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Question

what are deflationary policies?

Answer 1

* The term deflationary policies means demand-side policies to reduce the growth of AD, e.g. tight monetary policy (higher interest rates). * Deflationary policies may not lead to outright deflation. Deflationary policies may just reduce the rate of inflation (disinflation).

Answer 2

1. Demand-pull inflation • If aggregate demand (AD) rises faster than aggregate supply (AS), then we will get inflation. • Demand-pull inflation occurs if the economic growth is too fast — i.e. if the growth is above the long-run trend rate. As the economy reaches full capacity, rising AD leads to more inflation. Demand- pull inflation could occur due to various factors. For example: • Lower interest rates. A cut in interest rates reduces the cost of borrowing — encouraging spending and investment. • Rising house prices, which increases consumers’ wealth and confidence. • Boom in exports from a rising global demand, e.g. strong growth in Europe. • Income tax cut, which gives consumers more disposable income to spend. • A rapid rise in the money supply, e.g. the Central Bank printing more money. 2. Cost-push inflation This occurs when there is a rise in the costs of firms, leading to short-run aggregate supply (SRAS) shifting to the left. Cost-push inflation could occur due to: • Rising oil prices/Raw material prices. This would increase the costs of most firms, due to higher transport costs. • Rising wages. If wages are pushed higher by trade unions or a shortage of workers, this will increase the costs of firms. (Rising wages may also cause demand-pull inflation as consumers spend more increasing AD.) • Import prices. One third of all goods are imported in the UK. If there is a depreciation in the exchange rate, then import prices will become more expensive, leading to an increase in inflation. • In 2011, the UK had cost-push inflation of 5% despite a lengthy recession. The inflation in 2011 was caused by higher taxes, depreciation in the pound, and higher raw material/food prices.

Answer 3

Monetarists argue that a key factor in determining inflation is the growth of the money supply. If the money supply grows faster than the rate of growth of real income, there will be inflation. Quantity theory of money MV = PQ • M = money supply. The stock of money (cash + bank deposits) • V = velocity of circulation. The number of times money changes hands • P = price level • Q = Quantity of goods Therefore, PQ = nominal national income • Monetarists believe that in the short term, velocity (V) is fixed. • Monetarists also believe output Y is determined by supply-side factors. • Therefore, an increase in the money supply (M) faster than the growth of national income will lead to an increase in (P) inflation.

Answer 4

* Quantitative easing did not cause inflation. In the great recession of 2008-13, even quantitative easing (increasing monetary base) didn’t lead to higher inflation, because the economy was depressed. * The velocity of circulation (V) is not stable. The velocity of circulation can change due to factors such as an increase in the use of credit cards. Growth in the money supply can be erratic and due to institutional factors, e.g. more cash machines caused an increase in M0 * Economy not always at full employment. Keynesians argue that the LRAS is not necessarily inelastic; they argue that the economy can be below full capacity for a long time. In this depressed state, increasing the money supply may not cause inflation.

Answer 5

If people expect low inflation, low inflation is more likely to occur. • If workers expect low inflation, they will be more likely to accept low wage increases. • If firms expect low inflation and low cost of raw materials, they will keep prices competitive. • If inflation expectations rise, it can cause inflation — as firms push up prices, and workers try to secure higher wages. • In the 1970s the UK experienced high inflation. This was partly caused by rising oil prices, but also by strong wage growth. Trade unions bargained for higher wages because they expected inflation. • If a Central Bank has strong anti-inflation credibility, it can make it easier to keep inflation low. This is why many governments gave the responsibility of monetary policy to an independent Central Bank.

Answer 6

In the short term, we can often see a trade-off between unemployment and inflation. • If the government increased spending (G), we would see an increase in AD. This leads to a rise in real GDP (Y1 to Y2). • As output rises, firms will hire more workers, and unemployment falls. • But as the economy gets closer to full capacity (positive output gap), we start to see inflationary pressures (P1 to P2).

Answer 7

This monetarist model suggests there will only be a temporary trade-off between unemployment and inflation. the phillips curve * If the Monetarist view is correct, it would suggest that demand-side policies to reduce unemployment will be ineffective in the long run. Therefore, Monetarists place greater stress on supply-side policies. * If the Keynesian view of the Phillips Curve is correct, then demand-side policies could play a role in reducing cyclical unemployment. However, they would still have to be careful not to cause inflation. * L-shaped curve. In some situations, e.g. deep recession, it is possible to reduce unemployment without inflation. However, when the economy gets close to full capacity, reducing unemployment has a much bigger impact on inflation.

Answer 8

1. Supply-side policies to reduce structural unemployment. If the government introduced successful supply-side policies, we could see a fall in structural and frictional unemployment. This would reduce the natural rate of unemployment and shift the Phillips curve to the left. 2. Economic growth close to long-run trend rate of growth. If the economic growth is kept close to the long-run trend rate (e.g. 2.5%), then the growth is sustainable. In this case there will not be a positive output gap, but we will reach full employment with minimal inflationary pressure.

Answer 9

* Medium of exchange (widely accepted in society) * Store of value * Deferred payment * Unit of account

Answer 10

Money supply. This measures the total amount of money in the economy. The money supply includes cash (notes and coins), but also bank deposits (deposits that can easily be converted into cash or used by debit cards.

Answer 11

1. Narrow money. This definition of money just includes the level of notes and coins in circulation. For example M0 = the level of notes and coins in circulation + banks’ operational balances at the Bank of England. 2. Broad money. This includes notes and coins in circulation + private sector deposits in banks and building societies. For example M4. This figure is much higher than M0.

Answer 12

* Stock markets — enabling the buying and selling of shares on listed stock markets. Firms can use stock markets to issue more shares and raise finance. * Bond markets — this involves buying and selling government bonds to fund public sector borrowing. Besides government bonds, there are also private sector bond markets for firms. * Commercial banking — offering firms the chance to save and borrow for investment. * Personal banking — offering individuals the opportunity to save and borrow. * Capital market — a financial market for buying or selling long-term debt, e.g. bonds and equity-backed securities. It includes both government debt and corporate debt. * Money markets — a wide range of financial markets which enable banks and companies to borrow and lend for the short term. * Foreign exchange markets — where individuals and firms can buy and sell foreign exchange reserves.

Answer 13

1. Saving. Banks and building societies offer consumers and firms a place to save and gain interest on savings. Consumers can also save through buying bonds and other investment funds. 2. Lending. Financial markets are critical to enable borrowing by firms and consumers. This enables firms to borrow to fund investment, and enable higher economic growth. 3. Reducing risk. Financial markets can be used to insure against unexpected losses/risk. 4. Forward market in commodities. This means that firms can agree to buy commodities at certain prices in the future. It offers a way to ‘hedge’ (insure) against the risk of fluctuating prices. For example, since oil prices can be volatile, a forward market enables a firm to buy oil at an agreed price in the future. 5. Shares. Firms list their company on the stock market so that they can raise money from shareholders. This can be beneficial for raising finance for long-term investment. Shareholders are often willing to take more of a risk than a bank. E.g. the Eurotunnel was financed by selling shares to investors.

Answer 14

* Debt incurs fixed payments to repay the outstanding loan. If you raise money by selling a bond, this is counted as debt as you are contractually obliged to pay it back in a certain time frame. Debt holders do not have any share in the business. * Equity does not have any fixed repayment plan. However, if you sell equity (e.g. shares) it means the shareholders own part of the business and are allowed to vote in important meetings. Firms usually pay a voluntary dividend to shareholders to keep them happy.

Answer 15

* Suppose the government issued a £1000, 5-year Treasury Bond at an interest rate of 5%. * This means that if you bought the £1,000 bond, you will receive a fixed interest rate of £50 every year (5% of £1,000). • At the end of the fixed 5-year period the government will also repay your £1,000. However, bonds are often bought and sold on the open market. * If people buy bonds, the demand rises and so the price of bonds rises to reflect the increased demand. * Suppose the price of bonds rises from £1,000 to £1,500. This bond is being sold for more than its face value, but the interest payment remains the same — £50 a year. * This means that now bonds have a market price of £1,500, the effective interest rate is £50 / £1,500 = 3.33%. • Therefore, because the demand for bond rises, the price of bonds rises and the effective interest rate (yield) falls. If the price of bonds fell below its face value, the effective interest rate would rise.

Answer 16

* Suppose investors became nervous that a country (e.g. Greece or Italy) might default on its debt. * Investors would be more likely to sell the bond. * The bond would fall in value, increasing bond yields. • With fear of default, investors demand a higher bond yield to compensate for the increased risk. • This is what happened in the Eurozone crisis of 2010-12. Bond yields rose.

Answer 17

A commercial bank deals mainly with deposits and loans from consumers and firms. In the UK these are often known as retail banks. An investment bank concentrates on raising funds for banks and helping expansions and mergers. An investment bank does not take bank deposits (savings).

Answer 18

* Taking deposits from consumers, and keeping money safe. * Offering interest payments for consumers who save. • Maintaining sufficient liquidity. Ensuring sufficient cash is available for consumers when they seek to withdraw money from banks/cash machines. • Offering loans to householders and firms. Using part of the deposits from consumers.

Answer 19

* Assets — anything that can be sold. Assets include cash reserves, loans, and securities. * Liabilities — anything that is an obligation for the bank to repay. Customer deposits are liabilities because the bank has an obligation to give deposits back, should customers wish to withdraw money. Bank equity/Bank capital = these are the cash reserves — what is left after selling assets and repaying liabilities. It could be thought of as a ‘buffer’ — the amount of spare cash/equity. • Bank assets = Bank capital + bank liabilities (A bank’s assets include all the liabilities (e.g. deposits) plus the bank capital)

Answer 20

* Business loan * Consumer loan (personal loan, credit card) * Mortgage loan (loan to buy a house)

Answer 21

* Profitability. A bank makes money by attracting deposits and lending to consumers at a higher interest rate. For example, if a bank pays 2% to savers, but charges 5% to lend money, it is making a profit from the different interest rates. * Liquidity. A bank needs to make sure it has sufficient liquidity to meet daily demands for cash from consumers. This is why banks must keep a certain cash reserve. * Security. If a bank lends money to a firm or household, there is always a risk that the bank will not get the money back. A firm could default on the loan, causing the bank to lose its money. A bank needs to make sure its assets/loans are reliable.

Answer 22

1. Profitability vs liquidity. If banks kept all deposits as cash, they would have 100% liquidity, but they would make no profit. The more that banks lend out, the greater the potential profit. However, the lower the cash reserve, the greater the chance of running out of money. 2. Profitability vs security. Some loans are more risky. Consumers with bad credit history, or new firms, are more likely to default on loans. In these cases, banks can charge a higher interest rate to compensate for the risk. These loans can be more profitable, but they are also more risky and increase the chance of default.

Answer 23

* This is the percentage of customer deposits that are kept in cash reserves (and not lent out on more profitable loans). * Central Banks usually set a minimum reserve ratio that commercial banks must keep, so that banks have enough cash to meet withdrawal requests.

Answer 24

* The banking system enables banks to create credit and increase the money supply. * If a bank received deposits of £1 million, the bank may lend out 90%, creating £0.9 million of loans. * In turn, this loan may be deposited back in the banking system. • With an increase in the number of money lent out, the money supply increases and the banks will eventually receive another £0.9 million in deposits. • With more deposits, the process of lending a certain percentage can start again. Money multiplier = 1/R • R = reserve ratio (e.g. 10%) • If the reserve ratio is 10%, then the multiplier will be 1/0.1 = 10 • Therefore, with a reserve ratio of 10%, the money multiplier would cause the initial £1 million to increase to £10 million.

Answer 25

1. Alternatively, if banks start holding onto cash and not lending out money, then the money supply can fall. 2. This happened in the credit crunch of 2009/10 — banks increased their reserve ratio. It was hard to get bank loans and the money supply fell.

Answer 26

1. Monetary policy. Central Banks are usually responsible for monetary policy. This involves changing interest rates to meet the government’s target for inflation (and other macro-objectives). The Bank of England meet every month to set interest rates. They look at a range of data to predict future inflation and economic growth. 2. Banker to the government. Central Banks manage the government’s financial account. 3. Lender of last resort. An important role is acting as the lender of last resort, for both the government and private banks. If the government runs out of money, the Central Banks can step in to buy government debt, preventing panic about the government’s liquidity. They can also lend money to commercial banks if they are temporarily short of liquidity (money). 4. Printing money. The Central Bank is often responsible for managing the money supply; this involves printing new money and possibly quantitative easing (creating money electronically). 5. Regulation of the banking industry. With other financial watchdogs, Central Banks can be responsible for regulating the financial sector. This can involve setting reserve ratios and preventing financial market rigging.

Answer 27

Monetary policy involves changing the interest rate or manipulation of the money supply by the monetary authorities. • In the UK monetary policy is managed by the Bank of England’s, Monetary Policy Committee (MPC). Aims of monetary policy 1. Control the rate of inflation. Inflation target for MPC is CPI - 2.0% +/-1 2. Maintain sustainable economic growth/low unemployment 3. Influence the exchange rate (not so important) UK monetary policy • Every month, the MPC meets to decide future interest rates. If they feel the inflation rate is likely to go above the target (e.g. due to a higher rate of economic growth), then they will increase interest rates to moderate demand and keep inflation low. • If the MPC feels that inflation is likely to fall below the target and there is slow economic growth, they are likely to decrease interest rates to boost economic growth and prevent unemployment.

Answer 28

1. The effect of interest rates depends on the situation of the economy. If the economy is close to full employment, a cut in interest rates is likely to cause a significant increase in inflation, but only a small increase in real GDP (AD3 to AD4). 2. Other components in the economy. The effectiveness of monetary policy depends upon other variables in the economy, for example: • If confidence is low, a reduction in interest rates may not increase demand. • If taxes are rising, this may counter a fall in interest rates. • If the world economy is slowing, this will reduce exports and AD; this would keep spending low — even if there was a reduction in interest rates. 3. Time lags. There may be time lags for lower interest rates to have an effect. For example, higher interest rates may not reduce investment in the short term, because firms will continue with existing investment projects. 4. Conflicts of objectives. Monetary policy may conflict with other macroeconomic objectives. If the MPC reduces inflation, this may lead to lower growth or higher unemployment.

Answer 29

* Exports will become more expensive, reducing the demand for exports. * Imports will become cheaper, increasing spending on imports. • AD will tend to fall. If the demand for exports and imports is relatively elastic, then an appreciation will cause lower AD and, therefore, lower economic growth. • Reduced inflation. Inflation will fall for three reasons: o Imports are cheaper, reducing the cost of imported raw materials and goods. o Exports and AD will tend to fall, reducing demand-pull inflation. o Exporters have more incentives to cut costs to remain competitive • Current account will tend to worsen. This is because the quantity of exports goes down, and imports increase. • Lower economic growth and higher unemployment. If the exchange rate causes a fall in AD, we will see lower economic growth.

Answer 30

A depreciation will cause the opposite: • Cheaper exports • More expensive imports • Economic growth should increase • Inflation more likely to occur (more expensive imports, and rising AD) • Improvement in the current account deficit

Answer 31

* Elasticity of demand. The effect of an appreciation depends on the elasticity of demand. If the demand for exports is price-inelastic, the appreciation will have little impact on reducing the demand. * Time lag. In the short term, export demand may be inelastic, but in the long term, export demand becomes more price-sensitive. * Other components of AD. An appreciation will, ceteris paribus, reduce AD. But if the spending of consumers is rising, we will probably see AD continue to rise. (X-M) is only approx. 15% of AD, so is not the most important. * State of economy. If the economy is close to full capacity and growing strongly, an appreciation may help to reduce inflationary pressures, but will probably not cause a fall in GDP. But in a recession, an appreciation is likely to be more harmful.

Answer 32

• Quantitative easing — electronically creating money. • Reserve ratio. Setting a minimum reserve ratio can influence the money supply. For example, if the Central Bank made commercial banks hold a higher % of cash reserves, then the money supply would fall.

Answer 33

1. Quantitative easing involves the Central Bank creating more money and trying to reduce bond yields. 2. The aim of quantitative easing is to: 1. Increase the supply of money 2. Increase the inflation rate and avoid deflation 3. Increase bank lending and increase economic growth

Answer 34

How quantitative easing works • The Central Bank creates money electronically (this is a similar effect to printing money). • The Central Bank uses these extra bank reserves to buy various securities, such as government bonds and corporate bonds. • Commercial banks sell assets (bonds) to the Central Bank for cash. • Therefore, banks see an increase in their liquidity (cash reserves). • In theory, with more cash reserves, the bank will be more willing to lend to customers. This lending will be important for increasing investment and consumer spending. • Buying assets reduces their interest rate. Lower interest rates on these securities may also encourage banks to lend. Higher lending should help improve economic growth.

Answer 35

* The UK Central Bank engaged in quantitative easing QE — £375bn of new money asset purchases. * It is hard to quantify the effect of QE. At the same time, the UK growth was affected by deflationary fiscal policy and low growth in Europe. Perhaps, without QE, the recession would have been deeper. * Government bond yields did fall, making it cheaper for the government to borrow, though some feared a bond bubble. * Future inflation? Some fear that quantitative easing creates the possibility of future inflation because, when the economy recovers, there is excess money supply in the financial system, which may be hard to remove. However, inflation has stayed low. * Economic growth was low/negative between 2009 and 2012.

Answer 36

• ASYMMETRIC INFORMATION. Financial bodies may not be aware of the real state of a company’s increasing likelihood of debt default. • A problem in the credit crunch was that many banks bought bundles of US mortgage debt, not realising that many US mortgages were highly likely to default. • Financial regulation is needed to make sure firms are transparent and offer proper accounts. • MORAL HAZARD Moral hazard occurs when financial guarantees alter economic behaviour and increase risk-taking. • A Central Bank commits to guaranteeing all bank deposits. If a commercial bank goes bankrupt, the Central Bank will bail it out. • Arguably, this bailout guarantee encourages commercial banks to take more risks because, if they lose money, the Central Bank will step in. • SPECULATION AND MARKET BUBBLES. In the finance sector, we often see ‘market bubbles’ due to speculation and over-confidence. o If an asset (such as housing) rises in price, people think this is a very good investment and so buy to try and benefit from rising house prices. Due to over-confidence, the price of the asset can become inflated above its true value. o Later, prices can fall significantly as the asset returns to its true value. MARKET RIGGING This occurs where those with inside knowledge are able to manipulate financial markets. • For example, traders may try to fix interest rates so that they can make more profit e.g. the Libor scandal with commercial banks guilty of fixing inter-bank lending rate. SYSTEMIC RISK This occurs when problems at one bank put the whole financial system at risk. For example, if one bank went bust, it would cause a loss of confidence, and customers would try to withdraw their money, causing a panic. • Banking failures can be contagious. If one bank goes bankrupt, the whole banking system will be negatively affected.

Answer 37

* LOSS IN CONFIDENCE. In normal circumstances, a bank can keep a low liquidity ratio, e.g. just 1% cash reserves. However, if consumers lost confidence in banks, they may want to withdraw much more cash than usual. But the bank cannot necessarily get enough cash because it is tied up in long-term loans. * LENDING FOR A LONG TIME PERIOD. Banks make many long-term loans, e.g. mortgages which have repayment for 40 years. This means the money is tied up and the bank cannot get it back in an emergency. • BORROWING IN THE SHORT TERM. Before the credit crisis, banks borrowed money on money markets for a short time period at low interest rates. They used this money to lend out to more profitable long-term loans (e.g. mortgages). o The problem is that in the credit crunch banks could no longer engage in short-term borrowing. No one wanted to lend, but banks relied on this short-term borrowing to remain liquid. o This was a problem for banks like Northern Rock and Bradford & Bingley who had taken too many risks. * INVESTMENT/COMMERCIAL DIVISION. Many commercial banks have investment divisions. Investment banks engage in more risky lending, putting customer deposits at more risk. * SYSTEMIC RISK. A bank may be caught up in the contagion of a banking crisis. For example, many European banks were adversely affected by their exposure to US mortgage loans.

Answer 38

• This is the ratio of short-term assets which can be used to pay short-term debts. - It is, essentially, the level of cash (or cash equivalent) to debt. • A high liquidity ratio makes a bank have greater safety in meeting debt requirements. • A low liquidity ratio could make a bank susceptible to not being able to meet debt requirements. • Changing liquidity ratio. If a bank made a long-term loan, its level of assets would stay the same, but its liquidity ratio would fall, because this long-term loan cannot be quickly converted to cash to meet any debt requirements.

Answer 39

Capital adequacy ratio (CAR) is the ratio of its bank capital to the risk of its assets. It places a weighting on the risk of different assets. * It is effectively the cushion that a bank has to absorb any potential losses (e.g. from loan default). * A high capital adequacy ratio means that a bank has a higher level of reserves to meet any potential risk from default on loans. * A low capital adequacy ratio means banks have greater risk and customer deposits could be at greater risk. A bank could increase its capital ratio by • Holding greater equity/cash reserves • If banks increased the quantity of ‘safe’ assets, such as government bonds and reduced exposure to risky credit card loans.

Answer 40

1. Financial Policy Committee (FPC) at the Bank of England. The objective of the FPC is to remove or reduce systemic risks in the financial system. The FPC has a secondary objective to support the economic policy of the government. This involves: * Examining levels of debt or credit growth, e.g. in an economic boom there may be a rapid growth in credit. * Examining potential risks in the financial system. Is risk adequately shared? * Levels of cash reserves (capitalization)

Answer 41

1. Financial Policy Committee (FPC) at the Bank of England. The objective of the FPC is to remove or reduce systemic risks in the financial system. The FPC has a secondary objective to support the economic policy of the government. This involves: * Examining levels of debt or credit growth, e.g. in an economic boom there may be a rapid growth in credit. * Examining potential risks in the financial system. Is risk adequately shared? * Levels of cash reserves (capitalization) FUNCTIONS OF THE FPC • Warning banks of potential risks. • Setting levels of capital buffers. The FPC can make banks hold more cash during a boom. This enables a bank to better survive a downturn. • Setting sectoral capital requirements. This involves setting levels of exposure to particular sectors, e.g. reducing a bank’s reliance on variable mortgages. • Warning the MPC if monetary policy poses risk to financial stability.

Answer 42

Evaluation of macroprudential capital buffers • The FPC may have insufficient information about all the risks banks are taking. • It may be difficult to predict how much capital buffers are required. • Raising capital reserves could lead to lower lending and investment, leading to lower growth.

Answer 43

Prudential Regulation Authority PRA The PRA supervises firms that take significant risks in their business, e.g. banks, insurance companies, and large investment banks. Their functions include: • Promoting financial soundness of rims. • Securing appropriate degree of protection for those who hold insurance. • Facilitating effective competition. Financial Conduct Authority FCA Set up to protect consumers from misleading information or unsuitable financial products/services. For example: • Helping consumers claim for mis-sold PPI (payment protection insurance) • How to spot and avoid scams. • Tackling firms who engage in manipulating interest rates (Libor rate)

Answer 44

Fiscal policy is the government’s attempt to influence AD through changing spending and tax levels. The aim could be to: • Stimulate economic growth in a period of recession • Maintain low inflation

Answer 45

Fiscal and supply side • Fiscal policy can also influence the supply-side of the economy. For example, higher government spending on education can increase AD, but may also reduce structural unemployment.

Answer 46

* This involves lower tax rates and/or higher government spending, with the aim to increase AD. * Expansionary fiscal policy will increase AD and increase the size of the budget deficit. It may cause inflation.

Answer 47

* This involves higher tax rates and/or lower government spending. * The aim of deflationary fiscal policy is to decrease AD and inflation. * Deflationary fiscal policy will also improve the budget deficit.

Answer 48

1. Supply-side. Fiscal policy can also influence the supply-side of the economy. For example, expansionary fiscal policy which involves higher government spending could be targeted on education and infrastructure spending. If successful, this can increase productive capacity and improve long-run economic growth. 2. Poor information may reduce the accuracy of forecasting future economic growth and inflation. Therefore, the government may be unsure whether they need to boost or reduce AD. In practice, governments find it difficult to ‘fine-tune’ the economy with fiscal policy. But in major recession, they may try expansionary fiscal policy. 3. It depends on other components of AD. For example, if the government cut income tax to increase AD, it may be ineffective if consumer confidence is low and people just save the extra income. 4. Disincentives to work. Higher income tax to reduce inflation can create disincentives to work, reducing productivity and AS. 5. Time lag involved in influencing AD. If the government wanted to increase AD, they could commit to more government spending. But there will be delays in actually implementing higher spending, and then delays in this spending affecting the wider economy. 6. Budget deficits. Expansionary fiscal policy (higher spending, lower tax) will increase government borrowing. This could lead to higher interest rates in the long term, or even cause markets to lose confidence in debt levels. 7. Crowding out. If the government spends more by borrowing from the private sector, it may reduce the amount of money the private sector has to spend.

Answer 49

Government spending includes all forms of spending by central and local government. The main types of government spending are: • Capital expenditure. This is government spending on capital projects and creating new assets. It is investment that increases the capital stock of the economy. o This typically involves building new roads, railways, hospitals, and improving communication. This capital spending can increase the productive capacity of the economy in the future, because it helps shift long-run aggregate supply to the right. • Current expenditure. This is government spending on items that are recurring and only lasts a limited time, e.g. spending on public sector wages and consumable products. o E.g. building a school which lasts 50 years is capital expenditure. Paying teachers’ wages and paying electric bills is current spending. * Transfer payments. These are simple payments from the government to individuals. It represents a redistribution of income in society. A key feature of transfer payments is that you get them without any exchange of goods or services. Examples of transfer payments include: * Pensions * Welfare payments, such as unemployment benefit and housing benefit

Answer 50

There are two key measures of government spending: 1. Real government spending — Spending levels adjusted for inflation. 2. Government spending as a % of GDP — Government spending as a share of national income. • For example, if government spending increases by 5% in nominal terms, but inflation is 3.5%. o Real government spending has increased (5-3.5) =1.5% • If the real GDP of the economy increased by 2.5%, and real government spending increases by 1.5%, then o We see government spending is increasing at a slower rate than the increase in real GDP. o Therefore, government spending will fall as a % of GDP (even though real spending is rising).

Answer 51

* Higher taxes may be required to fund higher spending. Higher income tax rates could create disincentives to work. Higher corporation tax could discourage firms from setting up in that country, leading to lower growth. * Potential inefficiency of government spending. Often, government bodies lack a profit incentive to be efficient. Therefore, government spending could be wasteful, misused, and inefficient. On the other hand, it could overcome market failure, e.g. lack of education. * Efficiency. Government spending could become more efficient through competitive tendering and public-private partnerships, which involve both public and private sectors. There is no reason government spending has to be inefficient. * Crowding out. An increase in the government sector has an opportunity cost. More government spending means a decline in the size of the private sector and a reduction in private sector enterprise. • Kind of spending. It depends on what the government is spending the money: o E.g. spending on welfare benefits (transfer payments) may increase equality, but be detrimental to efficiency and productivity. o Spending on transport links (capital spending) can help the economy become more efficient and competitive in the long term.

Answer 52

* Progressive tax. This occurs when those on higher income levels pay a higher % of their income in tax, e.g. the UK has a top rate of 45% on marginal income over £150,000; this is a progressive tax. * Regressive tax. This occurs when an increase in income leads to a smaller % of their income going on the tax, e.g. excise duties and VAT take a bigger % of low income earners. * Proportional taxation — takes same % of income, whatever income band. * Direct taxation — taken from people’s earnings directly, e.g. income tax and NI. * Indirect taxation. Paid by firms selling goods, e.g. VAT is included in the final price consumers pay.

Answer 53

• Raising revenue • Promoting redistribution of income and wealth • Discouraging consumption/production of goods with negative externalities or demerit goods

Answer 54

1. Horizontal equity, i.e. those in the same circumstances should pay the same taxes 2. Vertical equity. A degree of proportionality is important, e.g. progressive income tax 3. Cheap to collect 4. Difficult to evade 5. Efficient, non-distorting, e.g. if income taxes are too high, people may be put off working 6. Easy to understand

Answer 55

• Disincentives? Some fear higher income tax rates could create disincentives to work. But other economists suggest evidence is mixed. o The substitution effect of a tax rise may make people work less, because with higher tax, work gives a lower reward. o But the income effect encourages them to work more (with lower wages, longer hours are needed to achieve a target income). • It depends how tax revenue is used. If income tax revenue is invested in improved infrastructure, it can the benefit long-run productive capacity and help improve the rate of economic growth. If income tax revenue is needed for welfare payments, such as pensions there will be no increase in productive capacity.

Answer 56

* Cost-push inflation. If we increase VAT, the price of goods will rise. This will cause a higher price level and inflation. * However, this price rise will be a one-off increase and, after 12 months, the price rise will no longer count toward inflation. • Output. Higher taxes will cause the SRAS to shift to the left, leading to inflation and lower output. o However, it does depend on other factors affecting AD and AS. A rise in indirect tax is unlikely to cause a fall in economic growth on its own. * Equity. Indirect taxes such as VAT and excise duties tend to be more regressive, taking a higher % of income from low income earners. * Social efficiency. Higher taxes on petrol, cigarettes and alcohol may be desirable for micro-economic factors, such as a more socially efficient level of cars (reducing congestion).

Answer 57

* Countries may seek to encourage foreign direct investment (FDI) through offering lower tax rates. For example, countries may set low corporation tax rates to encourage multinationals to set up in those countries. For example, Ireland has attracted many big multinationals to invest through low tax rates. * The problem with tax competition is that it can encourage countries to keep trying to offer lower tax rates to attract big companies. This leads to countries having to increase tax on consumers and workers.

Answer 58

* The budget deficit is the annual amount the government needs to borrow from the private sector. * The budget deficit will be the difference between government spending (G) and tax revenue. * Public sector net borrowing (PSNB) is one statistic which measures the budget deficit.

Answer 59

During a recession, it is likely that we will see a rise in government borrowing, due to cyclical factors. * With lower growth, tax revenues will be lower. If people earn less, they will pay less income tax. With less spending, receipts from VAT will fall. * Government spending will increase. In a recession, the government will need to spend more on unemployment benefits and income support benefits.

Answer 60

This refers to a budget deficit, even if we ignore cyclical factors. If the government has a budget deficit when the economy is growing at its long-run trend rate, this shows the underlying, structural deficit.

Answer 61

This refers to how tax rates and government spending automatically have an influence on the rate of economic growth and help to counter swings in the economic cycle. For example, in a period of high economic growth, automatic stabilisers will help to reduce the growth rate. With higher growth, the government will receive more tax revenues from the same tax rates — people earn more and so pay more income tax. With higher growth, there will also be a fall in unemployment, so the government will spend less on unemployment and income support benefits.

Answer 62

Supply side policies are government attempts to increase productivity, make the economy more efficient, and shift aggregate supply to the right. Supply-side policies can be either: 1. Interventionist — involving government spending to overcome market failure, e.g. building new roads to reduce congestion. 2. Market-oriented — policies to reduce regulation and allow free markets to function more efficiently, e.g. reduce minimum wages. Supply-side improvements. This refers to general improvements in the productivity of the economy. Supply-side improvements could be due to private innovation, improved technology or government supply-side policies.

Answer 63

1. Lower inflation. Shifting AS to the right will cause a lower price level. 2. Lower unemployment. Supply-side policies can help reduce structural, frictional and real-wage unemployment. 3. Improved economic growth. Supply-side policies will increase economic growth by increasing AS. 4. Improved trade and balance of payments. By making firms more competitive, they will be able to export more.

Answer 64

* They will take time to have effect, e.g. it will take several years to create a more educated workforce. * It will cost money to improve information and education, and therefore taxes will need to rise. * Deregulation, such as lower benefits and reduced minimum wages may cause side-effects, such as increased poverty. * Government failure may occur. For example, the government may have poor information about what to spend money on. For example, the government may finance the wrong kind of scheme, such as a new train line that is not used very much. * In a recession, increasing AS may be insufficient. In a recession, policies to increase aggregate demand are more important than supply-side policies.

Answer 65

Globalisation refers to the process of how national economies are becoming increasingly interdependent and integrated. • In practice, globalisation refers to the increased flow of labour, capital and trade between different countries, and a breakdown of barriers between countries.

Answer 66

* Growth in free trade between countries * Growth in movement of labour and capital across national borders * Increased importance of global financial systems * Growth in trading blocs (groups of countries, like EU) * Growth of multinational companies who operate around the world

Answer 67

* Growth of free trade. Trade is increasingly important to the global economy. Economies increasingly rely on importing raw materials and exporting goods to foreign markets. Increased trade has made countries more closely integrated. * Multinational companies. There has been a growth in the number of multinational companies who have an influential cross-border presence. Multinationals have different production processes across the globe. * Technology. The development of technology, such as the internet, has helped improve communication and made it easier to connect to all corners of the world. * Transport. Improved transport, especially air transport and shipping, has helped to make trade cheaper, and also made it easier for labour to move between different countries. * WTO. Institutions like the WTO have helped reduce barriers to trade and provide a forum for discussing global issues. * Trading blocs. Trading areas like the EU have considerably reduced barriers to trade within Europe, and also raised the profile of international co-operation. * Opening up of China and Eastern Block. Since the1980s, China, India, Brazil and Russia have become much more open to the global economy. China has been a key player in the development of the global economy, e.g. its investment in Africa to benefit from raw materials.

Answer 68

• Global trade cycles. Because economies are more closely linked, a recession in a major economy like the US or Eurozone is likely to push many economies into recession. o On the other hand, countries can benefit from growth in other countries through selling more exports. * International co-operation. Globalisation has increased the importance of reaching global agreements. For example, it is no good reducing carbon emissions for one country; it needs to involve all countries. * Interdependence. Countries are increasingly interdependent. China has become reliant on Africa for raw materials. Africa is reliant on China for inward investment.

Answer 69

• Wages. Globalisation has also helped equalise wages across the world. For example, self-employed computer programmers in India can work for US firms through the internet. o However, only a small percentage of workers in developing countries can benefit from globalisation and they still retain low pay. • Skilled labour. A key factor is whether workers have the sufficient skills to thrive in a global economy. For example, those who are well-educated and fluent in English have far more opportunities than unskilled workers, who are less likely to benefit from globalisation • Uncompetitive domestic firms. Some local firms may be pushed out of business by large multinationals that can use economies of scale and monopsony buying power. The forces of globalisation can lead to temporary, structural unemployment, as local firms become uncompetitive. o However, equally, globalisation creates opportunities for new firms who have the flexibility to meet the new demand for products and services from globalisation. • Economies of scale. Global scale production has enabled greater economies of scale and lower costs. This is significant for industries with high fixed costs, like cars and aeroplanes. o However, some domestic firms are not able to gain sufficient economies of scale and so have lost out. Environmental costs. Globalisation has meant goods are increasingly imported from across the planet, rather than using local produce. This increases the carbon and pollution impact of food and trade. • Also, globalisation enables firms to switch production to countries with weaker environmental legislation. Globalisation has slowly raised the importance of global co-operation to deal with environmental challenges. • Some aspects of globalisation have helped to improve the environment, e.g. the media can make us more aware of the environmental costs elsewhere in the world, and the internet has reduced need for some travel.

Answer 70

* International trade allows countries to specialise in goods and services which they are relatively best at producing. * International trade enables higher living standards, as countries can export raw materials and goods, as well as import goods they do not produce. * Absolute advantage: This occurs when one country can produce a good with fewer resources than another. * Comparative advantage: A country has a comparative advantage if it can produce a good at a lower opportunity cost, i.e. it has to forego less of other goods in order to produce it. * The law of comparative advantage. This states that trade can benefit all countries if they specialise in the goods in which they have a comparative advantage.

Answer 71

• Assumes no transport costs but, in reality, transport costs can prohibit the benefits of trade. • Increased specialisation may lead to diseconomies of scale (though also economies of scale). • Governments may restrict trade through tariffs. • Comparative advantage measures static advantage, but not any dynamic advantage. For example, in the future, India could become good at producing books if it made the necessary investment.

Answer 72

• Higher tariffs (type of tax on imports) • Non-tariff barriers, e.g. the US have charges on packages under grounds of ‘aviation security’, and this increases the costs of imports. Other rules and regulations can make trade more difficult. • Voluntary export restraint is effectively a type of quota where voluntary limits are placed on imports of goods. • Embargo, e.g. US embargo with Cuba. • Government subsidy. Government subsidies effectively give the firm an unfair competitive advantage. This has often occurred with national airlines. • Distorted exchange rate. Keeping your currency artificially low makes exports relatively more competitive. • Weakest environmental law. A way to attract certain types of businesses.

Answer 73

* Infant industry argument. If developing countries have industries that are relatively new then, at that moment, these industries would struggle against international competition. Therefore, they need tariff protection while they develop their industries to be more competitive. * The senile industry argument. If industries are declining and inefficient, they may require a large investment to make them efficient again. Protection for these industries could act as an incentive for firms to invest and reinvent themselves. * Protection against dumping. The EU sold a lot of its food surplus from the CAP at very low prices on the world market. This caused problems for world farmers because they saw a big fall in their market prices. Tariffs can protect against dumping.

Answer 74

1. Reducing tariff barriers leads to trade creation. Trade creation occurs when consumption switches from high cost producers to low cost producers, enabling an increase in economic welfare. 2. Increased exports — if UK firms have a comparative advantage then, with lower tariffs, they will be able to export more, and create more jobs. 3. Economies of scale — if countries can specialise in certain goods, they can benefit from economies of scale and lower average costs. This is especially true in industries with high fixed costs, or those that require high levels of investment. 4. Increased competition — with more trade, domestic firms will face more competition from abroad and, therefore, there will be more incentives to cut costs and increase efficiency. It may prevent domestic monopolies from charging too high prices. 5. Trade is an engine of growth. World trade has increased by an average of 7% a year since 1945; it is a big contributor to global economic growth. 6. Make use of surplus raw materials. Countries with large reserves of raw materials need trade to benefit from their natural wealth.

Answer 75

A trading bloc is a group of countries who agree on common rules for trade and tariffs. It may also involve greater economic integration. Free trade areas — Free trade areas concentrate on free trade and removing tariff barriers, e.g. • NAFTA — US, Canada and Mexico • ASEAN — A free trade area based in South-East Asia Customs union — Areas of free trade with common external tariff. The EEC was, in the beginning, a customs union.

Answer 76

1. More trade and gains from comparative advantage. The EU is now our main trading partner (roughly 60% of trade with EU) 2. Greater competition, increasing efficiency, and reducing prices 3. Lower costs for firms to have common rules and regulations, e.g. acceptance of educational qualifications 4. Increased direct investment, which helps promote better efficiency EU spends a high percentage of its budget on agriculture (40%), which benefits the UK less, because UK farming is relatively small and efficient. Structural unemployment resulting from increased specialisation. May get caught up in other countries’ trade disputes.

Answer 77

The World Trade Organisation is responsible for trying to promote and regulate free trade and trade agreements between countries. The WTO helps to resolve conflicts between nations, and provides a forums for creating and implementing trade agreements. The aim of WTO is to help trade flow as freely as possible, except where free trade conflicts with other objectives, such as environmental or legal. It is argued that promoting free trade can lead to economic advantages of lower prices, greater choice, and greater competition. * Some argue that free trade benefits developed countries more than developing countries. For example, arguably, some developing countries need tariff protection to develop their new, infant industries. * WTO has difficulties in balancing regional trade agreements and global agreements, e.g. the EU may agree on a common external tariff to protect its agriculture, but this harms free trade with Africa or Latin America.

Answer 78

The balance of payments is a record of a country’s transactions with the rest of the world. It shows the receipts from trade, and consists of the current and financial account/capital account. Current account = Financial + capital account

Answer 79

The current account is primarily concerned with the balance of trade in goods and services. The full components of the current account include: • Trade in goods (visible), e.g. cars, computers, food • Trade in services (invisible), e.g. tourism, insurance, banking • Net income flows (interest, dividends and investment income from abroad) • Net current transfers (e.g. government aid, payments to EU) * A deficit on the current account means that the value of imports is greater than the value of exports. * A deterioration in the current account means that we get a bigger deficit or we go from a surplus to a deficit.

Answer 80

This is the other part of the Balance of Payments. It is a record of all transactions for financial investment. It includes financial flows (e.g. saving in banks) and net investment (e.g. foreign firms building factories in the UK).

Answer 81

This involves capital transfers or the acquisition of non-financial assets.

Answer 82

overvalued exchange rate economic growth inflation / decline in competitiveness

Answer 83

1. Devaluation (expenditure-switching policy). This involves reducing the value of the currency against others, and making exports cheaper and imports more expensive. This should increase the quantity of exports and reduce imports. We would expect a devaluation to lead to an improvement in the current account. However, it does depend upon the elasticity of demand for exports and imports. Demand needs to be relatively elastic for a devaluation to improve the current account. * A problem with devaluation is that it can lead to imported inflation. This will reduce competitiveness in the long run, and will mean that the improvement in the current account might only be temporary. * Also, in a floating exchange rate, the UK government does not set the exchange rate; therefore, they would need to rely on a market depreciation in the exchange rate. * The UK has a high marginal propensity to import; therefore, a reduction in AD improves the current account significantly. * Deflationary policies will also put pressure on manufacturers to reduce costs — this will lead to more competitive exports, and so exports will increase. * However, this policy will conflict with other macroeconomic objectives. With lower AD, economic growth is likely to fall, causing higher unemployment. The government is likely to feel that growth and employment are more important than the current account deficit. 3. Supply-side policies. These are policies aimed at increasing productivity and competitiveness. If successful, they will make UK exports more competitive and export demand will rise. For example, the government could try to deregulate labour markets to reduce wage costs and lower costs for exporters. * Supply-side policies will take a considerable time to have an effect (e.g. it takes time to build new roads). Also, there is no guarantee that more flexible labour markets would improve competitiveness, because lower wages may reduce worker morale. * However, supply-side policies would help other areas of the economy like economic growth and unemployment.

Answer 84

• Allowing the exchange rate to appreciate, reducing competitiveness • Encouraging consumer spending (e.g. lower income tax), leading to higher import spending.

Answer 85

* The exchange rate measures the value of a currency against other currencies. * Real exchange rate takes into account inflation and measures the amount of goods you can exchange. * Appreciation = increase in value of exchange rate * Depreciation/ devaluation = decrease in value of exchange rate • Floating exchange rate = value of exchange rate determined by market forces • Fixed exchange rate = government committed to keeping exchange rate at set value • Semi-fixed exchange rate = government committed to keeping exchange rate within a certain band, e.g. £1 = €1.1 to €1.2

Answer 86

* Inflation. If inflation in the UK is relatively lower than elsewhere, UK exports will become more competitive, and there will be an increase in demand for Pound Sterling to buy UK goods. Countries with lower inflation rates tend to see an appreciation in the value of their currency. * Interest Rates. If UK interest rates rise relative to elsewhere, it will become more attractive to deposit money in the UK. Therefore, the demand for Sterling will rise, causing “hot money flows”. Higher interest rates cause an appreciation. * Speculation. If foreign currency dealers become pessimistic about the state of the UK economy, they may sell Pounds. They could become pessimistic about prospects for growth, high government debt, and future inflation. Movements in exchange rates don’t always reflect fundamentals. * Balance of payments. If a country has a large current account deficit, it may cause depreciation because there is a net outflow of currency.

Answer 87

* Provide greater stability for firms involved in trade. E.g. exporters don’t have to fear a rapid appreciation which would reduce their profitability. * Can help reduce inflation as countries have an added discipline to keep inflation low, otherwise the currency would be weaker. * May reduce speculation if markets believe the country will stick to an exchange rate

Answer 88

* May lead to the exchange rate being overvalued, this can harm exports and economic growth * Maintaining a fixed exchange rate may require high interest rates (this may conflict with other objectives, such as causing lower growth and higher unemployment) * UK forced out of ERM in 1992, because markets felt they had joined at the wrong rate. Government unable to maintain value of Pound in ERM.

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