Macro Economic Objectives of the Government:

1. Sustainable Economic Growth 2. Low unemployment 3. Control of inflation. (Inflation target is CPI = 2%, +/-1) 4. Satisfactory Balance of Payments 5. Supporting a stable exchange rate 6. Low government borrowing 7. Environment 8. Equality

• Nominal GDP A Measure of national income, output and expenditure.

This is the monetary value of all goods and services produced in the economy

• Real GDP This is National income measured in constant prices.

• Real GDP = Nominal GDP *100/ price index

• Real GDP per Capita = This is the Real GDP / population AD = C+I+G+(X-M) : AD is the Total Demand for goods and services. It includes

• C = Consumer expenditure on goods and services.

• I = Gross Capital Investment (spending on capital goods)

• G = Government Spending

• X = Exports

• M = Imports

An increase in AD (shift to the right) could be caused by a variety of

factors:

1. Increased Consumption: due to i) An increase in consumers wealth ii) Lower Interest Rate which make borrowing cheaper iii) Higher wages which increase disposable income. iv) Lower Taxes v) Increased consumer confidence about the future

Consumer Expenditure accounts for about 66% of AD and therefore is a very important component of AD. 2. Increased Investment: due to

i) Lower interest rates, this makes borrowing for investment cheaper

ii) Increased confidence in the economic outlook. iii) Improved technology making investment more efficient. iv) Increased economic growth.

3. Increased Government spending

4. Increased exports i) Increased growth in other countries, ii) Lower value of Sterling, this makes exports cheaper

5. Decreased M i) UK more competitive ii) Lower value of Sterling

Aggregate Supply AS

Short Run Aggregate Supply curve SRAS.

• Shifts in the AS can be caused by:

1. Changes in Labour costs 2. Changes in Raw Material costs 3. Taxation and subsidies

A fall in oil prices would cause SRAS to shift to right (SRAS 1 to SRAS2)

Long Run Aggregate Supply Curve LRAS

In the Long Run, classical economists argue that the productive capacity of the economy is determine by factors other than price and demand. They argue that in the long run AS is determined by:

1. The Labour Force 2. The Capital Stock 3. Available Land 4. Technology 5. Productivity 6. Enterprise 7. Attitudes to work 8. Strength of banking system e.t.c

• Keynesians believe that in the

long run there can be spare capacity in the economy

• Therefore they argue that the

LRAS can be elastic when there is a recession

Economic Growth

• Economic growth means an increase in real GDP. An increase in GDP means an increase in the volume of goods and services produced in an economy.

• The rate of economic growth measures the annual % change in real GDP

• An increase in the productive capacity (LRAS) of an economy is known as an increase in potential growth.

• The Long Run Trend Rate of Economic Growth: This is the sustainable rate of economic growth in an economy. For example in the UK this is about 2.5%.

• The trend rate of growth is related to the increase in LRAS.

Benefits of Economic growth:

1. Higher Incomes. Consumers will be able to enjoy more goods and services

2. Lower unemployment: With higher output firms will employ more workers. A sustained period of economic growth will lead to lower unemployment.

3. Lower Government Borrowing. Economic growth creates higher tax revenues and there is less need to spend money on unemployment benefits. This reduces government borrowing.

4. Improved public services. With higher tax receipts more can be spent on health care and education.

5. Firms make more profit. Firms will make higher profit; this may

encourage more investment, which leads to a virtuous circle of higher growth.

Costs Of Economic Growth

1. Inflation. If AD increases faster than AS then economic growth will be unsustainable and inflationary. There will be a positive output gap and firms will respond by putting up prices. However, if growth is not above the trend rate and AD increases at the same rate as AS, growth will not cause inflation.

2. Boom and Bust Economic Cycles. If economic growth is unsustainable then high inflationary growth may be followed by a recession. This occurred in the late 1980s and recession of 1991.

3. Balance Of Payments Deficit. Higher consumer spending causes an increase in imports therefore causing a deficit on the current account. However, if growth is export led, this will not occur.

4. Environmental Costs. Increased economic growth will lead to increased output and therefore will cause increased pollution and congestion which reduces living standards. However, higher growth may enable more resources to be spent on the environment.

5. Increased Inequality: Higher rates of economic growth have often resulted in increased inequality. However this depends upon things such as tax rates and the nature of economic growth

Circular Flow of Income

The circular flow of income shows how money flows from households to firms (to buy goods). Then firms pay households wages to produce goods. It shows three ways to calculate GDP.

1) Total National income (wages, dividends,) 2) Total National expenditure (consumption and investment) 3) Total National output (value of goods and services produced)

Injections This is an increase of expenditure into the circular flow of income, leading to an increase in Aggregate Demand. Injections can include:

• Exports – spending from abroad on domestic goods.

• Government spending.

• Investment. Spending on capital goods by firms. Withdrawals (leakages)

A reduction of money in the circular flow. Withdrawals can include:

• Saving – depositing money in banks

• Imports – spending on foreign goods

• Taxation – Government raising money from consumers and firms.

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Causes of Economic Growth

Short Term - Increased AD

• If there is spare capacity in the economy an increase in AD will cause an increase in Real GDP.

• An increase in AD could occur for various reasons such as lower interest rates, increased wages or higher govt spending

Long Term Economic Growth

Long run economic growth requires an increase in the LRAS as well as AD. LRAS or potential growth can increase for the following reasons:

1. Increased capital e.g. investment in new factories or investment in infrastructures such as roads and telephones.

2. Increase in working population (e.g. immigration or later retirement age)

3. Increase in Labour productivity, through better education and training

4. Producing more raw materials (e.g. discovering oil deposits)

5. Technological improvements to improve the productivity of capital e.g. microchips and the internet have both contributed to economic growth.

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Trends in Economic Growth

• The average sustainable growth rate in the UK is about 2.5% (average

quartely growth rate = 0.7%)

• In the late 1980s, the UK experienced rapid growth, but this caused inflation and the growth was unsustainable. To reduce inflation, the government increased interest rates and this caused the recession of 1990-91.

Fall in Growth Rate

• Between 1987 Q3 and 1989 Q3 there is a fall in the growth rate. This means Real GDP increased at a slower rate. GDP only falls if there is a negative growth rate, e.g. 1990 and 2008.

Sustainable Growth

• Sustainable economic growth means that the growth can be maintained for a long time. It implies that inflation will remain low and AD increases at a similar rate to AS. It may also refer to environmental sustainability.

Output Gap

• The output gap is the difference between potential GDP and actual GDP.

• A negative output gap implies that actual GDP is less than potential. (e.g. in a recession, with spare capacity and high unemployment)

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• A positive output gap occurs when actual GDP is above the sustainable potential. A positive output gap leads to inflation.

Inflation

• Inflation means a sustained increase in the general price level

• If there is inflation the value of money declines and there is an increase in the cost of living

Measuring Inflation – Consumer Price Index (CPI)

1. Household expenditure survey- This seeks to measure what people spend their money on. From this we get a typical basket of goods which is used to measure typical prices.

2. This basket of goods gives a relative importance to each different item. E.g. if price of petrol increased this would have more effect than an increase in the price radios because petrol has a higher weighting.

3. The basket of goods is updated each year to take into account changes in expenditure

4. Every month changes in prices of goods and services are monitored and combined into a single figure with using the weights in the basket.

Problems with Calculating CPI

1. Family Expenditure survey does not include everybody e.g pensioners are excluded, but pensioners have different spending habits e.g. heating is more important. Young people will benefit more from falling prices of mobile phones.

2. Changes in Quality: Computers have many more features than 10 years ago, so it is difficult to compare prices because they are different goods.

3. Ignores housing costs and is often lower than old RPI method.

Costs of Inflation

1. Cost of reducing inflation: High inflation is deemed unacceptable therefore governments feel it is best to reduce it. This will involve higher interest rates, the reduction in AD will lead to a decline in economic growth and unemployment

2. International competitiveness: Higher prices will make British goods less competitive, leading to a fall in exports. However this may be offset by a decline in the exchange rate

3. Confusion and Uncertainty: When inflation is high people are uncertain what to spend their money on. Also, when inflation is high firms may be less willing to invest because they are uncertain about future profits.

4. Menu Costs. This is the cost of changing price lists

5. Income redistribution. Borrowers will become better off, lenders will become worse off, however it depends on the real rate of interest.

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Causes of Inflation

Demand Pull inflation

If AD increases faster than AS inflation will occur

Cost Push Inflation

If there is an increase in the costs of firms then AS will shift to the left causing inflation. This can be caused by:

1. Wage Push Inflation . Trades unions can bargain for higher wages, this will lead to an increase in costs for firms. It may also cause demand-pull inflation as consumers spend more increasing AD.

2. Import prices. One third of all goods are imported in the UK. If there is a devaluation then import prices will become more expensive leading to an increase in inflation.

3. Raw Material Prices If raw materials such as oil prices increase then this will have a significant impact on costs and inflation.

4. Declining productivity. Lower productivity increases costs.

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Supply Side Policies

Supply side policies are government attempts to increase productivity and shift AS to the right. Supply side policies can help the economy in various ways:

1. Lower Inflation. Shifting AS to the right will cause a lower price level.

2. Lower Unemployment

Supply side policies can help reduce structural, frictional and real wage unemployment.

3. Improved economic growth Supply side policies will increase economic growth by increasing AS

4. Improved trade and Balance of Payments. By making firms more competitive they will be able to export more.

Examples of Supply Side Policies

1. Privatisation. This involves selling state owned assets to the private sector. It is argued that the private sector is more efficient in running business because they have a profit motive to reduce costs and develop better services.

2. Deregulation This involves reducing barriers to entry in order to make the market more competitive.

3. Reducing Taxes. It is argued that lower taxes (income and corporation) increase incentives for people to work harder, leading to more output.

4. Increased education and training Better education can improve labour productivity and increase AS. Often there is under provision of education in a free market, leading to market failure. Therefore the govt may need to subsidise suitable training schemes.

5. Reducing State Welfare Benefits This may encourage unemployed to take jobs.

6. Providing better information

7. Improving Transport and infrastructure. In a free market there is likely to be under provision of public transport. If this was increased firms would benefit from lower costs

Evaluation of Supply side policies 1. They will take time to have effect.

2. It will cost money to improve information and education.

3. Lower benefits and reduced Minimum wages may cause poverty to increase.

4. Govt failure may occur, this is because the govt may have poor info about what to spend money on, e.g the govt may finance the wrong kind of scheme.

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Unemployment

Economic Costs of Unemployment

1. Loss of earnings to the unemployed

2. More difficult to get work in the future

3. Stress and Health problems of being unemployed

4. Increased govt borrowing: Tax revenue falls, spending on benefits rises.

5. Lower GDP for the economy, this is pareto inefficient.

Measuring Unemployment

1. Claimant Count Method. This is the govt official method of calculating unemployment. It counts the number of people receiving benefits (Job Seekers allowance)

Problems with Claimant count

o The Count excludes those over 60, under 18, those on govt training schemes, and married women looking to return to work

o Some people may claim benefits whilst still working in the “black Market”

2. The Labour Force Survey. This is a survey asking 60,000 people whether they are unemployed and whether they are looking for a job. It includes some people not eligible for benefits

Types of Unemployment

1. Frictional Unemployment:

• This is unemployment caused by people moving in between jobs, e.g. graduates or people changing jobs. There will always be some frictional unemployment.

• Also high benefits may encourage people to stay on benefits rather than get work this is sometimes known as “voluntary unemployment”

2. Structural Unemployment

• This occurs due to a mismatch of skills in the labour market it can be caused by

1. Occupational immobilities. This refers to the difficulties in learning new skills applicable to a new industry, and technological change.

2. Geographical Immobilites. This refers to the difficulty in moving regions to get a job.

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3. Classical or Real Wage Unemployment:

• This occurs when wages in a competitive labour market are pushed above the equilibrium. This could be caused by minimum wages or trades unions.

4. Demand Deficient or “Cyclical Unemployment”

• This occurs when the economy is operating below full capacity. In a recession when AD falls there is a fall in output therefore firms will employ less workers. Some firms will go bankrupt leading to more unemployment.

• Demand deficient unemployment is often the biggest cause of unemployment in the UK. E.g. after recession of 1991 and 2009, unemployment rose close to 3 million.

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Policies To Reduce Unemployment

1. Fiscal and Monetary Policy This involves cutting interest rate or taxes to increase AD. Higher output will cause firms to demand more workers. This will be effective for reducing demand deficient unemployment.

• However demand side policies may cause higher rates of inflation and will not reduce supply side unemployment.

2. Lower benefits and taxes.

These increase the incentive for the unemployed to look for work rather than stay on benefits. This will reduce frictional unemployment, but will cause a fall in AD and increase relative poverty.

3. Better job information.

This could help reduce frictional unemployment by giving the unemployed better information about available job vacancies.

4. Education and Training.

By improving labour productivity and the skills of the workforce there will be a reduction in occupational immobilities making it easier for workers to switch jobs. o However this will cost the govt money, also there could be govt failure

with the wrong kind of training subsidised. 5. Reform Trades Unions and reduce Minimum Wages

This will help reduce real wage unemployment.

o However the effect on employment may be small if demand for labour is inelastic.

6. Regional Grants

These can help overcome geographical unemployment by encouraging firms or workers to move. o However subsidies may prove ineffective for encouraging workers to

move because they may be attached to their local community

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Monetary Policy

This involves changing the interest rate or manipulation of the Money Supply by the monetary authorities.

Aim of Monetary policy

1. Control the rate of inflation. Inflation target for MPC is - 2.0% +/-1 2. Maintain sustainable economic growth. 3. Influence the Exchange rate

Effect of Higher Interest Rates. (Tight monetary policy)

If inflation is forecast to rise above the inflation target, the MPC are likely to increase interest rates. This will help reduce AD and inflation because higher interest rates:

1. Makes borrowing more expensive, therefore people spend less on credit.

2. Firms will be less willing to invest by borrowing money.

3. The cost of mortgages increases, therefore people have less disposable income causing a fall in consumption. Therefore AD decreases

4. Saving money in a bank is more attractive therefore there is less spending

5. Exchange rate increases, due to hot money flows into the UK. The appreciation in the exchange rate depresses demand for UK exports

Evaluation of Monetary Policy

1. The effect of higher interest rates depends on the situation of the economy. If the economy is close to full employment, a rise in interest rates is likely to reduce inflation significantly without reducing Real GDP.

• However if the economy has spare capacity, (e.g. at Y3 to Y4) reduced AD may not reduce inflation but only reduce GDP

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2. The effectiveness of Monetary policy depends upon other variables in the economy e.g.

a) If confidence is low, a reduction in interest rates may not increase demand

b) If taxes are rising this may counter a fall in interest rates c) If the world economy is slowing this will reduce exports and AD,

this would keep spending low even if there was a fall in interest rates

3. There may be time lags for lower interest rates to have an effect. E.g.

higher interest rates may not reduce investment in the short term because firms will continue with existing investment projects

4. Monetary policy may conflict with other macro economic objectives.

If the MPC reduces inflation this may lead to lower growth or higher unemployment. The below diagram shows the effect of higher interest rates in leading to lower growth.

5. Interest rates may conflict with the exchange rate. If the Bank increased interest rate this would cause a fall in AD but also would cause an increase in the exchange rate (due to hot money flows). This would harm manufactures who export the most.

6. Monetary Policy may also affect the Balance of Payments. If AD falls

people buy less imports, improving the current account

• However if interest rates increase the exchange rate will and may lead to a worsening of the deficit, because exports are more expensive.

7. Fine Control of Monetary Policy is not possible. It is difficult to get

accurate information about the economy. Time lags in policy mean interest rates affect the economy too late.

8. Monetary Policy will have a big effect on the housing market. This is

because they effect mortgage payments. E.g. an increase in interest rates will reduce the attractiveness of buying a house.

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Fiscal Policy

Fiscal Policy involves the government changing the levels of Taxation and Govt Spending in order to influence AD.

The purpose of Fiscal Policy is to: 1. Maintain low inflation 2. Stimulate economic growth in a period of a recession

• Expansionary or loose fiscal policy – involves lower tax, higher spending to increase AD.

• Deflationary or tight fiscal policy – involves higher tax and lower spending to reduce AD.

The Multiplier

This states that if there is an initial injection (e.g. higher govt spending) into the economy, then the final increase in AD and Real GDP will be greater.

Problems of Using Fiscal Policy

1. Poor info may reduce accuracy of forecasting economic growth and inflation

2. It depends on other components of AD, e.g. consumer confidence.

3. Higher Taxes can create disincentives to work, reducing productivity.

4. Time lag involved in increasing AD.

5. Expansionary fiscal policy will increase government borrowing.

Budget Deficit

A budget deficit occurs when government spending is greater than tax revenues. Therefore the government has to make up the shortfall by borrowing from the private sector.

• Public sector net Borrowing (PSNB). The annual amount the government needs to borrow

• Public Sector Net Debt PSND (The National Debt): This is the total (cumulative) amount of debt that the government owes the private sector at the moment this is over £800bn (or 57% of GDP)

• Annual interest payments on the debt are close to £40bn

• (N.B. Don’t get a government budget deficit confused with the Trade Deficit which occurs when omports are greater than exports)

Problems of a Government Borrowing

1. National Debt will increase leading to higher debt payments in the future

2. Govt may have to increase taxes in the future which may create disincentives to work.

3. Govt may have to cut govt spending which leads to deterioration in public services. (for more details see: A2 notes)

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Exchange Rates

Factors which influence the exchange rate

1. Inflation If inflation in the UK is lower than elsewhere, then UK exports will become more competitive and there will be an increase in demand for £s. Also foreign goods will be less competitive and so UK citizens will supply less £.

2. Interest Rates If UK interest rates rise relative to elsewhere it will become more attractive to deposit money in the UK, Therefore demand for Sterling will rise. This is known as “hot money flows”. Therefore the value of £ will appreciate

3. Speculation If speculators believe the sterling will rise in the future They will demand more now to be able to make a profit. This increase in demand will cause the value to rise.

4. Strong Economy If the British economy is growing strongly interest rates are likely to rise to keep inflation low. Therefore the £ is likely to appreciate in value.

5. Current Account. A large deficit on the current account, is likely to cause a depreciation in the value of the exchange rate. This is because a deficit implies a flow of exchange out of the country to buy imports.

Government Intervention in the Foreign Exchange

Market

1. Changing interest rates

Higher interest rates will cause hot money flows, increase demand for sterling and increase the value of the currency.

2. Reduce Aggregate Demand

By decreasing AD, consumers will spend less and purchase less imports and so will supply less pounds. This will increase the value of the currency.

• Lower inflation rate will also help as British goods become more competitive. Thus demand for Sterling will rise.

• However this policy has an obvious side effect because lower AD will cause lower growth and higher unemployment

Economic Effect of a Devaluation of the Currency

1. A devaluation of the exchange rate will make exports more competitive and appear cheaper to foreigners. This will increase demand for exports

2. Imports will become more expensive. This will reduce demand for imports

3. Inflation is likely to occur because:

o Imports are more expensive o AD is increasing o With exports becoming cheaper manufacturers may have less

incentive to cut costs and become more efficient

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4. AD = X-M Therefore higher exports and lower imports will increase AD

• Higher AD is likely to cause higher Real GDP and inflation.

• The size of this increase depends upon factors such as a) Spare capacity in the economy b) Other determinants of AD

6. Current Account. There is likely to be an improvement in the current

account balance of payments. This is because quantity of exports are increasing and imports are falling

Evaluation: The impact on the current account depends upon the elasticity of

demand for exports and imports. If demand for exports is inelastic, a depreciation will only cause a small increase in quantity.

Economic Effects of an Appreciation

1. Exports more expensive, therefore less UK exports will be demanded

2. Imports are cheaper, therefore more imports will be bought.

3. A fall in AD, causing lower growth

4. Lower inflation because:

o import prices are cheaper o Lower AD o More incentives to cut costs

5. Current account deficit will tend to deteriorate. In a period of high growth and high inflation, an appreciation may help. In a recession an appreciation is likely to lead to lower growth and higher unemployment.

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Balance Of Payments

The Balance of Payments is a record of a country’s transactions with the rest of the world. It shows the receipts from trade. It consists of the current and financial account

1. Current account i) Balance of trade in goods (visible) ii) Balance of trade in services (invisibles) e.g. tourism,

insurance iii) Net income flows (wages and investment

income) iv) Net current transfers (e.g. govt aid,

payments to EU) 2. Financial account (note this used to be called the Capital Account) This

is a record of all transactions for financial investment. It includes financial flows and net investment

Factors which cause a current account deficit

1. Overvalued Exchange Rate If the currency is overvalued, imports will be cheaper and therefore there will be a higher Q of imports. Exports will become uncompetitive and therefore there will be a fall in the quantity of exports.

2. Economic Growth If there is an increase in AD and National Income increases, people will have more disposable income to consume goods. If domestic producers cannot meet the domestic AD, consumers will have to imports goods from abroad.

3. Decline in Competitiveness. If there is high inflation or a decline in productivity there will be less demand for UK exports and British consumers will prefer buying imports.

Policies to reduce a balance of Payments Deficit

1. Devaluation.

• This involves lowering the value of the currency against others, making exports cheaper and imports more expensive.

• Therefore we would expect a devaluation to lead to an improvement in the current account. However it does depend upon the elasticity of demand for exports and imports.

2. The Marshall Learner Condition (note: ML condition not explicitly required for AS, but could count towards evaluation)

This states that a devaluation will improve the balance on the current account, on the condition that the combined elasticity’s of demand for imports and exports is greater than one.

• If (PED x + PED m > 1) then a depreciation will improve current account and an appreciation will worsen the current account

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• A problem with devaluation is that it can lead to imported inflation. This will reduce competitiveness in the long run and will mean the improvement in the current account might only be temporary.

3. Reduce Consumer Spending. If govt reduces AD by raising interest rates or increasing taxes then people will have less money to spend so they reduce consumption of imports.

i) The UK has a high marginal propensity to import therefore a reduction in AD improves the current account significantly.

ii) Deflationary policies will also put pressure on manufacturers to reduce costs and this will lead to more competitive exports and so exports will increase

iii) However this policy will conflict with other macroeconomic objectives With lower AD, growth is likely to fall causing higher unemployment

4. Supply Side Policies These can improve the competitiveness of the economy and exporters, but

this will take time to have effect 5. Protectionism. This involves restricting trade through tariffs, however it is likely to fail

because it will lead to retaliation (other countries place tariffs on UK exports.

Definitions

• Investment: This refers to an increase in the level of the capital stock, e.g. the purchase of machines. (don’t confuse with saving money in bank)

• Labour productivity: This refers to output per worker

• Output Gap. A positive output gap means output (GDP) is above potential

(growth above long run trend rate. A negative output gap means there is spare capacity – output less than potential.

• Economic Cycle – the cyclical nature of economic growth.

• Economic Stability – This refers to sustainable economic growth, low inflation and low unemployment with low inflation. Macro economic stability will avoid booms and busts

• Savings Ratio This is the % of a person’s income that is not spent but

saved

• Human Development Index (HDI) A measure of economic welfare that

includes GDP, health care and education standards.

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International Trade

Since 2000, the UK has experienced a current account deficit. This means we import more goods and services than we export.

Benefits of International Trade

• Comparative advantage. Comparative advantage occurs when a country can produce a good at a lower opportunity cost. If countries specialise in goods where they have a comparative advantage there will be an increase in economic welfare.

• Lower prices for consumers. Consumers will benefit from lower prices of imports. This is due to competition and gains from comparative advantage.

• Greater competition. International trade gives firms more competition which helps to reduce costs and increase efficiency.

• Economies of scale. International trade allows firms to adopt greater specialistion. This can lead to lower average costs of production.

Protectionism

This occurs when a government seeks to protect domestic industries from free trade and foreign competition. Protectionism can include:

• Tariffs. This is a type of tax on imports. It increases the cost and discourages domestic consumers from buying.

• Non-tariff barriers. These are other obstacles to trade. They may include complicated rules and regulations which make it more expensive for foreign companies to adopt.

Reasons for Protectionism

• Protects domestic industries and allows them to develop.

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• Help countries diversity into new industries. (important for developing countries)

• Raise revenue (though tariffs would be a minor source of income)

Conflicts of Macro Economic Objectives

Conflicts of Policy Objectives

A period of negative growth (1991 and 2009) caused a rise in unemployment

In practise it is difficult to achieve all policy objectives at once. For example, increaing the rate of economic growth could lead to inflation and a bigger deficit on the current account.

Increase In AD

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• In this diagram an increase in AD leads to an increase in economic growth. However, as the economy gets closer to full capacity, there is an increase in the rate of inflation.

• Also as consumer spending increases, the level of imports will rise. This tends to cause a deterioration in the current account.

However, higher economic growth will help:

1. Reduce the level of unemployment. Higher output leads to higher

employment levels 2. Improved government finances. Tax receipts increase with higher

growth.

Evaluation

• Higher economic growth doesn’t have to cause inflation and a deterioration in current account. If AS increases at same rate as AD, growth can be sustainable and non-inflationary. If growth is export led, (like China), the economy can have a current account surplus.

Phillips Curve

• The Phillips curve shows a trade off between unemployment and inflation.

• A rise in AD leads to higher growth. This higher growth causes inflation but helps reduce unemployment.

• Therefore, in the short term, policy makers face a trade off between unemployment and inflation.

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Evaluation

• Evaluation requires more than knowledge, but also the ability to consider a question in more detail and apply critical distance to the question.

Evaluation questions start with words such as:

1. Discuss 2. Evaluate 3. To what extent 4. Assess 5. Examine

Usually they will be the longer questions towards the end of the paper, however this isn’t always the case, it is most important to check the key word at the start.

Methods of Evaluation:

1. How important is a factor? For example: Consumption is 66% of AD therefore higher C has a significant effect on AD. A fall in exports to the US, would have a limited impact on its own.

2. Time lags involved. A cut in govt spending may reduce AD, however it may take time for this to affect the economy. Interest rate changes can take up to 18 months to have an effect on economy, one reasons could be because some people may have a two year fixed mortgage.

3. It depends upon the situation of the economy. An increase in AD will only increase economic growth if there is spare capacity. Therefore the elasticity of AS is important.

4. Conflicts of the policy involved: An increase in taxes may reduce the

budget deficit, however it may reduce incentives to work. Higher interest rates may reduce inflation, however it may cause the exchange rate to increase reducing demand for exports

5. It depends upon other variables in the economy. An increase in

interest rates is likely to reduce AD and inflation, however if consumer confidence is very high and wages are increasing, this is likely to keep AD high despite the increased interest rates.

• These same concepts can be used for different questions.

• The most important idea is that you don’t give a simple answer but always consider another viewpoints as well.

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