Economics Unit 4 Revision

8/8/2019 Economics Unit 4 Revision

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Economics Unit 4 Revision

Economic Growth, Development and Standards of Living

Long-run growth Increase in productive capacity of an economy:

Or an outward shift in a production possibility frontier.

Short run growth (or can be seen as an economic recovery) an increase in output resulting from

making use of spare capacity within the economy. It is shown by a rightward movement of the SRAS

curve.

Such short-run growth can stem from government stimulus (fiscal/monetary policy) to

increase aggregate demand, in response to cyclical unemployment (which is a result of an economy

operating within its PPF). Once an economy starts operating on its LRAS (due to increased AD), the

economy may no longer grow in the short-run, and must grow in the long-run (shift its PPF/LRAS to

the right).

Economic growth is not the same as economic development. Economic development is an indicator

of human welfare and also the ability to continue an improvement in welfare. Economic growth

often just gives wealth to the already wealthy, and the growth only aids military and police powers

to protect this wealth. Usually, even when growth allows the mass to have improved living

standards, this growth and welfare is unsustainable. Economic development can be measured by:

y General living standards (Real GNP per capita) a decrease in poverty and human suffering.However, GNP per capita can hide great inequalities in wealth (likely to occur in developing

nations).

y Access to resources (food, healthcare, housing).y Access to opportunities for human development (education, training)y Sustainability and regeneration through reducing resource depletion and degradation (by

use of renewable resources).

Causes of long-run growth:

y Technological progressy Increased labour productivity (stemming from investment accumulation capital goods and

human capital).

Productivity = Output per Unit of Labour Employed (per Time Period). Measured by either average

product of labour or marginal product of labour.


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This can be increased in the short-run by increasing capital (with fixed labour) or increasing labour

(with fixed capital), that is until the law of diminishing returns sets in, which eventually reduces

productivity of the inputs. In order to avoid this occurring, both these factors of production must be

changed allowing increasing returns to scale. When this occurs, total factor productivity can be

measured, which measures the changes in total output whenallfactors of production are changed.

Technical progress increases productivity also, and many economists argue that it is this technical

progress which is the main cause for economic growth, however, causes of technical growth are

speculative (e.g. investment).

Fluctuations in economic activity:

y Seasonal fluctuations occur in a 12 month cycle and are down to climate and weather (e.g.winter causes the building industry to slow down, consumption increases dramatically over

December).

y Cyclical fluctuations are longer and more deep-rooted and can be part of either the shorteconomic cycle (over a few years) or the long economic cycle (over several decades).

The Economic Cycle (or Trade Cycle or Business Cycle) it is defined as fluctuations in economicgrowth. An economic cycle starts and finishes at points which are judged to be on trend in terms of

growth.

Output gap it is the difference in output between the actual output and the on-trend output.

During the boom and slow-down phase of the economic cycle, there is a positive output gap, as

opposed to a negative output gap during the recession and recovery stages. The on-trend rate of

growth is the rate at which output is able to grow without putting upward or downward pressure on

the inflation rate, and is measure over a period of more than one economic cycle. For the UK, this

trend rate is 2.25%. With this being a percentage, and if growth is dealt with in absolute figures, the

following can be seen with the trend rate:

Recession 2 or more quarters with negative growth. The UK suffered recessions: 1979-81, 1990-92

and now 2008/9.

An economic slow-down a decrease in the rate of economic growth (but not necessarily a negative

figure).

Explanations of the economic cycle:

y Keynes theory of fluctuations in aggregate demand as business confidence rises and falls.y Supply-side changes (e.g. technological changes).


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y Climatic factors e.g. how the solar cycle affects the yield of crops, how El Nino (a largeoceanic disturbance every 7-14 years) affects yield of fishing and other industries etc.

y Speculative bubbles growth causes rises in asset prices. Once people realise that theassets prices are far above their real values, asset selling occurs (as opposed to asset

buying). Decreases in these prices are then seen, causing generally low business confidence

and pessimism; the economy may fall into a recession.

y Changes in inventories firms hold stocks of raw materials and finished goods in order tosmooth the production process and be able to cope with swings in demand. When demand

falls, extra stock of finished goods is created. With this being the case, firms have to cut

production by more than the decrease in demand (cut in production = decrease in demand +

extra stock of unfinished goods). This resultant de-stocking may turn a slowdown into a

recession.

y Political business cycle theory Elections occur every 4/5 years. In the build up to anelection, the government may try to buy votes via using stimuli to grow demand and the

economy (unsustainably) and creating optimism. However, after the election it is likely that

injections decrease (government spending) and withdrawals increase (taxation), in order to

pay back any debt incurred in plumping up the economy. However, this is less the case

now after the establishment of the Bank of England.

y Exogenous shocks e.g. external shocks that affect both the demand and supply side of theeconomy.y Supply-side causes generally a controversial theory, examples include variations in the pace

of innovation, supply-side shocks etc.

y Marxist theory Marxist economists explain the business cycle as a restructuring process inorder to make firms within a capitalist economy more profitable. When recessionary times

come, lesser/smaller firms are threatened with bankruptcy and are taken over or are forced

out of business (and the assets of which are sold to competitors at a low price). This process

is deemed necessary for the regeneration and survival of capitalism.

They also believe that, in the upswing of the cycle, high employment generates wage

inflation. This increase is at the expense of investment by firms and, more importantly, the

future output of firms. This subsequent reduction in output reduces demand for labour and

employment, causing lower wage inflation or, in fact, wage deflation. With labours share offirms output having decreased, this allows for more to be spent on investment. Demand for

labour increases wage inflation etc.

y Multiplier/Accelerator effect Keynesian economics has argued that economic cycles are atleast partly down to the interaction of these two processes, e.g. an increase in investment

leads to a greater increase in aggregate demand (multiplier effect), which in turn, via the

accelerator effect, causes a further change in investment.

Stabilising the economic cycle

Keynes theory dictates government fiscal/monetary intervention to change aggregate

demand stabilises an economy. However, some economists argue that this, in fact, widens the peaks

and troughs in the economic cycle, maybe even lowering the trend rate of growth. This is for three

reasons:y The success of demand management relies on timing. However, as the government reacts to

changes in unemployment (as opposed to GDP/output), this may be several months too late

as this is a delayed effect of a decrease in GDP, and often output has already begun to

recover.

y Intervention by government (especially in expanding demand) may have been for the wrongreasons, i.e. to win votes rather than manage the economy.


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y By using expansionary fiscal policy, causing the public sector to grow in size, the governmentmay have crowded out the private sector somewhat, thereby reducing the economys trend

rate of growth.

History of UK stabilising devices:

Before this timeline (1950s to 1979), fiscal policy was used to expand/contract

demand; this would have involved the multiplier effect.

Using statistics to measure living standards:

Problems:

y The non-monetised economy - e.g. DIY or general work carried out without a fee, which isboth difficult to account for and under-represented in statistics.

y The hidden economy otherwise known as the black market, this economic activity isunable to be accounted for in statistics due to the tax evasion that occurs in such an

economy. It is thought that the hidden economys output is about 10% of the UKs current

GDP.y Quality of goods and services the quality of goods/services naturally rises and declines and

this cannot be taken into account in the figures. Even if there is an increase in GNP, welfare

could still fall as the quality of goods/services decrease significantly.

y Negative externalities although output (and thus GNP) increases, there may actually be awelfare loss, e.g. due to increased production of cigarettes or that people have to work over-

time in order to increase production, leading to little spare time and a lower quality of life,

or traffic congestion increases cost of motoring and thus aggregate demand, but does not

increase living standards by an means. Regrettables also fall into this category, e.g. increased

consumption on burglar/fire alarms would increase GNP per capita, but people would much

rather these dangers not exist.

Comparing between countries/economies

GNP per capita comparison between countries may be misleading if the difference in

significance of the hidden/non-monetised economy between the two countries is great. As well as

this, sophistication in data collection varies greatly, and also methods in general. This leads to

difficulties in making direct comparisons.

Standard of living =

Other measures of economic welfare:y The United Nations Human Development Index (HDI) takes into account GNP per capita

($), life expectancy and educational attainment. The maximum HDI is 1.

y The Index of Sustainable Economic Welfare (ISEW) attempts to capture the effects ofexternalities on human happiness and welfare.

y The Genuine Progress Indicator attempts to evaluate whether the growth of a country hasbeen good or worthwhile.

Sustainable economic growth


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Environmentalists and the like believe that it is impossible for an economy to grow

(increasing output), without depleting natural resources at a faster rate. However, economic theory

dictates that prices themselves will inhibit resources from running out due to their allocative

characteristic. As resources run low, their price will increase, ensuring that less of that resource is

consumed and alternatives are found; whether this is alternative materials or alternative methods of

production. Sustainable growth has been defined as an acceptable rate of growth per capita

incomes without depleting the national capital/environment asset stock.

Benefits to growth:

y Low unemploymenty More competitive export industriesy Generally living standards increase (especially significant for emerging countries)y Leads to technological advances (due to more investment), which can be environmentally

friendly

y Produces fiscal dividend (tax revenue), which can be used to correct market failuresDisadvantages:

y Generally unsustainable, and often entails inflationary pressurey Can cause greater inequalities of wealthy Growth has to end at some point, leading to high unemployment, lower living standards etcy Greater negative externalitiesy Leads to urbanisation (destroying agricultural land)y Leads to greater population (out of which more people will be poor than before)

Aggregate Demand: measuresplannedspending within an economy.

Aggregate Demand = C + I + G + (X M)

Explaining the shape of the aggregate demand curve:

y Wealth effect a decrease in price level, increases an individuals real money balance and sothey are able to consume/purchase more goods with their money.

y Export/Import market a decrease in price level leads to an increase in demand for exports.Similarly, in the domestic market, imports are less in demand as people consume the now

relatively cheaper domestic alternative.

Determinants of the SRAS curve:

y Costs of productiony Taxation on firmsy Technologyy Productivityy Attitudesy Enterprisey Factor Mobilityy Economic Incentives facing workers and firmsy Institutional Structure of the Economy

Explaining the shape of the SRAS:

The shape relies on two microeconomic assumptions: firms aim to maximise profit and

the law of diminishing returns. Initially, price level increases as output does, due to the profit

incentive. However, as output increases, factors of production become scarcer (and thus more

expensive), increasing the cost of production. Also, as more factors of production are employed, the

combination becomes less efficient/productive, meaning the marginal cost of a unit of output

increases as output increases. This is the law of diminishing returns.


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Equilibrium when AD=AS or planned consumption = planned supply

The naturallevelof output is that where there is fullemployment, towards which

market forces anda flexibleprice mechanism willeventuallyadjust. This is at the output of the

vertical LRAS (favoured by supply-side and free-market economists). Any increase in demand past

this point will only lead to inflation, and it is for this reason the aforementioned economists believeit is irresponsible for a government to try and use fiscal and monetary stimuli to increase GDP and

employment above their natural rate. Instead, supply-side theory says that government should use

supply-side microeconomic policy to reduce unemployment, rather than increase aggregate demand

(to only increase price level not so much employment). These policies include increased training and

education, reduced unemployment benefits, remove minimum wage etc. However, moderate free

market economists do have faith that in recessionary times, expansionary fiscal and monetary policy

would go some way to improving the situation by reflating demand etc. This has been seen with the

recent recession, where many countries (UK and USA included) have reverted by to Keynesian

theory of demand management.

In terms of supply and demand curves, an output gap is when an economy produces

either side of the LRAS curve:

However, a positive output gap means the economy is producing above the full employment level of

output, and thus this is not sustainable.

The Keynesian long-run supply curve looks as follows:

This explains how economies can settle into a non-full employment equilibrium, with the view that

with government stimulus (and only with government intervention, as he believed without this


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demand would always be deficient), there could be seen an increase in output without an increase in

price level.

National income multiplier explains how a certain change in aggregate demand results in a larger

change in national income itself. Component multipliers measure how a change in a component of

AD results in a larger change in national income. This is especially important for fiscal policy

(knowing the suitable amount to inject/withdraw from the economy). The smaller the multiplier, theless effective fiscal policy is.

Consumption multiplier = 1/1-MPC (Marginal Propensity to Consume)

Or 1/MPS (Marginal Propensity to Save)

This is a common model for it; however, a more realistic model is as follows:

1/ (MPS + T + MPM)

T = Marginal Tax Rate

MPM = Marginal Propensity to Import

Fiscal demand management or discretionary fiscal policy was used throughout the

Keynesian era, where governments ran up budget deficits in order to increase AD. But sometimes(due to the multiplier) the government injected too much into the economy, leading to demand-pull

inflation and/or too many imports, causing a severe balance of payments deficit.

Nominal national income can increase in two ways: through reflation of real output or

through demand-pull inflation. Keynesians believed (providing the economy has spare capacity) that

expansionary fiscal policy stimulates real output more than inflation. By contrast, supply-side and

free-market economists believe that instead, fiscal policy stimulates prices rather than output, and

that the increased public sector spending crowds out the private sector of the economy. This

argument against Keynesian economics led to the decline of it through the 1970s, and was replaced

by the free-market revival. This was reversed in the 2008 recession.

Effect of multiplier:

Real World: In recent years, a new AD/AS model has been created that holds truer to the real world:


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Employme

and unemployment

Full employment occurs when 3% or less of the labour force are unemployed (according to the

Beveridge definition).

Labour Market:

he demand curveslopes downwards because:

y Due to labour s diminishing marginal product (law of diminishing returns), firms will notemploye tra labour unless the real wage rate decreases (making it economically

worthwhile, despite the diminished returns).

y If the real wage rate increases (relative to capital costs), firms will employ morecapital anduse morecapital-intensive production processes.

Supplycurveslopes upwards as, as the real wage rate increases:y Workers are willing to work longer hours.y People are brought into the labour market (e.g. adults with family).

With this, full employment is when, at the prevailing real wage rate, the number of people willing to

work e

uals the number of aggregated workersemployers are willing to hire.


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Equilibrium unemployment is the levelof unemployment when the aggregate labour market is in

equilibrium. This unemployment is said to comprise of solely frictional and structural

unemployment.

The natural rate of unemployment (NRU) is the rate of unemployment when the aggregate labour

market is in equilibrium.

At any one time, the aggregate labour may look as follows, with AS (LN) signifying the peopleavailable for work without taking into account willingness:

Employment rate

It is generally strongly correlated with the economic cycle, however, with a few months lag. This is

for two reasons:

y At the start of the downturn, firms hold on to their best workers, maybe putting them ontopart-time contracts, until they are sure demand for their output is actually falling.

y At the start of any recovery, firms will tend to get their current workers to work extra hours;that is until they are sure demand for their output is actually increasing.

Claimant count measures the number of people claiming jobseekers allowance. Free market

economists often argue this is overstated as many people falsely claim the benefits. But in other

ways, the claimant count understates unemployment as some may not bother to obtain the

benefits, plus some groups of society (e.g. young persons on government training schemes, people

nearing retirement etc) have been removed from the register.

The Labour Force Survey (LFS) surveys a cross-section of society (60,000 people) to assess

unemployment.

Both these methods do not take into account discouraged workers people who have given up hope

on finding a job, however, would take one should the opportunity arise.

Types of unemployment:

y Frictional (transitional) unemployment this is the people that are between jobs. It resultsfrom frictions in the labour market, but the assumption is made that for every person thatis frictionally unemployed, there is a vacancy available. Thus, it follows that the number of

vacancies is an economy is the level of frictional unemployment. The time delay of

occupying a new job from becoming unemployed is partly down to the geographical

immobility of labour, e.g. family ties, ignorance to vacancies in other parts of the country

and mainly cost of moving and obtaining housing. Occupational immobility may include the

requirement of training and the like. As well as this, there is the SearchTheory of

Unemployment, which dictates that after being laid off, a person may have too high


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aspirations initially, and that despite vacancies, they choose not to accept these due to the

wage being lower than the previous job. However, eventually the person will choose to

accept these vacancies. According to this therefore, frictional unemployment is a voluntary

search period, in which newly unemployed workers scan the labour market for a vacancy

that suits their aspirations. The availability of a state safety net (benefits) lengthens this

period of searching. It is for this reason free-market economists believe benefits should be

minimised and also take home pay should be increased (decrease income tax) to createincentive to work (& contribute to GDP) and ensure aspirations are decreased at a faster

rate. The replacement ratio is a factor influencing the search period. A high replacement

ratio (near 100%) leads to the unemployment trap, as there is very little monetary

motivation to work.

y Casual and seasonal unemployment casual unemployment is when workers are laid off ona short-term basis. Seasonal unemployment is a type of this, resulting from seasonal

fluctuations in demand.

y Structural unemployment results from the decline of an industry (usually resulting fromuncompetitiveness on a global scale. Technological unemployment is a type of this, wherefirms in an industry use more capital-intensive production techniques. Mechanisation

(workers operating machines) usually increases demand for labour, whereas automation

(machines operating machines) decreases demand for labour. An example of structural

unemployment can be seen from the deindustrialisation throughout the 1980s. In 2008,

some deindustrialisation occurred in the service sector of the UK.

Disequilibrium unemployment occurs either when the supply of labour exceeds the demand for

labour, or wage stickiness causes the real wage rate to be too high to reach unemployment

equilibrium.

The latter leads to Classical or Real-Wage Unemployment:

The amount that is unemployed = Q(S) Q(D). Reasons for the existence of this type of

disequilibrium include the power of trade unions (which is no longer).

Cyclical, demand-deficient or Keynesian Unemployment:

The economy in general:


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And its effect on the labour market:

Hysteresis effect over prolonged periods of higher unemployment, the section of people that have

been unemployed throughout this period will become less and less attractive to potential

employers. As well as this, theyre core skills will begin to break down (social and technical), and this

group of people will increase the core structural unemployment, which may end up increasing the

natural rate of unemployment.

Flexible Labour Market a flexible labour market, one that is able to respond to economic change, (a

good model of which is the Danish labour market) has several characteristics:y Occupational flexibility workers can perform a range of tasks and have transferable skills,

can be encouraged through education and training.

y Contractual flexibility e.g. month-to-month, 6 month, zero hour (weekly hours change)contracts, with easy termination and creation.

y Wage flexibility wage rate changes easily with demand and supply of labour (non-sticky inthe downward direction), stems from lack of collective bargaining power and low trade

union power.

y Geographical flexibility workers should be able to move across the country.


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Advantages to a flexible labour market:

y Flexible wages allow the labour market to move back to long-run equilibrium easily.y Occupational flexibility reduces structural unemployment and decreases the natural rate of

unemployment also.

y Improvement in the Phillips Curve trade-off (caused by an increase in productivity growth).y Reduced time lag in economic indicators (unemployment will rise and fall quicker, ensuring

better timing by government policy, as well as any recessionary period lasting for a shortertime).

y Makes domestic investment more attractive.y Stronger employment creation through economic upturns.

Disadvantages:

y Having short-term contracts usually compromises the training a worker obtains, thusreducing job possibilities at the end of the contract (may cause skills gaps in the economy).

y Short-term contracts damage job security, unsettling workers and their families (lowerstandard of living?).

y Welfare is likely to fall due to a reduction in the real wage rate as collective bargainingpower is significantly reduced.

y Pensioner poverty as those with short contracts will have a very low pension.y Slash and burn may occur in economic downturns, where firms aggressively lay off

workers (probably worsening the situation).

Barriers to a flexible labour market (examples):

y Minimum wagey The EU (and its working hours directive)y Minimum holiday requirement

Costs of unemployment:

y Increase in crime?y Decrease in average welfare marital break-ups, worse access/less healthcare, social

exclusion, greater stress etc

y Loss of marketable and useful skills from the labour market, which could contribute to thecountrys GDP.

y Operating within PPFy More is being spent on unemployment benefits; the opportunity cost of which is that less

can be spent on healthcare, schools and other useful resources.

Possible benefits:

y Reduced inflationary pressure as a smaller workforce does not have as much leverage toincrease the real wage rate; a view offree market economists.

y Possible environmental advantage GDP grows at a slower rate, therefore less strain onnatural resources.

Policies to reduce unemployment:

y Reducing labour immobility can be done through supply-side policies such as improvingeducation and training (which is said to be very much undervalued in the UK), as thiswill

give the unemployed the necessary skills to find re-employment. Benefits can be reduced to

ensure people look for a job, even if it is in another geographical area. Other supply side

reforms include reducing income tax and eradicating the minimum wage.

y Demand side policy (reflating demand)y Employment subsidies subsidies given to firms that take on unemployed workers on longer

term contracts.


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Inflation a continuous and persistent rise in the general price level and a consequent fall in the

value of money.

Reflation an increase in AD, causing an increase in real output and employment.

Stagflation high inflation coupled with low, non-existent growth.

CPI includes house prices and mortgages interest rates, and has a target of 2%. It is used throughout

the European Union.RPI is said to be the underlying rate of inflation and does not include mortgage interest rates or

housing. The government uses it when deciding on level at which welfare benefits should be.

This changed from 2008 onwards, with the UK suffering a recession.

Quantity Theory (Monetarist):

Money Supply x Velocity ofCirculation of Money = Price Level x Total Transactions(Stock of Money)

MV = PT

The velocity of money circulation and total transactions (both determined by the level of real

national output) are both fixed/at least stable. Therefore any increase in the money supply is likely

to see an increase in price level. Money is assumed to be a medium of exchange rather than store of

value, and thus is quickly spent once obtained.

When the money supply is increased, households and firms hold excess money balances which,

when spent, pull up the price level. It is assumed real output cannot expand in line with the increase

in spending power.


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Keynesian rejections to this theory generally centre on the fact V (the rate at which money is spent)

is not always constant, as their theory is that expectations will alter this (especially if, let s say,

share/bond prices are expected to fall, it would seem sensible to hold idle money rather than spend

it straight away).

Demand-pull inflation (Keynesian)

The economy generally suffered this throughout the Keynesian period (1950s 1970s) as the

government seeked full employment, leading to people behaving in an inflationary way.

Both monetarist and Keynesian theory assume price level is pulled up by excess demand; however,

the underlying causes for each differ. Demand-pull inflation can stem from use of expansionary

monetary/fiscal policy, a depreciation in the exchange rate, rising consumer confidence or rapid

growth in foreign countries (increasing exports).

Cost-push (also Keynesian)

This was introduced as, during the Keynesian period (particularly late 1950s/1960s), it was noticed

inflation was occurring despite no evidence of excess demand. This was also suffered in late

2007/2008, due to increased oil, gas and commodity prices. This type of inflation locates the cause

to structural and institutional conditions on the supply side of an economy, and there are various

types of theories (including wage-push, profits-push and import cost-push, as well as if indirect taxes

increase - VAT).

Wage push theories dictate that the power ofcollective bargaining in the labour market increases

(for whatever reason, in the Keynesian era it was the growing power of trade unions), and

monopolistic firms were able to pass the resultant wage increases on in the price of good (in a

continuation of their costpluspricing regime).


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The Phillips Curve

This is a Keynesian Phillips Curve.

It is said to be evidence of both cost-push and demand-pull inflation; as unemployment decreases

(linked with increased demand), inflation increases. Also, as unemployment decreases, trade union

power increases, making wage increases (and thus production cost increases) more likely.

It explicably shows the policy conflict or trade-off of unemployment and inflation, however, also

suggests how this can be dealt with (shows menu of choice unemployment rate and its respective

inflation rate). It is important for setting interest rates and forecasting economic growth.

The Monetarist Theory of Inflation:y The revival in 1956 by Milton Friedman of the Quantity Theory of Money.y The Theory of the Expectations-Augmented Phillips Curve (1968) gave rise to gradual

monetarism.

y The incorporation of the Theory of Rational Expectations into the explanation of theinflationary process, which became known asnew-classicalmonetarism.

The breakdown of the Phillips relationship


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This occurred in the 1970s, when accelerating inflation and growing unemployment

were occurring at the same time (stagflation or slumpflation). This triggered new theories to be

developed (see above).

Expectations-Augmented Phillips Curve and the Natural Rate of Unemployment

This includes that expectations of the future inflation rate is a determinant of the

current inflation rate. It is recognised now that the original Phillips curve (curving downwards fromleft to right) is a short-run curve, showing only the relationship between inflation and

unemployment rate in the short-run. A more accurate long-run Phillips curve than the one above can

be seen below, as it intersects the short-run curve when the inflation rate is 0, giving the natural rate

of unemployment.

Free-market economists argue that it is impossible to reduce unemployment without

experiencing ever-accelerating, unanticipated inflation (developing into hyperinflation, which is

economy-killing). The explanation for this is in the fact that the Keynesian curve only took into

account current rate of inflation, and not any expectation of future inflation. The expectations-augmented Phillips curve brings together two important, free-market

supported theories:

y The free-market theory of the labour market natural level of employment/unemploymentoccurs at the equilibrium real wage rate (when demand for labour equals the number willing

to work at the prevailing real wage rate).

y The theory of the role of expectations in the inflationary process.A demonstration of how expectations have an effect can be seen from the following,

assuming productivity remains constant and wage inflation will equal price inflation. AS well as this,

an assumption is made that peoples expectations of future inflation are solely based on the current

rate of inflation.


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At point A (Natural Rate of Unemployment), the inflation rate is 0, thus there is an expectation of

zero inflation. Suppose the government were to expand AD, trading off the Phillips Curve to point B,

where there is inflation of P1, leading to wage inflation of P1, and unemployment of U1 (less than

the natural rate). In the short-run, this could lead to more workers entering the labour market with

the (false) belief that this increase in wages would give a real wage increase as well as absolute wage

increase. Similarly, firms may be willing to employ more labour, due to their (also false) belief that

the increase in prices would give an increase in revenue (due to the thought that prices are rising

faster than labour costs). In both instances, this is called money ilusion.

There is a different Phillips Curve for different expected inflation rates, with a higher expectation

leading to a rightward shift and vice/versa.

From this, free-market economists believe the only way to maintain unemployment below the NRU

is to allow the money supply to expand and have an ever-accelerating inflation rate. This also relies

on the fact that expected rate of inflation is always below the actual rate of inflation, thus money

ilusion occurring for both employers and workers (but in opposite directions). The end result of

persistent (and irresponsible) attempts to lower unemployment below the NRU is hyperinflation

and/or perversely, an increase in the NRU.

If a government realises it has expanded AD unnecessarily, it can stabilise the rate of inflation,

allowing the money illusion to disappear, and the NRU can be obtained again at point C.

Improvement in the trade-off conditions of the Phillips Curve may stem from:

y Credible inflation targets which lower expectations of future inflation rates.y Flexible labour market with lower collective bargaining power.y Technological improvement.y Low global inflation also reduces expectations.y Benefits of immigration.y Increased competition both domestically and globally.


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Inflation psychology dictates that it is possible for a government to control the level of inflation by

talking it down; however, this relies on credibility, which can be lost.

With deflation (the danger of which occurred late 1990s/early 2000s) people believe prices are going

to fall, which leads to big ticket consumption decisions (e.g. car) being postponed. This erodes

business confidence and could in itself make the danger of a recession reality or just prolong the

already existing recession. However, this is on the assumption that it is bad deflation occurring

(demand deficient deflation), as opposed to deflation caused by improvements in the supply side ofthe economy.

Whether inflation is good or bad depends on whether it is anticipated or not. Anticipated inflation is

not a problem as households and firms are able to make their economic decisions with this in mind.

Benefits associated with having a creeping inflation (stable, low positive inflation rate) include:

y Growing marketsy Healthy Profitsy Business Optimismy A necessary side-effect of government expansionary policies to reduce unemployment.

Costs/disadvantages to inflation:

y Money illusion can occury People on fixed incomes (such as pensioners) will have their living standards significantly

reduced as their savings lose value, meanwhile some peoples wages, who have more

bargaining power, rise in real terms. People in poor bargaining positions (i.e. people on low

wages) will usually see a fall in their real wage. Also, it can occur that real rate of interest are

negative, meaning money is effectively re-distributed from creditors to debtors.

y Wage-price spiral where inflation causes wage inflation, which in turn increasesconsumption and thus inflation again.

y High and unexpected levels of inflation disrupt business planning, leading to reducedinvestment (affecting an economys long-run growth potential).

y Leads to a loss in international competitivenessy Shoe leather (consumers look around more for firms offering prices that have not suffered

inflation yet) and menu (firms constantly having to re-label prices) costs.

y Breakdown in the function of money if/when hyperinflation sets in, the currency becomesrarely used due to its lack of store of value.

y Distortion of economic behaviour goods are bought prior to being necessary and are oftenhoarded in order to beat inflation. People are affected by inflationary noise, where

relative prices change (as opposed to price level).

Money, banks and monetary policy

Money has two main functions:

y Medium of exchangey Store of value (wealth) using money for this function makes one vulnerable to inflation


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A bank is an institution that accepts deposits from the general public and creates deposits when

lending to customers.

The Bank of England is the UKs central bank the bank that implements monetary policy and also

issues and controls fiat money or cash.

For a while there were intermediate policy objectives other than control the inflation rate (and

ultimately improve economic welfare), e.g. control the money supply (from the mid 1970s to 1985)or control the exchange rate (1985-1992). Since then, the target has been to control inflation

directly.

Monetary policy instruments

y Controlling the availability of credit (Keynesian) in the Keynesian era, the governmentwould either impose required reserve ratios on the banks or quantitative or qualitative

controls on lending (imposing limits or imposing directional controls on lending). These were

abolished in the 1980s as free-market theory ruled and the limitations were, in fact, driving

banks offshore.

y Interest rates lower interest rates (stemming from a lower base rate, causing the LIBOR todecrease also) lead to an increase in consumption as saving is discouraged, interest-paying

households have more dispensable income and also they often cause housing and shareprices to increasing, leading to the wealth effect and high business confidence. Low interest

rates also lead to increased investment as borrowing is cheaper and saving is discouraged.

Furthermore, lower UK interest rates lead to the selling of pounds sterling, as

individuals and firms choose to hold their money in countries (and their respective

currencies) where they will reap more interest. A decrease in exchange rate (caused by the

selling of the pound) will most likely cause the value of exports to increase as they are now

more competitive internationally, and similarly the value of imports would decrease.

y Quantitative easing issuing of government gilts and bonds to increase the money supplywithin the economy.

The Bank of England will compare the inflation forecast should interest rates remain

unchanged with the target inflation rate, and thus attempt to pre-empt any significant rise in theinflation rate.

Fiscal and supply-side policy

Taxation a tax is a compulsory levy charged by the government (or public authority) to pay for

expenditure. In the UK, 89% of taxation is levied by the government itself, whereas the remaining

11% is by local authorities.

Progressive tax the proportion of an individuals income paid in tax increases as income increases.

Regressive tax the proportion of a persons income paid in tax decreases as income increases.

Proportionate tax (flat tax) proportion of income paid in tax remains the same.

Average tax rate = Total tax paid / Total incomeMarginal tax rate = Total tax paid / Total income

Average tax rate indicates the burden of the tax on the taxpayer, and the marginal rate comes in to

play when making a decision in terms of what/how much tax etc.

Adam Smiths Principles (Canons) ofTaxation: a good tax is:-

y Equitable (fair) usually based on ability payy Economical


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y Convenienty Certain

General government expenditure central government and local government expenditure, plus any

spending on net investment by nationalised companies/industries(however this is often excluded

due to the fact it is more often than not funded by revenue from that industry, rather than taxation).

Often a more significant figure than the absolute spending is the ratio of public expenditure tonational income, indicating the share of the nations resources taken up by the government (with

this ratio having been ever-increasing).

Aims of fiscal policy:

y Allocation taxes are used to alter relative prices (to income) and patterns of consumption.Demerit goods and goods that create negative externalities are taxed to discourage

consumption of them, while merit goods, like museums, remain untaxed and are, in fact,

subsidised. Taxes are also used to provide public goods (healthcare, defence etc).

y Distribution the price mechanism is said to be value-neutral, as in it is not influenced byfairness.

Government spending can be split into three main categories:

General government expenditure - includes capital and current spending (roads etc andbenefits). General government final consumption - cost of current goods/services Transfer payments - transfers of money from taxpayers to benefit recipientsThe Laffer Curve (dictating there is an optimum taxation level, where tax revenue is at its highest):

Keynesian fiscal policy (used in the decades preceding 1979) - using fiscal instruments to control AD.

The key elements of the theory were: The belief that left to itself, an unregulated market results in low economic growth, high

unemployment and a volatile business cycle.

A lack of AD, often caused by the private sectors tendency to save too much and invest toolittle, would specifically lead to demand-deficient unemployment.

By Keynes theory, this deficiency could be eradicated by use of government spending injectingdemand into the economy.

Central to the Keynes fiscal policy was the assumption that the government spending multiplierwas very high.


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Supply-side fiscal policy (used from 1979) - the idea being to reduce the economic role of the state,

through deregulation and privatisation, in order to increase the role of markets. This shifts the LRAS.

Fiscal policy was no longer used for demand management, as this was though to be damaging inthe long-run (generally inflationary). Supply-side economists also argued the fact that, with a low

multiplier, the stimulatory effect of government spending was very little and again would only

be inflationary. They also argued the fact that the private sector could be overcrowded by large government

spending.

Microeconomic elements policy overran the macroeconomic elements, such as the creation ofwork incentives, with the aim of improving economic performance on the supply-side of the

economy.

Also, the government saw/thought that such macroeconomic policy would not be necessaryshould monetary policy be successful in controlling monetary growth and inflation thus giving

monetary policy a front seat instead.

A budget deficit (G>T) leads to a Public Sector Net Cash Requirement (PSNCR), which is positive in

this case (and negative when a surplus occurs). A balanced budget is one where G=T, although

equilibrium can occur as a surplus or deficit. A budget surplus allows repayment of past governmentdebt.

Automatic Stabilisers (factors that change in such a way as to automatically stabilise AD and the

economic cycle without government intervention).

Examples of this are progressive tax and certain unemployment benefits. As demand decreases, and

consequently jobs are lost and wages decrease, there is demand-led public spending on

unemployment benefits and a decrease in taxation as wages are lower (if existent), thus decreasing

the amount of tax paid. This acts in the opposite direction also, to inhibit the economy overheating

in boom phases.

The governments budget is contributed to by both cyclical and structural factors, and thus is said to

comprise of two respective parts. For example, deindustrialisation and globalisation havecontributed to the growth of the UKs structural budget deficit.

Crowding Out:

Resource crowding out - by using more resources in the private sector, it inevitably leads toresources for the public sector being scarcer, and sacrificing the use of the same resources in

private employment.

Financial crowding out - funding the government spending often makes firms and individualspoorer (however, funding is more likely to come through borrowing). Because of this, the

following explanation is given. Say the government is borrowing money through the issuing of

gilts to insurance companies and the like, however, in order to persuade the companies to buy

the debt, the government would have to increase the interest rates given on them. Such an

increase in interest rates would be seen across the board, making firms worse off (as it is more

difficult to raise capital), leading to a reduction in investment in the private sector.

Crowding out theories rely on the full employment of resources. If this is not the case,

government spending merely takes up loose slack (through the use of spare capacity) in the

economy. Similarly, crowding in can be seen, where public spending via firms not only increases

investment (and other components of AD through the multiplier effect), but also that firms

spending, increasing business for the private sector in general. Crowding out can be seen from an

economys PPF, where it is producing on its frontier and there is a movement to production of more

public goods relative to private goods.


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When this occurs, the size of the multiplier is 0, as despite an increase in public investment,

this leaves no room for private investment and its consequent effects. Free-market economists go

as far as saying the multiplier is negative in this situation, as they say public sector spending

(healthcare, roads etc) is wealth-consuming and unproductive, whilst in contrast private sector

spending is wealth-creating, even such things as gambling.

Crowding in may be seen when an economy is producing within its PPF, where an increase in

both public and private sector output.

UK governments now realise that monetary and fiscal policy are interdependent, rather than

independent. The government can either borrow short-term via Treasury bills or long-term via

selling gilts, which are sold to non-bank institutions. To sell these (gilts), interest rates may have to

be raised (discouraging investment). Both, however, increase the money supply and thus increase

inflationary pressure.

Fiscal Policy objectives (1997); short-term:

Allow automatic stabilisers to smooth the path of the economy. Take other necessary action so that fiscal policy supports the role of monetary policy.Medium-term:

Fulfil the governments tax and spending commitments, while avoiding a damaging theunsustainable increase of the public sector debt.

Ensure the generations that benefit from the public spending, as far as possible, are the onesthat pay the tax revenue that finance this spending.

Added to this was a Code for Fiscal Stability, which dictated that throughout the economic

cycle, any net government borrowing should only be to fund new social capital (capital spending),

and not benefits or any other current spending (which does not create assets for future generations

to use); this was the golden rule. It also said that debt should be no more than 40% of GDP; this was

the sustainable investment rule.

The general public will notice cuts in current spending immediately, due to this affecting

them (e.g. cut in benefits), however, capital spending will not be noticed so much as it is usually

long-term projects. Credibility for the golden rule, though, seems to have been lost due to the

flexibility of when an economic cycle starts and ends, and also due to the blurring of the line by thegovernment between current and capital spending. However, the idea still remained that fiscal

policy should no longer be used in a discretionary manner to manager AD.

Like monetary policy, the government is often slightly late to react due to the time lag of

economic indicators. This is further delayed by the decision making for the relevant response, and

then again by the time delay for the response to take affect.

Does a budget deficit matter?:

There is the problem of financing such a government debt, which may eventually affect interestrates (in the attempt to sell gilts), having a negative effect on the economy. This debt may build

up over the years and, even if the government does not struggle to finance it, there are

opportunity costs to this debt, I.e. spending on healthcare etc.

Crowding out may occur Wasted public spending - neo-liberaleconomists believe it is not so wise to spend greatly on the

public sector, which is know for a lack of efficiency/productivity relative to the private sector.

Form of demand management Can lead to economic growth through capital spendingIn summary, taxation affects:

Work incentives


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Labour productivity Patterns of demand Business investment decisions - lower corporation tax will lead to greater investmentSupply-side policy - set of government initiatives that aim to change the underlying structure of an

economy and improve the economic performance of markets. They believe that an economy is

usually never too far from its natural rate of output and employment, however, when it is it is oftenblamed on Keynesian neglect. Supply-side is generally anti-interventionist, changing the

governments role to enabler.

International trade and globalisation

Benefits of international trade:

Widening consumer choice Reduced prices Both the above lead to a welfare gains due to this allocative efficiency Specialisation and division of labour (see Law of Comparative Cost) - allows economies of scale,

optimise use of resources and thus greater efficiency (including dynamic efficiency - for future

growth). Access to new technology is also allowed, which increases economic growth (as long as

there is no net labour loss).

Import substitution - to effectively produce goods/services that have been generally imported

domestically. This would be encouraged by the government via subsidisation and/or protectionism.

Export promotion - allow the industry to be solely private (for profit seeking and motivation) and

provide incentives for exporting. Labour-intensive production techniques can be used if labour costs

are low, in order to get a competitive advantage.

Law of comparative cost

Assumptions made:

There are two countries, country A and country B, each with 2 units of production Factors of production are fixed and immobile

Constant returns to scale Implied is stable demand and cost conditions No transport costs There are two goods: good A and good B

Each country puts one unit towards each good, providing the following outputs:

Output of Good A Output of Good B

Country A 4 2

Country B 1 6

TotalWorld 5 8

Country A has an absolute advantage in producing Good A, whereas Country B has a similar absolute

advantage in producing Good B. Therefore, by the law of comparative cost, trade is economically

worthwhile, as demonstrated by the table below, with each country employing all resources to

producing the good theyre best at:


Country A 8 0

Country B 0 12


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TotalWorld 8 12

However, in the real world, this is only the case if there is a double coincidence of wants,

where the goods traded must be in demand in the respective countries they re being imported into.

As well as this, trade will only be economically worthwhile if transport and administration costs

allow it to be.

Comparative advantage:


Country A 4 2

Country B 1 1

TotalWorld 5 3

Country B has a comparative advantage in the production of good B, as the opportunity cost

of producing this for Country B is less than that for Country A. Generally, the comparative advantage

for the country with the absolute advantage for both goods is with the good forwhich it has the

largest absolute advantage. Similarly, the comparative advantage for the other country is for the

good for which the absolute disadvantage is least.

However, full specialisation as a result of this does not lead to an output gain. Instead,

partial specialisation should be taken that will increase world output in both. An output gain is said

to lead to a welfare gain.

Terms of trade = 100 x Average Export Price Index / Average Import Price Index

Protectionism - controlling imports via quotas (limit to the amount of imports), trade embargos (full

bans on imports) or tariffs/import duties. This is argued against by supporters of free trade, who say

specialisation is inhibited and so production occurs inefficiently, possibly leading to a welfare loss

(although this argument is largely based on the assumption in the law of comparative cost, which, in

reality, are not so significant).

Possible justifications for protectionism:

Infant industries - allows newly established industries to obtain economies of scale beforebecoming exposed to generally more efficient, foreign competition.

Strategic trade theory - governments can protect certain industries in order to allow them to benurtured whilst a competitive advantage is created. This theory also dictates that protectionism

can help avoid exploitation by a foreign-based monopoly.

Agricultural efficiency - specialisation in agriculture (monoculture) leads to inefficiency in itself,as soil becomes infertile etc, thus making it more worthwhile for a economy to protect its

agriculture industry, maintaining a certain degree of self-sufficiency within the economy.

Changes in demand or cost conditions - overspecialisation can cause an economy to becomevulnerable to changes in costs and/or demand, thus some sort of protection may be needed

when efficiency is compromised.

Sunset industries - in order to avoid certain industries becoming non-existent due to foreign,more efficient competition, the government may impose protectionism. In this way, many jobs

are saved. This protectionism, though may not save the industry, will ensure that the process of

deindustrialisation occurs more gradually - minimising the social and economic cost as economic

agents and the structure of the economy in general are able to adapt better.

Anti-dumping - stops foreign surplus of goods being dumped onto the UK market at cut-prices,


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which UK firms and industries are unable to compete with.

Demerit goods or bads (which result in disutility and negative externalities) - to inhibit theimporting of goods that may not necessarily lead to a welfare gain, e.g. drugs, cigarettes, guns

etc.

Self-sufficiency - sometimes it is no longer an economic issue, instead more a military orstrategic one, where a government believes there is some significance in being able to produce

domestically what is needed in case of disaster or war. Employment - multinational firms, instead of exporting to the UK, may instead locate production

within the UK, providing employment.

Welfare losses and welfare gains

The following diagram shows the consumer (and producer) welfare within the domestic

market.

Consumer surplus is an indicator of consumer welfare, and likewise producer surplus is an

indicator of producer welfare.The following diagram now includes international trade:

There is a welfare gain of both are B (transfer from firms to consumers) and C, with the

remaining producer surplus being area D.

The effect of a tariff can be seen below:


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The net welfare loss from the economy can be seen by areas A and C, as areas B and D are

welfare transfers from consumers to producers and the government (through tariff revenue).

Patterns of trade:

There is significant North-North trade (between UK and USA), as well as trade between these two

nations and newly industrialising countries (NICs) or emerging markets, which include the BRIC

countries (Brazil, Russia, India, China). Commodities, such as copper, are imported by these

countries from such countries as Zambia. Crude oil (another commodity) is imported from Saudi

Arabia and Venezuela, amongst others.

Globalisation - the process of growing economic integration pf the worlds economies.

Free-market economists argue that the growth of globalisation is inevitable, the benefits of which

(more production and higher living standards) outweighing the disadvantages (exploitation of the

poor in emerging nations, destruction of local cultures etc). Other unwanted effects of globalisation

include farmers being forced to grow GM crops or accept low prices due to multinational

organisations having monopoly power, privatisation of industries so that they qualify for loans from

the IMF or the dominance of multinational companies like McDonalds. However, the counter-

argument is that these firms come in to dominance as consumers see their products as superior than

other, more locally-produced goods.

Features of globalisation:

Growth of international trade and reduction in trade barriers Great mobility across international borders of capital (and to some extent labour as well) Increase in power of multinational corporations and international capitalism Deindustrialisation in older industries, and the movement of these to newly emerging,

industrialising countries. The movement of more labour-intensive, low-skilled jobs to NICs A decrease in power of the government to influence decisions of multinational corporations

(MNCs)

Employment practices

Often MNCs are accused of selling products at prices far above the cost of production, and in

response they claim the so-called low wages to actually be far above those paid by the local

companies of that area/country. In this way, local wages may actually rise. As well as this, more


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often than not these MNCs offer better health and safety conditions than the local employers (or so

they claim). By threatening to close down factories in the UK, MNCs are said to reduce wages and

consequently living standards, though this is debated.

Globalisation in the service sector (often having been regarded as relatively immobile in comparison

with manufacturing) is occurring at an ever-more faster rate, take, for example call centres, which

are posted overseas now for various reasons: Low wages Cheap telecommunications 24-hour shift employment to overcome the problem of time zones Foreign workers are now fluent in English (with it being the business language)

Labour and capital mobility has been seen especially with the creation of the European

Union, which has seen Eastern European workers enter Britain for employment.

Globalisation has also seen a reduction in power for national governments, along with them

experiencing less freedom enforcing import controls and, in the case of the EU, having restrictions in

terms of implementing laws and regulations. The decrease in use of import controls has been in part

down to the World Trade Organisation (WTO), stemming back from the post-war times when a

General Agreement on Tariffs and Trade (GATT) was made, with the aim of trade liberalisation.

The belief that globalisation benefits most countries (rich or poor) has been attacked by the

dependency theory of trade and development and its supporters, which dictates that developing

countries possess little capital as the world trade system has been organised by already-developed

industrial economies to their own advantage. The terms of trade (see above) have moved in favour

of these countries, and are more against the primary producers. This means that a developed

country is able to import a greater amount than it exports with no net loss from the economy. This is

furthered by profit flows from MNCs from developing nations to the developed nations, along with

interest payments from developing countries to western banks.

The balance of payments - this equals the value of exports minus the value of imports and is made

up of the current account and the capital account. The current account comprises of four mainaspects:

Balance of trade in goods Balance of trade in services Net income flows - this is made up mostly of investment income;- income flows generated from

profit and interest payments from UK firms (often MNCs) working overseas.

Net current transfersCapital flows are the purchases of/investment in capital by MNCs (which subsequently reap net

income flows), often in countries which are seen to have resources that give them a

competitive/comparative advantage. These can be short-term or long-term; long term:

Direct overseas investment - productive capital, e.g. factories, offices etc. Portfolio overseas investment - for example shares.Short term capital movements (hot money flows) are largely speculative. They occur as the owners

of the money believe they can make a short-term profit by moving their money through different

currencies, and are generally triggered by differing interest rates within countries. International

crises such as war also lead to these occurring, when money is moved to safe, stable currency. The

magnitude of these has grown significantly.

Balance of payments equilibrium occurs when trade and capital flows in and out of an economy are

more or less equal over a number of years (thus allowing deficits and surpluses in this time). An

equilibrium can also be defined when the only the current account needs to balance over a similar


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period. Disequilibrium occurs when a surplus or deficit is persistent. A deficit of one economys

balance is anothers surplus.

Causes of a deficit:

Strong consumer demand Strong exchange rate Weakness of the global economy Shifts in comparative advantage Substitution effect after experiencing lower prices in the foreign markets Supply-side deficiencies Low product innovationBenefits/compromising factors of a deficit:

Increase in living standards, at least in the short-term, as households consume more raisingwelfare via increased utility.

Partial auto-correction - if the deficit is due to strong demand, this will be slightly correctedthrough the downturn in the economic cycle.

Could be due to increased investment in capital from abroad, which would eventually improvethe supply-side of the economy.

Current account deficits can be contrasted by capital inflows.

Short-run deficits are linked with the upturn in an economic cycleDisadvantages of a deficit:

Sign of structural weaknesses within the economy Shows an imbalance of the economy - too much consumption, this is unsustainable and would

have to be addressed at some point.

Downward pressure on exchange rate Potential loss of output and employment - import penetration into the domestic market Government may have problems financing a deficit for a sustained period

However, a deficit is only damaging in the long-run.

Policy to eradicate a current account deficit is based on the three Ds: Deflation, Direct Controls orDevaluation.

Deflationary policy

By using policy to reduce AD, imports will naturally reduce also (how much depends on the

marginal propensity to import). This means this method is primarily an expenditure-reducing policy,

but it also has an expenditure-switching element. This is because, with deflation occurring, the price

of domestic goods relative to imports decreases (and an opposite effect on exports), meaning

imports would decrease. However the latter effect is seen as a small one in modern economics;

output and employment tend to fall more so due to the lesser demand for domestic goods. This

leads to firms going on export drives, which are less profitable than the domestic market and thus

require a sound and expanding home market.

Direct controls do not address the underlying reasons of a deficit, and arguably reduce

specialisation, resulting in a welfare loss.

Devaluation:- The extent to which this would affect the balance of payments depends on the

elasticities of imports and exports.

The J-Curve


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The Marshall-Lerner condition - for an improvement in the balance of payments as a result of a

depreciation in the exchange rate, the sum of the elasticities of exports and imports must equal

greater than one (ignoring the minus sign), and similarly a surplus can be reduced by an

appreciation. However, otherwise (when the elasticities are very inelastic and sum to less than one),

the balance can, in fact, be worsened by such a depreciation. This may not hold in the short-run as

elasticities differ over this time period.

The initial worsening of the balance on the J-curve is explained by the contracts firms have already

tied themselves in to and also the fact that demand is more inelastic in the shorter-run. It is because

of this initial worsening that devaluation is not the tool of choice when improving the balance of

payments, as it can lead to falling confidence and consequently increased capital outflows. A J-curve

can be reversed to show the effect of an appreciation in the exchange rate on the balance of

payments.

Balance of payments surplus - it is inflationary, with it being a sign of injections into the circular cash

flow. If there is spare capacity within the economy, it reflates the economy, causing positive

economic growth. However, if not, demand-pull inflation will occur.

The policies used to decrease this surplus are the opposite of the 3 Ds: reflating demand

(increasing import demand), liberalised trade and revaluing the currency.

Exchange Rates, the Pound, the Dollar and the Euro

Economics Unit 4 Revision

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Transcript of Economics Unit 4 Revision