Unit 5 - The UK Economy - Income, Growth and Policies

Distinguish between stocks and flows

flow has movement - it moves inwards (inflows) and outwards (outflows). A stock does not move but stays still until an inflow increases it or an outflow decreases it. So a stock is the result of past inflows and outflows whereas a flow is an addition to or a subtraction from a stock. Suppose that John has £1000 in a savings account. This is a stock. In July John spends less money and manages to put £50 into the savings account; this inflow has increased the stock to £1050. In August John's car breaks down and the garage bill is £300. He can't afford to pay this out of his monthly income so he withdraws money from his savings account to pay the bill. This is an outflow from the savings stock and the balance is now £750. A stock acts as a buffer to changes in flows. John was able to use his savings resources to pay a bill which he couldn't have afforded otherwise.

Decide what the immediate effects of the following changes would be - a shift in the AD curve or a shift in the AS curve? 1. Improvement in the health of workers 2. Land reclamation 3. Increase in household wealth 4. Reduction in consumer confidence 5. Reduction in fish stocks

1. An increase in the aggregate supply curve 2. An increase in the aggregate supply curve 3. An increase in the aggregate demand curve 4. A decrease in the aggregate demand curve 5. A decrease in the aggregate supply curve

Government policies

Governments are responsible for achieving the economic objectives which you have just studied, and they use a range of economic policies to do this. Policies can be sub-divided into two main groups. - Demand-side policies act on aggregate demand and are further sub-divided into monetary and fiscal policy. - Supply-side policies are a range of policies that act on aggregate supply by improving the efficiency of product and labour markets. Monetary policy refers to those measures that make changes in the money supply and the general level of interest rates. Monetary policy in the UK is carried out by the central bank, the Bank of England. Fiscal policy refers to those measures which make changes in government spending, taxation and therefore in the government's borrowing requirement. - Monetary policy: Monetary policy is carried out in most countries by the government and/or the central bank. The central bank of the UK is the Bank of England, which is independent of the government but works closely with it. Since 1992 the UK government has had a stated inflation target, which is announced by the Chancellor of the Exchequer (the Economics Minister) in the annual Budget statement. Since 2003 this target has been 2% as measured by the CPI. The government has given the task of achieving the 2% inflation target to the Bank of England. This does not mean that inflation must always be at 2% - and it would be impossible to achieve this. But if inflation deviates from target, the Bank of England must act to bring it back to that level in the medium term, which is probably around one or two years. The Bank of England also has a secondary target of supporting the government's economic objectives, including those for growth and employment (but no specific targets for growth or employment have been set). Reducing inflation requires policies that reduce economic activity, but boosting growth and employment requires policies which increase it. Given that these targets require opposite policies, it is reasonable to say that the Bank of England needs to aim to achieve a good balance between keeping inflation near to target but not at the expense of creating high unemployment. Note that the Bank of England carries out many other functions but here we are looking only at its monetary policy role. The Bank of England uses two main instruments or methods to achieve the inflation target and to support the government's growth and employment objectives. These are interest rates and asset purchases. Changes in these two instruments are the responsibility of the Bank of England's Monetary Policy Committee. - Interest rates: An interest rate is the charge made by a lender to a borrower and is expressed as a percentage of the amount borrowed. The Bank of England has an official interest rate called 'Bank Rate'. Commercial banks and building societies hold reserve balances at the Bank of England (similar to savings accounts) and they are paid Bank Rate on these reserves. Banks react to a change in Bank Rate by changing the rates they charge their borrowers and pay to their savers. They are not obliged to do this but they usually do so overall, although they may decide not to follow suit in the case of individual lending or savings products in order to be more competitive. So a change in Bank Rate causes a change in other interest rates in the economy. This is known as conventional monetary policy. Changes in the level of interest rates affect the overall level of economy activity for the following reasons: - Business investment and a lot of household consumption is financed by borrowing. When interest rates are higher, investment is more expensive and a lot of firms cancel their projects. Consumption also costs more and people borrow and spend less. So aggregate demand decreases. Conversely, a fall in interest rates makes borrowing cheaper and stimulates investment and consumption and therefore aggregate demand increases. - Both firms and households save money that they do not want to spend and they receive a rate of interest on their savings. When interest rates are higher, they earn more interest and there is more incentive to save and not to spend. Conversely, when interest rates are lower, they save less. So the higher the level of interest rates, the less money is spent and the more is saved. Aggregate demand falls and so does economic activity. Conversely, the lower the level of interest rates, the more money is spent and the less is saved. Aggregate demand and economic activity rise. Note that the phrase 'Bank Rate' is used by the Bank of England, but you may see it described in the less technical phrase 'base rate'. The Monetary Policy Committee (MPC) consists of nine members who meet every month to decide whether or not to change the level of Bank Rate. The MPC attempts 'to influence the overall level of activity in the economy in order to keep the demand for, and supply of, goods and services roughly in balance. Doing so results in a rate of inflation in the economy consistent with the Bank's 2% inflation target.' This connects with the output gaps that you studied in the last topic. If aggregate demand is greater than aggregate supply, inflation may rise above the 2% target and so the MPC may decide to raise Bank Rate to reduce the level of economic activity and bring down inflation. So when the MPC meets each month, it has to consider the overall state of the economy and also look at international economic development. It looks at a wide range of economic indicators; these are important variables which show the levels of aggregate demand and supply and therefore what the inflation rate is likely to do. Here are a few of the important indicators that the MPC considers: - growth rates in the UK, euro area, US, and the emerging economies, especially China - current rate of inflation and the state of people's inflation expectations - levels of unemployment and productivity - behaviour of costs, in -particular raw materials and labour costs - exchange rate of sterling. The MPC looks at all these indicators as a whole. If it feels that, on balance, the risks of inflation rising above the 2% target are greater than those of its falling below the target, it may decide to raise the Bank Rate. Suppose that the MPC believes that the rate of inflation is going to increase and increases Bank Rate. This means that banks will receive a higher rate of interest on their deposits but they will also have to pay a higher rate if they borrow from the Bank of England (they do this when there is no other source of funds and the Bank lends as lender of last resort). When they in turn lend to others, they now charge a higher rate, and they can also afford to pay more to their savers to be competitive. The overall result is that a rise in Bank Rate will result in a rise in most other interest rates in the economy and this is known as the transmission mechanism. As explained above, the demand for borrowing will fall and the supply of savings will rise. Aggregate demand will fall and will begin to approach aggregate supply, reducing the output gap. Other things being equal, the rate of inflation will fall. Another aspect of this process is that, because the demand for bank loans has reduced, banks are lending and creating less money. When banks make loans, they create credit. This is because, when a customer borrows money and spends it, it becomes income for someone else and comes back into the banking system. It is then lent out again. This is similar to the multiplier process you learnt about in Topic 1 of this section and you will study it in more detail in the second half of this course. - Interest rate policy since the financial crisis: In June 2007, before the financial crisis began to make itself felt, Bank Rate stood at 5.5%. The MPC began to bring it down gradually, and then, when the economy went into recession, more quickly. By March 2009 Bank Rate was 0.5%, the lowest it had been since the Bank of England was founded in 1694. Interest rates had to fall because inflation was low and the economy was experiencing low and, for a period, negative growth. However, even when Bank Rate had reached 0.5%, the economy was not responding well and further stimulus was needed. The MPC could not bring interest rates down much further - it had already reached its 'effective lower bound'. Interest rates could not become negative as that would have had strange effects - depositors would have been obliged to pay banks to keep their savings for them. So the Bank followed the example that the Japanese central bank had set in the early 2000s when it was trying to avoid recession. This is the policy of quantitative easing or asset purchase facility. - Quantitative easing: This is known as unconventional monetary policy and it was first instituted by the MPC in March 2009 as an emergency measure to try to stimulate the economy. Quantitative easing (QE) is a process by which the central bank creates new money and pushes interest rates down further. It works as follows. The Bank of England is able to create new money whenever it needs to. It prints the notes we use as cash but this forms only around 3% of the total money supply. It can also make new electronic money, simply by pressing a few keys on its computer and putting more money into its money issvue account. Some people have referred to this process as 'printing money' but the new money is in electronic form and no actual notes are printed. The bank then uses this new money to buy financial assets in the financial markets. These are mostly government bonds. Government bonds are securities that are issued by the government. The people who purchase them are lending money to the public sector and they keep them as assets. They are claims on the government by the purchasers. Large companies called investment funds and pension funds hold sizeable quantities of these bonds. When the Bank of England goes into the market to buy bonds, it buys them from these companies. It pays with the new money it has just created and the investment funds put the money into their bank accounts. Banks now have more deposits and they can lend out more to their customers, thus boosting investment and consumption. Because there is a bigger demand for the bonds, the price of the bonds goes up and the rate of interest on the bonds goes down. (There is an inverse relationship between the price of an asset and the interest rate on the asset. You will explore this in more detail later.) This has a knock-on effect on other interest rates in the financial markets and other interest rates fall below what they would have been. Thus QE adds to the effect of a low Bank Rate. In summary, QE adds to the money supply and brings down interest rates. The Bank of England is left with a stock of assets (at the time of writing this stands at the very large amount of £375bn), which it can sell at some point in the future when it feels that interest rates can rise again, perhaps if inflation gets too high. - An assessment of monetary policy: A change in Bank Rate affects all other interest rates in the economy and it therefore covers all forms of borrowing and saving. So monetary policy is effective to the extent that people respond to interest rate changes by changing their borrowing and saving behaviour. Quantitative easing has been criticised on this score as it is felt that, although new money has gone into bank accounts, banks have used some of this money to repair their broken finances rather than lend it out to customers. The Bank of England's monetary policy is fairly transparent. People know that an interest rate decision is made every month and they expect that action will be taken if, for example, inflation starts to rise. This affects their inflation expectations and this in turn affects the extent to which workers push for wage rises and firms raise prices. If people think that inflation is under control, they are less likely to go for these rises. Expectations become self-fulfilling and inflation stays low. One weakness of monetary policy is that changes in interest rates are subject to time lags and do not have an immediate effect on aggregate demand and prices. For example, it takes some time for higher interest rates to work their way through to bank lending rates and actually to reduce the amount of money people are borrowing. The Bank of England estimates that it takes up to one year for an interest rate change to have an effect on output and up to two years to have a maximum effect on consumer price inflation. So interest rate (and asset purchase) decisions are taken on the basis of what the MPC judges inflation will be in the future. It is also worth noting that interest rate and QE policy have an effect on the exchange rate of sterling. When interest rates rise, companies and financial institutions move their savings into the currency that pays the highest interest rate. If sterling interest rates rise but euro interest rates do not, money balances are moved from euro accounts into sterling accounts. The increase in demand for sterling and increased supply of euro cause sterling to appreciate against the euro. This has effects on the volume of exports and imports made by the UK. Neither the Bank of England nor the UK government has a stated policy on exchange rates and interest rate changes aim at the 2% inflation target, but there is still an effect on exchange rates.

Macroeconomic policy objectives

Governments set themselves a number of macroeconomic objectives for the economy including: - economic growth - low unemployment - low and stable rate of inflation - balance of payments equilibrium on current account - balanced government budget - greater income equality - protection of the environment. Economic growth: You studied economic growth in the last topic and learnt its meaning, causes and impact in terms of its benefits and costs. You also learnt about the output gap and the trade cycle. Because economic growth has many benefits and is linked to other objectives, in particular that of low unemployment, it is seen as desirable for a country to have a reasonable annual rate of growth which can be maintained. Growth is particularly important to a country that is emerging from a period of recession. But it must also be balanced against the need for sustainable development and the need to reduce negative externalities. - UK government policy on growth The UK government does not have a growth target as such but its long-term plan is to enable 'the recovery to become established' by 'a comprehensive package of structural reforms to back business and raise productivity growth'. It wants growth to be 'broadly balanced across sectors'. Office for National Statistics (ONS) figures show that the UK economy grew by 0.7% in the second quarter of 2015 (this is written as Q2). Services increased by 0.7%, production increased by 1%, construction growth was flat and agriculture decreased by 0.7%. Quarterly figures are useful but it is good to see the annual figure too. UK GDP was higher in 2015 Q2 by 2.6% than the same quarter in 2014. Low unemployment: The government's objective on employment used to be described as 'full employment' or 'zero unemployment'. It is now recognised that it is unrealistic to aim for a situation where every person who wants to work can find a job for as many hours as he or she wants. This is because, for this to happen, the economy would have to be in a permanent state of boom which is not the case, as we saw in Topic 2 when we studied the trade cycle. In addition, and even in good times, there are always some people who are between jobs (frictional unemployment). So it is more realistic to aim for low unemployment. The UK government does not have a stated maximum target for unemployment but would simply aim to reduce it to as low a level as possible, given that there are other targets to meet which may conflict. (We will look at conflicts between objectives later in this Topic.) Governments also hope that any periods of unemployment are of a short duration and that the quality of jobs that workers undertake is high. In July 2015 the ONS published the following figures. In the UK there were 30.98m people in work and 1.85m unemployed people, according to the Labour Force Survey. 5.6% of the economically active population were unemployed. The Bank of England believes that the long-run sustainable level of unemployment is 5% - in other words, this is a level which can be achieved on a fairly permanent basis. - The effects of unemployment: Unemployment is a bad experience for someone who is without a job and it is a situation which imposes costs on a country; this explains why governments seek to keep unemployment low. The main cost of unemployment for an economy is lost output and this is the opportunity cost of potential workers being idle. Output is being foregone and so people enjoy fewer goods and services than would have been available if the unemployed had been working and producing output. The personal costs are high for the individuals who are unemployed. They are not receiving any income and they depend on state benefits. There is a loss of status, frustration and, in some cases, ill health, both physical and mental. The longer people are out of work, the lower their chances of finding a job because their skills become out of date and they are likely to lose confidence in their own abilities. Unemployment is particularly bad for young people who have never worked since leaving school, as they have never developed the habit of working. And it is also bad for people of 50 or over because it is not easy for them to find another job. Those with skills and some experience and who are geographically mobile are more likely to be reemployed. The government's budget is adversely affected. First it loses tax revenue from both direct and indirect taxes as a result of unemployment. This is because incomes are lower, so less is received in income tax and National Insurance contributions, and people spend less so less VAT is collected. At the same time, government spending increases as more has to be spent on benefits. There is also an increased cost to the health services and to the police service because there is likely to be increased crime. There is a school of economic thought that unemployment can provide benefits for the economy. The argument is that, if there is a pool of unemployed workers, firms can expand rapidly as it is easy to recruit new workers. They also claim that unemployment imposes some discipline on the labour market, keeping down wage claims and discouraging strike action. Higher unemployment is usually accompanied by low inflation so perhaps unemployment is the 'price' to be paid for a low inflation rate. This does however ignore the social and human costs of unemployment. Low and stable rate of inflation: Governments do not aim for zero inflation; not only is this hard to achieve, but it is not desirable as it is usually accompanied by a low rate of growth and a high rate of unemployment. The objective is to achieve a low and stable rate of inflation. The UK government has set itself an actual target, which is 2% Consumer Price Index (CPI) inflation. The task of achieving this target has been given to the Bank of England and you will read more about this later. The European Central Bank also has a target of 2% inflation. We saw in Section 4 Topic 1 that there are several theories that explain inflation. (Reread the topic if you feel that will help.) Here we will illustrate two of the theories in graphical form. - Demand-pull inflation: Figure 3.1 illustrates demand-pull inflation, which occurs when aggregate demand exceeds aggregate supply, pulling up the price level. In other words, it is a situation where total demand exceeds the ability of the economy to meet that demand in full. Aggregate demand increases if any of its components increase, other things being equal. For example, an increase in net exports can result in a rise in the price level. This becomes more likely the closer the economy gets to full employment. Indeed, if the economy is operating at the full employment level of output, it will not be possible to raise output and so any rise in aggregate demand will result in a rise in the price level. This is shown in Figure 3.2. - Cost-push inflation: Cost-push inflation happens when the price level is pushed up by an increase in one or more of the costs of production (raw materials, wages or other costs). Again, this can be shown on an aggregate demand and supply diagram. As shown in Figure 3.3, the increase in costs shifts the aggregate supply curve to the left and so raises prices.

The causes of economic growth

There are various factors that cause economic growth and that account for the fact that some countries grow more rapidly than others. However, the most important factor determining growth is investment and you will see that investment is either explicit or implicit in all the causes discussed below. -An increase in aggregate demand: In the short term an increase in aggregate demand can result in more goods and services being produced by employing previously unemployed resources. This would be especially likely if there had been high unemployment in the previous period and if the country is coming out of a recession (see later on when we discuss the trade cycle). If people have increased confidence, they begin to spend more on consumer goods and services and this encourages firms to spend more on capital goods. Once investment begins, there is a multiplier effect that creates more growth. -Investment: Investment is the key to economic growth as it influences output from both the demand and the supply side. Net investment (rises in the capital stock) increases the demand for capital goods. It also increases the productive capacity of the economy as it creates more resources with which to make goods and services. Investment may come from domestic firms, foreign firms or it may be investment financed by the government. Whatever the source, investment is money spent on creating and developing factors of production and increasing the productive capacity of the economy. Capital widening is investment that rises in line with the labour force so that the amount of capital per worker is fixed. Capital deepening is investment where the amount of capital per worker is increased. Capital equipment depreciates over time as it becomes worn out and as it is superseded by new versions and new inventions. So an amount of money has to be spent each year by firms on updating their assets. Capital depreciation has to be taken into account when calculating the amount of investment made each year. The net investment figure is gross (total) investment minus depreciation. -Technological progress: Advances in production methods and product design can increase productivity and free up resources to produce additional goods and services. As an economy develops, it benefits from technological progress. Examples are in computer hardware and software, in pharmaceuticals and in materials. Technical advances are the result of the research and development carried out in domestic companies, universities and research institutions both within the country and abroad. Technical advances originating in other countries enter the country through joint academic projects, technical journals, in the form of imports and through multinational companies setting up businesses in the country. -Investment in infrastructure: An advanced economy needs a modern and developed infrastructure, made up of roads, airports, rail links, telecommunications, broadband connections and renewable energy production. Some of these are financed by the government , some by the private sector, and some are jointly provided. They are all vital in order for firms to have access to transport and communications networks and for the production of goods and services to take place. The construction of a large infrastructure is in itself an important injection into the economy. Crossrail is a good example of a huge project. It is a 73-mile rail link that will provide an east-west route across Greater London. It is due to begin full operation in 2019 and it is budgeted at £14.8bn. Another example is the proposed additional runway capacity in south east England. Business and public sector organisations are claiming that added runway capacity in the south east is vital for continued growth and to maintain London as an important transport hub. Various proposals have been put forward and it seems, at the time of writing and following the report of a commission, that a third runway will be built at Heathrow Airport. -Investment in education, training and health: Investment in further and higher education and also in training for the workplace produces qualified, skilled workers who are more productive and who can be innovative. This is known as human capital and it is vitally important. The UK is highly dependent on its service sectors such as health, education, the creative industries, the leisure sector and a wide range of consultancies. All of these require specialist workers as well as lower skilled ones. Even low-skilled jobs require workers to receive training in areas such as health and safety. Investment in health is also vital so that the workforce can be healthy and strong, both physically and mentally. Healthy people work better, take fewer days off work and may be able to continue working beyond the conventional retirement age. -Increases in quantity and quality of labour force: For economic growth to continue into the long term, the productive capacity of the economy has to increase. One cause of a rise in productive capacity is an increase in the number of people in the labour force. For instance, if more women decide to seek employment, or if there is immigration of people of working age, the labour force will rise. Another cause is an increase in the quality of the labour force which could come about as a result of an improvement in education, training or healthcare. A country like the UK is not solely dependent on demand from its own population for its growth; it can also greatly boost its aggregate demand by selling in foreign markets. If the export sector is large enough, this is known as export-led growth. Some countries rely more than others on their export sector. This depends on the structure of their economy, what their main goods and services are, and the extent to which they can supply the needs of the population from domestic sources.

The causes of economic growth continued - the trade cycle

This is also known as the business cycle or the economic cycle. Many natural phenomena go through regular cycles, such as the human body and the weather, and the economic system is no different. From the early days of the science, economists have noticed that the total amount of output fluctuates at intervals, which may be regular or more irregular, from being very high to very low and back to very high again. These swings produce a pattern, shown in Figure 2.8. As you can see, there are different phases in the trade cycle, starting with the highest point: - Boom: This is the peak or highest point of the cycle. Growth and employment are very high and unemployment is low. The rate of inflation may be high and possibly getting higher. The economy stays at this high point only for a limited amount of time before growth begins to slow. - Recession or downturn: This is the phase during which growth is slowing down. Employment is falling, unemployment is rising and the rate of inflation is probably slowing. The economy continues to contract until growth reaches its lowest point. - Slump or depression: This is the trough or lowest point of the cycle. Growth is very low and may even be negative. Employment is low and unemployment high. The rate of inflation is low and may even have turned into deflation, with falling prices. Like the boom, this point lasts for only a limited period and then the economy begins to grow again. - Recovery or upturn: Now the growth rate is beginning to rise. Employment is rising, unemployment falling and the rate of inflation is beginning to rise. The economy continues to expand until the boom point is reached and the cycle begins all over again. Note that the term recession has a specific meaning in economics: it is defined as 'a period of two consecutive quarters of negative economic growth', which means declining real GDP. This means that GDP has been falling in absolute terms for six months or more. There has been much comment in the media in recent years about the word 'recession' and it has become a word that inspires fear because it signifies that unemployment is worsening and people fear they will lose their jobs. Also note that governments do not sit back and watch trade cycles happening. They intervene by using policies to limit the effects of the various stages. In particular, they intervene to try to soften and shorter the downturn period and to avoid recession. We will look at the economic policies of government in the next topic. - The post-crisis recession and debt: The recession that followed the financial crisis of 2007/08 was a particularly deep one. The factor that made it particularly difficult to emerge from recession was that, in 2008, many individuals and firms (and the government) were over-indebted. This means that, in order for people to buy houses and consumer products and for firms to expand, they had borrowed more money than they could afford. When the banking system almost collapsed in 2008, the economy was thrown into recession, unemployment rose and property prices fell. Not only did many people lose their jobs but they also had large debts to repay. This meant that consumption was lower than it would have been as people were using their spare money to reduce their debt. The fact of high indebtedness continues up to the time of writing (August 2015). Financial institutions are now much more careful when lending money and there are new regulations which oblige them to take affordability into account when granting mortgage loans. Both the need to repay old debt and the increased difficulty of taking out new debt have put a brake on the ability of the economy to recover from the recession. Study hint Remember that a fall in the rate of economic growth from one positive figure to a lower positive figure means that real GDP is still increasing. Such a change just means that the increase in output is slowing. This is different from a fall in real GDP, which would result in negative economic growth. The trick is always to read carefully the descriptions of a table. The title tells you what is being measured and you should check to see what the variables are being measured in. In the case of growth, are they absolute GDP figures or are they percentage growth rates?

Demand-side policy and inflation

To lower demand-pull inflation, a government may seek to reduce aggregate demand. Monetary and fiscal policy measures designed to reduce aggregate demand are called deflationary (also called contractionary policies). You have learnt what these measures are and how they work and now we will draw the graphs. Figure 3.4 illustrates the effect on aggregate demand of monetary policy that raises interest rates, or of fiscal policy that decreases the size of the government's budget deficit. - Demand-side policy and unemployment To lower unemployment and raise employment a government may implement reflationary (also called expansionary) monetary and fiscal policies. Again you know how these work. Figure 3.5 illustrates the effect on aggregate demand of monetary policy which decreases interest rates, or of fiscal policy which increases the size of the government's budget deficit. These changes in aggregate demand can be matched by similar changes in aggregate supply in the short run. For example, a rise in aggregate demand can be supplied if there are unemployed resources. However, when factors of production are all being fully utilised, the only way for growth to be sustained into the long run is for aggregate supply to increase too. This may happen on its own, but it may need help from the government and this is why governments also carry out supply-side policies. - Demand-side policies in times of crisis At a time of severe economic depression or in a crisis people's confidence falls, causing households and firms to consume and invest less. Aggregate demand falls, unemployment rises and there may even be deflation with falling prices. This is a time when demand-side policies are needed to encourage people to begin spending their money again and to encourage aggregate demand to begin to rise to its old levels. There is no doubt that the recent financial crisis was a very frightening experience to many countries and governments made serious attempts to reboot their economies. It is interesting to compare these policies with those which were put into effect in 1929 and afterwards. The late 1920s was a period of frantic speculation during which people borrowed large amounts of money in order to invest in stocks and shares. The reasons for this speculation are beyond the scope of this qualification and its specification but it is enough to say that share prices kept on rising, causing more people to buy for fear of losing out on a speculative profit. Such a situation could not continue and in 1929 the Wall Street stock market in New York crashed. Share prices plunged and many people were bankrupted, especially those who had borrowed money to buy their shares. Confidence in the economy was at rock bottom, people were impoverished and aggregate demand fell precipitously. The Wall Street crash, as this event was known, led to a period of economic depression in the US, during which the money supply fell and unemployment soared, and many people's incomes were at poverty level. The Great Depression peaked in around 1933 but it lasted throughout the 1930s and spread to other countries. Depressions are contagious because of international trade. The US was unable to purchase its previous level of imports and so countries which exported to it also suffered - and this included the UK. Economist John Maynard Keynes explained the depression in terms of the economic theory you have already learnt. He said that it was a case of a massive decline in aggregate demand - because expenditure was low, so were employment and incomes. He argued that, since the private sector was not spending enough, governments should do it for them. His solution was for governments to run budget deficits to increase injections and stimulate the economy. US President Roosevelt did actually spend government funds on public works and one example was the building of the Hoover Dam. But the amount spent was insufficient because the US and UK governments believed that government budgets should be balanced. They thought that running a deficit was bad housekeeping and so the economies of the US and UK did not receive sufficient stimulation to bring unemployment down to low levels. The economies only really recovered from 1939 onwards with the onset of World War II. As soon as the UK, and later the US, were at war there were jobs for everyone: in the armies and munitions factories and on the farms. It is interesting to note that, even though the UK and US had not learnt enough from history to avoid the crash and subsequent recession in 2008, their governments were willing to invest a lot of public sector money into preventing the recession from developing into a full-blown depression. They interpreted the recession in a different way from governments in 1929, perhaps because they knew that a depression is very damaging to an economy for a long time. In 2008 and afterwards, monetary policy was used in the UK to try to 'kick-start' the economy, with interest rates being reduced to record lows and with the central bank purchasing assets to boost the money supply and keep interest rates even lower. Similar policies were carried out in the US. The Federal Reserve Bank (the central bank of the US) lowered interest rates and kept them low; it also carried out its own version of quantitative easing, which it later reversed. As we said above, UK fiscal policy was not expansionary as the government was concerned to reduce the amount of public sector debt. But public expenditure and the budget deficit were reduced only slowly and gradually because of the high level of unemployment and the low level of growth. - Strengths and weaknesses of demand-side policies Demand-side policies have strengths and weaknesses that balance each other. The main strengths are as follows: - Both monetary and fiscal policies act on the macroeconomy and have large effects. A change in Bank Rate affects all other interest rates and this influences the money borrowed and spent by most households and firms. Equally, changes in public expenditure and taxation affect the population as a whole. So they can act in a big way to address either too much inflation or too high unemployment. - Demand-side policies are quite flexible, especially interest rate policy. Interest rates can be raised if the central bank fears a rise in inflation but they can be dropped again if these fears do not materialise and if it proves necessary to stimulate the economy instead. - Open and transparent interest rate policy can mould people's expectations and this can help to achieve their objective. - Demand-side policies are based on government intervention and are supported by those who believe it is the government's job to manage the economy in a proactive way. Here are the main weaknesses of demand-side policies: - Changes in interest rates and budget changes affect aggregate demand only after a time lag and so they do not have an immediate effect. - There can be conflicts between policies and it is not easy for governments to achieve a balance between price stability and low unemployment. This is because the positive effects of a policy on one of these can have negative effects on the other. For example, a rise in interest rates to prevent inflation from exceeding 2% can cause a rise in unemployment. - Using monetary and fiscal policy to stimulate a low-growth economy leads to higher levels of debt, both in the private and in the public sector. - Expansionary fiscal policy can have a 'crowding-out' effect. This means that if the government is borrowing more to increase its expenditure, it may be accessing funds that otherwise would have been lent to private sector firms to carry out investment. - Because demand-side policies are based on government intervention, they are not supported by those who prefer to let economic problems be addressed by market forces. This is an example of how political views can colour economic decision. -Reflationary monetary and fiscal monetary policies that increase aggregate demand may increase actual economic growth and reduce unemployment. They are likely to be implemented when there is spare capacity in the economy. There is a risk, however, that a government may overestimate the size of a negative output gap and may underestimate the size of the multiplier. In such a case, it may inject too much additional government spending into the economy. Figure 3.6 shows that the output gap has been closed but inflation has occurred.

2 Which of the following is a benefit of a reduction in unemployment? a) fall in government expenditure on benefits b) fall in real GDP c) increase in the gap between actual and potential output d) increase in direct and indirect tax rates

a) fall in government expenditure on benefits A fall in unemployment will mean that the government will not have to pay out as much in Jobseeker's Allowance. Real GDP will increase and the gap between actual and potential output will narrow. Direct and indirect tax revenue will rise but the tax rates may stay the same or even fall.

What does 'weak productivity' mean and why is this a risk to UK economy growth?

'Weak productivity' means that there is little or no growth in the amount of average output per worker hour. This is a risk to UK economy growth because it shows that workers are not increasing their potential output. The only way that growth can happen in such a case is for more workers to be employed, but this is costly to firms.

Topic 2 - Economic growth

We have mentioned economic growth in relation to production possibility curves and we have showed how economic growth is measured but in this topic we will be looking at growth more closely, discussing its meaning, causes, benefits and costs. By making use of production possibility curves and aggregate demand and aggregate supply diagrams, you will examine the difference between actual and potential economic growth and the significance of output gaps. You will explore the causes and consequences of economic growth and consider its positive and negative externalities.

Conflicts and trade-offs in policy objectives

At the beginning of this topic we discussed seven macroeconomic objectives. However, it would not be possible to achieve all of these simultaneously, and some of them conflict with each other. So governments have to choose which objectives they want to give more emphasis to. The main macroeconomic objectives out of the seven are low inflation and low unemployment, which supposes a degree of growth. Governments give greater priority to these but, in trying to achieve them, they are constrained by their other objectives: to minimise public debt and the balance of payments deficit. If they can achieve greater income equality, they might be pleased but it is unlikely to be their first priority. Protecting the environment is an objective that some people believe should be top of the agenda but it comes at a cost to growth, and governments might not be willing to pay this cost. Let us suppose that priority is given to achieving low inflation and low unemployment. There is still a problem because these operate against each other to some degree and they require opposing macroeconomic policies. To reduce inflation, the government needs to impose contractionary monetary and/or fiscal policy, but this will depress growth and lead to more unemployment. This is clearly a basic conflict. The answer for most governments is to trade one objective off against the other. This means that, even though the government wants to achieve 2% inflation, it may have to accept a slightly higher rate if achieving 2% means creating an unacceptable level of unemployment. This is not the case in the UK at the time of writing (August 2015) but it is a possible scenario. However, we have seen that the Bank of England has said in 2015 that it has to do the following: 'deliver price stability - low inflation - and, subject to that, to support the government's economic objectives including those for growth and employment.' It is clear from this that low inflation is the main target and that growth and employment are seen as secondary aims. Another example is that pursuing economic growth may result in an increase in a current account deficit, in the short term at least. As firms raise their output, they buy more imported raw materials; as incomes rise, households purchase more imported products. This situation could be balanced by the government using supply-side policies to boost exports. - The short-run Phillips curve: Falling unemployment may be associated with an increase in the inflation rate. This relationship is shown in what is known as the Phillips curve, named after the economist Bill Phillips. He investigated UK data on unemployment rates and changes in money wages for the period 1861-1957. (The latter was taken as an indicator of inflation; charts now normally use the inflation rate.) He discovered a relationship between the unemployment rate and the inflation rate. The relationship that Phillips identified is a stable inverse one. This means that, as the unemployment rate rises, the inflation rate falls, and vice versa. Here is what the Phillips curve looks like. Figure 3.8 shows that as unemployment falls from 5% to 3%, the inflation rate increases from 2 to 6%. (These rates are hypothetical and for illustration purposes only.) As unemployment falls, the growing shortage of workers pushes up wages and so adds to firms' costs of production. Higher wages also create inflationary pressure by raising aggregate demand. The Phillips curve relationship suggests that a government will have to decide if it wants to reduce unemployment, accepting higher inflation, or reduce inflation and accept higher unemployment. Some economists challenge the Phillips curve and argue that a high rate of inflation can lead to a high rate of unemployment, because people lose confidence in the value of the money supply. This may happen at higher rates of inflation but would be unlikely at lower controlled rates. The period 2000 to 2008 witnessed both low unemployment and low inflation in the UK. Economists suggested that inflationary pressures were kept down by increased global competition, labour market reforms and advances in technology. After the financial crisis in 2007/08, there was recession and unemployment rose considerably. Inflation varied but was not high and this seemed to tally with the Phillips curve. Since the recovery, unemployment has fallen to around 5% but inflation is very low and was 0% in July 2015. The main reasons for the price stability are the fall in the global prices of commodities, especially oil, and the high value of sterling that makes imports cheaper. It is likely that, as the economy grows, inflation will rise. As we have noted above, the Bank of England's priority is price stability but it does also have to take unemployment and growth rates into account when changing Bank Rate. This means that the policy demonstrates a degree of trade-off between the two objectives.

Explain how people's income could fall but their wealth could increase.

People's incomes could fall if they lose their jobs but their wealth could increase if they own their homes and if house prices rise. However, they will experience problems in meeting their interest payments. House prices remained high during the UK recession.

Which of the following is a factor income? a) labour b) profit c) saving d) taxation

b) Profit is the payment for enterprise. (a) is a factor of production rather than a factor income.(c) and (d) are leakages from factor incomes.

Classify the following as either income or wealth. 1. Christmas bonus paid out to shop assistants 2. Yacht 3. Government bond 4. Jobseeker's Allowance 5. Money in a savings account 6. Interest earned on money in a saving account

1, 4 and 6 = income 2, 3 and 5 = wealth

Explain what is meant by a current account deficit. (2 marks)

A current account deficit is a situation where the value of the country's imported goods and services is greater than the value of its exported goods and services.

Supply-side policies

Supply-side policies act on aggregate supply and aim to achieve macroeconomic objectives from the other side of the market from demand-side policies. They aim to increase the productive potential of the economy by improving the efficiency of individual markets in a microeconomic way. They seek to provide incentives to suppliers and increase competitiveness, productivity and flexibility in both product and labour markets. People who support these policies believe that a long-term and sustainable increase in GDP is possible only when long-run aggregate supply is increased. When firms are allowed to make profits under conditions of competition, aggregate supply increases and unemployment decreases. There are two types of supply-side policies: market-based and interventionist. - Market-based supply-side policies: These aim to reduce government intervention in economic life. People who believe in these policies have faith in the ability of markets, on their own, to achieve equilibrium and to achieve a high level of output with a low level of unemployment. They believe that government intervention in markets causes distortions and creates disequilibrium. Here are the main categories of market-based supply-side policies: - Deregulation: This means the reduction or elimination of rules, regulations and barriers to entry imposed on an industry. It is argued that this will allow firms to operate freely, will encourage innovation and profit initiatives and thereby create more competition within the industry. This is a strong argument in markets which contain many small and medium-sized competitors which have a lot of incentive to treat their customers well. Minimising regulations is advantageous as regulations impose compliance costs on firms and restrict the way they operate. When firms are free to act in an unencumbered way, aggregate supply increases. But interventionists take the view that many markets are dominated by a few large companies that have more market power than their unorganised customers. They believe that bad behaviour by suppliers to customers make it vital for their activities to be limited by regulation. A prime example is the financial services industry. Regulation had indeed been very 'light' before the financial crisis, but many argue that it was a lack of regulation that led banks to take the risks which led to the failure of some and the near-failure of others. Since the crisis, a number of examples of malpractice and mis-selling have come to light and regulations have been tightened as a result. For example, lenders must carry out stringent affordability checks on customers before granting them a mortgage to finance the purchase of a home. - Privatisation: This means the selling off of nationalised industries to the private sector. A nationalised industry is one that belongs to the state. A number of UK industries were taken into public ownership in the post-war period after 1945. Most of these have gradually been sold back into the private sector. Examples are the electricity, gas and telephone/ telecommunications sectors. Supporters of market-based supply-side policies believe that nationalised firms do not operate efficiently because they are not constrained by the need to make profits and because, if they make a loss, they can be subsidised by the public sector. When firms are privatised, supporters argue, they keep their costs down and this promotes competition and output. Therefore there is a rise in aggregate supply. Some people disagree with this and believe that vital public services and utilities should be in the public sector. If they do not have to make profits for shareholders, they can operate in the public interest. - Labour market reform: Policies under this heading aim to 'free up' labour markets in order to encourage wage competition. This means removing what are seen as restrictions to the operation of the free market, such as a national minimum wage, trade union rights to collective bargaining and the right to strike. Adherents of these policies argue that freer labour markets would reduce firms' costs, as labour would be willing to work for lower wages. Clearly, there is great opposition to such policies from people who support the rights of the lower paid to push for higher wages and to improve their standard of living. - Cutting taxes and benefits: Although general fiscal policy is a macroeconomic demand-side policy, changes in the balance between specific taxes have microeconomic supply-side effects. For example, cutting income tax would encourage an increase in the supply of labour, as existing workers may decide to work longer hours and those not working may be attracted into the labour force. Another example is cutting corporation tax to attract firms into the country, stimulate investment and give companies more incentive to expand. Some economists also suggest cutting unemployment benefits to force the unemployed to seek work more actively. - Interventionist supply-side policies: Interventionist supply-side policies aim to improve the conditions of supply but allow the government to play a more important role. Supporters of intervention believe in markets but they also accept that governments must intervene at those points where the market fails to take action. Here are the main categories of interventionist supply-side policies. Some projects may be funded completely by the public sector and others may be public/private partnerships. - Investment in infrastructure: The government should spend money on public infrastructure projects such as new road and rail links, airports, bridges and many others. These make transport and communications faster and easier and thus cut the costs of firms who are moving goods or whose employees have to travel on business. An example of an infrastructure project currently under development in the UK is Crossrail, the high-frequency, high-capacity rail link which will span London from west to east. Crossrail has been funded by Transport for London (TfL) and by the Department of Transport. An example of an infrastructure project currently under discussion is the third London airport. It has not yet been decided where this will be sited and the latest suggestion is to build a new runway at Heathrow. - Investment in new technology and research and development: Governments can make funding available for research into new technology, such as new computer systems, new materials or new, cleaner methods of energy production. The results of this type of investment give great opportunities for new businesses and also for existing businesses to develop new products. For example, the UK government helps to fund research in universities in areas such as engineering and biotechnology. - Improving the skills and quality of the labour force: This involves spending government funds on improving education and training in order to raise the productivity of workers, and thereby increase the quality and quantity of output. This covers the whole area of education, from the direct funding of schools to the provision of loans to university students via the government-owned Student Loans Company. For example, there are apprenticeship schemes to fund in-work training for school-leavers. - Industrial policies: The government supports firms, and especially small and medium-sized ones, by making available grants, loans and business support such as mentoring and consultancy to provide advice on products and markets. This helps firms to invest in expansion, new equipment and training. The Department for Business, Innovation & Skills in the UK provides a wide range of financial assistance to help businesses invest in new equipment and training programmes to equip them with the know-how to help them to reduce their costs and deal successfully in competitive markets. The government could also levy a green tax on firms which have a high carbon footprint. Figure 3.7 shows the effect on real GDP of a successful supply-side policy.

Fiscal policy

The word 'fiscal' comes from the Latin for 'state treasury' and fiscal policy acts on the public sector finances. In the UK, fiscal policy is carried out by HM Treasury, the government's economic and finance ministry. We are concerned with three aspects of these finances: - public sector revenue - public expenditure - the balance between the two. The public sector has no money of its own but it represents the people of the country. So it receives revenue by taxing firms and households and it spends the money on the public goods and services which the government considers to be necessary. The total received from taxes is unlikely to exactly equal the total spent on services and so there is a difference or balance. If revenues are greater than expenditure, the public sector has a surplus. If expenditure exceeds revenues, there is a deficit. Fiscal policy acts on this surplus or deficit and on the taxation and spending which have created it. To understand the effect of fiscal policy on aggregate demand, we must remember that government spending is an injection into, and taxation is a withdrawal out of, the circular flow (Topic 1). This leads to the following conclusions: - If the public sector has a surplus, tax revenue exceeds public expenditure, that is, withdrawals exceed injections. This reduces aggregate demand and discourages growth. - If the public sector has a deficit, public expenditure exceeds tax revenue, that is, injections exceed withdrawals. This increases aggregate demand and stimulates growth. Just as monetary policy acts to encourage or discourage aggregate demand by changing interest rates, so fiscal policy acts to manage the economy by changing the amount of the public sector deficit or surplus by making changes to public spending and taxation. In the following explanation, we refer to a public sector deficit rather than a surplus because the UK public finances have been in deficit for many years. If the government wants to bring down a high rate of inflation, it will carry out contractionary fiscal policy by cutting public spending, increasing tax receipts and thereby cutting the deficit. Withdrawals will exceed injections: more money is being taken from people in taxation than is being put back in public sector and people will have less money to spend. Aggregate demand will fall and there will be downward pressure on prices. The opposite will happen if growth is low or slow and the government wants to stimulate the economy. By increasing public spending and cutting taxation, it can increase its deficit and put more money back into the economy, thereby increasing aggregate demand and putting upward pressure on prices. - UK fiscal policy: Between 1945 and 1990, the UK public sector fluctuated between surpluses and deficits but these were small when measured against the size of GDP. Deficits started to get bigger after 1990 but these later turned into surpluses. The last time the UK had a budget surplus was in 2001. Since then the deficit has grown considerably, especially after the financial crisis, which began in 2007, and the ensuring recession. (Look at Table 3.2 below and study the fluctuations in the public sector deficit.) It is interesting to note that once the deficit had peaked in 2009/10, it began to fall both in absolute terms and as a percentage of GDP. You might think that there should have been expansionary fiscal policy after the recession began, but apart from one big leap in 2009/10, the deficit began to fall. There are two main reasons for this. The first reason is that expansionary monetary policy was the policy of choice to fight the recession, with interest rates being reduced to the lowest level possible and with asset purchases boosting this. At the same time that the Bank of England was trying to stimulate spending by making borrowing cheaper, the Treasury was trying to reduce the fiscal deficit. The second reason is that the UK's total debt was at a level that the government considered to be dangerous. Total debt is the total amount owed by the public sector to the private sector and it is the aggregate of all past budget deficits. When the government borrows money to finance a deficit, it adds to the total of debt. In June 2015, UK total public sector debt was £1.5 trillion, which is 81% of GDP (ONS, 2015). This figure was just over £500 billion in 2006/07 so you can see how much it has increased. Despite the recession which was unfolding, the government felt strongly that it had to reduce the total amount owed by the public sector. A high level of debt is a problem for the public sector for several reasons. Interest has to be paid on it and this becomes a great burden on the public finances. It adds on to the amount which needs to be borrowed and, eventually, a government can find itself borrowing money just to pay the interest on its outstanding debt. Public sector debt has to be financed by issuing bonds that are purchased by financial institutions. The lower the government's reputation for paying back its debts, the higher the rate of interest it will have to pay on these bonds. Greece is a country that has become completely over-indebted. It has had three bailouts from its creditors (the institutions to which it owes money) and, in return, its government has had to agree to harsh austerity conditions - it must cut public spending and raise taxes. It is unlikely ever to pay back all of the debt it owes and it will be controlled by its creditors for many years to come. The UK government wanted to avoid getting into this situation, especially after having to bail out some of its banks, and so it instituted an austerity programme that will continue until the budget goes back into surplus. - An assessment of fiscal policy: Fiscal policy can be very effective because the large sizes of the changes in government spending and taxation can have a significant impact on the economy. It can also be used in a discriminating way by, for example, encouraging the consumption of merit goods by means of subsidies, and discouraging the consumption of demerit goods by means of taxes. Progressive taxation coupled with welfare benefits can make the distribution of income more equal. However, there are a number of possible drawbacks. Fiscal policy measures designed to reflate a depressed economy can cause inflation to accelerate and the balance of payments position to worsen. Added to this, fiscal policy is rather inflexible. Tax changes take time to implement and bring in more revenue. On the other side of the account, there are areas of expenditure that it is difficult or even impossible to change. For example, pension payments depend on the number of pensioners. And capital expenditure is planned over the long term so if, for example, a government decides to build four new hospitals, this will involve a long-term commitment to expenditure. Another disadvantage is that some fiscal policy measures can have a disincentive effect. For example, a rise in income tax and/or a rise in unemployment benefit may discourage some people from working.

What could cause a shift to the left of the AS curve? a) decrease in the size of the labour force b) decrease in the number of days workers have off due to illness c) increase in the rate of technological progress d) increase in the rate of government and private sector spending on training

(a) A decrease in the size of the labour force may reduce the output that an economy can produce and so shift the AS curve to the left. (b), (c) and (d) would all increase aggregate supply.

Which change would increase the size of the multiplier? a) fall in consumer spending b) fall in the rate of taxation c) increase in imports d) increase in saving

(b) A decrease in a withdrawal (leakage) will mean that more of an injection will be passed on in the form of higher spending round the economy. This will result in an increase in the size of the multiplier. (a), (c) and (d) would all reduce the amount of spending passed on and so would reduce the size of the multiplier.

Which difference between income and wealth is the correct one? a) Income can generate wealth but wealth cannot generate income b) Income is a flow while wealth is a stock. c) Income is a payment for working while wealth is a payment for saving. d) Income is an injection into the circular flow while wealth is a leakage.

(b) Income is a payment someone receives on a regular basis while wealth is a stock of assets someone owns. (a) can be rejected as not only can income, if it is high enough, enable someone to accumulate wealth but wealth can also generate income.(c) One form of income is a payment for working but while wealth can result from saving, it is not a payment for saving.(d) Income flows from firms to households in the circular flow rather than being an injection. One form of wealth, saving, can arise as a result of a leakage.

Which of the following is a withdrawal from the UK's circular flow? a) The UK government's spending on healthcare b) UK firms' revenue from products sold abroad c) UK firms' spending on capital goods d) UK households' spending on products produced in China

(d) UK households' spending on products produced in China results in money leaving the country (import). (a) government spending,(b) exports and(c) investment are all injections.

Look at the statistics in Table 2.2 showing GDP growth (annual %) and comment on the differences in the growth rates of the countries. As in Activity 1, you should supplement the figures in Table 2.2 by doing your own research.

- China's growth rate is spectacular when compared with that of most other countries but it is falling. This fall will have a knock-on effect on any country that depends on China as an import or export market. - Germany's growth rate was quite high in 2010 but has fallen to very low levels because of the post-crisis recession and problems within the euro area or eurozone. - India presents a similar picture to China, although with slightly lower growth rates. - Japan's growth rate has fallen badly and was negative in 2012 and 2014. - The UK also experienced a fall in growth but this has picked up again. - The US shows a similar picture to the UK.

Supply-side policies continued

- Strengths and weaknesses of supply-side policies: You should be aware that there is a political divide between those who believe that markets can fail (and who therefore support government intervention in markets), and those who argue that markets will eventually resolve imbalances and should be left free to operate without interference. The main strengths are as follows: - Successful supply-side policies enable an economy to grow while avoiding inflationary pressure. They can be successful in helping a government to achieve its macroeconomic policy objectives of growth and higher employment. They can also have the effect of keeping inflation down as they encourage an increase in aggregate supply to match an increase in aggregate demand and thus close the output gap. - Market-based supply-side policies do not cost public money as they do not involve spending on investment programmes. - Interventionist supply-side policies can result in investment and research being undertaken which would not otherwise have happened. The government is in a position to note which areas are particularly important and need supporting, such as the promotion of cleaner energy production. Here are the main weaknesses of supply-side policies: - There is no guarantee that incentive policies will be successful as workers and firms may not respond in the way expected. Workers, for example, may choose to work fewer rather than more hours when income tax is cut and privatised firms with considerable market power may not feel any pressure to become more efficient. - Some programmes, such as educational reforms, take place over a number of years and therefore have an effect only in the long run. - Interventionist supply-side policies are expensive and have an opportunity cost to the public budget in terms of other projects that could have been financed with the same money.

The causes of economic growth continued

-Actual growth rates and long-term trends: In Section 4 Topic 1 we defined actual economic growth 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'. The actual growth rate is the rate at which real GDP is increasing from period to period, even if there is unemployment. The actual growth rate must be distinguished from the long-term trend in the growth rate. The trend rate of growth is the average rate of economic growth that is sustainable over a period of time without causing inflation. It is also known as the 'underlying trend rate of growth'. It depends on the growth of long-run aggregate supply (LRAS) and this is dependent on the growth of productivity. The trend rate of growth in the UK has tended to be around 2.5% per annum. The actual rate of growth can diverge from the trend rate according to fluctuations in the economy - you will see this when we discuss the trade cycle. If the economy is in recession, the actual rate of growth will be below the trend rate, and inflation will be lower and unemployment higher. But if the economy is booming, the actual rate of growth will be higher than the trend rate and inflation will be higher. This rate of growth will be unsustainable and it will fall back again later. -Output gaps: As we have seen, an economy has a point of full capacity. It is possible that it could be working at this level, with all factors of production fully employed. However, this does not happen in the real world and, if it did, it would not last for long. In practice, the economy is either working below capacity or above capacity; we say that there is an output gap and this may be either negative or positive. A negative output gap occurs when an economy is producing below its maximum potential output as shown in Figure 2.5 below. In such a case, the economy is operating with spare capacity and is experiencing unemployment. In contrast, a positive output gap arises when an economy is producing more than its maximum potential output as shown in Figure 2.6 below. In this case, the economy is operating with overcapacity and is experiencing inflation. It may not seem possible that a positive output gap could exist, but an economy may be able to produce a higher output for a short period of time as a result of workers working overtime and firms using their capital equipment without breaks for repairs and maintenance. It is difficult to measure output gaps and a lot of the current figures you may see are estimates. Growth rates can be measured only after the event and, in any case, it is hard to obtain full information on the output of all sectors. We referred to some of these problems in Section 4 Topic 1 and it may be useful for you to go back and reread that topic now. An output gap can also be seen in terms of the difference between the growth of actual real GDP and the growth in potential real GDP (trend growth). Figure 2.7 shows the actual growth rate varying around the trend growth rate, sometimes growing more quickly and sometimes more slowly. The two points where the two curves meet show where the actual growth of the economy is equal to the trend. At point a, actual growth is above the trend and at point b, it is below the trend.

Equilibrium levels of real national output continued

-Shifts in aggregate demand: We saw in Section 4 how the aggregate demand and aggregate supply curves can shift. Here we will consider how such shifts cause changes in the equilibrium price level and in real national output. We will begin with aggregate demand. An increase in aggregate demand may raise real GDP and/or the price level depending on the initial level of economic capacity. A decrease in aggregate demand, on the other hand, will have the opposite effect. Unexpected changes in aggregate demand, known as demand-side shocks, can have a significant impact on an economy. A good example of this is the 'credit crunch' of 2007. The crisis started in the US when a number of banks went out of business, having suffered huge losses on the mortgage loans they had made to low-income, high-risk borrowers. This spread through the global markets and led in 2008 to the failure of other banks, including several in the UK. At one point, banks stopped lending to each other, making it almost impossible for them to cover their normal short-term deficits. So banks became much more cautious in their lending policies and firms and households had difficulty in obtaining loans. This, combined with a general fall in confidence, reduced aggregate demand and led to a deep recession, with high unemployment and very low or negative growth. The effect of such a demand-side shock is shown in Figure 1.6. If we turn the direction of the arrows around, we see the effects of an increase in aggregate demand. -Shifts in aggregate supply: An increase in aggregate supply would, other things being equal, reduce inflationary pressure and result in an increase in real GDP. In contrast, a decrease in aggregate supply may put upward pressure on the price level and may reduce real GDP. As with aggregate demand, unexpected changes in aggregate supply (supply-side shocks) can have a significant impact on the economy. For example, an increase in world oil prices raises the cost of making and transporting a wide range of products. This increases firms' costs of production. The AS curve shifts to the left, as illustrated in Figure 1.7. -Shifts in aggregate demand and supply: Over time, both aggregate demand and aggregate supply usually increase. Households buy more products, firms buy more capital goods and governments spend more. Increases in productive potential are driven mainly by advances in technology and improvements in education and training. Such changes enable a combination of capital equipment and workers to produce more goods and services. There may also be net investment. This means that the new capital goods produced exceed the capital goods that have worn out and so the capital stock increases.

Which of the following would make income more evenly distributed? 1 Increase in state benefits 2 Increase in the top rate of income tax 3 Increase in executive pay 4 Reduction in VAT on fuel 5 Reduction in child benefit6 Reduction in state pension

1, 2 and 4. State benefits mostly help the poor, while an increase in the top rate of income tax would reduce the income of the rich. VAT on fuel takes up a larger percentage of the income of the poor and so the poor would benefit most from its reduction. Whereas the rich would benefit most from 3, the poor would be hit by 5 and 6 more than the rich.

1. What effect would a fall in spending on imports have on the multiplier? 2. If the multiplier is 2, how much would a government have to raise its spending to increase GDP from its current level of £80bn to the full capacity level of £110bn?

1. A fall in spending on imports would reduce the size of a withdrawal. This has a similar effect to an autonomous injection and so more money would be spent on domestic goods and services and passed on to future spending rounds. As a result, the size of the multiplier would increase. 2. The government would want to raise real GDP by £30bn (£110bn - £80bn). As the multiplier is 2, it would have to inject £30bn ÷ 2 = £15bn.

There are a number of factors that can influence the rate of inflation. A rise in the exchange rate, if sustained, will put downward pressure on inflation. In contrast, cost pressures can build up in the labour market. 1. Explain why a rise in the exchange rate would exert downward pressure on inflation. 2. What cost pressures can arise in the labour market?

1. A higher exchange rate means a reduction in import prices. This reduces directly the price of some products bought, lowers the cost of imported raw materials and puts pressure on UK firms to keep their costs and prices low. 2. The cost pressures that can arise in the labour market are increases in wages above productivity increases and falls in productivity. Either would cause an increase in unit labour costs and so may lead to cost-push inflation. Wages are most likely to rise when labour shortages are being experienced.

1. Identify three policy measures that could reduce aggregate demand. 2. Explain two macroeconomic objectives that might benefit from a reduction in aggregate demand.

1. A rise in income tax, a fall in government spending and a rise in the rate of interest. 2. The objective of low inflation might benefit from a reduction in aggregate demand. If inflation is caused by demand-pull factors, a reduction in aggregate demand could reduce the pressure on the price level. Another macroeconomic objective that might benefit from a reduction in aggregate demand is an improvement in the current account position. If households spend less, they will buy fewer imports. This fall in import expenditure will directly contribute to a reduction in a current deficit. The fall in demand for domestically produced products may also encourage firms to put more effort into exporting.

Education and training are both a cause and an effect of economic growth. Rich countries can afford to spend a large amount on education and training; the UK spends around 6% of GDP on education. In such countries, earnings and tax revenue are high, so both households and the government can afford to make human capital investment. This investment raises labour productivity and raises trend growth. In contrast, in poor countries there is a lack of household income and tax revenue to spend on education. This results in a shortage of schools, colleges, universities, education equipment and teachers and trainers. 1. What is meant by human capital investment? 2. Explain the barrier to economic growth that exists in poor countries.

1. Human capital investment is expenditure on education and training. Such expenditure would be expected to raise the productivity of workers. 2. The barrier to economic growth in poor countries is the lack of resources available to devote to education and training. This results in a vicious circle of poverty: lack of income causes a lack of spending, which in turn results in a lack of income.

The table below shows Ireland's economic growth rate 2010-14. Table 2.3 Ireland's economic growth rate (%) 2010-14 2010 = -0.3 2011 - 2.8 2012 = -0.3 2013 - 0.2 2014 - 4.8 1. Explain what happened to real GDP in 2010 and 2012. 2. Explain the change you see between 2013 and 2014. What might be the reasons for this change?

1. In 2010 and 2012 Ireland experienced negative growth. This means that GDP actually fell in nominal terms. This was due to the collapse of the banking and property sectors in 2008 and the post-crisis recession. 2. Ireland's growth rate took off between 2013 and 2014, due to much higher investment and export growth following the years of austerity imposed on the country by the euro area. One reason for the higher investment is that Ireland has reduced its corporation tax. This is 25% on non-trading income, 12.5% on trading income and only 10% for manufacturing companies. Reducing the tax on a firm's profits will free up money for them to invest.

The service sector in the UK is sub-divided by the Office for National Statistics (ONS) as follows: 1. Business services and finance 2. Transport, storage and communication 3. Distribution, hotels and restaurants 4. Government and other services. Give two examples of services that might be included in each of the above categories, other than health and education. Why are they important to people's quality of life?

1. Insurance, which enables people to transfer their risks, and accounting services that enable firms to produce their financial statements and take decisions based on financial data. 2. Airlines that link cities all over the world, and mobile phone links. 3. Hotels that provide accommodation for both leisure and business, and retail which makes a wide variety of goods available to consumers in one place. 4. The Environment Agency, which deals with matters concerning floods, fisheries and waste disposal, and government agencies that give advice to people starting a business.

Comment on the differences in the export sectors of the countries. There are no specific answers to this question and you should do your own internet research to find out about the export sectors of these countries. You could also do some research to find out the latest export position in each of the countries. Table 2.1 Exports as a percentage of GDP (average 2010-14) 1. China - 22.6% 2. Germany - 45.6% 3. Japan - 15.3% 4. Slovak Republic - 91.9% 5. UK - 28.4% 6. US - 13.2%

1. It may seem surprising that only 22.6% of China's GDP comes from exports but the country has a huge domestic population and also a very large state sector. 2. Germany's economy is very dependent on its export sector. It has a highly developed manufacturing base in cars, machinery and metals. 3. Japan's export sector is much weaker than in the past and it has been suffering from economic recession for many years. 4. The Slovak Republic has a strong manufacturing sector and makes machinery, metals and chemicals that it exports mostly to other EU countries. 4. The UK depends on its export sector, which is strong in services. 5. The US has a much smaller export sector proportionately. It is a large country and a lot of domestic demand is supplied by domestic firms. The UK has a large export sector which accounts for 28.4% of GDP. It is important for these markets to be maintained, as a fall in overseas demand might not automatically be replaced by domestic demand. The relationship between exports and growth can be seen from two angles. The growth rate of the country affects the volume of exports made. If the economy is starting to grow and investment is taking place, some of the new goods and services produced as a result will be sold in export markets. But, conversely, an increase in growth and aggregate demand in the domestic economy will mean that fewer goods and services are available for export. It is nevertheless true that exports boost a country's growth rate. The UK government is keen to develop the export sector for this reason. If exports lead the way, this is known as export-led growth. International markets are very competitive and a country's products need to be attractive in terms of their price, their quality, reliability of their delivery and after-sales service where applicable. Marketing, advertising and public relations are very important in finding and keeping customers.

In 2015 the Duke of Westminster was the ninth wealthiest person in the UK. He had an estimated wealth of £8.56 billion (£8 560 000 000). He has inherited vast estates in Lancashire and Cheshire and much of London's Mayfair and Belgravia. In the same year, the author J K Rowling had a fortune of around £1 billion. She receives royalties for every one of her books sold and also payments from film rights and merchandise sales. 1. Identify two reasons why the Duke of Westminster's wealth may increase. 2. Are royalties a form of wealth or income? 3. List the ways in which someone may become wealthy.

1. The Duke of Westminster may use some of the rent he earns to buy more property and his existing property may rise in value. 2. Royalties are a form of income. They are a flow of money earned from selling books. 3. Inheritance, enterprise, saving and chance (e.g. a Lottery win).

The government operates an Employ an Apprentice scheme in England whereby firms are given a grant if they employ an apprentice over 16 years of age. The firm must pay the apprentice at least the minimum wage and apprentices must work with experienced staff, learn job-specific skills and study for a work-based qualification. 1. Why is the government willing to spend money on the apprentice scheme? 2. Explain why an improvement in the skills of young people would increase output.

1. The government spends money on the scheme now, but it saves benefit payments later when the young people are qualified and can use their skills in jobs. They will pay income tax when they are earning money. 2. An improvement in the skills of young people will increase output because they become more efficient in their work and productivity rises. They can continue to learn and may become specialists in their field.

1. How will the UK government aim to achieve the projected fall in the public sector deficit after 2015/16? 2. What factors might make it hard for it to achieve these figures? 3. Why are the figures in 2019/20 negative? 4. Why does the percentage of borrowing to GDP ratio fall sharply?

1. The government will try to increase its tax receipts and cut its spending. 2. These figures will be harder to achieve if the projected rate of growth does not materialise or if some external shock causes a large rise in public spending. 3. The figures in 2019/20 are negative because they are a surplus - negative borrowing. 4. Not only is the government deliberately cutting its spending and raising its tax receipts but GDP is also rising as the economy grows. So lower borrowing as a percentage of higher GDP gives a lower borrowing to GDP ratio. Study hint Do not confuse a balance of payments deficit or surplus with a government fiscal deficit or surplus. A balance of payments imbalance is a foreign currency imbalance of the country with the rest of the world. A fiscal imbalance is largely a domestic currency imbalance between the government and the people of the country. You should be careful of this difference both in your studies and also when answering examination questions.

Between 1997 and 2007 the US economy grew at an average of 3.5%. This growth was stimulated in part by rising investment. Some top executives enjoyed staggering bonuses in excess of £20m but some US citizens did not see their income rise in line with economic growth. Indeed, the spending power of some US citizens stagnated and some low-skilled workers experienced a decline in their real incomes. Nevertheless, low-skilled workers bought dishwashers, installed air conditioning and built up other forms of material wealth. In the ten-year period from 1997 to 2007, US citizens also purchased more imports and this rise in the purchase of foreign products contributed to a growing account deficit. In 2007, the sub-prime mortgage market collapsed, leading to a global crisis. A number of large US financial institutions failed and the economy was sent into recession. 1. Identify an injection and a withdrawal from the passage. (2 marks) 6. Explain how the growth experienced in the US in the decade up to 2007 was unsustainable. (5 marks)

1. The injections mentioned in the passage are investment and consumption. The withdrawal mentioned is imports. 6. The growth experienced in the US between 1997 and 2007 was unsustainable because it was based on unrealistically high bonuses for some and on debt for others. Banks lent money for house purchase to people who could not afford to repay and eventually the low end of the mortgage market (the sub-prime sector) collapsed, leading to a knock-on effect on banks and governments in many countries. If lenders create credit beyond their ability to lend and beyond borrowers' ability to repay, this is unsustainable and will lead to defaults and a financial crisis.

Which of the following may cause demand-pull inflation and which may cause cost-push inflation? Choose the correct answer for each. 1. A rise in the price of oil 2. A rise in government spending 3. A fall in the rate of interest 4. A rise in exports 5. A fall in the productivity of workers

1. cost-push 2. demand-pull 3. demand-pull 4. demand-pull 5. cost-push A rise in the price of oil will increase firms' fuel and transport costs and a fall in the productivity of workers will increase wage costs. So both of these may cause cost-push inflation, whereas an increase in government spending and a rise in exports increase demand for the country's products and so may cause demand- pull inflation. A fall in the rate of interest will also increase aggregate demand by stimulating investment and consumption.

Which of the following groups do you think will tend to suffer a fall in real income during a period of inflation? 1 The government 2 Debtors 3 Producers in countries with high inflation 4 Workers in strong trades unions 5 Holders of fixed-interest securities

3 and 5. Producers in countries with high inflation are likely to sell fewer exports and buy more imports. Their balance of payments on current account would be expected to deteriorate and their income and employment would be expected to fall. Holders of fixed-interest securities will receive the same rate of interest in money terms, but its real value will fall. They will therefore be able to buy fewer goods and services with the interest they earn. In contrast, the government and debtors tend to gain as the real rate of interest they pay will probably fall. The government may also benefit from a rise in real tax revenue if fiscal drag occurs. This means that as wages rise a higher proportion of aggregate income is paid in tax. Workers in strong trades unions are likely to receive wage rises that match or even exceed the rate of inflation, so their earnings will tend to remain constant or rise.

Identify two benefits of a fall in inflation.

A fall in inflation benefits an economy because prices are stable and people on low incomes are better able to afford to buy necessary goods and services. Low inflation means that interest rates can also be low and this gives a boost to borrowing and therefore to GDP. If people expect inflation to continue to be low, there is more likely to be higher consumption and investment because of confidence in the future.

Relationship between income and wealth

A high income means that people can spend more on consumption and can support an expensive lifestyle. However, there is a limit to how much people can spend and, as their income rises, they tend to save more as well. So a high income enables people to accumulate wealth, and this wealth in turn generates income. For example, the chief executive officer of a large company will earn a very high salary and will also receive bonuses. They will use some of this money to buy assets such as shares and a house. The shares will pay a regular dividend and so they add to the person's income. The house may not pay an actual income but it provides accommodation services and prevents the family from having to pay rent. Banks nowadays offer equity release schemes for people who are retiring. They either borrow a lump sum against the value of their house or they sell all or part of it in exchange for a regular monthly income (an annuity) for the rest of their lives. There are advantages and disadvantages of these schemes but they are a way in which older people can turn their wealth stock into an income. Wealth also allows people to dissave - to spend more than their income, either by financing some of their current consumption by drawing from their savings or by borrowing on the value of their assets by using them as security for a loan. For example, someone who owns a house or a portfolio of investments can use these as security for a loan to start a business. People on low incomes are likely to spend most, if not all, of their disposable income on basic necessities. This makes it difficult for them to accumulate wealth by saving money or buying their home. It is not only households that have income and wealth. Profits are the main part of a firm's income and the firm can use them to finance investment in new capital equipment, which is a stock of assets of wealth. Governments receive income in the form of taxes, which they use to finance their expenditure. They can use some of this income to buy assets - they may buy shares in a private sector company, for example. The UK government bought large shares in the Royal Bank of Scotland and in Lloyds Banking Group in 2008 when these banks were facing failure.

Why would a large-scale write-off of Greek debt be a threat to global growth?

A large-scale write-off of Greek debt would be a threat to global growth because it would reduce the value of Greek government bonds held by banks, pension funds, firms and individuals. They would have to absorb this loss and their wealth will fall, making them less able to boost growth by spending.

What does a nominal growth rate of 3% mean?

A nominal growth rate of 3% means that GDP (aggregate output) has grown in money figures by 3% - this year's money figure is 3% higher than last year's money figure.

Protection of the environment

As an economy grows there is a risk that more damage may be caused to the environment. For instance, building destroys natural habitats, traffic congestion builds up and increased output by firms generates more pollution. Higher carbon consumption contributes to climate change. So protecting the environment has become an important objective of governments and spans all areas of the economy. This is a huge area and we can only mention a few aspects of it. Here is a quote from the Environment Policy Area of the UK government's website: The government is working to protect our environment by reducing pollution, reducing the amount of waste sent to landfill, protecting areas of parkland, wildlife reserves and marine biodiversity, and enforcing regulations that keep our water and air clean. We also help communities avoid or recover from flooding and other weather-related hazards. Like other governments, the UK government also takes part in international initiatives such as the United Nations Framework Convention on Climate Change and a large number of European Union environmental programmes.

Greater income equality

As an economy grows, the average standard of living rises. However, this is not evenly distributed and market forces mean that some people earn higher incomes than others. Since the early 1980s there has been a trend in advanced economies such as the UK and US towards a greater inequality of incomes. A number of reasons have been suggested to explain this trend. Globalisation has meant that developed countries like the UK face strong competition in the manufacturing sector from low-wage emerging economies such as China. This has caused higher unemployment among lower-skilled people in the UK. (Skilled workers are able to demand higher wages while unskilled workers have to accept lower incomes.) At the same time, the ability of trade unions to keep wages high has decreased. This is partly because of legislation that limits the power of unions and partly because of the contraction of the manufacturing sector in the UK, which tended to be more highly unionised in the past. The above is exacerbated by the current trend towards more part-time working and to what are known as 'zero-hour' contracts, where workers are not guaranteed the number of hours they will work each week. This tends to happen in lower-skilled jobs and it means that many people are working for little more than the minimum wage and for a limited number of hours. Many of these jobs are taken by women who, despite equal pay legislation, earn less on average than men because of the nature of the work they do. An ageing population means that an increasing number of people are now living on retirement pensions, which are lower than the incomes they earnt while they were working. At the other end of the scale, rapid technological progress in fields such as IT and telecommunications has increased the demand for highly skilled employees, who can command high salaries. And there has been salary and bonus inflation among the top executives of large corporates (such as banks) who can earn incomes which are expressed in millions rather than thousands of pounds. Inequalities grow if not addressed and they have a cumulative effect. People who earn higher incomes can afford private healthcare. They can send their children to high-performing schools and ensure that they in their turn can earn a higher income. They can amass large amounts of wealth, the return on which earns them even more income. Children of professional people and people with skills often have the advantage of acquiring knowledge from their parents which they would not be taught in school. Their parents may also have higher expectations for them, which they try to live up to. There are also social reasons for inequality on the negative side. For example, children who grow up in a family where everyone is unemployed may see unemployment as the norm and this may stunt their own personal ambitions. Certain groups in society suffer from discrimination of various types and children in such families may find it harder to get a good education that leads to a higher paid job. There are various ways of measuring inequality but one which is easy to understand shows how much bigger are the incomes of the richest 10% of the population when compared with the poorest. A report by the Organisation for Economic Cooperation and Development (OECD) shows that the average income of the richest 10% of the UK population is 10.5 times that of the poorest 10%. This figure varies widely between countries. It is 5.2 times in Denmark but 30.5 in Mexico. In recent decades, it has been the policy of UK governments to aim for a greater degree of income equality between the country's citizens. There are two main ways that governments achieve a degree of income redistribution. The first is progressive taxation. This means that people on higher incomes pay a higher percentage of their incomes in tax than those on lower incomes. Income tax in the UK has a progressive element in that people on higher incomes have to pay a higher rate of 40% on income over a certain threshold. The second is the payment of welfare benefits to people who are retired, unemployed or on lower incomes. This in effect sets a minimum income for those who are not earning any or enough money to secure them a reasonable living standard. The government also provides free health and education which means that everyone can access these services, however low their income.

Compare the performance of the UK economy in 2007 with that of the US and Germany.

In 2007, the UK's unemployment rate was slightly higher than that in the US but much lower than that in Germany. UK inflation was lower than in both the US and Germany. The UK's current account deficit as a percentage of GDP was lower than that in the US but compared badly with the high German surplus. Growth in the US was similar to that in the UK but German growth was lower.

Balance of payments equilibrium on current account

As you saw in Section 4 Topic 1, a government will try to achieve an equilibrium on the current account balance in the long run. This means that, over a period of perhaps five to ten years, it aims to break even. In practice, countries like the UK and US have tolerated current account imbalances for many years because of the structure of their economies, which forces them to depend on many foreign imports. Their objective is really to keep the deficit manageable so that they have no trouble in financing them. The country does not want a current account deficit because this means that it is importing more than it is exporting. (You will remember from Topic 1 that exports and imports are one of the three pairs of injections and withdrawals.) In terms of the circular flow of income, the withdrawal of imports is greater than the injection of exports and this has a depressing effect on aggregate income and on growth. The other reason for trying to avoid a deficit is that the difference between foreign currencies earnt and spent has to be financed, usually by borrowing. On the other hand, the country does not want to have a balance of payments surplus because this means that the economy is not consuming as many goods and services as it can afford and people's material living standards are lower than they could be. It does promote growth, since there are net injections from trade, but it can also create inflationary pressure as it results in a net outflow of products but a net inflow of money. The other reason is that, if a country has a large and long-standing balance of payments surplus, as in the case of China, there is a lot of pressure from its trading partners to reduce the surplus. Total deficits on a global scale equal total surpluses and so one country's surplus is another country's deficit. The UK balance of payments shows a particular pattern. There is usually a deficit on trade in goods and a surplus on trade in services. The services surplus is usually insufficient to balance the deficit in goods and so the overall balance of payments on current account is in deficit.

Comment on the performance of the UK economy between 2005 and 2007.

Between 2005 and 2007, the UK economy was experiencing a steady unemployment level of 5.3% to 5.4%. This is similar to the level being experienced in 2015. Inflation rose from 1.9% to 2.2%, quite a lot higher than the level of 0.1% at the time of writing (September 2015). The current account balance was in deficit throughout the period and it remains quite high in 2015. Growth was fluctuating but was much higher than in the period during and after the recession. Overall we can see that the economy was growing but we know, in hindsight, that this was built on high levels of debt, which were not sustainable.

Definition of economic growth

Economic growth arises when a country produces more goods and services in the current period than it did in the previous period. It can also be defined as a situation where the productive capacity of the economy increases. In other words, economic growth occurs when an economy experiences an increase in either real GDP or in potential real GDP. Most countries measure economic growth in terms of percentage changes in real GDP. An economic growth rate of 2%, for example, would mean that the country had produced 2% more goods and services this year than the previous year. -Actual and potential economic growth: An increase in the output of goods and services is sometimes referred to as actual economic growth. It can occur as the result of making use of previously unemployed resources or using new or improved resources. Potential economic growth is an increase in a country's ability to produce goods and services because of an increase in the quantity and quality of resources. It is represented by a shift to the right of the production possibility boundary. It is possible for potential growth to occur without actual growth taking place. This would happen if there were insufficient demand to make use of the new resources. Figure 2.1 distinguishes between actual and potential growth. The movement from point A to point B represents actual growth occurring - the economy is making greater use of existing resources. The movement of the production possibility boundary from XX to YY shows potential growth. If output moves from point A to point C, actual growth would result both from employing more existing resources and from employing new resources. -Economic growth and aggregate demand and supply curves: Actual and potential economic growth can also be illustrated using aggregate demand and aggregate supply diagrams. If there is spare capacity in an economy, an increase in aggregate demand will increase output and so result in economic growth. Figure 2.2 shows aggregate demand shifting to the right and as a result real GDP increasing from Y to Y1. Potential economic growth occurs when the productive capacity of an economy increases. This change is represented by a shift to the right of the AS curve as illustrated in Figure 2.3. Figures 2.2 and 2.3 both show national output increasing, but for economic growth to be sustained both AD and AS must increase. Figure 2.4a shows AD increasing but no change in real GDP. Figure 2.4b shows AS increasing but no change in real GDP. Figure 2.4c shows both AD and AS increasing and as a result real GDP increasing.

Benefits and costs of economic growth

Economic growth sounds as if it is a 'good thing' and indeed, it does bring many benefits to a country. But it also has costs. We are going to consider these costs and benefits and look at the impact of economic growth on consumers, firms, the government and on current and future living standards. The benefits of growth: - Higher living standards: The main potential benefit is that in a growing economy, employment is rising, unemployment is falling and wages are rising. Since more people are in work and receiving a higher income, they can spend more. And since more goods and services are being produced, there is more for them to spend it on. So material living standards rise, consumption of non-necessity products rises, and home ownership rises (in the UK, at least, where owning one's home is considered desirable). - Optimistic business climate: Firms also benefit from growth because their markets become bigger, they sell more products and, as long as they can keep their costs down, their profits rise. They can use some of these profits to fund future expansion. -The government's finances: The government benefits from the above situation because its tax revenues rise as a result of the income tax paid by the larger workforce, the VAT from higher spending and the corporation tax from higher company profits. At the same time, it pays out less in unemployment benefits since there are fewer people out of work. It can use the money to fund more and better public sector projects in areas such as education, health, infrastructure and housing. Improvements in these services mean that fewer people will live in poverty and people can have a better quality of life and can live longer. - Structure and influence of the economy: If we put all of the above together and look back, perhaps over the last 30 years, we can see that in the UK productivity has risen and people are working fewer hours and so have more free time to enjoy a greater range of leisure goods and services. As people become better off, they tend to spend an increasing proportion of their income on services. This is reflected in the structure of the economy, and we can see that as countries become more developed there is an increase in the proportion of GDP generated by service industries. The service sector in the UK accounted for around 78% of GDP in 2014. Economic growth also raises the status and bargaining power of a country. Indeed, the voting power at the International Monetary Fund (IMF) depends, in part, on the size of a country's real GDP. It is economic growth that explains the increasing influence on the world stage of emerging economies such as China and India.

The multiplier process continued

Effects of the economy on the multiplier The size of the multiplier, after an additional injection, is bigger the more people spend and the less they save, pay tax and import. The propensities we studied above are affected by the state of the economy and by people's expectations. Here are some effects: - The stage of the trade cycle. If an economy is booming, then people may be spending more and the marginal propensity to consume (MPC) may be high. However, as they expect the boom to finish, they may begin to save more so they can have a stock of wealth to help them through the coming downturn. The MPS will then be higher. - If the economy is experiencing recession, and unemployment is high, many people will be struggling to buy their basic needs and will not be able to save at all so the MPC will be higher. The MPS will be much lower. - If the government is trying to reduce a fiscal deficit, as is the case at the time of writing (August 2015), taxes will rise and so will the MPT. - If the economy is booming, people will be purchasing more imports along with their overall expenditure and the MPM will be high. This will especially be the case if foreign goods and services are seen to be high quality. -The significance of the multiplier to shifts in AD: The higher the multiplier, the more an initial piece of private sector or government investment will cause aggregate demand to increase. So a high multiplier will result in a wider distance between the original AD curve and the higher one. But it does not necessarily mean that the economy will reach a state of full employment. It is also worth noting that the multiplier process can work in reverse in a recession when firms are closing down and factors of production are becoming unemployed. People have less money to spend and less is passed on in each round. The eventual effect of the initial piece of de-investment will be multiplied in the way described above.

What is the problem if growth is financed by too much borrowing?

Growth depends on investment and most investment is financed by borrowing. But problems arise if this borrowing is too much; if governments, firms and individuals borrow more than they can afford to repay, they will eventually default. Such defaults have a domino effect on the economy and can cause recession.

Balanced government budget

Here we are dealing with another pair of injections and withdrawals - government expenditure (injection) and taxation (withdrawal). The government takes money from individuals and firms and spends it on public goods and services but the account does not always balance. If total government expenditure exceeds total tax receipts, there is a deficit on the public sector (fiscal) accounts. This is expansionary and promotes growth as injections are greater than withdrawals, but it has to be financed by borrowing. The amount a government has to borrow each year is known as the public sector net cash requirement (PSNCR). Conversely, if total tax receipts exceed total government expenditure, there is a surplus on the public sector accounts. This is contractionary and slows growth as withdrawals are greater than injections, but it enables the government to make a saving and this can be used to repay past debt. There is clearly a limit to how much a government can borrow without losing its creditworthy status. Most government borrowing is financed via the financial markets. If a country's fiscal borrowing becomes very large, it appears less creditworthy to prospective lenders. Because of the higher risk, they will lend only at a higher interest rate. So a country that is over-indebted has to pay a very high price for any further borrowing. Greece is a good example of this. There is also a limit to the amount of surplus a government would be able to amass because the reduction in public spending which would be necessary for this to happen would mean cuts in essential services. No government can afford to take the political risk of making large cuts in areas such as health, welfare and education. So the ideal situation for a government would be to balance its budget over a period of years. A balanced budget would have a neutral effect on GDP. Note in what follows that public sector borrowing can be expressed in terms of actual money but it is more often given as a percentage of GDP. The UK government's annual deficit increased by a large amount at the time of the financial crisis. This was because huge amounts of public sector money were used to bail out several failing banks. The deficit continued to rise in the recession that followed the crisis. High unemployment meant that tax receipts fell and spending on welfare rose. It is now the aim of the Conservative government to reduce the fiscal deficit each year and to turn it into a surplus by 2018/19. The following table from the ONS shows UK public sector borrowing 2007/08 to 2019/20. You can see how the deficit rose and then fell again and what the projections are for the next few years. Notes to Table 3.2: The government's financial year begins on 6 April each year and this is why each year is expressed as a spread of two years. So, for example, 2014/15 means 6 April 2014 to 5 April 2015. The borrowing figures exclude borrowing made on behalf of public sector banks.The figures from 2015/16 onwards are projections.

Topic 3 - Macroeconomic objectives and policies

In Topic 1 of Section 4 you explored the key indicators of economic performance and learnt how they are measured. In this topic you will see how these indicators form the basis of the macroeconomic objectives of governments. We will discuss the reasons for the objectives and the policies which government can use to achieve them and consider some possible conflicts and trade-offs between different macroeconomic objectives and between macroeconomic policies. In this topic you will be introduced to the three main forms of government policy. In exploring the effects of these policies on the main government macroeconomic policy objectives, you will be able to make use of the aggregate demand and supply analysis you have learnt in previous sections. We will be referring to certain concepts and statistical measurements which you met in Section 4 Topic 1. Go back to that topic to check these if you are unsure of their meaning. To understand government policies clearly, you need to keep up to date with what's happening in the news to find current examples of what you read about in this topic.

What happened in the UK in the years 2008/09 and 2009/10?

In the years 2008/09 and 2009/10 public sector debt rose very sharply because of the financial crisis and the recession that followed. Tax receipts fell and welfare payments rose.

Summary of National income

In this topic you have considered the nature of the circular flow and injections and leakages into the circular flow. You have also considered the difference between income and wealth and the relationship between the two. The key points are: - Income is a flow while wealth is a stock. - A high income can enable a person to accumulate wealth and wealth can generate income. - The circular flow of income refers to the flow of money, products and factor services between households and firms. - The three injections into the circular flow are investment, government spending and exports. - The three withdrawals (leakages) from the circular flow are savings, taxation and imports. - The multiplier is the number by which an initial injection is multiplied to show the overall eventual effect on the size of real GDP in the circular flow.

Income and wealth

Income is a flow of money that is paid regularly to the people who comprise households. This money is in return for factor services; they receive wages and salaries from their employment or self-employment, income from their savings and investments in the form of interest and profits, and rent if they own and let out property. Some also receive state benefits if their other income is below a certain level. People use their income to fund their regular expenditure and they may save some of it to use in the future. Wealth is a stock of all the assets that people own. Some is in the form of physical assets such as houses and cars, and some in the form of financial assets, such as shares in companies and membership of pension funds. Income arrives in the form of money, usually paid into someone's bank account by the employer, tenant, company or government. It is in liquid form, which means that it can be spent immediately and turned into other goods and services. But wealth is not in the form of money (unless someone keeps cash under their mattress because they do not trust their banking system, as happened in Greece during the debt crisis in the summer of 2015). Wealth, such as a house or a block of shares, is not liquid and if holders want to spend the value contained in the wealth they must sell. There are markets in which they can do this - the property market or the stock market.

Conflicts and trade-offs in policies

Just as there are conflicts in objectives that need to be resolved by means of trade-offs, so there are conflicts in the policies that are implemented to achieve the objectives. Here are some examples: - Interventionist supply-side policies intended to act as a spur to growth may also cause inflation in the short run. For example, a government may increase its spending on education, training and healthcare and make cuts in income tax to increase work incentives, but these policies may give rise to bottlenecks in the short run. If the economy is operating close to full employment, productive capacity may not be sufficient at all stages to produce more final products. So there will be a time lag while the necessary additional investment is made and before the measures can result in an increase in aggregate supply. - In a period of inflation, deflationary fiscal policy measures can have an adverse effect on aggregate supply, shifting the aggregate supply curve to the left. For example, an increase in income tax may act as a disincentive for workers to work long hours and for new people to enter the labour force. A reduction in government spending on education may reduce productivity in the long run and so decrease aggregate supply. - A government may reduce the excise duty on fuel in order to reduce costs for businesses and households. However, this is an incentive for consumers to be less careful in the way they use their energy and it may lead to an increase in the consumption of fossil fuels, thus causing more harm to the environment. - A government which wants to expand the economy by reducing taxes and increasing expenditure will cause the budget deficit to increase. This makes it harder for the government to work towards achieving a balanced budget. - If fiscal expansion takes place to achieve a higher level of growth and the public sector has to borrow more, it is competing with private sector firms for funds in the financial markets. This may 'crowd out' private sector investment.

Equilibrium levels of real national output

Now that we have an overall idea of the model of the economy, we need to think about the point at which the level of real national output and the price level are in equilibrium. This means that point at which there is no need for anything to change until some external factor enters to disturb matters. The equilibrium level of real national output and the price level occurs where aggregate demand and aggregate supply are equal, as shown in Figure 1.3. This is known as macroeconomic equilibrium. At this level there is no tendency for real national output or the price level to change. Firms can sell the quantity of goods and services they want to supply (AS) and households, firms and the government can buy the quantity of goods and services they want to demand (AD). Note that in the diagrams that follow we are using the long-run aggregate supply curve. If the economy were not at the equilibrium level, real national output and the price level would change. For example, if the quantity of goods and services that firms want to sell is less than the quantity that households want to buy, the price level will be pushed up and real GDP will expand. Conversely, if aggregate supply exceeds aggregate demand because people are not spending money, there will be downward pressure on prices and real GDP will contract.

What is meant by 'real incomes'?

Real incomes are money incomes adjusted for inflation, that is, income expressed in terms of purchasing power. A rise in real incomes means that incomes have risen by more than inflation and so purchasing power has risen.

The circular flow of income

The circular flow of income is a very important model of the macroeconomy which had been postulated by nineteenth-century economists but which was put into its modern form by John Maynard Keynes. This model shows how both money and real goods and services flow around the economy. The two main groups in the model are: - households - the consumers who demand goods and services - firms - the organisations that supply goods and services. The simple form of the model shows that there are two sets of flows between households and firms, and these flows go in opposite directions. Firms produce goods and services to satisfy households' demand. To enable the firms to make their production, the households provide 'factor services' to the firms - they supply them with the factors of production (labour, land and capital) they need in order to produce the goods and services. In return, the firms pay the households wages, rent and interest. So there is an exchange in which households receive money in return for real services. With the money from their incomes, the households purchase the goods and services produced by the firms. This time the households are paying money in return for the real products they want to consume. So the circular flow model has two flows: the real goods and services exchanged between the households and the firms and the money which each receives in return. Figure 1.1 shows the simple model with the two sets of flows, goods and money, moving in opposite directions.

Benefits and costs of economic growth continued

The costs of growth: - Living standards and lifestyle implications: As we said above, the living standards of people in general rise during a period of economic growth. But the statistics give us overall figures and averages and they disguise the fact that not everyone benefits. People who remain unemployed despite a growing economy are left behind and their relative quality of life seems to them to be worse. Higher output can also impose personal costs. A growing economy means more pressure for those in work and some people find it difficult to keep up with the increased pace of change and the extra stress involved. Working longer hours and having to meet continual deadlines can result in physical stress and breakdown and mental illness. Parents spend less time with their children and the situation can lead to family break-up and divorce. These problems place a greater burden on the healthcare system and on social services, which have to deal with these negative effects of growth. A growing economy encourages consumers to spend more and they do a lot of their spending on credit. Even if they can cope with their debt repayments while the boom period lasts, they may be in trouble when the cycle turns and if they lose their jobs, as they will be unable to pay off their debts. - The opportunity cost of investment: In order to produce more goods and services in the future, resources have to be transferred from making consumer goods to making capital goods. Investment can be defined as 'a giving up of current consumption'. In other words, the opportunity cost of economic growth in the longer term is the consumer goods foregone in the shorter term. So in a developing economy that is investing, consumers may have to wait before they are able to purchase a wider range of consumer products. However, in economies with unemployed resources, the opportunity cost of investment is lower because there is capacity to produce the capital goods with the previously unused or under-used labour and capital. - The external sector: Economic growth can lead to a growing deficit on the current account of the balance of payments (see Section 4). This is because, as people's incomes rise, they consume more, including imported goods and services. Indeed, one of the first indicators of a period of growth is a rise in imports. At the same time, fewer products may be available for export. On top of this, a period of controlled growth makes the country's currency more attractive on the financial markets and its exchange rate may rise. This makes imports cheaper to buy at home and exports more expensive abroad. All of this together has a negative effect on the balance of payments and the deficit is likely to widen - or a surplus may turn into a deficit. - The environment: Arguably, the biggest disadvantage of economic growth is the cost to the environment. As consumption and investment grow, there is an increase in pollution of all types: air, water, visual and noise, and the depletion of natural resources, such as the rainforests, and non-renewable resources such as oil and coal. Perhaps the biggest threat to the planet is that of climate change. There is an increasingly strong consensus amongst the scientific community that human action is causing a rise in the global temperature and resulting in more unpredictable weather and more extreme weather events. The conclusion is that, as a planet, we should burn less carbon. In order for the world to reduce its carbon footprint, countries need to switch from fossil fuels to renewable energy sources. This requires a vast amount of investment, and energy producers and consumers will have to make fundamental and expensive changes in the way they operate. There is a cost to this too, but environmentalists would argue that this is a short-term cost which will bring about long-term advantages. - Current and future living standards: For decades, economists and politicians have been pushing for higher growth in order to expand the productive potential of their countries or, at least, to help their economies grow after a period of recession. Growth has become the great objective that everyone wants to achieve and politicians have included higher growth in their election promises. However, people are beginning to realise that a growing global population is putting increasing pressure on natural resources and that more and more industrialisation is posing a threat to the environment and is probably a prime cause of climate change. Growth appears less attractive when looked at in this way and many economists are revising their ideas. The emphasis now is more on sustainable economic growth. Sustainable economic growth: 'Sustainable development is development that meets the needs of the present without compromising the ability of future generations to meet their own needs.' This is the official definition of sustainable development that emerged from the World Commission on Environment and Development of the United Nations that was convened in 1983 to unite countries to pursue sustainable development. As you can see, this is not a new idea. The definition means that people should use the world's resources carefully in such a way that there will be enough left for people in the future to be able to live their lives. There is a clear implication here for growth - that if countries go for maximum growth now, they will compromise the living standards of people in the future. This is a question of inter-generational equity. The conclusion is that countries should seek to grow only at a rate which reduces the rate of depletion of non-renewable resources, such as mineral deposits, and which limits the amount of carbon and other greenhouse gases released into the atmosphere. Instead of achieving as much growth in the short term, they should take a longer-term perspective. They should recognise that the opportunity cost of high consumption now is much less consumption in the future. In other words, governments should aim for sustainable economic growth. We mentioned above that the trend rate of growth for the UK is 2.5% and many people have suggested that 2% growth per annum would be acceptable. It also tallies with the inflation target of the UK and of the eurozone. However, strict environmentalists and sustainability theorists would argue that it is not sustainable for the world's nations to grow by 2% every year. The cumulative effects of such a growth rate would be very large after several decades. They say that growth itself should not be an economic objective and that it should be replaced by development. This means finding greener and more sustainable ways of satisfying human needs. The Intergovernmental Panel on Climate Change was set up under a United Nations programme in 1988 to give a scientific view on the potential environmental and socio-economic impacts of climate change. Based in Geneva, Switzerland, it involves195 countries and holds conferences at regular intervals. Most countries agree that action needs to be taken to reduce global warming but these actions involve reducing growth rates and no country wants to do this. In particular, developing countries with high levels of poverty feel that they should not have to reduce their growth programmes because of the pollution caused by other countries. Up to now, the US has been uncooperative in agreeing to carbon-reducing measures but, in August 2015, President Obama announced that the US will implement climate change regulations.

Macroeconomic policy objectives continued

The effects of inflation: In Section 4 Topic 1 we looked in some detail at how inflation affects individuals, firms and the government. Here we will add some additional thoughts on the effects of inflation on the economy as a whole. The level of inflation is very important as a high level is a big problem for a country. It can become entrenched and the wage/price spiral can be very difficult for a government to breakout of. A high and accelerating rate of inflation can fuel expectations of further inflation. If inflation expectations are high, the rate at which prices and wages are increasing can accelerate as workers want to secure wage rises before prices go up and firms want to raise their prices before their wage costs increase. In such a case, all the negative effects of inflation that you learnt about in Section 4 Topic 1 become exacerbated. A high and accelerating inflation rate brings uncertainty as people do not know how high future rates are going to be. This can reduce investment as firms are unwilling to take the risk of expansion if they are unsure whether people will be able to afford to buy their products. A lower stable rate of inflation is more predictable so firms and households can more easily adjust their plans to protect their profit levels and real wages. Low demand-pull inflation can benefit an economy if there are spare resources. It means that the economy is growing and it will stimulate firms to produce more as they will be optimistic about being able to sell their additional output. Deflation, or a situation of falling prices, is a problem because it means that the economy is hardly growing or may even be suffering from negative growth rates. Unemployment is high in this situation and the economy can stagnate. In 2011, CPI inflation in the UK was 5.2%. Since then the rate has fallen gradually and, at the time of writing (August 2015) it is 0.0%. This means that the country is actually experiencing zero inflation (although it is expected to rise). The main factors that have brought UK inflation down over the period 2011-5 are the fall in global commodity prices, especially oil, and the high value of the exchange rate of sterling, which means that imports are cheaper to buy.

The multiplier process

The multiplier is an implicit part of the Keynesian analysis of the circular flow of income. It measures the overall eventual effect on the economy of an increase or decrease in aggregate demand. To explain it we will use the example of an increase in aggregate demand. Suppose that an overseas company decides to spend £1bn by opening a new factory in the UK. It has made an investment - an injection in the terminology of circular flow theory. This is clearly a good thing for the country as it will create new demand, but how much? The quick answer is that it will create more than the £1bn invested and this is because of the multiplier process. The initial £1bn will become income for all the employees of the firms who were contracted to build and equip the factory and for those that are working there. Some of these people may have been unemployed or under-employed before and those who have moved from other jobs have freed them up for unemployed people to take. So more people are now working and earning an income. They spend this income on their everyday needs and wants and, here is the crucial point: their spending becomes income for the people who have sold them their food, clothes, new kitchens and insurance policies. People who work for supermarkets, kitchen-fitting firms and insurance companies now have additional income and they too go out and spend it. Their expenditure becomes income for others in turn. In other words, there are successive rounds of spending, all based on the initial £1bn spent by the foreign investor. This cumulative effect is known as the multiplier process. The above example happened because of an autonomous increase in private sector investment, but it could equally have taken place as a result of a new piece of government spending, such as the building of a new hospital or because of a rise in exports due to an increase in demand in other countries. -The multiplier ratio: We need to calculate the size of the overall eventual spending generated by an initial investment. In other words, we want to know by how many times the initial investment is multiplied after successive spending rounds. What is the size of the multiplier? Let us return to the example of the foreign firm investing £1bn in the UK. As we said, this £1bn becomes income for a large number of people; they spend it and it becomes income for others and so it goes on. If the whole £1bn was spent on each round GDP would rise by £1bn each time and this would go on for ever. But this is not what really happens. In real life, as we have seen above, there are withdrawals from the circular flow. When people receive their incomes, they spend quite a lot of it but some of this will be on imported goods and services - they might go abroad for their holiday or buy a foreign car. They also cannot avoid paying more tax, both income tax on their earnings and indirect taxes on what they spend. And, because they are now better off, they may put some of their extra income into savings. So because of savings, taxation and imports, not all of the money earned at each spending round is passed on to the next round. This means that a proportion of the original £1bn will be withdrawn and less than £1bn will be passed on to others in spending. This lower amount will also be subject to withdrawals and an even smaller amount will be passed on to the third round. As the spending rounds continue, an even smaller amount of money is passed on until the process fizzles out. If we want to know the total amount of additional income generated by the original £1bn, we need to add up all the money spent at each round. We could then work out the multiplier. For example, if the total money generated were £3bn, out of an original £1bn, then the multiplier would be 3. It would be impossible to keep track of all the spending taking place at each round but, if we have certain information about people's spending habits, we can make a good estimate. -Marginal propensities: The most basic information we need is what people do with their income. How much of it do they spend and how much do they save? These tendencies are called 'propensities'. So someone who spends most of their income has a high propensity to spend. But we are interested in how much people tend to spend and save out of an addition to their incomes - in other words, out of their marginal (extra) income. This gives us the marginal propensities we need: - The marginal propensity to consume (MPC): This is the proportion of an additional amount of income that people tend to consume - to spend on domestically produced goods and services. It is the amount of additional income that is passed back into the UK economy to fuel the next round of spending. - The marginal propensity to save (MPS): This is the proportion of an additional amount of income that people tend to save - not to spend. It goes into bank accounts and other forms of saving and is not passed on into the next round of spending because it is a withdrawal. - The marginal propensity to tax (MPT): This is the proportion of an additional amount of income that is taken from people in direct and indirect taxes. They do not spend it and it goes to the government and is not passed on into the next round of spending because it is a withdrawal. - The marginal propensity to import (MPM): This is the proportion of an additional amount of income people spend on imported goods and services. It becomes income for sellers in other countries and is not passed on into the next round of spending in the UK because it is a withdrawal. - The marginal propensity to withdraw (MPW): This is the total of the three above propensities to save, tax and import and it is the total amount not spent and passed on to the next round. Let us illustrate this with some simple numbers. Suppose that the propensity percentages were as follows: MPC: 50% MPS: 10% MPT: 20% MPM: 20% So out of an initial investment of £1,000, people would spend £500, save £100, pay £200 in tax and buy £200 worth of imported goods and services. Put more simply, they spend £500 and withdraw £500. From this we can see that: MPC = MPS + MPT + MPM or MPC = MPW Expressing this in language, out of an additional amount of income people spend some and withdraw the rest in savings, taxes and import purchases. -Calculating the multiplier: Now we can use the above propensities to calculate the multiplier, which is traditionally known as K (probably named after Keynes who formulated this theory). The more people spend in each round, the bigger the multiplier will be. Put another way, the less they save, pay in taxes and import, the bigger the multiplier. So if we know the percentages we can calculate it. It is not necessary for you to know the actual percentages that apply to the UK but the researchers and statisticians calculate them. To calculate the multiplier we use the following formula, of which there are two versions that give the same answer: K=1 / 1−MPC or K=1 / MPW Let us use the same figures as in the example above but it is easier to use fractions instead of percentages. The MPC is 50% or ½. Substituting in the first formula above K=1 / 1−MPC K=11−MPCK=11−MPC K=1 / 1 − 1/2 K=1 / 1/2 K=2 If you are dividing 1 by a fraction, you turn the fraction upside down (a reciprocal) and divide. So ½ becomes 2 divided by 1, which is 2. If (1 - MPC) were ¼, the multiplier would be 4. It is actually easier to use second formula K = 1 / MPW because it cuts out one of the stages: K=1 / MPW K=1 / 1/2 K=2 A multiplier of 2 means that the overall effect of an initial investment is twice the amount invested. So the £1bn in our original example would bring a total of £2bn to the economy by the time all the spending rounds had been exhausted.

Why do you think the UK has a deficit in goods and a surplus in services?

The pattern of the UK balance of payments on current account reflects the structure of the UK economy. The UK service sector comprises around 78% of the economy and so sectors such as banking, insurance, tourism and consultancies are important sectors that are able to sell their services to other countries. Because the UK manufacturing sector has shrunk, the country has to import large amounts of raw materials, components and manufactured goods. The UK does not have a big problem in financing this deficit because it is partly balanced by investment coming into the country from overseas and partly financed with the country's foreign currency reserves. So the current account deficit is a fact of life. Similarly, other countries like China are able to achieve a large surplus on their current account over a period of years. So it might seem that this situation does not really matter as countries are not experiencing balance of payments crises. However, there are threats to the stability of the world economy when big surpluses and deficits build up and cause global imbalances that can end in crisis.

Topic 1 National income

The quality of people's lives is influenced not only by their income but also by their wealth. In this topic you will examine the difference between income and wealth and see how they are related. You will study how income flows around an economy and consider how additional spending and withdrawals of spending can affect an economy.

Direct and indirect taxation

There are two main types of taxation: direct and indirect. Direct taxation: Direct taxes are imposed (levied) directly on the people who are liable to pay them and they take account of their personal circumstances and therefore their ability to pay the tax. Here are some examples of direct taxes in the UK: - Income tax: This is levied on the income earnt by individuals from their jobs and savings and by the owners of small businesses (that are not companies). It is levied on different bands of income at different rates so that people on higher incomes pay a higher percentage of their income in tax than people on lower incomes. There is a minimum annual threshold which, in 2015/16, stands at £10,600. This means that someone can earn up to £10,600 in the financial year without paying any income tax but tax is levied on all income above that threshold. - Corporation tax: This is levied on the profits made by companies. For the financial year 2015/16 it stands at 20%. - Inheritance tax: This is levied on the 'estate' or amount of money left by a person when they die. For the tax year 2015/16 it stands at 40% on inheritances over £325,000. Direct taxes must be paid by the person being taxed (or their heirs in the case of inheritance tax) and cannot be passed on to anyone else. - Indirect taxation: Indirect taxes are consumption taxes levied on the sale of certain goods and services. They are paid to the government by the suppliers of the products but they are passed on to consumers when they buy them. Here are some examples of indirect taxes in the UK: - Value-added tax (VAT): This is a consumption tax which is levied on the value added to a product at each stage of product. The total of the tax accumulates with the value added throughout production and the final amount is added to the cost of the product and paid by the final customer, who cannot pass it on to anyone else. - Customs and excise duties: Customs duties are taxes levied on goods coming into the country from abroad and depend on the arrangements made with other countries. For example, customs duties are not placed on products coming from EU countries. Excise duties are special taxes levied on particular products such as alcohol and tobacco. - Stamp duty: This is a tax levied on the completion of certain contracts. The best-known stamp duty in the UK is that levied on the contract for the sale of a house. Indirect taxes do not take any account of personal circumstances or the ability of the consumer to pay the tax. People in all income groups pay the same amount of tax on the same product. This constitutes a higher percentage of the income of a person on a lower income and so the taxes are said to be regressive. On the other hand, people can avoid paying indirect taxes by choosing not to purchase products that are subject to tax.

Summary of Macroeconomic objectives and policies

This topic has covered a wide area. You have seen what the main macroeconomic objectives are and then examined the consequences of unemployment, the causes and consequences of inflation and the effects of a current account surplus. You learnt the difference between demand- and supply-side policies and studied the main policies under these headings. You also considered the causes of inequality in incomes and some possible policy conflicts. The key points are: - The main government macroeconomic policy objectives are full employment, balance of payments equilibrium and high and sustainable economic growth. - The costs of unemployment include lower output, lower tax revenue, more spending on benefits and personal costs. - Demand-pull inflation occurs when prices are pulled up by increases in aggregate demand. - Cost-push inflation occurs when prices are pushed up by increases in the cost of production. - Inflation may reduce a country's international competitiveness and it also increases firms' costs and redistributes income. - The causes of income inequality include differences in wealth, education, skills, susceptibility to unemployment, household composition and discrimination. - The government influences the distribution of income through taxation and benefits. - A current account surplus may increase inflationary pressure and means that a country is not consuming as many products as it can afford. - A fall in unemployment may lead to higher inflation.

Summary of Economic growth

This topic has covered the nature, causes and consequences of economic growth. The key points are as follows. - Actual economic growth is an increase in the output of goods and services. Potential economic growth is an increase in the productive potential of the economy. - Output gaps arise when an economy does not produce at its productive potential. - A key determinant of economic growth is investment. This increases both total demand and the productive potential of the economy. - Other factors contributing to economic growth are increases in the quantity and quality of labour, technological progress and increases in total demand. - The main benefit of economic growth is higher living standards. - The main costs of economic growth are the depletion of non-renewable resources, the risk of pollution and stress. - A high rate of growth is not sustainable.

Explain two factors that can affect people's spending power.

Two factors that can affect people's spending power are changes in disposable income and changes in the price level. A rise in wages or a cut in income tax would increase disposable income and, if nothing else changes, spending power will increase. A rise in the price level, with unchanged disposable income, would reduce spending power. If the inflation rate is higher than any rise in wages, real income and spending power will fall. People's spending power is also affected by the amount of money they hold in savings and the amount of money they can borrow to finance consumption.

Discuss two of the costs of the high unemployment in Tower Hamlets.

Unemployment of 11.3% in Tower Hamlets (an area in east London) is very high. This gives us a picture of social deprivation, with many families depending on benefits and probably suffering from physical and mental health problems. The area itself is probably rundown, with many people living in poor housing.

The circular flow of income: Injections and withdrawals

We now have to make the above model a little more complicated. If all the money earnt by the households was spent on goods and services, and if all the money received by the firms was spent on factor services, real GDP would stay the same from period to period. But in practice, this does not happen and real GDP either increases or decreases. This is because there are changes to the flow. Some of the money received by both households and firms gets out in the form of withdrawals (W), also known as leakages. At the same time, some additional money comes into the flow from outside in the form of injections (J). There are three withdrawals and three injections and they come in pairs. The three withdrawals are savings (S), taxation (T) and imports (M). They represent that part of a household's income which is not spent and which does not flow back to the firms and that part of a firm's income which is not spent and which does not flow back to the households. - When people save money, they put it into bank accounts (for example) and do not spend it. - When we pay taxes, we give it to the government and we cannot spend it. - When people or firms buy imports, the money becomes income for firms in other countries. It goes into the circular flow of those countries but not into that of our country. The three injections are investment (I), government expenditure (G) and exports (X). These do not come from people's incomes but come from outside the flow. - The money that has been saved is recycled by banks in loans. It finances investment made by firms and households and goes back into the circular flow. - The money taken by the government in taxes is spent on public services and goes back into the circular flow. - People in other countries buy our exports and the money they spend becomes income for us and goes back into our circular flow. So we can pair savings with investment, taxation with government expenditure and imports with exports.

Discuss whether an increase in wealth always leads to an increase in income.

Whether an increase in wealth will lead to an increase in income depends on the form of wealth held and how the wealth performs in terms of income generation. Some forms of physical wealth, such as cars, may provide satisfaction but do not provide a flow of income. They may also depreciate in value over time and so may not make a profit if sold on. Houses usually rise in value but there can be periods of negative equity when the market price of a house falls below the amount owed on it to the mortgage lender. Shares may pay out good dividends during periods of economic growth, but there is a risk that they may not pay out any dividends and may fall in value during economic downturns. Government bonds and savings accounts will pay out interest. If, however, the rate of interest paid is below that of the inflation rate, people will lose out from saving. This is because the quantity of products they will be able to buy when they are repaid will be less than the quantity they could initially have bought. In practice, however, accumulating wealth in the form of property and financial assets usually leads to a noticeable increase in income.

The circular flow of income: The impact of injections and withdrawals

Withdrawals reduce the circular flow (real GDP) and injections increase it. So if total injections are greater than total withdrawals, real GDP will grow. If total withdrawals exceed total injections, real GDP will fall. If total injections and total withdrawals are equal, the effect on real GDP is neutral (as regards the total flow). Figure 1.2 shows this. All of the components of the circular flow are interlinked and a change in one affects all the others to a greater or lesser degree. Imagine the effect on the whole model if there is a slowdown in one of the elements. For example, if there is a fall in firms' confidence about the future and they invest less, this puts less money into the flow, and there are lower incomes for those who would have been employed in building the investment, consumption falls, etc. Imagine the circular flow model as a central heating system in which water goes round a system of pipes. As long as the water keeps on circulating, the system works and produces heat. We could say that the water represents money and the heat represents the real goods and services. Now imagine that the system of pipes has holes through which water leaks out - these are the withdrawals. As there is now less water in the system, less heat is produced. But to balance these leaks, now imagine that the system has other pipes coming in from outside and they bring in new water to replace the water that has leaked out. These are the injections.

9 What effect is an increase in the rate of interest likely to have on aggregate demand and aggregate supply? Aggregate demand, Aggregate supply a) decrease decrease b) decrease increase c) increase increase d increase decrease

a) decrease decrease An increase in the rate of interest will be likely to reduce consumption and investment as borrowing will be more expensive and saving will be more rewarding. Lower consumption and investment will reduce aggregate demand. A reduction in investment will also reduce aggregate supply.

If GDP has risen by 5%, population by 2% and the price level by 2%, then a) real and nominal GDP per head have risen b) nominal GDP per head has risen but real GDP per head has fallen c) nominal and real GDP per head have fallen d) real GDP per head has risen but nominal GDP per head has fallen

a) real and nominal GDP per head have risen Nominal (money) GDP has risen by 5%. It has also increased per head of population as the percentage rise in GDP exceeds the percentage rise in population. Real GDP per head has also risen, albeit by a small amount, since the percentage increase in GDP exceeds the percentage increases in the price level and population.

3 Which condition would make it easier for a government to achieve its macroeconomic objectives? a) conflict of macroeconomic policy objectives b) absence of external demand and supply-side shocks c) time lag between a policy measure being implemented and affecting the economy d) unexpected reactions of households and firms to government policy measures

b) absence of external demand and supply-side shocks An absence of external demand and supply-side shocks would mean a more stable economy and that any government policy measures should have more predictable results. (a), (c) and (d) would all make it more difficult for a government to achieve its objectives. A time lag may mean, for instance, that by the time a cut in income tax is having an effect, the economy may be experiencing problems of inflation rather than unemployment. Unexpected results may mean that consumers and firms do not increase their spending when the rate of interest is cut. Policy conflicts may mean that the government cannot achieve all its objectives. It may have to decide, for instance, between low unemployment and low inflation.

4 Which of the following would be likely to deflate the economy? a) increase in government spending b) increase in the rate of interest c) decrease in the rate of income tax d) decrease in the range of items covered by VAT

b) increase in the rate of interest Deflating the economy means reducing demand in the economy. An increase in the rate of interest will tend to reduce consumption and investment. In contrast, (a), (c) and (d) would increase aggregate demand. (a) would directly increase spending - government spending is one of the components of aggregate demand. (c) would be likely to raise consumption as it will increase disposable income and (d) would also tend to encourage consumption as a number of products would now be cheaper.

1 Which of the following could cause cost-push inflation? a) increase in bank lending b) increase in wages c) reduction in interest rates d) reduction in direct taxation

b) increase in wages An increase in wages, above productivity increases, will raise firms' labour costs and so may lead to cost-push inflation. Factors (a) and (d) will increase demand and so may contribute to demand-pull inflation. Factor (c) will also tend to increase demand and may reduce firms' costs.

8 What is the main aim of a green tax? a) to discourage the purchase of imports b) to protect the environment c) to raise revenue d) to redistribute income

b) to protect the environment A green tax's prime aim is to improve the quality of the environment. It will also raise revenue but this is not its main objective. It is not designed to discourage imports or redistribute income.

6 Which of the following is an example of a supply-side measure designed to increase economic growth and employment? a) increase in Jobseeker's Allowance b) transfer of firms from the public to the private sector c) restriction on pay rises for public-sector workers d) increase in the rate of VAT

b) transfer of firms from the public to the private sector Transferring firms from the public sector to the private sector makes them more efficient and able to produce more output. (a) is a benefit paid to people looking for work but it does not directly promote employment. (c) acts on public sector workers and does not affect private sector firms. (d) would be a contractionary measure as people will have to pay more for their goods and services.

Which of the following is likely to cause economic growth? a) increase in the rate of interest b) increase in the tax on firms' profits c) decrease in income tax d) decrease in investment

c) decrease in income tax A decrease in income tax will increase the amount of money people have to spend. This is likely to result in a rise in demand which in turn, at least in the short term, is likely to increase output. An increase in the rate of interest is likely to reduce demand. A rise in the tax on firms' profits (corporation tax) is likely to discourage firms from expanding and will reduce the funds that might enable them to do so. A reduction in investment may reduce the productive potential of the country.

5 Which of the following is an example of a reflationary fiscal policy? a) cut in interest rates b) reduction in the exchange rate c) increase in the money supply d) increase in government spending

d) increase in government spending An increase in government spending injects money into the economy and increases aggregate expenditure and demand. (a) and (c) are monetary policy measures. (b) is the result of trades in the foreign exchange market.

7 An economy is experiencing both high cyclical unemployment and a current account deficit. Which policy measure would tackle this combination of problems most effectively? a) increase in income tax b) increase in the exchange rate c) reduction in government spending d) reduction in the rate of interest

d) reduction in the rate of interest A reduction in the rate of interest will be likely to increase aggregate demand. A rise in aggregate demand should reduce cyclical unemployment. A lower interest rate would also be likely to reduce the exchange rate and so lower a current account deficit. An increase in income tax and a reduction in government spending might reduce a current account deficit but they will probably increase cyclical unemployment as it will increase aggregate demand. An increase in the exchange rate is likely to make both problems worse as it will reduce demand for domestically-produced products.