MACRO Unit 2 The UK Economy

The performance of the economy can have a major impact upon people s
lives. It will influence the type of jobs people have and the goods and
services available to them, and whether they can afford to buy
them.
The government has 4 macro-economic objectives:
1)
2)
3)
4)

low unemployment
low and stable inflation
sustainable Economic growth
balance of payments equilibrium

A number of key indicators can be used to illustrate the success of

an economy:
1)
2)
3)
4)

the level of output, and Economic growth

the inflation rate
level and rate of unemployment
the Balance of Payments

If the economy is growing it can normally be judged as successful.

In addition the government will also consider:
a more equal the distribution of income
protection of the environment & sustainability of growth

The Circular Flow of Income and Injections &

Leakages
In the simple, closed economy, it is assumed that households own
all factors of production, which they then sell to firms for financial
rewards. It is these rewards which enable households to carry out
their day to day purchases.

Unit 2 The UK Econom y 6EC02

ls School 2011

St Pau

However the simple circular flow, as depicted in Figure 7, is too

simplistic to be of any real use. In the open economy there are 3
injections into the circular flow.
Investment by firms
(I)
Government spending (G)
Exports
(X)
Each represents an autonomous addition to the circular flow income.
Leakages on the other hand represent withdrawals from the circular
flow and are:
Savings
Taxes (T)
Imports

(S)
(M)

TP Transfer Payments are payments received for no corresponding

level of output, such as unemployment benefit or Job Seekers Allowance.
For an economy to be in equilibrium, injections must equal leakages.
If injections are greater, then the economy will overheat and
inflation may result. However, if the leakages are greater than
injections, then the economy will shrink in size and an economic
downturn or recession will ensue.

ECONOMIC GROWTH
An economys growth can be measured in terms of its Gross Domestic Product
(GDP) or its Gross National Product (GNP). GDP is the total output of
goods and services produced by domestic factors in production (in
the UK) over a period of time usually 1 year.

It is also the sum of all incomes earned in one year and all
expenditure in one year. Consider this in terms of the circular flow

where for everything that is earned

Unit 2 The UK Econom y 6EC02
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St Pau

(income), there must be an output produced, and equally something

must be spent (expenditure). The government measures all three
money flows, goods & services, expenditure and income and they
should be identity be equal.
The preferred measure is the expenditure method which takes
spending by consumer (C), government spending (G), spending by
firms (I) and the net trade the UK enters into (X-M).
The Expenditure Method: C + I + G + (X - M)
For this method to be accurate the value of subsidies must be added
and taxes on goods deducted. This converts the products value from
market prices to factor cost.

Converting from Nominal to Real

Nominal GDP is GDP measured in terms of money values, and so is
influenced by the level of inflation. This can give a misleading
impression of a countrys performance. If inflation is running at 20%,
then at the end of a year, GDP will have risen by 20%, this will
suggest that output has remained the same but the value of the
output has risen as prices rise. Thus to overcome such calculation
difficulties GDP figures are returned to a base year to remove the
affects of inflation. This is known as converting to real GDP.
Real GDP is Nominal GDP x price index in base year.
Nominal GDP 1048 x

100
120 = Real GDP = 873m

It is often suggested that as a measure of the standard of living,

GDP per capita has its weaknesses. This is undoubtedly true;
however, whilst many criticisms exist, and there are also alternative
measures, GDP per capita is still the most widely used measure of
economic performance.
Concerns exist as to what is meant by Standard of Living. It is
subjective, and therefore can only mean different things to different
people. Thus a purely monetary measure such as GDP will not deal
with the issue of Standard of Living as comprehensively as many
economists would like.

Other areas that may be considered:

When dealing with standard of living, it is worth considering some of
the factors outlined.
(1)

Birth Rates.

(6)

(2)
(3)
(4)

Mortality Rates.
Life Expectancy.
% of Population in

(7)
(8)
(9)

No. of doctors. per

head.
Distribution of
Income.
Climate.
Political Freedom.

Agric.
(5)

Literacy Rates.

% of GDP spent on
(10) Military.
Unit 2 The UK Econom y 6EC02
ls School 2011

St Pau

HUMAN DEVELOPMENT INDEX

HDI is an index which measures national socio-economic
development developed by the United Nations. Up until 2009, it was
based on measures of life expectancy, educational attainment and
was adjusted for real per capita income.
The HDI combined three basic dimensions:

Life expectancy at birth, as an index of population

health and longevity Knowledge and education, as
measured by the adult literacy rate (with two-thirds
weighting) and the combined primary, secondary, and
tertiary gross enrollment ratio (with one-third
weighting). Standard of living, as measured by the
natural logarithm of gross domestic product (GDP) per
capita at purchasing power parity (PPP) in United States
dollars.
In 2010, the measures of knowledge and living standards were
changed so that now HDI is defined as:

Access to knowledge: mean years of schooling and

expected years of schooling
Standard of living: measured by GNI per capita (PPP US $)
Life expectancy at birth (as an index)
However HDI is not perfect as a measure of development:
Advantages
Broader measure than GNI or
GDP.
The data is compiled regularly by
the UN
and is relatively easy to construct,
as the
three elements can be easily
found on
their own and exist
independently, and
the fact it is put together by the
UN
suggests neutrality.
Takes into account income but
adjusts
for PPP and so living costs.

Disadvantages
It gives no indication of income
distribution, or by region or
gender.
There may be problems of data
accuracy,
especially with some developing
countries that will have an
incentive to
paint a rosier picture of their
citizens'
well being. This could undermine
the
HDI's validity in practice.
Its weightings of 1/3 each seem
arbitrary
and one might argue that rising
incomes
have a diminishing impact the
richer a

Focused on government policies

and so
it is a good target for
governments to
aim towards, and is obtainable.

country becomes.
Limited in its inclusion of only
three
quality of life indicators when
other
measures like access to clean
water
omitted.

Unit 2 The UK Econom y 6EC02

ls School 2011

St Pau

ECONOMIC GROWTH
If a countrys output is rising, this suggests that a countrys citizens are
experiencing higher living standards. The most common indicator of
economic growth is a rise in real GDP.

Actual and Potential Growth

An increase in the productive capacity of an economy increases the
potential growth, whilst an increase in output results in an actual
increase in output. A shift in the PPF illustrates an increase in
productive potential.

However a movement in the actual amount of output from A to B

illustrates an increase in economic growth. There is however still
potential to increase actual output from B to the boundary of PPF 2
by employing previously unemployed sources.

Production and Productivity

A countrys output can increase either b ecause greater resources are
employed or because of a rise in productive potential. However an increase
doesnt necessarily result in an increase in output, this will depend
upon whether this increase in productive capacity is matched by an
increase in actual output or a great level of employment.

Output gaps
Growth above the trend growth rate, where AD grows faster
than LRAS, leads to a positive output gap and demand-pull
inflation, as well as cost-push inflation
Unit 2 The UK Econom y 6EC02 5
St Pau
ls School 2011

Growth below the trend growth rate, where AD and so actual

growth is below LRAS and the economys potential growth rate. This
leads to a negative output gap and so unemployment and
downward pressure on prices.

GDP Measurement Problems

1. Black Economy: This exists because when the output of some
goods and services is deliberately not declared. This can be for 2
reasons, to avoid tax, for example cash in hand deals with plumbers
etc. In addition some people may not declare economic activity if that
activity is illegal, for example drug dealers will not declare their
income.
As people will spend any income they might receive in this
undeclared way, a gap will tend to exist between the final figures
for the expenditure method and income method of calculating
GDP. The gap that exists will give an indication as to the size of
the black economy.
2. Non-Marked Goods and Services: GDP figures only include
those goods that are bought and sold and so have a price
attached to them. Services which are produced and which either
are not traded, or which are exchanged without money being
exchanged. For example homegrown products, DIY or voluntary
work are not included in the official figures.
3. Government Spending: Some government spending goes on
financing some services which are not sold, such as Defence, and
the Police. The cost of production is therefore used, however this
can be misleading. If productivity in the Police Force were to rise
as a result of the introduction of some new technology, staff
numbers and so cost could be reduced. This overall reduction will
result in a fall in the Police services contribution to the final GDP
figures.
To overcome this problem the government has introduced a
method for estimating output based on key performance
indicators.

Cost and Benefits of Economic Growth

Benefits

Standard of Living Improves: This is usually measured by

per-capita real income. If the economy is growing faster than
the population then per-capita incomes are rising and the
standard of living is said to be improving as households can
buy more goods and services than before.
There are problems with this notion; mainly the belief that
standard of living is more than a monetary factor. GDP

ignores factors such as the distribution of income, the size

of the informal economy, the nature of public spending, such
as on health or education, the size of negative externalities &
political freedom.
Unit 2 The UK Econom y 6EC02
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St Pau

Increased Tax Revenue: Greater economic growth could

result in higher tax revenue allowing the government to
increase spending on health, education or whatever else is
seen to be a priority.

Higher Employment: Economic growth can result in greater

demand and therefore greater employment.

Increased investment as confidence improves, or due to the

accelerator, or higher profits for firms. This means the
economy will have more capital per worker and so higher
productivity and more future growth.
Costs

Inflation: Increases in demand, without a rise in supply can

create demand-pull inflation (see AD2 and AD3 on LRAS1,
causing a rise in average prices), or alternatively if wage
pressures persist cost-push inflation may occur.

Non-Renewable resources: The use of non-renewable

resources to produce goods and services for use in the current
time period means that these are unavailable in the future
and so growth may not be sustainable.

Environmental Costs: As the economy grows, and output

increases, manufacturing firms may increase pollution,
resulting in a decline in the ozone layer for example. As living
standards rise, the number of cars, or other consumables
rises, further increasing pollution and also the need for landfill
sites to deal with rubbish.

Structural Unemployment: As an economy grows its structure

changes and demand for certain skills decreases, resulting in
structural unemployment.

Stress & Psychological problems: Professor Yew Nwang Ng

has suggested that Economic Growth can create competitive
pressures between families trying to outdo each other
materially. This can result in, suicide, stress and depression.
Sustainable Economic Growth
Governments are keen to encourage sustainable economic growth
rather than rapid economic growth which results from the rapid
depletion of scarce resources. Sustainability in part implies the need
for recycling of natural resources such as aluminium, paper and

glass, whilst encouraging the use of renewable sources of energy for

power.

Unit 2 The UK Econom y 6EC02

ls School 2011

St Pau

INFLATION
Inflation can be defined as a sustained rise in the agreed general
price level.
A low and steady inflation rate allows business to maintain
confidence in the economy. A high level of inflation, in excess of a
countrys main trading partners can create problems in competitiveness
resulting in a decline in trade.

The main measure of inflation in the UK is calculated through the

use of the Retail Price Index (RPI). This is a measure of changes in
the prices of consumer goods bought in the UK.

Calculating the RPI

The RPI is a weighted price index, so not only must price variations
be obtained, but also weights must be attributed to various goods
and services.
In order to establish appropriate weights the Office for National
Statistics (ONS) uses the Expenditure and Food survey to establish
what items people buy in what quantities. Approximately 7000
families are asked to keep a record of what they spend over a 2
week period, and to give details of other major spending such as the
telephone bill.
Expressed as a fraction the weights are draw from the information
gathered by the ONS.
The ONS will then record how much the price of some 650 goods
and services have changed by. This is due in a variety of locations
throughout the country. In total approximately 180,000 price
quotations are collected from 150 areas around the UK each month.
Finally the percentage change in price for each item is multiplied by
its weight.

Unit 2 The UK Econom y 6EC02

ls School 2011

St Pau

Other measures of inflation

RPI X: This measure is the RPI minus mortgage interest payments.
There are 2 arguments for excluding mortgage interest.
1. For comparison purposes a number of other countries do not
include it
2. Mortgage interest payments are influenced by changes in
interest rates, so a rise in interest rates designed to reduce
inflation may have opposite effect of raising it.
The Bank of England target is 2.0% 1% (was 2.5% 1% until Dec
2003) using the CPI measure of inflation.
RPI Y: This measures the RPI minus mortgage interest payment and
also both indirect and local authority taxes. This shows the
underlying rate of inflation undistorted by changes in tax or interest
rates.
CPI: This measure excludes a number of items that are included in
RPI, mainly related to housing. These included council tax and a
range of owner-occupier housing costs such as mortgage interest
payments, house depreciation, buildings insurance, estate agents and
conveyancing fees.
The CPI covers all households, while the RPI excludes the top 4% of
income earners. The CPI also includes university accommodation and
foreign students university tuition fees.

Measurement Problems
1. Changes in Quality: Measures of price change do not take into
account changes in quality. For example a computer is less
expensive now in comparison to 15 years ago, but is also a great
deal more powerful and better in quality.
2. Special Offers: the retail price index doesnt make special account for
out of season discounts or special offers. This may act to reduce
the rate of inflation.
3. Changes in expenditure: although the weights are reviewed
each year, even this might not be enough. Spending patterns can
change more quickly as new products become available.
4. Due to the limited number (6785) of households surveyed, there
is potential for sampling error.

Unit 2 The UK Econom y 6EC02

St Pau ls School 2011

Causes of
Inflation
Ther
e
are
two
mai
n
cau
ses
of
infla
tion:

Co
stpu
sh
in
fla
ti
on
Th
is
is
wh
en
co
sts
of
pr
od
uc
tio
n
inc
re
as
e
(fo

r
e
x
a
m
p
l
e
d
u
e
t
o
h
i
g
h
w
a
g
e
d
e
m
a
n
d
s
o
r
a
w
e
a
k
e
n
i
n
g
e
x
c
h
a
n
g
e
r
a
t
e
w
h

i
c
h
m
a
k
e
s
i
m
p
o
r
t
e
d
r
a
w
m
a
t
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r
i
a
l
s
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r
e
e
x
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e
n
s
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e
)
,
a
n
d

ar
e
th
en
pa
ss
ed
on
to
co
ns
u
m
er
s
in
th
e
for
m
of
hi
gh
er
pri
ce
s.
In
th
e
di
ag
ra
m
(ri
gh
t),
thi
s
is
sh
ow
n
by
a
shi
ft
to
th
e
lef
t
in
th
e
AS
cu

r
v
e Dema
,
ndw
h pull
i inflati
c on
This
h
s occurs
e when
e AD
s increa
p ses
r (due
i to
c greate
er
s
consu
r
i mptio
s n,
e invest
t ment,
o govern
P ment
2 spendi
. ng or
net
export
s),
pushin
g
agains
t the
limits
impos
ed by
the AS
curve
at full
emplo
yment
.
In
the
diagra
m
(left),
as AD
shifts
from
AD to
AD1,
the
price

leve l

rises to P2.
d infl ght
infl atio unaware
n s people
ati rat will be
C
on e, unsure
o
the what to
n Anti n expect
s cipa the about
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This can
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e result in
is
e whe me a fall in
nn
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c the res ption.
e rise to Fiscal
avo drag
s in id may
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pe ster
ns than
io pric
ns es.
ris
e Cos
wi
th ts
th of
e Anti
ra cipa
te
of ted
pr Infl
ic atio
e n
ch
an
ge
,
M
th
en
ey
u
te
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nd
os
to
ts
fal
l
be
Pri
hi
ce
nd
s
w
be
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es
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,
e
w
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hi
t
ch
of
ris
da
e
te
fa

Unit Eco C02

2
no
The m y 10
UK 6E

an
d
ne
ed
to
be
up
dat
ed;
the
cos
ts
of
doi
ng
so
are
me
nu
cos
ts.
Thi
s
wo
uld
incl
ud
e
the
cos
ts
of
rep
rint
ing
cat
alo

g
u
e
s
/
m
e
n
u
s
,
u
p
d
a
ti
n
g
v
e
n
d
i
n
g
m
a
c
h
i
n
e
s
e
t
c
.

St Pau
ls
School
2011

Shoe Leather Costs - As inflation increases, the

opportunity cost of holding cash increases. People will hold
more money in interest-bearing accounts, and more trips to
the bank will become necessary.
Costs of Unanticipated Inflation

Confusion of Market Mechanism - Consumer sovereignty

relies on producers responding to changes in prices. Inflation
means that producers may believe that demand for their
good has risen (and hence increase production) when, in
fact, only the general price level has increased. As a result,
scarce resources may not be allocated in the most efficient
way.

Uncertainty - Inflation creates uncertainty, particularly

amongst the business community and when inflation
fluctuates, firms cannot predict costs and revenues and may
be deterred from investment projects.

Redistributional Costs - Income is distributed, away from

those on fixed incomes and those in a weak bargaining
position (e.g. pensioners), to those who can use their
economic power to gain large increases in income.
Furthermore, borrowers benefit as the real value of debt is
eroded; savers lose out.

International Costs - Exports lose their competitiveness,

whilst imports become relatively cheaper. The trade position
will therefore deteriorate, unless the exchange rate
deteriorates to compensate, other countries have higher
inflation, or exports do not sell on the basis of price alone.

Accelerating Inflation
If for example inflation was rising at a faster rate each year, i.e. 80%
in year 1, 12% in year 2 and 18% in year 3 people would naturally
expect prices to continue to rise. As a result they will demand higher
wages, and firms may raise prices to cover expected higher costs,
and consumers may bring forward consumption before prices rise.
All of this will contribute to increasing inflation.

Unit 2 The UK Econom y 6EC02

11

St Pau ls School 2011

EMPLOYMENT AND UNEMPLOYMENT

Unemployment will result in output being less than potential output,
tax revenue will be reduced and greater state benefits will have to
be paid. The unemployed may experience increased incidence of
divorce, and mental breakdown in addition to falling behind in
training, so making it harder to get employment in the future.

Measures of unemployment
In the UK there are two main measures of unemployment. The
claimant count, and the labour force survey.
The claimant count is the number of people claiming the jobs
seekers allowance. It is easy and cheap to collect, however it has
been criticised for a number of reasons. It might actually overstate
the number of people unemployed. For example some of those
collecting benefit may not be actively seeking work. In addition
there are groups of people who have productive potential, who
would like to work but are excluded from the calculations. For
example those over 60, and those under 18, in addition to those on
government training schemes.
The alternative method adopted in 1998 is the Labour Force Survey.
This is based on the International Labour organisations definition of
unemployment; this includes all people of a working age who are
without work during a specified period and available to work in the
next two weeks, having sought work in the previous four weeks.
Typically the ILO/LFS measure of unemployment is greater than the
claimant count measure, as it includes a greater number of the
unemployed, as illustrated below.

This method is based on a survey of sixty thousand households (100

000 people), asking whether they have a job, and what steps they
have taken to seek employment. As a result of this method being
based on all international standards, comparisons with other

countries are easier.

Unit 2 The UK Econom y 6EC02
ls School 2011

12

St Pau

Measurement Problems
1. If the Claimant count is used, everytime government changes the
eligibility for claims, the unemployment figures will change e.g.
as occurred when males over the age of 60 were excluded.
2. If the Labour Force Survey is used, the sample questioned may
not be truly representative.
3. Whichever measure is used it can be difficult to assess whether
those included in the unemployment figures are genuinely
unemployed.

Consequences of Unemployment
To the Individual
Loss of earnings means a lower standard of living.

An unemployed person loses work skills, thus decreasing

their chances of becoming employed again.

The unemployed tend to feel useless and not a part of

society. This can lead to problems such as depression, worse
health, lower life expectancy.
To the Economy

There is lost tax revenue to the government but more

spending on benefits. This could lead to a budget deficit.

There can be a negative multiplier effect and so lower

demand for local goods and services, housing etc.

Loss of national output this could lead to a negative output

gap or if people lose skills or leave labour market then
hysteresis could occur and
LRAS shift inwards.

Areas of high unemployment tend to suffer from increased

crime, violence and vandalism.

Unit 2 The UK Econom y 6EC02

13

St Pau ls School 2011

BALANCE OF PAYMENTS
The Balance of Payments is a record of all monetary payments
between one country and the rest of the world over a period of time.
The Balance of Payments is made of
3 sections:
1) The Current Account
2) The Capital Account
3) The Financial Account
In addition to these there is also the International Investment
position, which shows the level of external assets and liabilities at
the end of the calendar year.

Current Account
The current account is made up of 4 main parts.
1) Trade in Goods: This covers the export and import of goods
and services.
2) Trade in Services: This covers the export and import of
services such as shipping, financial services, insurance and
tourism.
3) Income flows: income from investments is the main
component - interest, profits and dividends (IPD) from
overseas assets such as bank deposits, UK owned companies
overseas, shares quoted on foreign stock markets but held by
UK residents (less IPD earned in the UK by foreign held
assets).

4) Current transfers: These include central government transfers,

including for example the UKs net contribution to the European Union
and aid which
Unit 2 The UK Econom y 6EC02 14
St Pau
ls School 2011

is provided to developing countries, and net remittances from

migrants and immigrants. In this category, no goods or service
is being exchanged, just a flow of money.

The Capital Account

This is a minor part of the Balance of Payments, and includes
government investment grants, and the purchase or sale of nonproduced, non financial assets such as patents, trademarks and land
for foreign embassies.

The Financial Account

This was previously known as the capital account, and refers to the
flows of money entering and leaving the country. This can take a
number of forms, including the purchase and sale of companies and
foreign exchange.

Net errors and omissions

Formerly known as the balancing item, this figure is included to
ensure that the current account, plus the capital account plus the
financial account equals zero. In other words to ensure that the
Balance of payments always balances.

International Investment Position

This account reflects the total of external assets held by the UK
government, companies and individuals and the total of UK assets
held by foreign governments, companies and individuals.

Causes of a Current Account deficit

1. High levels of income (economic growth) in the
domestic economy. Imports tend to have a high income
elasticity of demand so that, in a boom, imports are 'sucked'
into the economy. The UK has a high marginal propensity to
import (MPM), therefore economic growth usually results in
greater demand for imports.
2. An overvalued exchange rate which makes exports less
price competitive in foreign currency and imports more price
competitive in Sterling.
3. High unit labour costs the average cost of labour per
unit of output (perhaps a reflection of low investment in
capital and labour in the past and hence lower productivity)
means that average production costs may be higher than our
competitors, again making UK goods seem less price
competitive. Higher wage costs in the UK than in low cost
LEDC manufacturers would also raise our unit labour costs.

Unit 2 The UK Econom y 6EC02

15

St Pau ls School 2011

4. Poor non price competitiveness of UK goods in terms of

quality, design, reliability, delivery times, after sales service
may mean the 'taste' for UK goods is low.
However, the current deficit is not such a problem if:

it is only short term and is caused by high rates of economic

growth which should subside

if it can be easily financed, perhaps by investment inflows on

the financial account
the deficit is caused by the import of raw materials and
capital equipment which will be used to produce final goods
for export or helps to raise productivity

Policies to remove the Current Account deficit

Although there are several policy options, including reducing AD and
consumption and so import spending, or devaluating the exchange
rate or being protectionist, the policy favoured by the UK
government is to focus on increasing competitiveness by
applying Supply Side policies these policies will aim to boost
productivity and so lower the UKs unit labour costs:

increase investment (perhaps through lower corporation tax)

and thus capital per worker and productivity
increase spending on education and training to improve
human capital

encourage R & D spending to promote the use of new

technology, perhaps by giving tax breaks on profits reinvested
into R & D

EXCHANGE RATES
A fixed exchange rate system, is one determined by the government
or an international body. The rate is maintained through the
purchase or sale of the currency on the money market, and through
the manipulation of interest rates. On the other hand a managed
rate is one which is permitted to move within bands. Whilst a
floating exchange rate is allowed to float, and so is determined by
changes in the demand and supply of the currency.

Consequences of unstable exchange rates

1. Planning frequent changes in the exchange rate may create a

number of problems with firms trading abroad finding it difficult

to plan ahead, particularly as they will not know how much they
are to receive or owe in terms of their domestic currency.
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2. Trade uncertainty about the amount to be paid may mean that

trade will be reduced, cheaper imports may be sought.
3. Productive potential productive potential may decline as a
result of firms going out of business when the exchange rate is
high, as they find it hard to export goods. Investment may also
fall as the chances of additional output being sold declines.

CONFLICTS IN MACROECONOMIC POLICY

Governments will find it hard to achieve all four macro-economic
objectives at once. For example a government may wish to reduce
unemployment by raising aggregate demand. This will have the
desired effect, but also encourage firms to expand output,
accelerating economic growth. This may however result in demandpull inflation. The increase in growth may result in an increase in the
demand for goods from abroad and raise imports causing a deficit.
For the government to reduce inflationary pressure and correct any
deficit that exists on the current account a government might
decide to reduce aggregate demand. This policy of inflating the
economy, followed by deflation is referred to as the stop-go cycle.
Governments often decide that sacrificing one policy objective is a
price worth paying to satisfy the others. For example if
unemployment is high, then a rise in AD will act to reduce
unemployment, but result in raised prices. The trade-off between
unemployment and inflation exists.

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AGGREGATE DEMAND
Aggregate demand can be defined as the total demand of goods
and services in an economy. It consists of 4 components, and is
usually expressed as:
AD = C + I + G + (X-M)
where

consumer
C=
spending
investment
I =
expenditure
government
G=
spending
(X-M) = The net expenditure on exports and imports

The AD curve depicted in Figure 2, shows the level of output or Real

GDP at a given price level.
The AD curve is downward sloping for 3 main reasons:
1. Exports of goods and services are likely to be higher when the
price level is low as they are more internationally competitive.
Imports, on the other hand are likely to appear more expensive,
domestic demand may therefore transfer into domestically
produced goods adding to the increase in AD.
2. If the average price level were to fall, then people s purchasing power with
their disposable income would increase, allowing them to raise
their spending and so adding to AD.
3. Peoples expectations also play a part in the shape of the AD curve. If prices
are low people will tend to expect prices to rise in the future, and so

bring forward their spending. This will act to raise AD. On the other
hand, if prices are high, and expected to fall, people will delay
spending and so demand will be low.
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Determinants of Consumer Spending

Consumer spending is the most significant component of Aggregate
Demand. A key determinant of this spending is the level of
disposable income, in other words income after the addition of state
benefits and deduction of direct.
The marginal propensity to consume (MPC) is the amount of new
income that is spent on consumption.
At low levels of income any increase in income is taken up entirely
on increased consumption, the MPC is 100 per cent. So if a family is
very poor, and it receives some additional money, this will be spent
on food, clothing and other essential items. As living standards and
income rises the MPC will fall, yet remain high, reflecting the ability
to save, so the MPC may be 80%. As incomes increase, the very rich
are unconcerned by increases in their income, as they are already
spending to meet their needs. Most of the new income received is
therefore saved.
Ultimately as depicted in figure 3 as income rises so does
consumption, even if it is at a slower rate, thus the MPC steadily
declines.

where
a = Autonomous consumption spending which
occurs at 0
income financed by borrowing, using savings or state benefit
on basic food, clothing and shelter

Other factors affecting consumption

If the government increases old age pensions and increases tax
thresholds for low income earners, whilst increasing taxes for the
highest income earners, total disposable income may remain the
same. However consumer spending will increase, as will aggregate

demand. This will result in a rightwards shift of AD.

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Higher interest rates will reduce consumer spending, and require

those with a mortgage to make higher monthly repayments,
therefore consumer spending falls, as does aggregate demand,
which results in a leftwards shift of the AD curve.

Determinants of Investment Expenditure

Investment by the private sector, varies inversely with the rate of
interest, i.e. the cost of borrowing money. If interest rates rise,
businesses find that fewer projects yield a sufficient rate of return
for the investment to be profitable. This concept is referred to over
the Marginal Efficiency of Capital (MEC). If rates of interest rise and
investment falls, the AD curve will shift to the left.

The accelerator principle also influences the level of investment. It is

felt that will react to increases in demand and national income by
increasing their demand for capital goods to meet this growth. The
result of this increase in I is a shift in the AD curve to the right.
Accelerator:

I = a (Yt-Yt-1)

I=

Investment by firms

a=

Capital output ratio

Yt = Income in current time period

Yt-1 = Income in previous time period
Investment is therefore a function of a , where the capital -output ratio
represents the amount of capital i.e. machinery required to meet a
level of output. For example should 3 be required to raise output
by 1 per year then the capital-output ratio is equal to 3.

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ie

I=
I=
3
I=
3

therefore

I = 60m

Therefore
or

a (Yt-Yt-1)
(100m 80m)
(20m)

Another factor which has an impact on investment is the role of

expectations in the future. Keynes referred to this as Animal Spirits , with
firms often basing investment plans on all sorts of external factors which
may affect business well being.

Determinants of Government Spending

Government spending is particularly sensitive to a change in
economic policy on the part of government in order that many
achieve their particular macro-economic objectives. On the other
hand it is important to remember that the pattern of taxation and
expenditure may be manipulated in line with political beliefs and
aspirations.

Determinants of expenditure on Exports and

Imports
One of the key determinants of a countrys trade position, is the value of its
currency, its exchange rate. For example if Japanese importers are
purchasing Scottish whisky they will be offering Yen for the goods,
whilst the Scots will seek payment in . The relative strength of the
Yen will determine how much whisky the Japanese will demand, and
therefore the amount the Scots can export.
Interest rate changes can have an influence on the exchange rate, a
rise in the UK rate of interest will result in Hot Money flowing in, (Hot
Money is money that is highly liquid, seeking out the highest rates
of return anywhere in the world) and therefore an increase in the
demand for , thus raising the value of the and the exchange rate.
This rise in the value of the means that it is easier (and cheaper)
to import goods and more expensive to export goods and services,
hence it is likely our Balance of Trade will deteriorate.
Beyond this the other main determinant of imports is the level of
overall demand in the economy. The UK has a relatively high
Marginal Propensity to Import (MPM) therefore as the level of income
in the economy rises, the demand for imports rises.

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AGGREGATE SUPPLY
Aggregate supply can be defined as the total output of the economy.
The aggregate supply curve shows the relationship between the
total quantity supplied in the economy and the price level. It is
therefore upward sloping, as at low prices businessmen collectively
do not feel that it is worth producing commodities, because they do
not expect to be able to sell them and make a profit. However, as
the price level rises entrepreneurs feel that it is worthwhile to start
producing, or produce more and therefore supply increases.

In the short-run changes in the price level result in a movement

along the AS curve. If there is spare capacity in the economy, any
increase in demand will result in a rise in output rather than a rise in
prices. Using Figure 4, this is shown by the movement along the AS
curve from A to B. Beyond B as the economy reaches full capacity,
costs rise and diminishing marginal returns set in, so the AS curve
becomes steeper.
In the long-run there are many factors, which can cause a shift in
the entire curve. There are referred to over Supply Side policies (see
section below on Supply Side policies for further information) and
include:
1. Education and Training
2. Technological change
3. Increasing geographical mobility of both employees and
employers
The period since 1979 has seen a strong commitment on the part of
the government to create economic candidates which favour such a
shift.
The problem with supply side policies, is that their actions are
relatively uncertain in impact and can take a long time to have any

effect. In addition, their use is likely to impinge on other government

policies because they may involve greater government expenditure,
interfere with other social objectives, involve foregoing tax revenue,
or
Unit 2 The UK Econom y 6EC02 22
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require the reduction of interest rates, when other objectives require

the opposite. Therefore supply side policies are difficult to introduce,
uncertain in their impact and may take a long time to have an
impact.

Long-Run Aggregate Supply

Keynesian
The Keynesian Long-Run Aggregate Supply curve contains two main
elements, an area which represents unemployed resources and the
economy operating below full capacity (region A-B in Figure 6) the
second element corresponds to the economy operating close to or
at full capacity. With little or no unemployed resources (region B-C in
Figure 6).

The economy operates at equilibrium, where aggregate demand

intersects with aggregate supply. It is clear at AD, the economy is
not operating at full capacity, a shift to the right in the AD curve will
cause output to rise, but with unemployed resources still in
existence prices remain stable. It is only when the economy reaches
full employment and the AD curve continues to shift to the right that
prices will rise P1 to P2), as a result of the economys inability to increase
supply at fast enough a rate to meet the rise in demand. At this point,
the only way to expand the economy without experiencing inflation
is to employ supply side policies and shift the AS curve to the right,
LRAS1 to LRAS2.
Classical
The classical long-run aggregate supply curve is vertical, as a result
of the belief that the economy always operates at full employment.

Any unemployment which exists is voluntary unemployment, in

other words the market left to itself would be able to
Unit 2 The UK Econom y 6EC02 23
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clear this unemployment, however workers who remain

unemployed, according to this theory, do not wish to take the
available jobs at the prevailing wage rate.

Classical economists argue that any expansion in AD, such as AD 1 to

AD2 will only result in price rises (inflation) from P1 to P2. Therefore if
demand management policies employed to shift the AD curve are to
be successfully utilised they must be accompanied by supply side
policies, which will shift the LRAS to the right, LRAS1 to LRAS2.
The accepted relationship between output and employment is that,
as output increases, employment increases. However, in the longrun if aggregate supply increases, as a result of an improvement in
technology or a better educated workforce, output may increase
without an increase in employment.
THE MULTIPLIER EFFECT
Changes in AD or AS may actually have a larger total effect on GDP
than the particular tax reduction or expenditure that set it off. This
is known as the multiplier effect. The multiplier can be defined as
the factor by which an increase in one of the factors of aggregate
demand is multiplied by to calculate the total rise in national
income. The multiplier, in a closed economy can be calculated
through the formula
1
1
1 MPC or MPS
Where MPC is the marginal propensity to consume, and the MPS is
the marginal propensity to save. In a closed economy the MPC and
MPS must always total 1.

Therefore if the MPC = 0.8 then the multiplier can be calculated as

5.
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1
1 MPC

or

1
1 0.8

1 =
5
0.2

Therefore a rise in AD of 200m will result in a total rise in national

income of 1000m. In the more realistic open economy the
multiplier formula follows the same principle but includes both
leakages and injections.
1
1
(1 MPJ ) or (1 MPC MPI MPG MPX )
1
or

MPL or

1
(MP
S

MPT

MPM )

If for example the government were to increase expenditure on

health and education, this will not only mean that the salaries of
nurses and teachers increase but also there is an increase in
expenditure on school buildings, computers, hospitals and scanners.
This increase in expenditure is referred to as the first round effect.
However with their increased salaries, teachers and nurses will
increase their spending on clothing, cinemas and restaurants. This
increase in demand results in a second round effect, which is added
to by the builders of the schools, hospitals, computes and scanners.
Furthermore, the owners of the clothing manufacturers, cinemas
and restaurants see their income rise and their purchasing power
increase, this is the third round effect.
These successive rounds of expenditure carry on and would seem to
have the potential to carry on forever, however their impact
diminishes with each round because of the leakages inherent in the
system.
However the multiplier works, its impact must be taken into account
by policymakers when investigating the impact on the economy of a
change in AD.

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MACROECONOMIC POLICY INSTRUMENTS

Fiscal Policy
Fiscal policy refers to the manipulation of taxation and government
spending to achieve macroeconomic objectives. It is used by
governments to influence the level of AD in the economy and it can
also affect aggregate supply through changing incentives facing
firms and individuals.
A boom in the economy will raise employment, but at the same
time, because of increased incomes and expenditures, the
government automatically receives more revenue from income tax,
excise duty and VAT. In addition, government spending on social
security for the unemployment falls.
On the income side the key areas that may be manipulated are
income tax, VAT, excise duties and national insurance contributions.
An increase in almost all types of government expenditure will have
an impact on aggregate demand, but other increases may have a
greater impact on aggregate supply.
To boost aggregate demand the government has two main options,
either cutting taxes or increasing expenditure. Consumers will have
greater disposable incomes than before, and as a result consumer
expenditure rises and aggregate demand is boosted. Disposable
incomes rising will result in a high proportion being dependent upon
the marginal propensity to consume. If on the other hand,
government were to cut excise duties, the price of petrol, on
inelastic goods will fall. As a result consumers will have more money
to spend on other goods and services, raising consumer spending
and aggregate demand.

Monetary Policy
Monetary Policy is the manipulation of interest rates, the money
supply and exchange rates to achieve governments macro -economic
objectives. The importance of monetary policy over the last 20 years
has risen, as successive governments have sought to combat
inflation.
All three monetary variables (money supply, interest rates and
exchange rates) are inter-related and furthermore have an impact
on aggregate demand.
If the government were to print money, for example, to finance an
increase in spending, the money supply would increase. The rate if
interest would fall and as a consequence AD would shift to the right.
The impact of too much money being printed, and not enough
goods to meet this increase in demand is inflation. However, as the
rate of interest falls, the exchange rate will depreciate as hot money
flows out of the economy. Exports will become more competitive
and rise, and imports more expensive, with wither delayed falling or
if they are inelastic the price of the imports rising. Either way the
impact of this change will place added pressure on aggregate

demand.
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This same series of events would apply if the government were to

lower the interest rate, or sell on the foreign exchange market and
depreciate the .

Supply Side Policies

A wide-range of supply side policies are potentially available, these
policies are much more focussed in their objectives, although they
can be expensive to introduce and have limited and relatively
uncertain long-run effects on the economy. The aim of government
when using supply side policies is to remove market imperfection
and restrictive practices so that the economy can operate in a more
efficient manner.

Providing incentives to work

The guiding principle here has been to encourage more people to
join the labour force and bring about an increase in output. The
Labour government has introduced the working families tax credit to
supplement working families income and increase the number
participating in the labour market.
By reducing income tax, the government can also raise the
incentive for individuals to provide their labour. Laffer suggested
that individuals would be willing to offer more hours of labour if
taxes fell, whilst enabling the government to take in more revenue,
as illustrated in Figure 10.

Education and Training

Many people who are unemployed lack the skills necessary to obtain
a job, particularly those 16 year olds leaving school with few if any
qualifications or those who have unemployed for some time. The
provision of training opportunities will reduce skill shortages in the
economy, making the workforce more effective. Recent years have
seen many schemes designed to promote educational opportunities
for the young, through Training and Employment Agencies, the New
Deal, and Youth Training Scheme.

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Trade Union Reform

By restricting the supply of workers, trade unions seek to increase
wages for their members, but at the cost of unemployment. It is
argued that the existence of trade unions seeks only to increase
costs, reduce efficiency and international competitiveness. During
the last 20 years there has been a succession of employment acts
designed to reduce the impact of trade unions. This has seen the
number of days lost through strike action fall dramatically from the
watershed era of the late 1970s.

Privatisation and Deregulation

Under private ownership, companies are more efficient, more
competitive and felt to be less of a drain on the public purse. In the
period since 1979 privatisation has been extensive and including
some high profile programmes of denationalisation, such as BT,
BGas, and the railways. Through privatisation there has been a
greater movement toward private individuals owning shares, adding
to the incentive for these firms to improve their efficiency, and
maintain growing profits.
Deregulation, the removal of barriers to enter an industry, has also
taken place, creating a greater competitive environment, or indeed
has contracting out of activities normally undertaken by the private
sector, such as hospital and school cleaning and catering.

Application of the AD/AS model

The policies employed to influence AD and AS do not operate
independently. If the government tries to boost aggregate demand
in the economy by lowering taxes, this will raise consumption and
the demand for money, with the result that interest rates must rise.
The rise in interest rates will result in a fall in AD as both investment
and consumption are hit by the rise in interest rates. So a policy
designed to raise AD can have the opposite effect, or at the very
least see its positive impact mitigated by the effects of other
variables. The interest rate rise will also have an impact on the
exchange rate, causing exports to fall and imports to rise.
Furthermore if the government were to attempt to influence AD by
increasing spending through borrowing this may also cause interest
rates to rise. By borrowing the government is entering the money
market, and reducing the available funds for private firms to borrow,
which means that firms must compete to borrow for investment
projects, causing the price, i.e. the rate of interest to rise. This is
referred to as crowding out, and is a concern of many monetarist
economists when advising government not to increase the public
sector net cash requirement (PSNCR: Government borrowing).
The application of any policies to influence AD or AS, such as fiscal,
monetary or supply side policies involves a time lag. Some policies
will undoubtedly have a more immediate effect, such as changes in
fuel duties and VAT, while changes to government spending or direct
taxes, take much longer to have an effect on the

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macro-economy. The Bank of England estimates it can take between

18 months and 2 years to witness the impact of a change in interest
rates.
Supply side policies tend to be a long-term measure and can be
difficult to predict the outcome of successfully, as they require
structural changes to be made to increase aggregate supply in the
economy.
Table 1, below provides a summary of the policies a government
might adopt to achieve their macro-economic objectives.
Objective

Aim to shift:
AD to right and
AS to right

LR Policies
Educatio
1. cut direct and 1. n
and
indirect tax
training
for
2. raise Govt
spending
structurally
the
3. cut
rate
of unemployed
interest
2. Reduce social
security payments

Reduce Inflation

Rais
1. Remove
1. e
direct and restrictive

Reduce
Unemployment.

SR Policies

AD to left and

indirect tax
2. Cut Govt
spending
Rais the
3. e
rate

AS to right

interest

Aim to shift:

Raise direct
ReduceBalanceof
1. taxation
cutting D for
Payment deficit
M
Cut rate of
2. interest:
Aim SR: Shift AD to left
Depreciate
to
3. currency
cut D for M, but Shift
AR
and raise X
to right in the LR as X
rise
Shift the AS to right

practices
2.
Privatisation
of

Promote
international
competitiven
ess

Problems
1. Short run the
rise
in AD may cause
inflation
2. Not all
unemployed
realistically
retraine
d

the
can
be

1. Appreciation of
Exchange rate =
fall in
exports
2. Reduced
demand in
econom
y
=
unemployme
nt
i.e. The
Phillips
curve
relationship
Unemployment in
SR

Policies to reduce unemployment

Fiscal and monetary policies can be applied in the short-run to
increase aggregate demand and so reduce unemployment. However
this can result in a rise in prices, ie. inflation. This trade-off is
referred to as the Phillips Curve, and suggests that it is virtually
impossible to have both low unemployment and inflation, and
certainly this is the case if supply side policies are not used.

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If interest rates are cut to reduce the unemployment, consumption,

investment and exports will rise, raising aggregate demand and
putting pressure on prices; fuelling inflation in the domestic
economy. In the long-run this problem with inflation can be
overcome through the use of supply side policies.

Policies to control inflation

In recent years the government has had as its principle economic
objective the aim of law and stable inflation. To control inflation
governments have moved away from the use of fiscal policy to using
monetary policy, through regular changes in interest rates. This task
has been in the hands of the Bank of England s Monetary Policy
Committee, since the Bank was given independence and a target of
2.5% in 1997.

Policies to promote Economic Growth

Most governments seek to promote economic growth as a means to
improve living standards. By increasing the quantity and quality of
factors of production the economic growth can be achieved through
an expansion of the PPF. This increase in quality and quantity can be
achieved through the employment of supply side policies, such as
education and training designed to improve productivity per worker.

Policies to affect the Balance of Payments

The UK has experienced a Balance of Payments deficit in most of the
last 20 years. However, the importance of this as a government
objective in recent years has declined, in part because the deficit
remains a very small proportion of GDP and also its growth is
continuing to be managed.
In theory the best way to control a balance of payments deficit is to
apply fiscal and monetary policies to depress the economy by
cutting AD, and so cut imports. In the long-run supply side policies
concentrating on an improvement of competitiveness could result in
an increase in exports. This is a long process, which may coincide

with other countries seeking to increase their competitiveness.

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