Theme 2: The UK Economy - Performance and Policies

What is AD?

The demand of all goods and services in the entire UK economy, at a given price level and period of time.

What are the four components of AD?

Consumption (C)

Investment (I)

Government (G)

Net Exports (X-M)

How much of our GDP is made up of consumption expenditure?

65% - with Investment taking up 15%

What causes a movement along the AD curve?

It is caused by a shift in the distribution of factors of AD.

What causes a shift in AD?

A change in:

Real income and employment

Government spending

Monetary policy interest

External value of a country's exchange rate

Rate of economic growth of trading partner nations

Consumer and business confidence

What are the components that affect Consumption Expenditure?

Real Discretionary/ Disposable Income

Interest Rates

Consumer Confidence

Wealth Effect

What is disposable/ discretionary income?

Disposable income is income after income tax.

Discretionary income is disposable income after necessary payments (such as utility bills)

What is the APC?

APC stands for Average Propensity to Consume which is the ratio which tells how much an economy depends on consumption for every dollar it earns.

What is APS?

APS stands for Average Propensity to Save, and its a ratio which tells how much an economy spends on saving for every dollar it earns.

What is the equation connecting APC and APS?

APC + APS = 1

What is the MPC?

MPC stands for the Marginal Propensity to consume and its an index of how much of an increase will be developed to increase consumption spending.

What is the equation for MPC?

MPC = Change in C/ Change in Y

What is MPS?

MPS is the marginal propensity to save and it is an index which tells us how much of an increase in national income will be developed to increase savings spending.

What is the the equation for MPS?

Change in S/ Change in Y

What is the equation linking MPS to MPC?

MPS+MPC=1

How does an increase in interest rates affect consumption expenditure?

An increase in interest rates leads to a decrease in consumption because high interest rates increase the incentive to save because it increases the cost of borrowing.

What does an increase in consumer confidence lead to?

Increase in consumer confidence leads to an increase in consumption, because of positive expectations about the future including interest rates, prices and jobs.

What is the wealth effect?

The idea that changes in the perceived or actual value of a person's assets (like stocks, bonds, or real estate) influence their spending habits.

What does an increase in the wealth effect lead to?

An increase in wealth leads to an increase in consumption which leads to an increase in AD.

What are some examples of physical wealth?

House, Car, Assets

What are some examples of monetary wealth?

Money in bank, stocks and shares, pension and assurance policies

What can increase wealth?

It can increase because of changes in house prices, and changes in stocks and share prices.

What components affect Investment expenditure?

Retained profits - Corporate Tax

Interest Rates

Business Confidence

Economic Growth - accelerator effect

How does a fall in tax affect AD?

A fall in corporate tax means that there is an increase in retained profit, which can lead to increased investment and spending on capital goods, which will increase productivity which will lead to a rise in AD.

How does an increase in interest rates impact AD?

Rise in interest rates will cause a higher cost of borrowing leading to less retained profits and also increases the incentive to save, also investment by firms will decrease leading to a fall in AD.

What is business confidence?

It reflects expectations about future sales, revenues, costs and profits. Keynes labelled these as 'animal spirits'.

Why might a decrease in business confidence?

It might be caused by the start of a recession, expecting a slow down in an economy (GDP goes down.)

What effect would this have on AD?

Firms would expect sales to go down as a result will decrease planned investment, leading to a fall in AD.

How does economic growth impact the accelerator effect?

The accelerator effect describes how there will be more investment because of economic growth, more employment, more income, more revenue and profits, leading to more investment which leads to more economic growth, leading to and increase in AD.

What are the components of Government expenditure?

State of the economy (Boom and bust cycles)

What happens to government expenditure in a period of economic boom?

A economic booms means that there is rising economic activity, employment, and income levels. Governments might reduce spending due to increased tax revenue and lower unemployment benefits. A decrease in government expenditure leads to a decrease in AD.

What happens to government expenditure in a peak?

Economic activity is at its highest. Government expenditure may stabilise as revenues peak.

What happens to government expenditure in a recession?

A recession is due to decreasing economic activity, falling employment, and income levels. Government expenditure will increase in order to stimulate the economy through programs like unemployment benefits and public works.

What happens to government expenditure in a trough?

When economic activity is at its lowest, government spending is typically high to counteract recession and this will lead to an increase in government expenditure and eventually an increase in AD.

What is the national debt?

The accumulated government debt created through government borrowing when it is running a budget deficit.

What are the different types of budget?

Deficit budget: Expenditure > Revenue

Balanced budget: Expenditure = Revenue

Surplus budget: Expenditure < Revenue

What are the components affecting Net Exports?

Product competitiveness

Protectionism

Inflation

Consumer affordability

Exchange rates

What are the factors are under product competitiveness?

Price Competitiveness

Quality Competitiveness

What factors come under Price Competitiveness?

Exchange rate

Inflation

Close substitutes availability

Type of good

Reducing average cost and improving productivity

What factors come under Quality Competitiveness?

Technology and innovation

What does an increase in product competitiveness abroad do for aggregate demand?

An increase in product competitiveness (price competitiveness/ quality competitiveness) would lead to more exports being purchased an increase in exports will lead to an increase in net exports and therefore an increase in AD.

What are examples of protectionist policies?

Tarrifs, Quota, Embargos

What impact does protectionism have on AD?

More protectionist policies lead to less imports being purchased in the domestic UK market, which leads to an increase in net exports and therefore an increase in AD.

What impact does inflation have on AD?

Less price competitive in the international market, which means less demand for UK products, which means a decrease in exports, which leads to a decrease in net exports which could lead to a fall in AD.

What impact does consumer affordability in a economic boom have on net exports? (mention foreign countries + domestic country)

Foreign country: going through a boom then there is more income and therefore foreign consumers will have more purchasing power, making our exports go up.

Domestic country: there is more income and therefore domestic consumers will have more purchasing power leading to more imports being purchased.

What impact does consumer affordability in an economic recession have on net exports?

Foreign: There is less income and therefore foreign consumers will have less purchasing power, making our exports go down.

Domestic: There is less income and therefore domestic consumers will have less purchasing power which would lead to less imports coming in.

What impact does exchange rates have on net exports?

The British pound gets stronger which means exports decrease as the pound becomes more expensive to foreigners, imports increase as our imports become cheaper for domestic consumers.

What is Aggregate Supply?

The total supply of goods and services produced within an economy at a specific price level and given time.

Why is the SRAS curve upwards sloping?

The combined supply curves of all supply curves in the economy are also upwards sloping.

As real output increases, firms have to spend more to increase production -> increased costs means higher average prices.

How is a movement along the SRAS curve caused?

By a change in the average price level.

How is a shift of the SRAS curve caused?

By changes in the the cost of the factors of production:

Change in the cost of raw materials and energy

Changes in wage rates

Changes in tax rates

What does the LRAS curve represent?

It represents the potential capacity of an economy's factors of production. Any factor that changes the quantity or the quality of a factor of production will impact the long run aggregate supply of an economy.

What is the Classical School of thought about the LRAS?

Classical Economists use this to stress the needlessness of government intervention in the economy. In the Long Run the economy will sort itself out - because of wage flexibility.

What are the factors of LRAS?

Technological advances

Changes in relative productivity

Changes in education and skills

Changes in government regulations

Demographic changes and migration

Competition policy

What are the factors of production?

Land, Labour, Capital and Enterprise

Why is the Keynesian LRAS graph curved the way it is?

The Keynesian view believes that an economy will not always self-correct and return to the employment level of output, and so it believes that there is a role for the government to increase its expenditure as to shift AD.

What is inflation?

Inflation is the sustained rise in the general price level over time.

What is deflation?

Is the opposite, where the average price level in the economy falls.

What is disinflation?

The falling rate of inflation. This is when the average price level is still rising, but to a slower extent.

What is the government target for inflation?

2%-4%.

What is the measure of inflation?

CPI (Consumer Price Index)

What do you need to know about CPI?

Its a survey is used to find out what consumers spend their income on. A weighted basket of goods is created. It measures average price change of the goods and the CPI is updated annually.

What are the limitations of CPI?

The basket of goods is only representative of the average household. So its not entirely representative

Different demographics have different spending patterns.

CPI is slow to respond to new goods and services.

What is RPI?

Retail Price Index is an alternative measure of inflation. RPI includes housing costs, such as payments or mortgage interest and council tax. It excludes top 4% of earners and low income pensioners.

What are the causes of inflation?

Demand pulled

Cost pushed

Monetary inflation

What is demand pulled inflation?

When aggregate demand grows unsustainably, there is pressure on resources. Producers increase their prices and earn more profits.

What are the main triggers of demand pulled inflation?

A depreciation in the exchange rate

Monetary inflation

Expansionary Demand side policy

Lower interest rates

High economic growth

What is cost pushed inflation?

This is from the supply side of the economy, and occurs when firms face rising costs.

What triggers cost pushed inflation?

Increase in the price of factors of production.

Expectations of inflation.

Indirect taxes

Change in exchange rate

Monopolies

What is the negative effect of inflation on consumers?

Those on low fixed incomes are hardest hit by inflation - the purchasing power of money falls, which affects those with high incomes the least.

What is the positive effect of inflation on consumers?

If consumers have loans, the value of the repayment will be lower, because the amount owed does not increase with inflation.

What is the effect of inflation on firms?

Cost of investing will increase.

Higher wage demanded, increase cost of production.

Less price competitive globally

Unpredictable inflation reduces business confidence

What is the effect of inflation on the government?

The government will have to increase the value of the state pension and welfare payments because of the cost of living is increasing.

What is the effect of inflation on workers?

Real incomes fall with inflation -> less disposable income.

If firms face higher costs, most redundancies when firms try to cut costs.

What are the two measures of unemployment?

The Claimant Count

The International Labour Organisation (ILO) Labour Force Survey (LFS)

What is the Claimant count?

This counts the number of people claiming unemployment benefits, such as the Job Seeker's allowance. They have to prove that they are actively looking for work.

Evaluation of the Claimant count:

Not every unemployed person is eligible for, or bothers claiming JSA. Those with rich partners are not eligible .. so the Claimant Count generally underestimates the level of unemployment.

How does the LFS measure unemployment?

It directly asks people (by random sampling) if they meet the following criteria:

Been out of work for 4 weeks

Able and willing to start working within 2 weeks

workers should be available for 1 hour per week. Part time unemployment is included.

Does the LFS have a higher/ lower figure than the Claimant Count?

Higher because it takes into account those who are also part time unemployed.

What are dependents?

Those below 16 or above 65.

What is the working population?

Those from 18- 65

What are the two categories within the working population?

The Labour force and the economically inactive.

What is the labour force?

All those who are willing and able to work within the working population.

What three factors fall under the labour force?

Employed (within in underemployed)

Unemployed

Economically inactive

What does employed mean?

All those who are employed in the labour force

What does underemployed mean?

Those who are employed but work for less hours than they want to work or work for a job that has less skills than they possess.

What does unemployed mean?

Those who are unable to get a job but are looking for a job within the labour force.

What does economically inactive mean?

Those who are either unwilling or unable to work or both.

What are discouraged workers?

Those who were part of the labour force but have not applied to a new job in 4 weeks (they are under economically inactive)

What is the effect of unemployment on consumers?

They have less disposable income and their standard of living may fall as a result. There are also psychological consequences of losing a job, which could affect the mental health of workers.

What is the effect of unemployment on firms?

Firms have a larger supply to employ from, wages fall, reducing firms costs.

Though since disposable income has fallen, consumer spending falls so firms lose profits. But firms that sell inferior goods will see a rise in profit.

What is the effect of unemployment on workers?

There is a waste of worker's resources. They could also lose their existing skills if they are not fully utilized. Fall in wages as labour supply increases.

What is the effect of unemployment on the government?

The government has to spend more on unemployment benefits, such as JSA (Job seeker's allowance).

The government also gets less tax revenue because of lower wages and less indirect tax revenue because real disposable income has decreased.

What is the effect of unemployment on society?

Opportunity costs to society as workers could have produced goods and services if they were employed.

Negative externalities in forms of crime.

What are the different types of unemployment?

Structural unemployment

Cyclical unemployment

Frictional unemployment

Seasonal Unemployment

What is structural unemployment?

Occurs with a long term decline in demand for the goods and services in an industry, which costs jobs.

What is frictional unemployment?

The time between leaving a job and looking for another, this isn't typically harmful as it is only temporary. (why it is rare to get 100% employment)

What is seasonal unemployment?

This occurs during certain points in the year, usually around summer and winter.

What is cyclical unemployment?

This is caused by a lack of demand for goods and services, and it usually occurs during periods of economic decline or recessions.

What is Balance of Payments (BOP)?

A record of all the financial dealings over a period of time between the economic agents of one country and all other countries.