The Macroeconomic Environment

Question 1

A4 Macro-economic factors

(a) Define macroeconomic policy and explain its objectives.
(b) Explain the main determinants of the level of business activity in the economy and how variations in the level of business activity affect individuals, households and businesses.
(c) Explain the impact of economic issues on the individual, the household and the business:
(i) Inflation
(ii) Unemployment
(iii) Stagnation
(iv) International payments disequilibrium

Answer 1

(d) Describe the main types of economic policy that may be implemented by government and supra-national bodies to maximise economic welfare.
(e) Recognise the impact of fiscal and monetary policy measures on the individual, the household and businesses.

Question 2

1. The Structure And Objectives of the Economy

Answer 2

1. The Structure And Objectives of the Economy

Question 3

Macroeconomics is the study of the aggregated effects of the decisions of individual economic units (such as households or businesses). It looks at a complete national economy, or the international
economic system as a whole.

Answer 3

Macroeconomic policy describes the policies and actions a government takes to control economic
issues, including economic growth, inflation, employment and trade performance.

We look in detail at macroeconomic policy and objectives later in this chapter (in Section 8). We now
turn our attention to the flow of income and expenditure in an economy.

Question 4

Income and expenditure flows 1

There is a circular flow of income in an economy, which means that expenditure, output and income will
all have the same total value.

Firms must pay households for the factors of production (this generally means that firms pay wages to members of households) and households must
pay firms for goods and services. The income of firms is the sales revenue from the sales of goods
and services.

Answer 4

This creates a circular flow of income and expenditure, as illustrated in Figure 1. This is a basic closed
economy, without foreign trade. It assumes the economy has only two sectors (firms and households),
with no government intervention and no imports or exports. In this model, we assume that households
spend all that they earn (in economics this spending is known as consumption), and all the firms’ goods
and services are sold to the households.

Question 5

Income and expenditure flows 2

Figure 1 Circular flow of income, see OneNote

Answer 5

Households earn income because they have provided labour which enables firms to provide goods and
services. The income earned is used as expenditure on these goods and services that are made.
(a) The total sales value of goods produced should equal the total expenditure on goods, assuming
that all goods that are produced are also sold.
(b) The amount of expenditure should also equal the total income of households, because it is
households that consume the goods and they must have income to afford to pay for them.

At this stage we are assuming there are no withdrawals from, or injections into, the circular flow of
income.

Question 6

Withdrawals and injections into the circular flow of income

Now we assume that there are withdrawals from the circular flow of income (savings, taxation, import
expenditure) and injections into the circular flow (investment, government spending, export income).

Our simplified diagram of the circular flow of income in Figure 1 needs to be amended to allow for these
two things.

Be aware that saving is different from investment. Saving simply means withdrawing money from
circulation. Think of it as cash kept in a money box rather than being put into a bank to earn interest.
Whereas investment covers expenditure on capital items, such as plant, machinery, roads and houses.

Answer 6

Figure 2 Circular flow of income showing withdrawals and injections, see OneNote

The important point to note is that changes in behaviour of one of the components of the circular flow (for example, investment) can lead to significant changes in economic performance as a whole.

Question 7

2. Factors Which Affect the Economy

Answer 7

2. Factors Which Affect the Economy

Question 8

The economy is rarely in a stable state because of the various changing factors which influence it. These
include investment levels, the multiplier effect, inflation, savings, confidence, interest rates and
exchange rates.

Answer 8

The economy is explained by the various factors that influence it, such as investment levels, the multiplier effect, inflation, savings, confidence, interest rates and exchange rates. These factors are subject to change which means that the economy is rarely in a stable state. Economists use the business cycle (explained later in the chapter) to describe the fluctuating level of activity in the economy.

Question 9

The multiplier in the national economy

The multiplier involves the process of circulation of income in the national economy, whereby an
injection of a certain size leads to a much larger increase in national income. An initial increase in
expenditure will have a snowball effect, leading to further and further expenditures in the economy.
Since total expenditure in the economy is one way of measuring national income, it follows that an initial
increase in expenditure will cause an even larger increase in national income. The increase in national
income will be a multiple of the initial increase in spending, with the size of the multiple depending on
such factors as what proportion of any new investment is spent or what proportion is saved.

Answer 9

If you find this hard to visualise, think of an increase in government spending on the construction of roads. The government would spend money paying firms of road contractors, who in turn will purchase raw materials from suppliers, and subcontract other work. All these firms employ workers who will receive wages that they can spend on goods and services of other firms. The new roads in turn might stimulate new economic activity, for example amongst road hauliers, house builders and estate agents.

Depending on the size of the multiplier, an increase in investment would therefore have repercussions
throughout the economy, increasing the size of the national income by a multiple of the size of the
original increase in investment.

Question 10

Aggregate supply and demand

Two of the main problems in the economy are inflation and unemployment. In order to understand how
these problems arise, it is first necessary to understand aggregate demand, aggregate supply and how these combine to determine the level of national income and prices in the economy.

Answer 10

No Note

Question 11

Aggregate supply and demand - Aggregate demand

The total demand in the economy for goods and services is called the aggregate demand and it is made up of several components of the circular flow. These components include consumption, investment,
government spending and exports minus imports. Put simply, the aggregate demand curve represents
the sum of all the demand curves for individuals and businesses in a country.

Answer 11

Figure 3 The aggregate supply and demand model

Figure 3 shows that the aggregate demand curve slopes from left to right (ie demand will rise as prices
fall because people can afford more) but may shift as shown. A shift may be due to a factor such as an
increase or decrease in consumer confidence. This is explained below.

Question 12

Aggregate supply and demand - Aggregate supply

The aggregate supply refers to the ability of the economy to produce goods and services. Aggregate
supply is positively related to the price level. This is because a price rise will make more profitable sales
and encourage organisations to increase their output. The aggregate supply curve slopes upwards from
left to right and does not shift in the short term, as shown in Figure 3.

Answer 12

Where the aggregate demand curve intersects with the aggregate supply curve, the total demand for
goods and services in the economy is equal to the total supply of goods and services in the economy.
(This is known as the equilibrium level of national income.)

Note that the graph highlights the fact that a change in either the aggregate supply or demand will have
an effect on the price level and the national income. Assuming that employment levels are related to
national income levels, the model shows how unemployment and inflation (a change in price level)
could arise.

Question 13

Aggregate supply and demand - A shift in aggregate demand

Say, for example, that the equilibrium level is currently where national income = Y0 and price = P0 .
Then suppose there is a drop in consumer confidence so consumers stop spending (ie demand falls).
The new equilibrium would be where national income = Y1 and where price = P1.

Answer 13

If, on the other hand, consumer confidence increased (for example due to more access to affordable credit), consumers would buy more (an increase in demand) and so the new equilibrium would be where national income = Y2 and price = P2.

Question 14

3. The Determination of National Income

Answer 14

Equilibrium national income is determined using aggregate supply and aggregate demand analysis.

Question 15

Aggregate demand and supply equilibrium

Aggregate demand (AD) is total planned or desired consumption demand in the economy for consumer
goods and services and also for capital goods, no matter whether the buyers are households, firms or government.

Answer 15

Full-employment national income

If one aim of a country’s economic policy is full employment, then the ideal equilibrium level of national income will be where AD and AS are in balance at the full employment level of national income, without any inflationary gap – in other words, where aggregate demand at current price levels is exactly sufficient to encourage firms to produce at an output capacity where the country’s resources are fully
employed.

Question 16

Inflationary gaps

In a situation where resources are already fully employed, there may be an inflationary gap since
increases in demand will cause price changes, but no variations in real output.

A shift in demand or supply will not only change the national income, it will also change price levels.

Answer 16

Example

If you are not sure about this point, a simple numerical example might help to explain it better. Suppose
that in Ruritania there is full employment and all other economic resources are fully employed. The
country produces 1,000 units of output with these resources. Total expenditure (that is, aggregate
demand) in the economy is 100,000 Ruritanian dollars, or 100 dollars per unit. The country does not have any external trade, and so it cannot obtain extra goods by importing them. Because of pay rises and easier credit terms for consumers, total expenditure now rises to 120,000 Ruritanian dollars. The economy is fully employed, and cannot produce more than 1,000 units. If expenditure rises by 20%, to buy the same number of units, it follows that prices must rise by 20% too. In other words, when an economy is at full employment, any increase in aggregate demand will result in price inflation.

Question 17

Deflationary gap

In a situation where there is unemployment of resources there is said to be a deflationary gap. Prices are fairly constant and real output changes as aggregate demand varies. A deflationary gap can be described as the extent to which the aggregate demand function will have to shift upward to produce the full employment level of national income.

Answer 17

Stagflation

In the 1970s there was a problem with stagflation: a combination of unacceptably high unemployment,
unacceptably high inflation and low/negative economic growth. One of the causes was diagnosed as the major rises in the price of crude oil that took place. The cost of energy rose and this had the effect of rendering some production unprofitable. National income fell, and both prices and unemployment rose. Any long-term major increase in costs (a price shock) is likely to have this effect.

Question 18

Summary

An equilibrium national income will be reached where aggregate demand equals aggregate supply. There
are two possible equilibria.
(a) One is at a level of demand which exceeds the productive capabilities of the economy at full
employment, and there is insufficient output capacity in the economy to meet demand at current prices. There is then an inflationary gap.

Answer 18

(b) The other is at a level of employment which is below the full employment level of national income. The difference between actual national income and full employment national income is called a deflationary gap. To create full employment, the total national income (expenditure) must be increased by the amount of the deflationary gap.

Question 19

4. The Business Cycle

Answer 19

Business cycles or trade cycles are the continual sequence of rapid growth in national income, followed
by a slowdown in growth and then a fall in national income (recession). After this recession comes
growth again, and when this has reached a peak, the cycle turns into recession once more.

Question 20

Phases in the business cycle

Four main phases of the business cycle can be distinguished.
 Recession 
 Recovery
 Depression 
 Boom

Answer 20

Recession tends to occur quickly, while recovery is typically a slower process.

Question 21

Diagrammatic explanation 1

At point A in the diagram below, the economy is entering a recession. In the recession phase, consumer demand falls and many investment projects already undertaken begin to look unprofitable. Orders will be cut, inventory levels will be reduced and business failures will occur as firms find themselves unable to
sell their goods. Production and employment will fall. The general price level will begin to fall. Business
and consumer confidence are diminished and investment remains low, while the economic outlook
appears to be poor. Eventually, in the absence of any stimulus to aggregate demand, a period of full
depression sets in and the economy will reach point B.

Answer 21

Figure 4 The business cycle, see OneNote

Question 22

Diagrammatic explanation 2

At point C the economy has reached the recovery phase of the cycle. Once begun, the phase of recovery is likely to quicken as confidence returns. Output, employment and income will all begin to rise. Rising
production, sales and profit levels will lead to optimistic business expectations, and new investment will be more readily undertaken. The rising level of demand can be met through increased production by
bringing existing capacity into use and by hiring unemployed labour. The average price level will remain constant or begin to rise slowly.

Answer 22

In the recovery phase, decisions to purchase new materials and machinery may lead to benefits in
efficiency from new technology. This can enhance the relative rate of economic growth in the recovery
phase once it is underway.

Question 23

Diagrammatic explanation 3

As recovery proceeds, the output level climbs above its trend path, reaching point D, in the boom phase
of the cycle. During the boom, capacity and labour will become fully utilised. This may cause bottlenecks in some industries which are unable to meet increases in demand, for example because they have no spare capacity or they lack certain categories of skilled labour, or they face shortages of key material inputs. Further rises in demand will, therefore, tend to be met by increases in prices rather than by increases in production. In general, business will be profitable, with few firms facing losses. Expectations of the future may be very optimistic and the level of investment expenditure high.

Answer 23

It can be argued that wide fluctuations in levels of economic activity are damaging to the overall
economic well-being of society. The inflation and speculation which accompanies boom periods may be
inequitable in their impact on different sections of the population, while the bottom of the trade cycle
may bring high unemployment. Governments generally seek to stabilise the economic system, trying to
avoid the distortions of a widely fluctuating trade cycle.

Question 24

Inflation

Inflation is the name given to an increase in price levels generally. It is also manifest in the decline in the purchasing power of money.

Answer 24

Historically, there have been very few periods when inflation has not been present. We discuss below
why high rates of inflation are considered to be harmful. However, it is important to remember that
deflation (falling prices) is normally associated with low rates of growth and even recession. It would
seem that a healthy economy may require some inflation. Certainly, if an economy is to grow, the money supply must expand, and the presence of a low level of inflation will ensure that growth is not hampered by a shortage of liquid funds.
(Liquidity is the ease with which assets can be converted into cash.)

Question 25

Why is inflation a problem?

An economic policy objective which now has a central place in the policy approaches of the governments of many developed countries is that of stable prices.
Why is a high rate of price inflation harmful and undesirable?

Answer 25

Why is inflation a problem? - Redistribution of income and wealth

Inflation leads to a redistribution of income and wealth in ways which may be undesirable.
Redistribution of wealth might take place from accounts payable to accounts receivable. This is because debts lose ‘real’ value with inflation. For example, if you owed $1,000, and prices then doubled, you would still owe $1,000, but the real value of your debt would have been halved. In general, in times of
inflation those with economic power tend to gain at the expense of the weak, particularly those on fixed
incomes.

Question 26

Why is inflation a problem? - Balance of payments effects

If a country has a higher rate of inflation than its major trading partners, its exports will become relatively expensive and imports relatively cheap. As a result, the balance of trade will suffer, affecting employment in exporting industries and in industries producing import-substitutes. Eventually, the exchange rate will be affected.

Answer 26

Why is inflation a problem? - Uncertainty of the value of money and prices

If the rate of inflation is imperfectly anticipated, no one has certain knowledge of the true rate of
inflation. As a result, no one has certain knowledge of the value of money or of the real meaning of
prices. If the rate of inflation becomes excessive, and there is ‘hyperinflation’, this problem becomes so
exaggerated that money becomes worthless, so that people are unwilling to use it and are forced to resort to barter. In less extreme circumstances, the results are less dramatic, but the same problem exists. As prices convey less information, the process of resource allocation is less efficient and rational decision-making is almost impossible.

Question 27

Why is inflation a problem? - Resource costs of changing prices

A fourth reason to aim for stable prices is the resource cost of frequently changing prices. In times of
high inflation, substantial labour time is spent on planning and implementing price changes. Customers
may also have to spend more time making price comparisons if they seek to buy from the lowest cost
source.

Answer 27

Why is inflation a problem? - Economic growth and investment

It is sometimes claimed that inflation is harmful to a country’s economic growth and level of investment..
Although some studies have indicated that the adverse influence of inflation on economic growth and
investment appears to be small in the short term, it could affect a country’s standard of living fairly
significantly over the long term.

Question 28

Consumer price indices

We have already referred to the way in which inflation erodes the real value of money. In order to
measure changes in the real value of money as a single figure, we need to group all goods and services
into a single price index. A consumer price index is based on a chosen ‘basket’ of items which consumers purchase. A weighting is decided for each item according to the average spending on the item by consumers.

Answer 28

Consumer price indices may be used for several purposes, for example as an indicator of inflationary
pressures in the economy, as a benchmark for wage negotiations and to determine annual increases in
government benefits payments. Countries commonly have more than one consumer price index because
one composite index may be considered too wide a grouping for different purposes.

Question 29

Consumer price indices - The RPI and the CPI

One important measure of the general rate of inflation in the UK used over many years has been the
Retail Prices Index (RPI). The RPI measures the percentage changes month by month in the average
level of prices of the commodities and services, including housing costs, purchased by the great majority of households in the UK. The items of expenditure within the RPI are intended to be a representative list of items, current prices for which
are collected at regular intervals.

Answer 29

Since 2003, the Harmonised Index of Consumer Prices (HICP) has been used as the basis for the UK’s
inflation target. The UK HICP is called the Consumer Prices Index (CPI). The CPI excludes most housing costs.

Question 30

Consumer price indices - The underlying rate of inflation

The term underlying rate of inflation is usually used to refer to the RPI adjusted to exclude mortgage costs and sometimes other elements as well (such as the local council tax). The effects of interest rate changes on mortgage costs help to make the RPI fluctuate more widely than the underlying rate of inflation.

Answer 30

RPIX is the underlying rate of inflation measured as the increase in the RPI excluding mortgage interest
payments. Another measure, called RPIY, goes further and excludes the effects of sales tax (VAT) changes as well.

Question 31

Causes of inflation

The following can cause inflation:
 Demand pull factors
 Expectations

Answer 31

 Cost push factors

 Excessive growth in the money supply

Question 32

Causes of inflation - Demand pull inflation

Demand pull inflation arises from an excess of aggregate demand over the productive capacity of the
economy.

Demand pull inflation occurs when the economy is buoyant and there is a high aggregate demand, in
excess of the economy’s ability to supply.

Answer 32

(a) Because aggregate demand exceeds supply, prices rise.
(b) Since supply needs to be raised to meet the higher demand, there will be an increase in demand
for factors of production, and so factor rewards (wages, interest rates, and so on) will also rise.
(c) Since aggregate demand exceeds the output capability of the economy, it should follow that
demand pull inflation can only exist when unemployment is low. A feature of inflation in the UK
in the 1970s and early 1980s, however, was high inflation coupled with high unemployment.

Demand pull inflation: inflation resulting from a persistent excess of aggregate demand over aggregate supply. Supply reaches a limit on capacity at the full employment level.

Question 33

Causes of inflation - Cost push inflation

Cost push inflation arises from increases in the costs of production.

Cost push inflation occurs where the costs of factors of production rise regardless of whether or not they
are in short supply. This appears to be particularly the case with wages.

Cost push inflation: inflation resulting from an increase in the costs of production of goods and services, eg through escalating prices of imported raw materials or from wage increases.

Answer 33

Causes of inflation - Import cost factors

Import cost push inflation occurs when the cost of essential imports rise regardless of whether or not
they are in short supply. This has occurred in the past with the oil price rises of the 1970s. Additionally, a fall in the value of a country’s currency will have import cost push effects since a weakening currency increases the price of imports.

Question 34

Causes of inflation - Expectations and inflation

A further problem is that once the rate of inflation has begun to increase, a serious danger of expectational inflation will occur. This means, regardless of whether the factors that have caused inflation are still persistent or not, there will arise a generally held view of what inflation is likely to be, and so to protect future income, wages and prices will be raised now by the expected amount of future inflation. This can lead to the vicious circle known as the wage-price spiral, in which inflation becomes a relatively permanent feature because of people’s expectations that it will occur.

Answer 34

Causes of inflation - Money supply growth

Monetarists have argued that inflation is caused by increases in the supply of money. There is a considerable debate as to whether increases in the money supply are a cause of inflation or whether
increases in the money supply are a symptom of inflation. Monetarists have argued that since inflation is
caused by an increase in the money supply, inflation can be brought under control by reducing the rate
of growth of the money supply

Question 35

6. Unemployment

Answer 35

6. Unemployment

Question 36

The rate of unemployment 1

The rate of unemployment in an economy can be calculated as:

Number of unemployed / Total workforce
× 100%

Answer 36

The number of unemployed at any time is measured by government statistics.

If the flow of workers through unemployment is constant then the size of the unemployed labour force
will also be constant.

Question 37

The rate of unemployment 2

Flows into unemployment are:
(a) Members of the working labour force becoming unemployed
 Redundancies 
 Voluntarily quitting a job
 Lay-offs

Answer 37

(b) People out of the labour force joining the unemployed
 School leavers without a job
 Others (for example, carers) rejoining the workforce but having no job yet

Question 38

The rate of unemployment 3

Flows out of unemployment are:
 Unemployed people finding jobs
 Laid-off workers being re-employed
 Unemployed people stopping the search for work

Answer 38

In the UK, the monthly unemployment statistics published by the Office for National Statistics (ONS)
count only the jobless who receive benefits.

The ONS also produce figures based on a quarterly survey of the labour force known as the International
Labour organisation measure (ILO measure) that provides seasonally adjusted monthly data. This figure
is considered to be more useful because it is also an internationally comparable measure.

Question 39

Consequences of unemployment

Unemployment results in the following problems.
(a) Loss of output. If labour is unemployed, the economy is not producing as much output as it
could. Thus, total national income is less than it
could be.

(b) Loss of human capital. If there is unemployment,
the unemployed labour will gradually lose its skills, because skills can only be maintained by working.

Answer 39

(c) Increasing inequalities in the distribution of income. Unemployed people earn less than employed people, and so when unemployment is increasing, the poor get poorer.
(d) Social costs. Unemployment brings social problems of personal suffering and distress, and possibly also increases in crime, such as theft and vandalism.

(e) Increased burden of welfare payments. This can have a major impact on government fiscal
policy.

Question 40

Causes of unemployment 1

Unemployment may be classified into several categories depending on the underlying causes.
(Category/Comment)

Real wage unemployment
- This type of unemployment is caused when the supply of labour exceeds the demand for labour, but real wages do not fall for the labour market to clear. This type of unemployment is normally caused by strong trade unions which resist a fall in their wages.
Another cause of this type of unemployment is the minimum wage rate, when it is set above the market clearing level.

Answer 40

Frictional
- It is inevitable that some unemployment is caused not so much because there are not enough jobs to go round, but because of the friction in the labour market (difficulty in matching quickly workers with jobs), caused perhaps by a lack of knowledge about job opportunities. In general, it takes time to match prospective employees with employers, and individuals will be unemployed during the search period for a new job. Frictional unemployment is temporary, lasting for the period of transition from one job to the next.

Question 41

Causes of unemployment 2

Seasonal
- This occurs in certain industries, for example building, tourism and farming, where the demand for labour fluctuates in seasonal patterns throughout the year.

Structural
- This occurs where long-term changes occur in the conditions of an industry. A feature of structural unemployment is high regional unemployment in the location of the industry affected. The primary cause is a significant reduction in the level of demand.

Answer 41

Technological
- This is a form of structural unemployment, which occurs when new technologies are
introduced.
(a) Old skills are no longer required.
(b) There is likely to be a labour saving aspect, with machines doing the job that people used to do.

With automation, employment levels in an industry can fall sharply, even when the industry’s total output is increasing.

Question 42

Causes of unemployment 3

Cyclical or demand deficient
- It has been the experience of the past that domestic and foreign trade go through cycles of boom, decline, recession, recovery, then boom again, and so on.

(a) During recovery and boom years, the demand for output and jobs is high, and unemployment is low.
(b) During decline and recession years, the demand for output and jobs falls, and unemployment rises to a high level.

Cyclical unemployment can be long term, and a government might try to reduce it by doing what it can to minimise a recession or to encourage faster economic growth.

Answer 42

Seasonal employment and frictional unemployment will be short term. Structural unemployment, technological unemployment and cyclical unemployment are all longer term, and more serious.

Question 43

Government employment policies 1

Job creation and reducing unemployment should often mean the same thing, but it is possible to create
more jobs without reducing unemployment.

(a) This can happen when there is a greater number of people entering the jobs market than there are new jobs being created. For example, if 500,000 new jobs are created during the course of one year, but 750,000 extra school leavers are looking for jobs, there will be an increase in unemployment of 250,000.

Answer 43

(b) It is also possible to reduce the official unemployment figures without creating jobs. For example, individuals who enrol for a government-financed training scheme are taken off the unemployment register, even though they do not have full-time jobs.

Question 44

Government employment policies 2

A government can try several options to create jobs or reduce unemployment.

(a) Spending more money directly on jobs (for example hiring more civil servants)
(b) Encouraging growth in the private sector of the economy; when aggregate demand is growing,
firms will probably want to increase output to meet demand, and so will hire more labour

Answer 44

(c) Encouraging training in job skills, as there might be a high level of unemployment amongst unskilled workers, and at the same time a shortage of skilled workers – a government can help to finance training schemes, in order to provide a ‘pool’ of workers who have the skills that firms need and will pay for
(d) Offering grant assistance to employers in key regional areas
(e) Encouraging labour mobility by offering individuals financial assistance with relocation expenses,
and improving the flow of information on vacancies

Question 45

Government employment policies 2

A government can try several options to create jobs or reduce unemployment.

(a) Spending more money directly on jobs (for example hiring more civil servants)

(b) Encouraging growth in the private sector of the economy; when aggregate demand is growing,
firms will probably want to increase output to meet demand, and so will hire more labour

Answer 45

(c) Encouraging training in job skills, as there might be a high level of unemployment amongst unskilled workers, and at the same time a shortage of skilled workers – a government can help to finance training schemes, in order to provide a ‘pool’ of workers who have the skills that firms need and will pay for
(d) Offering grant assistance to employers in key regional areas
(e) Encouraging labour mobility by offering individuals financial assistance with relocation expenses, and improving the flow of information on vacancies

Question 46

Government employment policies 3

Other policies may be directed at reducing real wages to market clearing levels.

(a) Abolishing closed shop agreements, which restrict certain jobs to trade union members
(b) Abolishing minimum wage regulations, where such regulations exist

Answer 46

QUESTION Types of unemployment
Match the terms (a), (b) and (c) below with definitions
A, B and C.
(a) Structural unemployment (c) Frictional unemployment
(b) Cyclical unemployment
A Unemployment arising from a difficulty in matching unemployed workers with available jobs
B Unemployment occurring in the downswing of an economy in between two booms
C Unemployment arising from a long-term decline in a particular industry

ANSWER
The pairings are (a) C, (b) B and (c) A.

Question 47

7. The Objective of Economic Growth

Answer 47

Economic growth may be measured by increases in the real gross national product (GNP) per head of
the population.

Question 48

Economic growth

It is not unusual to find economic growth measured simply as increases in total GNP, regardless of
inflation and changes in population size. Over periods in which the population changes relatively little, this approach will be satisfactory.

Economic growth may be measured by increases in the real gross national product (GNP) per head of the population.

Answer 48

Economic growth may be balanced, when all sectors of the economy expand together, or unbalanced. Less developed countries in particular find it difficult to achieve economic growth, because many of the
factors necessary for growth are absent in these countries.

Actual economic growth is the annual percentage increase in national output, which typically fluctuates
in accordance with the trade cycle. Potential economic growth is the rate at which the economy would grow if all resources (eg people and machinery) were utilised.

Question 49

Actual growth

Actual growth in the long run is determined by two factors.
 The growth in potential output (in other words the aggregate supply)
 The growth in aggregate demand (AD)

Answer 49

These factors should move in step with one another as we explained in Aggregate supply and demand and Figure 3 The aggregate supply and demand model

Question 50

Potential growth

The causes of growth in potential output are the determinants of the capacity of the economy (the
supply side) rather than actual spending (the demand side), and are as follows.
(a) There may be increases in the amount of resources available.
(i) Land and raw materials. Land is virtually in fixed supply, but new natural resources are continually being discovered.
(ii) Labour (the size of the working population). The output per head will be affected by the proportion of the population which is non-working.
(iii) Capital (eg machinery).

Answer 50

(b) Increases in the productivity of resources may result from technological progress or changed labour practices, for example.

Question 51

Factors needed for sustained economic growth

Sustained economic growth depends heavily on an adequate level of new investment, which will be
undertaken if there are expectations of future growth in demand. After investment has taken place on
the basis of expectations, the level of income will increase, by the operation of the multiplier. But there
is no reason why the actual level of income should end up increasing as much as the investing business
people thought it would. It follows that investment, a factor in growth, is dependent on business
confidence in the future, which is reflected in expectations of growth in consumption.

Answer 51

Natural resources

The rate of extraction of natural resources will impose a limit on the rate of growth. Production which uses up a country’s natural resources, such as oil, coal and other minerals, depletes the stock of available resources; it is therefore, in a sense, disinvestment.

Question 52

Technological progress 1

Technological progress is a very important source of faster economic growth.
 The same amounts of the factors of production can produce a higher output.
 New products will be developed, thus adding to output growth.

There can be technical progress in the labour force. If workers are better educated and better trained
they will be able to produce more. For example, if there is a fault in the production process, a skilled worker will be able to deal with it quickly, whereas an unskilled worker might have to call for a superior
instead.

Answer 52

Technological progress can be divided into three types.

(a) Capital saving: technical advances that use less capital and the same amount of labour per unit
of output

(b) Neutral: technical advances that require labour and capital in the same proportions as before, using less of each per unit of output
(c) Labour-saving: technical advances that uses less labour and the same amount of capital per unit of output

Question 53

Technological progress 2

If technological progress is of type (c) and the new technology seems to be labour-saving, then
unemployment will rise unless there is either a simultaneous expansion of demand or a reduction in
hours worked by each person. In the latter case there is no productivity increase associated with the
technological progress.

Answer 53

Technological progress may therefore stimulate growth but at the same time conflict with the goal of full employment. A further consequence of this could be that those people in work would benefit from
economic growth in the form of higher wages, but those people put out of work by the new technology
would be left with a lower income. There is thus a danger that the rich will get richer and the poor will
get poorer in spite of economic growth, and this would be regarded by many people as an undesirable
development.

Question 54

External trade influences on economic growth

An improvement in the terms of trade (the quantity of imports that can be bought in exchange for a given quantity of exports) means that more imports can be bought or alternatively a given volume of exports will earn higher profits. This will boost investment and hence growth. The rate of growth of the rest of the world is important for an economy that has a large foreign trade sector.

Answer 54

If trading partners have slow growth, the amount of exports a country can sell to them will grow only slowly, and this limits the country’s own opportunities for investment and growth.

Question 55

Advantages and disadvantages of economic growth

Economic growth should lead to a higher income per head which can in turn lead to higher levels of
consumption and a better standard of living.

A country with economic growth is more easily able to provide welfare services without creating
intolerable tax burdens on the community.

Answer 55

There are possible disadvantages to growth, however.
(a) Growth implies faster use of natural resources. Without growth, these resources would last longer.
(b) Much economic activity tends to create pollution, such as acid rain and nuclear waste. It leads to
emissions which threaten to produce disruptive climatic changes through an increase in the
‘greenhouse effect’. It results in more roads, new and larger towns, and less unspoilt countryside.
(c) There is a danger that some sections of the population, unable to adapt to the demands for new
skills and more training, will not find jobs in the developing economy. This structural unemployment might create a large section of the community which gains no benefit from the increase in national income.
(d) In order to achieve growth, firms need to invest more and this requires financing. This finance can only come from higher savings which in turn require the population to consume less. In the short run, therefore, higher growth requires a cut in consumption.

Question 56

8. Government Policies for Managing the Economy

Answer 56

8. Government Policies for Managing the Economy

Question 57

Macroeconomic policy objectives relate to economic growth, inflation, unemployment and the balance
of payments.

All modern governments are expected to manage their national economies to some extent. Electorates
generally suppose that government action can support or hinder the growth of prosperity and look to them for serviceable macroeconomic policies.

Answer 57

There are four main objectives of economic policy, though debate continues about their relative priority.

(a) To achieve economic growth, and growth in national income per head of the population. Growth
implies an increase in national income in real terms. Increases caused by price inflation are not real increases at all.

(b) To control price inflation (to achieve stable prices). This has become a central objective of UK economic policy in recent years.

Question 58

(c) To achieve full employment. Full employment does not mean that everyone who wants a job has one all the time, but it does mean that unemployment levels are low, and involuntary unemployment is short term.
(d) To achieve a balance between exports and imports (on the country’s balance of payments accounts) over a period of years. The wealth of a country relative to others, a country’s creditworthiness as a borrower, and the goodwill between countries in international relations might all depend on the achievement of an external balance over time.

Answer 58

The problem with trying to satisfy these objectives is that when any are satisfied, they invariably cause a problem with the others. For example, creating full employment may lead to increased inflation rates. As explained later in the chapter, governments use ‘fiscal’ or ‘monetary’ policies to manage these objectives.

Question 59

Government spending

Governments spend money. Expenditure must be allocated between departments and functions such as
health, social services, education, transport, defence, grants to industry, and so on.

 Wages and salaries to employees
 Materials, supplies and services

Answer 59

 Capital equipment
 Interest on borrowings and repayments of capital
 Benefits and pensions to those entitled to such

Question 60

Significance of government tax and spending decisions to companies

(a) Expenditure decisions by government affect suppliers to the Government, such as producers of
defence equipment, medicines and medical equipment, and school text books.

(b) There is a ‘knock-on’ effect throughout the economy of government spending; that is, companies might supply companies which in turn supply the Government.

(c) Taxation affects consumers’ purchasing
power.

Answer 60

(d) Taxes on company profits and tax allowances affect the after-tax return on investment that companies achieve.
(e) Investment by the public sector will tend to be directed towards activities in which the public sector is involved or on fulfilling social needs. Hence industries in these fields will benefit.
(f) Public sector investment might have a longer time scale (eg health) or have less quantifiable economic benefits (eg education) than the private sector is able to cope with.

Question 61

Economic planning

At one time, many people believed the Government should plan economic activity in detail. This is now
out of favour, perhaps as a result of the failure of communism in the eastern bloc. In this model,
government is a director of economic activity.
Economic planning on a lesser scale, with the Government as an enabler of private sector activity and as corrector of market imperfections, is now seen by many as more appropriate.

(a) Government’s most important economic role is the legal system relating to business. Law relating to property, contracts in corporation, competition, employment, and so on provides a framework
which enables businesses to be done with confidence.
(b) Government also has a responsibility for macroeconomic management. Such management, like
the legal framework, should provide stable conditions in which business can operate with confidence.
(c) Governments can raise trade barriers to protect domestic industry, although the trend has been
to lower such barriers.

Answer 61

(d) Governments can subsidise exports, or promote them in other ways (eg by trade missions, export credit insurance and so forth).
(e) Governments can also encourage inward investment by foreign countries..
(f) Regional policy is an example of small scale economic planning.
(i) Tax incentives or grants for investing in certain areas
(ii) Relaxing or enforcing town and county planning restrictions
(iii) Developing new towns to reduce population pressure in major conurbations, although this policy is perhaps a thing of the past
(iv) Promotion of infrastructure developments (eg roads, rail, airports).

The Government also attempts to influence businesses by persuasion and encouraging certain actions.

Question 62

Government influence over commercial decisions
(decision/comment)

Output capacity - Grants or tax incentives to invest

Competition
- Forbid or allow takeovers/mergers , Outlaw anti-competitive practices, Opening markets to new
entrants (eg gas)

Answer 62

Monopolies - Break them up; regulate them

Sales demand - Government policy affects demand

Question 63

Government influence over operational decisions

Health and safety - Legislation, regulations

Employment - Equal opportunities legislation

Answer 63

Consumers - Product safety standards

Tax - Sales tax procedures, income tax, accounting control

Question 64

9. Fiscal Policy

Answer 64

Fiscal policy provides a method of managing aggregate demand in the economy.

Fiscal policy: government policy on taxation, public borrowing and public spending.

Question 65

10. Monetary Policy

Answer 65

10. Monetary Policy

Question 66

Fiscal policy and the Budget 1

A feature of fiscal policy is that a government must plan what it wants to spend, and so how much it
needs to raise in income or by borrowing. It needs to make a plan in order to establish how much
taxation there should be, what form the taxes should take and so which sectors of the economy (firms or
households, high income earners or low income earners) the money should come from. This formal
planning of fiscal policy is usually done once a year and is set out in the Budget.

Answer 66

The two components of the budget which the Government determines and through which it exercises its fiscal policy are:

(a) Expenditure. The Government, at a national and local level, spends money to provide goods and
services, such as a health service, public education, a police force, roads and public buildings, and to pay its administrative workforce. It may also, perhaps, provide finance to encourage investment by private industry, for example by means of grants.

Question 67

Fiscal policy and the Budget 2

(b) Revenues. Expenditure must be financed, and the government must have income. Most government income comes from taxation, although some income is obtained from direct charges to users of government services, such as National Health Service charges.

Answer 67

A third element of the fiscal policy is:
(c) Borrowing. To the extent that a government’s expenditure exceeds its income it must borrow to
make up the difference. The amount that the Government must borrow each year is now known
as the Public Sector Net Cash Requirement (PSNCR) in the UK. Its former name was Public Sector Borrowing Requirement (PSBR). Where the Government borrows from has an impact on the effectiveness of fiscal policy.

Question 68

Budget surplus and budget deficit 1

If a government decides to use fiscal policy to influence demand in the economy, it can choose either
expenditure changes or tax changes as its policy instrument. Suppose, for example, that the Government wants to stimulate demand in the economy. If the Government kept its own spending at the same level, but reduced levels of taxation, it would
stimulate demand in the economy because firms and households would have more of their own money
after tax for consumption or saving/investing.

Answer 68

(a) It can increase demand directly by spending more itself – eg on the health service or education,
and by employing more people itself.
(i) This extra spending could be financed by higher taxes, but this would reduce spending by
the private sector of the economy because the private sector’s after-tax income would be lower.
(ii) The extra government spending could also be financed by extra government borrowing. Just as individuals can borrow money for spending, so too can a government.

Question 69

Budget surplus and budget deficit 2

(b) It can increase demand indirectly by reducing taxation and so allowing firms and individuals more after-tax income to spend (or save).
(i) Cuts in taxation can be matched by cuts in government spending, in which case total demand in the economy will not be stimulated significantly,
if at all.
(ii) Alternatively, tax cuts can be financed by more government borrowing.

Answer 69

Just as aggregate demand in the economy can be boosted by either more government spending or by tax
cuts, financed in either case by a higher PSNCR, so too can demand in the economy be reduced by cutting government spending or by raising taxes, and using the savings or higher income to cut government borrowing.

Question 70

Budget surplus and budget deficit 3

Expenditure changes and tax changes are not mutually exclusive options, of course. A government has several options.

(a) Increase expenditure and reduce taxes, with these changes financed by a higher PSNCR
(b) Reduce expenditure and increase taxes, with these changes reducing the size of the PSNCR
(c) Increase expenditure and partly or wholly finance this extra spending with higher taxes
(d) Reduce expenditure and use these savings to reduce taxes

Answer 70

When a government's income exceeds its expenditure, and there is a negative PSNCR or Public Sector
Debt Repayment (PSDR), we say that the Government is running a budget surplus. This may be a deliberate policy (known as contractionary policy) to reduce the size of the money supply by taking money out of the economy. When a government's expenditure exceeds its income, so that it must borrow to make up the difference, there is a PSNCR and we say that the Government is running a budget deficit. When the government is injecting money into the economy, this is known as expansionary policy.

Question 71

Functions of taxation

Taxation has several functions. Some of these include the following.
(a) To raise revenues for the Government as well as for local authorities and similar public bodies (eg the European Union).

(b) To cause certain products to be priced to take into account their social costs. (For example, smoking entails certain social costs, such as hospital care.)

Answer 71

(c) To redistribute income and wealth.
(d) To protect industries from foreign competition. If the Government levies a duty on all imported goods, much of the duty will be passed on to the consumer in the form of higher prices, making imported goods more expensive.

Question 72

Direct and indirect taxes

A government must decide how it intends to raise tax revenues, from direct or indirect taxes, and in what proportions tax revenues will be raised from each source.

A direct tax is paid direct by a person to the Revenue authority. Examples of direct taxes in the UK are
income tax, corporation tax, capital gains tax and inheritance tax. A direct tax can be levied on income
and profits, or on wealth. Direct taxes tend to be progressive or proportional taxes. They are also usually
unavoidable, which means that they must be paid
by everyone.

Answer 72

An indirect tax is collected by the Revenue authority from an intermediary (a supplier) who then attempts to pass on the tax to consumers in the price of goods they sell. Indirect taxes are of two types.

 A specific tax is charged as a fixed sum per unit sold.
 An ad valorem tax is charged as a fixed percentage of the price of the good.

Question 73

Tax and income levels

Note the following distinctions.

(a) A regressive tax takes a higher proportion of a poor person’s salary than of a rich person’s. Television licences and road tax are examples of regressive taxes since they are the same for all people.
(b) A proportional tax takes the same proportion of income in tax from all levels of income.

Answer 73

(c) A progressive tax takes a higher proportion of income in tax as income rises. Income tax as a whole is progressive, since the first part of an individual’s income is tax free due to personal allowances and the rate of tax increases in steps in the UK from 20p in £1 to 45p in £1 as taxable income rises.

Direct taxes tend to be progressive or proportional. Income tax is usually progressive, with high rates of
tax charged on higher bands of taxable income. Indirect taxes can be regressive, when the taxes are
placed on essential commodities or commodities consumed by poorer people in greater quantities.

Question 74

Monetary policy uses money supply, interest rates or credit controls to influence aggregate demand.

Monetary policy: government policy on the money supply, the monetary system, interest rates, exchange rates and the availability of credit.

Monetary and fiscal policies attempt to attain the macroeconomic policy objectives by influencing
aggregate demand.

Answer 74

QUESTION Effects of policy
How are businesses affected by fiscal and monetary policy?

ANSWER :
Businesses are affected by a government’s tax policy (eg corporation tax rates) and monetary policy (high interest rates increase the cost of investment, and depress consumer demand).

Question 75

11. The Balance of Payments

Answer 75

The balance of payments accounts consist of a current account with visibles and invisibles sections and
transactions in capital (external assets and liabilities including official financing).

Question 76

Objectives of monetary policy

Monetary policy can be used as a means towards achieving ultimate economic objectives for inflation,
the balance of trade, full employment and real economic growth. To achieve these ultimate objectives, the authorities will set intermediate objectives for monetary policy.

Answer 76

In the UK, the ultimate objective of monetary policy in recent years has been principally to reduce the rate of inflation to a sustainable low level. The intermediate objectives of monetary policy have related to the level of interest rates, growth in the money supply, the exchange rate for sterling, the expansion of credit and the growth of national income.

Question 77

The money supply as a target of monetary policy

To monetarist economists, the money supply is an obvious intermediate target of economic policy. This
is because they claim that an increase in the money supply will raise prices and incomes and this in turn will raise the demand for money to spend. The current trend is to call this quantitative easing, a policy whereby a government prints more money in order to stimulate the economy.

Answer 77

When such a policy is first introduced, the short-term effect would be unpredictable for three reasons.
(a) The effect on interest rates might be erratic.
(b) There might be a time lag before anything can be done. For example, it takes time to cut government spending and hence to use reduction in government borrowing as an instrument of monetary policy.
(c) There might be a time lag before control of the money supply alters expectations about inflation
and wage demands.

Growth in the money supply, if it is a monetary policy target, should therefore be a medium-term target.

Question 78

Interest rates as a target for monetary policy 1

The authorities might decide that interest rates – the price of money – should be a target of monetary
policy. This would be appropriate if it is considered that there is a direct relationship between interest rates and the level of expenditure in the economy, or between interest rates and the rate of inflation.

Answer 78

A rise in interest rates will raise the price of borrowing in the internal economy for both companies and
individuals. If companies see the rise as relatively permanent, rates of return on investments will become
less attractive and investment plans may be curtailed. Corporate profits will fall as a result of higher interest payments. Companies will reduce inventory levels as the cost of having money tied up in inventory rises. Individuals should be expected to reduce or postpone consumption in order to reduce borrowings, and should become less willing to borrow for house purchase.

Although it is generally accepted that there is likely to be a connection between interest rates and
investment (by companies) and consumer expenditure, the connection is not a stable and predictable one,
and interest rate changes are only likely to affect the level of expenditure after a considerable time lag.

Question 79

Interest rates as a target for monetary policy 2

Other effects of raising interest rates
(a) High interest rates will keep the value of sterling higher than it would otherwise be. This will keep
the cost of exports high, and so discourage the purchase of exports. This may be necessary to
protect the balance of payments and to prevent ‘import-cost-push’ inflation. UK manufacturers
have complained bitterly about this effect and BMW cited it as one of the reasons for disposing of
Rover.

(b) High interest rates will attract foreign investors into sterling investments, and so provide capital
inflows which help to finance the large UK balance
of payments deficit.

Answer 79

An important reason for pursuing an interest rate policy is that the authorities are able to influence interest rates much more effectively and rapidly than they can influence other policy targets, such as the money supply or the volume of credit.

Question 80

The exchange rate as a target of monetary policy

Why the exchange rate is a target
(a) If the exchange rate falls, exports become cheaper to overseas buyers and so more competitive in
export markets. Imports will become more expensive and so less competitive against goods produced by manufacturers at home. A fall in the exchange rate might therefore be good for a domestic economy, by giving a stimulus to exports and reducing demand for imports.

(b) An increase in the exchange rate will have the opposite effect, with dearer exports and cheaper
imports. If the exchange rate rises and imports become cheaper, there should be a reduction in the rate of domestic inflation. A fall in the exchange rate, on the other hand, tends to increase the cost of imports and adds to the rate of domestic inflation.

Answer 80

When a country’s economy is heavily dependent on overseas trade, as the UK economy is, it might be
appropriate for government policy to establish a target exchange value for the domestic currency. However, the exchange rate is dependent on both the domestic rate of inflation and the level of interest rates. Targets for the exchange rate cannot be achieved unless the rate of inflation at home is first brought under control.

Question 81

Targets and indicators 1

An economic indicator provides information about economic conditions and might be used as a way of
judging the performance of government.

(a) A leading indicator is one which gives an advance indication of what will happen to the economy in the future. It can therefore be used to predict future conditions. For example, a fall in the value of sterling by, say, 2% might be used to predict what will happen to the balance of payments and to the rate of inflation.

Answer 81

(b) A coincident indicator is one which gives an indication of changes in economic conditions at the
same time that these changes are occurring. For example, if the narrow money supply rises by 5%, this might ‘confirm’ that the rate of increase in GDP over the same period of time has been about the same, 5% in ‘money’ terms.

(c) A lagging indicator, you will have guessed, is one which ‘lags behind’ the economic cycle. Unemployment, to take an example, often continues to rise until after a recession has ended and only starts to fall again after recovery has begun.

Question 82

Targets and indicators 2

There are a number of monetary indicators.
(a) The size of the money stock
(b) Interest rates such as the banks’ base rate of interest, the Treasury bill rate and the yield on long dated government securities
(c) The exchange rate against another currency, for example the US dollar, or the trade-weighted
exchange rate index

Answer 82

(d) The size of the Government’s borrowing

(e) Government borrowing as a percentage of Gross Domestic Product

Question 83

Monetary policy and fiscal policy

Monetary policy can be made to act as a subsidiary support to fiscal policy and demand management.
Since budgets are once-a-year events, a government must use non-fiscal measures in between budgets
to make adjustments to its control of the economy.
(a) A policy of low interest rates or the absence of any form of credit control might stimulate bank
lending, which in turn would increase expenditure (demand) in the economy.
(b) High interest rates might act as a deterrent to borrowing and so reduce spending in the economy.
(c) Strict credit controls (for example restrictions on bank lending) might be introduced to reduce
lending and so reduce demand in the economy.

Answer 83

Alternatively, monetary policy might be given rominence over fiscal policy as the most effective approach by a government to achieving its main economic policy objectives. This might not, however, be possible: from 1990 to 1992, for example, monetary policy in the UK was heavily constrained by the need to set interest rates at levels which maintained sterling’s position in the European exchange rate mechanism (ERM). From 1997, the Government has given the Bank of England the role of setting interest rates, although it is still the Government which sets an inflation target. If the UK joined a single European currency, interest rates would largely be determined at the European level.

Question 84

Monetary policy, inflation control and economic
growth

Monetarists argue that monetary control will put the brake on inflation, but how does this help the
economy? We might argue like this.

(a) High inflation increases economic uncertainty. Bringing inflation under control will restore business confidence and help international trade by stabilising the exchange rate.

Answer 84

(b) A resurgence of business confidence through lower interest rates (due to less uncertainty and lower inflation) will stimulate investment and real output.
(c) A controlled growth in the money supply will provide higher incomes for individuals to purchase the higher output.

Question 85

11. The Balance of Payments

Answer 85

The balance of payments accounts consist of a current account with visibles and invisibles sections and transactions in capital (external assets and liabilities including official financing).

Question 86

The nature of the balance of payments 1

EXAM FOCUS POINT :

Confusion of the balance of payments with the Government budget is common. Make sure that the
distinction is clear in your mind.

Answer 86

Under the current method of presentation of the UK balance of payments statistics, current account
transactions are subdivided into four parts.
 Trade in goods  Income
 Trade in services  Transfers

Question 87

The nature of the balance of payments 2

Before 1996, the term visibles was used in official statistics for trade in goods and the term invisibles
was used for the rest. These terms have now been dropped in order to give more emphasis to the
balances for trade in goods and services, although you may still find them mentioned.

Answer 87

Income is divided into two parts.

(a) Income from employment of UK residents by overseas firms
(b) Income from capital investment overseas

Question 88

The nature of the balance of payments 3

Transfers are also divided into two parts.
(a) Public sector payments to and receipts from overseas bodies, such as the EU. Typically these are
interest payments
(b) Non-government sector payments to and receipts from bodies, such as the EU

The capital account balance is made up of public sector flows of capital into and out of the country,
such as government loans to other countries.

Answer 88

The balance on the financial account is made up of flows of capital to and from the non-government sector, such as direct investment in overseas facilities; portfolio investment (in shares, bonds, and so on); and speculative flows of currency. Movements on government foreign currency reserves are also included under this heading.

Question 89

The nature of the balance of payments 4

When journalists or economists speak of the balance of payments they are usually referring to the deficit
or surplus on the current account, or possibly to the surplus or deficit on trade in goods only (this is also
known as the balance of trade).

Answer 89

EXAM FOCUS POINT :
Do not equate a trade surplus or deficit with a ‘profit’ or ‘loss’ for the country. A country is not like a company and the trade balance has nothing to do with profits and losses.

Question 90

Equilibrium in the balance of payments

A balance of payments is in equilibrium if, over a period of years, the exchange rate remains stable and
autonomous credits and debits are equal in value (the annual trade in goods and services is in overall
balance).

Answer 90

However, equilibrium will not exist if these things require the government to introduce measures which create unemployment or higher prices, sacrifice economic growth or impose trade barriers (eg import tariffs and import quotas).

Question 91

Surplus or deficit in the current account 1

A surplus or deficit on the balance of payments usually means a surplus or deficit on the current
account.

A problem arises for a country’s balance of payments when the country has a deficit on current account
year after year, although there can be problems too for a country which enjoys a continual current
account surplus.

Answer 91

The problems of a deficit on the current account are probably the more obvious. When a country is
continually in deficit, it is importing more goods and services that it is exporting. This leads to two
possible consequences.
(a) It may borrow more and more from abroad, to build up external liabilities which match the deficit
on the current account, for example encouraging foreign investors to lend more by purchasing the
government’s gilt-edged securities.
(b) It may sell more and more of its assets. This has been happening recently in the US, for example,
where a large deficit on the US current account has resulted in large purchases of shares in US
companies by foreign firms.

Question 92

Surplus or deficit in the current account 2

Even so, the demand to buy the country’s currency in the foreign exchange markets will be weaker than
the supply of the country’s currency for sale. As a consequence, there will be pressure on the exchange
rate to depreciate in value.

Answer 92

If a country has a surplus on the current account year after year, it might invest the surplus abroad or add
it to official reserves. The balance of payments position would be strong. There is the problem, however, that if one country which is a major trading nation (such as Japan) has a continuous surplus on its balance of payments current account, other countries must be in continual deficit. These other countries can run down their official reserves, perhaps to nothing, and borrow as much as they can to meet the payments overseas, but eventually they will run out of money entirely and be unable even to pay their debts. Political pressure might therefore build up within the importing countries to impose tariffs or import quotas.

Question 93

How can a government rectify a current
account deficit?

The government of a country with a balance of payments deficit will usually be expected to take
measures to reduce or eliminate the deficit. A current account deficit may be rectified by one or more of
the following measures.

Answer 93

(a) A depreciation of the currency (called devaluation when deliberately instigated by the government,
for example by changing the value of the currency within a controlled exchange rate system)
(b) Direct measures to restrict imports, such as tariffs or import quotas or exchange control regulations
(c) Domestic deflation to reduce aggregate demand in the domestic economy.

The first two are expenditure switching policies, which transfer resources and expenditure away from
imports and towards domestic products, while the last is an expenditure reducing policy.

Question 94

Question and Answer

Answer 94

Question and Answer

Question 95

1 Government policy on taxation, public borrowing and public spending is:
A Monetary policy
B Fiscal policy

2 A government can increase demand by using fiscal policy.
True False

Answer 95

1 B Monetary policy is policy on the money supply, monetary system, interest rates, exchange rates
and the availability of credit.

2 True. A government can increase demand by spending more itself or by reducing taxation so that firms and households have more after-tax income to spend.

Question 96

3 A tax which takes a higher proportion of a poor person’s salary than of a rich person’s is:
A Proportional tax C Progressive tax
B Regressive tax D Indirect tax

4 High rates of personal income tax are thought to have a disincentive effect. This refers to the likelihood
that the high rates of tax will:
A Encourage illegal tax evasion by individuals
B Lead to a reduction in the supply of labour
C Lead to a reduction in savings by individuals
D Discourage company investment

Answer 96

3 B This is the definition of regressive tax.

4 B The disincentive effect refers specifically to the disincentive of individuals to work.

Question 97

5 The government of a certain country decides to introduce a poll tax, which will involve a flat rate levy of
$200 on every adult member of the population. This new tax could be described as:
A Regressive C Progressive
B Proportional D Ad valorem

6 Which of the following will not be the immediate purpose of a tax measure by the Government?
A To discourage an activity regarded as socially undesirable
B To influence interest rates
C To protect a domestic industry from foreign competition
D To price certain products so as to take into
account their social cost

Answer 97

5 A A flat-rate poll tax, with no concession for the lower paid, would take a higher proportion of the income of lower-income earners than of higher-income earners. This is a regressive tax system.

6 B The main purpose of taxation will be to raise revenue for the government. Other aims might be to redistribute wealth or affect demand in the economy. Changes in rate of tax do not have a direct influence on interest rates, which can be influenced by a government’s monetary policies.

Question 98

7 Which of the following government aims might be achieved by means of fiscal policy?
1. A redistribution
of income between firms and households.
2. A reduction in aggregate monetary demand.
3. A change in
the pattern of consumer demand.
A Objectives 1 and 2 only C Objectives 2 and 3 only
B Objectives 1 and 3 only D Objectives 1, 2 and 3

8 Other things remaining the same, an increase in the money supply will tend to reduce:
A Interest rates C The volume of bank overdrafts
B Liquidity preference D Prices and incomes

Answer 98

7 D Objective 1 could be achieved by raising (or lowering) taxes on firms and lowering (or raising)
taxes on households. Objective 2 could be achieved by raising taxation in order to reduce consumers’ disposable income and so to reduce aggregate expenditure in the economy: these consequences should lead to a fall in the demand for money. Objective 3 can be achieved either by taxing income or by means of selective indirect taxes on certain goods.

8 A Lower interest rates should be a consequence of an increase in the money supply, with a movement along the liquidity preference curve rather than a
shift in the liquidity preference curve.

Question 99

9 Injections into the economy are:
A Consumption and Investment
B Investment and Government Expenditure
C Investment, Government Expenditure and Export Demand
D Consumption, Investment, Government Expenditure and Export Demand

10 A deflationary gap occurs when:
A Aggregate demand is insufficient to buy up all the goods and services the company is capable of
producing.
B Aggregate demand is more than sufficient to buy up all the goods and services produced by an economy.
C A government attempts to spend its way out of recession.
D A government is cutting its level of expenditure.

Answer 99

9 C

10 A

Question 100

Now try …
Attempt the questions below from the Practice Question Bank
Q13
Q14

Answer 100

Q15

Q16