OCR AS Economics

F582 The National and International Economy

Exam dates:
Mon 28 January 2013 pm (A2 resit only)
Mon 13th May 2013 am

Duration: 1 h 30 min
60 marks

Wish Id
revised for
economics

Do you know?

Yes/No

The components of aggregate demand

The causes of changes in aggregate demand
The causes of changes in aggregate supply
The difference between injections and leakages
Government macroeconomic objectives and how they are measured
The difficulties of measuring and interpreting objectives
The causes and consequences of inflation
The causes and consequences of economic growth
The causes and consequences of unemployment
The causes and consequences of current account deficits and surpluses
Why exchange rates change
Fiscal, monetary and supply side policies
How Fiscal, monetary and supply side policies affect inflation, unemployment,
economic growth and the current account of the B of P
The effectiveness of different policies
The benefits of international trade
Possible conflicts between policy objectives (trade offs)

The methods of protectionism

What is the economy models of it

The Circular Flow of Income

Money circulates through the economy as shown in the diagram below. Money can be
injected into the circular flow and it can leak out (aka withdrawals)

Injections
Investment

Leakages
Households

Imports

Exports

Govt.
Spending

Saving

Firms

Taxes

The economy is made up of households and firms, i.e. producers

and consumers. They interact and this is shown on an aggregate
demand and supply diagram. This is how it works:

This shows the

equilibrium
price level in the economy and indicates output and unemployment of resources

Aggregate supply why is it this shape?

Aggregate supply is the total output of goods and services that producers are willing
and able to supply at different price levels in a given time period.

The AS curve shows the POTENTIAL CAPACITY OF THE ECONOMY i.e. how much it could
possibly produce.

Aggregate demand what is the formula

Aggregate demand = C + I + G + X - M

Any change in a component of aggregate demand will result

in a shift to the right

What happens when AD increases?

When AD increase the economy grows.

(this is shown on the horizontal axis Y to Y1
to Y2.
Unemployment should DECREASE
The price level (inflation) could increase
AS

Price level

P1

AD2
P
AD

AD1

Y1

Y2
Real GDP

Aggregate demand is important. If aggregate demand increases then the economy can
grow in the short run, unemployment will decrease as more people will have to be
employed to meet the increased demand for goods and services and output will increase.
Increasing aggregate demand can result in a MULTIPLIER EFFECT. This means that any
change in aggregate demand or injection of spending into the economy will result in a
greater final change in Real GDP due to the amount of times it can circulate through the
economy between households and firms.

What affects aggregate demand?

Aggregate demand is the total demand for a countrys goods and services at a given price
level over a period of time. AD = C + I + G + (X M)
Consumption

Investment

Spending by households on consumer products

Affected by:
Real disposable income If it rises then more is spent
Wealth property, savings accounts and shares. If this increases people feel
more confident about spending
Consumer confidence and expectations if consumers are optimistic i.e. in a
boom then spending could increase. If they are not confident about their
future or job security then spending could decrease.
Rate of interest if it rises, people have to pay more back on their mortgages,
borrowing becomes more expensive and savings are more attractive as more
interest is received therefore consumption decreases. The opposite is true if
interest rates fall
The age structure of the population. The young and the elderly usually spend
a high proportion of their income. The elderly can disave i.e. draw on their
savings however, they might still save in order to leave money to their
relatives or pay for healthcare in the future.
Distribution of income the poor spend a higher proportion of their income
than the rich therefore if the govt. tries to redistribute income from rich to
poor then spending is likely to increase
Inflation if people expect prices to rise in the future they may spend their
money now to avoid paying higher prices later, but another view says that
they may save instead so that the value of their savings doesnt decrease.
Spending on capital goods (i.e. spending by businesses on production equipment)
Affected by:
Changes in disposable income if incomes are increasing then demand for a
businesss goods may increase so they buy (invest in) more production
equipment to expand productive capacity.
Expectations if a firm expects demand for its products to be good in the
future it will invest (buy) more capital goods (production equipment)
Capacity utilisation and profit levels firms are more likely to invest in capital
goods if they are producing/operating near to full capacity and if their profits
are high as they believe they can make more profit and sell more goods (think
of Manchester United expanding their stadium)
Corporation tax (tax on profits). If this is reduced a firm can keep more of
its profits and use the extra money to invest.
Interest rates - if they rise, firms find it more expensive to get loans (to spend
on capital goods), they are more likely to want to save their money and gain
interest on it in a bank, firms would assume that a higher rate of interest
would reduce consumer spending which would affect the future profits of an
investment not making it worthwhile.

Government
Spending

Exports

Imports

Net Exports
(X-M)

Spending by central and local government on goods and services (but not benefits
as these are transfer payments and affect consumption) )
Affected by
Desire to please the electorate i.e. before a general election a govt. may
increase or promise to increase spending as this pleases voters (can someone
tell this to David Cameron)
War terrorist attacks and rising crime can increase Govt. spending
The state of the economy i.e. in a recession when there is high
unemployment govt. spending may increase in order to increase AD, output
and employment. If there is a boom and there is inflation they may try to
reduce spending.
The govts view on whether there should be intervention in markets through
spending or whether they think the market should be left alone.
Products sold abroad (e.g. a British business selling its products to people in other
countries
An increase in exports increases aggregate demand
Products bought from abroad (e.g. a fridge from Comet will have come from
China)
An increase in imports decreases aggregate demand
The value of exports minus the value of imports. An increase in net exports is
good = exports increasing, imports decreasing. It is desirable to have more
exports than imports. This is called a surplus
Affected by:
Real disposable income abroad if economies abroad grow and people
abroad become better off they may demand more products some of which
will come from the UK
Real disposable income at home if income rises at home, there may be
fewer goods exported as home firms may switch production into domestic
markets as here is more demand. In a crisis firms may look abroad to sell
their goods but in a boom they may try and sell at home instead. Additionally,
if people increase their spending some of this will be spent on imports as the
UK imports a large amount of its consumer goods.
The domestic price level If prices at home are rising, exports become less
competitive and demand may fall. Also if imports become relatively cheaper
then people may choose them over domestic products leading to a decrease
in net exports
The exchange rate SPICED strong pound imports cheaper exports dearer
(and the opposite). If the exchange rate falls export prices fall, import prices
rise. If export prices fall, demand could increase = increase in net exports
Govt. restrictions on free trade if tariffs and quotas and VERs are used
import prices can be higher. If removed it can make it easier to export .

What affects aggregate supply?

Shifts in aggregate supply
Changes in the
costs of
production ( in
the short run)

Costs of production such as raw material costs (oil),

wages, transportation, land.
An increase in costs will shift AS to the left
A decrease in costs will shift AS to the right

Changes in the
quality of
resources

Improvements in education and training increases the

quality of labour and their productivity (how much they
can produce)
Advances in technology i.e. better machinery can
increase production
Land can be improved with fertilisers

Changes in the
quantity of
resources

Resources can be increased through:

Increasing immigration
More women entering the labour force
Increasing the retirement age
Firms purchasing more capital goods can increase
production
Reducing regulations and rules on businesses and selling
off govt owned business to private individuals to run
them strictly for profit helps increase production.
Giving grants to small businesses to start up increases
the number of enterprises and therefore production.
The quantity of land as a resource can be increased e.g.
through discovering new oil fields

Macroeconomic equilibrium is a situation where AD equals AS (I.E. the lines

cross).

What shifts both AS and AD?

Investment
Shifts AD because business are buying capital goods (buying = demand)

Shifts AS because businesses are increasing the amount they can produce (their
productive capacity) by getting better machinery and equipment

Cuts in direct tax (tax on income, tax on firms profits)

Shifts AD because businesses can keep more of their profits so can buy more capital
goods and consumers can keep more of their earnings so have more disposable income
and can spend more on goods

Shifts AS because workers can keep more of their wages and may be tempted to work
more hours or to not claim benefits and get a job instead. More workers = more
production. Also if firms spend money on capital goods (equipment and machinery)
they will be able to produce more = more supply
All this depends

on the size of the tax cut or the amount invested.

Government macroeconomic objectives and how they

are measured
These are what the government wants to achieve in the economy to make us
better off:
There are 4 main macro-economic objectives

1. Economic growth
2. Low unemployment
3. Low and stable inflation
4. Balance of Payments equilibrium
There are also some minor objectives that are related to the main ones. These are

income redistribution (making sure that the rich are not too rich and the poor
are not too poor by e.g. using taxation to take more from the rich and less form the poor)
and economic

stability (this means making sure economic growth is steady and

does not fluctuate through booms and slumps)

GDP and Real GDP

GDP (Gross domestic product) Output measured in current prices and so not adjusted
for inflation

Real GDP takes into account price rises during the year that it is being measured and
takes these off so that GDP can be compared to previous years to see if it has actually
gone up or down. Otherwise it would look like the economy is growing just because
process in general have gone up

How are these 4 objectives measured, what do they mean and what are the difficulties of measuring them
Objective
Economic growth
in the short run an increase in aggregate
demand, in the long run an increase in the
productive capacity of the economy. Govt
wants this to be stable. Around 3% growth
per year is good. Higher or lower can cause
other problems
Unemployment
A situation where people are out of work
but willing and able to work. The
unemployment rate is the % of the labour
force who are out of work but willing and
able to work

Inflation
A sustained rise in the price level. The %
increase in the price level over a period of
time* Some inflation is desirable Bank of
England controls inflation and sets a target
of 2%

How is it measured
Measured by the actual % change in
real GDP. It shows the change in the
countrys output. GDP can also be
measured as income or expenditure
and the circular flow of income shows
that these figures should in theory be
the same
This is measured through
1. The labour force survey (a survey:
based on the ILO definition of
unemployment
2. The claimant count people
claiming unemployment relate
benefits in the UK.

Measured by choosing a basket of

goods and seeing if on average the
price of buying a basket of goods has
rise,
CPI consumer price index. it is a
measure of the changes in prices of a
representative basket of consumer
goods and services
RPI retail price index (this is a bigger
basket than the CPI) The CPI is the one

Difficulties of measuring
Could be double counting e.g. raw materials may be counted
as output and then the same raw materials could be counted
as finished goods which would mean they had been included
twice.
Some income and output is not declared to avoid paying tax
this is the informal economy
The LFS survey includes more people who are without a job
than the claimant count but is more difficult to collect than
the claimant count.
Some people may be claiming benefit but not actively
seeking work
Some people may not be claiming benefits but are
unemployed
NB. The claimant count is usually lower and more people are
excluded.
Changes in Quality of goods. Changes in the quality of goods
mean that price rises may not reflect inflation, but just the
fact it is a different good. For example, computers have
many more features than 10 years ago, so it is difficult to
compare prices because they are effectively different goods.
This is similar situation for many goods such as mobile
phones and cars.
People have different inflation rates. Rising electricity and
gas prices may affect old people more than young people.
Therefore, old people could have a higher inflation rate than

that is used by the Bank of England to

see if it has met its inflation target
Balance of payments
A record of money flows coming in and
going out of a country. Govt wants more
money coming in through exports and less
going out through imports. See B of P
below

the national average. This is important if pensions are index

linked because their cost of living may rise more than prices
causing a decrease in living standards.

Structure of the balance of payments

Current account = trade in goods and trade in services (imports and exports)income and transfers
Capital account = the movement of direct investment
The point of this is that money coming in from the above should exceed money going out
(injections>leakages. The foreign currency it has from exports and money coming in can be used to pay
for the imports and money going out. If there is more money needed to go out then the difference has
to be borrowed.
At AS level you are only interested in the current account (exports, imports and income). You need to
know that exports imports = net exports and that this affects aggregate demand.

*price level = the average of the prices of all the products produced in the economy

Difficulties in interpreting economic growth There may be economic growth as indicated by an increase in GDP but the
income may not be distributed evenly throughout the economy e.g. the rich may have benefited but not the poor. The
rise in output may also be exceeded by a rise in population therefore GDP per capita may have actually fallen meaning
that people werent actually better off through an increase in economic growth.

In the short term, economic growth is caused by an increase in AD. If there is

spare capacity in the economy then an increase in AD will cause a higher level
of Real GDP.
AD can increase for the following
reasons.
a) Lower interest rates this
reduces the cost of borrowing
and so encourages spending and
investment
b) Increased wages. This increases disposable income and encourages
consumer spending
c) Increased Govt spending. G is a component of AD
d) A fall in the exchange rate could increase net exports and result in export
led growth
In the long run a shift in aggregate supply to the right is also necessary to
achieve economic growth
a) Increased Capital e.g. investment in new factories or investment in
infrastructure such as roads and telephones.
b) Increase in working population
c) Increase in Labour productivity, through better education and training
d) Discovering new raw material
e) Technological improvements to improve the productivity of Capital and
labour e.g. Microcomputers and the internet have both contributed to
increased economic growth

1. Inflation. If AD increases faster than AS then economic growth will be

unsustainable. The output gap will narrow causing inflation to increase.
2. Boom and Bust Economic Cycles. If Economic growth is unsustainable then
high inflationary growth may be followed by a recession. In the 1980s there
was an economic boom with growth over 5% a year. However this caused
inflation to rise to over 10%. To reduce inflation the govt increased interest
rates, this caused the economy to slow down and then enter into a
recession. However if economic growth is at a sustainable rate this will not
occur
3. Balance Of Payments Deficit.
Increased Economic growth causes an increase in spending on imports
therefore causing a deficit
4. Environmental Costs.
Increased economic growth will lead to increased output and therefore
increased pollution and congestion. This will cause health problems such as
asthma and therefore will reduce the quality of life
5. Reduced Inequality.
Higher rates of economic growth have often resulted increased inequality,
however this depends upon things such as tax rates and the nature of
economic growth

The Benefits of economic growth include:

1. Higher Incomes. This enables consumers to enjoy more goods and services
2. Lower unemployment - with higher output firms tend to employ more
workers creating more employment.
3. Lower Government borrowing. Economic growth creates higher tax
revenues and there is less need to spend money on benefits such as
unemployment benefit.
4. Improved public services. With increased tax revenues the govt can spend
more on the NHS and education e.t.c.
5. Money can be spent on protecting the environment

1. Frictional Unemployment:
This is unemployment caused by people moving in between jobs, e.g. graduates or people
changing jobs. There will always be some frictional unemployment.
2. Structural Unemployment
This occurs due to a mismatch of skills in the labour market it can be caused by:
a) Occupational immobilitys. This refers to the difficulties in learning new skills applicable
to a new industry, and technological change.
b) Geographical Immobilitys. This refers to the difficulty in moving regions to get a job.
c) Technological Change. If there is the developments of labour saving technology in some
industries there will be a fall in demand for labour.
d) Structural change in the economy. The decline of the coal mines due to a lack of
competitiveness meant that many coal miners were unemployed and they may find it
more difficult to get jobs in new industries such as computers
3. Demand Deficient or Cyclical Unemployment

This occurs when the economy is below full capacity.

E.g. in a recession when AD falls there will be a fall in output, therefore firms will
employ less workers because they are producing less goods.

Consequences (costs) of unemployment

Loss of earnings to the unemployed

Those who are unemployed will find it more difficult to get work in the future (this is
known as the hysteresis effect)
Stress and Health problems of being unemployed
Increased govt borrowing (PSNCR). Tax revenue will fall because there is less people
paying income tax and VAT. Also the govt will have to spend more on unemployment
benefits.
Lower GDP for the economy, the economy will be below full capacity this is inefficient
and will lead to lower output and incomes.
Increase in social problems. Areas of high unemployment (especially youth
unemployment) tend to have more crime and vandalism.

Demand pull inflation

If the economy is at full employment then an increase in AD leads to an increase in the price
level.
AD can increase due to an increase in any
of its components C+I+G+X-M

Cost Push Inflation

If there is an increase in the costs of firms, then firms will pass this on to consumers. There
will be a shift to the left in the AS.
Cost push inflation can be caused by many factors
1.The Labour Market

If trades unions can

present a common front
then they can bargain for
higher wages, this will lead
wage inflation.

to

2. Import prices

One third of all goods are imported in the UK. If there is a devaluation then import
prices will become more expensive leading to an increase in inflation
E.G. a German car costs DM 40,000. If the exchange rate is DM 1:3DM then it will
be priced at 13,333. If the E.R falls to 1 : 2DM then it will be priced at 20,000

3. Increased costs of production

The best example is the price of oil, if the oil price increase by 20% then this will have
a significant impact on most goods in the economy and this will lead to cost push
inflation.
3

International competitiveness:
A relatively higher inflation rate will make British goods less competitive, leading to a fall in
exports. However this may be offset by a decline in the exchange rate.

Confusion and Uncertainty:

When inflation is high people are uncertain what to spend their money on. Also, when
inflation is high firms may be less willing to invest because they are uncertain about future
profits and costs. This uncertainty and confusion can lead to lower rates of economic growth
over the long term.

Menu Costs.
This is the cost of changing price lists. When inflation is high, prices need changing
frequently which incurs a cost. However, modern technology has helped to reduce this cost.

Shoe leather costs.

To save on losing interest in a bank people will hold less cash and make more trips to the
bank.

Income redistribution.
Inflation will typically make borrowers better off and lenders worse off. Inflation
reduces the value of savings, especially if the saving is not index linked. However it
does depends on the real rate of interest. e.g. if a saver gets a higher rate of interest
than the inflation rate he will not lose out.

Fiscal Drag.
The amount of tax we pay will increase if there is inflation. This is because with rising wages
more people will slip into the top income tax brackets.

low inflation is often seen as harmless or even beneficial because it allows prices to adjust
more easily

The Balance of payments this is just a summary of all the money that has
come into the country and left the country. The government needs to count this up to
check what money has left the economy (leaked out of the circular flow) and what money
has come in (been injected into the circular flow)
What could come in and go out?

IN

OUT

Exports
Transfers (Money people have earned
abroad and sent back)
Interest from shares and investments
held abroad
Profits from businesses owned abroad
Money foreign businesses have invested
in the UK (e.g. IKEA, Nissan, Aldi)

Imports
Transfers (Money people have earned in
UK and sent back to their own country)
Interest and dividends on shares and
investments held in UK but owned by
foreigners
Profits from businesses owned by
foreigners
Money UK businesses have invested in
other countries (e.g. Cadburys have
factories in Poland)

Everything
is in the current account except for the last bullet point which is in
the capital account.
This is then divided up between the current account and the capital account.

Causes of a current account deficit

1. Exchange rate high
If the currency is overvalued, imports will be cheaper and therefore there will be a higher Q
of imports. Exports will become uncompetitive and therefore there will be a fall in the
quantity of exports.

2. Economic Growth
If there is an increase in national income, people will tend to have more disposable income
to consume goods. If domestic producers can not meet the domestic demand, consumers
will have to import goods from abroad. In the UK we have a high Marginal propensity to
imports because we do not have a comparative advantage in the production of
manufactured goods. Therefore if there is fast economic growth there tends to be a
significant increase in the quantity of imports.
3. Decline in Competitiveness.
In the UK there has been a decline in the exporting manufacturing sector, because it has
struggled to compete with developing countries in the far east. This has led to a persistent
deficit in the balance of trade.
4. Higher inflation
This makes exports less competitive and imports more competitive. However this factor
may be offset by a decline in the value of sterling.
5. Recession in other countries.
If the UKs main trading partners experience negative economic growth then they will buy
less of our exports, worsening the current account.

Significance of this...

A deficit means a country is consuming more than it is producing. This could put it into
debt, lower unemployment lower economic growth
A small one is not that important or one that lasts a short time
A deficit may indicate that the economy is growing (i.e. people have jobs and have
money to spend, a lot of which will be spent on imported consumer goods.)
The deficit could mean that there is low productivity, inflation and/or a lack of
competitiveness meaning low demand for exports.

Significance of a surplus

It could mean that the economy is in recession and there is little demand for imports
It could mean that the country produces high quality, low priced goods (like China) and
is very competitive, therefore demand for exports is high.

This is the value of one currency against another

NB when you change money to go abroad you are actually buying it Money can be
bought and sold in the same way other products are. E.g. you buy Euros with
pounds.

Exchange rates are determined through supply and demand

S
S1
S

P
P1
P

P
P1

D1
D

D
q q1

If people want to sell pounds then

supply will increase and the exchange
rate will fall

If demand for the pound increases,

the exchange rate will rise

q q1

If the exchange rate rises, the cost of imports becomes cheaper and the price of
exports becomes more expensive
If the exchange rate falls, the cost of imports becomes more expensive and the price
of exports becomes cheaper.

Exports and imports are part of aggregate demand. If exchange rates rise and imports are
cheaper and exports are more expensive, demand for exports should fall and demand for
imports should rise. This will make net exports fall and aggregate demand fall.
This could affect the macro economy as AD could shift to the right which would indicate
higher economic growth and output and a decrease in unemployment.

S
strong

P
Pound

I
Imports

C
Cheaper

E
Exports

D
dearer

The application of macroeconomic policy instruments and the

international economy

Fiscal policy
taxation and public spending AFFECTS
AGGREGATE DEMAND (mainly)

Monetary policy
the use of interest rates, money supply and
exchange rates (but mainly interest rates) AFFECTS
AGGREGATE DEMAND (mainly)

Supply side policies

any measure that improves the productive
capacity of the economy. These aim to improve
the efficiency of businesses and make it easier for
them to produce at a lower cost. AFFECTS
AGGREGATE SUPPLY
8

1. Fiscal policy
Fiscal policy involves the Government changing the levels of Taxation and Govt Spending in
order to influence Aggregate Demand (AD) and therefore the level of economic activity.
AD is the total level of planned expenditure in an economy (AD = C+ I + G + X M)

The purpose of Fiscal Policy:

Reduce the rate of inflation, (UK government has a target of 2%)
Stimulate economic growth in a period of a recession.
Basically, fiscal policy aims to stabilise economic growth, avoiding the boom and bust
economic cycle.
This refers to whether the govt is increasing AD or decreasing AD

Expansionary (or loose) Fiscal Policy.

This involves increasing AD,

Therefore the govt will increase spending (G) and cut taxes. Lower taxes will increase
consumers spending because they have more disposable income(C)
This will worsen the govt budget deficit

Deflationary (or tight) Fiscal Policy

This involves decreasing AD

Therefore the govt will cut govt spending (G)
And or increase taxes. Higher taxes will reduce consumer spending (C)
lead to an improvement in the government budget deficit

This will

Automatic Fiscal Stabilisers

If the economy is growing, people will automatically pay more taxes ( VAT and
Income tax) and the Government will spend less on unemployment benefits. The
increased T and lower G will act as a check on AD.

In a recession the opposite will occur with tax revenue falling but increased
government spending on benefits, this will help increase AD

Discretionary Fiscal Stabilisers

This is a deliberate attempt by the govt to affect AD and stabilise the economy, e.g. in a
boom the govt will increase taxes to reduce inflation

2. Monetary policy
The Bank of England studies inflationary trends in the economy. This involves looking at a
range of economic variables such as:

Unemployment

Consumer confidence

Spare capacity in the economy

Exchange rate index

House prices

Economic Growth

If the Bank of England anticipates inflation falling below the governments target of 2% and
economic growth is sluggish or the economy is facing a recession. They are likely to cut
interest rates.
Lower interest rates in theory, should stimulate economic activity (BENEFIT). This is because
lower interest rates reduce borrowing costs. This increases the disposable income of
consumers with mortgage interest payments and should encourage spending.
If the Bank feels the economy is growing too quickly and inflation is expected to exceed the
governments target, then they are likely to increase interest rates to reduce the rate of
growth and inflationary pressures.

10

3. Supply side policies

Supply Side Policies are government attempts to increase productivity and shift
Aggregate Supply (AS) to the right.

Examples:

Education and training

Better education can improve labour productivity and increase AS.
Often there is under-provision 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, It will
take time to have effect and govt may subsidise the wrong types of training
Government assistance to small firms
This encourages business start ups and therefore increases production
(supply/output)
Reduction in direct taxes
It is argued that lower taxes (income and corporation) increase the incentives for
people to work harder, leading to more output. However this is not necessarily true,
lower taxes do not always increase work incentives
National minimum wage
Introducing a minimum wage can help people get back into work as their income
should increase. On the other hand a minimum wage could increase a businesss
costs. Opinion is divided on this.
Reduction in unemployment and other benefits
This may encourage unemployed to take jobs.

Reduction in trade union power

This should
a) increase efficiency of firms e.g. less time lost to strikes
b) reduce unemployment ( if labour markets are competitive)

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.
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.

11

Where successful supply side policies will

lower firms costs of production

increase productive capacity by increasing the efficiency of labour and production
markets

Benefits
1. Lower Inflation. - Shifting AS to the right will cause a lower price level. By making the
economy more efficient supply side policies will help reduce cost push inflation.
2. Lower Unemployment - Supply side policies can help reduce structural, frictional and real
wage unemployment and therefore help reduce the natural rate of unemployment.
3. Improved economic growth - Supply side policies will increase the sustainable rate of
economic growth by increasing AS.
4. Improved trade and Balance of Payments.

By making firms more productive and competitive they will be able to export more.
Diagram Showing effect of Supply Side Policies

Most supply side policies aim to enable the free market to work more efficiently by
reducing govt interference.

12

Effectiveness of policies
Fiscal

Good because automatically adjusts to offset fluctuations in real GDP.

Tax cuts and e.g. training grants affect both AD and AS

but..

Can take time to plan and implement tax and spending changes

Time lag between introducing policies and impact on economy

Decisions need to be based on accurate information

Consumers may not react in a desirable way e.g. saving in stead of spending

Tax cuts/increases and spending cuts/increases could have a negative effect if taken
too far

Success depends on
The size of the tax cut/increase or spending increase/decease
Other factors not affecting it e.g. interest rates
Consumers reacting in the right way e.g. saving/spending

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Monetary

Influencing the exchange rate can be offset by money speculators (e.g. George
Soros)
Interest rates successful in controlling short run economic activity but MPC criticised
for keeping interest rate too high and limiting growth
Can take up to two years for interest rate change to affect economy
When rate is very low e.g. 1% further cuts are not effective
Effect on other objectives e.g. B of P

Success depends on
Depends on accurate information
Consumers reacting in the right way e.g. saving/spending

Supply side

Designed to raise efficiency

If supply side of economy can be improved then growth can be achieved without
inflation.
Exports can be more competitive = better current account B of P
If unemployment is caused by demand deficiency and a fall in AD then supply side
policies may not be effective.
But.if AD does not also increase the extra capacity would not be used
And e.g. education can take a long time to work and no guarantee that it will work

Success depends on
When the economy is an a recession the economy needs higher levels of AD supply side
policies would not be able to solve the immediate problem

Policy trade offs

Growth

Low and stable inflation

Low unemployment

Growth that is caused by

and increase in AD can
cause inflation if AS is
inelastic (I.e. if there is
no output gap or a
positive one)

Growth and low

unemployment should
happen at the same time
no trade off

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Sustainable balance of
payments
Growth can cause a trade
deficit as some of the
extra income can be
spent on imported
goods. This is especially
true in a consumer led
boom

Trade Protectionism
Despite the advantages of free trade countries may wish to restrict imports for various
reasons this can be done through different methods.
1. Tariffs
This is a tax on imports.
2. Quotas
This is a physical limits on the quantity of imports
3. Embargoes
This is a total ban on a good or service entering the country. This may be done to stop
dangerous substances
4. Subsidies
If a govt subsidises domestic production this gives them an unfair advantage over
competitors. This is quite common
5. Administrative barriers
The advantages that may be gained from international trade are:

Increased exports
Increased competitiveness
Greater choice for consumers and lower prices
Greater efficiency due to increased competition
Higher economic growth

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