MACROECONOMICS UNIT 2

UNIT 2 MACROECNOMICS: THE NATIONAL ECONOMY

CONTENT:

measurement of macroeconomic performance

how the macroeconomy works
aggregate demand and aggregate supply
macroeconomic policy objectives
economic growth and economic cycle
inflation, deflation, employment and unemployment
balance of payments on the current account
monetary policy
fiscal policy
supply side policies

MEASUREMENT OF MACROECONOMIC PERFORMANCE

Macroeconomics considers the economy as a whole- the total quantities of good and
services produced by firms in an economy. Aggregate demand is the total demand in the
economy made up of consumption, investment, government expenditure and net exports
C + I + G + (X-M); whilst Aggregate supply is the total value of goods and services supplied
in the economy.
Performance of the macro economy is outline by:
economic growth- is our capacity to produce goods and services growing over time?
Full employment- efficient or idle resources?
Stable prices- are we able to control prices so that we are competitive with other
economies?
current account- are we buying more from abroad than we are selling abroad?
Policy of any government is to improve the well-being (economic welfare) of the people by
macroeconomic policies.
GROWTH- economic growth is the capacity of the economy to produce more goods and
services over time. It is measured by looking at the change in the level of output.
draw graph to show trend growth and actual growth below

GDP is a standard measurement of output. It is measured as a percentage and stands for

Gross Domestic product (the total value of goods and services produced in an economy).
The actual growth displays the cyclical activity of the economy where we can be above or
below trend. A negative output gap is where the economy is producing less than trend whilst
a positive output gap is when actual GDP exceeds trend causing inflationary pressure,
otherwise known as a recovery or boom; inflationnary pressure will reduce AD. A negative
output gap also resembles a recession.
These can lead to a conflict in macroeconomic policies and as a result there will be a trade
off (where on macroeconomic objective has to be curtailed to favour another objective)
For example: increasing growth conflicts with price stability if AD exceeds AS. In this
positive output gap unemployment will be low and wages rising causing greater costs for
producers being passed onto consumers- domestic inflation will also cause UK international
competitiveness to fall (imports likely to increase whilst exports decrease)
EMPLOYMENT AND UNEMPLOYMENT
This is measured as a % of workforce i.e. those looking for work but not employed compared
to total working and non working. When high unemployment, there is a waste of resources
and the economy cannot be working at full efficiency or potential. Unemployment occurs in
a negative output gap. High opportunity cost as waste scarce resources- effects economy
widely:
hurts individuals confidence and level of income, greater problems may occur such
depression alcoholism etc... leading to economic consequences of gov expenditure
therefore there is an opportunity cost.
standard of living falls, and personal or household poverty may increase
negative externalities may occur
income tax may rise have Gov has to pay benefits to unemployed.
As economy becomes more efficient, less workers needed, so growth will maintain levels of
employment. Economies which are undergoing technological change at a rate higher than
econmic growth may suffer from unemployment in the future.
INFLATION
Inflation is defined as the rate of change in the average price level or the persistent increase
in the level of prices occuring over time. The principal measurement of which is Consumer
Price Index (CPI/CPIX).
Inflation increases in a positive output gap; as actual growth is above trend leading to scarce
labour and increasing wages- As AD is increasing firms pass these higher wage cost into
their price leading to less demand eventually due to price, as a result unemployment rise
AD falls and imports will increase.

Inflation reduces the purchasing power of money as prices increase people will need more
money income to buy the same quantity of goods. The Gov target for inflation is 2% with
a tolerance of 1% either side. Accelerating inflation i.e. a rate increasing year upon year is
considered as an economic detriment.
Inflation is an important mesurement of performance as it indicates whether the UK is price
competitive internationally and whether gov policies to control price rise are successful
CURRENT ACCOUNT/ INTERNATIONAL COMPETITIVENESS
This measures the value of exports minus the value of imports of goods and services and the
net income of assets available. E.g. consume more than income then must have rundown
savings sold assets or borrowed money.
A surplus is when X> M. A deficit is when M>X. Countries may have to cut domestic
expenditure to curb imports but only if the deficit is large and persistent.
Exporting- the sale of goods and services to a foreign country- generating household
income
Importing- the purchase of goods and services from abroad leads to expenditure of home
country
If our prices are higher then our international competitiveness is decreased as not only will
exports decrease in sale but domestically as well as imports are cheaper than our own
domestic produce. This maybe down to inefficiency within production, exchange rates or
inflation. These can affect macro policies as falling sales may lead to unemployment. When
a positive output gap increased sales abroad would widen gap between actual and trend
growth.
THE ECONOMIC CYCLE: GAPS AND TRADE OFFS
Fluctuations of economic cycle produces both positive and negative output gaps. Gov do
not want price instability, because of the causes of a positive or negative output gap Gov's
have to take a view to which objective they consider to be most likely to increase economic
welfare. Idea of re-election and will not want economy performing below optimum levels.
In a positive output gap, they have to decide which objective is most important as have to
control inflationnary pressure as it is vital to other objectives and increase the welfare.
INDICATORS OF MACROECONOMIC PERFORMANCE
Economic indicators are economic statistics that provide information about expansions and
contractions in business cycles.
GDP is used to measure value of all goods and services within the economy by three
sectors- manufacturing, agriculture and services. Stated in monetary terms such as

percentage; nominal figures display data not adjusted for inflation whilst real figures are
adjusted for inflation. GDP/GNP may give an idea to size of economy but does not display
spending power of the average person, hence why there is GDP per capita (per person)displays standard of living increases or decreases. Index numbers maybe used showing
the overall increase- base index is 100. For example:
Commodity A price in year 1 5p 100 index, year 2 10p 200 index
Commodity B price in year 1 1 100 index, year 2 80p 80 index.
(Change/Original) x 100
Retail Price Index- the main domestic measurement of inflation in the UK. Measures
average change per month in goods and services consumed by households.
Consumer Price Index- that is used to asses price stability within the Eu by using this we
can compare our inflation rate to those of Euro using countries. CPI does not include house
prices but shows overall changes in prices.
HOW THE MACROECONOMY WORKS: THE CIRCULAR FLOW OF INCOME
Economic models are used to show the essential characteristics of complicated economic
conditions in order to analyse them and predict the result of changes of variables. Flow is
measured over a specified time period. The model below allows us to examine outcomes
with simplified economy, where the stock of money ( a quantity measured at a point in time )
creates a flow of goods and services. Model GDP= National Output= National Income=
National expenditure. PAGE 139 AQA
Flow of money and income is circular as:
the income earned by households allows them to buy the goods and services sold
by firms
the firms use factors of production to produce
households buy with their income
the money passes from firms to households and back again.
PAGE 140 AQA
Output in the economy results from the utilisation of the four factors of productionland = rent
labour = wages
capital = interest
enterprise = profit

Injections into the economy is money that originates outside of the circular flow and will
increase national income/output/expenditure. Withdrawals is any money not passed on
in the circular flow and has the effect of reducing national income/output/expenditure.
Investment compared to svaings. If injections and withdrawals are equal the economy is
in equilibrium whilst if not they are in disequilibrium and can occur as a result of differences
in plans.
Multiplier effect- where an increase or decrease in spending leads to a larger than
proportionate change in the national income.
If planned saving > planned investment then national income falls
If planned saving < planned investment then national income increases
If planned saving = planned investment then national income in equilibrium
Evidence that an injection will as a result cause a multiplier effect.
In a two sector economy economy equilibrium occurs where:
planned injections= planned withdrawals
investment= savings
AD = income i.e C + I
Diagram of a THREE sector economy
Equilibrium occurs in a three sector economy where:
Planned injections= Planned withdrawals
Investment and Gov Expenditure= Savings and taxes
AD = income i.e. C + I + G
Net Government spending- the difference between Government spending and taxation.
Diagram of FOUR sector economy
In a four sector economy the overall level of economic activity depends on:
whether the sum of injections = the sum of withdrawals then national income is in
equilibrium
AD = income where C + I + G + (X-M)
if the sum of injections> the sum of withdrawals national income will rise
if the sum of withdrawals> the sum of injections national income will fall

Importance of consumption- consumption makes up about 60% of aggregate expenditure,

disposable income can either be spent or saved. Changes in consumption can come about
by:
wealth effect- consumers will change consumption levels if they see changes in the
level of wealth. When prices rise consumers feel worse off and will reduced their
consumption. A change in the value of financial assets can also cause a wealth
effect
Inflation- if inflation is expected to be higher in the future, the price of goods will
rise, so consumers will instead buy now called anticipatory buying. If it rises there
is a negative wealth effect
Interest- changes in interest change the cost of borrowing effecting overal
consumption. Borrow more as interest falls would be a sign that consumption will
in turn rise as well.
Expectations- positive expectations are said to occur when consumer expects futur
to imrpove and will as a result increase consumption
Credit availability- if credit is widely available households will be able to finance
house purchases and finance the purchasing of goods. There are few restrictions
on credit creation by the state
Composition of households and distribution of income- young tend to borrow more
and spend more of their income. Therefore youth have high consumption. Elderly
tend to rundown savings and spend high proportions of their income. Higher income
groups tend to save a higher proportion of their income while lower income groups
tend to spend; in a society where income is distributed more evenly there will be
more consumption especially on domestic produce.
AGGREGATE DEMAND AND AGGREGATE SUPPLY
AGGREGATE DEMAND
Aggregate demand is total planned expenditure or total demand for goods and services
produced within an economy and is composed of consumption, investment, government
expenditure and trade balance. C + I + G + (X-M). AD slops from lef to right due to the
following factors:
when price falls consumer experience wealth effect so will buy more, wealth effect
increases consumption so more will be purchased at a lower price.
a fall in the price of UK goods also reduces the prices of UK exports meaning that
more will sell abroad and import price increases.
expectations- consumer expect pries to rise they will increase consumption now
whilst prices are still relatively low.

AD will shift due to an increase (right) or decrease (left) when any of the factors which make
up AD change so C, I, G, X-M
Diagram to show shift in AD
Investment- the decision to invest is affected by a number of factors:
rate of interest- marginal efficieny of capital theory, firms will tend to invest more
when the rate of interest is much lower due to the overall cost of investment. There
is also risk in the investment because of interest rates due to what the consumer
does with their money whether they save it or not, the MEC is representative of the
rate of return. When interest rates are higher the opportunity cost is also higher.
cost of capital goods- if capital goods price rise then the rate of return will fall if firms
cannot pass on higher prices. Increase in price of capital with all other things being
equal will lead to reduced.
business expectations- if interest rate is falling businesses will expect to make
more sales as consumer demand will increase due to increased borrowing. Such a
positive expectations (businesses expecting for future sales and profits to improve)
will likely increase investment whilst negative expectations will lead to a decrease
in investment and in AD.
rate of technological progress- with new equipment and technology becoming more
widely available then there will be an increase in investment by businesses as there
is a possibility that they may loose sales. E.g Windows XP to Windows Vista.
rate in change of income- this will affect firms demand and an increase in demand
at virtually full capacity will lead to an increase in investment expenditure. This
investment is a large injection into the circular flow shifting AD and producing a
multiplier effect. This reaction of investment in to terms of changed rate of income
is called the accelerator effect, the relation between the change in new investment
and the rate of change in national income.
Government expenditure- mainly spending on public, merit goods and local government
services. Gov spending has decreased recebtky as privatisation has transferred previously
nationalised industries into the private sector. Also, reduced spending to reduce taxation
and their own levels of borrowing.
Net exports (X-M)- UK exports depend on AD of trading apterners so therefore if EU
increases then our exports should also increase shifting AD as well vice versa. Exports
and imports are also impacted by exchange rates, if pound has decreased in value then
our exports are cheaper in EU so would therefore increased AD, if greater pound value,
exports decrease imports increase, shift to the left in AD. However, if economy is growing
and incomes rising consumers are likely to spend more on imports reducing AD.
AGGREGATE SUPPLY

The curve slopes upwards from left to right and shows the total output that the economy
can produce using available factors of production at a given price level. As prices increases
firms will increase their output. As labour market tightens, wages increases leading to the
exponential price level rise. Referred to as a Keynesian approach that wages would remain
fairly stable up to full employment and then rise as labour becomes scarce.
This classical view shown above distinguishes between SRAS and LRAS. In short run,
wages remain constant and price of all other factors in the economy remain constant.
Classical view is when economists who believe that recessions and slumps will cure
themselves. Assumption that in short run firms can increase output by overtime work,
earnings increase but increase in demand will have a larger effect on output rather than
price.
A shift in SRAS will be caused by any factor that changes the cost for firms. Increase in
cost is a shift upwards whilst a decrease is a shift downwards; increasing or decreasing AS
at every price level. Factors affecting SRAS include:

an increase in the money wage rate will increase firms costs

an increase in interest rate
a rise in price of imported raw materials
an increase in corporation tax

Classical economists believe that LRAS will become vertical and reach its productive
capacity before full employment is reached. Other words, actual output is not productive
capacity but reaching its potential output. AS curve becomes vertical is called the natural
rate of unemployment and is the normal capacity output for the economy. LRAS also
resembles the production possibility frontier/boundary of an economy. Factors affecting
LRAS are:

economic growth
influx of capital
technology advancements
attitudes in enterprise culture prepared to set up businesses
policies to reduce natural rate of unemployment
productivity
increased factors of production

MACROECONOMIC EQUILIBRIUM
An increase in AD- increased consumption, investment, gov expenditure or exports will shift
AD to the right. This changes the equilibrium so that output will increase as unemployment
begins to decrease with a slight increase in price level. If increases too far there will be no
longer an increase in output but just an increase in price level due to the SRAS. Wages
rising in order to attract new workers would increase price level even further= inflation which

the Gov will then try to reduce AD by cut in expenditure or increased interest rates decided
by the MPC.
A decrease in AD- A fall in AD also leads to movement along the SRAS curve, the economy
would then be working at underemployment as output would have fallen. Demand deficient
unemployment has occured leading to lower prices. Deflationnary output where Gov will try
to increase AD via increased expenditure or reduce interest rates.
Shifts in SRAS- a shift in SRAS where it has increased down AD leads to lower prices and
an increased level of output respectively; this would make an economy more competitive.
In contrast a supply side shock will lead to an increase in price having consequences on
an economy.
Shift in LRAS
An increase will represent an increase in economic growth leading to lower prices of the
economy. A fall however, will lead to higher prices and may come about due to economic
mismanagement or little productive capacity leading to inflationary pressure.
MACROECONOMIC POLICY OBJECTIVES
Policy objectives are targets or goals which the Gov want to achieve. Policy instruments
are techniques that the Gov will use to achieve these policies.
Objectives, instruments and indicators are below:
Full employment- monetary, fiscal, supply side (claimaint count + ILO statistics)
Economic growth- same as full employment (GDP)
Stable prices- same (RPI and CPI)
Balance of payments- same ( % of GDP and ONS figures)
FULL EMPLOYMENT- unemployment is waste of scarce resources within an economy;
increase standard of living, reduces Gov expenditure on unneccesary goods with an
opportunity cost, tax can increase spending on public and merit goods if more funds in
LRAS. Increase employment by increase in AD via boom bust policy which was used
to stimulate then contract economy when there was inflation. Healthier to increase AS
as increase competition etc.... no trade offs needed either INCREASE OUTPUT OF
ECONOMY.
ECONOMIC GROWTH- where economy can produce more goods and services over time.
Actual growth would be shown by LRAS as it can be within PPB . Pursue growth as
it increases standard of living within economy, increasing GDP per head via increase
output. This may not be sustainable however via environmental factors leading to a

negative externality. Above trend leads to inflation and increase imports possibly, restrained
via Monetary policy. When below, interest rates reduced to encourage AD and growth.
Economists consider that it is supply side factors that are likely to cause economic growth
and while Govs cannot directly affect all causes they can put the private sector in the right
direction.
INFLATION- persistent rise in prices; interacts with other Gov policies. Inflation can be hard
on some social groups which will increase inequality, redistributes income from lenders to
borrowers as interest may be below inflation rate so lenders loose out and investment will
slow down reducing growth rates within the economy. Consumers try to buy before prices
rise which only causes greater inflation and more savings reducing AD leading to a possible
recession. Increased wage demands lead to cost push inflation, firms likely to increase
prices to cover these costs. Unemployment likely to increase as people turn to relatively
cheaper imports and balance of payments becomes seriously adverse towards a deficit.
BALANCE OF PAYMENTS- the relationship: a balance is where what is imported equals
what is exported/ a surplus is where income from exports exceeds expenditure on imports/
a deficit is where expenditure on imports exceeds income from exports. Continuing deficits
is attributed by a shift from manufacturing to a service economy, UK consumers wanting
imported goods and interest rates high compared to our trading partners. Difficult for Gov to
achieve all of its policies therefore. Less spending by Gov to increase our competitiveness
may actually lead to a credit crunch to reduce demand for imports. TRADE OFFS AND
CONFLICT BETWEEN OBJECTIVES OCCUR
ECONOMIC GROWTH AND ECONOMIC CYCLE
BOOM
A boom occurs when real national output is rising at a rate faster than the trend rate of
growth. Some of the characteristics of a boom include:
A fast growth of consumption helped by rising real incomes, strong confidence and
a surge in house prices and other forms of personal wealth
A pick up in the demand for capital goods as businesses invest in extra capacity to
meet rising demand and to make higher profits
More jobs and falling unemployment and higher real wages for people in work
High demand for imports which may cause the economy to run a larger trade
deficit because it cannot supply all of the goods and services that consumers are
buying
Government tax revenues will be rising as people earn and spend more and
companies are making larger profits this gives the government money to increase
spending in priority areas such as education, the environment, health and transport

 An increase in inflationary pressures if the economy overheats and has a positive

output gap.
SLOWDOWN
A slowdown occurs when the rate of growth decelerates but national output is
still rising
If the economy grows without falling into recession, this is called a soft-landing.

RECESSION
A recession means a fall in the level of national output i.e. a period when growth is negative,
leading to a contraction in employment, incomes and profits.
The simple definition:

A fall in real GDP for two consecutive quarters i.e. six months
The more detailed definition:

A recession is a significant decline in economic activity spread across the

economy, lasting more than a few months, normally visible in real GDP,
real income, employment, industrial production, and wholesale-retail sales.
There are many symptoms of a recession here is a selection of key indicators:
A fall in purchases of components and raw materials from supply-chain businesses
Rising unemployment and fewer job vacancies
A rise in the number of business failures including high profile names such as
Woolworths
A decline in consumer and business confidence
A contraction in consumer spending & a rise in the percentage of income saved
A drop in the value of exports and imports of goods and services
Deep price discounts offered by businesses in a bid to sell excess stocks
Heavy de-stocking as businesses look to cut unsold stocks when demand is weak
Government tax revenues are falling and welfare spending is rising
The budget (fiscal) deficit is rising quickly

The difference between a recession and a depression

A slump or a depression is a prolonged and deep recession leading to a significant
fall in output and average living standards
A depression is where real GDP falls by more than 10% from the peak of the cycle
to the trough.
What are the main causes of a recession?
Recessions are unusual. To some economists they are an inevitable feature of a
market economy because of the cyclical nature of output, demand and employment.
Every recession is different! It is undeniable that the global credit crunch has been
hugely significant in causing the downturn even though macroeconomic policy has
tried hard to prevent it.
AD/AS Neoclassical diagram display economic growth/decline
Can also be shown by trend/actual growth diagram via positive and negative output gaps.
INFLATION, DEFLATION, EMPLOYMENT AND UNEMPLOYMENT
Causes of inflation:
Demand pull inflation is where AD exceeds AS leading an increase in price level. Demand
side factors which effect this are all those which affect AD C + I + G + (X-M). An increase in
these components will have different effects on the economy at different times, for example
during a negative output gap there would be benefits from an increase in aggregate demand
but if it was a positive output gap this would cause inflation. As AS does not increase the
higher price acts as a rationing of the market.
Cost push inflation is where increased cost of production results in firms increasing their
prices leading to an increase in general price level. This can be done by the rise in the cost
of imported raw materials, an increase in wage levels due to a tight labour market (where
firms increase wages to attract new workers) and due to a rise in indirect taxes or measures
imposed by the Government such as corporation tax or regulations.
Full employment is defined as when all those looking for work and are willing to accept
offered pay etc can find work or looking for work are in work. Causes of unemployment can
be demand side or supply side.
Demand side- Cyclical unemployment otherwise known as demand deficient
unemployment is that which occurs as a result of the economic cycle and will occur when
there is not enough demand to satisfy the market. AD falls and into a negative output gap.
Seasonal unemployment is when you are unemployed only on a season basis such as
tourism.

Seupply side- Frictional/search unemployment occurs as people leave jobs and maybe
temporarily unemployed while they explore new jobs, called frictional as do not always allow
labour markets to match the supply of labour in different areas. Structural unemployment
is more caused by a change in either demand or supply of an economy for example UK
moving from a manufacturing based economy to a service based.
Positive Output Gap diagram
In this output gap we'd expect a tight labour market as cyclical unemployment decreases
due to increased AD. People can find new jobs and there is an encouragement to join
labour force due to the tight labour market offering higher wages. In negative output gap
the opposite is true.
THE BALANCE OF PAYMENTS ON THE CURRENT ACCOUNT
The balance of payments provides us with important information about whether or not a
country is paying its way in the international economy.
WHAT IS THE BALANCE OF PAYMENTS

records all of the many financial transactions that are made between consumers,
businesses and the government in the UK with people across the rest of the World.

tell us about how much is being spent by British consumers and firms on imported
goods and services

how successful UK firms have been in exporting to other countries and markets. Why
is the export sector of the economy vital for the UK?
Trade in goods includes items such as: Manufactured goods Semi-finished goods and
components Energy products Raw Materials Consumer goods (i) Durable goods e.g. DVD
recorder and new cars (ii) Non-durable goods e.g. foods and beverages Capital goods (e.g.
new plant and equipment)
Trade in services includes: Banking, insurance and consultancy services Other financial
services including foreign exchange and derivatives trading Tourism industry Transport
and shipping Education and health services Services associated with research and
development Cultural arts
TRADE IN GOODS

includes exports and imports of oil and other energy products

manufactured goods, foodstuffs, raw materials and components.

exporting and importing of tangible products

SERVICES

Overseas trade in services includes the exporting and importing of intangible products

for example, Banking and Finance, Insurance, Shipping, Air Travel, Tourism and
Consultancy.
MEASUREMENT

comprises the balance of trade in goods and services plus net investment incomes
from overseas assets

Net investment income arises from interest payments, profits and dividends from
external assets located outside the UK

We also add in the net balance of private transfers between countries and government
transfers (e.g. UK government payments to help fund the various spending programmes
of the European Union).

essentially a reflection of whether the British economy is paying its way with other
countries

The annual balance is volatile from year to year, because each of the four component
parts is subject to wide fluctuations.
WHAT DOES IT MEAN

means that the UK economy is not paying its way in the global economy.

here is a net outflow of demand and income from the circular flow of income and
spending

The current account does not have to balance because the balance of payments also
includes the capital account. The capital account tracks capital flows in and out of the UK
EXCHANGE RATES

Changes in the exchange rate can have a big effect on the balance of payments

these effects are subject to uncertain time lags

When sterling is strong then UK exporters found it harder to sell their products
overseas and it is cheaper for UK consumers to buy imported goods and services because
the pound buys more foreign currency than it did before.
STANDARD OF LIVING


In the short term if a country is importing a high volume of goods and services this is
a boost to living standards because it allows consumers to buy more consumer durables.

However, in the long term if the trade deficit is a symptom of a weak economy and
a lack of competitiveness then living standards may decline.
CURRENT ACCOUNT AND AD/AS
Both imports and exports are components of AD, deficit or surplus will effect
macroeconomy. With a surplus, foreign demand will increase AD for UK goods increasing
exports. Less imports will be bought as well and vice versa.
Diagrams showing current account surplus and fall in AD
Authorities would like equilibrium for this current account as lead to greater stability within
economy but disequilibrium will impact AD via surplus or deficit. This may not be possible to
earn equilibrium due to consumer wants, exchange rates, interest rate and inflation within
economies.
DOES A DEFICIT MATTER?
No: due to investment they can finance its current account deficit. Deficit will be self
correcting if it is due to strong consumer demand as the economic cycle will at some point
reduce demand and some of deficit maybe due to imports of new capital equipment that
will increase productivity.
Yes: as may indicate a loss of competitiveness in foreign markets due to insignificant
investment etc continous excess of imports over exports which leads to withdrawals from
circular flow and reduced output and employment, structural unemployment.
MONETARY POLICY
Role of government in influencing demand for supply of money and the interest of the Bank
of England, rate of interest is the price of money. The principal instrument in recent years
has been the rate of interest set by central bamk and which influences the rates set by
commercial banks.
Interest influences AD in several ways:
consumer durables- these are purchased on credit and higher interest leads to a
higher cost and higher opportunity cost. Less C AD falls
house prices- mortages increase in prices so less house buyers, fall in demand
for housing. Leading to a negative multiplier effect in the circular flow as less
investment on housing, less demand for complementary goods such as furniture
etc.... People less inclined to borrow so negative wealth effect.

 savings as r rises opportunity cost of spending households more likely to save so

less C
investment as r risers, worthwhile projects decreases according to MEC, rate of
return margin falls below rate of interest so not worth the risk
a fall in C due to accelerator theory leads to less I, negative multiplier.
Exchange rates- foreigners will seek to deposit their funds in UK banks and finance
institutions to gain higher rate of return if interest is higher, also increases demand for
sterling. Rising value of pound leading to greater imports as the price is lower; high r
also dampens inflation as a criticism as decrease in X. Strong pound has advantages of
cheaper imports, lower cost of production and lower inflation lower interest rates whilst
disadvantages of strong pound are increase in trade deficit, slower economic growth and
impacts upon business confidence and investment. To decide interest rates MPC look at
multiple factors such as where the inflation is coming from, exchange rates, house prices
etc...
The MPC sets the repo rate, the rate at which it lends to banks. Bank use this rate as basis
for setting rates. If inflation building will raise interest. 7.5% record high 0.5% lowest.