in employment that has taken place in the UK since 2013 has happened to a significant degree among lower-skilled workers.

Unemployment and under-employment

There is a distinction between unemployment and under-employment. We have seen above that unemployment means either people who are without a job or people who are claiming unemployment benefit. In both the above definitions, a person is classed as either unemployed or not unemployed - either claiming or not claiming unemployment benefit. But just because someone has a job, it does not mean that this person is fully employed. Under-employment measures the degree of labour utilisation in the country - to what extent people's time, skills and experience are being used. In terms of time, someone who is available to work for 40 hours a week but can only find work for 20 hours a week is under-employed, even though this person is not classified as unemployed. We could say that the person is half-employed in this case. Under-employment also applies to people with skills and experience who are working in jobs which require only low skills, say a qualified engineer who can only find a job as a shop assistant. Under-employed people are working below their capacity and capability; they are not contributing their full benefit to society or to themselves and are not using the education and training they have received. In the recession that followed the financial crisis, unemployment did not rise as fast as many people had predicted. One of the reasons for this is thought to be the existence of under-employment. It was thought that many firms were keeping their workforce but on lower hours. This meant they did not have to make workers redundant and pay compensation, the workers would not lose their skills and the firms would not have to rehire staff again after the end of the recession. This indicates that some workers had more flexible contracts and were obliged to accept fewer hours and lower wages. It is also possible to find people who are over-employed - highly skilled and qualified people who are persuaded to work additional hours when there are skills shortages. This might suit the over-50s who are trying to save more money for their retirement;

National product, income and expenditure

We have measured a country's output by aggregating the value or volume of the goods and services it produces. But the output of the country can be estimated by using three different methods: The production method, based on the value of the total productive output of the economy in the period. This gives us Gross Domestic Product. The expenditure method, based on the value of the total expenditure on goods and services in the economy in the period. This gives us Gross Domestic Expenditure. The income method, based on the value of the total incomes earned by individuals and businesses in the economy in the period. This gives us Gross Domestic Income. Note that, if we add net income from abroad to each of these identities, we have Gross National Product, Gross National Expenditure and Gross National Income (GNI). These three identities - production, expenditure and income - are the same thing looked at from different angles. The value of what the country produces gives incomes to all the people involved in that production, and the incomes are used to make expenditure on the products made. If statisticians had perfect information available to them, the three aggregates would come out at the same number, but this does not happen in practice because of errors and omissions and because estimates have to be made. In other words: Expenditure = Production = IncomeExpenditure = Production = Income This analysis is very simplified. In practice, a number of adjustments have to be made in order to produce these national income figures, as they are called. (This goes beyond the scope of this course.)

What is the shape of the AS curve when the economy is operating at full employment?

vertical: When the economy is operating at full employment, there is a supply constraint. The economy cannot produce any more. The limit is shown by the AS curve becoming vertical. The AS curve is horizontal when there is considerable spare capacity in the economy. It is upward-sloping when the economy is approaching full employment. It is the AD curve and not the AS curve which is downward-sloping.

Balance of payments

A country's balance of payments could be renamed as the balance of international payments. It is a statement that sums up the transactions of the country's residents with the residents of the rest of the world over a particular period of time. The ONS releases balance of payments figures every quarter and also gives the annual position. It covers all transactions in goods and services and also capital transfers, as detailed below. The balance of payments measures financial inflows and outflows between an economy and the rest of the world. Components of the balance of payments: The balance of payments is sub-divided into three main sections: the current account, the capital account and the financial account. The main emphasis here is on the current account and this, in turn, is broken down into sub-sections as follows: - Trade in goods: This shows the balance between the revenue earned from exports of physical goods and the expenditure on imports of physical goods. These are sometimes called visible exports and imports. The UK usually spends more on buying goods from abroad than it earns on selling goods abroad and so the balance on this section of the account is usually in deficit (export revenue minus import expenditure). Examples of goods imported and exported by the UK are finished goods such as computers, semi-finished goods such as parts and components and commodities such as oil, minerals and foodstuffs. - Trade in services: This shows the balance between the revenue earned from exports of services and the expenditure on imports of services. These are sometimes called invisible exports and imports. In contrast to trade in goods, the UK usually has a surplus on its trade in services balance, meaning that it earns more from its export of services than it spends on buying services from abroad. Examples of traded services are commercial shipping, civil aviation, banking, insurance and other financial services, tourism and a wide range of consultancies such as engineering, software development and management. - Balance of trade in goods and services (the ONS calls this total trade): This is the addition of the trade in goods and the trade in services. Over the last few years, the UK deficit on goods has been larger than the surplus on services so that the total trade balance is a deficit, but this would not always be the case. There are several other categories in the official balance of payments accounts: - Primary income, the most important of which is investment income. This includes interest, profits and dividends, both received by UK residents from abroad and paid by them to people abroad. Interest is received and paid on financial investments and loans. Profits are from business activities of subsidiaries located abroad, and dividends are earned by people who own shares in foreign firms. For example, interest paid by a UK company on a loan it has taken out from an Italian bank would appear in this section as an expenditure item as it involves money leaving the UK. But profits earned by a UK-owned firm based in Germany and sent back to the parent company in the UK would appear as income. Another type of primary income is employment income and expenditure - payments to employees who are residents of one country and employed in another. - Secondary income: This includes transfers of gifts (remittances) between people living in different countries, donations to foreign charities, receipts from and payments to the European Union and overseas aid received and paid by governments. The capital and financial accounts of the balance of payments follows the current account and consists of investments made between the UK and other countries (note that these are the investments and loans which give rise to the interest, profits and dividends in the current account). If the ONS had full information, the capital account would balance the current account. You will study the capital account in a later topic.

GDP as an indicator of living standards

We have seen how GDP statistics are used to identify changes in national output and living standards over time and to make comparisons with growth rates in other countries. The question remains: To what extent do GDP comparisons indicate differences in living standards between people, both over time and between different countries? In practice, the data must be interpreted with care. You need to be aware of the following: - We have already noted that real GDP is a more appropriate measure to use when assessing changes in living standards because it adjusts the nominal figures for changes in prices. - Changes in either nominal or real GDP figures give us a general idea of the overall state of a country's economy but they do not take account of the number of people in the country. So economists also examine real GDP per head (or per capita) which is real GDP divided by the population of the country. For instance, if real GDP rises by 20% over a ten-year period it might seem that living standards have risen. However, if over the same period the population has increased by 30% then the standard of living has actually fallen. Comparing GDP per head takes care of this problem but it brings up another one. - Like all averages, average national GDP per capita covers up and ignores wide differences between the two ends of the scale - in this case, between people with higher income and wealth and those with lower income and wealth. So we must study the distribution of GDP among the population. If GDP per head increases but is very unevenly distributed, the benefit is felt by only a few and most people will not experience a rise in their living standards. - A better way of comparing living standards is to measure the percentage of the population in a country that lives below a desired minimum standard. These are people who do not have access to proper nutrition and housing, to basic sanitation or to education and health services. The higher this percentage, the worse the living standards overall, and so the objective is to reduce the percentage who fall into this minimum. - The composition of real GDP is also important. If real GDP rises because more capital goods are being made (more investment in productive machinery and equipment), the country's population will be able to enjoy more consumer goods in the future. However, at the moment they may not feel any better off because they are not immediately experiencing the benefits of the capital goods. In some other cases, the effects may not be clear-cut. If real GDP rises because more weapons are being made, some would argue that people will never feel any better off and may even feel worse off if they believe that the production of weapons will make war more likely. On the other hand, the output of defence goods might make people feel better off if it makes them feel safer. A rise in the size of the police force to keep pace with rising crime will result in an increase in real GDP, but the quality of people's lives may be reduced if their civil liberties are affected. - GDP figures may not provide a total picture of living standards because they do not take into account all the factors that influence the quality of people's lives. For instance, they do not measure working hours, working conditions or externalities. So if real GDP rises but leisure time falls or pollution increases, people may not think that their living standards have risen because they are working more hours for their income or because they are living among air and noise pollution. Each of these factors can be measured (although qualitative factors are always harder to assess), but it would be a huge and perhaps impossible statistical exercise to devise a unit of measurement which took all factors into account. - Another factor that limits the effectiveness of official GDP figures is the size of the illegal economy (sometimes called the black economy because it doesn't show). Clearly people are not going to incriminate themselves by declaring money which they earn but on which they do not pay tax, or money which they earn while receiving state benefits, or if they receive money from illegal activities such as drug dealing. So the living standards of such people may be enhanced but this does not show up in the statistics. - The existence of the informal economy has a similar effect to the above. Most people do jobs for themselves, such as painting their home or making their own clothes, but the value of this production is not declared for GDP purposes because another person was not hired to do the work. However, it does result in an increase in living standards. For example, the cost to someone of painting their living room would be the paint and a notional amount for their time, but hiring a painter might cost £1,000.

Explain the meaning of GDP per head. (2 marks)

GDP per head is the total output of goods and services produced by a country, divided by its population.

Factors influencing the LRAS curve

Shifts in the LRAS curve happen for reasons that are connected with external factors, changes that affect a firm's ability to produce more or less supply at the same price level. - Technological advances: Capital equipment is improved by continuous advances in technology that result in better production techniques and innovation. The availability of more efficient and smarter computers, robots and machinery allows firms to cut their unit costs and to supply more output at the same price level - to shift the LRAS curve to the right. Scientific advances also result in the development of new and better materials, for example the development of the new material graphene, which is much stronger than steel, an efficient conductor of heat and electricity and nearly transparent, which is used in the semiconductor and electronics sectors. Materials of this kind are revolutionary and enable the development of cheaper and more efficient inputs into other industries. - Changes in relative productivity: Productivity means the average amount of output produced by one employee in a given period of time, say in one hour or one week. If productivity rises, this is good for firms because the value of the employees' output rises and a firm's profits increase. If wages rise at the same time and by the same extent, then the firms are back in the same position as before. From the employees' point of view, a rise in productivity is a good opportunity to ask for higher wages as they can claim that the firms can afford to pay more. Productivity depends on the extent to which workers are trained and experienced, on the quality of the capital equipment they are given to work with and on the quality of the relationship between management and employees and the degree to which employees are motivated to work hard. If firms can achieve higher productivity in the current period than in the previous one, the LRAS curve shifts to the right. The same factors of production are able to produce more units of output than before. For example, workers in a factory are better equipped, receive regular training in how to use the equipment, are involved in decision-making by their managers and are more motivated. - Changes in education and skills: The quality of labour is enhanced by education, training and by a culture of lifelong learning. This results in higher labour productivity (output per worker per time period worked) and so unit cost falls, allowing more supply at the same price level. So any moves made by the government to fund education and training or by private firms to invest in training programmes improve the quality of the workforce. They become more skilled, more confident and motivated and are more likely to be able to have innovative ideas within their firms. A developed economy like the UK would expect to increase the amount of money invested in education and skills and this shifts the LRAS curve to the right. The small merchant bank Close Brothers has an apprenticeship scheme called ASPIRE, which is a two-year structured programme for school leavers. Apprentices move around different departments and regional offices and gain valuable work experience and on-the-job training. They are also sponsored to do a professional banking certificate from the Institute of Financial Services. - Changes in government regulations: Governments pass laws and set up regulatory bodies to make rules on how firms do their business. Regulations affect all areas of a firm's work and here are some examples: Employees' working conditions - employers must pay at least the minimum wage. Health and safety at work, for example in hotel kitchens, on the factory floor and in call centres. Trading standards on the design and content of products such as meat content in pies or safety of domestic electrical equipment. Regulations on the way that products are sold - banks and other lenders must not lend money to consumers unless the loans are affordable. All of these regulations restrict firms in some way and cause an increase in their costs. For example, they may not be allowed to use the cheapest materials in smoke alarms. In addition, the existence of regulations means that staff must be trained to comply and this is an additional cost. An increase in regulation can cause costs to rise and the LRAS curve to shift to the left. There is some balance here. Compliance with rules and regulations means that firms produce more consumer-friendly goods and services and avoid having to face the high costs of litigation and customer compensation. In the last few years all the major UK banks have been forced to pay out huge amounts in compensation to customers who had been mis-sold a product known as 'payment protection insurance'. - Demographic changes and migration: Demographics is about the size and structure of the population and, in the case of aggregate supply, we are concerned with the working population. The size of the overall working population boosts the productive capacity of the country but it is also important to look at the structure to understand the quality of the workforce. This analysis will concentrate on the UK. Migration. The size of the UK's working population has increased in recent years because of migration. Here are some statistics from The Migration Observatory, University of Oxford (2015): - The number of people of working age who were born outside the UK increased from 2.9 million in 1993 to just over 6 million in 2013. - The proportion of foreign-born employees in the working population increased from 7.2% in 1993 to 15.2% in 2013. - Foreign-born workers are particularly prominent in relatively low-skilled occupations such as transport drivers and food and drink process operators. There is a general perception that migrants work hard because they have come to a new country to earn money and have a better life. This might be true and they may achieve a high level of productivity. - Gender: Since the 1970s there has been a significant increase in the number and proportion of women in the workforce. In 2013 around 67% of women between the ages of 16 and 64 were in work, whereas the figure for 1971 was 53%. Interestingly, the figures for men have fallen from 92% in 1970 to 76% in 2013. So the labour force has been boosted by the fact that far fewer women are inactive and this increases the production potential of the economy. As we can see from the figures, there is still scope for more women to go out to work. Men and women have different representations in different occupation groups. For example, women comprise 82% of the employees in caring, leisure and other services, 50% in professional jobs and only 10% in skilled trades. If we assume that both men and women are attracted to those jobs to which they are better suited and therefore more productive, overall productivity should increase. - Age: The main trend in this aspect of demographics is the fact that people are living longer - and working longer. Indeed, it is becoming increasingly important that people should work beyond the traditional age of 65 as they need to save more money to finance a longer retirement and the state pension age has been raised. So the size of the working population is again boosted by the fact that people are not retiring as early as used to be the case. The quality of the work contributed by employees tends to change as they get older. If they are doing heavy physical work, say warehouse or building site work, their productivity will fall as they cannot lift weights or move as quickly. However, in the case of professional jobs, they are able to bring more experience and reliability to their work and can help to mentor their younger colleagues. An example of a firm that believes that older people make good employees is B&Q. More than 25% of its shop staff are over 50 and the company believes that its employees have good relationships with the customers and are able to give sound advice. - Competition policy: When a firm faces competition, it has a strong incentive to make a better product, offer a better service and charge a more attractive price. Conversely, if a firm has few or no competitors, it may not search for ways to improve its efficiency in order to keep its price down and to make better quality products. So the potential production of a country is probably bigger when its firms have competitors. The UK government has an active policy on competition and encourages new firms to set up and discourages uncompetitive practices. The Competition and Markets Authority has a wide range of responsibilities in this area. For example, it looks into proposed mergers between large companies and can recommend that they be stopped. There are campaigns to encourage consumers to switch to a different provider of a service. The best examples here are to personal current account holders to switch to a different bank and for gas and electricity consumers to switch to a different provider. It is felt that suppliers will produce a better quality service if they know that customers are likely to move to a competitor if they are not happy with the service they are receiving. The total value of the output of these companies should be higher. - Exogenous shocks: These are shocks that come from outside the economy, either from natural factors, such as a catastrophic storm that causes destruction, or the effect of a political crisis. Firms could find their supplies of imported inputs are reduced or even cut off. These shocks might come from within the country itself but could also originate in countries with which the country trades and could have a major effect on markets. An example is the tsunami that hit Fukushima in Japan. It hit firms that make certain automobile parts and this affected the ability of car manufacturers to produce completed vehicles.

Main influences on government spending

The government raises money via taxes and, if tax receipts are not sufficient to cover the spending, it borrows the difference. This is known as a budget deficit. If the government has a budget deficit then it is spending more than it is taking from people in taxation and this raises aggregate demand. Conversely, a situation where tax receipts exceed public spending gives the government a budget surplus and this reduces aggregate demand as more money is being taken away from people as a whole than is being given back to them. Government spending can be sub-divided into two main classes: - Discretionary spending: This is money that the government can choose to spend or not spend because it is not bound by systems that have already been set up or by past promises. Examples of this optional spending are whether to make cuts in defence spending, whether or not to build a new hospital and what grants to make to private sector businesses. - Automatic, autonomous or non-discretionary expenditure: This is expenditure that is not affected by the level of the real income in the economy. It is spending that happens automatically because of systems that have been already set up and because of promises that have been made by past governments. Examples are the state pension and other social security benefits. The government decides on how people qualify to receive these benefits and how much each person will receive. But it does not know, and does not control, how many people will be entitled to these benefits so it does not know in advance how much it will spend in total on them in a particular year. This depends on the state of the economy. The trade cycle: The trade cycle is the graph that emerges if we draw the progress of GDP over a period of years. This graph shows fluctuations between high and low levels of activity. The highest point the economy reaches is called a boom, where activity and employment are high and inflation is rising. This does not last for ever and it gives way to a downturn or recession, where confidence decreases, unemployment and growth rates fall and inflation becomes lower. This eventually reaches its bottom point, the slump, and it begins to recover again. The upturn gets going and the economy grows towards the next boom period. It is beyond the scope of this topic to consider the reasons why the trade cycle happens but it is of interest to us here because it has implications for government spending. When the economy is in its growth phase, people are earning and spending more money and firms are making more profits. So government receipts from taxation rise. At the same time, because fewer people are unemployed and more people are earning higher wages, less public money is being spent on social benefits (there is less autonomous spending). So the government is in the happy position of borrowing less and perhaps even achieving a surplus, where tax receipts are greater than public expenditure. Conversely in the recession phase, the government receives less money in tax receipts and has to spend more on benefits, and so non-discretionary spending will rise. The government may have to run a deficit and this can become large. Fiscal policy: Fiscal policy is about the decisions the government makes about its budget. There are three main variables: - government expenditure - taxation - budget deficit or surplus. (Note that the deficit or surplus is the annual balance between the two sides of the account. It adds to or subtracts from the total amount of public sector debt.) The central question of fiscal policy is whether the government should run a deficit or a surplus on its budget and how large or small this should be. Each government has a specific policy on what it wants and it has to manage the public finances accordingly. The UK government is facing an annual deficit on its public sector budget of £90bn for the year 2014/15. This is 5% of GDP. It will have to borrow this money and the deficit will add to total public sector debt, which is £1,440bn or 80% of GDP. The current government believes that this deficit is too large and is adding too much to public sector debt. Its stated policy is to reduce the deficit by cutting public spending and increasing tax receipts. This is contractionary fiscal policy as it is pumping less money than before into the economy and so it will have a downward effect on aggregate demand. You will be looking at fiscal policy in more detail in Section 5 Topic 3.

Influences on investment

Because the level of investment depends on expectations of the future, it is more volatile than consumption as a component of aggregate demand. Investment is influenced by the following factors. -The rate of economic growth: The rate at which the economy is growing exerts a strong influence on the amount of money spent by firms on buying capital goods. In a time of high economic activity, the rise in income and the accompanying rise in demand for goods and services stimulate investment. Entrepreneurs, seeing that they can sell more, will wish to increase their productive capacity in order to meet this demand. During the consumer boom of the late 1980s investment rose significantly. On the supply side, a growing economy means that firms are making higher profits and they can use these to finance expansion into new markets and products. -Business expectations and confidence: This is allied to the last point. Entrepreneurs make investment decisions based not only on how fast or slowly the economy is growing at the moment but, perhaps more importantly, on the speed at which it is expected to grow in the future. Investment takes a time to happen, from the initial decision to the research into what equipment to purchase and from whom and through to the actual purchase and installation. This last stage can take some time as it may involve complex engineering procedures and even building works. So investment decisions taken today depend on firms' view of the future. Even if current demand is low, entrepreneurs may increase their investment if they believe that economic conditions will improve in the near future. Confidence is at the centre of business expectations. Nobody can foretell the future but there are signs on which predictions can be based. The worst situation for a firm considering an investment project is uncertainty or, rather, more uncertainty than usual. The UK government has decided to hold a referendum on membership of the European Union in either 2016 or 2017. Doubts over the result are not good for businesses, especially those which trade with EU countries. Some firms may put investment plans on hold until they see the result of the referendum. Animal spirits: In his book The General Theory of Employment, Interest and Money', the economist John Maynard Keynes said the following: 'Most of our decisions to do something positive, the full consequences of which will be drawn out over many days to come, can only be taken as the result of animal spirits - a spontaneous urge to action rather than inaction...' What Keynes meant by 'animal spirits' is that people will often act on their instincts rather than on the basis of complicated mathematical calculations. It certainly seems to be true that animal spirits can be contagious. If enough entrepreneurs have a positive view of the future and decide to invest, it is likely that others will follow them and the positive view will become self-fulfilling. -Demand for exports: Firms therefore look to the likely strength of their markets when deciding whether or not to invest. These markets are not only domestic but foreign markets as well for many firms, and this certainly applies to many UK companies that depend on their export market. So their investment decisions will depend on their confidence and expectations regarding other countries as well as the UK. The Greek debt crisis that played out in the summer of 2015 was a source of great worry and uncertainty to UK firms that supply the Greek market and also to those who sell to countries which in turn depend on the Greek market. International trade is a network of links between importers and exporters in many countries and the economic condition of a trading partner has a large effect on its foreign supplier. Another example is the desire by many firms to export to China. China has a population of over 1.3 billion and is therefore a huge potential market. Over the last few years, there has been a great boom in domestic consumption by the emerging Chinese middle class. Some of this will create demand for the products of firms in the UK and other countries and so these firms will spend more money on investment. -Interest rates: In order to buy capital goods, firms have to issue new shares, borrow from banks or use past profits, known as 'retained earnings'. Whichever they do, there is a cost and this is the rate of interest charged by the lender. (Note that using past profits is not interest-free as a firm must take into account the opportunity cost of what it could have done with the funds if it had deposited them in a bank account or lent them to another firm.) So changes in interest rates influence investment as they change the cost of investing and therefore the expected rate of return from a piece of investment. Other things being equal, a rise in the rate of interest will tend to cause a fall in investment. This is because investment will become more expensive and the firm will have to earn a higher return from the investment to cover its costs and make a profit. In addition, a higher interest rate is likely to cause people to spend less because savings will be more attractive and personal borrowing will be more expensive. So there will be less demand for the products that the firm makes with the investment. For example, suppose that a firm wants to spend £1m on developing a new type of gas cooker. It will borrow this money at 7% and it estimates that the expected sales of the gas cooker will cover all the costs of the project, including the current interest rate, and leave it with a profit. But if market interest rates rise to 8%, the firm now has an additional cost to pay and the expected return from the investment will be lower. If the original estimates at the lower interest rate gave the firm a marginal profit (it was just making a small profit), it is very likely to pull out of the project and not make the investment. -Access to credit: Access to credit is connected to what we said above about interest rates. Large companies find it much easier to access investment funding either by issuing bonds on the market (which are purchased by people who want to lend them money) or by borrowing from a bank. Smaller firms find this much more difficult as they do not have the same credit history and often cannot provide security for a loan. They are seen as being less creditworthy. Large firms called credit-rating agencies do research into the creditworthiness of large companies and give credit ratings to show how safe or otherwise it is to lend them money. And small firms have a credit score at their bank. There is a close link between a firm's creditworthiness and the rate of interest it must pay on a loan. Only companies with a good credit rating can issue bonds on the financial markets or secure a long-term bank loan. The better an individual company's credit rating, the lower the interest rate it will pay on a bond or a loan. Small firms do not have credit ratings and so they find it hard to raise funds to finance investment. -Technological advances: Improvements in technology and new inventions not only give rise to new products for consumers to buy but also provide businesses with more efficient methods of producing their goods and services. For example, all major car assembly plants now use robot machinery and this not only reduces the cost of production per unit but also ensures better standardisation and quality of the cars. Therefore, as new productive equipment comes on the market, firms spend money on adopting them. -The influence of government and regulations: Governments can help firms to invest in two main ways. The first is making the tax regime more favourable to investing companies by reducing corporation tax (the tax on company profits) when they spend money on long-term investment. The second is giving them subsidies or investment grants that will pay part of the cost of an expansion programme. Grant for Business Investment was a government scheme in England that provided capital grants to businesses carrying out sustainable investment. This scheme came to an end in 2014 and a replacement is being designed.

1. In what three ways can GDP be calculated? 2. How are the national accounts built up? 3. How many times a year are the accounts compiled? 4. What are the GDP figures used for?

1. By measuring output, income or expenditure. 2. From a variety of surveys of manufacturing and service industries and government departments and from administrative sources. 3. Four times to give the quarterly figures and these are then combined to give an annual figure. 4. As an indicator of economic activity and in setting interest rates.

The causes and types of unemployment - continued

-Frictional unemployment: Frictional unemployment consists of those who are temporarily unemployed as they move from one job to another job. It can be subdivided into the following categories: - Search unemployment: This consists of those who do not accept the first job they are offered if it does not meet their requirements of pay and working conditions. They search around until they find a suitable job. - Seasonal unemployment: This consists of those people who are unemployed because of seasonal fluctuations in demand and seasonal changes in weather and climate conditions. For instance, there is demand for more workers in the UK tourist sector during the summer season and at periods like Christmas. - Casual unemployment: This includes people like actors who do not have regular work and who from time to time find themselves between periods of employment. Frictional unemployment is often exacerbated by immobilities - these are reasons why people are unable or unwilling to move from one type of job to another or from one geographical area to another. Lack of information also makes the situation worse as people do not always know what jobs are available. This is an example of the concept of information failure. -Seasonal unemployment: Seasonal unemployment is a type of frictional unemployment but it is worth treating it separately as well. It exists in those industries where demand and/or supply are not regular all year round. For example, demand in the tourist sector is highly seasonal with large numbers of holidays being sold during the summer months of June to September in Europe. Tour companies have reduced some of this seasonality by offering holidays in longer-distance destinations at other times of the year. Agriculture is an example of a sector where the supply is seasonal, with the timing and volume of crops being subject to the weather. Investment in technology like greenhouses can help to prolong the growing season. The construction sector too faces seasonal factors such as bad weather during the winter. The consequence of this seasonality is that there are a lot of jobs in these sectors at certain times of the year and not at others. This is on top of any cyclical unemployment that may exist at the same time. Real wage inflexibility: This is unemployment that happens in a situation where wages being paid to workers are above the equilibrium wage level. This may be because of trade union pressure or because the government has set a minimum wage which is above equilibrium. In such a case, the supply of labour is greater than the demand and the market wage would be lower but the artificial factor keeps the wage higher. Employers, faced with such a situation, may decide to cut their wage bills by shedding labour. This would be especially likely to happen if aggregate demand in the economy were to fall. This approach to unemployment suggests that labour markets should be more flexible so that wages could fall where necessary and unemployment would not rise so sharply during a downturn. However, from a macroeconomic point of view, cutting wages in a recession is likely to make matters worse since workers now have less money to spend and aggregate demand will fall further.

Answer the following questions: 1. Into what three groups does the ILO categorise everyone over 16? 2. Which groups of people are included in the claimant count? 3. Which measure gives a higher unemployment figure and for what two reasons? 4. Which measure is used for international comparisons?

1. In employment, unemployed and economically inactive. 2. Those in receipt of Jobseeker's Allowance, National Insurance credits or the Universal Credit. 3. The ILO measure gives a higher unemployment figure because it includes people who are looking for only a few hours part-time work per week. And not all unemployed people claim benefit. 4. The ILO measure is used for international comparisons.

Current account deficits and surpluses

A current account deficit means that more money in the form of foreign currencies is going out of the country than is coming in. Money going out is in the form of spending on imports of goods and services and investment income spent, while money coming in is in the form of earnings from exports of goods and services and investment income earned. A current account surplus is the opposite of the above and means that the country is earning more foreign currency from trade in goods and services and investment income than it is spending. Note that here we are discussing deficits and surpluses on the current account. If the country has a deficit on its current account, then it must balance it with a surplus on its capital and financial accounts, even if this means borrowing foreign currencies. A current account deficit on the balance of payments is undesirable as the country is spending more foreign currencies than it is earning. It would seem logical that a country would be happy to make a surplus but this too can have problems, as you will see below. Every export made by the UK is an import for another country and its imports are balanced by other countries' exports. If we added up all the balances of payments of all the countries in the world, and if we had perfect information, the total would come to zero. In other words, if one country is running a deficit, some other country or group of countries must have surpluses. Thus, if the UK has a current account surplus, it is contributing to other countries' deficits. If its surplus is very big, as in the case of China, this causes problems for other countries which have deficits and they will put pressure on the surplus country to reduce its surplus. A current account deficit is a problem and has to be faced in two ways. In the short term, the country has to finance the deficit by finding capital funds to balance the account. These funds might come naturally in the form of inward foreign investment into the country, but if not, the country has to borrow foreign currencies from those who hold them, mainly from banks. In the long term, and if the current account continues to be in deficit, the country must take steps to reduce its deficit. To know how it can do this, you must understand why the deficit happens in the first place. We will use the UK as an example and explore the main reasons for changes in imports and exports. - If the UK has a higher inflation rate than those countries with which it competes in foreign markets, the prices of its goods and services will be uncompetitive and its exports will fall. At the same time, foreign products will be cheaper for people in the UK to buy and imports will rise. - If the UK is experiencing a boom, aggregate demand will be high and people will be buying more products. Many of these will be imports such as South Korean mobile phones, Italian cars and Australian wine. At the same time, they will also be buying more UK products and goods destined for foreign markets will be diverted to the domestic market instead. Firms will be producing more and will be importing more raw materials and components. - However, if a trading partner is experiencing a fall in income, such as Greece at the time of writing (July 2015), there will be a fall in demand for UK exports to that country. - Changes in the exchange rates between countries' currencies affect the prices of imports and exports and therefore affect the volume of trade. If sterling is high in terms of currencies like the US dollar and the euro, UK exports will be more expensive for other countries to buy and demand will fall. However, the UK will be able to buy its imports more cheaply. The opposite would be the case if the exchange rate of sterling falls. - There may be more fundamental, long-term problems that can result in a deficit. A country may devote resources to producing products that are not in high demand. The quality of the products may be poor, or the standard of marketing and after-sales service may be low. It may also have higher costs of production than rival countries. All these factors will reduce foreign demand for products but increase the domestic demand for imports. A government will seek in the long run to achieve equilibrium on its current account balance. This means that money entering the country equals money leaving the country.

What is the difference between a budget deficit and a current account deficit? (5 marks)

A budget deficit arises when government spending exceeds tax revenue. A current account deficit occurs largely as a result of import expenditure exceeding export revenue. Therefore, while the budget position is concerned with the government's financial position, the current account position of the balance of payments is concerned with the trade position of the country.

The Human Development Index

A development index measures a country's performance by choosing a mixture of specific development indicators. The best-known composite measure of economic development is the United Nations Human Development Index (HDI). It is used by international organisations to compare the economic development of different countries. It is a weighted mix of indices which takes into account not only GDP. The HDI uses GNI per head but also life expectancy at birth and education as measured by adult literacy and school enrolment. The HDI is measured between 0 and 1, with 0 being low and 1 high. The 2018 data show that Norway has the highest index of 0.953 and that Niger has the lowest at 0.354. A country's HDI ranking may be different from its GDP ranking. For example, Vietnam and Pakistan have a similar GDP per head, but Vietnam has a HDI index of 0.694 while Pakistan has 0.562. Even though the HDI takes into account more of the factors that affect living standards and wellbeing than GDP per head, it does not include many important factors such as inequalities, the quality of the environment and political freedom.

Economic growth

Economic growth is defined in economic theory as an increase over a period of time in a country's productive capacity or potential to produce goods and services. It can be stated in terms of the production possibility frontiers that you learned in Topic 2 in Section 1. Thus growth is an increase in what a country can produce if all factors of production are fully employed and it is illustrated graphically by a shift outwards in the production possibility curve (as in Figure 2.8 in Section 1 Topic 2). However, economic growth is also defined more generally as an increase in the value of the goods and services produced in the country over time, even if resources are not fully employed. In terms of the production possibility frontier, it can represent a movement from a position of unemployment towards the frontier. In Figure 2.6 in the same topic it is a movement from Y towards Z. This is actual economic growth and it is a more realistic definition since, in practice, no country ever achieves completely full employment. It is the way that governmental statistical services measure their growth. The increase can be over any period of time, usually a year, but monthly figures are also produced. It is useful at this point to distinguish between several pairs of concepts: - Actual and potential growth: Actual growth is the speed at which the economy is actually growing, even if all factors of production are not being used. Potential growth is the speed at which the economy could grow if all factors of production were fully used. - Short-run and long-run growth: There is no specific dividing line in time between the short run and the long run. The short run refers to a period of perhaps one or two years, within the period of an economic cycle, whereas the long run looks to the future and could be 10, 20 or even 30 years. - Positive and negative growth: Positive growth is always hoped for but negative growth (i.e. shrinkage) happens during a period when total output is falling.

Measuring economic growth

Economic growth is measured in most countries as the rate of change of real Gross Domestic Product (GDP). This is explained in more detail below. GDP is the money value of the total output of goods and services produced by a country in a given time period. Growth figures are published every month, every quarter and every year but it is common to measure it in quarters of a year. It is defined by the ONS as follows: 'GDP is a measure of economic activity which captures the value of goods and services that the UK produces during a given period.' There are different ways of presenting GDP. - Nominal and real GDP: There is an important distinction between nominal and real GDP and, when reading government GDP statistics, you need to be sure which is being referred to. Nominal GDP expresses the value of all the goods and services produced in the UK over the period in terms of the actual prices charged or paid for the goods and services at the time of their production or consumption. It is also referred to as value GDP or cash GDP and it has not been adjusted for inflation. Real GDP expresses the value of the goods and services at constant prices, after the effects of inflation (price rises) have been removed. This means that only the volumes of the goods and services change and so it is also known as volume GDP, or GDP at constant prices. The inflation is taken out of the figures by means of an inflation index, which is a statistical method of bringing together price rises to calculate an overall rate of inflation. (You will be studying inflation later in this topic and this includes an explanation of the price index.) For example, suppose that a country had a GDP of £200bn in 2010 and £250bn in 2015. It looks as if output has risen by 25% over the five-year period. However, if the country's price index was 100 in 2010 and 125 in 2015, inflation was also 25% over the period. Although nominal GDP has risen by 25%, real GDP has not increased at all as the difference in the figures is accounted for by price rises and not by a rise in the production of goods and services. To convert nominal into real GDP the UK government uses the following formula: 𝑁𝑜𝑚𝑖𝑛𝑎𝑙𝐺𝐷𝑃×𝑝𝑟𝑖𝑐𝑒 𝑖𝑛𝑑𝑒𝑥 𝑖𝑛 𝑏𝑎𝑠𝑒 𝑦𝑒𝑎𝑟 / 𝑝𝑟𝑖𝑐𝑒 i𝑛𝑑𝑒𝑥 𝑖𝑛 𝑐𝑢𝑟𝑟𝑒𝑛𝑡 𝑦𝑒𝑎𝑟 = 𝑅𝑒𝑎𝑙 𝐺𝐷𝑃 So with the example used above, real GDP is: £250𝑏𝑛×100 / 125=£200𝑏𝑛 -Total and per capita GDP: GDP figures are used to make comparisons between countries. A country's GDP can be stated as a total figure in money terms. But simply stating the absolute figure does not give a good basis for comparison because countries have different populations. For example, the GDP of the UK in 2014-15 was approximately £1.8 trillion (£1,800,000,000,000) and the figure for the US was around £11 trillion. (Note that the US figure would be given in dollars but we have converted it into sterling for ease of comparison.) But this does not mean that each person in the US is six times better off than each person in the UK because the populations of the two countries are very different. We can adjust for this by expressing GDP per head of population (per capita). To do this, we simply divide total GDP by the number of people in the country; the UK has a population of 64 million and the US has 319 million. So the GDP per head in each country is: UK: £1,800,000,000,000/64,000,000 = £28,125 per capita US: £11,000,000,000,000/319,000,000 = £34,483 per capita The US figure comes out higher, showing that the average US citizen produces more than the average British citizen, but the figures are much closer than might be supposed by looking at the raw total data.

International trade and inter-connectedness of economies

'When America sneezes, the rest of the world catches a cold', so someone once said. The balance of payments shows the net position of a country's trade with other nations. Like other countries, the UK engages in a huge volume of international trade and this fact means that there are close links between countries' economies. Each country specialises in producing those goods and services at which it has an advantage and it exports them abroad. Then it buys those products which it cannot produce at all or which it cannot produce so effectively. We referred to this specialisation in Section 1 Topic 2 and it is a central concept in the study of international trade. The main link between economies is the fact that, for each country, other countries are both markets to sell to and sources to purchase from. This means that the state of the economy of any country has an effect on its trading partners. For example, growth in a country like China is a great opportunity for UK firms to enter or grow their share of that market. Conversely, a country that is experiencing economic recession or, even worse, is in a war situation, is unlikely to make large orders for goods and services. Sensitivity to other countries' situations also affects the other side of the market. Many countries in the world do not have their own supplies of oil and gas and they rely on foreign supplies. If there is economic or political disruption in the countries that supply these essential raw materials, the purchaser countries have a big problem. There is unrest in a number of oil-producing countries such as Iraq and this affects world supplies and world prices. A recession or a boom in a large country like the US or China is very likely to be passed on to the rest of the world because of the effects on international trade. Another aspect of international connections is that of debt. As we have seen, some countries have balance of payments current account surpluses and others have deficits. In addition, the governments of many countries borrow money on the global financial markets by issuing bonds. These are securities which represent the debt and on which interest is paid. But if a country gets into serious debt (sometimes called perilous debt), there is a chance that it will default and that its creditors will lose the money they are owed. At the time of writing, the Greek economy is in crisis because of the huge amount of its debt, much of which is considered to be unsustainable. This will probably mean that some of it will be written off at some stage and that the countries and banks that have lent money to Greece will be unable to recover their assets.

Which of the following is the largest single item of government expenditure? a) education b) defence c) the National Health Service d) social security provision

(d) Expenditure on social security provision, such as state pensions, Jobseeker's Allowance and tax credits, is the largest item of government expenditure.

The long-run (LRAS) curve continued

- Shifts in the LRAS curve: The LRAS curve can shift position in response to changes in factors other than those affecting the price level. Figure 3.9 shows a decrease (shift to the left) in the AS curve from AS to AS1 - in other words, less is being supplied at the same price level.

Give four possible causes of a decrease in aggregate demand.

- cut in government spending - decrease in wealth - rise in taxation - fall in population - increase in pessimism - decrease in the money supply - rise in interest rates - decrease in the relative quality of domestic products - rise in the exchange rate - fall in incomes abroad.

Note down which type of unemployment each of the following situations falls into: 1. Building workers unemployed in the winter. 2. Gas workers made redundant as a result of people switching demand from gas to electric power. 3. UK car workers losing their jobs as a result of a multinational company switching production to its Spanish plant. 4. Shop assistants made redundant as a result of an economic recession. 5. Cricket players being laid off in the winter. 6. People turning down new jobs because they are unhappy with the wages offered.

1. Frictional (seasonal) 2. Structural 3. Structural 4. Cyclical 5. Frictional (seasonal) 6. Search (wage inflexibility)

It is an extract from the Minutes of the Bank of England's Monetary Policy Committee in July 2015: As expected, the ONS had revised UK GDP growth in 2015 Q1 up slightly, to 0.4%. Upward revisions to previous quarters had been larger, meaning that four-quarter growth to Q1 was now estimated to have been 2.9%, rather than 2.4%. The bulk of the revisions to output had come from the construction sector. On the expenditure side, there had been revisions to a number of components. Consumption growth in Q1 had been revised up to 0.9%, indicating that the boost to real incomes from the past reduction in oil prices might have begun to feed through to spending at the start of the year. Business investment growth had been revised up to 2.0%. Net trade [i.e.net exports] had detracted from growth by less than in the previous estimate, while the contribution from stock-building had been large and positive. 1. Identify the components of aggregate demand referred to in the above extract. Which component is not referred to? 2. What contribution did each component make in Q1 to the improved growth in aggregate demand?

1. The components referred to are consumption, investment and net trade (i.e. net exports). Government expenditure is not referred to. 2. Consumption grew by 0.9% in Q1. This was more than expected and was probably because of the fall in oil prices. Investment grew by 2% and stock-building was large and positive. The contribution from net trade was negative but less than estimated.

Briefly note down the effect of each of the following factors on the UK's current account position, other things being equal in each case. 1. A cut in income tax in Ireland, one of the UK's main export markets. 2. A rise in labour productivity in the UK without a corresponding rise in wages. 3. The removal by the US of import restrictions on a wide range of products traded with the UK. 4. A rise in the domestic rate of inflation. 5. A fall in the speed of dealing with overseas orders.

1. This will improve the UK's balance of payments. People in Ireland will now have more disposable income and will be more able to afford to buy UK exports. 2. This will improve the UK's balance of payments. It is equivalent to a fall in costs for UK businesses and will enable them to keep their export prices more competitive. 3. This will improve the UK's balance of payments. UK exports will now be more able to enter the US market. 4. This will cause the UK's balance of payments to deteriorate as the prices of UK products will now be less competitive in world markets. 5. This will cause the UK's balance of payments to deteriorate as foreign importers will have to wait longer for their goods and they may find alternative suppliers in other countries.

1. What do the weights in the Consumer Prices Index indicate? 2. Unemployment in an economy indicates that the country is operating at which point? 3. In 2013 the GDP of a country is $900,000m, its population is 50m and its price index 100. In 2014 its nominal GDP rises to $920,000m, its population falls to 46m and the price index rises to 125. What is its real GDP per capita in 2014?

1. Weights are given to different categories of products in the CPI to reflect the proportion of consumer spending they represent. 2. Unemployment will mean that an economy is not producing at its full capacity, so it will be operating at a point inside its production possibility curve. 3. Nominal GDP per head in 2014 is $920,000m divided by 46m making $20,000. In real terms GDP per head is $20,000×100 / 125=$16,000

Investment

A word of caution is necessary before starting this section. The word 'investment' in everyday language refers to money saved by people in stocks and shares. In other words it is a type of saving, but in economics it has a different meaning. Investment, which is also known as 'capital formation', is total expenditure by businesses on capital goods such as factories and machinery, and on additions to inventories (stocks of goods held). Investment is determined by firms' expectations about future profit levels. More specifically, firms invest when they expect the rate of return on the investment to exceed the cost of the investment. Investment comes under several main headings: - Development of new products: This could be a new version of existing products such as a new generation of mobile phone, or a completely new product such as a new type of antibiotic. - Expansion into new markets: This could be either into new segments of the domestic market or it could be into new exports markets. In either case, investment may be made in building new premises. For example, a supermarket may open new branches. - Investment in new technology: This could be a call centre changing its computer system for a new, faster and smarter one. Or it could be a manufacturing company purchasing a new production line or buying new equipment and tools. - Investment in staff: One very important type of investment that almost all firms do nowadays is investing in the training and development of their staff. This could be providing training courses for care workers in new methods of helping old people to be mobile. Or it might be a bank taking on new apprentices to learn on the job and also to attend university to get a degree. Gross and net investment: We must distinguish between two main investment identities. Gross investment is the total amount spent on investment by firms in a particular period - the total addition to the economy's capital stock. Put simply, it is fixed assets such as buildings, machinery and vehicles and unsold stocks. However, capital assets lose value over time and this is known as depreciation or capital consumption. Depreciation of buildings and equipment happens for several reasons: - Assets like factory machinery that are in continuous use suffer from wear and tear. - Assets like buildings and vehicles deteriorate because of the effects of the weather. - Assets also lose value because of obsolescence. This means that they become old-fashioned and are superseded by newer models. So to give a true picture of the amount of investment in the economy during a period, we need to subtract an amount of depreciation to allow for the amount of capital used up during the period. Net investment = gross investment - depreciation

Components of aggregate demand

Aggregate demand (AD) is one of the fundamental concepts in macroeconomics. It is closely connected with other macroeconomic variables and especially with the level of employment. It is the total amount of money spent in a country during a given time period. Demand comes from several sectors of the economy (we will use the UK as our example). - Households spend money on everyday items such as food, clothing and transport. This is consumption (C). - Businesses spend money on purchasing capital items such as computers, vehicles, equipment and other long-term assets which will enable them to produce their goods and services. This is investment (I). - The government spends money on a wide range of public services such as health and education. This is government spending (G). - People in other countries spend money on buying goods and services produced in the UK such as banking services and engineering components. This is exports (X). However, UK residents also spend money on goods and services from other countries. This is imports (M). The net effect of the external overseas sector on aggregate demand is found by subtracting imports from exports - net exports (X - M). All these four elements together give us aggregate demand and we can express it in the following way: Aggregate demand = consumption + investment + government spending + (exports - imports) Or AD = C + I + G + (X - M) We will now look at each of these components in more detail. Remember what you learned in Topic 1: total expenditure, income and output in a country refer to the size of the activity of the economy looked at in three different ways. So output creates income and leads to expenditure, and expenditure leads to more income and output. When you have studied all the components, you will draw graphs of aggregate demand curve.

Aggregate supply

Aggregate supply (AS) is the total volume of goods and services that all firms in the economy are willing and able to sell at a given price level in a given period. In the last topic you learned about aggregate demand (AD) and how this shows us the total size of the economy in terms of the amount of money spent by the various sectors during a period. In this topic we are looking at the capacity (ability) and willingness of the supply side of the economy to use factors of production to produce the output to satisfy aggregate demand. Remember that AD includes consumption, investment, general government expenditure and net exports. Aggregate supply is a measure of the potential output of the economy and it includes the production of the following components: - consumer goods and services which are purchased by households such as food, clothing and entertainment - capital goods and services which are purchased by firms when implementing their investment programmes such as industrial plant, computer systems and training programmes - public and merit goods supplied by the public sector such as new motorways, education and health services - goods and services which are sold as exports such as industrial components and banking and insurance services.

Comparing growth rates over time

Growth occurs over time and so it is logical for a country to compare its GDP from one period with another to see whether it has increased or decreased and by how much. The statistical services in all countries measure growth rates on an annual, quarterly and monthly basis. Some governments may set themselves growth targets and others may simply monitor the figures in the hope that the growth rate is rising. Growth can also be measured for particular sectors of the economy, for example, for financial services, the leisure sector, manufacturing sector or for individual regions. Growth rates that are calculated using absolute figures (based on nominal GDP) do not take account of inflation so it is best to make time comparisons using real GDP figures. Most governments aim to achieve real GDP growth as they see it as improving the welfare of people in the country. When the economy grows, incomes have risen and people are able to spend more on consumption. Conversely, if growth is negative (falling), then incomes, consumption and living standards are lower. Later in this topic you will look at GDP as an indicator of living standards, which will give you more thoughts on whether GDP comparisons are useful.

Summary of Aggregate demand

In this topic you have been introduced to the concept of aggregate demand and explored the factors influencing the components of aggregate demand. You have examined the relationship between aggregate demand and the price level and the causes of shifts in the aggregate demand curve. The key points are as follows: - Aggregate demand is total demand and is composed of spending on consumer goods and services, total investment, government spending and exports minus imports: AD = C + I + G + (X-M). . The aggregate demand curve slopes down from left to right as a rise in the price level will raise the rate of interest, reduce the price-competitiveness of domestic products and reduce wealth. - The main influence on consumption is income. Other influences include wealth, the age structure of the population, the availability of credit, the range and quality of products and the distribution of income. - Investment is spending on capital goods and changes in stocks. Influences on investment include changes in income, corporation tax, relative price of capital goods, rate of interest, technology, expectations and government incentives. - Government spending is influenced by consumer demand for government-financed products, the degree of market failure and the state of the economy. - Net exports are influenced by income levels at home and abroad, price and quality competitiveness.

Summary of Measuring economic performance

In this topic you have considered the key indicators of economic performance. The key points are as follows: - The main indicators of economic performance are the economic growth rate, inflation rate, unemployment rate and the current account position of the balance of payments. - Real GDP is nominal GDP adjusted for inflation. - A rise in real GDP per head will mean a rise in output per head but not necessarily a rise in the quality of people's lives. Inflation is a sustained rise in the price level. By its nature, it involves a fall in the value of money. - The two main measures of unemployment are the ILO measure and the claimant count. - Cyclical, structural, frictional, seasonal and real wage inflexibility are the main types of unemployment. - The main sections of the current account of the balance of payments are trade in goods, trade in services, income and current transfers. - A deficit on the current account of the balance of payments may be caused by a lack of price competitiveness, poor quality products, a fall in income abroad or a rise in the exchange rate. - A current account deficit may reduce inflationary pressure but can also reduce employment and increase economic growth.

Summary of Aggregate supply

In this topic you have explored the nature of aggregate supply and examined the influence of changes in aggregate demand on aggregate supply via the price level. You have also discussed the causes of shifts in aggregate supply. The key points are: - Aggregate supply is the total output firms are willing and able to supply at different values of the price level. - A shift in the AD curve will cause a movement along the AS curve via a change in prices. - An increase in the costs of production will cause a shift of the AS curve to the left. - An increase in the quantity and/or quality of resources will shift the AS curve to the right.

Effects of inflation

Inflation has effects on the standard of living of all stakeholders in an economy, but it has different effects on different groups and has a redistributive effect. You will note the different ways that inflation affects different stakeholder groups, and also the different ways it can affect the same people. -Individual consumers and workers: Inflation affects individual people in their capacity as both consumers and employees. Inflation causes the value of money to fall so the effect on people depends on whether or not, and the extent to which, their incomes are able to rise enough to keep pace with rises in prices. Those who work in key occupations and who have strong wage bargaining power are more able to push for rises in their wages and salaries and thus can afford to pay the rises in prices of goods and services (although there may be a time lag between the rise in prices and the rise in their wages). But inflation reduces the living standards of those who are not in this category, and who are more likely to be low-skilled and low-paid workers, as well as people on fixed or relatively fixed incomes such as pensioners living on fixed interest annuities. Their purchasing power is eroded as prices rise and so inflation has a redistributive effect from the weaker members of society to the stronger. -Savers and borrowers: Inflation affects savers and borrowers differently. If we ignore interest rates, we can say that inflation erodes the value of savings in bank accounts or other forms of savings and investments, as the money saved has an increasingly low real value as inflation progresses over time. Conversely, borrowers gain as debts are also eroded and this is especially clear in the case of people who take out mortgages to buy their homes. As the years pass, their incomes rise with inflation, but the amount of the debt stays the same in nominal terms and falls in real terms. In practice, savers are paid interest and borrowers pay interest. If we take interest into account, the redistributive effect on savers and borrowers depends on whether interest rates are higher or lower than the rate of inflation. If the rate of inflation is 1% but a saver is able to secure 1.5% by agreeing to leave money in an account for a long period, the saver is being more than compensated for inflation. But someone who is paid only 0.5% is losing real value. The difference between the nominal interest rate and the rate of inflation at any point in time is called the real interest rate: Real interest rate = nominal interest rate - rate of inflation Interest rates charged on loans by banks are higher than interest rates paid on savings, so it is unlikely that any borrower could pay a rate of interest which is lower than inflation. But it might not be much more and the borrower would gain from any rise in the value of the goods purchased with the loan, especially in the case of a house.

Inflation

Inflation is the rate at which the general level of prices for goods and services as a whole is rising. It is therefore the rate at which the purchasing power of money is falling. When a country is experiencing inflation, the following can be observed: - Prices rise. - Money incomes, including wages, rise. - The amount of money in circulation rises. These are the symptoms of inflation but the underlying situation needs to be explained. In Section 1 Topic 2 you studied the functions of money that showed why a country has a money supply. The amount of money in circulation in an economy must be limited and must bear some relation to the volume of goods and services produced, since money represents these goods and services. But if the money supply becomes too big relative to the goods and services, then prices rise and the value of each unit of money falls. This can be restated as follows. Inflation is a situation where the speed at which the money supply is increasing is faster than the speed at which the production of goods and services is increasing. Imagine a situation where the government or central bank suddenly increases the money supply by a significant amount and this money goes into circulation. People now have more to spend and their demand for goods and services rises. Market theory tells us that this puts upward pressure on prices, since the demand is higher but the supply is the same. So the extra amount of money which people are holding is eventually eaten up by higher prices - since no more goods and services have been produced, people are not better off simply because they hold more money. There is an argument between economists as to whether a growing money supply actually causes inflation or is simply the result of it. However, it is true to say that there is a very close relationship between the rate of inflation and the rate of growth of the money supply. -Deflation: Deflation is the opposite situation to inflation in that it is the rate at which prices, wages and the money supply are falling. Because inflation is seen as being a problem, it might seem as if deflation is desirable, but actually it can develop into a vicious spiral of falling prices, incomes and employment and can accompany or lead to an economic recession. -Disinflation: Disinflation is a situation in which the rate of price inflation is slowing down and it is often the result of deliberate government policies to reduce inflation. Disinflation should not be confused with deflation, which is a situation where prices are actually falling. Study hint: Think about the following situation. A government minister appears on television and social media announce that inflation is falling. People go to the supermarket the next day and discover that some prices have risen so that their bill is bigger. They say 'The government minister was wrong - inflation can't be falling because prices are still rising'. The people who made this statement have failed to understand the meaning of inflation. Inflation measures not the fact that prices are rising but the speed at which they are rising. So the government minister could be right. If inflation was 2% last month and is now only 1.5%, then the rate of inflation is falling. But prices are still rising - by 1.5% instead of 2% and so they are rising more slowly. This could be part of a process of disinflation but it is still inflation. You must think of the rate of inflation in terms of acceleration and deceleration - are prices rising faster or more slowly?

(a) Explain the relationship that you would expect to find between adult literacy percentages and GDP. (4 marks)

It would be expected that there would be a positive relationship between adult literacy percentages and GDP. High literacy rates are likely to mean that the workforce is well educated. This in turn is likely to mean that productivity is high. Workers will be skilled, adaptable to change, capable of inventing, implementing and using new technology. So a more literate population is likely to be associated with a higher GDP than a population with a low rate of adult literacy. Similarly, a country with a high GDP is likely to have more resources to devote to education and hence to have a more literate population than a country with a low GDP.

Constructing a weighted price index

Several stages are involved in building up a weighted price index. Each category of expenditure must be allocated a weight, which is found by calculating the proportion of total expenditure spent on each product. For instance, if £500 out of a total expenditure of £2,000 is spent on food, then food would receive a weighting of ¼. The weight is multiplied by the percentage price change to give the weighted price change. The example given in Table 1.3 shows this more clearly. Note that the price changes are calculated in comparison with the base year (Year 1) which is given the value of 100. We begin with the expenditure to find the initial weighting. Consumers' expenditure in total comes to £100. Food will therefore receive a weighting of 30/100 = 3/10 and so on for the other categories. To find the price change, we need to look at how the price indices vary between different periods. Food has risen in price by 30%. So the weighted price change is 3/10 x 30% = 9%. To find the overall weighted price index, we need to add all the weighted price changes for all the categories

Comparing growth rates between countries

Similar points to those made above have to be considered when comparing the GDP of different countries. Again, it is more useful to compare real GDP per head, but there are other factors that need to be taken into account when making inter-country comparisons: - Differences in the types of economy and goods and services produced - whether the country depends on agriculture, manufacturing or services. - Differences in the distribution of wealth, income, working hours and conditions - whether there is a reasonable amount of equality in the country or whether it is polarised into a few very rich people and a large number of very poor people. - The extent to which the country experiences externalities, both positive and negative - whether it suffers from a high level of pollution and congestion in its cities. - The size of the illegal economy (people who work but do not declare their income). If this is very high, the official GDP figures will underestimate output and incomes. - In all countries, but especially in developing countries, there is a lot of non-traded activity which people do for themselves, such as growing their own food or painting their own houses. This is not recorded in the national accounts but is still valuable. - Differences between countries in people's tastes and needs. For example, people who live in a warm climate may, other things being equal, enjoy a similar standard of living to people living in a cold climate, even if heating systems in the former country are less efficient. Purchasing power parity GDP is measured in terms of money value and this creates a problem when comparing the GDPs of different countries, as a common standard of value has to be used. An internationally accepted currency such as the US dollar could be used. But this is subject to changes in exchange rates and it only applies to products which are traded between countries and not to products which are purchased within the country and not traded. In order to convert local currency values in many countries into one common unit for the purposes of comparison, exchange rates must be used. But instead of using the official exchange rates given in the financial markets, the problem of fluctuations is overcome by using the device of purchasing power parity (PPP). Purchasing power parity: converts GDP in terms of each national currency into a common currency (probably the US dollar) by using a PPP exchange rate. This rate reflects the amount of each country's currency that would have to be spent in order to buy a basket of commonly consumed and representative goods and services. In other words, the PPP-adjusted exchange rates show how much people would have to spend in their own local currency in order to purchase the basket of goods. For example, if a basket of basic foodstuffs costs £10 in the UK and the same basket costs $20 in the US, the PPP rate would be £1 = $2. So PPP rates use real comparisons to create a common measuring device. They fluctuate less than official rates and they include values from both traded and non-traded goods and services.

A comparison of ILO and claimant count

The ILO survey gives a higher unemployment figure than the claimant count because it includes people who are looking for only a few hours part-time work per week. But the claimant count may underestimate the figure because not all unemployed people claim benefit. For example, some cannot prove that they are looking for work, and part-time employees are less likely to register as unemployed than are full-time employees. This factor is however balanced by people who make fraudulent claims. The claimant count is also subject to the fact that the number of people who are eligible for Jobseeker's Allowance can change with changes in government policy which affects the claimant figures. In addition, the claimant count does not provide other labour market information and has only limited use in making international comparisons as most other countries rely principally on the ILO measure. While the ILO measure provides considerably more information and is appropriate for international comparisons, it is costly and time-consuming to compile. It is also subject to sampling errors. For instance, the sample selected may not be representative of the population as a whole and some of those interviewed may misinterpret the questions they are asked.

The Retail Prices Index

The Retail Prices Index (RPI) is an alternative measure of inflation and exists alongside the CPI. Like the CPI, the RPI measures changes in the prices of a 'basket' containing around 650 individual goods and services. However, it is considered to be more of a cost of living index. This is because it gives a higher weighting to those items which people consider to be more important, such as food, heating, housing and petrol, and a lower weighting to items such as tobacco, which are not considered to be necessaries. It is notable that the RPI includes some of the costs of housing, such as mortgage interest payments and council tax, whereas the CPI excludes housing costs. This is so that a change in interest rates will not affect the CPI, since interest rates are also used as a tool of monetary policy. The RPI is measured on the assumption that, when prices rise, consumers will switch to a cheaper alternative. So it addresses one of the limitations with the CPI we noted above. A different mathematical formula is used to calculate the RPI from that used to calculate the CPI and this usually means that the RPI gives a slightly higher figure than the CPI. For example, the RPI for June 2015 was 1%, while the CPI figure was 0%. Note that the ONS believes that the RPI overstates inflation and is considering replacing it with a new measure called the RPIJ, which uses yet another statistical formula. Certain types of savings and also state benefits are index-linked. This means that the amount paid in interest or in benefits rises each year in line with the rate of inflation. The government, and most pension funds, use the CPI for index-linking pensions and benefits but some index-linked investments still use the RPI.

The aggregate demand curve

The aggregate demand (AD) curve plots total demand as denominated in terms of real GDP against the price level. It shows the total planned spending at different values of the price level, as illustrated in Figure 2.2 below. It slopes down from left to right (it has a negative slope) because a rise in the price level will cause a contraction in aggregate demand. This inverse relationship occurs because a higher price level: - is usually associated with a rise in the rate of interest - this usually results in a fall in consumption and investment because it is more expensive to borrow money to finance these types of spending - makes domestic products less price-competitive in foreign and home markets, and so is likely to reduce exports and raise imports - reduces the value of wealth which in turn tends to discourage consumption Figure 2.2 shows a movement along the AD curve. When the price level is P, total real GDP is Y. When prices rise to P1, total demand moves along the curve to Y1. Note that although a curve is shown in the above diagram, some textbooks and online resources use a straight line curve. Note that the aggregate demand curve looks very like the microeconomic demand curve you studied in Section 1 Topic 3. Like this demand curve, it plots quantity spent against prices. But remember that this graph represents the macroeconomic variable of aggregate demand. -Shifts in the aggregate demand curve Like the microeconomic demand curve, the AD curve can shift in position across the graph. A shift in aggregate demand is caused by a change in one of the factors affecting aggregate demand, other than a change in the price level. If there is a rise in planned spending, there will be an increase in aggregate demand which is represented by a shift to the right of the aggregate demand curve. A decrease in aggregate demand is shown by a shift to the left of the aggregate demand curve. An increase in aggregate demand is shown in Figure 2.3, from AD to AD1. See that the following will result in an increase in aggregate demand: - An increase in household consumption. This could happen when the economy is in an upturn and would arise from an increase in incomes and wealth accompanied by an increase in the money supply and probably by increased optimism. It could also originate in a rise in the population. - An increase in investment by firms because of a rise in expectations of future profits, a fall in the rate of interest or because of changes in technology. - An increase in government expenditure, either because the economy is growing or because the government is making a deliberate attempt to raise aggregate demand in order to reduce the rate of unemployment. - An increase in exports because of a rise in their quality, a fall in the exchange rate of the currency or because of a rise in incomes abroad.

Key indicators of economic performance

The key indicators of how an economy is performing are the following: - economic growth rate - inflation rate - employment and unemployment rates - balance of payments position. Generally, it is thought that an economy is doing well if it has steady and sustainable economic growth, low and stable inflation, low unemployment and a current account balance on the balance of payments Sustainable development was defined in 1983 by the United Nations Brundtland Commission as: 'development that meets the needs of the present without compromising the ability of future generations to meet their own needs'. Or in other words, an economy which is growing sustainably is providing for the needs of its present population but is not consuming so much that there will be nothing left for people in the future.

The causes and types of unemployment

There are several reasons why unemployed people lose or cannot find jobs. You will now look at the main factors that cause unemployment. -Cyclical unemployment: Cyclical unemployment happens when people lose their jobs as a result of a deficiency in aggregate demand. (Aggregate demand is the total demand in the economy for all goods and services by households, firms and the government.) It is perhaps the most basic reason for unemployment and it is so-called because it happens at the low part of the trade cycle (which you will cover in the next topic). This is a period when economic activity has fallen and there is a lack of aggregate demand - the economy is producing less than its capacity (the amount it is capable of making). As individuals, businesses and perhaps the government are all spending less, there is less demand for labour and other factors of production to make goods and services. People therefore lose jobs and cannot find new ones. Cyclical unemployment affects the whole economy and not only specific sectors, although it may be higher in industries which produce goods and services which are considered to be less necessary and which people give up when their incomes are lower. Cyclical unemployment disappears when the economy is working at the top of the trade cycle and aggregate demand is very high. -Structural unemployment: Structural unemployment happens when a country experiences a decline in particular industries because of long-term changes in market conditions on either the demand side, the supply side or both. Over the last 30 years or so, the UK has suffered from a lot of structural unemployment as old industries have closed down, often because of foreign competition. Examples are the car-making, shipbuilding and coal industries and the closure of factories, plants and mines has affected some regions of the country more than others. For example, coal mines were concentrated in South Wales and parts of the Midlands and the North of England. These areas have suffered from higher than average unemployment over the years and the closure of the coal mines exacerbated this. Another aspect of structural unemployment is technological unemployment, whereby human employees lose their jobs because of the introduction of new technology. Examples are car assembly plants, many of which are robotised nowadays, and the banking sector, where branch employees have lost jobs as a result of the introduction of internet and mobile banking. Interestingly however, in such cases there is still a demand for the computerised equipment which replaces the humans and this creates new jobs in the IT sector. Before the introduction of computers, many people were afraid that their widespread use would result in massive unemployment. The opposite has been true and the computer and IT sectors have become vital sectors in their turn and employ millions of people.

What US-related factors have affected Mexican output and how?

There are two US-related factors: 1. Growth in the US has boosted Mexico's export sector and caused growth in GDP, since export earnings are part of aggregate demand. 2. Lower migration to the US has resulted in a rise in the Mexican labour force and this has put downward pressure on wages.

Migration and skills

There has been a lot of migration into the UK over the last decade and this has certain effects on unemployment. A large number of migrants are of working age and so they boost the labour force and increase the country's productive potential. At the same time, they spend the incomes they earn and so boost aggregate expenditure which in turn causes an increase in demand for goods and services and therefore an increase in the demand for labour. However, they do send some of their earnings to relatives in their own countries in the form of personal remittances. So it is important to remember that an increase in inward migration creates employment as well as constituting competition for jobs and creating unemployment among nationals. Inward migration affects some sectors more than others. For example, many of the workers from Eastern European EU countries during the mid-2000s, and especially from Poland, had building and plumbing skills and found jobs in the construction and domestic repairs sector. There can be deliberate attempts by the government to attract members of particular trades or professions to cover skills shortages such as doctors and nurses. Net immigration as a whole puts increased pressure on the country's infrastructure (roads, railways systems, hospitals, schools and housing). If this pressure is not addressed, there can be severe negative externalities in the form of congestion and urban pollution, but if it leads to more capital spending by both the private and the public sectors, then more employment will be created. The increase in the workforce and in the population as a whole will lead to higher tax revenues for the government and will help it to make these expenditures. Despite what is sometimes written in the press, researchers have found no clear link between migration and unemployment. In a period of high unemployment, migrants will find it harder to get work and are less likely to stay. Their impact on unemployment mainly comes from their skills and qualifications. As we saw earlier, there are shortages of certain skills in the UK and migrants may help to relieve these shortages. There is also a general perception that migrants are willing to accept lower wages and therefore push wage levels down. This may be true to the extent that migrants are illegal and working in the black market, but legal migrants are covered by the minimum wage law.

Using an aggregate demand and aggregate supply diagram, in each case show an increase in AD causing: 1. an increase in the price level but having no effect on real GDP 2. an increase in real GDP but having no effect on the price level.

check notes