ECONOMICS UNIT 12

Macroeconomic Objectives

Economic Growth: An increase in the amount of goods and services

produced over a period of time, usually a year. Measured by change in GDP.

Government primary objective. Target is 2.5% long term average with 0.7%
quarterly growth.
Unemployment: when an individual without a job is seeking employment.

Measured by Labour Force Survey and Claimant Count (CC is always lower as
some people looking for jobs are unable to claim benefits). Target is full
employment.
Inflation Rate (price stability): sustained increase in the general price

level of goods and services in an economy over a period of time, generally

annually in the UK. The annual rate of inflation shows how much higher or
lower prices are compared with the same month a year earlier (BBC). Target is
2%1%. Measures using CPI (650 goods)/RPI (RPI basket includes mortgage
interest payments, council tax, etc)
Balance of Payments: The purpose of the balance of payments is to record

of all financial dealings with foreigners, i.e. exports imports. Target is

equilibrium.
Budget surplus: this happens if the government collects more money in

through taxation than it spends on services.

Budget deficit: this happens if the government spends more money than it

collects in through taxation

Nominal Values = current prices | Real values = constant prices (adjusted for
inflation)

Ethics and Economic Growth

Ethics: informal code of conduct which dictates whether behaviour is seen as

morally correct or not. The UK wants to achieve income equality which it

attempts to do via the benefit and taxation systems to prevent poverty.
Equity involves trying to understand and give people what they need to enjoy

full, healthy lives. Equality, in contrast, aims to ensure that everyone gets the
same things in order to enjoy full, healthy lives
Economic growth can lead to an increase in income gap because workers may

be replaced by automated machines, or the money goes to shareholders who

become richer while the workers stay at same level of health. It can also lead
to sustainability issues: increased output means more greenhouse gases from
production, transport etc, due to CO2 being released.
However it causes fall in unemployment (labour is derived demand), increase
in living standards as wages increase with increase in GDP. Health and
education level inPoliccreases as increased wages means more taxation which
leads to more spending on public sector (NHS)

Policy Conflicts
Policy conflicts: where attempts to achieve a macroeconomic objective have an
adverse effect on other policy objectives
1. Economic Growth and Price Stability:
Higher growth higher incomes more spending scarcity of
resources upwards pressure on prices high inflation
2. Economic Growth and Full Employment:
No conflict high growth = high output, increased production, more
employment as labour is a derived demand
3. Economic Growth and BoP Equilibrium:
Higher growth higher income increased spending on imports

increased BoP deficit

However if reason for growth was increase in demand of UK exports,
this would decrease BoP deficit, but this is rare in the UK

The Welfare State

The Welfare State: Various forms of benefit payments and services designed to
take care for those who need support
In the UK, all is paid by taxpayers, including:

Department for Work and Pensions:

o State Pensions
o Housing Benefits
o Employment and Support Allowance (ESA)
o Job Seekers Allowance (JSA)
o Maternity Pay
NHS (Department of Health)
State Education (Department of Education)

Benefits of the Welfare State

Reduction in Poverty as absolute poverty level becomes 0 as peoples basic

needs are met

Reduction in inequality:
o As well as benefits pulling the absolute poor out of poverty, free

education gives everyone chance to increase future income level

o Funded from progressive tax system which reduces relative poverty
Overall health of the population is increased
o NHS provides free healthcare and medical treatment.
o If it was private only, poorer people would go untreated and would
have worse health

Costs of the Welfare State

May remove work incentives:

o If unemployment benefits are so high that they provide same income
as low paid jobs, it would discourage some people from finding work
o Called the unemployment trap
Higher Taxation

o
o
o

Financed from taxation people in work pay for other peoples benefits
People who earn the most pay the largest proportion
Arguably unfair on those who work hard

Alternatives to the Welfare State

Increase role of voluntary sector:

o Charities like Oxfam, Shelter, BHF, etc provide support to vulnerable
o

members of society like the hungry, homeless, etc.

They are funded by donations from members of the public with some

government support via tax breaks and subsidiaries

BUT there is no way to ensure all charities get enough funding with

everyone needing help getting it. May be wastage in resources if three

charities all do the same thing. Only one may be popular enough to
actually get enough funding.
Modify the Welfare State:
o Make benefits universal and available equally to everyone (child

benefits) which would reduce the costs of the system and make it
easier to administer, but would mean those who dont need it get the
same amount as those who do need it
Make all benefits means tested to ensure only those in need get it,
which would increase administration costs a lot which could be spent
on the benefits itself

The Economy at Work

Types of Economies

Free-Market Economic System

Where private individuals and businesses base all economic decisions on

what, how and for whom to produce, with little to no govt intervention
Aim to maximise profit, will produce whatever gets them this
Lots of competition, low prices but high quality

Planned/Command Economy (communism)

Aims for equality and social justice
Government planners decide what, how and for whom to produce, then send

instructions to firms who produce what govt them tells them to produce rather
than what is profitable
Leads to little inequality as everyone has same goods, no unemployment, and

dangerous goods like guns and drugs can be banned, and govt controls
pollution
However they may fail to understand what people want creating shortages of
certain goods and surplus of other goods, with no incentive to make profit and
thus no innovation

Mixed Economy
Free market combined with government planning
People and firms in private sector own resources with aim to maximise profits

Govt owns some resources to produce G+S that private firms wont always
provide, eg public or merit goods

Market failure
When a market fails to allocate resources efficiently, like when prices may be too
high/low to maximise consumer welfare or the good may be under produced/not
produced at all.
Public Goods: not provided by the free market because of their two main
characteristics

Non-excludability where it is not possible to provide a good or service to

one person without it thereby being available for others to enjoy

Non-rivalry where the consumption of a good or service by one person will
not prevent others from enjoying it

Due to free-rider problem (non-payers cannot be prevented from using it), they are
under supplied as very few firms are willing to produce them, but are needed in
society, so the government provides them out of taxation, e.g. street lighting,
defence systems, roads, public parks & beaches, etc.
Merit Goods: goods and services that the government feels that people left to
themselves will under-consume and which therefore ought to be subsidised or
provided free at the point of use. Consumption of merit goods is thought to generate
positive externality effects where the social benefit from consumption exceeds the
private benefit, e.g. health services, education, public libraries, etc.
Markets can fail due to a lack of competition, where lack of competitive pressure on
firms reduces their incentive to operate efficiently lower incentive to lower prices or
increase quality.

Externalities

Externality: an effect whereby those not directly involved in taking the

action are affected by it

Private Cost: The cost of an economic activity to an individual firm/consumer
Social Cost: The cost of an economic activity to the whole of society

(SC=PC+EC)
External Cost (negative externality): where production or consumption

decision imposes costs on rest of society, implying SC>PC

Private Benefits: The benefits directly accruing to those taking part in a

particular action
Social Benefits: The total benefits of a particular action (SB=PB+EB), eg

jobs created
External Benefit: Where consumption of a product creates benefits for rest
of society, implying SB>PB

When PB or PC does not match SB or SC, then market failure occurs.

To reduce neg externalities, taxes can be placed on harmful products like

petrol, tobacco, alcohol, etc or ban activities with fines, like dumping
To increase positive externalities, merit goods like healthcare and schooling
can be paid for by the govt for everyone to consume, or subsidised like
universities, or reduce taxes on them like books or make it a legal
requirement to consume certain merit goods like school or car insurance.

Aggregate Demand/Supply: see class sheets

The Economic Cycle

Boom:
high
levels of
consumer
spending,
business

confidence, profits and investment. Prices and costs also tend to rise faster.
Unemployment tends to be low as growth in the economy creates new jobs
Recession: falling levels of consumer spending and confidence mean lower

profits for businesses which start to cut back on investment. Spare capacity
increases + rising unemployment as businesses cut back and reduce stocks
The UK defined a recession as a period where there is negative economic

growth for two consecutive quarters of the year

Slump / depression: a prolonged period of declining GDP - very weak

consumer spending and business investment; many business failures; rapidly

rising unemployment; prices may start falling (deflation)
Recovery: things start to get better; consumers begin to increase spending;

businesses feel a little more confident and start to invest again and build
stocks; but it takes time for unemployment to stop growing
The economic cycle matters because an unstable economy is undesirable,
and large fluctuations in output, employment, and inflation creates
uncertainty, reducing the economys long term growth potential and thus not
allowing long term planning which hinders the quality and quantity of
investments

In a boom, C, I and unemployment is low, therefore AD must be high. Ad/AS thus

confirms about booms that real GDP increases. In a slump both AD and AS decrease.

Taxes
Taxes exist to raise revenue for welfare state, reduce inequality, and to manage the
economy via fiscal policy. They also raise the prices of goods with negative

externalities like alcohol and increase the price of imports, thus reducing
consumption of foreign goods and improving the BoP.
There are many different taxes. Direct taxes include Income Tax (progressive),
National Insurance (regressive) and Corporation Tax (progressive), Indirect Taxes
include VAT, custom duties and Excise duties (tobacco, alcohol, fuel, air passenger)
and other taxes include stamp duty (house payments, progressive), council tax
(based on value of house), and inheritance tax.

The Budget
Whenever the government spends more than it receives, it must borrow money from
the private sector or overseas, which has to be paid back in the future with interest.
The Budget is an estimate of government spending and revenue for the coming year.

Budget Deficit: G>T, expansionary fiscal policy more money in economy,

greater spending
Budget Surplus: G<T, contractionary fiscal policy less money, decreased

spending
Balanced budget: G=T

National Debt is the accumulation of the all previous public sector debt borrowings
(what govt borrows in one year when it runs a deficit) that have not yet been repaid.
This amount has grown significantly recently due to government rescue package for
banks and rising unemployment.

Fiscal Policy
Fiscal Policy: The decisions about government spending, taxation and borrowing

planned for the future.

1. In Panel (a), the economy faces a recessionary gap (YP Y1). An expansionary fiscal policy seeks to shift
aggregate demand to AD2 to close the gap. In Panel (b), the economy faces an inflationary gap (Y1 YP). A
contractionary fiscal policy seeks to reduce aggregate demand to AD2 to close the gap.

Expansionary Fiscal Policy

AD shifts right
Govt Spending increases
Taxation decreases
Used in slump/recession
Inflation goes up
Economic growth goes up
Unemployment reduces
BoP deficit increases as M increases as
income (Y) decreases

Contractionary Fiscal Policy

AD shifts left
Govt Spending decreases
Taxation increases
Used in boom/growth (big deficit)
Inflation goes down
Economic growth goes down
Unemployment increases
BoP deficit decrease as M decreases as
Y decreases

Monetary

Policy

Monetary policy involves changing the interest rate that represent the cost of
borrowing money to control inflation and economic growth. This rate is set by the
Bank of England.

Most house purchases are financed by mortgages. Interest payments on these

mortgages will be paid monthly and depend on the level of interest rates.
Higher interest rates means higher monthly repayments meaning households
have less money available to spend. This should ease pressure on inflation.
Many high-value purchases (e.g. new cars) are financed on credit where

consumers buy now but pay later. Higher interest rates discourage this sort of
purchase as payments for the product (including higher interest charges)
increase. This also eases pressure on inflation.
Higher interest rates encourage saving due to the higher interest on savings.
Obviously, this leads to less spending in the economy.

These changes take a long time to come into effect 18months to two years.
Tight/Deflationary Monetary Policy
Interest rates go up less people willing and able to
borrow money C and I decrease. Government can borrow
less money from banks and earns less in taxes (VAT
from C). AD shifts left from AD1 to AD2. Inflation
decreases from PL1 to PL2 but RO also decreases, therefore
slower eco growth, increasing unemployment.

Loose/Reflationary Monetary Policy

Interest rates go down more people willing and able to
borrow money C and I increase. Government can borrow
more money from banks and earns more in taxes (VAT from C).
AD shifts right from AD1 to AD2. Inflation increases from PL1 to
PL2 and RO also increases, therefore faster eco growth from Y1 to
Y2, decreasing unemployment.

Supply-Side Policies
Supply-

Side Policies are a set of government measures

designed to boost the UKs productive capacity and shifting AS
right, hence increasing the full employment level of output.

If AS shifts to the right, P goes down from P1 to P2 meaning that inflation has gone
down. RO has increased which means increased economic growth, and employment
level increases from Y1 to Y2, getting closer to full employment. Closer to BoP
equilibrium as output increases therefore more goods available to export.
1. Privatisation
This involves selling state owned assets to the private sector. It is argued that the
private sector is more efficient in running business because they have a profit motive
to reduce costs and develop better services. Businesses sold were very inefficient,
with huge losses paid for by the taxpayer, like BT, BP, and British Rail etc. It raises
revenue to fund other SSPs and boosts innovation, etc due to market discipline.
However excessive cost cutting can decrease quality and safety, like with Railtrack
cutting costs for 400m+ profit by cutting maintenance, leading to train crashes,
etc.
2. Deregulation
This involves reducing barriers to entry in order to make the market more
competitive. For example BT used to be a Monopoly but now telecommunications is
quite competitive. Competition tends to lead to lower prices and better quality of
goods / service. Arcane rules like only Royal Mail could deliver a letter for less than

1 were removed in Jan 2006. Increased competition leads to wastage on advertising

etc to keep lead on competition.
3. Reducing Income Taxes.
It is argued that lower taxes (income and corporation) increase the incentives for
people to work harder, leading to more output. Corp taxes cut from 33% to 28%
since 1997, increasing quality of innovation as increased capital can be spent on
R&D, but sometimes given to shareholders. Also involves cutting income taxes,
reducing JSA and incapacity benefits, etc, meaning unemployed people stay out of
work for shorter and have more of an incentive to work. Since 1979, income taxes
have been cut from 83% to 45% for the top band. This also means those who really
need benefits are not as easily able to get it and it may not be enough sometimes.
4. Increased education and training
Better education can improve labour productivity and increase AS. This is done by
increasing money on education, increasing school leaving age from 16 to 18, adding
Ofsted reports to schools so they can be improved, etc. Often there is underprovision of education in a free market, leading to market failure. Therefore the govt
may need to subsidise suitable education and training schemes. However govt
intervention will cost money, requiring higher taxes. There is a very lengthy time lag
for it to have effect, between 10-20 years and thus providing no short term help.
5. Reducing the power of Trade Unions
It involves taking power away from trade unions by reforming things like compulsory
membership via closed shop agreements by removing the ability to do that. Other
reforms include secret ballots, etc. The advantage is that it reduces working days
lost via strikes as they are now a last resort. However it is now impractical to weaken
them any further as it would simply under-represent workers leaving them open to
exploitation.

The European Union

The EU started off as a customs union which involves the removal of tariffs and
quotas on trade between member states and agreeing to a common external tariff
(CET) on trade with non-members.
Tariff: Tax on imported goods.
Today the EU consists of 28countries with a combined population of 500 million and a
GDP of $15.39trillion. It allows free migration within the member states.

Trade creation: where the removal of trade barriers causes a country to switch

from purchasing goods from high cost producer to low cost in the customs
union.
Trade diversion: Where the CET causes a country to switch from low cost
producer outside customs union to high cost producer inside the union.

Advantages of the Single European Market:

1) UK firms have access to much larger market from 1 country and 64mill to 28
countries and 500million population
2) UK consumers have access to much larger market, free from trade barriers,
with a great choice of G+S from 28 countries.
3) Firms encouraged to lower price or increase quality to remain competitive
4) UK firms can relocate to any country within the EU with cheaper land/wages,
therefore sell products for cheaper
5) UK and other EU workers can relocate to any EU country for a job to fill
shortages in skills eg plumbers in the UK.
Disadvantages of the Single European Market:
1) Trade diversion due to CET meaning things like New Zealand lamb have 50%
tariff on them, making it very expensive, restricting choice and undermining
living standards
2) UK consumers may switch to buying imports which would worsen BoP
equilibrium and reduce demand for UK goods, increasing unemployment
(labour is derived demand)
3) UK firms relocating to cheaper EU countries means there would be higher
unemployment in the UK and lowered export earnings
4) Influx of foreign workers may increase unemployment as they are willing to
work for lower wages than domestic workers
5) Loss of sovereignty as UK has to comply with 1000s of pages of EU rules and
regulations
6) UK net contributor to EU - 11bn net contribution in 2013, showing an
opportunity cost as money could have been spent domestically

The Single European Currency

The Euro is a common currency shared by 18 of the EU member states, together
known as the Eurozone.
Advantages of joining the Euro:
1) Elimination of transaction costs, with no need to pay commission fees when
changing currencies, which can amount to 0.5% of the GDP, making it
cheaper to trade within EU
2) Reduced exchange rate uncertainty as fluctuating exchange rates with 36months trade credit would mean many firms do not like to sell abroad.
Entering into the Euro would end this uncertainty largely but there would still
be some, like with the US.
3) Price transparency easy to see and compare prices between different
countries as all the prices are in the same currency, meaning customers
would shop around more for the best deal, leading to more competition and
overall lower prices.
Disadvantages of joining the Euro:
1) Rounding up inflation as firms may take advantage of consumers struggling to
get used to the new currency as thus round up their prices, eg if rate was

1:1.13, a 100 item might be sold for 115 instead of 113. But this is a
one off cost.
2) Menu costs inflation as there would be additional charges in changing menus,
price lists, accounting systems, etc from pounds to euros, with new tills, etc
needing to be bought, increasing CoP and thus prices. But this is again a one
off cost.
3) Single currency means single interest rate which may not be suitable for the
UK. This would be set for Eurozone, not just UK. UK is in stronger economic
position than rest of Europe and needs higher interest rates than the
Eurozone, now has interest rate of 0.5% rather than 0.05% in Eurozone.
4) Stability and Growth Pact would mean Eurozone countries must maintain
budget deficit of <3% of their GDP, and national debt of <60% of GDP. This
means UK may not be able to use expansionary fiscal policy during recession
which could mean high unemployment, etc. Current national debt is 77% of
GDP.
Advantages of Enlargement:

Cheaper labour costs

Western European firms can operate in new member countries where costs of living

are lower.
The average monthly wage in the UK is equivalent to 2600 however in in Hungary is

500. This shows that workers from Eastern Europe have an incentive to move to the
UK to live and work to gain a higher living standard.
Increase supply of workers from EU Enlargement countries will depress (lower)

average wages in industries such as construction and agriculture, as it has already

done in plumbing. This will lower firm's costs of production which increases their
profit margins.
High skilled workforce: 60% of new migrants from western and southern Europe are

now university graduate. The educational levels of east Europeans who come to
Britain are also improving with 25% of recent arrivals having completed a degree
compared with 24% of the UK-born workforce.
Lower wage costs will also make UK firms more internationally competitive

(assuming the lower costs are passed on to customers) and this will improve the
balance of payments deficit which was 71.1 billion in 2013
Strengthen ties with neighbouring regions
Turkey may provide direct link to Middle East and route for the transportation of oil

which is not via Russia

This will give UK businesses and consumers a more stable source of fuel and given

problems in Ukraine (where Russia threatened to cut off its gas & oil supply) this is a
vital issue for the EU at 30% of Europe's gas is provided by Russia
More choice for consumers
CET ensures existing consumers can now import goods for less money, i.e. goods

previously with the CET would have no tariff = cheaper

Turkey's main exports are food, textiles, clothing, iron, steel, ships, consumer

electronics, appliances and automotive goods

A wider market may encourage more foreign investment into EU (& UK)
2004 enlargement increased the EU's population by 20%, therefore increasing the
level of potential customers by 20%. This makes the EU and UK a more appealing

place for Multi-National Corporations to invest and set up offices so they can trade
more with EU citizens
This increases the demand for workers in the UK, hopefully in high end managerial

roles which reduce unemployment and increase living standards for UK citizens
Turkey's young population could meet need for more workers in EU - increase

quantity and average quality of factors of production (labour/ enterprise)

Average age in Turkey is 29, whereas in the UK it is 40. If Turkish workers emigrate to
the UK then they will be paying taxes which will help pay for our dependents (e.g.
Old Age Pensioners).
Disadvantages of Enlargement:

Businesses face greater competition

Although may be an advantage for consumers;
Turkey already exports a high proportion of its goods to the EU ($50 billion in 2010)
showing that it is already a major competitor for EU businesses. Turkey's exports will
become even more competitive once the Common External Tariff (CET) is not
charged on its exports.
Increased competition = lower sales and/or lower prices= increase in bankruptcy of
EU firms= lower demand for labour= lower employment & higher unemployment
Difficult to achieve integration with a broader EU
Or benefit, the EU could be viewed on the world stage as an open and progressive
organisation which is create better ties with the Middle East.
Too many members may make it hard to agree on EU policy.
28 plus Croatia, Turkey, Albania, Bosnia-Hercegovina, Iceland, Macedonia,
Montenegro and Serbia (8) = 36 countries
The economic disparity between, for example, the UK and Slovakia makes the
implementation of common economic policies near impossible. A much looser
association is likely to work better. This may mean that more policies are
implemented on an EU level that is not beneficial for the UK.
May lead to mass immigration into Western Europe.
Turkey has a population of nearly 77 million people, all who would be free to move to
other EU countries (not only a small proportionate are likely to do so).
Enlargement in 2004 added 20% to the EU total population (381m plus 75m) this
shows the potential for mass migration. Note GDP per capita (per person) fell by 9%
due to the 2004 enlargement showing how low living standards are in some of these
countries and therefore the incentive to emigrate to central EU countries
Counter argument: European migrants made a net contribution of 20bn to UK public
finances between 2000 and 2011. Those from the 15 countries which made up the
EU before 2004, including France, Germany, Italy and Spain, contributed 64% 15bn more in taxes than they received in welfare while east European migrants
contributed 12%, equivalent to 5bn more. The study shows that not only are
European migrants more highly educated than the UK-born workforce but they are
less likely to be in receipt of state benefits - 43% less likely among migrants in the
past decade - and more likely to be in employment. They are 7% less likely to live in
social housing. Immigrants from the 10 countries that joined the EU in 2004
contributed 5bn more in taxes than they took in public services from 2004 to 2011
Large subsidies given to new members - 10 countries in 2004 led to 4bn outflow