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AS Economics Mind Map

A fairly literal mind map of the stuff covered so far in the AS course. Additional information will be added over time as more is learnt. Special features include: info not included on the presentation path, imperfect information and much more.... :)

Ian Chiang

on 14 May 2015

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Transcript of AS Economics Mind Map

Depreciation of pound

Appreciation of pound
Market failure
is when the market mechanism or price mechanism in a free market economy leads to an inefficient allocation of resources.
Government and Market Failure
The Labour Market
Supply and Demand is a key concept in Economics. They are represented by curves on a graph where quantity of... (x) and price (y) are the axes.
Supply and Demand and Elasticities
The basics
Imagine you are stranded on an island...
The economic problem - Infinite wants but finite resources leading to a need for efficient allocation of resources
Production Possibility Frontier - The limit of production possible if all resources are utilised (as drawn on a graph).
Efficient point - A point on the PPF showing all resources utilised efficiently.
Inefficient point - A point below the PPF showing not all resources used.
Opportunity Cost - The cost of next best opportunity that's forgone for the chosen output.
Positive Statement - A statement that can be proven or disproven as it's based on facts or evidence.
Normative statement - A statement that can't be proven nor disproven as it's based on value judgement.
Value judgement - Means "opinion" except you can't say opinion in the exam so have to say this instead.
Key Definitions
Key definitions
Law of demand- The greater the price, the fewer people are willing to pay for a good or service.
Law of supply - The greater the price, the more people are willing to sell a good or service.
Equilibrium - The price where the two factors meet e.g: wage and employment (see labour market).
Elasticity - How much a factor affects supply and/or demand.
Inferior good - A good that is bought more as incomes decrease; as opposed to a normal good.
Key definitions
AS Economics Mind Map
You can choose to fish...
or farm...
or build shelter...
but not all at once.
This is because though our
wants are infinite, resources are finite

This is the
economic problem
This means that production is limited by the current amount of resources we own, so every hour spent fishing is an hour less to farm or build. This is the opportunity cost.
We can show this on a production possiblity frontier (PPF). The red line shows the limit of possible production.
Here is possible but inefficient
Here is impossible right now..
but may be possible when the PPF shifts out
So if we have 8 hours to work:
Changing output to increase one good/service production has the
opportunity cost
of the other.
Positive and Normative Evaluation
In economics it's important to separate the facts and data from the
value judgements
as there isn't always a definitive right or wrong answer to explain, assess or evaluate an economic concept. Here are some examples:
Taxes should be raised to assist economic growth in the UK.
Income taxation is too high to be good for this country.
An ageing population will lead to China's dependency ratio falling in later years.
Economics would be more fun if there was cake on Mondays.
I like cheese!
These statements:
Can be (dis)proven
Rely on facts
Are objective
These statements:
Cannot be (dis)proven
Rely on value judgement
Are subjective in nature
Firstly, an
is a system that tries to overcome the basic economic problem. Resources can be categorised into
factors of production
Labour: The workforce required.
Entrepreneurship may be included.
Land: Area/Natural resources used.
Capital: All tools and goods needed.
It resolves this by considering what, for whom and how to produce goods/services, this is the
market mechanism
There are two main kinds of economy:
Free Market
In this economy the features are:
The invisible hand
: Individuals pursuing their own best interests leading an economy to it's optimum.
Free enterprise and
where anyone can sell anything against others selling similar goods & services. This leads to consumers and producers agreeing on an optimum price (See supply and demand)
There are issues with this system such as that merit goods are under-produced and monopolies can form. (See market failure)
In this economy the features are:
Minimal government intervention to provide merit goods
The government is in control of all the allocation of resources and plans the economy.
Labour is allocated by their skill set (human capital) meaning there may be 0% unemployment
Consumers get their rations and goods in return for effective input into the economy.
Luxuries aren't usually produced in a command economy as they aren't necessary and carry an opportunity cost of resources
There are issues with this system such as being less effective than free market, black markets existing and a lack of choice.
A mixed economy has free market mechanism but also government planning to ensure choice and protect consumers and producers.
As the price rises, more producers are willing and able (can afford to) supply goods so supply increases as price increases.
This is the
Law of Supply
As the price rises, fewer consumers are willing or able to buy the good/service so demand decreases as price increases.
This the Law of Demand
These curves are price
as a small change in price leads to a large change in demand/supply meaning they are shallow.
These curves are price
as price has little impact on demand/supply. In other words, they are steep.
is the measure of responsiveness of supply or demand to a factor (e.g. income). We calculate the price elasticity of demand using:
Percentage change in quantity of demand
Percentage change in price
N.B: In real life demand and supply curves are unlikely to be straight, it is just represented like that for simplicity.
Hot-dogs cost $2 one month where 100 were sold. The next month, it costs $3 and 75 are sold.

% change Q.d.
% change Price = +50% = 0.5
Due to the laws of demand and supply,
is usually negative and
is usually positive but the number is usually shown positive.
2 elastic 1 inelastic
inelastic 1 elastic 2
There are many types of elasticity, as well as PED and PES there is also:
Income Elasticity of Demand (YED) - How sensitive demand is to a change in real income.
Cross Elasticity of Demand (XED) - How much the demand for one good/service affects the demand for another.
Wage Elasticity of Demand (WED) - How responsive the demand for labour (employment) is to a change in wages in real terms. (See the Labour Market)
Wage Elasticity of Supply - How much [relatively] the supply of labour (job seekers and applicants) changes to a change in wages. (See the Labour Market)
Factors that might affect elasticity:
Time - The longer the time the easier to adjust to the change in a factor.
Necessity - The more necessary a good, the less demand is affected by changes (N.B. for
inferior goods
, this may or may not be true [see YED]).
Marginal Cost of Production - The cheaper it is to produce the next unit of goods or services, the easier it is to create more, this might be due to
advances in technology
We say that the demand for labour is
as it come from the demand for the final good. We assess the labour market by the demand and supply of employment against wage. Since the greater the wage, the more people want to work (i.e. supply)
[see Backwards Bending Supply Curve]
and the less employers want to employ (ie. demand) the diagram for this is very similar to the basic supply and demand diagram.
Efficiency - Better workers mean fewer are needed.
Technology - Improved technology
Population - More people, larger workforce and lower wages .
Income Tax - Greater tax, less willing to work.
Welfare - May reduce incentive to (find) work.
Wage Elasticity of Demand
Human to capital ratio: more people, changes to wages are costly.
PED for final good - If elastic demand, WED will be elastic as well.
Substitutes available.
(due to competition)
If you notice this notice then you will notice that this notice has noticed that you're not focusing on your studies. Now get back to work!!
The Commodity Market
A commodity is a raw material used to produce final goods and is never bought as itself, their demand is therefore derived. Since they are necessary, finite and non-renewable (mostly) their demand and supply is usually v. inelastic. Their demand is affected by how necessary it is and supply by how scarce.
Various Graphs
Backwards Bending Supply Curve
Hours Worked
Hours worked increases as wage increases initially due to the
income effect
meaning that workers are willing to work more to gain a better living.
W1 Here optimum work is done ->
Then a
substitution effect
means the opportunity cost of working is too great or the same income can be made working fewer hours so worker decide to work less.

Minimum and Maximum Price Controls
Sometimes the market equilibrium is too high or too low so there has to be government intervention. A minimum or maximum price will be set to prevent market failure (see market failure).
The maximum will be below PeQe as the market price is too high so must be reduced and vice versa.
Minimum Price
Maximum Price
One way of stablising the fluctuating commodity prices (esp. for staple foodstuffs) is a buffer stock-scheme. The diagram is similar to the one above but the curves are more inelastic (steep), the government tries to keep it inside the two boundaries (instead of either above minimum or below maximum) and the minimum and maximum are called the
high price
low price
(respectively). When there is excess supply

the price is below the low price, the government will buy it up at the low price to sell later when there is excess demand and the equilibrium price is above the high price. The issues with such a scheme are: food can spoil if there are inadequate facilities, it requires excess supply first in order to build up a buffer stock and it's an incentive to greatly overproduce if the low price is assured for producers.
The Housing Market
Houses are necessary but they aren't commodities as they're not a raw material and are bought by the final consumer. The supply and demand for housing is, however, governed by pretty much the same factors as the commodity market except there are
more substitutes and similar goods (renting, flats, council housing), it is normally a once-in-a-lifetime buy, income is a factor
and the
supply is slower (building and planning permission takes a long time

Also, there is
foreign investment
which provides demand and can cause competition thus raising prices. Too much demand can cause great opportunity costs and negative externalities [see market failure].
Positive and Negative Externalities
Every decision to produce or consume goods and services has direct impacts on the consumer and/or the producer and these are called the
private costs
private benefits
, but they often have indirect effects on third parties not involved, these are the
external costs/benefits
. We call the total repercussions to society the
social costs/benefits
so is a
Negative Externality
so is a
Positive Externality
Each unit after the equilibrium carries an increasing external cost so the total loss to society or
welfare loss
is this area in yellow
Social Equilibrium...............
Marginal Social Cost (MSC)
- the social cost of the next unit
Marginal Private Cost (MPC)
- the private cost of the next unit
Marginal Social Benefit (MSB)
- which for simplicity, equals the MPB, i.e. there's no external benefit.
Market Equilibrium or Market Price........
Each unit from the equilibrium to the market price carries an increasing external benefit so the total gain to society or
welfare gain
is this area in yellow
ient Output...........................
ient Output.....
- which for simplicity, equals the MPC, i.e. there's no external cost
Market Failure Examples
Positive Externalities
Goods that carry positive externalities are called
merit goods
, for example:
Textbooks (
is the main merit good here but is
harder to quantify
Healthcare (Employment at least)
Fracking (Competitive markets leading to lower gas/oil prices [topical])
Negative Externalities
Goods that carry negative externalities are called
demerit goods
, such as:
Smoking (Passive smoking is one negative external cost)
Public Transport (Climate change)
Fracking (possible disruption/pollution depending on closeness to towns)
Supply shifts out, scarcity lessens and prices drop
These tend to be "under-produced" as firms produce them by market demand instead of social demand which is higher (due to external benefits).
These tend to be "over-produced" as firms produce them by market demand rather than social demand which is lower (due to external costs).
In society's eyes:
Solution :
Regulation - Easy to impose but hard to enforce, exact level is tricky to determine, may affect different firms differently like a specific tax, also may have a large incidence on consumers.
Permits - Again numbers are tricky, hard to get the system to take off (Carbon Credits, Kyoto Protocol) however as a free market approach, may requires less government intervention.
Pos'/Neg' Externality - A benefit/cost to third parties from the consumption and/or production of a good or service or the difference between the two terms below.
Marginal Social Cost/Benefit - The C's/B's of producing and consuming the next unit of a good/service to 3rd parties.
Marginal Private Cost/Benefit - The C's/B's of making/buying the next unit of a good/service to the economic agents.
Labour immobility - Unemployment caused by lack of necessary resources hence leading to market failure
Geographical Immobility - Immobility due to inability to move locations.
Occupational Immobility - Immobility due to lack of skills required.
Information failure - Where the economic agents don't have complete information or understanding about a good or service leading to mis-allocation of it.
Imperfect information - Where the consumer & supplier don't know everything.
Asymmetric information - Where the consumer knows less than the supplier.
Government failure - Government intervention leading to overall market failure.
Key definitions
MSC = Ext Cost + MPC or MSB = Ext Benefit + MPB
Imperfect Market Information
In an ideal market, there would be an full knowledge about a product for both consumers and producers, i.e. perfect, symmetric information. Often but not necessarily always the seller or producer is more aware of the product's benefits and flaws than the consumer, this is
asymmetric information
and in some cases neither are fully aware of the full potential as in the case of leaded petrol, this is
imperfect information
. This leads to market failure as there is over-consumption or under-consumption of some goods as consumers may not have the full picture.
Geographical immobility
Labour Immobility
Full employment is a near impossibility in a free market economy as people are not usually completely free to move and find jobs and their skills set limit the jobs they can fill. These factors are
Occupational immobility
Local ties (Family and Convenience)
House prices nationally
Lack of knowledge about other locations
Change in economic sector type.
Large industry or monopoly closure
Government intervention - subsidised retraining, relocation schemes, adjust wage rates to incentivise .
Government Failure
occurs when a government makes the wrong choices and causes market failure. This can be due to imperfect information, the effects of self-interest, costs of action, general mistakes and other faults.
This is the
equilibrium price
as the supply and demand are equal here. It is also known as the market price
Labour immobility happens in situations where there are huge layoffs from a company or industry such as from Microsoft who announced they would cut 18,000 workers. The impact of could be fairly limited if it is spread across 6 months. However since they're a technology company, there may be occupational immobility as such jobs have limited skill sets suitable for other jobs.
CityLink laid off over 2,350 workers after a collapse so causing labour immobility. The effects may not be severe since the government plans on intervening and there are alternative companies willing to employ, however there will be costs to the tax-payer, this may be greater than the gains hence potentially leading to government failure.
There are always cases of government failure in every economy. Such examples are ...
- Obamacare: Introduced to provide affordable healthcare, caused a debt from the cost of implementation and increased price so causing market failure.
- HS2: The costs of constructing a new railway may be greater than the benefits gained from it; especially if there is labour immobility.
The idea of market failure due to asymmetric information is famously applied by George Akerlof to the market for second-hand cars called "lemons" and new-ish cars called "peaches". In the case that the consumer is none the wiser, they will aim for an average price (assumed to be mid-way). This leads to the worse used cars whose actual value is less than the assumed price to flood the market where as the better cars to not be sold as they will make a loss. This concept is also known as 'the bad driving out the good'. It can also be applied to other markets such as coins (actually copper coins kept, "copper" coins spent).

Another common example of asymettric information is Ebay where people can be scammed into buying similar but less valuable/fake/faulty goods. An example of imperfect information would be the introduction of cane toads to Australia.
featuring opportunity cost and potential information failure
Supply with tax
Tax incidence of consumer
Tax incidence
Tax Incidence
There are two types of tax:
specific tax
is the same no matter the output and is a fixed cost (parallel to supply curve),
ad valorem tax
is usually charged as a percentage of price and is a variable cost (sloped away from the supply curve).

However not all the tax is paid by the supplier, they can also pass on the costs to the consumer. The change in equilibrium price is the increase to what the consumer pays i.e. the
tax incidence
on consumer, and the rest is the tax incidence on supplier which the supplier pays. The more elastic the supply curve or inelastic the demand curve, the less the tax incidence of supplier and vice versa.

The same can be said of grants or subsidies, they too have a
subsidy incidence
that works similarly.
Government Provision - The government can provide (merit) goods using tax revenues, like the National Health Service, education system, roads etc. These are known as
public goods
The issue with providing public goods for free is the
free rider
problem whereby people benefit despite not having contributed to its provision. This is because public goods are in theory
(one person's usage doesn't affect anyone) and
(cannot stop people benefitting) however some public goods like beaches may not be a "pure" public good (overcrowding so not non-rival) and others such as streetlamps may have negative exernalities (disturb sleeping residents) but still count as a public/merit good.
these are called
quasi-public goods
Government taxation/subsidies - May cost more than would benefit society, depends on size and incidence of tax/subsidy
All resources are privately owned through and the owners try to benefit themselves.
Factors affecting supply:
Costs of Production
Reserves of Remaining Resource
Factors affecting demand:
Derived Demand
Economy - A system that tries to overcome the basic economic problem
Market mechanism - Considering What/How/For who to produce.
Factors of Production - Resources needed to produce goods and services.
Free market - Using the market mechanism to solve the economic problem.
Invisible hand - An invisible force which brings the economy to an optimum, eventually.
Command Economy - Centrally planned production.
Mixed Economy - The best of both worlds (still not perfect though).
Wage Elasticity of Supply
Time - Allows for retraining and restudying.
Competition - More rivals reduces chances of acceptance.
Difficulty - Hard jobs require specialist skills so suit a limited market.
This is Micro-economics...
...and this is

The Circular Flow of Income
In an economy as a whole, all the economic agents interact and money is transferred from place to place.

Households give firms factors of production
Households spend on goods & services
Firms provide goods & services
Firms provide wages, employment and rent
Financial Institutions lend money/ invest
and give interest
World Markets import goods
Governments spend
Financial Institutions take savings and charge interest
World Markets export goods
Governments tax
Injections - These increase the flow of Income
Withdrawals - These reduce the flow of Income
Let's start with households and firms
Economic Growth
The amount of goods and services that an economy
produces or consumes i.e. its output, is its gross domestic product or GDP. An increase in this is usually a indicator that an economy has increased in size / economic growth. Economic growth can also be an increase in the total potential output (Yf).
Aggregate Supply and Aggregate Demand
Aggregate means total or overall so aggregate demand (AD) is the total demand in an economy; it is calculated by the formula:
C +I +G +( X - M )
onsumption nvestment overnment E ports I ports
Price Level
Output/ GDP
As the price level increases:
People are less wealthy
More demand for borrowing so higher interest rates
Investment is costlier as interest rates rise
Less competitive prices so less net exports
These all decrease AD, hence the curve is downwards sloping.
Aggregate supply (AS) slopes upwards in the short run as costs of production stay the same as prices increase so more can be made and curved near Yf as there is diminishing returns on additional resources. In the long run, there is a limit to how much capital can be employed and so output so the curve is vertical.

The AS curve will shift if there is a change to the factors of production (quality, quantity or cost)
The AD curve shifts if there is a change to any of the factors in the AD formula eg increasing interest rates would lead to more borrowing so more investment and consumption and so AD shifts out.
Price Level
Output/ GDP
Yf (full output)
In the UK: about 65% of AD, about 15% of AD, about 20% of AD roughly balancing at +/- 30%
Output gap is the difference between the current output of an economy and the full potential output. GDP is measured as either total value of goods produced, the total revenue from goods or total spending on goods. Real GDP has been adjusted for inflation and Nominal GDP hasn't. GDP can fluctuate as the economy follows the business cycle: recession, recovery, peak, downturn; we use the long run average known as trend growth to see how the economy is overall, when the actual GDP is below the trend growth line, there is a there is high unemployment and a negative output gap and when the actual GDP is above the trend growth line, there is a positive output gap and low unemployment.

GDP isn't the perfect measure of growth as it doesn't take into account factors such as informal/black markets, distribution of wealth or the population of a country. Also High GDP can therefore mean/lead to inflation (greater employment and wages paid leads to higher prices), over-consumption of non-renewable resources and greater pollution and the more negative externalities.
Another measure of growth is the Human Development Index, HDI; this takes into account the health, wealth and education of the population of a country instead of its output, this may be a better measure in less developed areas where basic needs are not met however GDP would be a better measure in countries where they are already provided and quality of life is good.
Many countries try to maintain low levels of inflation as it leads to more spending now rather than later without it spiraling upwards unsustainably with higher wages and higher prices, this would lead to less competitiveness on the world market. Economies also try to avoid deflation (negative inflation) as this leads to delayed demand (cheaper later) and prices to spiral downwards unsustainably. Inflation can occur from demand pull where demand rises without a matching rise in supply, or from cost push where costs rise and lead to greater prices in the economy this can be because of changes to the costs, quantity or quality of factors of production, government taxes or inflation in another country thus affecting imports.
We use price level (the average price of all goods in an economy) instead of price as the y-axis on AD and AS graphs. A sustained rise in price level over time is called inflation. Inflation causes money to be devalued as it takes more to buy the same good now than then. We usually calculate Consumer Price Index (CPI) as the measure of inflation. This uses a representative basket of 700 goods chosen every year and gives a weighting based on its significance. The average national price price is multiplied by the weight every month and its total is compared to that of the month the year before. The percentage change is the CPI inflation rate. CPI is limited as other factors than inflation may affect prices, it is average so may not represent certain groups of people and there may be substitute goods which aren't in the basket.
Retail Price Index (RPI) is calculated using a different method and also includes mortgages, interest repayments and taxes.
Item (Weighting)
Price (PxW)
last year
Price (PxW)
this year
Cake (11)

Soap (25)

Perfume (9)

Potatoes (36)

Paper (16)

Music CDs (3)
Total 100 473.20 539.20
(539.20-473.20) / 473.20 x 100% = 13.95%
3.50 (38.50)

2.00 (50.00)

14.99 (134.91)

2.99 (107.64)

8.20 (131.20)

3.65 (10.95)
4.20 (46.20)

2.20 (55.00)

16.00 (144.00)

3.50 (126.00)

9.99 (158.40)

3.20 (9.60)
Inflation can mean that written prices need to be changed and increased "shoe leather costs", i.e. cost of comparing prices, purchasing power is decreased and less investment, less competitive exports and uncertainty if it is volatile (likely to change). On the other hand inflation can also mean erosion of debt as the nominal value stays the same as wages increase and increased tax revenue and so government spending.
Unemployment is the percentage of people that are able and willing to actively find jobs but not currently in work.
The two main ways to measure unemployment, the Labour Force Survey (LFS or ILO) which asks 60,000 people around the country if they are able to work in the next 2 weeks and have seeked jobs in the past 4 weeks; collected by the Office of National Statistics. The LFS is also limited as it is subject to potential sampling errors.The Claimant Count is the number of people seeking Job Seekers' Allowance and is produced by JobCentre Plus. The Claimant Count doesn't account for all unemployed as they may not/ cannot seek JSA, especially in the case of frictional unemployment.
Causes of Unemployment
Lack of Demand - If demand decreases there will a greater output gap so more unemployment.
Government Intervention (NMW) - If the NMW increases e.g. to match inflation, then there is an excess supply of labour leading to unemployment in the short run.
State benefits - If the state benefits are highly attractive compared to work then there may be some who choose it over work so become unemployed.
Frictional Unemployment - Students just out of university or workers between jobs may be temporarily unemployed.
Reverse Multiplier - Decreased flow of income which reduces consumption and investment further
Falling Incomes - Unemployment increases the supply of labour so causes more competitive and lower wages.
Lower Quality of Life - Unemployment leads to potential physical and mental issues and less disposable income.
Increased Government Spending - Benefits, retraining programs the loss of skill and taxes all costs money.
Higher Output Gap - This reduces growth as less is produced than potentially possible at Yf.
Effects of Unemployment
There are a few types of unemployment:
Frictional - Workers that are soon to have jobs, but not yet.
Seasonal - As some jobs are season specific (tourism)
Cyclical - Caused by the business cycle in recessions
Structural - Changes to the economy such as outsourcing, migrant workers or improvements in technology
Multiplier Effect
With any change in the CFOI (particularly injections and withdrawals), there will be a shift in the aggregate demand. John Maynard Keynes suggested that this causes further shifts in AD as the money was further circulated. This is the multiplier effect.
So if a person earns £100 and spends £75 on bonds
the company may pay dividends of £20 to investors
one of whom might buy a £2 cup of tea and so on...
Note that a) the percentage of income that is spent is inconsistent, we call this ratio the
marginal propensity to consume (MPC) or invest (MPI)
and b) that the multiplier effect is gradually reduced as there is also a
marginal propensity to save (MPS)
Balance of Payments
The Balance of Payments is similar to net exports but considers all income flows in and out of a country and separates the elements out into the current account, the capital account and net errors and omissions to balance it to 0. Here only the current account is discussed.
Net foreign investment and savings
The current account
What's it made of ? What affects it? What does it affect?
The current account is the net
trade of an economy
Visibles - The trade in goods such as wheat, sweets and handbags.
Invisibles - The trade in services: tourism, banking, driving lessons etc.
Net transfers - Aid and remittances (money sent back from foreign workers).
Net income transfers - Dividends, interest, profits from foreign assets.
A net export in trade is a
current account surplus
and net imports a
current account deficit
. These would
have to be balanced by the capital
account with the reverse status i.e.
surplus for deficit and vice versa.
Since it's basically net exports, it is affected by:
Top left clockwise: Exchange rate, Strength of an economy, Quantity of Production, Quality of Production, Economic Growth, Interest Rates, Relative Rate of Inflation
Strong pound means less competitive exports and greater spending power for imports
Strong economy means strong pound and net exports
Greater supply reduces
A large sustained current account deficit would mean that there would have to be a capital account surplus or increased net borrowing which would result in higher levels of debt and very likely slower growth, higher unemployment and deflationary pressure (as AD shifts in and the economy/CFOI contracts; also there is a reverse multiplier effect).

On the other hand, a sustained current account surplus may lead to less supply of goods available for consumption and may lead to inflation, which could reduce the competitiveness of prices and offset the net exports, but it also boosts employment and growth and makes the economy a net lender and/or provides a capital account deficit.
The lower inflation and the exchange rate the more attractive exports are.
The greater growth, the strength of an economy and quality and quantity the better exports are.
High interest rates attract demand for the pound and so net exports.
Exchange Rates
The exchange rate affects the current account through encouraging foreign trade when low as euros for example buy more goods in the UK than elsewhere and similarly discourages foreign trade when high. When a currency strengthens it buys more of another currency.
£1 : $1.66
£1 : $1.54
The exchange rate is affected by:
The level of income in other countries - High income means more spending power and
greater demand for pounds to buy UK goods and so the exchange rate goes up.
The relative interest rate - High interest attracts foreign savers and so higher exchange rate.
The relative rate of inflation - Low inflation means cheaper goods and higher demand for £.
Speculation - If people expect a rise in the future, they will buy pounds and appreciate the £.
The level of Foreign Direct Investment - FDI must pay in pounds so high FDI = stronger £.
Monetary Policy
Monetary policy is a
demand-side policy
that aims to affect growth, employment but most of all inflation through
interest rates
(orthodox method) as well as
(unorthodox method). By raising interest, local and foreign consumers and firms will spend and invest less. This will contract the circular flow of income and shift AD inwards (AD1 to AD2) with a reverse multiplier (AD2 to AD3), this will reduce growth, employment (Y1 to Y3) and inflation (P1 to P3). This is
contractionary monetary policy
. The Bank of England controls monetary policy and tries to keep inflation at 2%.
Price Level

Y3 Y2 Y1 Yf
Lower interest
Expansionary MP
Savings decrease

Borrowing increase
Cheaper mortgages
and loans.

Cheaper investment

Less demand for £
Higher consumption, investment and net exports so CFOI/AD increases with multiplier and so economy expands (expansionary monetary policy).
However the effectiveness of monetary policy is affected by:
-The magnitude of change/history of MP, greater change has greater effect and may cause speculation if significant.
-The time span considered, MP usually takes 2 years to take effect.
-The current level of interest, if low and AD is still low then other methods may have to be used a.k.a. a liquidity trap.
-The investment caused, high investment may lead to AS increasing so balancing the inflation but increasing growth.
- Consumer and Investor Confidence - affects the MPC and MPS.
- The commercial banks may not adjust interest in line with the central Bank of England's base rate.
- Higher interest may cause net exports so strengthening the £ and decreasing competitiveness so causing net imports.
- Level of spare capacity - High output gap leads to greater growth without much inflation when interest rises and vice versa.
Supply Side Policies
Fiscal Policy
Fiscal Policy is a demand side policy controlled by the government in order to meet macroeconomic objectives like growth, inflation and most importantly employment. The government does this through changing taxes and spending.
Taxes can be described in two ways:
: Direct taxes are charged to the income of a worker (income tax) or to the profits of an organisation (corporation tax).
Whereas indirect taxes are on spending such as VAT and stamp duty
Who does it target in real terms? :
Progressive taxes
charge the rich more such as income tax in Britain.
Proportional taxes
are at the same rate for all.
Regressive taxes
charge the poor greater.
Government Spending
The government focuses spending on healthcare, education, infrastructure, welfare and defense. By increasing spending jobs are created and income is increased, AD shifts out as government spending is a component of AD and an injection into the CFOI so increasing growth, employment and inflation, therefore increased spending is called expansionary fiscal policy or loosening.
Spending on the public sector is also a supply side policy as education, healthcare, welfare and infrastructure all affect the quality and quantity of production so affects AS (this would shift in the same direction as AD, i.e. with contractionary/tightened fiscal policy AD and AS will both shift in).
In order to see
to what extent does fiscal policy work
we should consider:
~The magnitude and time lag: Changes to fiscal policy are fairly quickly felt.
~Offsetting factors:
~As discussed, AS will shift similarly to AD if there is spending changes meaning the effects may be offset (see output gap)
~If spending is high, the government has to borrow more from the banks potentially leaving less for firms and corporations to invest with, this is call "
crowding out
~Speculation: If governments are spending considerably more than they tax, firms may expect spending to fall and so adjust their employment and output in advance (potentially negating expansionary fiscal policy) this is known as
Ricardian equivalence
~Output gap: A high output gap yield more significant changes to output and less significant changes to inflation and vice versa.
~The incomes of people: If spending or a tax reduction causes a large change in employment, the government may lose out/ run up a large debt quickly, this can be balanced by the reduction in JSA spending or by the increase in different tax revenues (
automatic stabilisers
~Consumer and Investor Confidence: Higher means greater (reverse) multiplier effect.
~The effectiveness of spending:
~Number of people on JSA and similar: Changes to spending will have greater effect if more people are affected. This may be a result of the next factor.
~Economic/Budget status - In recession, the government is more inclined to spend despite the cost as the gain should outweigh it and the reverse in good times.
~Spending usage - Companies may invest in machinery rather than workers so not increasing employment potentially.
inflation - annual pay changes,
not immediately adjusted esp. when low
As well as changing demand through monetary and fiscal policy,
governments can also seek to change aggregate supply through supply-side policies.
Fiscal Policy related:
Since demand side policies (can) cause investment which increases the quantity, quality and even cost of production and governments control fiscal policy, they can use it as a supply side policy as well.
Education and Training boosts human capital by increasing the quality and quantity of workers available.
Decreasing the NMW makes employers more willing to employ workers where as raising the NMW will increase the supply of workers. Either way there can be an increase in employment
Increasing subsidies for housing and transport reduces geographical immobility and subsidies for R&D will lead to lower costs and greater quality.
Lower income and may lead to more willingness to work and spending so increasing employment.

Lower corporation tax will lead to more profits to invest so increasing AS
Lower level of benefits may encourage more to work and so expand the labour market.
Deregulation/Privatisation of the market may lead to it being better run so increasing the quality and cost of production and so increasing AS.

Also looser immigration policies may allow more skill and low paid workers to enter the country and increase AS and consumption.

Raising the retirement age increases the number of worker but may also increase the quality due to experience.

By strengthening trade unions, worker may feel more confident so increasing the quality of production, also if trade unions where weakened the number of strikes may be reduced so also increasing production, these would lead to increased AS.
kind of a free market
Elasticities (2)
However the effectiveness of supply side policy depends on the output gap (low = output increases more). Also in the long run, AD may increase (also consider multiplier) so raising inflation/ offsetting disinflation caused by the policy and the government's stance on the budget (austerity).
This is the average level of prices in the economy.

An increase in the price level is called inflation and a decrease is called deflation.
Conflicting Macroeconomic Objectives
So far we have covered the major macroeconomic objectives that an economy will try to maintain:
High and sustainable growth, measured with GDP.
- Uses fiscal policy as major tool. Controlled by the government.
Low and table inflation, measured by CPI and kept within 1% of 2% (i.e. 1% - 3%).
-Uses monetary policy as the major tool. Controlled by the Monetary Policy Committee.
Low unemployment - At the moment about 5.7% in UK (2015)
Balanced trade/ current account - Trade deficit is currently £2.8 billion.

However in trying to obtain these objectives, they may conflict with one another:
Another example is education, due this presentation maker learning then passing on the information making it non-rival and non-excludable, there is a loss of income for potential suppliers so disincentivising them from teaching so the service is underproduced and relies on the government to provide it.
There are conflicting objectives as higher economic growth causes or is caused by higher levels of consumption so driving up prices in an economy so raising inflation.
Unless inflation is below 1% in which case it may be beneficial for both to occur. HOWEVER, low inflation doesn't conflict with high growth as low inflation increases confidence so there may be more consumption and investment so raising growth.
Higher economic growth leads to lower unemployment as there is more production so more labour is required.
This in turn causes higher inflation as shown by the Phillips curve because of by higher GNI so more spending and so higher prices. HOWEVER, low inflation means greater confidence so more investment in labour.
Balance of payments

in equilibrium
Lower unemployment means higher growth, more goods produced and so less demand for imports i.e. aiding the balance of payments.
In summary:
Lower inflation,
lower growth, unemployment
- Using contractionary monetary/fiscal policy (short run), in the long run greater confidence means
higher employment and growth
inflation rises

Higher growth and employment,

- Using expansionary monetary/fiscal policy

Employment and lower inflation, higher growth
- Using supply side policies (short run, in the long run AD increases so causing inflationary pressure).
Education & Training - The length of unemployment, quality of scheme and the jobs targeted.
Taxes & Subsidies - Confidence, elasticity of supply and what's taxed and by how much.
NMW - Wage elasticity of supply and demand, higher may lead to excess demand and vice versa.
Deregulation - May be ineffective if there's market failure, e.g over/underproduction.
Immigration - Social tension as a negative externality, remittances, and their skills.
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