Economics AS Level

I. Basic Economic Ideas

A. Scarcity
1. Resources are limited in supply while wants are unlimited
2. Inevitability of choices:
a) Consumers: what to buy
b) Workers: which jobs to do
c) Firms: what to produce
d) Governments: what to spend tax revenue on
B. Opportunity cost = the best alternative forgone
1. Basic economic questions:
a) What to produce?
b) How to produce it?
c) For whom to produce
2. Economic goods have an opportunity cost, while free goods do not
C. Allocative mechanisms = a way to answer the three economic questions
1. Market economies
a) Resources are allocated by means of the price mechanism (Adam Smiths invisible hand)
(1) Consumers indicate what they are able to buy through the prices they are prepared to pay
(2) Firms alter what they produce according to changing consumer tastes
b) Property is privately owned
c) The governments role in the economy is minimal only handles taxes, issues money, controls
national defense
d) Consumer sovereignty
2. Planned/Command economies
a) All decisions on the allocation of resources are taken by the government
b) Property state-owned, workers employed in state-owned enterprises (SOEs)
c) Full employment of resources (incl. labour)
d) Sacrifices current standard of living to achieve future well-being (queuing becomes a way of life)
e) Slow response to changes in demand
3. Mixed economies
a) Both the private and public sectors play key roles
b) The government provides public goods and merit goods and intervenes with taxes and subsidies for a
better allocation of resources
4. Transition from central planning to the price system
a) Removal of price controls => inflation
b) Sale of SOEs privatisation => rise in unemployment
D. Production possibility curve/frontier = shows the max. output of two types of products that can be
produced with existing resources and technology
1. Production point on the curve = full employment of resources
2. A shift to the right is cause by an increase in the quantity or quality of resources
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3. A straight line PPC indicates a constant opportunity cost

4. Decision making at the margin deciding whether to buy/produce one more item
E. Positive and normative statements
1. Positive statement = statement of a fact (e.g. unemployment is 5%)
2. Normative statement = statement based on an opinion, a value judgement (e.g. the governments priority
should be)
3. Ceteris paribus = other things being equal
F.

Factors of production
1. Land = all natural resources (at the surface of and below the earth)
2. Labour = human effort (mental and physical) used in the production of goods and services the human
resource
3. Capital = man-made goods used to produce other goods and services
a) Improves output from land and labour
b) Fixed capital = assets that are not used up during production (they last > 1 year)
c) Working capital = single-use goods such as raw materials; money fully recovered when finished
products are sold
4. Enterprise = the willingness and initiative to organise the other factors of production; bearing the risks of
production
5. Factor mobility = the extent to which resources can be reallocated from one line of production to another
6. Factor endowment = the range of resources available in an economy
7. Derived demand = demand for a good or factor of production resulting from demand for an intermediate
good or service

G. Economic Sectors
1. Primary sector: agriculture, mining, oil extraction etc.
2. Secondary sector: manufacturing
3. Tertiary sector: services
H. Division of labour = breaking down the production into separate tasks and having each worker concentrating
on a particular task
1. First described by Adam Smith in The Wealth of Nations (pin factory)
2. Increases output, reduces average cost of production
3. Practice makes perfect, but workers get bored doing the same task
4. Low worker motivation and lack of mobility
I.

Money: its functions and characteristics

1. Functions:
a) Medium of exchange = sellers are willing to accept it in exchange for purchases
b) Store of value/wealth = can be stored with a financial institution before being used
c) Unit of account = different values can be added, measured and compared; prices are quoted in
terms of common monetary units
d) Standard for deferred payments = allows payments to be made in the future
2. Characteristics
a) General acceptability = people are prepared to accept it in exchange for products
b) Stability in value
c) Portability
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d) Durability (non-perishable)
e) Divisibility
f)

Recognisability

g) Uniformity
3. Items that act as money
a) Cash
b) Bank accounts
c) Cheques
d) Debit/credit cards
4. Advantages of money over barter
a) Avoids the need for a double coincidence of wants
b) Enables change to be given
c) Allows for a value to be placed on products/assets
d) Makes it easier for people to save

II. The Price System and the Theory of the Firm

A. Demand = the willingness and ability to buy a product
1. A demand curve shows the quantity demanded at different prices
a) Change in price = movement along the demand curve
b) Change in demand = shift in the demand curve
2. Law of demand = an increase in price leads to a decrease in quantity demanded, and vice versa
3. Factors influencing demand
a) Disposable income (financial ability to pay for the product)
b) Attitudes towards the product (tastes, preferences, reputation, reliability)
c) The price, availability and attractiveness of related products
(1) Substitute goods = alternatives that satisfy essentially the same wants or needs
(2) Complementary goods = products that enhance the satisfaction we derive from another product
(a) Joint demand = changes in price/attractiveness of a product impacts demand for its
complements
d) Composite demand = products are used for more than one purpose
B. Price elasticity of demand = measure of the responsiveness of demand to a change in price (PED = %
change in quantity demanded % change in price)
1. Relatively elastic demand: | PED | > 1 ( = perfectly elastic)
2. Unitary elasticity of demand: | PED | = 1
3. Relatively inelastic demand: | PED | < 1 (0 = perfectly inelastic)
4. Factors affecting PED
a) The range and attractiveness of substitutes
b) The proportion of disposable income spent on the product
c) Whether the product is habit forming, a luxury or a necessity
d) Whether the purchase can be postponed
5. Demand is more elastic over time (consumers have longer to see price changes and/or find alternatives)
6. Implications for revenue and business decisions

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a) Inelastic demand: rise in price causes rise in revenue

b) Elastic demand: price and revenue move in opposite directions
c) Elastic demand => close substitutes are available
C. Income elasticity of demand = measure of the responsiveness of demand to a change in income (YED = %
change in quantity demanded % change in income)
1. Superior/luxury goods: YED > 1
2. Normal goods: 0 < YED < 1
3. Inferior goods: YED < 0
4. Factors affecting YED:
a) Products which have higher quality substitutes sold at a higher price have a negative YED (i.e. they
are inferior goods)
b) Expensive, desirable products have an YED greater than 1
5. Implications for revenue and business decisions
a) Income rises => firms want to produce normal goods
b) Producing a few inferior goods reduces the risk of a recession
D. Cross elasticity of demand = measure of the responsiveness of demand for one product to a change in the
price of another product (XED = % change in quantity demanded for product A % change in the price of
product B)
1. Substitute goods: XED > 0
2. Complementary goods: XED < 0
3. Factors affecting XED:
a) Closer substitutes => higher positive XED
b) Closer complements => higher negative XED
4. Implications for revenue and business decisions:
a) Firms need to be aware of close substitutes
(1) Raising prices loses customers to rivals
(2) Lowering prices attracts customers away from rivals
b) Knowing about complements increases revenue (firms offer one product at a low price if purchased
with a more expensive complement)
E. Supply = the ability and willingness to sell a product
1. A supply curve shows the quantity supplied at different prices
a) Change in price = movement along the supply curve
b) Change in supply = shift in the supply curve
2. Law of supply = an increase in price leads to an increase in quantity supplied, and vice versa
3. Factors influencing supply:
a) Costs (wage rates, output per worker, raw material prices, energy, maintenance, transport costs,
available technology)
b) Size and nature of the industry (profitable product => new firms on the market => higher supply)
c) Government policy
(1) Indirect taxes (collected by an intermediary e.g. a retail store from the consumer)
(a) Specific tax = indirect tax; fixed amount per unit
(b) Ad valorem tax = tax charged as a given proportion of the price
(2) Subsidies = payments made to producers to reduce the market price of a product
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(3) In agriculture, the govt can release stocks (unsold items stored for future use) in case of a poor
harvest
d) In agriculture, weather
e) In financial markets, expectations of future prices
f)

Joint demand = production process that can yield two or more outputs (e.g. sheep used for milk,
meat and wool)

F.

Price elasticity of supply = measure of the responsiveness of supply to a change in price (PES = % change
in quantity supplied % change in price)
1. Relatively elastic supply: PES > 1 ( = perfectly elastic)
2. Unitary elasticity of supply: PES = 1
3. Relatively inelastic supply: PES < 1 (0 = perfectly inelastic)
4. Factors affecting PES:
a) The ease with which stocks can be accumulated or reduced (more easily = higher PES; not possible
for service providers)
b) The ease with which production can be increased (in the short run; in agriculture it takes time to alter
the type of crops produced => low PES)

G. Interaction of demand and supply: equilibrium price and quantity

1. Equilibrium = demand and supply are equal
2. Inequilibrium
a) Shortage: demand > supply => upward pressure on price
b) Surplus: supply > demand => downward pressure on price
3. Effects of changes in supply and demand on equilibrium price and quantity
a) Increase in demand => rise in price, extension in supply
b) Increase in supply => fall in price, extension in demand
4. Applications of demand and supply
a) Economists can make predictions about changes in market conditions
b) Governments can see the effects of taxes and subsidies
c) Firms can decide on production and prices
H. Consumer surplus and producer surplus
1. Consumer surplus = the difference between what consumers are willing to pay for a product and the
amount they actually do (above the price line and below the demand curve; has inverse relationship with
price)
2. Producer surplus = the difference between what firms are willing and able to sell a product for the what
they are actually paid (above the supply curve and below the price line; has positive relationship with
price)
I.

Prices as rationing and allocative mechanisms

1. The invisible hand = price variations act as a signal in response to changes in demand and/or supply
(e.g. if consumers are prepared to buy more of a product, the price will rise)
2. The price mechanism can ration (limit the quantity available for consumption) without govt intervention,
through higher prices

III. Government Intervention in the Price System

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A. Market failure occurs when a free market fails to make optimum use of scarce resources
B. Externalities = effects on third parties not involved in the production of a product (spillover effects)
1. Positive externalities (external benefits) = beneficial effects that third parties receive without paying for
them
2. Negative externalities (external costs) = harmful effects imposed on third parties who do not receive
financial compensation
C. Social costs and benefits
1. Social costs = total costs of an economic activity = private costs + external costs
a) Private costs = costs incurred by consumers and producers of the product
2. Social benefits = total benefits of an economic activity = private benefits + external benefits
3. Socially optimum output (allocatively efficient output) occurs when marginal social cost = marginal social
benefit
D. Decision making using cost-benefit analysis
1. Cost-benefit analysis (CBA) = method of appraising a major investment project; takes into account
social costs and benefits (as opposed to a private investment appraisal)
a) Very expensive and time-consuming
2. Stages of CBA:
a) Identification of all costs and benefits involved
b) Setting monetary values for those costs and benefits (shadow prices = price applied when there is no
recognised market price)
c) Forecasting future costs and benefits
d) Net present value is calculated after costs and benefits are compared
(1) Project goes through only if social costs > social benefits and if it is politically popular
E. Private goods and public goods
1. Private goods are excludable and rival
2. Public goods are non-excludable and non-rival and have to be financed out of taxation
a) Non-excludable = no one can be prevented from consuming the product
b) Non-rival = if one person consumes the product, everyone else can still consume it equally
c) Can be consumed without paying = free riders
d) Non-rejectable = people cannot reject public goods such as national defence
e) Zero marginal cost = once provided, it will not cost more to extend the benefit to another person
(again, such as defence)
3. Quasi-public goods = product which possesses some of the features of a public good (e.g. a beach can
become rival if it is crowded)
F.

Merit and demerit goods

1. A merit good is a product that a government considers people undervalue.
a) Provides external benefits
b) Underproduced and underconsumed if left to market forces
c) To encourage consumption, a govt can:
(1) provide it for free
(2) subsidise it
(3) set a maximum price
(4) provide information about its benefits
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(5) make consumption compulsory (e.g. seatbelts)

2. A demerit good is a product that a government considers people overvalue.
a) Generates external costs
b) Overproduced and overconsumed if left to market forces
c) To discourage consumption, a govt can:
(1) tax it
(2) set a minimum price
(3) provide information about its harmful effects
(4) ban its consumption (e.g. drugs, guns in some countries)
G. Government intervention
1. Maximum price controls (a maximum price is set below the equilibrium price)
a) Reasons:
(1) to encourage consumption
(2) to make a product more affordable to the poor
(3) to counterbalance the power of monopolies
b) Results in shortages, due to demand exceeding supply
c) Rationing system might need to be introduced, leading to the development of a shadow market
(producers selling illegally at higher prices)
2. Minimum price controls (a minimum price is set above the equilibrium price)
a) Reasons:
(1) to discourage consumption
(2) to increase the income of producers
b) Results in surpluses
3. Price stabilisation
a) Buffer stock = a store of a non-perishable commodity
(1) A government buys when prices are very low and sell when prices are threatening to rise too
much
4. Taxes imposed to raise revenue and to influence the products consumed (e.g. reduce consumption of
demerit goods)
a) Specific tax => parallel shift of the supply curve to the left
b) Ad valorem tax => non-parallel shift
c) Tax = marginal external cost => allocatively efficient level (internalising external costs)
d) Disadvantages:
(1) taxes may be set too high or too low (hard to measure external costs)
(2) politically unpopular (especially with the poor)
(3) inflationary
e) Inelastic demand: consumers bear most of the tax
f)

Elastic demand: producers bear most of the tax

5. Subsidies = payments by the government to consumers or producers to encourage consumption or

production
a) Specific subsidy causes a parallel shift in supply, while an ad valorem one causes a non-parallel shift
b) Subsidy = marginal external benefit => allocatively efficient level
c) Disadvantages:
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(1) may be set too high or too low

(2) may not be passed on to consumers through a lower price
(3) less effective if demand is inelastic
(4) opportunity cost for govt spending
6. Direct provision of goods and services: a government might provide merit goods or pay private firms to
produce them
7. Regulation (e.g. limits on pollution, standards of cleanliness for hotels)
8. Government failure (e.g. lack of information, wrong tax rates)
H. Information failure (e.g. lack of information about benefits of merit goods)
1. Moral hazard = the risk of taking advice from someone who is better informed (e.g. a doctor taking
advantage of you by recommending an expensive drug instead of a cheaper version)
2. Adverse selection (e.g. the buyer of an insurance policy knows he/she has a higher risk of claiming and
so takes advantage of it)

IV. International Trade

A. Principles of absolute and comparative advantage
1. Absolute advantage = the ability of a country to produce a product using fewer resources than another
country (Adam Smith)
2. Comparative advantage (comparative costs) = the ability of a country to produce a product at a lower
opportunity cost than another country (David Ricardo)
a) Can be difficult for a country to find their comparative advantage
b) A country may still import due to high demand
3. International trade enables countries to specialise and enjoy higher output
4. Overspecialisation makes an economy vulnerable to changes in demand
5. A trading possibility curve shows an economys post trade consumption possibilities
B. Arguments for free trade and motives for protection
1. Free trade = the exchange of products between countries without any restrictions
a) Allows countries to exploit their comparative advantages and so increase output
b) Countries can consume outside their PPFs, increasing welfare
c) Creates competition => low prices, high quality products
d) Greater range of products
e) Larger market => economies of scale
f)

Bilateral trade = trade between two countries

g) Multilateral trade = trade between multiple countries

h) The World Trade Organisation (WTO) promotes freer trade amongst all 161 members
2. Protection = protecting domestic industries from foreign competition by placing restrictions on
international trade
a) Arguments for protection:
(1) to protect infant (sunrise) industries
(2) to protect declining (sunset) industries
(3) to protect strategic industries (e.g. agriculture for food security, weapons)
(4) to prevent dumping

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(5) to improve the balance of payments position

(6) to protect domestic employment
(7) to protect industries against cheap foreign labour
b) Types of protection and their effects
(1) Tariff = tax on imports
(a) Extra revenue for the govt
(b) Lower demand for imports, comparative advantage for domestic products
(c) Leads to a fall in consumer surplus
(2) Quota = limit on the quantity of imports
(a) Lower supply => higher price => lower quantity demanded
(b) Increases the price foreign producers receive
(3) Embargo = ban on imports of particular products or from particular countries
(4) Excessive paperwork (red tape)
(5) Exchange control = limit on the amount of foreign currency that can be bought
(6) Voluntary export restraint = agreement between two countries to limit imports (shortage of
imports pushes up prices and reduces quantity demanded)
(7) Subsidy to domestic producers
C. Economic integration
1. Trade bloc = group of countries that have agreed to reduce or remove some trade restrictions between
themselves
a) Free trade area = group of countries that agree to remove barriers to the movement of products
between each country (e.g. NAFTA USA, Canada, Mexico)
b) Customs union = the above + members impose common external tariff on non-members (e.g.
Mercosur Argentina, Brazil, Paraguay, Uruguay, Venezuela)
c) Economic union = the above + members operate a common market: free movement of all factors of
production, common policies, similar tax rates (e.g. European Union, CSME CARICOM Single
Market and Economy)
2. Trade creation occurs when a country moves from buying products from higher cost non-members to
lower cost member countries (increase in trade among members)
3. Trade diversion occurs when trade is diverted away from more efficient non-members towards less
efficient member countries (tariffs make importing more expensive)
D. Terms of trade = ratio of products exchanged between countries, established between the two countries
opportunity costs (index of export prices index of import prices)
1. An improvement in the ToT occurs when export prices rise relative to import prices (the country can gain
more imports in exchange for a given volume of exports)
2. A deterioration occurs when the ratio declines
E. Components of the balance of payments
1. Balance of payments = record of the economic transactions between a countrys residents and residents
in other countries over the period of a year.
a) Credit = flows of money into the country
b) Debit = flows of money out of the country
2. Sections:
a) Current account:
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(a) Trade in goods (exports & imports of visible goods)

(b) Trade in services (exports & imports of invisible items)
(c) Investment income subsequent to investing (profits, dividends, interest PDI)
(d) Current transfers (e.g. govt contributions to intl organisations, bilateral aid)
(1) Current account surplus: credit > debit
(2) Current account deficit: debit > credit
(3) External balance: credit = debit
b) Capital account (a.k.a. financial account):
(a) Direct investment long-term capital investment (e.g. buildings)
(b) Portfolio investment shares and bonds
(c) Other investment bank loans to foreigners, hot money (flow of money from one country to
another to earn short-term profits on interest rate differences)
(d) Official reserves foreign currencies, gold
c) Net errors and omissions added to ensure that debit and credit are equal (not equal due to time
delays in reporting transactions, mistakes, items left out)
F.

Globalisation = the process by which the worlds economies are becoming increasingly dependent upon
each other

V. Theory and Measurement in the Macroeconomy

A. Employment statistics
1. Size and components of the labour force
a) Labour force (a.k.a. workforce, working population or economically active population) = the total
number of people who are available for work (employed + unemployed and seeking work)
(1) influenced by the size of the population, age structure and working age
b) Labour force participation rate = proportion of working age people who are in the labour force
(labour force total pop. of working age)
c) Dependency ratio = the proportion of the population that is not economically active (not of working
age of working age)
(1) Real dependency ratio = economically inactive economically active
(a) People of working age might be students, early retirees, disabled = inactive
d) Labour productivity = output per worker per hour
2. Unemployment rate; patterns and trends in (un)employment
a) Unemployed = without a job and actively seeking employment
b) Ways of measuring unemployment
(1) Claimant count records people as unemployed if they are in receipt of unemployment benefits
(a) Cheap and quick to collect (recorded every time benefits are paid)
(b) Does not include:
i)

Unemployed people who are not entitled to benefits (e.g. they have an employed partner)

ii)

People who choose not to claim unemployment benefits

(c) Does include:

i)

People illegally claiming benefits (not looking for a job or working in the shadow
economy)

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(2) Labour Force Survey people are unemployed if they are without a job and have looked for
work in the last month or are waiting to start a job in the next two weeks; found from a random
sample of the population (60,000 people in the UK)
(a) Accurate, but expensive, time-consuming and difficult to interpret
c) Unemployment rate = the proportion of the labour force who are without work but actively seeking
employment
d) The unemployment rate is usually higher amongst the young, old and unskilled
e) The longer one is unemployed, the harder it is for them to find a job (technological developments, loss
of work habit)
f)

As economies develop, employment switches from the primary sector to the secondary and tertiary
sectors

g) More women are entering the labour force throughout the world
h) High unemployment => civil unrest, increased crime rates, social problems for the unemployed
3. Difficulties involved in measuring unemployment
a) Easy to miss out unemployed people looking for work
b) See claimant count and labour force survey above
B. General price level: price indices
1. Cost of living = the cost of a range of goods and services that are necessary for normal existence
2. The general price level is calculated using a consumer price index = average change in the prices of a
representative basket of goods and services purchased by households
3. Steps taken to calculate a consumer price index:
(1) Selecting a base year (standard year, no unusual events), given an index figure of 100
(2) Undertaking a survey of household spending to find out what items to include in the
representative basket and what weights to give them.
(a) Weights = values given to goods to take into account their relative importance; reflect the
proportion spent on the products
(3) Collecting information on price changes of products in the basket
(4) % change in price x weight added for each product => index figure (inflation rate)
4. In the UK, a Retail Prices Index (RPI) is also measured (also includes mortgage payments and local
taxation)
C. Money and real data
1. Nominal value = value in monetary terms (current prices, not adjusted for inflation; e.g. 10% increase in
wages)
2. Real value = value measure in constant prices, adjusted for inflation (e.g. 10% increase in wages at 6%
inflation rate = 4% real increase in wages)
D. Shape and determinants of aggregate demand
1. Aggregate demand (AD) = the total demand for a countrys output at a given price level
a) Composed of consumer expenditure (C), investment spending on capital goods (I), govt spending
(G) and net exports (X-M)
b) AD = GDP = C + I + G + (X-M)
c) The AD curve slopes down because of:
(1) The international trade effect: as prices fall, the countrys products become more internationally
competitive
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(2) The wealth effect: a lower price means higher purchasing power (the peoples savings can buy
more)
(3) The interest rate effect: a fall in price is accompanied by a fall in the rate of interest, which
increases consumer expenditure and investment
d) An increase in the AD (shift to the right) can be triggered by:
(1) a rise in expectations about the future
(2) a cut in direct tax
(3) an increase in the money supply
(4) a fall in exchange rates
(5) a rise in the quality of domestic products
e) The short-run AD curve looks the same as the long-run AD curve
2. Aggregate supply (AS) = the total output that domestic producers are willing and able to sell at a given
price level
a) Short-run aggregate supply (SRAS) prices of the factors of production remain unchanged
(1) Slopes up because as output increases, average costs rise (less efficient resources used and
workers paid overtime for additional output)
(2) Shifts if there are changes in resource prices or productivity or changes in taxes
b) Long-run aggregate supply (LRAS) shows the relationship between AS and the price level after
prices had time to adjust to changes in the economy
(1) Monetarists (Milton Friedman) view: the LRAS curve is vertical (perfectly inelastic) because, in
the long run, the economy will operate at full capacity
(2) Keynesians view:
i)

Horizontal (perfectly elastic) at low levels of output considerable spare capacity in the
economy (e.g. enough trees = price of paper unchanged)

ii)

Upwards sloping (decreasing elasticity) over a range of output real GDP approaches
the full employment level; inflation rises with the price, but unemployment falls with the
increase of production permanent trade-off between inflation & unemployment

iii) Vertical (perfectly inelastic) when the economy reaches full capacity (Qmax)
(3) Factors for the increase of the LRAS (increase in the economys capacity):
(a) increase in quantity or quality of resources
(b) net immigration
(c) net investment
E. Interaction of aggregate demand and aggregate supply
1. An increase in AD when there is plenty of spare capacity:
a) has no effect on prices
b) increases output and employment
2. An increase in AD when the economy begins to experience shortages:
a) increases prices
b) increases output and employment
3. An increase in AD when the economy is at full capacity is purely inflationary. It:
a) increases prices
b) has no effect on output or employment
4. An increase in AS when there is plenty of spare capacity:
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a) increases productive capacity

b) has no impact on prices or output
5. An increase in AS when the economy is at or close to full capacity:
a) decreases prices
b) increases output
6. Sustained economic growth requires for the AD and AS to increase in line with each other

VI. Macroeconomic Problems

A. Inflation = a sustained rise in the general price level
Monetary inflation = sustained increase in a countrys money supply
Quantity theory of money = money supply has a direct, proportional relationship with the price level
1. Degrees of inflation
a) Creeping inflation rate = natural, almost impossible to eliminate, countries maintain a target of 1-5%
b) Chronic inflation = in industrialised, developing nations; it reaches annual rates of 10-35%, without
any downward movement; can lead to hyperinflation
c) Hyperinflation = over 50%
d) Accelerating inflation = the general price level is increasing at a more rapid rate
e) (Un)anticipated inflation = when the inflation rate is (not) what people expected
f)

Disinflation = a decrease in the inflation rate (prices rise more slowly)

g) Deflation = a sustained decrease in the general price level

h) Reflation = inflation after a period of deflation (opposite of disinflation)
i)

Stagflation = a situation where the inflation rate is high, the economic growth rate slows down, and
unemployment remains steadily high

2. Causes of inflation
a) Cost-push inflation is caused by increases in the costs of production
b) Demand-pull inflation occurs when AD grows at a more rapid rate than AS
c) The money supply grows faster than the countrys output
3. Consequences of inflation
a) Consequences are affected by the type of inflation stable/fluctuating, anticipated/unanticipated
b) Costs of inflation:
(1) Random redistribution of income = pensioners and people w/ fixed incomes will not have their pay
adjusted fast enough (e.g. some peoples pay could increase faster than inflation)
(2) Menu costs = cost to a firm resulting from changing its prices (restaurants have to print new
menus)
(3) Shoe leather costs = the opportunity cost of time and energy that people spend trying to
counter-act the effects of inflation (e.g. holding less cash and having to make additional trips to
the bank)
(4) Inflationary noise = inflation distorts price signals (i.e. if a prouct increases in price, its hard to
work out if its due to inflation or an increase in the real price)
(5) Fiscal drag = inflation and earnings growth may push tax payers into higher tax brackets (raising
government tax revenue without raising tax rates) opposite of fiscal boost
(6) Loss of international competitiveness
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(7) Administrative costs

(8) Discouragement of investment
c) Benefits of a low, stable inflation rate cause by demand-pull factors:
(1) Stimulus to output
(2) Reduction in real debt
(3) Ability to continue production in difficult times by cutting real wages
B. Balance of payments problems
1. Meaning of balance of payments equilibrium and disequilibrium
a) Should always balance (w/ net errors and omissions)
b) Current account deficit: expenditure on imports > earnings on exports
c) Current account surplus: earnings on exports > expenditure on imports
d) Capital account deficit: investment out of the country > investment into the country
e) Capital account surplus: investment into the country > investment out of the country
f)

To reach equilibrium, a deficit in one of the accounts has to be matched by a surplus in the other
account (e.g. a current account deficit matched by an inflow of foreign direct investment)

g) Deficits and surpluses are observable in the exchange rates

2. Causes of balance of payments disequilibrium
a) High propensity to import
b) Lack of confidence of foreign investors in the economy
c) Overvalued exchange rate, relatively high inflation rate, relatively low productivity => lack of
international competitiveness
d) Lack of intl competitiveness => structural (permanent) deficit
e) Incomes rising in comparison to other countries => cyclical deficit (temporary, related to the economic
cycle)
f)

Rise in interest rates abroad => net outflow of portfolio investment

g) Fall in corporate taxes abroad => net outflow of direct investment

h) Debit in the capital account => inflow in the investment income of the current account (PDI)
3. Consequences of balance of payments disequilibrium on domestic and external economy
a) Domestic
(1) Current account surplus =>
(a) increase in AD, rise in prices (higher money supply & net outflow of products)
(b) upward pressure on the currency
(2) Current account deficit =>
(a) decrease in AD, consuming more than producing living beyond their means
(b) downward pressure on the currency
b) External: Protectionist measures imposed on foreign countries
C. Fluctuations in foreign exchange rates
1. Definitions and measurement of exchange rates
a) Nominal exchange rate = the market price of one currency in terms of another
b) Real exchange rate = a currencys value in terms of its real purchasing power (adjusted by prices at
home and abroad) a measure of international price competitiveness

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c) Trade weighted exchange rate (effective exchange rate) = a weighted average exchange rate which
reflects the relative importance of different currencies in terms of their shares in the countrys
international trade
d) GDP has to be converted into a common currency at a purchasing power parity (PPP) rate for an
indication of purchasing power to be accurate. (PPP = rate at which two currencies could buy the
same quantity of products in the two economies)
2. Determination of exchange rate floating, fixed, managed float
a) Floating exchange rate = rate determined by demand and supply
(1) Rise in demand / fall in supply => appreciation (rise in the price of the currency)
(2) Fall in demand / rise in supply => depreciation (fall in price)
(3) Uncertain and possibly inflationary
b) Fixed exchange rate = one that is set at a particular level and maintained at that level by a
government or central bank
(1) Revaluation = change to higher fixed rate
(2) Devaluation = reduction in the fixed rate
c) Managed float (dirty float) = price largely determined by market forces, but the govt intervenes in
Forex markets to avoid large fluctuations in price
d) The central bank can maintain a fixed rate or influence a managed float by buying/selling the currency
(directly) or raising/lowering interest rates (indirectly)
3. Factors underlying fluctuations in exchange rates
a) Changes in intl competitiveness
b) Changes in income at home and abroad
c) Changes in the economic performance of the economy
d) Changes in interest rates at home and abroad
e) Speculation
4. Effects of changing exchange rates on the economy
a) Fall in the price of a currency => increase in net exports
(1) Raises aggregate demand and increases output given that there is spare capacity
(2) Reduces export prices, in terms of foreign currency => demand-pull inflation
(3) Raises import prices, in terms of the domestic currency => cost-push inflation
(4) If demand for exports is inelastic, producers can maintain the price in terms of foreign currency
and thus increase revenue when converting into the devalued domestic currency
b) A rise in the price of a currency reduces inflationary pressure as it:
(1) Reduces aggregate demand
(2) Raises export prices, in terms of foreign currency
(3) Reduces import prices, in terms of the domestic currency
c) The Marshall-Lerner condition: PEDX + PEDM has to be > 1 for a devaluation/depreciation to correct
a current account deficit
d) The J-Curve concept: deficit initially increases after devaluation/depreciation (buyers have no time to
notice and respond to the change in prices), then reduces as the elasticities exceed 1
e) The reverse J-Curve shows an revaluation/appreciation first increasing surplus and then reducing it
over time

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VII. Macroeconomic Policies

A. Policies designed to correct a current account deficit:
1. Expenditure dampening (expenditure-reducing) = reducing consumers expenditure
a) Lower spending on imports
b) Lower spending domestic products => producers encouraged to export
c) Policies:
(1) raising income tax
(2) cutting government spending
(3) increasing interest rates
d) Lower consumer expenditure => adverse effect on employment and economic growth (offset in the
long run by an increase in net exports)
2. Expenditure switching = encouraging consumption of the countrys domestic products (both by domestic
and foreign consumers)
a) Policies:
(1) trade restrictions
(2) government subsidies
(3) devaluation
(4) trade fairs
B. Policies designed to reduce a current account surplus:
1. Reducing income tax
2. Lowering interest rates
3. Increasing government spending
4. Raising the value of the currency
5. Removing import restrictions
C. Policies designed to influence exchange rates:
1. To increase the value of the currency:
a) Buy the currency using reserves of foreign currency
b) Increase the rate of interest (attracts inflows of hot money)
2. To devaluate the currency:
a) Reasons:
(1) To increase export revenue
(2) To reduce import expenditure
b) Such a policy involves a trade-off (low exchange rate => higher price for imports & increased
aggregate demand => increased inflation rate => increase in the curr. acc. deficit => lower exchange
rate)

Acknowledgements:
Following the CIE 9708 Economics Syllabus for examination in 2015 tiny differences in 2016-2018 syllabus;
Information taken from Cambridge University Press textbook by Colin Bamford and Susan Grant (Cambridge International AS and A Level Economics, Second Edition)
third edition textbook much better;
Compiled by /u/bdfh.

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