Macro Economic Essays

Transcription

1 Macro Economic Essays These are some suggested Macro Economic essays. The essays are from different exam boards. In practise they ask very similar questions. There are different ways to answer questions. But, all these answers contain enough material to get the top grade. Whenever the question requires evaluation, the essay contains the necessary critical distance. Note: These essays are for revision purposes giving suggestions for how to answer questions. Don t try to pass them off as your own work. For more macro economic help. See also the Macro Revision Guide available at / Copyright T.R.Pettinger All Rights Reserved 1

2 Macro Economics Essays 1. Compare the Effectiveness of Supply side and Fiscal Policies to Correct deficits on a country s current account of the Balance of Payments 2. Assess the Economic effects of a significant increase in taxation on the UK economy. 3. Evaluate the likely economic Effects of a decision by the UK to withdraw from the European Union. 4. Both the UK and US balance of payments accounts are recording large deficits on their trade in goods balance. Do such deficits matter? Justify your answer. 5. Explain how countries benefit from international trade even though they may produce similar goods and services. 6. Discuss the factors that determine the trade competitiveness of the UK economy 7. Explain how a decrease in Government Spending can result in a greater change in the equilibrium level of national income 8. A Government is faced with an unacceptably high level of unemployment, but does not wish to increase its overall expenditure. Discuss alternative Policies for reducing unemployment. 9. Explain the likely economic reasons for Government Borrowing. 10. Evaluate the possible Problems for the UK economy of increased government borrowing 11. Explain possible causes of Economic Growth. 12. Evaluate the potential impact on the economic growth of the UK economy if it were to adopt the single European currency. 13. Evaluate the possible impact of the expansion in the EU on UK economic performance. 14. Explain how a fall in the rate of inflation might be achieved by both demand-side and supply-side Policies. 15. Explain how exchange rates are determined in a floating exchange rate system 16. Evaluate the possible consequences of a falling rate of inflation for the performance of the UK economy. 17. Evaluate the possible impact on UK macroeconomic performance of a sustained rise in the value of the pound sterling against the euro and the US dollar. 18. Discuss the Impact of An Increase in Interest Rates 19. Explain What would cause an appreciation in the Euro 20. Discuss how the government might improve the UK s Long term Economic growth 2

3 1. Compare the Effectiveness of Supply side and Fiscal Policies to Correct deficits on a country s current account of the Balance of Payments (30) A Current account deficit means the country imports a greater value of goods and services than it exports. To reduce a current account deficit we need to either increase exports and or reduce imports. Supply side policies aim to increase the productivity of the economy. If the manufacturing sector becomes more productive, the relative cost of British goods will fall and therefore they will become more competitive. This will help increase exports and reduce the current account deficit. For example, the government could increase spending on education and training. Vocational training schemes may help increase labour productivity because workers will have more skills. A more productive workforce can improve the competitiveness of UK Exports. Alternatively, the Government could introduce a free market supply side policy such as reducing the power of trades unions. If unions are powerful, productivity may be lower due to frequent strikes and disruptive working practises such as working to rule. If union power is reduced it helps reduce time lost to strikes, increases labour market flexibility and therefore should help increase UK exports. The problem of supply side policies is that they will take time to have effect. For example, spending on education and training may take several years before the effects are noticed. Also, there is no guarantee that education spending may actually increase labour productivity, especially if the money is misspent or the workers don t want to learn. Also in the UK, trades unions are no longer very powerful, so this policy would only have limited impact. Also, some argue trades unions can actually help introduce new working practises and thereby increase productivity. Current account deficits often occur during times of economic growth and therefore high consumer spending on imports. Fiscal policy can be used to reduce consumer spending and therefore reduce demand for imports. For example, higher income tax would reduce consumer s disposable income and therefore reduce imports. In the UK, consumers have a high marginal propensity to import (people spend a high % of extra income on imports), therefore, a reduction in disposable income would have a big impact in reducing import spending. Deflationary fiscal policy would also reduce inflation and help to make UK goods more competitive. However, the problem with using fiscal policy is that it will conflict with other macroeconomic objectives. Higher taxes will reduce growth and could cause unemployment. Furthermore, unemployment and growth are considered more important than the current account deficit. Also fiscal policy doesn t address the fundamental underlying problem, which is a lack of competitiveness. This needs to be addressed through supply side policies. Deflationary Fiscal policy may be good in a boom when the economy is expanding too fast. However, in the long term supply side policies are best solution to addressing poor competitiveness. 3

4 2. Assess the Economic effects of a significant increase in taxation on the UK economy. (60) An increase in taxation would affect both Aggregate Demand and Aggregate Supply. If tax was increased, but spending remained the same, it is likely that aggregate Demand would fall. For example, an increase in income tax would reduce the disposable income of consumers and cause a fall in aggregate demand and therefore lower growth (Y1 Y2) Price Level LRAS P1 P2 AD2 AD1 Y2 Y1 Y However, it depends on the state of the economy. If the economy was in a boom, growing above the long term trend rate, an increase in taxes would help reduce inflation without causing a recession. Also, the impact of higher taxes may vary due to several factors. For example, if consumer confidence is very high, an increase in taxes might not reduce consumer spending very much because consumers may simply borrow more. If an increase in tax was met by an equivalent increase in government spending then AD may not change. Higher taxes lower AD, but higher government spending compensates for this. Therefore, the impact on growth and inflation would be neutral. The supply side effects of higher taxes are disputed. Some argue that an increase in income tax reduces the incentive for people to work because the take home pay is reduced. However, income tax in the UK, is quite low 22%, therefore a moderate increase may not reduce incentives to work because the income effect (people need to maintain certain income) counters the substitution effect. An increase in VAT or excise duties would not effect incentives to work, but, it could affect demand for goods which are heavily taxed. If indirect taxes (VAT and excise duty) are increased it is likely to reduce income equality. Excise duties tend to be regressive (poor pay a higher % of income). However, if the government increased income tax it may improve the distribution of income. Some argue higher tax and spending could cause a more inefficient economy. This is because it is argued the government is more inefficient at spending money than the private sector. However, others argue the government can overcome market failure such as spending on public transport and education. It depends on what and how the extra tax revenue is spent. Higher taxes will enable a reduction in national debt and therefore lower debt interest payments in the long term. Comment: 3. Evaluate This the question likely is economic quite open Effects ended. of Does a decision higher by tax the mean UK higher to withdraw government from the spending? European What Union. kind of tax is increased? It is easy to get evaluation marks by considering different possibilities. 4

5 3. Evaluate the likely economic Effects of a decision by the UK to withdraw from the European Union. If the UK withdraws from the European Union it will lose both the benefits and costs of being a member of the EU. Firstly it will save the annual cost of membership. Currently this is quite low (around 3billion) therefore, it is not a significant cost. It is equivalent to about 1.5p on the basic rate of income tax. However, the UK will also lose out on EU spending such as on regional policy and the Common agricultural policy. Overall, there is little monetary gain for the UK by leaving. It is argued that the European Union is inefficient in spending its money. For example, despite attempts at reform, the Common agriculture Policy costs a lot of money, most of which goes to subsidising large farms and landlords. The CAP also leads to distorted trade and higher prices of goods within the EU. Arguably, the UK, with it efficient farming system, would benefit by not being part of the CAP. If the UK left the EU, it could lose most of the benefits of being in a single market. The single market has abolished tariff barriers and reduced many non tariff barriers. This free trade zone helps British exports and enables cheaper imports. Since over 60% of UK s trade is with the EU, this is a significant aspect of the UK economy. Leaving the EU, would harm Britain s trade, especially exporters. However, the UK could leave and negotiate a free trade deal like Switzerland does. Also the EU, imposes a common external tariff on many imports from outside the EU, especially in agriculture. If the UK left the EU, it would be free to negotiate free trade with countries outside the EU. This would help developing countries who have their agriculture exports hit by EU tariffs. If the UK left the EU, it would also lose the potential to shape EU policy on issues such as agriculture, competition policy and regional development. Due to increased globalisation, issues such as competition policy are increasingly a European wide issue. Therefore, there are advantages to being a member and negotiating European wide policy. 5

6 4. Both the UK and US balance of payments accounts are recording large deficits on their trade in goods balance. Do such deficits matter? Justify your answer. (40) A deficit on trade in goods mean the countries are importing a greater value of goods than they are exporting. Firstly, a deficit on trade in goods, usually implies a current account deficit. However, if the deficit in goods was offset by a deficit in services, it would be much less of a problem because there wouldn t be a current account deficit. It is argued that a trade deficit is damaging to the economy. Firstly, it indicates a lack of competitiveness in the economy. It means consumers are preferring to buy imports rather than domestic production. Secondly a deficit on the current account means that the country requires a surplus on the financial account (used to be called capital account). This could involve short term capital inflows from abroad which might dry up. E.g. the US has financed a current account deficit by attracting capital inflows from China. This makes the US vulnerable to China withdrawing its dollar holdings. A deficit on the goods account, can cause a depreciation in the currency. This is because more currency is flowing out of the economy than coming in. The US has recently had a current account deficit of over 5%, during this period the US dollar depreciated significantly as the US struggled to finance the deficit. A depreciation in the exchange rate could lead to inflation as imports become more expensive. However, others argue a goods deficit is not a matter of concern. They argue that in a modern economy, capital flows can more easily finance the deficit. For example, Chinese investors have been willing to purchase US securities and effectively finance the US deficit. If there wasn t the capital flows, the currency would devalue and help to reduce the deficit. A devaluation is not necessarily a bad thing. In the US, the depreciation in the dollar helped to boost exports and avoid a recession. However, a depreciation is a bad thing if it causes inflation. A deficit in the goods account may indicate the economy is growing too quickly. Because insufficient domestic goods are being produced people buy from abroad. However, you could also argue a goods deficit is the sign of a strong economy better than having a large surplus but sluggish growth. 6

7 5. Explain how countries benefit from international trade even though they may produce similar goods and services. [10] OCR The law of comparative advantage states that there will be a gain in economic welfare if countries specialise in producing goods with a lower opportunity cost. Even if the difference is quite small, producing goods with a lower opportunity cost enables greater efficiency and scope for trading. Domestic exporters will benefit from greater sales increasing employment in these sectors. Consumers will benefit from a greater choice and lower price of imports. Through specialising in producing certain goods and services there will also be further economic advantages. For example, by specialising in producing a good like cars and aeroplanes, firms will be able to benefit from economies of scale. In industries with high fixed costs, specialisation enables lower average costs and more efficient production. Ultimately, consumers benefit from lower prices. Specialisation can also enable goods to be produced in several different countries. For example, producing cars is not just confined to one country. Tyres may be made in one country and fitted in another with low labour costs. International trade also opens up domestic monopolies to international competition. This increase in competition helps to cut costs and keep prices low. For example, the UK may have one car manufacturers. Without trade it would have a monopoly, but, with international trade, the market is relatively competitive. 6. Discuss the factors that determine the trade competitiveness of the UK economy (15) OCR The trade competitiveness refers to the relative export prices of the UK compared to other countries. The exchange rate plays an important role in determining the short term competitiveness of an economy. For example, an appreciation in the exchange rate makes exports more expensive and therefore less competitive. However, in the long term an exchange rate may appreciate because a country is becoming more competitive and therefore people demand more of the currency. A depreciation in the exchange rate will give a boost to competitiveness because exports will become cheaper. However, a depreciation may reduce incentives for firms to cut costs. Therefore, in the long term inflation may rise and competitiveness declines. This is why often the exchange rate affects competitiveness in the short term. Labour costs play an important role in determining competitiveness, especially in labour intensive manufacturing goods. For example, the past two decades have seen China become the most competitive manufacturer because of low wage goods. However, labour costs are not the only factor to consider. As well as labour costs, it is important to bear in mind labour productivity. For example, some goods require skilled labour, for these goods the education, skills and productivity of the workers is more important than their basic wage. The infrastructure of a country plays an important role. Good transport links and networks help to reduce the cost of exporting goods. For example, a landlocked country is at a significant disadvantage when it comes to exporting goods. Quality of Goods is another factor that determines trade competitiveness. Countries which can add a high value added to goods, will be able to sell more goods. Price is not the only factor in determining sales of exports. 7

8 7. Explain how a decrease in Government Spending can result in a greater change in the equilibrium level of national income (8) OCR Government spending is an injection into the circular flow. It is the multiplier effect which can lead to a greater change in the level of Real GDP. If the government spent an extra 2billion on a road building programme, there would be an increase of AD by 2billion. Workers would receive some of this money in wages, firms selling raw materials would gain additional revenue. Therefore, GDP could increase by 2bn. However, the workers with increased wages, will spend part of their extra income. Therefore, other retailers will benefit because they will sell more goods to the road workers. Therefore, there is an additional increase in National Income. Furthermore, if shops sell more goods to construction workers, they may even take on more staff and spend more money themselves. Therefore, there will be a further round of increases in National income. This is the multiplier effect because the final increase in GDP may be bigger than the initial increase in government spending. Note, the multiplier effect will be bigger if there is a high level of unemployment, taxes are not increased to pay for the government spending, and there is a high marginal propensity to consume (e.g. lower savings rate) 8. A Government is faced with an unacceptably high level of unemployment, but does not wish to increase its overall expenditure. Discuss alternative Policies for reducing unemployment. [12] OCR If the unemployment is caused by an economic downturn (low or negative economics growth), the government should pursue demand side policies to try and increase aggregate demand. The government could cut income tax. This would boost consumers disposable incomes and hopefully boost consumer spending. The increase in aggregate demand will lead to higher economic growth and therefore firms will need to employ more workers. This policy will be effective for reducing demand deficient unemployment without causing higher spending. Price Level LRAS P2 P AD2 AD1 Y1 Y2 Y Expansionary fiscal policy increases AD leading to higher Real GDP. As output increases firms demand more workers. However, tax cuts may not always work. In a recession confidence may be low, so tax cuts may be saved rather than spent. Also, it is possible that tax cuts could cause crowding out. To 8

9 pay for the tax cuts the government has to borrow from the private sector by selling bonds. This may reduce private sector investment and cancel the gain in aggregate demand. Also expansionary fiscal policy will not solve unemployment if it is due to supply side factors. The government could also cut interest rates because lower rates should also boost Aggregate demand but, monetary policy is often controlled by Central banks these days. Unemployment could be voluntary, e.g. high unemployment benefits create an incentive to remain unemployed rather than get a job. If this is the case, the government could cut benefits and make it harder to claim them. Also to increase the incentive to take a job, the government could increase the national minimum wage. A higher wage increases the gap between benefits and work so might reduce voluntary unemployment. However, in the UK, benefits are already quite low compared to the national minimum wage therefore a cut in benefits may not solve the problem. However, it might be useful for a country like Germany with generous unemployment benefits. If unemployment is caused by real wage unemployment (wages kept above equilibrium levels), the solution is to reduce the power of trades unions and minimum wages. These policies enable wages to fall to their equilibrium levels and increase demand for labour. however, in UK, trades unions have little power to keep wages above equilibrium levels. Finally, the government could consider tax credits to firms who train workers. Better education and training are a way to boost labour productivity and help overcome structural unemployment. Tax breaks for firms who train workers are a way to encourage training without spending money. However, there is a worry firms may misuse the tax breaks for their own ends..also there is no guarantee that subsidies on training will actually increase the productivity of labour and reduce structural unemployment. For example, workers may be unreceptive to training schemes. 9. Explain the likely economic reasons for Government Borrowing. (20) AQA Government borrowing occurs when spending is greater than tax revenue so they have to make up the shortfall by borrowing from the private sector (Govt sell bonds through the Bank of England) The first reason is to finance investment in the country s infrastructure. For example, increased spending on roads and transport could help increase the efficiency of industry, leading to higher rates of economic growth in the future. Therefore, the investment would lead to higher tax revenue in the future. Therefore, borrowing can be justified to finance the investment. Government borrowing is likely to occur during an economic downturn or recession. In a recession, there is negative economic growth. This leads to lower tax revenues. Firstly, people earn less so income tax falls. Secondly, firms make less profit so corporation tax falls. Thirdly, people spend less so VAT revenue declines. Furthermore, in a recession, unemployment rises so the government will face higher spending on unemployment benefits. Also in a recession, economists advise pursuing expansionary fiscal policy, e.g. cutting taxes rates and / or increasing government spending. This should help increase AD. Therefore, a recession can cause a rapid increase in government borrowing. Demographic changes can also lead to higher government borrowing. An ageing population tends to need more government spending but pays less in tax. Retired people earn little so income tax is low. However, they are entitled to a state pension. Also, old people are more likely to need expensive health care treatment. Therefore, if the average age increases, 9

10 government borrowing will increase - even if tax rates and government spending stay the same. A final reason may be because the government is bailing out the financial sector. E.g. banks like Northern Rock needing to be nationalised. 10. Evaluate the possible Problems for the UK economy of increased government borrowing. (30) AQA Higher government borrowing represents expansionary fiscal policy (government spending is higher than tax revenue.) In a period of high growth, expansionary fiscal policy may exacerbate the problem of inflation. However, if the economy is in a recession, expansionary fiscal policy could help the economy recover. Also if inflation does become a problem the Central Bank could increase interest rates. Higher borrowing may lead to crowding out. Firstly if the government has to borrow more, it may put upward pressure on interest rates as rates on bonds need to rise to attract sufficient lenders. If interest rates are forced upwards because of high borrowing, this will reduce consumer spending and investment and curtail economic development. This is known as financial crowding out. There could also be resource crowding out. This will occur because the government has to borrow from the private sector. If banks and individual buy bonds and lend money to the government, they may have less to invest in private sector schemes. Therefore, government borrowing doesn t increase Aggregate demand, but, just switches resources from the private sector to the (often more inefficient) public sector. However, Keynesians argue that in a recession, crowding out is unlikely to occur. This is because resources are idle. Therefore, if the government borrows, it does not reduce private investment. Furthermore, government borrowing can cause a multiplier effect to cause a bigger final increase in GDP. It is argued that the government sector is more inefficient than the private sector. This is because of a lack of incentives for people in the private sector. Therefore, government borrowing is not good because it switches resources from efficient private sector to less efficient public sector. However, the government spending may be to overcome market failure such as transport and health care. Higher borrowing presents a burden on future tax payers. Future tax payers will have to pay the debt and the interest payments on the debt. In the UK, debt interest payments are already over 30billion a year. A crucial issue is whether government borrowing rises faster than economic growth. If it does, national debt as % of GDP will increase making it harder to pay back in the future. Higher borrowing makes it difficult to finance expansionary fiscal policy in the time of a recession. For example, the government increase borrowing during economic growth of When the economy entered recession in 2008, it had little room for expansionary fiscal policy because borrowing was already quite high. 10

11 11. Explain possible causes of Economic Growth. (20) AQA Economic growth means an increase in Real GDP. It requires an increase in AD and or an increase in AS. In the short term, economic growth may be caused by an increase in Aggregate Demand. Diagram increase in AD Price Level LRAS P2 P AD2 AD1 Y1 Y2 Y For example, rising house prices would give most households an increase in wealth. This would increase their confidence to spend; it would also enable them to remortgage to gain equity withdrawal. This would cause a rise in consumer spending and therefore aggregate Demand. Alternatively, aggregate demand could rise due to higher global economic growth. Higher global growth would cause a rise in demand for UK exports, therefore increasing AD. A third factor that may increase economic growth could be a change in monetary or fiscal policy. For example, a cut in interest rates is likely to stimulate consumer spending and investment because of the lower borrowing costs and less incentive to save; this would cause economic growth. As well as demand side factors, it is also important to look at supply side factors. Long term economic growth requires an increase in the productive capacity of the economy and an increase in long run aggregate supply. For example, an increase in the population, due to immigration, would increase the labour force and increase aggregate supply. Also better education and training would help to increase labour productivity, enabling faster rates of low inflationary growth. P L LRAS LRAS 2 P1 AD Y1 Y2 Y 11

12 The above diagram shows economic growth in the long run. The rate of growth in the long run depends on the growth of AS how much productive capacity increases. Technology also plays an important role, improvements in technology are one of the best ways to increase AS and productivity. Countries like Japan and China have often had economic growth driven by export led growth. Their competitiveness in manufacturing has enabled them to export to the West and this has been an important factor in there growth rates. In the period , growth rates in the UK and US, were mainly caused by rising domestic demand often funded by low savings ratios, high borrowing and rising house prices. 12. Evaluate the potential impact on the economic growth of the UK economy if it were to adopt the single European currency. (30) If the UK joined the single currency, there could be some factors which help boost economic growth. Firstly, a single currency lowers transaction costs of trade and therefore, helps exports. Since exports to the EU account for 60% of the UK s trade it is important. However, transaction costs for trade between the UK and the EU are already low. Therefore, a single currency would only have a relatively modest impact on increasing exports and therefore growth. A bigger benefit could be the stability in exchange rates. At the moment, UK exporters could suffer from rapid appreciations in the exchange rate against the Euro. If we join the Euro, this will not occur. Therefore, this gives us greater stability and might encourage investment. However, firms already hedge (insure) against exchange rate volatility so the impact is not going to be huge. If the UK adopts a single currency it might encourage foreign direct investment from Japanese firms looking to invest in the Euro area. Investment would boost both aggregate demand and aggregate supply. Economic growth could be influenced to a greater extent by the impact of the single monetary policy. This means, if we join, UK interest rates would be set by the ECB. The concern is that EURO interest rates may be unsuitable for the UK economy. For example, if the UK economy entered a recession, but the rest of the Euro zone was still growing; interest rates are likely to be too high. If this is the case, UK growth could suffer. Higher interest rates would cause lower spending and investment and make the recession worse. Furthermore, because of the nature of the UK housing market (many people have large variable mortgage), higher interest rates would have a big effect on reducing growth rates. On the other hand, if the UK economy was growing and inflation in Europe was low. Interest rates may be kept low. This would cause the UK economy to expand more quickly, at least in the short run, and cause problems such as inflation and a housing boom. However, if the UK economy harmonises with the EU economic cycle, then a common monetary policy may not be such a problem, and UK economic growth would not be affected very much. 12

13 13. Evaluate the possible impact of the expansion in the EU on UK economic performance (30) AQA The EU has expanded to include several former eastern European countries such as Poland and Slovakia. This has increased the size of the European Union and potentially increases the economic benefits which accrue from EU membership. The EU has zero tariff among member states. Also many non-tariff barriers have been removed; the EU aims to be a single market. Therefore, trade between the UK and Poland should be easier. This is good for UK exporters and also reduces the cost of imports from the new countries. However, the new economies that have joined are relatively small in size. This means the gains from greater trade is fairly limited and will not affect the economy significantly. However, if the new countries continue to expand and develop, the export market could have more potential in the future. Another aspect of the EU is the free movement of labour and capital. This could have both benefits and costs for the UK economy. Because the UK has higher wages than many of the new members, there has been an influx of migrant workers coming to the UK. This influx of immigrants has had certain economic benefits. They have filled in job vacancies such as plumbers and teachers. They have helped increase economic growth. Since most immigrants tend to be of working age, it has helped to combat the demographic problems of an ageing population. (Young migrants generally pay more tax than they receive in benefits). However, the influx of migrants also creates problems. There is increased pressure on housing, transport and social services, especially in London and the South east where housing shortages are most acute. The EU acts like a single market and therefore, there is increased competitiveness between member states. New members with lower wages may increase the incentive for UK firms to cut costs and remain efficient. However, this factor is likely to be still small. Cost of Expansion. The new member countries are relatively poorer than the UK, therefore, there is likely to be a net flow of money from the UK to these poorer countries. However, since the cost of the EU is relatively small, ( 3.9 billion 2006), the impact on overall GDP will be marginal at best. 14. Explain how a fall in the rate of inflation might be achieved by both demand-side and supply-side Policies. (20) The first demand side policy could be monetary policy, which involves the Central Bank changing interest rates. If the Bank of England wished to reduce the inflation rate they could increase base rates (this would push up most of the different interest rates in the economy). Higher interest rates would make borrowing more expensive and reduce the incentive to save. With higher borrowing costs, firms and consumers would spend and invest less, leading to lower consumer spending and investment. Householders with variable mortgages would see an increase in mortgage interest payments and this would cause lower consumer spending. 13

14 P L Price Level LRAS P1 P2 AD1 Lower AD has caused a fall in inflation, but, at the expense of lower growth. Y2 Y1 AD2 Y Alternatively, deflationary fiscal policy could be used. For example, an increase in the rate of income tax reduces consumer spending and reduces aggregate demand. Supply side policies could also reduce inflation. For example, a policy of privatisation and deregulation may enable greater competition and incentives to cut costs. This could lead to lower prices for consumers and therefore lower inflation. To some extent, this was achieved after electricity privatisation in the UK, although the price cuts have recently been reversed. If wage inflation is a problem, reforming labour markets to increase labour market flexibility could be a solution. For example, reducing power of trades unions could reduce wage price spirals and therefore, keep inflation lower. Supply side policies may also help shift AS to the right, leading to lower inflation P L LRAS 1 LRAS 2 P2 P1 AD2 Y2 Y1 Y 14

15 15. Explain how exchange rates are determined in a floating exchange rate system (20 marks) Exchange rates are determined by basic supply and demand for the currency. For example, the value of the pound would increase if there was increased demand for pound sterling on the foreign exchange market. If UK interest rates increased compared to other countries, it would become more attractive to save in British Banks. This would cause international investors to move money to British banks and investment trusts. This hot money flows would increase demand for sterling and push up its value. When economic growth is high, currencies tend to appreciate. This is because higher growth rates tend to be compatible with higher interest rates. Another factor that affects the currency is long term competitiveness. If inflation in the UK, is lower than elsewhere then British goods become relatively more attractive increasing demand for British goods and decreasing supply of Sterling as British consumers buy less imports. Sometimes exchange rates move because of speculative demand. For example, if investors expected the pound to rise in the future because of stronger growth, people would buy now to try and make a profit. Therefore, changes in the exchange rate are not always a direct reflection of market fundamentals, but reflect the opinions of investors. 16. Evaluate the possible impact on UK macroeconomic performance of a sustained rise in the value of the pound sterling against the euro and the US dollar. (30) A rise in the value of the pound against our two main trading partners would be important because they account for over 75% of the total UK trade. A higher value of the pound would make UK exports more expensive, therefore, there would be a fall in the quantity demand for exports. Similarly imports would become cheaper, encouraging UK consumers to buy more imports and travel to EU / US. If demand is elastic. If the Marshall lerner condition is satisfied (PED x + PED m > 1) then the appreciation will cause a fall in X-M. Therefore, an appreciation will cause a fall in aggregate demand or cause the growth of AD to slow down. Price Level LRAS P1 P2 AD1 Y2 Y1 AD2 Y 15

16 Slower growth of AD will lead to lower economic growth, Higher unemployment and lower inflation. This diagram assumes a fall in AD, (even if in practical terms a slower growth in AD is more likely) It shows how a rise in the value of the pound causes lower economic growth A rise in the value of the pound will help to reduce inflation for three reasons. Firstly, lower aggregate demand, secondly the price of imports will be lower (e.g. TVs imported from abroad). Imports make up about 40% of the CPI, so are quite important. Thirdly a higher value of the pound may encourage firms to try and cut costs and be more efficient in order to remain competitive. If this occurs, then the UK may not lose out in the long run, but, gain from increased productivity. However, there is no guarantee that a higher pound will force increased efficiency. The impact on the current account again depends on the Marshall Lerner condition and the elasticities of demand. If demand for exports and imports is elastic then the current account deficit is likely to deteriorate. A key question is the elasticity of demand for UK exports. Arguably, demand for exports has become more inelastic over past few decades. The J Curve effect suggests demand can become more elastic over time. In other words, initially demand is inelastic and current account may improve. But, after time to adjust to the higher value, the current account deteriorates as demand becomes more elastic. The impact of a higher value of pound also depends on what else is happening in the economy. For example, if the economy is also experiencing higher interest rates and falling house prices then consumer spending is likely to be falling. In this situation a fall in X-M could push the economy into recession. However, if the rest of the economy is booming a rise in the value of the pound could be helpful in reducing inflationary growth. 17. Evaluate the possible consequences of a falling rate of inflation for the performance of the UK economy. (30) A falling rate of inflation can have various benefits for the UK economy. A lower inflation rate creates greater stability and confidence. It encourages firms to undertake investment. This investment will help boost the long term potential of the UK economy. A lower inflation rate will help make UK exports more competitive. This will boost exports and help reduce the current account deficit. Lower inflation is desirable because it avoids menu costs (costs of changing price lists) and also prevents redistribution of income from savers to borrowers. For these reasons the government have an inflation target of 2% +/-1. For example, an inflation rate of 8% would be seen as undesirable because it would create instability and discourage long term investment. A high inflation rate would also require high interest rates; these high interest rates would reduce investment further. Therefore, lower inflation would avoid these problems. However, it depends why inflation is falling. If inflation is falling because of weak consumer demand then there will be lower economic growth and the possibility of recession. If consumer spending falls too much then the economy may go into recession, with higher rates of unemployment. 16

17 If the inflation rate fell too much and became deflation, then the economy may really begin to stagnate. As prices are falling, people are reluctant to spend. (e.g. Japan in 1990s) This is why the government have an inflation target of 2%. They don t want interest rates to be too high and low inflation to be at the expense of low growth. However, some argue, if inflation is high, then it is necessary to reduce it, even if it means the short term pain of lower economic growth. However, if inflation is falling because of improved productivity and higher economic growth, this would be very desirable, because it would lead to improved economic growth. Lower costs and higher productivity will help increase the long run trend rate of growth and create new job opportunities. It is good to reduce inflation, so long as it doesn t conflict with negative growth. Ideally inflation will fall due to increased productivity rather than a fall in AD. Lower Inflation because of Increased Productivity. P L LRAS 1 LRAS 2 P2 P1 AD2 Y2 Y1 Y 18. Discuss the Impact of An Increase in Interest Rates (30) An increase in interest rates will impact on all the main macroeconomic objectives of the government inflation, economic growth, balance of payments and unemployment. An increase in interest rates makes borrowing more expensive, therefore it will deter firms and consumers from borrowing and therefore this will lead to lower spending and investment. Saving will be more attractive because you gain a higher rate of return on savings. Also people with variable mortgages will have higher mortgage interest payments. Therefore, this will leave them with lower disposable income. The combination of higher borrowing costs, more saving and lower disposable income will lead to a fall (or slower growth) in consumer spending and investment. Therefore, AD will fall (or increase at a slower rate). This will lead to lower economic growth and inflation. 17

18 Price Level P3 LRAS P4 P1 P2 AD3 AD4 Y2 AD2 Y1 AD1 Y If there is a fall in economic growth, we would expect the inflation rate to fall, and unemployment to increase. Also, an increase in interest rates would cause an appreciation in the exchange rate. This is because with higher interest rates, it becomes more attractive to save money in the UK, increasing demand for Sterling. The appreciation in the exchange rate would make exports more expensive leading to a further fall in AD and also lower inflation. The impact on the balance of payment is mixed. Higher interest rates will reduce consumer spending on imports, this will improve the current account. However, on the other hand, the appreciation in the exchange rate tends to worse the current account because exports are more expensive. In practice, the negative impact on import spending tends to outweigh the exchange rate effect. The impact of higher interest rates depends on a few factors. For example, if the government increased interest rates during a boom and high consumer confidence, there may be little decrease in consumer spending. However, if house prices were falling and confidence was low, even a small increase in interest rates would have a drastic effect on reducing consumer spending. If there was a fall in consumer spending, the impact would depend on the state of the economy. If the economy was in recession, higher interest rates would lead to a big rise in unemployment. However, if the economy was in a boom, higher rates may just reduce inflation but not cause lower growth. In the above diagram an increase in interest rates at AD3 would reduce inflation but not cause lower growth. However, reducing AD from AD1 to AD2 does cause a fall in real GDP. Finally, some people may benefit from a rise in interest rates. Savers would get more income from their savings and therefore, there disposable income would rise. However, these days the savings ratio is low and borrowers tend to outnumber savers. 18

19 19. Explain What would cause an appreciation in the Euro (20) An appreciation in the Euro, means the Euro increases in value compared to other currencies. There would be an appreciation in the Euro if there was higher demand for the Euro. Demand for the Euro would increase if European interest rates increased compared to other countries. This would make the EURO a better place to save money because the rate of return is higher. This is known as hot money flows and is an important factor in influencing exchange rates. Another factor is the relative competitiveness of the Euro. If euro exports become more competitive, lower inflation, better products then demand for the Euro would increase, causing an appreciation in the exchange rate. Another factor is the Euro could become the world s preferred reserve currency. If speculators lost confidence in the dollar, they may buy Euros and decide to keep foreign currency reserves in Euros rather than dollars. This would help increase the value of the Euro. Strong economic growth would help increase the value of the Euro, as stronger growth would encourage the ECB to increase interest rates and therefore, encourage hot money flows. A reduction in the current account deficit would help lead to an appreciation in the value of the Euro. It means that less foreign currency is flowing out of the euro zone than flowing in. 20. Discuss how the government might improve the UK s Long term Economic growth [15] Long term economic growth primarily depends on growth in Aggregate supply. Therefore, the government should focus on policies to improve productivity growth and help increase AS. The government could try to increase incentives to work and incentives for people to join the labour force. For example, the government could make it harder to claim unemployment, sickness and disability benefits. They could reduce benefits and make receiving benefits more rigorous. This could be controversial because it will lead to increased relative poverty. Also, there is a danger genuinely sick people will be left with no income because they don t qualify for benefits and can t work. Another strategy may be to make work more attractive. For example, higher minimum wages, better protection for part time workers, better childcare provision. This may encourage women into the labour market and increase labour productivity. However, childcare would be expensive and may not justify the small increases in labour supply. Also higher minimum wages and protection for workers could increase costs for business and actually damage growth prospects. The government could try to make markets more competitive. For example, they could privatise industries such as London Underground. Privatisation should increase the incentives for firms to be more efficient. However, there is a danger the government merely creates private monopolies who don t actually reduce prices and help the economy. A third policy could be to try and enhance the skills of workers. The government could try and increased educational standards, especially focusing on vocational training, relevant to the modern labour market. If successful, this would increase labour market flexibility and labour productivity helping to increase the competitiveness of the economy. 19

20 However, these policies would be quite expensive and there is no guarantee spending more money actually increases the skills of workers. Workers may be reluctant to undergo training schemes. Finally, to improve long term growth it is also important to think of the demand side of the economy. If the economy is prone to boom and busts, it will harm the long term economic growth, because resources will be misused. Instead, the government should aim at stable growth. For example, they could make the Central Bank independent to set interest rates. They could also try and use fiscal policy to fine tune the economy. The UK government could try to reform the housing market to make it less prone to boom and bust. However, this is quite difficult to achieve. 20

21 General Tips for Macro Economic Essays Don t forget the main macro economic objectives Economic growth Inflation Unemployment Balance of Payments Exchange Rates Government borrowing. For example, if a question asks the effects of higher interest rates, consider how interest rates will affect all of these. Do Draw AD/AS diagrams where appropriate. Evaluation This is worth 40% of most essays. It involves looking at essays with critical distance. These are questions which begin with: Discuss.. Evaluate To what extent.. Assess.. Macro Evaluation Evaluation for macro economic essays can include: Time Lags. E.g. the effect of an increase in interest rates can take upto 18 months to have an effect. Depends on Other variables. e.g an increase in interest rates may cause lower consumer spending. However, if house prices are rising, consumer spending may not fall. Depends on position of the economy. The effect of higher rates will be different if economy is in boom compared to if it is close to recession. Side Effects. Higher taxes may reduce consumer spending. But, as an unintended side effect may cause lower incentives to work as well. Monetarist vs Keynesian. A monetarist may say expansionary fiscal policy will not increase Real GDP, but, A Keynesian will say it is quite possible. Conflicts of objectives. Higher interest rates may reduce inflation but, cause stronger exchange rate and unemployment 21