REVISED GCE AS & A Level Student Guidance Economics. Course Companion. Unit AS 2: The National Economy. For first teaching from September 2008

Transcription

1 REVISED GCE AS & A Level Student Guidance Economics Course Companion Unit AS 2: The National Economy For first teaching from September 2008 For first award of AS Level in Summer 2009 For first award of A Level in Summer 2010

2 GCE AS Economics Course Companion For first teaching September

3 Unit AS 2: The National Economy What is this unit about? In this unit you will be learning about how the macro-economy works. Macroeconomics is the study of the national economy as a whole, rather than its individual parts. Beginning with a simplified model of how an economy works, you will learn how the government and other public bodies like the Bank of England monitor economic performance, and ways in which they seek to influence it. You will build on the model of the economy by studying how aggregate demand and aggregate supply interact. On completion of the unit, you should understand what policies governments may use to achieve certain economic objectives, how they are meant to work and why they sometimes fail. You will investigate issues which form the basis of news reports about the economy and learn, among other things: how inflation damages an economy; why it may be difficult to avoid some level of unemployment; how periods of increasing prosperity, though normally considered a sign of economic success, may also have some less desirable consequences; and how events in other parts of the world may affect the national economy. The focus is mainly on the economy of the United Kingdom, although in data response questions you may be given familiar types of information about other economies and asked to interpret it. 2

4 What are the main topics I need to study? The exact number and sequence of topics you will study in this unit will depend on how your teacher decides to organise the course. However the content is organised, you should always try and relate the concepts and theories you study to real world events and trends. It is likely that this unit will follow a structure similar to the one below: 1 National Income and the Circular Flow model You will learn how wealth and income differ, how income is calculated and what influences it. Wealth is a stock. A nation s wealth is its real assets, which may decline or grow over time in value or quality. Income is a flow. It is new welfare being created as a result of factors of production being put to work. Ideas and concepts you will be dealing with include: Sectors in the circular flow model: households, firms, government and other economies. Leakages from, and injections into, the circular flow. Components of expenditure: consumption, investment, government expenditure, net exports. The link between the flows in this model and national income accounting. Gross Domestic Product/Gross Domestic Income. Gross National Product. Net income from abroad. Capital consumption/depreciation. Net National Product. Real and nominal values of some of these measures. Limitations of national income statistics as comparative measures of welfare, including differences in population, social and working conditions, composition and distribution of GDP, or distortions due to different customs, definitions of productive activity or relative purchasing power of currencies. Alternative measures of welfare, such as the ISEW, UKMDP and UNDPHDI. 3

5 2 Economic problems, indicators and objectives This section should clarify the economic issues that make headlines in the news because they have such a direct effect on people s economic welfare. You will also learn that, whatever governing parties promise, it is often very difficult - or impossible - for those managing an economy to meet all their targets at once. Topics you will be investigating include: Inflation - the sustained fall in the value of money. Causes of inflation: demand-pull, cost-push and monetarist explanations. Adverse consequences of inflation, including the arbitrary redistribution of incomes, uncertainty and disincentive to investment and decline in international competitiveness. The measurement of inflation: the Consumer Prices Index (CPI) and Retail Prices Index (RPI). You may be asked to make calculations based on index numbers or on the concept of weighting or to explain why official agencies may prefer different measures in different circumstances. The possibility of deflation. Unemployment, including awareness that this is a problem with social implications. The concept of a natural or non-accelerating-inflation rate of unemployment. Types (categories or causes) of unemployment. The Claimant Count and International Labour Organisation approaches to measuring unemployment. The difference between economic inactivity and unemployment. Economic growth and its implications for material well-being, the environment, international payments and government finances. Factors which cause growth. The balance of international payments. At AS level, the main focus is on the negative consequences of trade imbalances. It is also important to consider the impact of changes in global demand or supply on a national economy. A detailed understanding of the structure of the UK balance of payments is not required at this stage. Pressures on governments to consider other objectives such as redistribution of income or protection of the environment. How pursuing one or more objectives may make others difficult to achieve. Why governments and economic agencies are interested in forecasting economic trends and why this is often difficult in practice. Priorities in economic objectives and why these vary over time and between political parties. 4

6 3 Aggregate demand, aggregate supply and macroeconomic equilibrium The theory of aggregate demand and aggregate supply is the basis for the formulation of economic policy in the United Kingdom and most other developed market-oriented economies. It seeks to explain the forces that determine the level of national income, and the likely effects of various changes within an economy, external events and policies. Key areas for understanding include: The aggregate demand (AD) curve showing planned national expenditure over a range of real prices. Shifts in the AD curve which can be brought about as a result of changes in expectations, fiscal policy, monetary policy, exchange rates or relative productivity in countries with which the nation trades. The aggregate supply (AS) curve showing planned national output over a range of real prices. The distinction between the short- and long-run AS curves. Factors causing shifts in the AS curve, including changes in costs of production, taxes and subsidies in the short-run and changes in the quantity or quality of factors of production or the efficiency with which existing resources are used in the long-run.. The relationship between the long-run AS curve and the natural rate of unemployment. The interaction of AD and AS to determine equilibrium levels of income, output and prices. The possibility of output gaps. 5

7 4 Economic policy and its effectiveness Here you will investigate how governments try to achieve their macroeconomic objectives and how success may be measured. In detail, this study area involves: Types of macroeconomic policy: fiscal, monetary and supply-side policies. Fiscal policy: adjustments to levels of government expenditure and taxation. Differences between current and capital government expenditure. The potential consequences of imposing various forms of taxation, for example, the effects on government revenues, consumption patterns and the possibility of disincentive effects. The possible automatic stabilising influence of fiscal policy on an economy. The effects of fiscal policy on levels of AD or AS. The comparative effects and effectiveness of automatic and discretionary fiscal policy. Monetary policy: interventions to affect the cost and/or availability of credit in the economy. How rises in interest rates increase the cost of credit and cause a fall in AD, and vice versa. The role of the Monetary Policy Committee of the Bank of England in combating inflation. Supply-side policies: a range of measures to stimulate the supply of goods and services in the economy including reducing the government s involvement in the economy, helping to create an enterprise culture, increasing the mobility of factors of production, increasing incentives to effort and enterprise, and the reduction of the power of monopolies in product and factor markets. The need for different policy instruments to address different aspects of a single macroeconomic problem. The possible consequences, including the social and political implications, of government failure to select or apply appropriate macroeconomic policies. The external constraints on the operation of certain policies, including international obligations or free movement internationally of goods and resources. Goodhart s law (that the chief or sole result of setting targets for improvement in an economic indicator is a reduction in its effectiveness as an indicator). The likely consequences in different economic conditions of polices aimed at influencing either AD or AS. The comparative effects of different policy instruments, including possible undesirable short- and long-term side effects. The potential pros and cons of the government relying on one type of policy for macroeconomic management. 6

8 How will I be assessed? As with Unit AS 1, assessment for this unit consists of a 1hour 30 minutes examination which you will sit either in January or in June. The examination will consist of two sections: a data response section and an essay section, each of which will carry 40 marks (50% of the total marks for the paper). As the marks for each section are equal, you should try to spend roughly 45 minutes on each question. Data response In the data response section, you will be asked a number of questions (normally 5 or 6) which relate to a piece of source material. The source material will contain written material and possibly charts, tables or graphs. It may require you to apply concepts and theories you have studied in a context slightly new to you. Some of the questions in this part of the paper will require short answers of a few lines while others will require you to write at greater length. Some of the questions may require you to analyse and interpret written, numerical, diagrammatic and graphical data. You may also be required to make calculations such as percentages, percentage changes and may be asked to calculate and interpret index numbers. The final question will normally require you to demonstrate your ability to evaluate. Essay In the essay section you will be required to answer one structured essay from a choice of three. Each essay will be broken down into three parts: Part (a) will normally test knowledge and understanding and will carry 10 marks. Part (b) will assess application and analysis and will carry 15 marks. Part (c) which is also worth 15 marks will have a particular emphasis on evaluation and judgement. Quality of written communication The assessment of essay and data response questions which require you to write extended answers takes into account the quality of your written communication. This does not mean that you have to write elegant phrases with long words to earn high marks. However it does mean that you should take care with your spelling, punctuation and grammar and that you should use economic vocabulary accurately. You should try to express your ideas clearly and concisely and present your arguments logically and coherently. You should always write in sentences and paragraphs and avoid lists of bullet points unless you are short of time to complete a question. Diagrams can be a valuable feature of many answers, helping to clearly illustrate the points you are making. 7

9 What areas cause students particular problems? Alternative measures of economic welfare Students are often able to criticise GDP as indicator of economic welfare but are less sure about what is involved in alternative measures. There are criteria other than GDP which some organisations feel should be included in assessing quality of life and its sustainability. These include: recognising that wealth as well as current income contributes to welfare. For example, if we have a fridge or a washing machine we bought last year which is still working, we continue to enjoy the benefits of it, even though it s only the electricity used to power it that s counted in this year s production; putting a value on unpaid activities omitted in conventional national income accounting such as voluntary work or a family member caring for an elderly relative; non-material factors - it is almost impossible to come up with a universally acceptable system for valuing some of these, such as civic pride, but education, medical care and other services may be worth more than their basic cost; making some allowance for depletion of irreplaceable resources and/or damage to the environment; some negative valuation for unpleasant aspects of people s lives, such as congestion leading to very long journeys for commuters; and making an allowance for social changes which affect the quality of life such as high levels of crime or a deterioration in personal relationships. The Index of Sustainable Economic Welfare (ISEW) modifies national consumption statistics to make allowance for income inequalities and then amends that figure by allowing for the first five of the factors listed above. Another proposed estimate is the United Kingdom Measure of Domestic Progress (UKMDP). It builds on the ISEW. Its compilers try to allow for all the factors listed above. The United Nations Development Programme Human Development Index (UNDPHDI) was designed to facilitate comparisons with less developed countries, but there is a version which attempts to make allowance for the effects of social exclusion on disadvantaged groups in richer nations. The basic components of the HDI are: the length of healthy life an average citizen may expect; the quality of education available to the average citizen; and the average real income per head in comparison to an international average. 8

10 Aggregate demand and aggregate supply This is the topic which seems to cause most difficulty for candidates at AS level. This may be because they do not make the connection between this topic and what they learnt earlier in the unit about the circular flow of income and national accounting. injections FIRMS GOODS and SERVICES INCOMES SPENDING leakages FACTOR INPUTS: Land, Labour, Capital, Enterprise HOUSEHOLDS SAVINGS INVESTMENT TAXES IMPORTS BANKING SYSTEM GOVERNMENT REST OF THE WORLD GOVERNMENT SPENDING EXPORTS The importance of the circular flow model is that it shows that it is possible to define the value of all the work done in the economy in three different ways. As, in theory, the accounting procedures of calculating national output (of goods and services), income (of providers of labour, land, capital and enterprise) and expenditure (on goods and services) are three different approaches to measuring the same thing, these elements are identical. They have the same value, not just by coincidence but because they all represent the value of the work that has gone on and the wealth created in an economy in a year. Therefore, in theory, Output = Income = Expenditure. This means that when we draw aggregate demand and supply curves and plot real output on the horizontal axis, this is the same as plotting real expenditure and real income. 9

11 Many students don t seem to appreciate what aggregate demand really measures. Aggregate demand is the total amount of real Gross Domestic Product that people, businesses and government plan to buy at any given level of prices. It is not only ordinary consumers in households who buy the goods and services produced in the UK economy. These consumers/providers of resources may not spend all the money they earn from their contributions to production. Some income may leak out of the flow of income illustrated in the diagram as savings, tax or spending on products of foreign economies. However, firms may want to borrow money that has been saved for creation of new capital resources, the government will use tax revenues to pay for X-ray machines for the NHS or school buildings and citizens of other countries will inject spending into the UK economy to pay for the exports of UK producers. Aggregate demand is therefore the total spending by households (on consumption), firms (on investment in capital goods) and governments (on goods and services) plus net export earnings. Aggregate demand = Real GDP demanded = C + I + G + (X-M) Why does the aggregate demand curve slope downwards from left to right? This is because the level of real prices affects the level of planned spending. As the real price level rises, people have less real income and are not able to afford as many domestically produced goods and services. As the prices of domestically produced goods and services rise, other things being equal, foreign produced goods and services become relatively more attractive and the level of imports will rise and the level of exports will fall. If prices rise, the value of money falls. This means that there is an increase in the demand for money by people and firms to pay for any given level of goods and services. As some of this expenditure is financed by borrowing, an increased demand for borrowed funds tends to cause a rise in interest rates. When interest rates rise, saving becomes relatively more attractive and financing consumption or investment through borrowing becomes more expensive and less attractive. 10

12 Price level P1 P2 AD Y1 Y2 Real output A change in the price level therefore causes a movement along the aggregate demand curve. A fall in the price level leads to a rise in aggregate demand and vice-versa. Aggregate demand can also change due to factors other than the price level. What factors may cause a shift in the aggregate demand curve? Any factor which causes any of the components of aggregate demand to increase or decrease independently of the price level will cause a shift of the aggregate demand curve. Any such factor which causes aggregate demand to increase will shift the aggregate demand curve to the right showing that more output will be demanded at any given price level; any factor which causes aggregate demand to decrease will cause the curve to shift to the left showing that less output will be demanded at any given price level. Changes in consumer and business confidence can affect the level of aggregate demand. If consumers and businesses expect incomes, spending and profits to rise in the future, then they are more likely to increase consumption and investment spending. Conversely, a fall in confidence will tend to lead to a decrease in aggregate demand. Wealth effects. Consumer expenditure tends to be influenced by the value of their stock of assets such as property and shares. If share and house prices are rising, this can encourage consumers to increase spending as they feel wealthier. A fall in house and share prices has the opposite effect and may reduce aggregate demand. Inflationary expectations. If consumers expect prices of goods and services to rise in the future, they may be encouraged to increase spending in the short-run to avoid price rises later. 11

13 A change in interest rates will affect the cost of borrowing and influence consumer and business expenditure. If interest rates rise, this increases the cost of borrowing and consumers and firms will be discouraged from borrowing to finance consumption and investment. A fall in interest rates reduces the cost of credit and encourages consumption and investment expenditure. Government fiscal policy may also affect aggregate demand. An increase in government spending on goods and services or a reduction in taxation will, other things being equal, lead to an increase in aggregate demand. On the other hand, a decrease in aggregate demand can be caused by a fall in government expenditure or an increase in taxation. International trade. In an open economy such as the UK, aggregate demand can be heavily influenced by changes in the level of imports and exports. A fall in the exchange rate or an increase in incomes in other countries may therefore increase UK exports and reduce imports thus raising aggregate demand. Conversely, a rise in the exchange rate or a fall in incomes abroad may worsen the UK s trading position and reduce aggregate demand. Price level P1 AD2 AD1 Y1 Y2 Real output Aggregate supply Aggregate supply is the total amount of goods and services or real GDP that producers in the economy are prepared to supply at any given price level. In the short-run, the aggregate supply curve shows total planned output at various price levels assuming that the prices and productivity of factors of production, for example, wage rates and the state of technology are constant. The short-run aggregate supply curve (SRAS) is assumed to be upward sloping from left to right as firms throughout the economy are prepared to supply greater outputs at higher prices because production is more profitable. A change in the price level therefore causes a movement along the curve. 12

14 As with aggregate demand, a change in a factor other than the price level can cause the SRAS curve to shift. Such a shift may be brought about by changes in firms unit costs of production. For example: a rise in wage rates or an increase in the costs of raw materials or fuel, will increase the level of prices needed to make any given level of national output profitable and lead to a decrease in aggregate supply, that is, a shift of the curve upwards to the left (conversely, a fall in firms costs will increase aggregate supply); a change in business taxes or subsidies can have a similar effect - a rise in taxes or a reduction in subsidies will lead to a decrease in aggregate supply and a fall in taxes or a rise in subsidies will cause an increase. Price level SRAS1 SRAS2 P2 P1 Y1 Y2 Y3 Real output In the long run, aggregate supply is often assumed to be fixed regardless of the price level. This is because there must be some upper level on how many goods and services firms can supply. Once all the available labour, capital and land are employed, aggregate supply cannot be expanded even if rising prices may provide the incentive to firms to do so. An increase in aggregate supply (a shift of the aggregate supply curve to the right) can only be brought about if there is a change in the quantity or quality of economic resources available to producers. This may occur as a result of a number of factors. For example: an increase in the available labour supply as a result of greater incentives for people to look for and find work, or an encouragement for migrant workers from abroad to enter the labour market; improvements in productivity due to extra investment in education and training; improvements in the capital stock due to increased capital investment or research and development expenditure that results in the introduction of new technology; and more efficient businesses due to greater competition between firms. 13

15 Price level LRAS1 LRAS2 (after economic growth) Real output You can think about the long run aggregate supply curve as another representation of the production possibility curve of the economy. They both show the potential output of the economy when all resources are fully utilised. An outward shift of the production possibility curve as shown in the following diagram is in effect showing the same thing as the shift to the right of the LRAS in the previous diagram. They both represent a growth in the potential output over time of the economy brought about by an increase in the quantity and/or quality of economic resources. Output of goods C A Output of services B D 14

16 Equilibrium national output and prices In the short run, equilibrium national income and output occurs where aggregate demand is equal to short run aggregate supply. Here, what producers are prepared to supply at the prevailing price level is equal to what the economy as a whole is prepared to demand. In such a situation, there is no reason for the price level to rise or fall. If the price level was temporarily above the equilibrium level, then there will be an excess aggregate supply of goods and services. Firms stocks will rise, output and prices will fall until equilibrium is restored. If the price level was temporarily below the equilibrium level, then there would be excess aggregate demand, firms stocks will fall, prices will rise and output will expand until equilibrium is re-established. If there is an increase or decrease in aggregate demand or supply, the short run equilibrium will be disturbed and the levels of prices, national output and income will change. For example, if the initial equilibrium is disturbed by an increase in aggregate demand brought about by a fall in interest rates, this will lead to an increase in the price level and the equilibrium level of output and income as shown in the diagram below. Price Level SRAS P2 P1 AD2 AD1 Y1 Y2 Real output The short run equilibrium may occur at a level of output that is below or above the economy s long run potential output. This potential output is what could be achieved if all resources were fully employed, that is, the full employment level of output and income. In these situations, an output gap is said to occur. This is the difference between the economy s actual and potential levels of output. It is often expressed as a percentage of the full employment level of output. 15

17 A negative output gap occurs when the short run equilibrium level of output and income is below the full employment level. In this situation, some economic resources will be lying idle and there is likely to be above a relatively high level of unemployment and downward pressure on prices. Assuming that real wage rates are flexible, an excess supply of labour will exert a downward pressure on real wage rates leading to an increase in short-run aggregate supply in the next period until the actual and potential levels of output are equal. A positive output gap occurs when the short run equilibrium level of output and income is above the full employment level and there are inflationary pressures. Some economic resources will be working beyond their normal capacity levels, for example, a great deal of overtime being worked and capital equipment operating without the normal breaks for maintenance. In such a situation, there is likely to be upward pressure on real wage rates leading in the next period to a decrease in short run aggregate supply until the equality of the actual and potential levels of output are restored. The diagram below illustrates the above situations. With AD1, the level of aggregate demand is insufficient to keep all resources fully employed in the short run and the equilibrium level of output and income occurs at Y1 which is below the long run full employment level of Yf. There is therefore a negative output gap of Y1-Yf. This will result in unemployed resources and a downward pressure on wages and prices in the long run helping to move the economy back towards its full employment level of output and income. With AD2, the level of aggregate demand is above that needed to keep all resources fully employed in the short run and the equilibrium level of output and income occurs at Y2 which is greater than the long run full employment level of Yf. There is therefore a positive output gap of Yf-Y2. This will cause an upward pressure on wages and prices which, in the long run, helps to move the economy back towards its full employment level of output and income. Price Level LRAS SRAS P2 P1 AD2 AD1 Y1 Yf Y2 Real Output 16

18 Once you have mastered the basic tools of aggregate demand and supply, you have a model which you can use to help you analyse and evaluate many macroeconomic problems, issues and policy options. The following section shows how AS and AD analysis can be used to examine different approaches to dealing with an economic recession. Dealing with a recession In late 2008, many economies were considered either to be in, or moving towards, economic recession following a period of sustained economic growth. The recession was thought by many commentators to have been brought about, or at least worsened, by the credit crunch when banks became unwilling to lend to one another, private customers and businesses. A recession is an extreme negative output gap in which real GDP is falling over a prolonged period of time due to falls in aggregate demand. This results in high and sustained levels of unemployment. There are two major schools of thought amongst economists when it comes to dealing with an economy in recession. Free market (neo-classical) economists believe that market forces alone can lift an economy out of recession. They argue that there is no need for any government intervention and any such intervention is likely to make the situation worse rather than better. In a recession, some economic resources will be lying idle and there is likely to be a relatively high level of unemployment. This exerts downward pressure on prices and wages. Assuming that real wage rates are flexible, an excess supply of labour will cause real wage rates to fall, leading to an increase in short-run aggregate supply. This rightward shift in the SRAS continues until the economy has returned to full employment and there is no longer any downward pressure on wages. This process is shown in the diagram below: Price Level LRAS SRAS1 SRAS2 P1 P2 P3 AD1 AD2 Y2 Yf Real Output 17

19 Assume that the economy is initially in equilibrium at the full employment level of income and output of Yf. The credit crunch reduces aggregate demand and the AD curve shifts from AD1 to AD2. Real GDP falls from Yf to Y2 and the economy now is in a state of recession with a negative output gap. There will be substantial unemployment which will drive down wages, causing the SRAS to shift rightwards from SRAS1 to SRAS2. The economy will now return to its full employment equilibrium at Yf with a price level of P3 and this has been achieved without any government intervention. Opponents of this school of thought argue that wages can very inflexible or sticky in a downward direction and may not adjust in this way. Eminent economist, J M Keynes, argued that wages would take a very long time to fall to the required level and that the government should therefore intervene. Keynes pointed out that In the long run we are all dead. This suggested that wage adjustment might take so long to happen that many firms might already have gone out of business with unacceptable consequences in terms of economic hardship for large sections of the population. Interventionist (neo-keynesian) economists argue that a recession will not be self-correcting and that governments should therefore pursue expansionary fiscal and monetary policies to increase aggregate demand. In other words, governments should spend their way out of recession. At the end of 2008, this kind of thinking seemed to be behind the policies that governments and monetary authorities in many major economies were adopting. In the UK, the Chancellor of the Exchequer announced a temporary reduction in the standard rate of VAT from 17.5 to 15% and the Bank of England s official interest rate was reduced to 2 percent, the lowest rate for over 50 years. This process is shown in the diagram below: Price Level LRAS SRAS P1 P2 P3 AD1 AD2 Y2 Yf Real Output Assume again that the economy is initially in equilibrium at the full employment level of income and output of Yf. The credit crunch causes a fall in aggregate demand shifting the AD curve from AD1 to AD2. The economy slips into recession and real GDP falls from Yf to Y2. 18

20 The government responds to this by expansionary fiscal and monetary policies and aggregate demand is restored to its original level at AD1. The economy now returns to full employment at a price level of P1. Free market economists argue that these policies are not certain to restore full employment because of a phenomenon known as crowding out. This usually occurs because excessive government borrowing will push up interest rates and reduce private investment expenditure. They would also argue that allowing the market to correct the recession would have allowed full employment to be restored at a lower price level of P3. Goodhart s Law This idea is useful in investigating the targets set by the government or public authorities in order to deal with particular economic problems. It states that any attempt by government to set a target for an economic variable will tend to distort the variable and make its control more difficult. An example of this might be the issue of waiting lists in the UK National Health Service. Critics of the way the NHS is being managed might cite cases of patients having to wait more than a certain number of weeks for treatment as evidence of inefficiency. A government might then insist on a reduction of all waiting times to within a certain period, and provide funding for this to be achieved. However, in order to achieve the target, NHS managers might possibly respond in ways which would be against some patients interests. For example: patients might receive partial treatment, just to meet the deadline, but it might take even longer than before until their illness was fully treated; or if all limits for waiting times are set at, say, 13 weeks, doctors may schedule their workload to meet this requirement, but some patients who might have urgently needed treatment within 4 weeks may not be seen in time. Not only are such negative outcomes possible; some would argue that they are likely. Thus focusing on waiting times for treatment in the NHS means that they are no longer a valid criterion for assessing how well the service is performing overall. Similar objections could be made to setting targets for the rate of inflation or the rate of economic growth. Once the subject of targets, are they still legitimate indicators of the health of the economy as a whole? 19

21 Glossary Activity rate: This is the proportion of the population which is either in work or registered as unemployed. It is a measure of the extent to which the population is economically active. It is also called the participation rate Aggregate demand curve: This plots the level of aggregate demand against the price level. It slopes downward from left to right showing that at lower price levels, there will be higher levels of aggregate demand for any given level of income. Aggregate demand: This is the total demand for goods and services in the economy. It includes consumer expenditure, investment by firms in capital equipment and stocks, government expenditure on goods and services and the net effect of exports minus imports. Aggregate supply curve: The aggregate supply curve plots the total amount of goods and services produced against the price level. In the short run the aggregate supply curve will tend to slope upwards from left to right as higher prices will raise profits and encourage producers to expand output. Aggregate supply: The total of all goods planned to be produced in the economy. In the short run, aggregate supply may increase in response to a rise in aggregate demand that forces up the general price level. However, in the long run aggregate supply can only be increased by the availability of extra resources, improvements in technology or increased efficiency. Balance of (international) payments: A statement of all financial payments into and out of a country over a given period of time such as a year. Circular flow of income: This describes the process by which income flows around the economy continually between firms and households and vice-versa. Consumer Prices Index (CPI): The CPI is the government's preferred measure of inflation and the one on which its inflation target is based. It is an internationally comparable measure of inflation also used by other European countries and the European Central Bank. Credit crunch: A period of financial difficulty in which banks are reluctant to lend to each other, business and individuals and interest rates are much higher than normal. A credit crunch as experienced in 2007/8 may cause or prolong a recession and make the operation of official interest rate policy less effective. Crowding-out: Heavy government borrowing which soaks up funds available for lending and drives up interest rates, thus preventing private firms from borrowing when they might otherwise want to. 20

22 Deflation: A sustained fall in the general level of prices. Businesses and consumers tend to postpone spending as they expect prices to fall further. This in turn may lead to businesses cutting output or closing and to a further rise in unemployment. Depression: Though there is no precise definition, a depression is normally considered to be an economic downturn that is far more severe and long-lasting than a recession (see recession). Distribution of income: The way in which the national income is divided between different income groups within a country, for example, the percentage of national income earned by the richest and poorest tenths of the population. Economic forecasting: The use of economic models (simplifications of real world economic activity) to predict future trends in key economic indicators such as economic growth, inflation and unemployment. Economic growth: An increase in the productive capacity of the economy. This can be shown by an outward shift in the production possibility frontier. The rate of economic growth is normally measured by the percentage increase in real gross domestic product (GDP) over a period of time such as a year. Economic welfare: The extent to which the economy is able to provide people with the resources required to ensure their physical and emotional well-being and allow them to lead satisfying lives. Equilibrium level of national income, output and prices: A situation in which aggregate demand is equal to aggregate supply. At this price level, buyers are prepared to purchase all the output that firms are planning to produce, there is no rise or fall in stocks and no reason for the price level to change. The equilibrium level of output may be less than the full employment level (see output gap). Fiscal policy: This is government policy in relation to its expenditure and revenueraising through taxation and borrowing. The main fiscal policy measures are set out in the Budget in the spring of each year. This follows an annual review of fiscal policy in the autumn in the form of the Pre-Budget Report. Goodhart s Law: This is the idea that any attempt by government to set a target for an economic variable will distort the variable and make control of it ineffective. Gross domestic product (GDP): This is the total value of all goods and services produced by an economy over a period of time such as a year. Gross national product (GNP): This is a measure of total spending power in the economy. It is obtained by adding net property income from abroad to GDP. Inflation: A significant and persistent rise in the general level of prices resulting in a fall in the value or purchasing power of money. 21

23 Injections: These are spending flows into the circular flow of income. The main injections are investment, government expenditure on goods and services and exports. Macroeconomic stability: The aim of keeping the economy growing in a sustainable way which avoids, as far as possible, a cycle of booms and recessions. Macroeconomics: The study of the economy as a whole. It deals with the aggregate or total values for variables such as aggregate demand and supply, national income, total consumption, investment and expenditure. Monetary policy: This is policy in relation to the cost and availability of credit in the economy. In recent years, the main lever of policy has been the use of interest changes to influence the cost of credit and thereby the level of aggregate demand in the economy. Since 1997, the Bank of England s Monetary Policy Committee has independent control over the official interest rate in attempting to achieve a target rate of inflation set by the Chancellor of the Exchequer. Natural (or non-accelerating inflation) rate of unemployment: Some economists believe that there is a long-term level of unemployment at which the economy will naturally settle. This is the level at which inflation is stable. Though unemployment may fall below this level in the short-run, this will only be at the expense of accelerating inflation which will in the long-run lead to job losses. Net national product (or national income): This is obtained by deducting capital consumption (the amount of capital that has worn out during the year) from GNP. Output gap: This is a situation in which the equilibrium level of output in the economy differs from that required to employ all resources to their full capacity. A negative output gap is typified by the existence of considerable unemployment and idle capital equipment. A positive output gap may occur in the short term when producers stretch existing resources beyond the capacity that could be maintained in the long run. Policy conflicts: The situation in which one policy objective can only be achieved at the expense of another, for example, control of inflation through a reduction in aggregate demand might have a trade-off in terms of increasing unemployment and reducing economic growth. Rate of inflation: The percentage rise in the general level of prices measured over a given period of time, normally a year. This is normally measured by the percentage increase in an indicator such as the CPI or RPI. 22

24 Recession: A situation in which real gross domestic product is falling over a prolonged period of time. In the UK, a recession is officially defined as two consecutive quarters of negative economic growth. In a recession, business and consumer confidence declines, there is a fall in investment and consumer expenditure, and unemployment tends to rise. Redistribution of income: The attempt to alter the distribution of income, normally to make it more equal by taking income from the richer sections of society and giving to the poorer sections. Retail Prices Index (RPI): The RPI is another indicator of changes in the general level of prices. It is sometimes referred to as the "headline" rate of inflation. It is used by trade unions as a benchmark for pay rise negotiations and is also used by government to make changes to social security benefits such as the state pension. The biggest difference between the RPI and CPI is that the latter excludes certain housing costs, such as mortgage interest payments and council tax. Supply-side policy: This refers to measures designed to encourage economic growth by helping markets to work more efficiently and thereby increasing total production from a given amount of resources. This allows long-run aggregate supply to increase and national income to rise without creating inflationary pressures. Unemployment: This refers to those people who are able and willing to work but unable to find jobs. It represents the loss of potential output to the economy. In the UK it is measured in two ways. The government s preferred measure is the ILO or Labour Force Survey figure. This includes people who register as unemployed but do not qualify for unemployment benefit. The Claimant Count measure excludes this group. Withdrawals (or leakages): These occur when money flows out of the circular flow of income. The main withdrawals are saving, taxation and imports. 23

25 Further resources Text books There are a number of excellent textbooks available which cover the content of this unit in detail. The list below covers some of the most commonly used texts and should in no way be interpreted as prescribing particular books at the expense of others. For more advice on which texts to read or purchase consult your teacher. Anderton A G: Economics Anderton, A G: Economics for AS Level Beardshaw, J et al: Economics: A Student s Guide Begg, D & Fisher, S: Economics and Economics Workbook Cramp, P: Understanding Economic Data Cramp, P: Labour markets Lipsey, R G & Harbury: C: First Principles of Economics Maunder, P et al: Economics Explained Begg, D & Fisher, S: Economics and Economics Workbook Sloman, J: Economics 24

26 Websites UK Treasury The Bank of England The Office for National Statistics The International Monetary Fund The OECD Economic resources on the net The Institute for Fiscal Studies The World Bank Competition Commission Debt Management Office Department of Enterprise, Trade and Investment Office of National Statistics OFCOM OPEC HSBC: UK economy explained The Financial Times The Times The Independent The Guardian The Telegraph The Economist BIZED Tutor2U BBC Business news David Smith economic blog Freakonomics blog freakonomics.blogs.nytimes.com/ 25

27 Think Economics Wikepedia Incomes Data Services en.wikepedia.org Other publications Economics Review magazine Economics Today magazine Economic Outlook and Business Review Phillip Allen Updates Anforme limited First Trust Bank 26

28 Revision checklist 1 National income and the circular flow model You should be able to: Notes Explain and illustrate the simple circular flow of income Identify and analyse the effects of leakages from and injections into the circular flow Define and explain Gross Domestic Product / Gross Domestic Income, net income from abroad, Gross National Product, capital consumption/depreciation and Net National Product Distinguish between real and nominal values of the above measures Evaluate national income statistics as comparative measures of welfare Evaluate alternative measures of welfare, such as the ISEW, UKMDP and UNDPHDI 2 Macroeconomic problems, indicators and objectives You should be able to: Notes Define inflation and explain its causes Explain the effects of inflation Examine the possibility of deflation Explain how the rate of inflation can be measured and distinguish between the Consumer Prices Index(CPI) and Retail Prices Index (RPI) Explain why official agencies may prefer different measures in different circumstances Distinguish between the different types or causes of unemployment 27

29 Define and explain the concept of a natural [nonaccelerating inflation] rate of unemployment Distinguish between the claimant count and ILO approaches to measuring unemployment Explain the difference between unemployment and economic inactivity Analyse the consequences of unemployment and economic inactivity. Define economic growth and explain the factors which cause growth Evaluate the effects of economic growth Define the balance of international payments and explain its importance Examine the impact of changes in global demand or supply on a national economy Identify and explain other possible objectives of economic policy such as redistribution of income or protection of the environment Examine possible trade-offs between objectives Explain the uses and difficulties of economic forecasting Discuss priorities in objectives and why these vary over time and between political parties 28

30 3 Aggregate demand, aggregate supply and macroeconomic equilibrium You should be able to: Notes Define aggregate demand and explain the shape of the AD curve Explain how and why the AD curve may shift Define aggregate supply and explain the shape of the short- run AS curve Explain how and why the short-run AS curve may shift Distinguish between movements along and shifts in AD and AS curves Explain what the long-run AS curve shows and what determines its position Explain the relationship between long-run AS and the natural rate of unemployment Explain how the interaction of AS and AD determines equilibrium levels of income, output and prices 29

31 4 Economic policy and its effectiveness You should be able to: Notes Distinguish between fiscal, monetary and supplyside policies Explain the main policy instruments available to the government in each of these categories Use AS/AD analysis to predict the effects of different policies Understand the operation of Goodhart s law Compare and evaluate the effectiveness of different policy options 30