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Aggregate Demand

Aggregate demand (AD) is the total demand for all goods and services produced in an economy in a given

price level and time period.

AD = C + G + I + (X M)

C means consumer expenditure. This makes up the majority of AD in most countries (about 65% of the

total). I means investment in capital goods from firms, and this is the most volatile component of AD. This

typically accounts for 15-20% of GDP, and the majority (75%) is from private sector businesses. G means

government spending on state-provided goods and services. Transfer payments (state benefits) do not

count because these payments are not producing an output they are a transfer of money from one

group to another. X means exports; M means imports. Exports are goods sold to overseas countries and

imports are what the UK buys from foreign countries.

(X M) represents net exports. If this is positive, there is a trade surplus which adds to AD. Conversely, a

negative net exports value means there is a trade deficit, which reduces AD.

Consumer Expenditure

Consumer expenditure is influenced by

The amount ofreal disposable income is the main influence on consumer expenditure. Households and

economies with more disposable income tend to spend more in total than poorer ones. The proportion of

income that is spent is called the average propensity to consume (APC).

Wealth (the value of a stock of assets) affects C. Wealthier people tend to spend more. Wealth can be

spent and can be used to borrow against. It also results in greater consumer confidence. For example, anincrease in house prices will make homeowners feel more wealthy, and this encourages them to spend

more.

Consumer confidence and expectations have a significant influence on consumer spending. When

consumers feel optimistic about the future (expecting good wages and job prospects), then they tend to

spend more. This is why sometimes; a rise in income also raises the proportion of income spent.

Interest rates are also important albeit less significant than consumer confidence. A fall in interest rates

should encourage spending because the cost of borrowing is reduced and there is a lower incentive to

save money. People paying back mortgages and loans will pay back less interest and will have more

money to spend. Net savers (people who save more than they borrow) lost out.

Population demographics (mainly age) affects consumer spending. It is generally thought that the elderly

and young people spend a higher proportion of their income.

Income distribution poorer people spend a higher percentage of their income than richer people.

Government measures that redistribute income from the rich to the poor (e.g. through income tax) are

likely to increase total consumer spending.

Inflation can affect consumer spending. If consumers expect price rises, they may buy more now.

Saving this is not a component of AD but it influences it.

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Increased real disposable income can result in households saving a higher proportion of income their

average propensity to save rises. Rising interest rates encourage saving by offering a greater reward for

it. Reduced consumer confidence or increased uncertainty of the future can also result in increased

savings. The age and structure of the population also affects savings.

Investment

Firms invest when they expect returns from the capital goods they buy. Investment is generally

proportional to the anticipated profitability of a certain project/venture.

Changes in real disposable income affect investment. A rise in real incomes is likely to increase demand

for consumer goods and services, which encourages firms to expand their capacity. However, a rise in

disposable income itself is not sufficient enough to make the decision to increase capacity. They need to

make sure that there is a need for the extra investment and whether demand increases enough to make

a profit on the extra investment.

Expectations also determine investment. If firms are optimistic about future economic prospects, theywill be more likely to invest. The extent and speed of expectations are the main reasons for the volatility

of investment.

Capacity utilisation if firms are operating close to full capacity, they are more likely to invest. Spare

capacity (unused capital goods) usually means firms will not invest as they may be able to increase output

without buying more capital goods.

Corporation tax and subsidies increasing subsidies or reducing corporation tax increases the amount of

profit firms can keep, which may drive investment.

Interest rates affect investment. A rise in interest rates may decrease investment because theopportunity cost of investment is increased (money could be saved). The higher interest rates increase

the cost of borrowing and may discourage some investment projects. A higher interest rate may reduce

consumer spending, which will affect the expected return on the investment.

Advances in technology mean that firms can produce better quality products more cheaply, which will

result in a higher expected profit, because the unit cost is reduced and there will be a higher demand for

the better products. The price of capital equipment also affects investment. Cheaper capital goods make

it more viable for firms to expand their capacity.

Government spending

The governments view on the extent of market failure and its ability to correct it affects its spending. In

countries where state intervention is high, government spending is likely to be greater than in countries

with a free market economy. For example, government spending in Sweden accounts for a higher

proportion of its AD than government spending in Singapore.

The level of economic activity influences government spending. A high unemployment rate may

stimulate increased spending in a bid to raise aggregate demand and output of the economy. In contrast,

high inflation may cause the government to reduce spending.

Governments may increase spending in order to increase its political support. War, terrorism rising crime

and other threats may also increase government spending.

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Net Exports

Real disposable income abroad affects net exports. An increased income abroad is likely to increase

exports due to the increased demand. The US is a major trading partner to the UK; if incomes in the US

rise, they will buy more goods and services some of these from the UK.

In real disposable income at home rises, exports may fall as firms could divert some products from the

export market to the home market to meet the rising demand.

The domestic price level affects net exports. If price levels rise too much, households and firms will

switch from domestic products to ones made in other countries (which increase imports).

Exchange rate changesaffect imports and exports. A fall in a countrys exchange rate reduces the prices

of exports and increases the price of imports.

Government restrictions on free trade affect net exports. If a country removes trade restrictions, then

other countries net exports may rise. If the USA removed tariffs on Chinese steel, China could export

more to the USA.

Aggregate Demand shocks

Unexpected events cause changes in aggregate demand. These unplanned events are called shocks.

One of the causes of fluctuations in the level of economic activity is the presence of demand-side shocks.

Some causes of demand-side shocks are:

A capital investment boom e.g. a construction boom to increase the supply of houses orcommercial/industrial buildings.

Exchange rate fluctuations. These affect net export demand and have knock-on effects on therest of the economy e.g. output, unemployment and incomes.

A consumer boom abroad in a country which is a major trading partner. This boosts demand forexports of our goods and services.

Large boom or slump in a specific market e.g. housing or share prices. An unexpected cut or rise in interest rates.

Shocks to aggregate demand have a big impact due to the interdependence of the worlds economies.

Countries which trade more with other countries are likely to feel a greater impact from a shock to their

economy compared to a country which trades very little with other countries.

Aggregate Demand Curve

Why is there an inverse relationship

between real GDP and price level?

Real incomes as price level rises,

the real value of peoples incomes

fall. The rise in the price level results

in consumers being able to buy less

UK produced goods.

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Aggregate Supply

Aggregate supply (AS) is the total output of goods and services that producers in an economy are willing

and able to supply at different price levels in a given time period.

In the long run (LRAS), the aggregate-supply curve is assumed to be vertical. It is closely linked with the

production possibility curve. In the short run (SRAS), the aggregate-supply curve is assumed to be upward

sloping. The SRAS curve is upward sloping because higher prices for goods and services make output

more profitable, and enable businesses to expand their production.

SRAS shows planned output when prices can change but prices of all factor inputs are held constant e.g.

wage rates and state of technology. The SRAS starts off as perfectly elastic. This is at a point where

unemployment is high and output is low, which means firms have a lot of spare capacity. More can be

supplied without increasing the price level. Real GDP is lower than potential GDP.

It becomes increasingly inelastic (unresponsive to changes in price level) as resources become scarcer.

There is a diminishing return because firms have to employ less productive labour and machinery, and

the unit costs of production increase.

At Yfc, producers are producing at full capacity it is not possible to produce anymore irrespective of the

increase in price level.

Shifts in short run aggregate supply

The main cause of shifts in the SRAS curve is due to the changing prices of the factors of production. A

change in the prices of commodities and raw materials affects the firms costs. These may be influenced

by exchange rates. An exchange rate fall increases the cost of exports. A change in the cost of labour

(wages) also affects the firms costs in a similar way.

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Changes in the governments fiscal policy relating to taxation and subsidies have effects on producers.

Increased taxation (could be through VAT or corporation tax) will cause an inwards shift in SRAS due to

the higher cost of production.

Long Run Aggregate Supply

Most supply-side policies are intended to improve the long term performance of the economy, but they

usually have short term effects too. LRAS is assumed to be independent of price level other factors

affect this. It is determined by the productivity of the factors of production (an expansion in this increases

LRAS). Changes in technology that benefit the whole economy also influence LRAS.

Macroeconomic equilibrium is when AD and AS are

equal. When these are equal, there is no reason for

output and price level to change and the economy isstable.

There may be situations where AD is greater than AS,

and the economy cannot cope with the increased

demand. The economy may have full employment.

This pushes up the price level due to shortages. SRAS

is inelastic in this case.

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The result of this is that the price level will increase if AD

increases. This is shown on the diagram to the right.

Macroeconomic equilibrium shifts to a point where a

greater quantity of goods and services are produced at a

higher price level. But the increase in price level will be

much greater than the increase in quantity due to the

inelasticity of the SRAS.

Anything that shifts AD or AS will cause a change in the

macroeconomic equilibrium.

The Circular flow of income shows the movement of spending

and income throughout the economy.

However, in reality, not all income is spent. Income that is not

spent on domestic output is said to leak out of circular flow.

These are known as leakages. Injections increase aggregate

demand, which cause additional spending.

The 3 main leakages are taxes (T), savings (S) and spending in

imports (M). Examples of injections are investment (I),

government spending (G) and exports (X). In macroeconomic

equilibrium, leakages equal injections, meaning that output is not changing.

The multiplier effect states that the initial injection/increase in AD will have a much greater effect on the

final AD rise. This is because of the knock-on effects that a change in AD has. Injections of demand into

the circular flow of income stimulate further spending.

This effect does assume that there is spare capacity for extra output is produced. Therefore, the effect is

more likely to be seen if an injection is made when AD is already at a lower level. Elasticity of SRAS also

determines the multiplier effect. Inelastic supply is likely to just increase the price level rather than

output.

Changes in AD and AS

The 3 main influences in the effect of a change in AD on the output, unemployment and inflation are the

size of the initial change, size of the multiplier effect and the original level of economic activity. If the

economy is operating with a lot of spare capacity, an increase in AD is likely to increase output and

reduce unemployment without affecting the price level. If macroeconomic equilibrium changes to a point

of more shortages, a rise in AD will increase both the price level and output. If the economy is at full

capacity, only the price level will increase as supply cannot be increased.

Changes in AS also depend on the size of change and initial level of economic activity. Increasing AS

occurring when the economy is close to/at full capacity will raise output and lower the price level. If the

economy is operating at a high level of unemployed resources, an increase in AS may not affect the

economy at all. In this case, only potential output increases; not actual output. The price level will remain

the same.

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In most economies, both AD and AS will change over time. If an AS increase can match an AD increase,

the effect on price level of the two changes will cancel each other out, meaning that the output increases

without affecting the price level, thus reducing

inflationary pressures.

However, if AD grows more rapidly than productivecapacity, inflation will occur. The higher output

comes at a cost of inflation, and this is

unsustainable. The economy is overheating. This is

similar to the situation in countries like India. This

can be shown in the diagram on the right.

Some events affect both AS and AD, for example,

government spending on increasing worker

productivity or immigration of people of working

age.

Output gap this is when an economy is not producing at full capacity. A negative output gap is when

production is below full capacity. A positive output gap is when an economy is producing more than

potential output this is only in the short term and is not sustainable unless AS shifts outwards. This is

achieved by overtime and overusing machines. Countries with positive output gaps usually experience

inflation.

Economic Growth

Between the years 1992-2007, the UK experienced the longest period of stable continuous economic

growth on record. This growth has been combined with low unemployment and low stable inflation.Aggregate supply has been increasing with aggregate demand, which has helped keep growth stable. The

UK has experienced a large current account deficit due to a large import of goods.

Economic growth is best defined as a long-term expansion of the productive potential of the economy. It

is measured by the annual change in real GDP (in the short term).

Both supply and demand factors impact on economic growth. Demand-side factors, such as consumer

and business confidence and aggregate demand cause temporary impacts on growth. Supply-side factors,

such as population and productivity growth, technology advancements and growth of stock capital,

impact on long-term aggregate supply.

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This can also be illustrated on a PPC shifting outwards a greater number of goods can be produced.

Benefits of economic growth

An increase in GDP per capita (total GDP divided by the population) increases the livingstandards. Strong economic growth can reduce poverty levels in developing countries.

Economic growth decreases unemployment and raises employment. Economic growth increases government revenue via taxation, which allows more government

spending on health, infrastructure and education.

The investment accelerator effect Rising demand and output encourages more investment oncapital goods, which increases long run aggregate supply and sustains economic growth.

Economic growth increasesbusiness confidence and has a positive impact on the economy. Could lead to environmental benefits. Economic growth may drive innovation in richer

countries, which may result in more money being invested in greener technology, which reduces

energy consumption per unit of GDP.

Negative effects of economic growth

Economic growth also has its risks. If the economy grows too quickly, problems can occur. If demand rises more than LRAS, rising inflation is a risk. Inflation puts pressure on interest rates

to rise and cause a loss in competitiveness in international markets.

Economic growth has a massive environmental impact. Environmental damage can affect ourquality of life and it limits our sustainable rate of growth.

Economic growth can cause increased income inequality. The gap between rich and poor canwiden, resulting in relative poverty. Income inequality is linked to social and health problems.

Opportunity cost of growth

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Point A barely represents the necessities. If a poor country tries

to increase production in capital goods by shifting from A to C,

there is a reduction in the number of consumer goods available.

This can be damaging to a country already suffering from a lack of

basic essentials.

The richer people will benefit as they can invest in the increased

production. This may increase the gap between the rich and poor.

If a country operates at full capacity, and discovers new resources

or improves efficiency of existing resources, the PPC shifts

outwards.

Current economic growth is not sustainable. Valuable finite resources are rapidly being depleted, and

some renewable resources are being over-consumed. The main environmental issues are:

Pollution of the environment and increasing amounts of waste. Over-population, which is putting pressure on resources. Loss of bio-diversity. Depletion of global resources and the impact of global warming.

Economic growth needs to be more sustainable. Sustainable economic growth meets the needs of the

present, and can continue without compromising the ability of future generations to expand

productive capacity. More developed countries are aiming for sustainable development, and the UK

publishes an annual report on progress towards the goal of sustainable development.

The current Government supports the concept of sustainable development and focuses on four mainobjectives:

Social progress which recognises the needs of everyone: Everyone should share in the benefitsof increased prosperity and a clean and safe environment. Needs must not be met by treating

others, including future generations and people elsewhere in the world, unfairly.

Effective protection of the environment: We must limit global environmental threats, such asclimate change to protect human health, wildlife and landscapes from hazards such as poor air

quality and toxic chemicals.

Prudent use of natural resources: Non-renewable resources should be used efficiently andalternatives should be developed to replace them in due course. Renewable resources, such as

water, should be used in ways that do not endanger the resource or cause damage.

Maintenance of high and stable levels of economic growth and employment, so that everyonecan share in high living standards and greater job opportunities.

Unemployment

Unemployment people are people who are willing and able to work and are actively seeking work but are

not employed. The 2 main measures for unemployment in the UK are claimant count and the labour

force survey.

The claimant count is then number of people claiming unemployment benefits. These figures are lower

than the true unemployment level as not all unemployed people can claim benefits. The labour force

A PPC of capital goods and consumer

goods.

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survey totals all people who have looked for work in the past month and are able to start in two weeks.

The figure also includes those who have found a job and are waiting to start in the next two weeks.

On average, the labour force survey has exceeded the claimant count by about 400,000 in recent years.

This may be due to a sampling error in the data. However, the survey is the internationally agreed

definition of unemployment and it is the best for cross-country comparisons of unemployment.

Causes of unemployment

Frictional unemployment is short term unemployment. It occurs when workers are between different

jobs e.g. university graduates taking a short break after education.

Structural unemployment is long term unemployment caused by the decline of certain industries and

occupations due to changes in demand. Globalisation has increased international competition, which has

caused a decline in Britains manufacturing industry. The workers in these industries do not have skills

that match the requirements of new job opportunities, and they have found it hard to get new jobs

without retraining. There is a problem ofoccupational immobility of labour.

Cyclical unemployment occurs when aggregate demand is low. The demand for labour is lower as less

output is required to meet the lower AD.

Seasonal unemployment is periodic unemployment in certain times of the year due to people working in

industries where they are not needed all year round e.g. ice-cream men.

Costs of unemployment there are economic and social costs of unemployment.

The unemployment face a loss of income, and the majority experience a decline in living standards. This

causes a decrease in consumer spending and AD, and may cause further unemployment.

Unemployment causes a fall in potential national output and represents an inefficient use of scarce

resources. If people leave the labour market permanently due to a loss of motivation of searching for a

new job, there is an impact on LRAS, and could damage economic growth potential.

Fiscal costs the government loses tax revenue and increases spending on welfare payments. The result

can be an increase in the budget deficit, and the government may have to increase taxation or cut back

on public spending. This will put strain on those who are still employed. There is an opportunity cost of

increasing spending on benefits.

Social deprivation is linked with rising unemployment. Areas of high unemployment experience falling

real incomes and increases in inequalities of income and health. Crime is also closely correlated with

unemployment, which will increase government spending on policing.

To firms, unemployment does have some advantages. There is downward pressure on wages as

unemployed people may be willing to work for less. There is also a greater availability of labour, and

firms may get skilled labour that adds value to the firm. If there is low unemployment, there is upwards

pressure on wages, and firms are forced to increase prices (inflation).

Government policies on unemployment

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Some countries are more successful than others at reducing unemployment. In the long term, both

demand and supply side policies need to be used so that new jobs are created and skilled workers take

those jobs. The most effective policies are ones that:

Stimulate an improvement in the human capital of the workforce. Then, unemployed peoplehave skills to take up new jobs. Policies usually concentrate on improving occupationalimmobility of labour so that structural changes can be handled.

Improve incentives for searching and accepting work. This may require changes to the tax andbenefits system, for example, reducing the lowest band of income tax or raising the income tax

threshold (so that lower paid jobs seem more attractive). Alternatively, benefits could be cut for

those unemployed; however, this is hard to do due to the complex nature of unemployment.

Employment subsidies. Government subsidies for firms taking on long-term unemployedworkers will create an incentive for a firm to expand the size of their workforce. They can offer

subsidisedjobs and training, and they can stop benefits for those who dont comply.

Achieve sustained economic growth. Aggregate demand needs to be sufficiently high so thatbusinesses are looking to expand their workforce small growth is unlikely to have a largeimpact. Also, not every rise in AD needs to be met with an increase in the workforce increasing

productivity (output per worker) can also meet some rises in AD.

Policies used in the UK for unemployment:

DEMAND SIDE POLICIES SUPPLY SIDE POLICIES

Employment subsidies for firms taking on long

term unemployed (New Deal)

Welfare reforms, including lower tax rates and

introduction of tax credits.

Financial assistance for overseas inward

investment.

Policies to promote entrepreneurship and growth

of small/medium sized businesses.

Monetary policy: low interest rates have allowedAD to grow despite global recession. Fiscal policy is

also boosting AD as the budget deficit increases.

Increased spending on education and attempts toincrease the private sector spending on training.

Evaluation points on policies

There are always cyclical fluctuations in employment. If growth can be sustained and government

policies can avoid a large output gap, then it should be possible to create a steady flow of new jobs.

Both demand and supply side policies have to be used to decrease unemployment in the long term.

Boosting demand if structural unemployment is a major cause is ineffective as it is not solving the

problem. If demand is stimulated too much, there is a risk of inflation.

There will always be frictional unemployment. It may help to have a small surplus pool of labour

available. A disadvantage of full employment is that if firms want to expand their labour force, there is a

massive inflation risk as there is a shortage of labour.

Trends in UK employment

Before the global recession, the UK was reducing the

unemployment rate, and many factors contributed

to this. There has been a slower population growth,

resulting in a slower rate of new people entering the

labour market. Expansion of higher education has

meant that people are entering the labour market

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later, which also puts less pressure on the number of new entrants into the labour market. Lots of jobs

have been created as a result of foreign investment. There has been increased investment in worker

training, which has reduced occupational immobility of labour.

One problem with the UK is that many adults are not as educated as in other countries. Because of this,

employers reduce their standards when recruiting new workers, and this has cut back on quality level.

Inflation

Inflation measures the change in the general price level over a period of time. Inflation is a sustained

increase in the average price level. When prices rise, the value of money is decreasing because less can

be bought for the same amount of money.

Measuring inflation

Inflation can be measured using multiple methods. The main measure is the consumer price index (CPI).

It measures the changes in price of a representative basket of consumer goods and services. The CPI is a

weighted price index the proportion of peoples expenditure on a certain type of good has the

equivalent weighting in the CPI (this is found out by the Family Expenditure survey). A base year has to be

selected this is a year where nothing unusual happens.

Another index is the retail price index (RPI). It differs from the CPI in methodology and is used for

adjusting pensions and other benefits. The RPI includes things like mortgage interest payments and

council tax.

The difficulty in measuring inflation is that the numbers may not reflect an accurate picture of what is

happening in the economy. Housing costs vary greatly between different people, and it accounts for 16%of the index. A price may rise due to a higher quality product being offered, which is hard to be

accounted for in the figures. The measures also tend to overstate inflation as they measure a fixed basket

of goods, and the measures dont take into account peoples ability to alter what they buy during t he

year. The CPI is slow to respond to the emergence of new products and services.

Types of inflation

Cost push inflation occurs when firms increase prices following an increase

in production costs. The SRAS shifts inwards, causing a contraction in AD.

Macroeconomic equilibrium shifts to a point where less output is sold at a

higher price.

Some causes of cost push inflation are:

An increase in the price of raw materials (may be caused byinflation in other countries or a weakening of the GBP).

Rising labour costs (increasing wages are greater than increases in productivity) Rising indirect taxes may also cause a firm to increase the price. The price elasticity of demand of

individual products impact whether the tax is passed on to consumers.

Cost push inflation is more likely to occur when unemployment is low as there is a lower availability of

skilled labour.

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Demand Pull inflation occurs when AD exceeds AS. At lower GDP levels, when there is spare production

capacity, firms can easily expand output to meet increases in demand, resulting in a relatively elastic AS

curve. AS becomes increasingly inelastic as output tends towards full capacity.

As employment grows, demand is likely to become more inelastic, which allows firms to pass on huge

price rises without a significant fall in demand.

Demand-pull inflation is likely when there is full employment of resources and when SRAS is inelastic. In

these circumstances an increase in AD will lead to an increase in prices. Causes in demand pull inflation

are related to increases in AD. Reduction in taxes, increased consumer confidence, exchange rate

depreciation, fast economic growth in UK export markets and a rapid increase in the money supply (may

be due to low interest rates and more borrowing) all contribute to increases in AD.

Impacts of inflation

A higher inflation will cause a loss in price competitiveness on international markets. However, this is at

a given exchange rate. Exchange rate depreciation can restore this. A rise in inflation can also decreasethe UKs share of the export market, which reduces economic growth and employment level.

Price rises can result in wage-price spiralling. Workers will demand a higher salary to keep their real

standard of living. If the increase in wage is greater than the increase in productivity, firms may increase

prices due to lower profit margins being offered. The process can repeat and inflation could get out of

control. Menu costs are the costs of changing prices due to inflation (printing new catalogues can cost a

lot of money).

Inflation can result in a reduction in the real value of savings . If inflation is greater than interest rates,

then real interest rates are negative and people are effectively losing money. People have to search out

for which financial institutions are offering the best interest. Households will incur shoeleather costs

costs in terms of the extra time and effort involved in reducing money holdings.

Consumers and businesses on fixed incomes will lose out. Some pensioners are on a fixed pension, and

inflation will reduce the real value of the income. Pensions are normally adjusted for inflation.

Inflation usually results in higher interest rates, which are designed to curb inflation. Higher interest rates

discourage spending and should reduce inflation.

Fiscal dragpeoples income being dragged into higher tax bands due to tax brackets not being adjusted

in line with inflation.

Business planning and budgeting can be harder if inflation is high and volatile. If inflation is high and

volatile, firms are more likely to want a higher return on any project to accommodate a potential cost

increase.

Inflationary noise is the distortion of price signals caused by inflation, and it leads to increased allocative

inefficiency.

However, inflation can have some benefits. If inflation is demand pull inflation at a low and stable rate, a

steady rise in price level may encourage firms to increase output. An increase in pay due to inflation,

despite increasing prices, has a positive psychological effect on workers.

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Cost push inflation tends to be more harmful for an economy than demand pull inflation. Cost push

inflation is often accompanies by a fall in GDP and employment. High rates of inflation cause problems

due to the massive shoeleather and menu costs. It becomes more difficult to judge what the best buys

are. Unanticipated inflation is more harmful than anticipated inflation, because it results in uncertainty

and can result in random redistribution of income.

Government policies

Controlling inflation has been a key objective of many governments macroeconomic policy.

Inflation targeting can lower the chance of both types of inflation. If people are convinced the central

bank has the ability to meet its target, then they will act in a way that doesnt cause inflation. It makes

monetary policy more transparent and the central bank more accountable.

The government can reduce cost push inflation in many ways. If excessive wage rates are the reason,

then they may try and restrict wage rates. It can easily control wages in the public sector by changing

government spending. The introduction of an incomes policy, e.g. limiting wage increases of a certainpercentage, can reduce inflation without causing unemployment. However, it may crease inflexibility in

labour markets. Firms wanting to expand will be limited as to how much they can offer workers. They can

also lower firms costs by reducing corporation tax or providing subsidies. This enables firms to reduce

costs without raising prices. However, there is a danger that firms may become dependent on these

measures and not try to minimize costs.

Reducing demand pull inflation involves slowing growth of AD/decreasing AD. The government could

raise income tax. This will mean people have less disposable income, leading to a reduction in the

amount of disposable income. The main anti-inflation measure is changing interest rates. Increasing

interest rates will reduce AD by reducing consumption, investment and next exports while increasing

savings.

Supply-side policies include those that seek to increase productivity, competition and innovation. These

cause a shift outwards of LRAS, and reduce cost push inflation. This is mainly for the long run. If

productive potential increases with AD, the economy can grow without the price level rising as the

increases in AS and AD have opposing effects on price level, which cancel out.

Why has UK inflation remained fairly low?

The last 12 years has been a period of low stable inflation in the UK, and there are many factors

contributing to this. There has been low wage inflation in the labour market. There has also been low

global inflation, and the UK has experienced this too. The monetary policy has been effective in keeping

AD under control through changing interest rates. The strength of the exchange rate has helped keep

costs of imported goods low and it squeezes demand for UK exporters. UK businesses are facing severe

foreign competition due to the emergence of many countries economies. This has helped create an

incentive for UK firms to maintain low costs and seek efficiency.

It has been a combination of demand and supply factors that have kept UK inflation low.

Balance of Payments

The balance of payments (BoP) is a record of all the financial transactions between a country and the rest

of the world. The accounts are split into 2 sections. The current account measures trade in goods and

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services in and out of the UK. The capital account tracks capital flows in and out of the UK, including FDI.

BoP is an important measure of the relative performance of the UK in the global economy.

If a country has a current account deficit, then the capital account has to balance this in order to finance

the additional expenditure on exports. Capital account flows can be increased in the short term by

offering an attractive interest rate. Alternatively, the country could get foreign direct investment.

The UK has had a trade deficit in many years in

the trade of goods (visible trade), mainly due to increased foreign competition in the manufacturing

sector. However, it has a surplus in the trade in services (invisible trade). Britain has a strong trade base

in services with over 30% of total export earnings come from services. It has a comparative advantage in

financial services over the rest of the world.

A current account deficitis when a countrys net imports exceed net exports.

Underlying causes

Strong consumer demand household spending has increased more than supply has. This results in a

high level of demand for imported goods and services.

The demand for imported products has a high income elasticity of demand.

The UKs strong exchange rate means imports are preferred over domestically produced goods.

The weakness of the global economyhas caused exports to decrease. Over half of the UKs exports go to

members of the Eurozone, which has witnessed slow economic growth.

UK trade balances have been affected by shifts in comparative advantage in the international economy.

The rapid growth of china has shifted the manufacturing sector over there.

The availability of goods from other countries at a relatively cheap price causes a substitution effect

from British consumers.

The trade deficit of the UK is mainly due to structural factors rather than cyclical factors.

Britain has many supply-side deficiencies in non-price factors. There is a lack of capital investment

compared to other countries. There is a low spend on research and development, which results in poor

innovation from British companies. The UK manufacturing sector has been in long-term decline.

The Effects of Changes in the Balance of Payments on the UK Economy

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There are more leakages in the economy, resulting in less aggregate demand. There is a contraction in

short run aggregate supply, which results in a decreased GDP.

There will be an increase in structural unemployment if exporting industries require less labour and if UK

businesses lose market share and output to cheaper imports from overseas.

There will be a dip in business confidence and capital investment if overseas demand falls.

There is a reduction inflationary pressure. If the UK imports more, then AD falls, and macroequilibrium

shifts away from full capacity. Reduced inflationary pressure may cause the Bank of England to reduce

interest rates in order to stimulate macroeconomic activity.

Why should we be relaxed about a current account deficit?

A trade deficit is not always bad. A short-term trade deficit is OK if it means that a country is importing

lots of goods to boost standards of living in the country. However, in the long-term, a trade deficit may be

a symptom of a weak economy.

If some of the deficit is due to strong consumer demand, the deficit will partially self-correct when the

economic cycle turns and there is a slowdown in spending.

Some of the deficit may because of increased imports of new capital and technology. This will have a

beneficial effect on productivity and competitiveness of producers in home and overseas markets.

Capital inflows balance the books. If a country has a stable economy, inflows of capital can finance the

current account deficit. The UK has run an average annual current account deficit of 10 billion from

1992-2004 and yet the economy has also enjoyed one of the longest sustained periods of growth and

falling unemployment during that time.

A continuous trade deficit may be a sign that a country is able to continually attract capital inflows.

However, this can be risky as capital inflows can be stopped at any time.

Why should we be concerned about a current account deficit?

A trade deficit may be due to structural weaknesses. There is a loss of competitiveness in overseas

markets, insufficient investment in new capital or a shift in comparative advantage towards other

countries.

A trade deficit is a sign of an unbalanced economy, where consumers are spending too much contrasted

with a weaker industrial sector. If consumers carry on overspending, there is a danger that an increased

demand for imports will be accompanied by a surge in household debt.

A current account deficit has to be balanced by the capital account, and a country cannot keep relying

on this. Investors may lose confidence and take money out. They may demand higher interest rates,

which decreases consumption.

A large amount of imported goods puts downward pressure on the exchange rate as there is a large

supply of the currency on the world market. This may result in an interest rate increase and also cause

inflation on goods imported into the country.

How can a high value currency result in a country having a trade deficit?

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A strong currency will mean countries buying from them will experience high export prices. High export

prices may discourage demand. A strong currency means import prices being low. The low import prices

may increase demand for products being imported. A lower export revenue and higher import

expenditure will result in a negative balance of payments.

Is a depreciation in its exchange rate is likely to improve a countrys trade in goods balance?

Depreciation is a fall in the exchange rate due to market forces. Depreciation will lower export prices and

raise import prices. Export prices will lower and so raise demand for exports. Import prices will rise and

therefore lower demand for imports. In theory, this should improve a countrys trade in goods balance.

However, it depends on the extent of the depreciation. A small depreciation is unlikely to have any

significant effect. It also depends on the increase in the costs of production by the higher price of

imported raw materials (due to the depreciation).

Exchange Rates

Exchange rate is the price of one currency in terms of another currency.

The UK operates with a managed floating

exchange rate, which is similar to most

currencies. This means that exchange rate is

determined by forces of supply and demand.

An increase in the demand for GBP in the

foreign exchange markets, in the absence of

other offsetting factors, will force sterling

higher against other currencies. The demand

will shift outwards from D1 to D2. Equilibrium

shifts from S1D1 to S1D2. At this point, more US

dollars need to be paid to gain the same

amount of GBP. The GBP is getting stronger.

What influences supply and demand for

exchange rates?

If UK products are internationally competitive, demand is likely to be high and supply is likely tobe low. Foreigners want to buy GBP to buy UK products, and UK citizens will not be selling many

pounds to buy imports. Labour productivity, investment and relative inflation rates affect

international competitiveness.

Changes in income abroad influence exchange rates. If incomes are rising abroad, demand for UKproducts is likely to increase, which will make the GBP stronger.

Rising domestic incomes may decrease the exchange rate. The supply of GBP on forex marketswill increase as pounds are sold to import products into the UK.

A rise in UK interest rates will increase demand for GBP. Foreigners will want to buy GBP to openbank accounts in the UK to benefit from the higher interest rates.

The attraction of FDI affects exchange rates. If the UK has a strong economic performance, askilful labour force and favourable government policies, the demand for GBP will increase asforeign companies will want to set up operations in the UK.

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Speculation is a key part of determining exchange rates. If speculators sell some of their holdingsin response to a fall in exchange rates, they are likely to drop even further. However, if they

expect that the falling rate will rise again soon, they will buy the currency, thereby preventing a

large fall.

Effect of an exchange rate change on export and import prices

A fall in exchange rate (depreciation if by market forces) will reduce the price of UK produced goods for

countries with foreign currencies. Most exporters are likely to let export prices fall in line with the

exchange rate as selling at a lower price should increase sales. Exporters selling price inelastic products

are likely to leave prices unchanged (they will receive more money for a product).

Exchange rates and interest rates

Changes in interest rate are closely linked to exchange rates. If the GBP gets stronger, this discourages

exports and encourages imports, leading to a fall in AD. Interest rates may then fall to encourage

spending. A fall in interest rate reduces the exchange rate because the return on money kept in UKfinancial institutions is lower. An outflow of funds increases the supply of currency, which reduces the

exchange rate.

There is an exception to the proportional relationship between interest rates and exchange rates. A cut in

interest rates may make foreigners confident about the prospects of economic growth in the UK. This will

push up the value of GBP as they are likely to buy more.

Exchange rates and inflation

An appreciation of the exchange rate will reduce the price of imported goods. This may have a direct

impact on consumer spending, as cheaper imports have a deflationary effect. Firms will also havereduced costs, and may pass this down to the consumer, which also has a deflationary effect. This will

only have an effect in economies that import a lot of goods.

An exchange rate appreciation makes UK goods more expensive to other countries. If exports reduce,

then exporters may cut their prices, reduce output and cut-back employment levels. A fall in export

demand will reduce real national income relative to potential output this might lead to a negative

output gap. This puts downward pressure on inflation.

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Changes in the exchange rate and the macroeconomy

An exchange rate reduction is likely to improve balance of payments. A fall in export prices will rise in

greater revenue if demand is elastic. A rise in import prices will reduce expenditure on imports if demand

is elastic.

Lower exchange rate will also increase aggregate demand. However, there is a risk of inflationary

pressure. This is because the price of imported raw materials will rise, thereby increasing the cost of

production. Domestic firms are under less pressure to keep costs low due to reduced competition from

foreign firms.

Advantages of a strong currency

Cheaper imports for domestic consumers. This boosts living standards in the short term. Lower costs for producers who import raw materials. The AS curve shifts outwards. If a country

can buy more productive technology, LRAS may also shift outwards.

Lower inflation because domestic suppliers face stiff competition from international firms.Cheaper prices on imported food/drink also reduce inflation.

Lower inflation = lower interest rates, which encourages consumer and capital spending.Disadvantages of a strong currency

Increase in trade deficit because there is increased expenditure on imports, and exporters areless internationally competitive due to the strong currency.

If exports fall, there will be a slower economic (GDP) growth. Falling exports leads to a fall in business confidence and capital investment.

Factors being assumed to be constant

The government can counter-balance these effects by changing the fiscal or monetary policy.

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Businesses do respond to a high exchange rate. They outsource components overseas and seek

productivity/efficiency gains to keep costs down. Many businesses cut their export prices in order to

maintain international competitiveness.

Application of macroeconomic policy instruments

The government can use a range of policy instruments to achieve macroeconomic objectives. The policies

used will change according to the desired outcomes and the effectiveness of each one.

Fiscal Policy

Fiscal policy covers spending, borrowing and taxation decisions of a government.

Goals of the fiscal policy are:

Investing money in infrastructure, healthcare and education (impacting LRAS). Redistribution of wealth by creating a safety net for poorer people through welfare. Macroeconomic stability by maintaining aggregate demand (AD).

Increasing government spending and reducing taxation (direct/indirect) can both stimulate a boost in AD.

Government spending is a component of AD. Higher spending is likely to have a multiplier effect, causing

a larger rise in AD. Cutting income and corporation taxation will increase disposable income (which

increases consumer spending) and encourage investment respectively.

To achieve changes in the private sector, the government can use discretionary fiscal policy, which is

when a government actively influences AS by changing tax or expenditure. Automatic stabilisers are

forms of spending and tax that change automatically to dampen economic fluctuations without changing

government policy. For example, during economic boom, JSA falls as less people claim it and taxation

increases, which takes more money out of the circular flow of income this is not because the

government changes spending.

Government spending can be split into:

Capital expenditure (hospitals, schools and roads). Current spending (running of public services e.g. teachers, NHS, medicines). Transfer payments.

Some key terms

Reflationary policy measures designed to increase aggregate demand.

Deflationary policy measures designed to reduce aggregate demand.

Progressive tax a tax which takes a higher percentage of income as income rises.

Regressive tax a tax which takes a higher percentage of income as income falls.

Recession two successive quarters of negative real GDP growth.

Exchange rate the price of one currency in terms of another.

Output Gap the difference between potential GDP and actual GDP.

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Debt interest payments payments to holders of government debt.Expenditure on health and education is affected by government priorities and changes in the

demographics of the population. The ageing population in the UK is putting immense pressure on health

spending. There are also increased expectations to develop new technology in medicine to do more

complex operations and to increase efficiency.

Changes to the fiscal policy can also impact on supply-side capacity (LRAS) of the economy, and can

contribute to long term economic growth. Capital spending by the government (e.g. infrastructure)

increases investment in the economy. Lower corporation tax also stimulates investment. Investment into

education improves the quality of labour, and enables the UK to stay competitive. Government spending

can also encourage research and development, which increases LRAS.

Every year, the Chancellor of the Exchequer presents a budget. It includes spending and tax reviews. A

budget position shows the relationship between government spending and tax revenue. A budget deficit

is when government spending exceeds tax revenue. In this case, borrowing is required. A budget surplus

is when tax revenue is greater than spending. This allows the repayment of debt. Both cyclical and

structural factors can affect this.

Types of tax

Income tax is the most important source of tax revenue in the UK. Income tax is a direct and progressive

tax. The percentage and amount rises with income. Value added tax (VAT) is the second most important

tax. It is imposed on the sale of goods and services, but at different rates. The standard rate is 20%, but

some goods and services are either exempt from VAT (most food, childrens clothing and books, or

services like gambling and sports) or have a reduced rate of 5% (energy saving products or smoking

cessation items).

Monetary policy

Monetary policy instruments include interest rate, the money supply and exchange rate. It is sometimes

referred to a demand-side policy. The main policy is interest rate, and the base rate is set by an

independent organisation to the government. A higher interest rate is likely to decrease AD as it

discourages consumption and tends to lower firms investment as it costs more to borrow money. It

encourages foreigners to save in UK financial institutions. The rise in demands for GBP will increase the

interest rate, which makes exports expensive to others and imports cheap for the UK.

There is a chance that if interest rates rise, foreigners may be concerned with economic growth

prospects, and may put money elsewhere (reducing exchange rate).

An increase in the money supply is likely to increase AD. If more money is printed or if lending becomes

easier, people will have more money to spend with increases AD. If the government increases the

amount that banks can lend, interest rate falls. If the central bank wants to raise exchange rate, it can

increase interest rates and/or buy foreign currency. This is a deflationary monetary policy.

The Monetary Policy Committee (MPC) of the Bank of England sets interest rates with the main objective

of achieving the governments inflation target (2%). Because it is hard to consistently maintain the same

rate, there is a 1% margin either side of the target. The MPC has been instructed to support economicpolicy of the government, including objectives for employment and growth.

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Factors considered by the MPC

GDP growth and spare capacity the MPC has to set an appropriate interest rate to promoteGDP growth in line with the increase in the economys productive potential.

Wages and labour costs the MPC may be concerned if wage inflation was too high as it couldlead to a rise in consumer prices due to demand-pull inflation.

Consumer and business confidence these provide useful indications of turning points in theeconomic cycle. For example, a dip in consumer optimism might herald a retrenchment of

spending which could lead to slower GDP growth and a weakening of inflationary pressure.

Trends in foreign exchange markets a weaker exchange rate may be a threat to inflationbecause it raises the prices of imported goods and services.

Supply side policies

Supply-side policies aim to increase aggregate supply. They can increase productive potential and canhelp prevent inflation, reduce structural and frictional unemployment and improve the countrys trade

position. They try to lower firms costs of production and increase productive capacity by increasing

efficiency of labour and product markets. Some supply-side policies are based on reducing government

intervention in the economy e.g. deregulation and privatisation. Others involve government intervention,

such as financed education and training, which could solve market failure.

Government investment in education and training, and government encouragement to firms to increase

their training should raise occupational mobility of labour and labour productivity. If output per worker

increases, AS shifts to the right and potential output rises. The government could encourage the

unemployed to undertake training, which develops skills, confidence and experience.

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Assistance to new firms by offering grants or reducing corporation tax helps them break into established

markets. Lower direct tax can also increase AS because firms have a greater incentive. Firms gain more

funds and are able to invest it. If investment does increase, productivity capacity of the economy will rise.

Some economists believe that an income tax cut can stimulate workers to work longer, and some may be

more willing to re-enter work. This increases the size of the labour force. Disposable income will also behigher. However, more disposable income could encourage more leisure time, which results in people

working fewer hours.

National minimum wage could either encourage people to enter the labour force or reduce efficiency of

the labour market. There is a debate whether it is a supply-side policy.

Reduction in unemployment benefit (JSA) may force unemployed people to seek employment more

actively. This may result in people accepting lower wage rates. However, for those who are in cyclical

unemployment, they will get a reduced income, which reduces AD. This also increases income inequality,

which has social consequences.

Privatisation may lead to increased efficiency as they have to try and minimize costs and constantly

innovate. They are subject to discipline of the market. However, some economists say that government

ownership is beneficial where there is a high risk of market failure.

Deregulation makes it easier for competitors to enter the market and gives firms the belief that they have

greater freedom. Recently, the UK government has removed restrictions on competition with Royal Mail.

Government Policies on macroeconomic indicators

Policies on inflation

Controlling cost-push inflation will depend on the factors causing it. If excessive increases in wage rates

are causing the problem, then they could restrict wages by imposing a maximum increase e.g. 3% per

year. The government can cut public sector spending if this is happening in the public sector. The

introduction of an incomes policy, e.g. limiting wage increases of a certain percentage, can reduce

inflation without causing unemployment. However, it may crease inflexibility in labour markets. Firms

wanting to expand will be limited as to how much they can offer workers.

The government could cut firms costs by either cutting corporation tax or providing subsidies. This has

the similar effect of stimulating investment. The main problem with this is that firms may become reliant

on subsidies and not try and minimize costs.

Reducing demand pull inflation involves slowing growth of AD/decreasing AD. The government could

raise income tax. This will mean people have less disposable income, leading to a reduction in the

amount of disposable income. The main anti-inflation measure is changing interest rates. Increasing

interest rates will reduce AD by reducing consumption, investment and next exports while increasing

savings.

In the long run, governments are likely to reduce the possibility of inflation by increasing AS. If productive

potential increases with AD, the economy can grow without the price level rising as the increases in AS

and AD have opposing effects on price level, which cancel out.

Policies on economic growth

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Short term GDP increases can occur due to increasing AD provided the economy has spare capacity. This

sort of increase can be increased by a fiscal or monetary policy. Some fiscal and monetary policy

instruments can increase both AD and AS. For example, a lower interest rate stimulates consumption and

investment (which increases AS). Increases in some government spending, e.g. education and research,

will also shift AS to the right.

In the long run, the only way to increase AS is if productive capacity of the economy increases. For this to

increase, the quantity and/or quality of resources must increase. Supply-side policies aim to achieve this.

For instance, measures that raise investment will boost AS. The extent of the AS increase depends on the

amount of additional investment and the efficient allocation of it.

To use capital efficiently, educated and healthy workers are required. Investing in human capital should

increase productive potential of the economy. The quality of investment, however, has an effect on the

extent of the increase. Workers need a range of skills in order to be productive, including literacy,

mathematical, ICT and interpersonal skills.

Governments tend to avoid AD increasing faster than trend growth because it can lead to inflation and

balance of payments problems. They also try to prevent AD rising slower than trend growth as this leads

to a negative output gap. This will result in stable growth.

Actual growth should match trend growth, and this has to be done over time.

Policies on balance of payments

Short run policies tend to concentrate on demand whereas long term measures focus on supply.

In the short term, the government may try to boost export revenue by many ways.

If a country feels that its currency is too strong, it may seek to weaken the exchange rate in order for

prices to be competitive on the international market. Selling its currency or reducing interest rate can

allow these changes to happen. This should only be done when demand for exports and imports is price

elastic as this will cause an increase in import revenue. This theory assumes ceteris paribus countries

may devalue the currency or increase import restrictions. Lowering the exchange rate in this way to

increase AD increases short run employment, but could lead to inflationary pressure.

To discourage spending in imports, the government may seek to reduce domestic spending by increasing

taxation and interest rates and cutting government spending. However, it could cause GDP to fall and

unemployment to rise.

Another strategy is to introduce tariffs (import taxes) and quotas on imports. Placing import taxes will

make international products less competitive, which should reduce imports. However, domestic firms

may lose the incentive to minimize costs due to the lower competition. Also, if other countries adopt a

similar policy in retaliation, then the UK runs the risk of losing out in export revenue. Membership of a

trading group (e.g. the EU) limits these actions.

If a trade deficit is because of low labour productivity, high inflation or a lack of quality competitiveness,

these measures will not provide solutions in the long term. In these circumstances, supply-side policies

should be implemented. This includes funding education and research to encourage innovation and

invention, and providing subsidies to infant industries in the belief that they have the potential to grow to

become internationally competitive.

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A current account surplus may also be bad. The government may want to eliminate a surplus due to the

threat of inflation. To reduce a surplus, the government may seek to increase the value of the currency,

introduce policies that boost economic activity through inflationary means and/or reduce import

restrictions.

The effectiveness of government policies

Effectiveness of fiscal policy

Changes in government spending directly affect the G component in AD, while changes in tax affect C and

I components of AD by altering the disposable income of households and post-tax income of firms. AS can

also be increased.

However, changes in government spending and tax rates usually have a time lag time is required to

have an effect on the economy. It can also take time to recognise the need for a change in policy and to

gather the information on which to base the change. There is also time taken to draw up and implementnew tax codes and government spending plans. Government spending in some sectors is inflexible e.g.

healthcare and pensions. Also, it is politically and economically difficult to stop an investment project

once started.

For fiscal policy objectives to work, decisions have to be based upon accurate information. In addition to

this, households and firms may not react in the ways expected by the government. For example, a cut in

income and corporation tax may not result in higher consumption and investment as confidence may be

low.

Changes in fiscal policy mat have an adverse effect on other macroeconomic objectives. Rising income

taxes may discourage some from working, and a higher corporation tax may discourage investment. Arise in tax designed to reduce inflation may reduce AD too far and cause a fall in real GDP and cause

unemployment. Similarly, there is a risk that reflationary fiscal policy, while raising real GDP and

employment, may increase inflationary pressure and worsen a current account deficit. Fiscal policy

changes can offset changes in economic activity in other countries. If trading partners are experiencing

recession, AD may not rise much in the UK.

Effectiveness of monetary policy

This also depends on reliable information. Monetary policy instruments can be hard to control. In the

past, the UK and US have tried to control inflation by controlling the money supply, which was not easy.

Changing the interest rate is considered to be very successful. Some criticise the MPC for overestimating

inflation and keeping the interest rate too high, which limits economic growth. There is also a time lag to

see any impact on the economy. There is also the question of what extent the AD will rise in response to

the change in interest rate. If people are optimistic, a rising interest rate may not cause a reduction in

spending and investment. When interest rates are low, a further reduction is unlikely to be effective in

stimulating economic activity.

EU countries with the same currency have limited independent control over monetary policy. The

interest rate is set by the European central bank.

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Changes in the monetary policy tend to affect more concentrated groups. An increased interest rate will

hit firms that export a lot because of higher costs and an unfavourable exchange rate. There are also

undesirable side effects an increased exchange rate can worsen balance of payments.

Effectiveness of supply side policies

These are selective. They are targeted at certain markets to raise efficiency. Increasing AS enables AD to

continue to rise over time without inflationary pressures. A higher resource quality makes domestic firms

more price and quality competitive, which will improve the countrys current account position.

However, this is not sufficient if there is a lack of AD. In this case, there would be a lot of spare capacity.

Many supply side policies, such as education spending, have a time lag. They can be expensive to

implement and there is no guarantee that they will work.

Conflicts between policy objectives

The objectives of economic growth and unemployment may benefit from expansionary demand side

policy measures. However, such measures make it hard to achieve low inflation and a good balance of

payments position. The MPC may face a conflict when setting interest rate. Raising interest rate to reduce

inflation may affect the exchange rate and balance of payments in a negative way.

Using a variety of policy instruments can help reduce conflict.

International Trade

International trade plays a massive part in the UK economy. UK firms are internationally competitive in

goods including aerospace engines and computer software. They are particularly strong in financial

services. The UK is not very competitive in industries that require heavy capital equipment or cheap

labour.

The majority of UK trade in goods and services is with EU countries. There has been a long-term shift in

our trade with EU since the UK joined the EEC in 1973. The share of UK trade with North American

countries has declined, but the United States remains the largest single export market accounting for 15%

of total UK exports. Trade with Asian countries has also increased, especially due to the number of

emerging economies, such as India, China and Malaysia. The growth of the Indian economy should help

ECONOMICS IN CONTEXT

The Peoples Bank of China (PBOC) usually uses changes in monetary supply. It does this by

changing the amount of funds available as well as placing direct limits on the amounts that banks

can lend.

PBOC favours changes in money supply because AD is interest inelastic. A rise in interest rate

does not significantly reduce investment because state-owned enterprises do not always

consider carefully the financial return on their purchase of capital goods.

The PBOC has been seeking to increase net exports by keeping the exchange rate low. It does

this by selling more of its currency (yuan) than by changing interest rate.

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to boost exports to the sub-continent in the years to come, providing that UK businesses take advantage

of the export opportunities available there.

Trade liberalisation is the process when a country opens its markets up to international trade.

Advantages of increasing international trade

Countries can import goods that they do not specialise in. Firms can achieve economies of scale due to the larger market to buy raw materials and to sell

products to. The cheaper cost of production can be passed onto the consumers.

Consumers benefit from lower prices and higher quality products due to the increasedcompetition, as well as an increased number of products being available.

Trade enhances consumer choice, which drives innovation for new products and technology. It can raise living standards and reduce poverty levels.

Disadvantages of increasing international trade

International competition can result in structural unemployment due to occupational immobilityof labour (difficulty in moving from one type of job to another).

Increased domestic economic instability International trade cycles severely impact ondomestic firms as they become reliant on trade.

International markets are not fair countries with surplus products dump them on worldmarkets at a lower cost. Poorer countries with largely agricultural economies can develop debts

as the import prices are less than their exports revenue.

Developing countries/smaller firms (infant industries) can find it hard to establish they facea lot of competition from TNCs, which benefit from economies of scale.

Increased environmental problems can stem from increased trade.Protectionism is the economic policy of restricting trade to protect domestic industries from foreign

competition. This can be done by:

Quotas quantitative limits on the level of imports allowed in. Tariffs taxation on imports. This is the best known method of protection. It increases the cost

of importing goods, which promotes buying from domestic firms.

Voluntary Export Restraint Arrangementstwo countries agree to limit the number of exportsto each another over an agreed period of time.

Foreign exchange restrictions reducing the amount of foreign exchange made available forthose wishing to buy imported goods.

Embargoes banning exports/imports of a particular product and/or banning trade with anothercountry. For example, a country may ban arms exports to a country notorious for having a poor

human rights record.

Administrative barriers this could be introducing time-delaying customs procedures todiscourage imports (increases costs to import products). High quality standards and complex

restrictions may also be set with the intention of increasing costs of foreign firms seeking to

export their products into the country.

Export subsidies paying domestic firms to reduce their costs.

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The main justification for protectionism is that infant industries can benefit from temporary protection

from foreign competition. However, these industries take a long time to develop, and temporary

measures often become permanent.

Arguments against Import Controls

Consumers are being taxed. EU measures often cause necessities to be most taxed. Thisregressive tax hurts the poorest consumers the most. Income inequality may increase.

Inefficiency increases protected firms have a lower incentive to lower production costs. Massive opportunity cost on imposing tarrifs employment could have been protected in other

ways. Protectionism policies are costly to implement.

Negative multiplier effect.