Economics Unit 2 Revision

Circular Flow of Income

Savings

Consumer

Taxes

Imports

Goods and Services

Expenditure
Rent, Wages, Interest, Profit

Producer

Factors of Production

Government
spending

Exports

Investment

Main Government Objectives

1) Low unemployment
2) Economic growth
3) Low/stable inflation
4) Stable balance of payments
National Income
Measured by GDP. GDP is a measure of output.
GDP definition: The final value of all goods and services produced within the geographic boundaries of a
country per year.
Output (O) = Income (Y) = Expenditure (E)
Living Standards
GDP is used to measure the living standards of a population.
There are many reasons why GDP is a good measure of living standards:
1) A higher income (and therefore a higher GDP) would mean consumers can buy more goods and
services so their living standards will rise.
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2) A rise in GDP also means a rise in output so more goods and services will be consumed leading to
increased living standards.
3) The data is easy to collect and so this will allow poorer countries to use this measure.
4) GDP is a common unit (as al values are in $) and so GDP values are easy to compare between
countries.
However, it is not a perfect measure of living standards because:
1) If GDP remained constant but the population increased, GDP per capita would fall GDP does not
measure this.
2) There are uneven distributions of wealth which GDP fails to take into account.
3) GDP does not take happiness into account.
4) Inflation is not taken into account.
5) Hidden economies are not included in the GDP value.
Human Development Index (HDI)
The HDI is an alternative measure of living standards. The HDI measures adult literacy, GDP and life
expectancy and a country is given a score out of 1. The greater the HDI value, the higher the living standards
in the country. The score of one country is then ranked against the scores from other countries.
Advantages of HDI:

The data is easy and cheap to collect.

The GDP rank of a country minus its HDI rank gives a ranking of life expectancy and adult literacy (a
rank of health and education).

The data collected is reliable.

Disadvantages of HDI:

No measure of poverty.

Does not take uneven wealth distributions into account.

Utility (happiness) is not taken into account.

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The Economic Cycle

GDP

Trend

3
4

1) Slump: GDP at its lowest. Growth is approximately

0. Unemployment is high. Low inflation and

Actual

investment. More exports than imports (due to weak

currency), causing living standards to fall.
2) Recovery/growth: Rising GDP, employment and

inflation. Balance of payments is neutral (exports =

Time

imports).

3) Boom: GDP at its highest. High inflation (and

therefore high interest rates), employment and investment. Negative balance of payments, caused by high living
standards.
4) Recession: A recession occurs when there are 2 quarters of negative GDP growth. Inflation, GDP and
investment falling. Unemployment rising.
What causes the economic cycle?

During a boom or a period of growth, the rise in demand for goods and services causes inflation to
rise (see notes on inflation). In order to decrease inflation and meet one of the 4 main macroeconomic
objectives, the central bank (e.g. Bank of England) increase interest rates. This increases the
incentive for consumers to save their money, causing demand in the economy to fall and so GDP also
falls.

A rise in commodity prices means that more money is spent paying for necessity goods and services
(e.g. electricity bills rise). As a result, disposable incomes fall so less goods and services are bought.

Prior to an election, parties that are in power increase their spending in order to win votes and remain
in power, causing GDP to rise. However, this spending is not sustainable and so after elections,
government spending falls and so GDP also falls.

Wars and natural disasters (e.g. earthquakes) also cause GDP to fall.

If confidence in an economy is high, consumers will continue to spend and so the consumption of
goods and services will rise, causing GDP to rise. If confidence falls, consumers will not be willing to
spend their money and so GDP will fall.

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Output Gap

Definition: The difference between trend growth and actual growth.

If the output gap is negative (when trend growth exceeds actual growth), GDP is falling.

If the output gap is positive (when actual growth exceeds trend growth), GDP is rising.
Economic Growth

Definition: An increase in real GDP over time.

Economic growth is caused by an increase in the quantity and/or quality of the factors of production.

Advantages of economic growth: Output of goods and services rises so consumption also rises,
meaning living standards increase. Increased provision of public goods e.g. education as tax revenues
rise. High interest rates are good for savers. Economy becomes more efficient and competitive so
Foreign Direct Investment (FDI) rises. Employment also rises.

Disadvantages of economic growth: High interest rates are bad for consumers lending money. Nonrenewable resources are used and pollution increases. Life expectancy increases so increased
spending on the elderly.
Inflation

Definition: A general increase in price levels over time.

Inflation rates are calculated by collecting a 'basket' of approximately 650 goods and services that are regularly
consumed by the public (e.g. milk, bread, petrol). Each good and service in the 'basket' is weighted such that
goods and services that make up a larger proportion of household spending are worth more when calculating
the inflation value. Once all of the goods and services are weighted, the value of all of the goods and services
is compared with the same value from previous months. The difference between the current and existing value
is expressed as a percentage of the existing value. This percentage is the current rate of inflation.
The 2 measures of inflation used are RPI and CPI. RPI includes all of the goods and services that are in CPI,
but it also includes mortgage payments. The UK uses CPI as its measure of inflation. The Bank of England
target for inflation = 2.0%.

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There are 2 types of inflation:

1) Demand-pull inflation: Occurs when demand for goods and services increases (e.g. economic growth
causes household income to rise). As a result, demand exceeds supply and so prices rise due to
excess demand, causing demand-pull inflation.
2) Cost-push inflation: Supply declines due to a rise in the costs of production (e.g. oil prices rise).
Demand stays constant, causing demand to exceed supply. As a result, prices rise, causing cost-push
inflation.
Inflation results in uncertainty (consumer and business confidence falls) and as a result investment falls. The
fall in investment causes reduced growth in the long run.
Costs of Inflation

Shoe leather costs: People are unaware of the new prices of goods and services so they have to shop
around. An opportunity cost is incurred as time has been wasted searching for new prices.

Menu costs: Inflation causes prices to change and so price lists e.g. menus have to be adjusted.
Someone must be employed to change the prices which is an additional cost to a firm.

Psychological cost: Knowing you could buy the same goods and services for much less in the past.

Re-distributional costs: Workers on fixed incomes suffer as the value of money is eroded; therefore
workers on fixed incomes effectively take a pay cut equal to inflation. In order to prevent this, wages
can be linked to inflation. The government must also increase their spending and taxation in line with
inflation.

Government Policies to reduce inflation

Via demand-pull inflation: Increase interest rate which causes consumption and investment to fall.
Increasing the interest rate also appreciates the currency, causing exports to fall, resulting in a fall of
aggregate demand (explained later on). Increase taxes which causes consumption to fall. Decreases
government spending.

Via cost-push inflation: Subsidise industries (causing costs of production for firms to fall. Decrease tax
on firms (e.g. corporation tax).

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Deflation
Definition: A general decrease in price levels over time.
Measured by a fall in CPI.
There are 2 types of deflation:
1) Benign Deflation: Prices fall because of an increase in productivity, advancements in technology etc.
This means that more goods and services are produced from the same amount of inputs and so prices
fall. The increase in output causes consumption to rise and so living standards rise. As a result,
benign deflation is OK.
2) Malign deflation: Prices fall due to a lack of demand. The lack of demand means there is excess
supply and so prices must fall to clear the market. If demand falls, businesses close, causing workers
to become unemployed which causes even less demand (there is a negative multiplier effect). Malign
deflation is BAD.
Despite there being benefits from benign deflation, deflation can be very dangerous. If consumers see prices
are falling, they may wait till the price of a product falls further. This will then cause malign deflation and prices
will fall more. This can carry on causing a huge lack of demand.
Unemployment
Definition: A person who is wanting, willing and able to work and actively seeking work, but doesn't have a job.
Measuring unemployment:

People claiming job seeker's allowance: Unemployment can be determined by the number of claimants
of this allowance. However, not everyone who is unemployed claims. This is because some people do
not fit the criteria (they have too many savings, they haven't been unemployed for long enough, they
are less than 18 years of age etc) and some people are not willing to claim.

ILO Labour Force Survey: A survey conducted by the International Labour Organisation (ILO). The ILO
conduct an interview by phone of 60,000 households. Questions are then asked about employment
status etc. The survey is completed by people aged 16+ and so is more accurate than the claimant
count (above).

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There are 4 types of unemployment:

1) Frictional: When people are between jobs they have recently lost a job and are searching for a new
one. This occurs with many skilled workers as they can afford to be temporarily off work.
2) Seasonal: Caused by seasonal shifts in the market e.g. an ice cream man is unemployed in the
winter.
3) Cyclical: Unemployment that follows the economic cycle. During a boom, demand for labour rises and
so unemployment falls. During a slump, demand for labour falls and so unemployment rises.
4) Structural: Caused by a mismatch of skills and jobs between industries. This is caused by competition
from other countries, changes in technology etc. In order to get structurally unemployed workers back
into work, they must be taught new skills as their existing trade is no longer in demand. Teaching
people new skills is difficult as people are unwilling to pay for the re-training and so the government
have to pay for it.
Cyclical and structural unemployment are the most important forms of unemployment; frictional and seasonal
unemployment is a short term problem, whereas cyclical and structural can be long term problems.
Effects of unemployment: Increase in crime, less tax revenue for the government so government spending falls,
fall in GDP so fall in living standards, hidden economies form, increased government spending on Job Seeker's
Allowance so cuts in other areas (e.g. healthcare), economy not at its productive potential.
The Labour Market
Derived demand is the increased demand of one good or service caused by the increase in demand of
another good or service. An example of this is in the labour market; If the demand of a good or service
increases, a firm must employ more labour in order to produce the extra good or service and so the demand
for labour rises.

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Wage

The diagram shows the effects of cyclical unemployment

as a result of a recession. The fall in demand for goods

and services causes a fall in derived demand from D to
D1. Before the fall in demand, employment = E. The fall

in demand causes new employment to equal E1. Wages

remain at W due to the National Minimum Wage and

E1

Unemployment

D1

Employment

trade union power. As a result, there is unemployment of

(E-E1).

Replacement ratio is the percentage of your current income that you could earn by not working. The higher
the ratio, the lower the incentive to work.
Policies to reduce unemployment:

To decrease frictional unemployment: Increase the notice period, increase the number of job centres.

To decrease structural unemployment: Subsidise firms (as firms can then afford to take on new
workers as their costs of production have fallen), reduce taxes (e.g. National Insurance contribution),
increase provision of training schemes such as the New Deal.

To decrease cyclical unemployment: Reduce VAT.

Other measures: Reduce benefits received by the unemployed and give the money to people in low
paid work, decrease National Minimum Wage.

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The diagram shows the effects of a National Minimum Wage

Wage

(NMW) on unemployment. Before a NMW was imposed,

there would be no unemployment as the market would clear

where D=S. However the NMW has now caused

NMW

unemployment of (E-E1). As a result, a NMW can cause

problems despite trying to protect the interests of the labour
D
E1

force.

Employment
Balance of Payments

Definition: A record of UK economic activities with other countries

One component of the balance of payments is the CURRENT ACCOUNT. The current account measures the
difference between the value of goods and services leaving an economy (exports) and the value of the goods
and services entering an economy (imports). If an economy imports more than it exports, it is said to have a
current account DEFICIT. If an economy exports more than it imports, it is said to have a current account
SURPLUS.
Disadvantages of having a current account deficit:

A current account deficit causes GDP to fall as there is more money leaving the economy than there is
entering the economy. However, the deficit will only be a small fraction of the money that is in the
circular flow of income.

Advantages of having a current account deficit:

An economy is consuming more goods and services than it could have produced domestically so
higher living standards.

A deficit implies that an economy is experiencing economic growth.

Advantages of having a current account surplus:

An increase in the number of exports means that jobs will be created to meet foreign demands.

Money injections into the circular flow of incomes creates economic activity.

The surplus will cause a rise in GDP and so tax revenues will rise. This will cause government
spending to rise, leading to an increased provision of public services such as education.

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Disadvantages of a current account surplus:

An increase in GDP causes demand-pull inflation; eroding the value of money.

Living standards are less than their potential as domestically produced goods and services are being
consumed abroad.

Non-renewable resources used.

A current account surplus causes GDP to rise as more money is entering the economy (and the circular flow of
income) than there is leaving the economy.
Exchange Rates
Definition: The value of one currency in terms of another.
Currencies are traded on the FOREX (Foreign Exchange) market. Exchange rates are determined by supply
and demand.
If a currency appreciates, the value of the currency increases relative to another currency. For example, if 1 =
$1.50, it will have appreciated if 1 = $1.60 in the future. A currency can appreciate through an increase in
demand for the currency (e.g. an American firm converts dollars into sterling in order to purchase a good from
the UK) or through a decrease in supply of the currency. If a currency appreciates, exports fall as foreign
countries have to spend more money to buy the same good or service. Imports rise as more goods and
services can be bought from abroad for the same value of the currency (e.g. 1 buys more goods from abroad
than before). As a result, currency appreciation worsens the current account position of an economy.
If a currency depreciates, the value of the currency falls relative to another currency. For example, if 1 =
$1.50, it will have depreciated if 1 = $1.40 in the future. A currency can appreciate through a decrease in
demand for the currency (e.g. foreign countries no longer to buy goods and services made in the UK) or
through an increase in supply of the currency (e.g. UK consumers buy foreign products so put onto the
FOREX market in order to buy another currency). If a currency depreciates, exports rise as foreign countries
have to spend less money to buy the same good or service. Imports fall as less goods and services can be
bought from abroad for the same value of the currency (e.g. 1 buys less goods from abroad than before). As
a result, currency depreciation improves the current account position of an economy.

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Interest rates can be used to alter exchange rates; a high interest rate causes a large amount of financial
investment (as money will be saved in UK bank accounts), so the demand for a currency increases and it
appreciates. A low interest rate will depreciate a currency.
Aggregate Demand

AD =

Consumption

I
Investment

Government Spending

(x m)
Exports - Imports

Consumption
Marginal Propensity to Consume (MPC): The percentage of additional income that will be spent. The poorer the
individual, the higher the MPC (it is highly likely that the last unit of money they have will be spent). MPC is a
value between 0 and 1.
Marginal Propensity to Save (MPS): The percentage of additional income that will be saved. The richer the
individual, the higher the MPS (it is highly likely that the last unit of money they have will be saved). MPS is a
value between 0 and 1.
Factors affecting consumption:

Income: Follows the economic cycle. High employment = high income = high consumption.

Interest rates: High interest rate = large incentive to save = lower consumption. Low interest
rate = large incentive to borrow = higher consumption.

Inflation: This erodes the value of money so high inflation = lower spending = lower
consumption.

Expectations: If people expect high inflation, they will save money in the previous periods so
consumption will fall.

Wealth: House prices are a major influence on wealth. Described below under 'The Wealth
Effect'.

The Wealth Effect: Your consumption is linked to your wealth. The wealthier you are, the more money you are
willing to spend. House prices are a major influence on wealth, so a rise in house prices will cause your MPC
to rise.
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Policies to increase consumption:

Decrease interest rate

Decrease taxes e.g. VAT and income tax.

Provide steady economic growth and inflation over time. This will give consumers positive
expectations of the future and so they will continue spending.

Make loans available for house deposits. This will cause the demand for houses to rise,
meaning house prices will rise and consumption will rise (by the wealth effect).

Investment
Definition: An addition to the capital stock.
There are two types of investment: fixed capital (machinery, buildings etc) and human capital (skills, training for
workers etc).
Investment contributes a small amount to aggregate supply and is a crucial determinant of aggregate supply.
The economy grows fast when there is investment as the supply-side can grow faster.
Investment is the most volatile component of aggregate demand.
The Marginal Efficiency of Capital:
Interest Rate, r

This states that any investment by a firm must

exceed its opportunity cost of the interest rate. So
if the interest rate is high, there would be a

r1

decrease in investment by firms as they are likely

to save that money instead and take the interest

r2

as there will be a higher return by saving

D
I1

compared to the return obtained from investing.

I2 Planned Investment, I

The Accelerator Theory:

This states that investment is related to the output of an economy. So if the economy grows, firms will invest in
human and fixed capital in order to expand. If higher demand is expected, firms may invest before the
economic growth happens e.g. by investing in a recession.
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Capital Goods

This diagram shows that investment in the short run(for

example point A or B) allows you to produce more
A

consumer and capital goods in the long run.

A certain amount of investment is always needed to

maintain GDP as people leave the labour market (so

human capital decreases) and machinery, buildings etc
Consumer Goods

wear our (fixed capital decreases).

Government Spending
Definition: Any spending by central government and/or local councils.
Governments fund their spending through taxation.
Advantages of government spending:

Every member of the population has a certain standard of living.

Increased provision of public and merit goods.

Maximises utility if income is re-distributed.

Disadvantages of government spending:

Taxation means people have less disposable income so their consumption decreases.

Government is non-profit and so inefficient with its resource allocation.

Exports and Imports

Definition: The current account on the balance of payments records the flow of trade between the home
economy and the rest of the world.
The value of the current account relies heavily on the exchange rate. The UK currently has a current account
deficit.
If an economy has a current account surplus, it is exporting more than it is importing and so its net foreign
assets increase.
If an economy has a current account deficit, it is importing more than it is exporting and so its net foreign
assets decrease.

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Aggregate Supply
All goods and services are made from different combinations of the four factors of production: land, labour,
capital and enterprise.
In the short run, at least one factor is fixed in availability.
In the long run, all factors of production are variable.
Price Levels

This diagram shows the short run aggregate supply

(SRAS) curve of an economy. The factors of

SRAS

production can be made to work harder in order to

increase output (such as a movement from Q to Q 1)

P1

e.g. by paying workers overtime. However, this

causes inflation (an increase in price levels such as

a movement from P to P1).
Q

Q1

National Output

Classical Labour Market

This diagram explains the effects on the labour market of a fall

Wages

in aggregate demand using a classical economics approach in

the short run. The fall in AD will cause a fall in derived

demand (shown by the shift from D to D1). People who lose

their jobs due to the fall in derived demand will decrease their

W1
D

wage rate to W1 in order to become employed again. People

not willing to work at the wage rate W1 will leave the labour
market. People who kept their jobs originally will also lower

E1

D1
their wage rate to W1 as this is the new wage that people are
Employment
willing to work for. This process takes a short amount of time
and following these changes, there is no unemployment and
the market clears.

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Price Level

LRAS

This diagram shows the effects on output in the long run

LRAS1

when wages change. It shows that output remains

constant (e.g. at Y) even when price levels (which are

directly affected by wages) change (e.g. from P to P1).

This is because in the long run, people remain in the

P1

labour market and so there is no unemployment. Although

wages are cut, everyone in the economy still has the
Y

Y1

National Output

same purchasing power as price levels will also fall.

The LRAS curve will shift (e.g. from LRAS to LRAS1) if
the quality or quantity of the factors of production increase
e.g. new technology, more labour (through immigration)
etc.

Keynesian Labour Market

This diagram explains the effects on the labour market

Wages

of a fall in aggregate demand using a keynesian

economics approach in the short run. When derived

demand falls, people become unemployed as they do

W1

not drop their wage expectations. Keynes described

D

E2

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E1

D1
Employment

wages as being sticky downwards as they would not

fall enough to clear the market. In the diagram to the
left, a fall in derived demand from D to D1 causes
employment to fall from E1 to E2.

Price Level

LRAS

This diagram shows the effect on output of a

change in wages; when wages (and therefore
price levels) fall, output also falls. There are 3
different scenarios in this diagram:
At point 1, output can increase without price

2
Y

levels (and therefore wages) rising; there are

3
Y1

Y2

National Output

high levels of unemployment.

At point 2, the amount of unemployed labour is
beginning to run out and so as output rises and

firms look to take on more workers, they demand higher wages, causing price levels to rise. At point 3, the
economy is at full employment (it is as its productive potential). Output is at its maximum and wage inflation is
very high (meaning price levels are also high).

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