AS Macroeconomics / International Economy

Aggregate Demand

This section gives you a platform for understanding issues such as inflation, economic growth
and unemployment. Aggregate demand (AD) and aggregate supply (AS) analysis provides a
way of illustrating macroeconomic relationships and the effects of government policy changes.
Aggregate Demand
The identity for calculating aggregate demand (AD) is as follows:
AD = C + I + G + (X-M)
Where
C: Consumers' expenditure on goods and services: This includes demand for consumer
durables (e.g. washing machines, audio-visual equipment and motor vehicles & non-durable
goods such as food and drinks which are “consumed” and must be re-purchased). Household
spending accounts for over sixty five per cent of aggregate demand in the UK.
I: Capital Investment – This is investment spending by companies on capital goods such as
new plant and equipment and buildings. Investment also includes spending on working capital
such as stocks of finished goods and work in progress.
Capital investment spending in the UK typically accounts for between 15-20% of GDP in any
given year. Of this investment, 75% comes from private sector businesses such as Tesco,
British Airways and British Petroleum and the remainder is spent by the public (government)
sector – for example investment by the government in building new schools or investment in
improving the railway or road networks. So a mobile phone company such as O2 spending £100
million on extending its network capacity and the government allocating £15 million of funds to
build a new hospital are both counted as part of capital investment. Investment has important
long-term effects on the s supply-side of the economy as well as being an important although
volatile component of aggregate demand.
G: Government Spending – This is government spending on state-provided goods and services
including public and merit goods. Decisions on how much the government will spend each year
are affected by developments in the economy and also the changing political priorities of the
government. In a normal year, government purchases of goods and services accounts for around
twenty per cent of aggregate demand. We will return to this again when we look at how the
government runs its fiscal policy.
Transfer payments in the form of welfare benefits (e.g. state pensions and the job-seekers
allowance) are not included in general government spending because they are not a payment to a
factor of production for any output produced. They are simply a transfer from one group within
the economy (i.e. people in work paying income taxes) to another group (i.e. pensioners drawing
their state pension having retired from the labour force, or families on low incomes).
The next two components of aggregate demand relate to international trade in goods and
services between the UK economy and the rest of the world.
X: Exports of goods and services - Exports sold overseas are an inflow of demand (an
injection) into our circular flow of income and therefore add to the demand for UK produced
output.
M: Imports of goods and services. Imports are a withdrawal of demand (a leakage) from the
circular flow of income and spending. Goods and services come into the economy for us to
consume and enjoy - but there is a flow of money out of the economy to pay for them.
Net exports (X-M) reflect the net effect of international trade on the level of aggregate demand.
When net exports are positive, there is a trade surplus (adding to AD); when net exports are
negative, there is a trade deficit (reducing AD). The UK economy has been running a large trade
deficit for several years now as has the United States.
Aggregate demand shocks

Economic events such as changes in interest rates and economic growth in the United States can
have a powerful effect on other countries including the UK. This is because the USA is the
world’s largest economy. 15 per cent of our exports go to the USA.
Lots of unexpected events can happen which cause changes in the level of demand, output and
employment in the economy. These unplanned events are called “shocks” One of the causes of
fluctuations in the level of economic activity is the presence of demand-side shocks.
Some of the main causes of demand-side shocks are as follows:
• A capital investment boom e.g. a construction boom to increase the supply of new
houses or to build new commercial and industrial buildings.
• A rise or fall in the exchange rate – affecting net export demand and having follow-on
effects on output, employment, incomes and profits of businesses linked to export
industries.
• A consumer boom abroad in the country of one of our major trading partners which
affects the demand for our exports of goods and services.
• A large boom in the housing market or a slump in share prices.
 • An unexpected cut or an unexpected rise in interest rates.

The Aggregate Demand Curve

The AD curve shows the relationship between the general price level and real GDP.

Why does the AD curve slope downwards?

There are several explanations for an inverse relationship between aggregate demand and the
price level in an economy. These are summarised below:
• Falling real incomes: As the price level rises, so the real value of people’s incomes fall
and consumers are then less able to afford UK produced goods and services.
• The balance of trade: As the price level rises, foreign-produced goods and services
become more attractive (cheaper) in price terms, causing a fall in exports and a rise in
imports. This will lead to a reduction in trade (X-M) and a contraction in aggregate
demand.
• Interest rate effect: if in the UK the price level rises, this causes an increase in the
demand for money and a consequential rise in interest rates with a deflationary effect on
the entire economy. This assumes that the central bank (in our case the Bank of England)
is setting interest rates in order to meet a specified inflation target.
Shifts in the AD curve
A change in factors affecting any one or more components of aggregate demand, households (C),
firms (I), the government (G) or overseas consumers and business (X) changes planned
aggregate demand and results in a shift in the AD curve.
Consider the diagram below which shows an inward shift of AD from AD1 to AD3 and an
outward shift of AD from AD1 to AD2. The increase in AD might have been caused for example
by a fall in interest rates or an increase in consumers’ wealth because of rising house prices.

Factors causing a shift in

AD
Changes in Expectations The expectations of consumers and businesses can have a
Current spending is affected powerful effect on planned spending in the economy E.g.
by anticipated future income, expected increases in consumer incomes, wealth or company
profit, and inflation profits encourage households and firms to spend more –
boosting AD. Similarly, higher expected inflation encourages
spending now before price increases come into effect - a short
term boost to AD.
When confidence turns lower, we expect to see an increase in
saving and some companies deciding to postpone capital
investment projects because of worries over a lack of demand
and a fall in the expected rate of profit on investments.
Changes in Monetary Policy An expansionary monetary policy will cause an outward shift
– i.e. a change in interest of the AD curve. If interest rates fall – this lowers the cost of
rates borrowing and the incentive to save, thereby encouraging
(Note there is more than one
interest rate in the economy,
although borrowing and
savings rates tend to move in
the same direction)
Changes in Fiscal Policy
Fiscal Policy refers to
changes in government
spending, welfare benefits
and taxation, and the amount
that the government borrows
consumption. Lower interest rates encourage firms to borrow
and invest.
There are time lags between changes in interest rates and the
changes on the components of aggregate demand.
For example, the Government may increase its expenditure e.g.
financed by a higher budget deficit, - this directly increases AD
Income tax affects disposable income e.g. lower rates of
income tax raise disposable income and should boost
consumption.
An increase in transfer payments raises AD – particularly if
welfare recipients spend a high % of the benefits they receive.

Economic events in the A fall in the value of the pound (£) (a depreciation) makes
international economy imports dearer and exports cheaper thereby discouraging
International factors such as imports and encouraging exports – the net result should be that
the exchange rate and foreign UK AD rises – the impact depends on the price elasticity of
income (e.g. the economic demand for imports and exports and also the elasticity of
cycle in other countries) supply of UK exporters in response to an exchange rate
depreciation.
An increase in overseas incomes raises demand for exports and
therefore UK AD rises. In contrast a recession in a major export
market will lead to a fall in UK exports and an inward shift of
aggregate demand.
The UK is an open economy, meaning that a large and rising
share of our national output is linked to exports of goods and
services or is open to competition from imports.
Changes in household A rise in house prices or the value of shares increases
wealth consumers’ wealth and allow an increase in borrowing to
Wealth refers to the value of finance consumption increasing AD. In contrast, a fall in the
assets owned by consumers value of share prices will lead to a decline in household
e.g. houses and shares financial wealth and a fall in consumer demand.

AS Macroeconomics / International Economy

Balance of Payments

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?
The balance of payments (BOP) 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. The BOP figures tell us about how much is being spent by British consumers and firms
on imported goods and services, and how successful UK firms have been in exporting to other
countries and markets. It is an important measure of the relative performance of the UK in the
global economy. At AS level we focus only on one part of the balance of payments accounts.
This section is known as the current account. We will go through the make-up of this account in
a later section.
Why is the export sector of the economy vital for the UK?
• Aggregate demand and the multiplier: An increasing share of Britain’s national output
is exported overseas as the nation becomes ever more integrated into the global
economy. Export earnings are an injection of AD into the circular flow. If British
companies can successfully sell more goods and services overseas, the rise in exports
boosts national income and should have a positive multiplier effect on the national
income, output and employment.
• Manufacturing industry: Export sales are particularly important for manufacturing
industry where exports are a high % of total production. Thousands of jobs depend
directly on the performance of the export sector and even more are affected in supply
industries. Select this link for more articles on British manufacturing industry
• Regional economic health: The relative success of failure of export industries is
important for certain regions of the UK. When export sales dip (for example as a result of
a global downturn or the impact of the strong exchange rate), output, employment and
living standards come under threat and threaten to widen the existing north-south divide.
Trade in goods includes items such as: Trade in services includes:
Manufactured goods Banking, insurance and consultancy
Semi-finished goods and components services
Energy products Other financial services including foreign
Raw Materials exchange and derivatives trading
Consumer goods Tourism industry
(i) Durable goods e.g. DVD recorder and Transport and shipping
new cars Education and health services
(ii) Non-durable goods e.g. foods and Services associated with research and
beverages development
Capital goods (e.g. new plant and Cultural arts
equipment)
Trade in goods
Trade in goods includes exports and imports of oil and other energy products, manufactured
goods, foodstuffs, raw materials and components. Until recently this was known as visible trade
– i.e. exporting and importing of tangible products. Since 1986 the net balance of trade in goods
for the UK has been in deficit. And as the following chart shows, the trade deficit in goods has
increased enormously in the last few years. In 2005 there was a record trade deficit of £66
billion, over three times the deficit seen in 1998.
 Trade in 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.
Britain has a strong trade base in services with over thirty per cent of total export earnings
come from services.
The balance of trade in services has been positive for many years. In 1999 the UK became the
second largest exporters of services in the world and in 2004 the UK achieved its highest ever
annual trade surplus in services although there was a smaller surplus in 2005 partly because of
higher insurance payouts arising from the effects of Hurricane Katrina in the United States.
Strong surpluses are especially common in financial and business services and hi-tech
knowledge services.
But the UK runs a deficit in international travel and transportation in part because of the growth
of demand for overseas holidays as living standards have improved. Once again, rising incomes
have caused a large rise in the demand for overseas leisure and business travel and the sustained
strength of the exchange rate against most European currencies and the rapid expansion of low
cost airlines offering short haul overseas breaks has also played its part.
Britain has a comparative advantage in selling financial services to the rest of the world.
London is one of the three main financial centres in the world and has the largest share of trading
in many international financial markets. Many overseas banks have established themselves in
London’s money and capital markets. And numerous British financial businesses have world
class status in their areas of expertise. Our UK based commercial banks, fund managers,
securities dealers, futures and options traders, insurance companies and money market brokerage
businesses are part of a complex network of financial and business services that represent a huge
asset for the UK balance of payments accounts.
Measuring the current account
The current account balance 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).
The net investment income flow for the UK is positive – a reflection of the heavy investment
overseas in recent years by British businesses and individuals. The transfer balance is negative –
one reason is that the British government is a net contributor to the EU budget.
The current account of the balance of payments
The current account balance is 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.
Balance of Balance of Net Investment Current Current account
trade in goods trade in Income transfers balance
services
£ billion £ billion £ billion £ billion £ billion
1996 -13.7 11.2 0.6 -4.8 -6.7
1997 -12.3 14.1 3.3 -5.9 -0.8
1998 -21.8 14.7 12.3 -8.4 -3.2
1999 -29.1 13.6 1.3 -7.5 -21.7
2000 -33.0 13.6 4.5 -10.0 -24.8
2001 -41.2 14.4 11.7 -6.8 -21.9
2002 -47.7 16.8 23.4 -9.1 -16.5
2003 -48.6 19.2 24.6 -10.1 -14.9
2004 -60.9 25.9 26.6 -10.9 -19.3
2005 -67.3 17.9 29.9 -12.2 -26.6
Source: Office of National Statistics
What are the main questions that concern economists regarding these figures?
• Causation: Why does the UK now run such large trade deficits in goods?
• Consequences: Does it really matter if the British economy is running persistent current
account deficits?
• Correction: Which demand and supply-side economic policies are likely to be most
effective in improving our trade balances in the years ahead?
The underlying causes of the UK trade deficit
It is useful to group the explanations for the record trade deficit in goods into short-term,
medium-term and long-term factors. Some relate to the demand-side of the economy, others to
supply-side economic influences
Short-term factors
• Strong consumer demand: Real household spending has grown more quickly than the
supply-side of the economy can deliver, leading to a very high level of demand for
imported goods and services
• High income elasticity of demand for imports: Evidence suggests that UK consumers
have a high income elasticity of demand for overseas-produced goods – demand for
imports grows quickly when consumer demand is robust. Nicholas Fawcett and Michael
Kitson in a recent article in the Guardian estimated that the income elasticity is around
+2.3 suggesting that a 2% increase in real incomes boosts demand for imports by 4.6%.
Because the overseas demand for UK exports rarely keeps pace with the surging demand
for imported products, so the trade deficit widens when the economy enjoys a period of
consumption-led growth.
• The strong exchange rate has helped to reduce the UK price of imports causing an
expenditure-switching effect away from domestically produced output.
• The weakness of the global economy and in particular the slow growth in the Euro Zone
has damaged UK export growth. Nearly 60% of UK manufactured goods exports and
over 50% of our exports of services are to fellow members of the European Union.
Medium-term factors
• UK trade balances have been affected by shifts in comparative advantage in the
international economy – for example the rapid growth of China as a source of exports of
household goods and other countries in South-east Asia who have a cost advantage in
exporting manufactured products
• The availability of imports from other countries at a relatively lower price inevitably
causes a substitution effect from British consumers.
Longer-term factors
• Much of our trade deficit is due to structural rather than cyclical factors
• Our trade performance has been hindered by supply-side deficiencies which impact on
the price and non-price competitiveness of British products in global markets - non-price
competitiveness factors such as design and product quality are now more important for
trade than merely price alone.
○ A relatively low rate of capital investment compared to other countries
○ The persistence of a productivity gap with our major competitors – measured
by differences in GDP per person employed or per hour worked – this is linked to
low investment and also to the existence of a skills-gap between UK workers and
employees in many other countries
○ A relatively weak performance in terms of product innovation – linked to a
low rate of business sector spending on research and development
• The UK manufacturing sector has been in long-term decline for more than twenty
years. This is known as a process of deindustrialisation. Although we still have some
world class manufacturing companies, the size of our manufacturing sector is not large
enough both to meet consumer demand in the UK and also to export sufficient volumes
of products to pay for a growing demand for imports
What does a current account deficit mean?
Running a sizeable deficit on the current account basically means that the UK economy is not
paying its way in the global economy. There 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. This includes portfolio capital flows (e.g. share transactions and the buying
and selling of Government debt) and direct capital flows arising from foreign investment.
The Effects of Changes in the Balance of Payments on the UK Economy
Consider the effects of a slowdown in exports and a faster growth in imports of goods and
services caused by a rise in the value of sterling against other currencies that leads to a
worsening of the balance of payments. This has further effects on the economy as a whole:
• Reductions in demand in the circular flow: There will be a net fall in AD because
more money is leaving the circular flow of income (through imports) than is coming in
from exports. An inward shift of AD would lead to a contraction along the SRAS curve.
• Lost jobs: There will be a loss of employment if exporting industries require less labour
and if UK businesses lose market share and output to cheaper imports from overseas.
• Dip in business confidence and investment: A fall in business confidence and a decline
in capital investment spending by UK exporting firms whose order books are less full and
whose profits take a hit from a fall in demand from overseas.
• Reductions in inflationary pressure: Lower inflation because imports coming into the
UK are cheaper and a fall in AD takes the economy further away from full capacity.
Reduced inflationary pressure might then persuade the Bank of England to reduce interest
rates to provide a boost to macroeconomic activity.
The exchange rate and the balance of payments
Changes in the exchange rate can have a big effect on the balance of payments although 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.
The Balance of Payments and the Standard of Living
A common misconception is that balance of payments deficits are always bad for the economy.
This is not necessarily true. 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.
Hyperinflation is a form of economic inflation in which the general price level increases
rapidly. No single definition is universally accepted. One simplistic definition requires a monthly
inflation rate of 50%; an even simpler definition simply requires out-of-control inflation at an
extremely high rate. The definition used by most economists is "an inflationary cycle without
any tendency toward equilibrium". What differentiates hyperinflation from regular inflation is a
vicious circle is created in which more and more inflation is created with each iteration of the
cycle.
Hyperinflation was rare before the 20th century; older economies would revert to either specie
metals or barter once inflation reached a certain level. The widespread use of fiat money created
the possibility of hyperinflation as governments often tended to print larger amounts of money to
finance their expenses. Inflation results where such an increase in money supply occurs without
regard for the actual market demand.
Rates of inflation of several hundred percent per month are often seen. Extreme examples
include Germany in the early 1920s when the rate of inflation hit 3.25 million percent per month;
Greece in the mid-1940s with 8.55 billion percent per month; and Hungary during the same
approximate time period at 4.19 quintillion percent per month. Other more moderate examples
include Eastern European countries in the period of economic transition in the early 1990s and in
Latin American countries as Bolivia and Peru in 1985 and 1988, respectively.
Nations such as Ghana in North Western Africa continue to this day to have inflation in the order
of 30% per annum.
Hyperinflation causes the production of some interesting banknotes.
One type has a big long row of zeros on the number. (like this: "10,000,000,000").
Another type uses words for part or all of the number (like this: "10 Billion" or this: "Ten
Billion")
Still others avoid the use of large numbers simply by declaring a new unit of currency (so,
instead of 10,000,000,000 Dollars, you might set 1 New Dollar = 1,000,000,000 old Dollars, so
your new banknote would read "10 New Dollars".)
In countries experiencing hyperinflation it is common to see men and women bringing enormous
grocery bags full of banknotes to the store, even for simple purchases like bread or milk.

Stagflation is a portmanteau word used to describe a period with a high rate of inflation
combined with an economic recession.
The Phillips curve, which is associated with Keynesian economics suggests that stagflation is
impossible because high unemployment lowers demand for goods and services which lowers
prices. This results in low or no inflation. By contrast, monetarism which argues that inflation is
due to the money supply rather than to demand predicts that inflation can occur with high
unemployment if the government increases the money supply.
Stagflation occurred in the economies of the United Kingdom in the 1960s and 1970s and the
United States in the late 1970s. The difficulty in fitting its existence within a Keynesian
framework led to a greater acceptance of monetarist theories in the 1970s and 1980s, but some
still believe in Keynesian economics, saying that there was no recession at that time. The coinage
of the term has been claimed for the UK Finance Minister Iain Macleod who died in 1970.

Cost push is a type of inflation caused by arbitrary increases in the cost of goods or services
where no suitable alternative is available. A situation that has been often cited as of this was the
oil crisis of the 1970s, which some economists attribute as the cause of the inflation experienced
in the Western world in that decade. It is argued that this inflation resulted from increases in the
cost of oil imposed by the member states of OPEC.
Monetarist economists such as Milton Friedman argue against the concept of cost push inflation
because they believe that increases in the cost of goods and services do not lead to inflation
without the government cooperating in increasing the money supply. The argument is that if the
money supply is constant, increases in the cost of a good or service will decrease the money
available for other goods and services, and therefore the price of some those goods will fall and
offset the rise in price of those goods whose prices have increased.
One consequence of this is that monetarist economists do not believe that the rise in the cost of
oil was a direct cause of the inflation of the 1970's.

Wholesale price index

A Wholesale Price Index (WPI) is the price of a representative basket of wholesale goods.
Some countries (like India and The Philippines) use WPI changes as a central measure of
inflation. However, India and the United States now report a producer price index instead.
The Wholesale Price Index or WPI is the price of a representative basket of wholesale goods.
Some countries use the changes in this index to measure inflation in their economies, in
particular India – The Indian WPI figure is released weekly on every thursday and influences
stock and fixed price markets. The Wholesale Price Index focuses on the price of goods traded
between corporations, rather than goods bought by consumers, which is measured by the
Consumer Price Index. The purpose of the WPI is to monitor price movements that reflect supply
and demand in industry, manufacturing and construction. This helps in analyzing both
macroeconomic and microeconomic conditions.
Calculation of Wholesale Price Index
The wholesale price index consists of over 2,400 commodities. The indicator tracks the price
movement of each commodity individually. Based on this individual movement, the WPI is
determined through the averaging principle. The following methods are used to compute the
WPI:
Laspeyres Formula (relative method):It is the weighted arithmetic mean based on the fixed
value-based weights for the base period.
Ten-Day Price Index: Under this method, “sample prices” with high intra-month fluctuations are
selected and surveyed every ten days through phone. Utilizing the data retrieved by this
procedure and with the assumption that other non-surveyed "sample prices" remain unchanged, a
"ten-day price index" is compiled and released.
Calculation Method: Monthly price indexes are compiled by calculating the simple arithmetic
mean of three ten-day “sample prices” in the month.
AS Macroeconomics / International Economy
Inflation

What causes rising prices in an economy? And what tools are available to keep inflation under
control? This chapter focuses on the causes of inflation and some of the consequences.
What is inflation?
Inflation is best defined as a sustained increase in the general price level leading to a fall in the
purchasing power or value of money. The greatest falls in the value of money came during the
mid-late 1970s and again in the late 1980s when there was acceleration in the rate of inflation in
the UK. In contrast, the last fifteen years have seen much lower rates of inflation – and as a
result, money has held value better. The next chart shows the UK consumer price index since
1970.
 The value of money refers to the amount of goods and services £1 can buy and is inversely
proportionate to the rate of inflation. Inflation reduces the value of money. When prices are
increasing, then the value of money falls.
The rate of inflation is measured by the annual percentage change in the level of consumer
prices. The British Government has set an inflation target of 2% using the consumer price
index (CPI). It is the job of the Bank of England to set interest rates so that AD is controlled and
the inflation target is reached. Since the Bank of England was made independent, inflation has
stayed comfortably within target range. Indeed Britain has one of the lowest rates of inflation
inside the EU.
There has been a fall in average inflation rates in most of the world’s developed countries
including the UK over the last fifteen years. Indeed lower inflation seems to have become a
global phenomenon. Japan has experienced negative inflation (i.e. price deflation) over recent
years (although in 2006, this period of price deflation came to an end) and the German economy
has also come close to experiencing deflation with inflation of less than one per cent.
Deflation
Price deflation is when the rate of inflation becomes negative. I.e. the general price level is
falling and the value of money is increasing. Some countries have experienced deflation in recent
years – good examples include Japan and China. In Japan, the root cause of deflation was slow
economic growth and a high level of spare capacity in many industries that was driving prices
lower. In China, economic growth has been rapid – but the huge amount of capital investment
and rising productivity has led to economies of scale being exploited and a fall in production
costs.
There has been some price deflation in the UK economy – not for the whole economy – but for
items such as clothing (where many prices of clothing on the high street have been driven lower
by cheaper imports); audio-visual equipment, computers and many other household goods. The
effects of technological change in increasing supply are important when explaining deflation in
some UK markets. Rapid advances in technology help to explain for example the sharp fall in the
prices of state of art digital cameras and televisions, which has made the digital age accessible to
millions of consumers.
Hyperinflation

A 500 billions bill with most zeros in the economy history. The product of hyperinflation in
Yugoslavia 1993
Hyperinflation is extremely rare. Recent examples include Yugoslavia Argentina , Brazil ,
Georgia and Turkey (where inflation reached 70% in 1999). The classic example of
hyperinflation was of course the rampant inflation in Weimar Germany between 1921 and 1923 .
When hyperinflation occurs, the value of money becomes worthless and people lose all
confidence in money both as a store of value and also as a medium of exchange. The current
hyperinflation in Zimbabwe is a good example of the havoc that can be caused when price
inflation spirals out of control.
Often drastic action is required to stabilize an economy suffering from high and volatile inflation
– and this leads to political and social instability. The International Monetary Fund is often
brought into the process of implementing economic reforms to reduce inflation and achieve
greater financial stability.
The main causes of inflation
Inflation can come from several sources: Some come direct from the domestic economy, for
example the decisions of the major utility companies providing electricity or gas or water on
their prices for the year ahead, or the pricing strategies of the leading food retailers based on the
strength of demand and competitive pressure in their markets. A rise in government VAT would
also be a cause of increased domestic inflation because it increases a firm’s production costs.
Inflation can also come from external sources, for example an unexpected rise in the price of
crude oil or other imported commodities, foodstuffs and beverages. Fluctuations in the
exchange rate can also affect inflation – for example a fall in the value of sterling might cause
higher import prices – which feeds through directly into the consumer price index.
We make a simple distinction between demand pull and cost push inflation.
Demand-pull inflation
Demand-pull inflation is likely when there is full employment of resources and aggregate
demand is increasing at a time when SRAS is inelastic. This is shown in the next diagram:
In the diagram above we see a large outward shift in AD. This takes the equilibrium level of
national output beyond full-capacity national income (Yfc) creating a positive output gap. This
would then put upward pressure on wage and raw material costs – leading the SRAS curve to
shift inward and causing real output and incomes to contract back towards Yfc (the long run
equilibrium for the economy) but now with a higher general price level (i.e. there has been some
inflation).
The main causes of demand-pull inflation
Demand pull inflation is largely the result of the level of AD being allowed to grow too fast
compared to what the supply-side capacity can meet. The result is excess demand for goods and
services and pressure on businesses to raise prices in order to increase their profit margins.
Possible causes of demand-pull inflation include:
1. A depreciation of the exchange rate which increases the price of imports and reduces
the foreign price of UK exports. If consumers buy fewer imports, while exports grow,
AD in will rise – and there may be a multiplier effect on the level of demand and output
2. Higher demand from a fiscal stimulus e.g. via a reduction in direct or indirect taxation
or higher government spending. If direct taxes are reduced, consumers will have more
disposable income causing demand to rise. Higher government spending and increased
government borrowing feeds through directly into extra demand in the circular flow
3. Monetary stimulus to the economy: A fall in interest rates may stimulate too much
demand – for example in raising demand for loans or in causing a sharp rise in house
price inflation
4. Faster economic growth in other countries – providing a boost to UK exports overseas.
Export sales provide an extra flow of income and spending into the UK circular flow – so
what is happening to the economic cycles of other countries definitely affects the UK
Cost-push inflation
Cost-push inflation occurs when firms respond to rising costs, by increasing prices to protect
their profit margins. There are many reasons why costs might rise:
1. Component costs: e.g. an increase in the prices of raw materials and other components
used in the production processes of different industries. This might be because of a rise in
world commodity prices such as oil, copper and agricultural products used in food
processing
2. Rising labour costs - caused by wage increases, which are greater than improvements in
productivity. Wage costs often rise when unemployment is low (skilled workers become
scarce and this can drive pay levels higher) and also when people expect higher inflation
so they bid for higher pay claims in order to protect their real incomes. Expectations of
inflation are important in shaping what actually happens to inflation!
3. Higher indirect taxes imposed by the government – for example a rise in the specific
duty on alcohol and cigarettes, an increase in fuel duties or a rise in the standard rate of
Value Added Tax. Depending on the price elasticity of demand and supply for their
products, suppliers may choose to pass on the burden of the tax onto consumers
Cost-push inflation can be illustrated by an inward shift of the short run aggregate supply
curve. The fall in SRAS causes a contraction of national output together with a rise in the level
of prices.
Which government policies are most effective in reducing inflation?
Most governments now give a high priority to keeping control of inflation. It has become one of
the dominant objectives of macroeconomic policy.
Inflation can be reduced by policies that (i) slow down the growth of AD or (ii) boost the rate of
growth of aggregate supply (AS). The main anti-inflation controls available to a government are:
1. Fiscal Policy: If the government believes that AD is too high, it may reduce its own
spending on public and merit goods or welfare payments. Or it can choose to raise direct
taxes, leading to a reduction in disposable income. Normally when the government wants
to “tighten fiscal policy” to control inflation, it will seek to cut spending or raise tax
revenues so that government borrowing (the budget deficit) is reduced. This helps to take
money out of the circular flow of income and spending
2. Monetary Policy:A tightening of monetary policy involves higher interest rates to
reduce consumer and investment spending. Monetary policy is now in the hand of the
Bank of England –it decides on interest rates each month.
3. Supply side economic policies: Supply side policies include those that seek to increase
productivity, competition and innovation – all of which can maintain lower prices.
The most appropriate way to control inflation in the short term is for the British government and
the Bank of England to keep control of aggregate demand to a level consistent with our
productive capacity. The consensus among economists is that AD is probably better controlled
through the use of monetary policy rather than an over-reliance on using fiscal policy as an
instrument of demand-management. But in the long run, it is the growth of a country’s supply-
side productive potential that gives an economy the flexibility to grow without suffering from
acceleration in cost and price inflation.

Why has inflation remained low in the UK over recent years?

The last twelve years has been a period of very low and stable inflation. No one factor explains
this – but among them we can highlight the following:
1. Low wage inflation from the labour market: Wages have been growing at a fairly
modest rate in recent years despite a large fall in unemployment. This has been helped by
a fall in expectations of inflation
2. Low global inflation and deflation in some countries: There has been a clear fall in the
average rate of consumer prices inflation among leading economies, and this decline in
global inflation has filtered through to the UK. World inflation has stayed low despite the
recent increases in the prices of many of the world’s globally traded commodities.
3. The effectiveness of monetary policy in the UK: The success of the Bank of England
through monetary policy in keeping aggregate demand under control through interest rate
changes
4. Increased competition: Many markets have become more contestable in the last decade
and this extra competition has placed a discipline on businesses to control their costs,
reduce profit margins and seek improvements in efficiency. Many UK businesses face
severe pressure from foreign competition as the process of globalisation continues
5. The strength of the exchange rate: The recent strength of the pound has lowered the
cost of imported products and also squeezes demand for UK exporters
6. Information technology effects: The rapid expansion of information and communication
technology has helped to reduce costs and has made prices more transparent for
consumers – e-commerce has contributed to falling prices in many markets
In short, low inflation is the result of a combination of demand and supply-side factors.
AS Macroeconomics / International Economy
Aggregate Supply

Having looked at the components of aggregate demand, we now turn to the supply-side of the
economy. Aggregate supply tells us something about whether producers across the economy can
supply us with the goods and services that we need.
A definition of aggregate supply
Aggregate supply (AS) measures the volume of goods and services produced within the
economy at a given price level. In simple terms, aggregate supply represents the ability of an
economy to produce goods and services either in the short-term or in the long-term. It tells us the
quantity of real GDP that will be supplied at various price levels. The nature of this relationship
will differ between the long run and the short run
• In the long run, the aggregate-supply curve is assumed to be vertical
• In the short run, the aggregate-supply curve is assumed to be upward sloping
Short run aggregate supply (SRAS) shows total planned output when prices in the economy
can change but the prices and productivity of all factor inputs e.g. wage rates and the state of
technology are assumed to be held constant.
Long run aggregate supply (LRAS): LRAS shows total planned output when both prices and
average wage rates can change – it is a measure of a country’s potential output and the concept is
linked strongly to that of the production possibility frontier
The short run aggregate supply curve
A change in the price level (for example brought about by a shift in AD) results in a movement
along the short run aggregate supply curve. The slope of SRAS curve depends on the degree of
spare (under-utilised) capacity within the economy.
• Negative output gap: At low levels of real national income where actual GDP <
potential GDP, firms have a large amount of spare capacity and can expand their output
without paying their workers overtime. The SRAS curve is therefore drawn as elastic
• Positive output gap: As national output expands and the economy heads towards full
capacity, so “supply bottlenecks and shortages” may start to appear in some sectors and
industries. Workers receive the same wage rate but require payment of overtime and
bonuses to work longer hours and increase GDP – SRAS is becoming more inelastic
• Diminishing returns? As national output expands, older less productive machinery may
be used and less efficient workers hired. This means that while wage rates remain
constant, unit costs of production may rise and thus the SRAS slopes upwards
• Full-capacity output at LRAS. Eventually the economy cannot increase the volume of
output further in the short-term no matter what bonus or overtime payments on offer, at
this point SRAS is perfectly inelastic – the economy has reached full-capacity (the LRAS
curve)
Shifts in short run aggregate supply (SRAS)
Shifts in the SRAS curve can be caused by the following factors
• Changes in unit labour costs: Unit labour costs are defined as wage costs adjusted for
the level of productivity. For example a rise in unit labour costs might be brought about
by firms agreeing to pay higher wages or a fall in the level of worker productivity. If unit
wage costs rise, this will eventually feed through into higher prices (this is known as an
example of “cost-push inflation”)
• Commodity prices: Changes to raw material costs and other components e.g. the world
price of oil, copper, aluminium and other inputs in many production processes will affect
a firm’s costs. These costs might be affected by a change in the exchange rate which
causes fluctuations in the prices of imported products. A fall (depreciation) in the
exchange rate increases the costs of importing raw materials and component supplies
from overseas
• Government taxation and subsidy: Changes to producer taxes and subsidies levied by
the government as part of their fiscal policy have effects on the costs of nearly every
producer – for example an increase in taxes designed to meet the government’s
environmental objectives will cause higher costs and an inward shift in the short run
aggregate supply curve. A rise in VAT on raw materials will have the same effect.
The short run aggregate supply curve is upward sloping because higher prices for goods and
services make output more profitable and enable businesses to expand their production by hiring
less productive labour and other resources
Shifts in aggregate supply in the short run
Shifts in the short run aggregate supply curve are illustrated in the diagram below

The most important single cause of a shift in the short run aggregate supply curve is a change in
wage rates. Higher wage rates without any compensating increase in labour productivity cause a
rise in production costs, leading businesses to produce less and the aggregate supply curve will
shift to the left (i.e. SRAS1 shifts to SRAS2). Conversely a fall in raw material prices or
component costs will reduce production costs, encouraging firms to produce more and the short
run aggregate supply curve moves to the right (i.e. SRAS1 shifts to SRAS3).

Long run aggregate supply (LRAS)

In the long run, the ability of an economy to produce goods and services to meet demand is
based on the state of production technology and the availability and quality of factor inputs.
A long run production function for a country is often written as follows:
Y*t = f (Lt, Kt, Mt)
• Y* is an aggregate measure of potential output in an economy
• T is the time period under consideration
 • L represents the quantity and ability of labour input available to the production process
• K represents the available capital stock, i.e. machinery, buildings and infrastructure
• M represents the availability of natural resources and materials for production i.e. land
LRAS is determined by the stock of a country’s productive resources and also by the
productivity of factor inputs (labour, land and capital). Changes in the state of technology also
affect the potential level of real national output.
The vertical long run aggregate supply curve
In the long run we assume that aggregate supply is independent of the price level. As a result we
draw the long run aggregate supply curve as vertical. In drawing the LRAS as vertical, we are
saying that there is a maximum level of physical output that the economy can produce. Neo-
classical economists view the LRAS curve as being perfectly inelastic at a level of output where
actual GDP has achieved its potential. There will be no unused labour in that all those who are
available for employment at the prevailing wage rate will be in employment – in other words, a
full-employment level of national income has been reached. There will remain the problem of
voluntary unemployment.
According to the neo-classical school of economics, real GDP will in the long run always return
to the level at which all available labour resources have found employment.
Causes of shifts in the long run aggregate supply curve
Any change in the economy that alters the natural rate of growth of output (i.e. trend growth)
shifts the long-run aggregate-supply curve.
Improvements in productivity and efficiency or an increase in the stock of capital and labour
resources cause the LRAS curve to shift out. This is shown in the diagram below. The result is
that a great volume of national output can be produced at any given price level.
The fundamentals of increasing long run aggregate supply
These all relate to the supply-side of the economy
• Expanding the labour supply - e.g. by improving incentives for people to search for
and then accept new jobs as they become available. Government policies seek to expand
the available labour supply by encouraging more people to join the labour force and
become economically active. The UK government has also been encouraging an influx of
migrant labour which has added to the supply of labour although it is also causing
concern about some of the social and political effects.
• Increase the productivity of labour and capital – e.g. by investment in training of the
labour force and improvements in the quality of management and human resource
management
• Increase the occupational and geographical mobility of labour to reduce certain types
of unemployment for example the level of structural unemployment which is caused by
occupational immobility of labour. A reduction in structural unemployment will reduce
the scale of unemployment and provide the economy with a great supply of available
labour.
• Expand the capital stock – i.e. increase the level of capital investment and research and
development spending by firms
• Increase business efficiency by promoting greater competition within and between
markets
• Stimulate a faster pace of invention and innovation – this will hopefully in the long
term promote lower production costs and also improvements in the dynamic efficiency of
markets
Aggregate supply shocks
Aggregate supply shocks might occur when there is
• A sudden rise in oil prices or other essential inputs
• The invention and diffusion of a new production technology

The effects of supply-side shocks are normally to cause a shift in the short run aggregate supply
curve. But there are also occasions when significant changes in production technologies or step-
changes in the productivity of factors of production that were not expected, feed through into a
shift in the long run aggregate supply curve.
In the long-run
In the long run we are all dead. Economists set themselves too easy, too useless a task if in
tempestuous seasons they can only tell us that when the storm is long past the ocean is flat
again.”

AS Macroeconomics / International Economy

Multiplier and Accelerator Effects

In this chapter we look at two ideas, the multiplier and the accelerator, both of which help to
explain how we move from one stage of an economic cycle to another
The multiplier process
An initial change in aggregate demand can have a much greater final impact on the level of
equilibrium national income. This is commonly known as the multiplier effect and it comes
about because injections of demand into the circular flow of income stimulate further rounds
of spending – in other words “one person’s spending is another’s income” – and this can lead to
a much bigger effect on equilibrium output and employment.
Consider a £300 million increase in business capital investment – for example created when
an overseas company decides to build a new production plant in the UK. This will set off a chain
reaction of increases in expenditures. Firms who produce the capital goods that are purchased
will experience an increase in their incomes and profits. If they in turn, collectively spend about
3/5 of that additional income, then £180m will be added to the incomes of others.
At this point, total income has grown by (£300m + (0.6 x £300m).
The sum will continue to increase as the producers of the additional goods and services realize an
increase in their incomes, of which they in turn spend 60% on even more goods and services.
The increase in total income will then be (£300m + (0.6 x £300m) + (0.6 x £180m).
The process can continue indefinitely. But each time, the additional rise in spending and income
is a fraction of the previous addition to the circular flow.
Multiplier effects can be seen when new investment and jobs are attracted into a particular town,
city or region. The final increase in output and employment can be far greater than the initial
injection of demand because of the inter-relationships within the circular flow.
The Multiplier and Keynesian Economics
The concept of the multiplier process became important in the 1930s when John Maynard
Keynes suggested it as a tool to help governments to achieve full employment. This
macroeconomic “demand-management approach”, designed to help overcome a shortage of
business capital investment, measured the amount of government spending needed to reach a
level of national income that would prevent unemployment.
The higher is the propensity to consume domestically produced goods and services, the greater
is the multiplier effect. The government can influence the size of the multiplier through changes
in direct taxes. For example, a cut in the basic rate of income tax will increase the amount of
extra income that can be spent on further goods and services.
Another factor affecting the size of the multiplier effect is the propensity to purchase imports.
If, out of extra income, people spend money on imports, this demand is not passed on in the form
of extra spending on domestically produced output. It leaks away from the circular flow of
income and spending.
The multiplier process also requires that there is sufficient spare capacity in the economy for
extra output to be produced. If short-run aggregate supply is inelastic, the full multiplier effect
is unlikely to occur, because increases in AD will lead to higher prices rather than a full increase
in real national output. In contrast, when SRAS is perfectly elastic a rise in aggregate demand
causes a large increase in national output.
The construction boom and multiplier effects
A study has found that the British construction sector alone has driven a fifth of UK GDP growth
in the past year and 34% of net job creation in the past two years. The construction boom has
been caused by the combination of large projects like Terminal 5, the Channel Tunnel Rail Link,
Wembley Stadium and the Scottish Parliament with a revival in house building, heavy
expenditure by the public sector on new schools and hospitals and a surge in home improvement
expenditure.
The study provides compelling evidence on the multiplier effects of major capital investment
projects. 'One characteristic of construction activity is that it feeds through to many other related
businesses. It has "backward linkages" into the likes of building materials; steel, architectural
services, legal services and insurance, and most of these linkages tend to result in jobs close to
home. This makes a boom in construction peculiarly powerful in fuelling expansion in the
economy - for a given lift in building orders, the multiplier effect may be well over two. This
means that every building job created will generate at least two others in related areas and in
downstream activities such as retailing, which benefits when building workers spend their wages.
Other industries, particularly those where much of the output value comes in the form of
imported components, might have a multiplier of less than 1.5 for new projects'.
Adapted from a report from the Centre for Economics and Business Research
The accelerator effect
Planned capital investment by private sector businesses is linked to the growth of demand for
goods and services. When consumer or export demand is rising strongly, businesses may
increase investment to expand their production capacity and meet the extra demand. This process
is known as the accelerator effect. But the accelerator effect can work in the other direction! A
slowdown in consumer demand can create excess capacity and may lead to a fall in planned
investment demand.
A good example of this in recent years is the telecommunications industry. Capital investment in
this sector surged to record highs in the second half of the 1990s, driven by a fast pace of
technological advance and huge increases in the ICT budgets of corporations, small-to-medium
sized businesses, and extra capital investment by the public sector (including education and
health).
The telecommunications industry invested giant sums in building bigger and faster networks, but
demand has slowed in the first three of the decade, leaving the industry with a vast amount of
spare capacity (an under-utilisation of resources). Capital investment spending in the
telecommunications industry has fallen sharply in the last three years – the accelerator
mechanism working in reverse.
AS Macroeconomics / International Economy
Monetary Policy

Monetary policy influences the decisions that we make about how much we save, borrow and
spend.
What is Money?
Money is defined as any asset that is acceptable as a medium of exchange in payment for goods
and services. The main functions of money are as follows:
1. A medium of exchange used in payment for goods and services
2. A unit of account used to relative measure prices and draw up accounts
3. A standard of deferred payment – for example when using credit to purchase goods
and services now but pay for them later
4. A store of value - money holds its value fairly well unless there is a situation of
accelerating inflation. As the general price level in the economy rises, so the internal
value of a unit of currency decreases.
Interest Rates
There is no unique rate of interest in the economy. For example we distinguish between savings
rates and borrowing rates. However interest rates tend to move in the same direction. For
example if the Bank of England cuts the base rate of interest then we expect to see lower
mortgage rates and lower rates on savings accounts with Banks and Building Societies.
The Real Rate of Interest
The real rate of interest is often important to businesses and consumers when making spending
and saving decisions. The real rate of return on savings, for example, is the money rate of interest
minus the rate of inflation. So if a saver is receiving a money rate of interest of 6% on his
savings, but price inflation is running at 3% per year, the real rate of return on these savings is
only + 3%.
The Job of Monetary Policy
“…to deliver price stability (as defined by the Government’s inflation target) and, subject to this
objective, to support the Government’s economic policy, including its objectives for economic
growth and employment…”
The Bank of England has been independent since 1997. In that time there has been a cycle of
small changes in interest rates. They have varied from 3.75% (in the late autumn of 2003) to
7.5% in the autumn of 1997. Generally though, the UK economy has experienced a sustained
period of low interest rates over recent years. And, this has had important effects on the wider
economy.
The Bank of England prefers a gradualist approach to monetary policy – believing that a
series of small movements in interest rates is a more effective strategy rather than sharp jumps in
the cost of borrowing money. Their aim is not to shock consumers and businesses to control their
spending, but to gradually increase the cost of borrowing money and increase the incentive to
save, so that the pace of growth moderates and the economy can continue to grow without
causing rising inflation.
Factors considered when setting interest rates
1. The State of Demand: Is aggregate demand too strong – for example is household
spending booming at an unsustainable rate?
2. The Housing Market: What are the economic signals coming from the housing market?
If house prices rising too strongly, this might feed through into increased consumer
demand and the risk of a surge in demand-pull inflation.
3. The Labour Market: Are their inflationary signals coming from the labour market in the
form of acceleration in wages and average earnings well above the growth of labour
productivity?
4. Inflation from overseas: Is there a risk from import costs such as a rise in oil prices?
5. Trends in the Exchange Rate: What is happening and what is projected to happen to the
sterling exchange rate?
It is important to note that monetary policy in Britain is designed to be pro-active and forward-
looking. This means that the MPC is aware that changes in interest rates take time to work
through the economic system. Making decisions on interest rates on the basis of today’s inflation
data simply does not make sense. The teams of economists at the Bank must make regular
forecasts of inflation and consider whether the current level of UK interest rates is appropriate in
order to meet the inflation target.
Interest rate changes since 1997
Effects of Changes in Interest Rates
There are several ways in which changes in interest rates influence aggregate demand. These are
collectively known as the transmission mechanism of monetary policy.
One of the principal channels that the MPC can use to influence aggregate demand, and therefore
inflation, is via the lending and borrowing rates charged by the market.
When the Bank’s base interest rate rises, banks will typically increase both the rates that they
charge on loans, and the interest that they offer on savings. This tends to discourage businesses
from taking out loans to finance investment and encourages the consumer to save rather than
spend — and so depresses aggregate demand. Conversely, when the base rate falls, banks tend to
cut the market rates offered on loans and savings. This will tend to stimulate aggregate demand.
Changes to the level of interest rates take time to have an impact on overall economic activity -
i.e. there is a time lag involved. A change in interest rates can have wide-ranging effects on the
economy.

The Bank’s view of the transmission mechanism resulting from a change in official base
interest rates is shown in the flow chart above – the key to it is that short-term changes in interest
rates feed through fairly quickly to the rest of the UK financial system (e.g. resulting in changes
in mortgage interest rates, rates of interest on savings accounts and also credit card rates) and
then start to influence the spending and savings decisions of millions of households and
businesses.
A key influence played by rate changes is the effect on confidence – in particular household’s
confidence about their own personal financial circumstances.
1. Housing market & house prices: Higher interest rates increase the cost of mortgages
and eventually reduce the demand for most types of housing. This will slow down the
growth of household wealth and put a squeeze on equity withdrawal (consumers
borrowing off the back of rising house prices) which adds directly to consumer spending
and can fuel inflation
2. Effective disposable incomes of mortgage payers: If interest rates increase, the income
of homeowners who have variable-rate mortgages will fall – leading to a decline in their
effective purchasing power. The effects of a rate change are greater when the level of
existing mortgage debt is high, leading to a rise in debt-servicing burdens for home-
owners. On the other hand, a rise in interest rates boosts the disposable income of people
who have paid off their mortgage and who have positive net savings in bank and building
society accounts.
3. Consumer demand for credit: Higher interest rates increase the cost of servicing debt
on credit cards and should lead to a deceleration in the growth of retail sales and spending
on consumer durables. Much depends on the impact of a rate change on consumer
confidence.
4. Business capital investment: Firms often take the actual and expected level of interest
rates into account when deciding whether or not to proceed with new capital investment
spending. A rise in short term rates may dampen business confidence and lead to a
reduction in planned capital investment. However, many factors influence investment
decisions other than rate changes.
5. Consumer and business confidence: The relationship between interest rates and
business and consumer confidence is complex, and depends crucially on prevailing
economic conditions. For example, when businesses and consumers are worried about the
risk of a recession, an interest rate cut can boost confidence (and therefore aggregate
demand) because it reassures the public that the Bank is alert to the dangers of an
economic slump. There are circumstances, however, where a cut in rates could
undermine confidence. For example, were the Bank of England to cut interest rates too
quickly, the fear might be that the Bank is particularly worried about the prospects of a
recession. The setting of interest rates nearly always calls for a finely balanced
judgement, particularly when the effects on consumer and business confidence are
concerned.
6. Interest rates and the exchange rate: Higher UK interest rates might lead to an
appreciation of the sterling exchange rate particularly if UK interest rates rise relative to
those in the Euro Zone and the United States attracting inflows of “hot money” into the
British financial system. A stronger exchange rate reduces the competitiveness of UK
exports in overseas markets because it makes our exports appear more expensive when
priced in a foreign currency (leading to a decline in export volumes and market share). It
also reduces the sterling price of imported goods and services leading to lower prices and
rising import penetration. If the trade deficit in goods and services widens, this is a net
withdrawal of demand from the circular flow and acts to reduce excess demand in the
economy.
Usually a UK interest rate cut will tend to weaken the pound as it makes it less attractive for
foreign investors to hold their money in Britain.
When the pound rises, British exports become more expensive, while imported goods from
abroad become cheaper. So a rising pound leads to a fall in demand for UK exports and a fall in
demand for domestically produced goods that compete with imports from overseas. A rising
pound therefore reduces aggregate demand, and so can dampen down the rate of inflation. An
increase in the pound also affects the inflation rate directly by bringing down the price of
imported goods.
Monetary Policy Asymmetry
Fluctuations in interest rates do not have a uniform impact on the economy. Some industries are
more affected by interest rate changes than others (for example exporters and industries
connected to the housing market). And, some regions of the British economy are also more
exposed (sensitive) to a change in the direction of interest rates.
The markets that are most affected by changes in interest rates are those where demand is
interest elastic in other words, market demand responds elastically to a change in interest rates
(or indirectly through changes in the exchange rate).
Good examples of interest-sensitive industries include those directly linked to demand
conditions in the housing market¸ exporters of manufactured goods, the construction industry
and leisure services. In contrast, the demand for basic foods and utilities is less affected by short
term fluctuations in interest rates.
The rate of interest is under the control of the Bank of England, but most other economic
variables are not! The MPC’s decisions can influence consumer and business behaviour but it
cannot determine directly the rate of inflation.
AS Macroeconomics / International Economy
Fiscal Policy

Fiscal policy involves the use of government spending, taxation and borrowing to influence
both the pattern of economic activity and also the level and growth of aggregate demand, output
and employment. It is important to realise that changes in fiscal policy affect both aggregate
demand (AD) and aggregate supply (AS).
Fiscal Policy and Aggregate Demand
Traditionally fiscal policy has been seen as an instrument of demand management. This means
that changes in government spending, direct and indirect taxation and the budget balance can be
used to help smooth out some of the volatility of real national output particularly when the
economy has experienced an external shock. For example, from 2001-2005 there has been a
fiscal stimulus to the UK economy through substantial increases in government spending on
transport, and in particular heavier spending in the twin areas of health and education. This fiscal
stimulus will come to an end in the next couple of years as the government slows down the rate
of which its own spending is increasing.
• The Keynesian school argues that fiscal policy can have powerful effects on aggregate
demand, output and employment when the economy is operating well below full capacity
national output, and where there is a need to provide a demand-stimulus to the economy.
Keynesians believe that there is a clear and justified role for the government to make
active use of fiscal policy measures to manage the level of aggregate demand.
• Monetarist economists on the other hand believe that government spending and tax
changes can only have a temporary effect on aggregate demand, output and jobs and that
monetary policy is a more effective instrument for controlling demand and inflationary
pressure. They are much more sceptical about the wisdom of relying on fiscal policy as a
means of demand management.
The fiscal policy transmission mechanism
How does a change in fiscal policy feed through the economy to affect variables such as
aggregate demand, national output, prices and employment? This simple flow-chart above
identifies some of the possible channels involved with the fiscal policy transmission mechanism.
The multiplier effects of an expansionary fiscal policy depend on how much spare productive
capacity the economy has; how much of any increase in disposable income is spent rather than
saved or spent on imports. And also the effects of fiscal policy on variables such as interest rates
Government spending
Government (or public) spending each year takes up over 40% of gross domestic product.
Spending by the public sector can be broken down into three main areas:
• Transfer Payments: Transfer payments are government welfare payments made
available through the social security system including the Jobseekers’ Allowance, Child
Benefit, the basic State Pension, Housing Benefit, Income Support and the Working
Families Tax Credit. These transfer payments are not included in the national income
accounts because they are not a payment for output produced directly by a factor of
production. Neither are they included in general government spending on goods and
services. The main aim of transfer payments is to provide a basic floor of income or
minimum standard of living for low income households in our society. And they also
provide a means by which the government can change the overall distribution of income
in a country.
• Current Government Spending: i.e. spending on state-provided goods & services that
are provided on a recurrent basis every week, month and year, for example salaries paid
to people working in the NHS and resources used in providing state education and
defence. Current spending is recurring because these services have to be provided day to
day throughout the country. The NHS claims a sizeable proportion of total current
spending – hardly surprising as it is the country’s biggest employer with over one million
people working within the system!
 • Capital Spending: Capital spending would include infrastructural spending such as
spending on new motorways and roads, hospitals, schools and prisons. This investment
spending by the government adds to the economy’s capital stock and clearly can have
important demand and supply side effects in the medium to long term.

Government spending is justified on economic and social grounds including the desire to correct
for perceived market failure when the market mechanism might fail to provide sufficient public
and merit goods for social welfare to be maximized.
Therefore we justify government spending on these grounds:
• To provide a socially efficient level of public goods and merit goods
• To provide a safety-net system of welfare benefits to supplement the incomes of the
poorest in society – this is also part of the process of redistributing income and wealth
• To provide necessary infrastructure via capital spending on transport, education and
health facilities – an important component of a country’s long run aggregate supply
• As a means of managing the level and growth of AD to meet the government’s main
macroeconomic policy objectives such as low inflation and high levels of employment
The Private Finance Initiative (PFI)
The Private Finance Initiative is a way of funding expensive infrastructure developments
without running up debts. Rather than borrowing to fund new projects, John Major's government
entered into a long-term leasing agreement with private contractors. Under a PFI, companies
borrow the cash to build and run new hospitals, schools and prisons for a period of up to 60
years. So far, about 150 PFI contracts have been signed, worth more than £40bn, with more in
the pipeline. PFI is often portrayed as using private money to pay for improvements in public
services. But, critics argue, it is still paid for through the public purse. It is not new money.
Furthermore, the critics say, private finance is, by its nature, more expensive than public capital.
The government of the day may feel it is getting a hospital or school at a bargain price but the
country will pay more in the long run.
Automatic stabilisers and discretionary changes in fiscal policy
Discretionary fiscal changes are deliberate changes in direct and indirect taxation and govt
spending – for example a decision by the government to increase total capital spending on the
road building budget or increase the allocation of resources going direct into the NHS.
Automatic stabilisers include those changes in tax revenues and government spending that
come about automatically as the economy moves through different stages of the business cycle
• Tax revenues: When the economy is expanding rapidly the amount of tax revenue
increases which takes money out of the circular flow of income and spending
• Welfare spending: A growing economy means that the government does not have to
spend as much on means-tested welfare benefits such as income support and
unemployment benefits
• Budget balance and the circular flow: A fast-growing economy tends to lead to a net
outflow of money from the circular flow. Conversely during a slowdown or a recession,
the government normally ends up running a larger budget deficit.
Taxation
We now turn to the revenue that flows into the government’s accounts from taxation. There are
so many different kinds of taxation and the tax system itself often appears to be horrendously
complex! But one important distinction to make is between direct and indirect taxes.
• Direct taxation is levied on income, wealth and profit. Direct taxes include income tax,
national insurance contributions, capital gains tax, and corporation tax.
• Indirect taxes are taxes on spending – such as excise duties on fuel, cigarettes and
alcohol and Value Added Tax (VAT) on many different goods and services
By far the biggest source of income for the government is income tax. In the last tax year the
state received over £127 billion in income tax receipts, nearly fifty billion pounds higher than the
income from national insurance contributions.
Income from selected range of taxes for the UK government 1999-00 2004-05
£ billion £ billion
Income tax 95.7 127.2
National Insurance contributions 56.1 78.1
VAT 56.4 73.0
Corporation tax 34.3 34.1
Fuel duties 22.5 23.3
Council Tax 13.1 20.1
Business rates 15.4 18.7
Other taxes 8.1 11.7
Stamp duties 6.9 9.0
Tobacco duty 5.7 8.1
Vehicle excise duty 4.9 4.7
Beer & cider duties 3.0 3.3
Inheritance tax 2.1 2.9
Spirits duties 1.8 2.4
Capital gains tax 2.1 2.3
Wine duties 1.7 2.2
Customs Duties & levies 2.0 2.2
Betting & Gaming duties 1.5 1.4
Petroleum revenue tax 0.9 1.3
Air Passenger duty 0.9 0.9
Source: HM Treasury Public Finance Statistics

Progressive, proportional and regressive taxes

 • With a progressive tax, the marginal rate of tax rises as income rises. I.e. as people earn
more income, the rate of tax on each extra pound earned goes up. This causes a rise in the
average rate of tax (the percentage of income paid in tax). The UK income tax system is
progressive. Everyone is entitled to a tax-free income. Thereafter, as income grows,
people pay the starting rate of tax (10%) before moving onto the basic tax rate (22%).
Higher income earners pay the top rate of tax (40%) on each additional pound of income
over the top rate tax limit. This is the highest rate of income tax applied.
• With a proportional tax, the marginal rate of tax is constant. For example, we might
have an income tax system that applied a standard rate of tax of 25% across all income
levels. If the marginal rate of tax is constant, the average rate of tax will also be constant.
National insurance contributions are the closest example in the UK of a proportional tax,
although low-income earners do not pay NICs below an income threshold, and NICs also
do not rise for income earned above a top threshold.
• With a regressive tax, the rate of tax falls as incomes rise – I.e. the average rate of tax is
lower for people of higher incomes. In the UK, most examples of regressive taxes come
from excise duties of items of spending such as cigarettes and alcohol. There is well-
documented evidence that the heavy excise duty applied on tobacco has quite a regressive
impact on the distribution of income in the UK.
Fiscal Policy and Aggregate Supply
Changes to fiscal policy can affect the supply-side capacity of the economy and therefore
contribute to long term economic growth. The effects tend to be longer term in nature.
• Labour market incentives: Cuts in income tax might be used to improve incentives for
people to actively seek work and also as a strategy to boost labour productivity. Some
economists argue that welfare benefit reforms are more important than tax cuts in
improving incentives – in particular to create a “wedge” or gap between the incomes of
those people in work and those who are in voluntary unemployment.
• Capital spending. Government capital spending on the national infrastructure (e.g.
improvements to our motorway network or an increase in the building programme for
new schools and hospitals) contributes to an increase in investment across the whole
economy. Lower rates of corporation tax and other business taxes might also be used as a
policy to stimulate a higher level of business investment and attract inward investment
from overseas
• Entrepreneurship and new business creation: Government spending might be used to
fund an expansion in the rate of new small business start-ups
• Research and development and innovation: Government spending, tax credits and
other tax allowances could be used to encourage an increase in private business sector
research and development – designed to improve the international competitiveness of
domestic businesses and contribute to a faster pace of innovation and invention
• Human capital of the workforce: Higher government spending on education and
training (designed to boost the human capital of the workforce) and increased investment
in health and transport can also have important supply-side economic effects in the long
run. An enhanced transport infrastructure is seen by many business organisations as
absolutely essential if the UK is to remain competitive within the European and global
economy
Free market economists are normally sceptical of the effects of government spending in
improving the supply-side of the economy. They argue that lower taxation and tight control of
government spending and borrowing is required to allow the private sector of the economy to
flourish. They believe in a smaller sized state sector so that in the long run, the overall burden of
taxation can come down and thus allow the private sector of the economy to grow and flourish.
However targeted government spending and tax decisions can have a positive impact even
though fiscal policy reforms take a long time to feed through. The key is to help provide the right
incentives for individuals and businesses – for example the incentives to find work and
incentives for businesses to increase employment and investment.

A2 Macroeconomics / International Economy

Government Monetary Policy

How does monetary policy work? What does the Bank of England consider when setting interest
rates and how effective has the Bank been in handling monetary policy since it was made
independent of government in May 1997. These are some of the issues that we consider in this
chapter.
A recap on the basics of monetary policy
Monetary policy involves changes in the base rate of interest to influence the growth of
aggregate demand, the money supply and price inflation. Monetary policy works by changing the
rate of growth of demand for money. Changes in short term interest rates affect the spending and
savings behaviour of households and businesses and therefore feed through the circular flow of
income and spending.
The transmission mechanism of monetary policy works with variable time lags depending on
the interest elasticity of demand for different goods and services. Because of the time lags
involved in setting an appropriate level of short-term interest rates, in the UK the Bank of
England sets rates on the basis of hitting the inflation target over a two year forecasting horizon.
 All countries experience an interest rate cycle as monetary policy responds to changing
economic conditions
Independence for the Bank
The Bank of England has been independent of the Government since 1997. In that time there
has been a cycle of small changes in interest rates. They have varied from 3.75% (in the late
autumn of 2003) to 7.5% in the autumn of 1997. Interest rates in the UK were raised from 4.5%
to 4.75% in August 2006 at a time when interest rates in other countries including the United
States and Japan have been rising. Generally though, the UK economy has experienced a
sustained period of low interest rates over recent years. And, this has had important effects on the
wider economy.
The Bank of England through the decisions of the Monetary Policy Committee prefers a
gradualist approach to monetary policy – believing that a series of small movements in interest
rates is a more effective strategy in achieving their aims rather than sharp and unexpected jumps
in the cost of borrowing money. Knee jerk changes in monetary policy can be very unsettling for
both consumers and businesses throughout the economy.
The role of monetary policy
A summary of the role that monetary policy plays is provided in this quote from the Government
of the Bank of England, Mervyn King.
The role of monetary policy – the Governor’s view
What is the mechanism by which monetary policy contributes to a more stable economy? I
would argue that monetary policy is now more systematic and predictable than before. Inflation
expectations are anchored to the 2% target. Businesses and families expect that monetary policy
will react to offset shocks that are likely to drive inflation away from target. In the jargon of
economists, the “policy reaction function” of the Bank of England is more stable and predictable
than was the case before inflation targeting, and easier to understand. More simply, monetary
policy is not adding to the volatility of the economy in a way that it did in earlier decades.
Adapted from “The Inflation Target – Ten Years On”, Mervyn King in October 2002
Monetary Policy and the Exchange Rate
There is no official exchange rate target for the British economy. The UK operates within a
floating exchange rate system and has done ever since we suspended our membership of the
European exchange rate mechanism (the ERM) in September 1992. The Monetary Policy
Committee has occasionally discussed the relative merits and de-merits of intervening in the
current markets to influence the external value of the pound but no official intervention has
occurred for over a decade. There are in any case doubts about the effectiveness of direct
intervention in the foreign exchange markets as a means of achieving a desired exchange rate.
Monetary policy and the money supply
There are currently no targets for the growth of the money supply measured by MO and M4.
Data on the growth of the stock of money provides useful information for the MPC on the
strength of aggregate demand but interest rates are not determined with reference to specific
targets for the money supply. In addition the UK no longer imposes supply-side controls on the
growth of bank lending and consumer credit. Instead monetary policy in the UK is designed to
control the growth in the demand for money through changing the cost of loans and influencing
the incentive to save via changes in interest rates.
The determination of interest rates – how the Bank gets to work in the markets
It is important to understand how the BOE influences interest rates via daily intervention in the
London money markets. Each day there are huge flows of money from the government to banks
and vice versa. Usually more money flows from the banks to the government (for example
people and companies paying their income tax) so, each day there is a shortage in the market.
The BOE is the main provider of liquidity to the wider financial system, in the markets it is
known as the “lender of last resort”. It can choose the interest rate it wishes to charge to financial
institutions requiring money. The interest rate at which the BOE is prepared to lend to the
financial system is quickly passed on, influencing interest rates in the whole economy - for
example the rate of interest on mortgages and the rates on offer to savers.
Monetary policy in Britain is designed to be pro-active and forward-looking because changes
in interest rates always take time to work through the economy. The reaction of businesses and
consumers to interest rate movements is uncertain, as are the time lags involved. The belief is
that by making interest rate changes in a pre-emptive fashion, for example raising rates before
the rate of growth of AD becomes too fast, or cutting rates to reduce the risks of recession, then
the scale of interest rate changes needed to meet the inflation target will be reduced. The thinking
is that a monetary policy regime that offers the prospects of relatively stable interest rates over
time can help to promote consumer and business confidence.
Factors considered by the Monetary Policy Committee
Before each meeting of the Monetary Policy Committee, a huge raft of economic information is
put before members of the MPC rate-setting board. Much of the data that is considered will be
information that you may have become familiar with during your AS and A2 economics courses.
The economic data considered each month by the MPC includes the following:
• GDP growth and spare capacity: The rate of growth of real national output and the
estimated size of the output gap are central to discussions within the MPC about setting
the appropriate level of interest rates. Their main task is to set monetary policy so that
demand grows more or less in line with the increase in the country’s productive potential.
• Bank lending and consumer credit figures including the levels of mortgage equity
withdrawal from the housing market and also monthly data on credit card lending.
• Equity markets (share prices) and house prices - both are considered important in
determining household wealth which then feeds through to borrowing and retail
spending. The state of play in the UK housing market has been influential in shaping
interest rate decisions over the last two to three years although we must remember that
the monetary policy committee has no official target for the annual rate of house price
inflation.
• Consumer confidence and business confidence indicators – confidence surveys are
thought to provide useful “advance warning” of possible turning points in the economic
cycle. So for example, a sharp dip in consumer optimism might herald a retrenchment of
spending which could lead to slower GDP growth and a weakening of inflationary
pressure.
• The growth of wages, average earnings and unit labour costs in the labour market –
these are considered important as indicators of demand pull and cost push inflationary
pressure. The Monetary Policy Committee might become concerned if the annual rate of
wage inflation surged above the 5% mark as this might eventually feed through into a rise
in consumer prices.
• Unemployment figures and survey evidence on the scale of shortages of skilled labour –
these are also labour market indicators as was mentioned in the last bullet point.
• Trends in global foreign exchange markets – for example the trend in the value of
sterling against the Euro or the US dollar. A weaker exchange rate could be seen as a
threat to inflation because it raises the prices of imported goods and services.
• Forward looking indices such as the Purchasing Managers’ Index and quarterly surveys
of business confidence including data from the Confederation of British Industry and the
British Chambers of Commerce
• International economic data including recent macroeconomic developments in the
twelve member nations of the Euro Zone and the world’s largest economy, the United
States.
The neutral rate of interest
One interesting and important feature of interest rate setting both in the UK and overseas is the
concept of a neutral rate of interest. The idea behind this is that there might be a rate of interest
that neither deliberately seeks to stimulate aggregate demand and growth, nor deliberately seeks
to weaken growth from its current level. In other words, a neutral rate of interest would be that
which is set at a level which encourages a rate of growth of demand close to the estimated trend
rate of growth of real GDP. There can be no such thing as an exact measure of the neutral rate,
and it will certainly differ from country to country.
Students who want to explore this further might want to read up on something called the Taylor
Rule
In Britain over the last two to three years, interest rates set by the Bank of England have almost
certainly been below the estimated neutral rate. Why? Well the Bank has been careful to
maintain economic growth given the absence of any serious threat from higher inflation. In the
summer of 2003, the MPC cut interest rates to 3.5% and it was quite clear at the time that
monetary policy was being expansionary. This means that monetary policy was actively seeking
to stimulate confidence and spending in the domestic British economy at a time of great global
economic uncertainty.
A recent survey of city economists (admittedly a small but pretty high-powered sample!) puts the
neutral rate of interest in the UK at between 4.5 – 5.5%. At the time of writing UK official short-
term interest rates are at 4.75%. This suggests that monetary policy in the UK is now broadly
neutral in terms of its effect on the rate of growth of demand.
The monetary policy transmission mechanism
The usual view of the transmission mechanism of monetary policy is illustrated in the flow
chart below:

Time lags and asymmetries in the transmission mechanism

Although a change in interest rates affects the macro-economy in several ways, there are
inevitable time lags in involved. It is also worth stressing that some sectors of the economy are
more affected by base interest rate changes than others and some regions of the economy are also
more exposed to a change in the direction of interest rates. For example industries that export a
high percentage of their output will be more exposed to movements in the exchange rate that
might follow from a change in monetary policy. Similarly markets whose demand is sensitive to
interest rate changes will be affected to a greater extent than markets where the interest elasticity
of demand is lower.
Consider for example the effect of a 2% rise in interest rates over a period of 6 months. The
demand for basic foods and clothing is unlikely to be influenced much by this whereas the
demand for new cars, expensive household durable goods and other “interest sensitive” products
will probably experience a much greater change in demand from consumers.
The impact of interest rate movements is not uniform throughout the economy. But the Bank of
England sets interest rates to meet a national inflation target, and cannot be expected to
determine interest rates to meet the particular needs of an individual industry, sector or region of
the country.
Macro-policies that seek to raise the level of demand and output in the domestic economy are
called “accommodatory policies”. In other words, they boost demand beyond what would
normally happen through the working of the automatic stabilisers.
The Role of Inflation Targets
Inflation targets have been in place in the UK since the autumn of 1992 and they have also
become a frequent feature of macroeconomic policy-making in many other countries. They were
first introduced following the UK’s departure from the ERM because it was believed that a
credible anti-inflation economic policy needed a clear anchor by which the policy could be
judged.
The inflation target that has been introduced in Britain is symmetrical – this means that
temporary deviations of inflation below the target are treated with the same degree of importance
as deviations above the target. The main reason for this design of the inflation target is that
monetary policy should not only deliver price stability, but also seeks to support the broader aims
of sustained economic growth and high employment.
If the inflation target was set at 2% or below, there might be a tendency for the Bank of England
to drive inflation as low as possible to ensure they meet the inflation target. But this would risk
creating deflationary pressures in many sectors of the economy to such an extent that
unemployment might be higher and national output lower than desired. The Bank of England is
as concerned to avoid some of the economic and social costs of deflation as it is the well
documented implications of a surge in inflation.
Inflation has been remarkably stable since the early 1990s. The next table provides long-term
data for UK inflation since 1950. The average annual rate of inflation fell from 13.1% during the
1970s to just 2.5% since the introduction of the inflation targets. Notice too that the standard
deviation of inflation (a measure of variance) has also come down sharply over the last ten years.
The 1970s and 1980s were by and large, decades of high and volatile inflation. By contrast, the
last fifteen years has been a period of much greater stability, leading to a sustained fall in
inflationary expectations
Long Term Inflation Data for the UK
Annual average percentage change in retail prices
Mean Inflation Standard Deviation
1950-59 4.1 1.06
1960-69 3.7 0.72
1970-79 13.1 1.81
1980-92 6.4 1.14
1993-02 2.5 0.21
Source: Bank of England www.bankofengland.co.uk
There is now a consensus that low and stable inflation can contribute to growth and employment
creation in the long run. To that end, many countries have put in place inflation targets.
Main Advantages of a Credible Inflation Target
Business planning and investment: Businesses are better able to plan ahead if they believe that
the inflation target will be met. They will be more certain about their costs and expected rates of
return on investment
Policy transparency: An inflation target provides improved transparency and accountability for
the conduct of monetary policy – the general public can see for themselves whether the target is
being achieved and whether economic policies are being effective. The target provides clear
rules for monetary policy which in the long term enhances policy-making effectiveness.
Controlling inflationary expectations: A credible target lowers expectations of inflation – and
this helps to control the growth of wages, in other words, a well designed inflation target can be
seen as a key policy “anchor.”
The Problems involved in Forecasting Inflation
Inflation in any economy can never be forecast with perfect accuracy! For a start, the published
inflation measure is the result of millions of pricing decisions made by businesses large and
small operating in thousands of different markets and sub-markets. The calculation of the
consumer price index in the UK although extremely thorough, is always subject to error and
omission.
Furthermore, the complex nature of the inflation process makes it difficult to forecast, even when
inflationary conditions appear to be benign. External economic shocks can make forecasts
inaccurate. For example, a jump in world oil prices or the deep falls in global share prices both
have feedback effects through the economic system. The exchange rate might fluctuate leading
to volatility in the prices of imports.
The Bank of England in its quarterly Inflation Report does not even attempt to forecast a precise
rate of inflation over its two year forecasting horizon. Instead it produces a colourful ‘fan-chart’
which encompasses its central forecast for inflation based on the probabilities of inflation falling
within certain ranges over the next twenty-four months. The central projection is always that the
inflation target will be met. But it could not be otherwise, for if the Bank was to say that its
current interest rates were not appropriate to meeting the inflation target going forward, and then
a change in policy would be required!
Price stability
Inflation has been low and stable in recent years. The former Chairman of the US Federal
Reserve, Alan Greenspan has defined price stability as follows:

“We will be at price stability when households and businesses need not factor expectations of
changes in the average level of prices into their decisions. Price stability" implies that business
and household decision-making should be able to proceed on the basis that "real" and "nominal"
values are substantially the same over the planning horizon
Source: Alan Greenspan, Chairman of the US Federal Reserve, in a speech made in 2000. The
current chairman of the US Federal Reserve is Ben Bernanke
There is no hard and fast numerical rule for price stability – but steady inflation of 1-3% must
come close to meeting the requirements – in this sense, the British economy has enjoyed a return
to price stability in recent years.
Reasons for low inflation in the UK in recent years
Average Unit Labour Producer Prices Retail Price Consumer Price
Earnings Costs Index (CPI) Index (CPI)
% change % change % change % change % change
2000 5 3.4 -0.2 2.9 0.8
2001 5.2 3.8 -0.6 1.8 1.2
2002 3.7 2.6 -0.1 1.6 1.3
2003 3.3 1.9 1.3 2.9 1.4
2004 4.5 2.2 1.2 2.9 1.4
Average 4.5 3.1 0.0 2.5 1.4
1997-2004
Among the factors helping to keep inflation in Britain low, we can identify the following:
• Low wage inflation from the labour market: There has been a very subdued growth of
wages and earnings which have grown at a fairly modest rate in recent years, staying
close to the Bank of England’s desired upper limit of approximately 4.5% per year
despite the sustained fall in unemployment. As the table above illustrates, during the
years 1997-2004, the average rate of growth of earnings has indeed been 4.5%.
• Low global inflation and deflation in some countries: The absence (until recently) of
major external global inflationary shocks such as a sharp jump in international
commodity prices. There has been a clear fall in the average rate of inflation among
leading economies, and this decline in global inflation has filtered through to the UK. Oil
prices have soared during 2004 – but thus far, the effect on the rate of inflation in the UK
has remained modest. This is explored in a separate section on the macroeconomic effects
of an oil price shock in an earlier section of this study companion.
• The effectiveness of monetary policy in the UK: The success of the Bank of England in
keeping aggregate demand under control through interest rate changes
• Increased contestability of many markets: Microeconomic supply-side reforms has led
to much greater competitive pressure in many industries – many markets have become
more contestable in the last decade and this extra competition has placed a discipline on
businesses to control their costs, reduce profit margins and seek improvements in
efficiency. In some industries there has been a huge reduction in the pricing power of
businesses, globalisation has accelerated this process
• Strength of the exchange rate: The recent strength of the pound over the years 1996-
2002 has undoubtedly helped to keep inflation under control because it lowers the
sterling cost of imported products and also squeezes demand for UK exporters
• Information technology effects: The rapid expansion of information and
communication technology has helped to reduce costs and has made prices more
transparent for consumers
• Price cuts within the utilities: Cuts in the prices charged by many of the privatised
utilities under the regulatory regime of bodies such as OFTEL and OFGEM
• Sharp decline in inflation expectations: Expectations of inflation have fallen – leading
to a fall in inflationary wage demands. The wage price spiral has been largely absent
from the British economy over the last decade or more. The Governor of the Bank of
 England, Mervyn King has coined the 1990s as the “nice decade” – a period of time
when a combination of favourable factors has kept inflation in check allowing continued
economic growth and a fall in unemployment!

Aggregate Supply and Aggregate Demand

Complete AS-AD Model

Unlike the aggregate demand curve, the aggregate supply curve does not usually shift
independently. This is because the equation for the aggregate supply curve contains no terms that
are indirectly related to either the price level or output. Instead, the equation for aggregate supply
contains only terms derived from the AS-AD model. For this reason, to understand how the
aggregate supply curve shifts, we must work from the AS-AD model as a whole.

Figure %: Graph of the AS-AD model

depicts the AS-AD model. The intersection of the short-run aggregate supply curve, the long-run
aggregate supply curve, and the aggregate demand curve gives the equilibrium price level and
the equilibrium level of output. This is the starting point for all problems dealing with the AS-
AD model.
Shifts in Aggregate Demand in the AS-AD Model
The primary cause of shifts in the economy is aggregate demand. Recall that aggregate demand
can be affected by consumers both domestic and foreign, the Fed, and the government. For a
review of the shifters of aggregate demand, see the SparkNote on aggregate demand. In general,
any expansionary policy shifts the aggregate demand curve to the right while any contractionary
policy shifts the aggregate demand curve to the left. In the long run, though, since long-term
aggregate supply is fixed by the factors of production, short-term aggregate supply shifts to the
left so that the only effect of a change in aggregate demand is a change in the price level.

Figure %: Graph of an expansionary shift in the AS-AD model.

Let's work through an example. For this example, refer to . Notice that we begin at point A
where short-run aggregate supply curve 1 meets the long-run aggregate supply curve and
aggregate demand curve 1. The point where the short-run aggregate supply curve and the
aggregate demand curve meet is always the short-run equilibrium. The point where the long-run
aggregate supply curve and the aggregate demand curve meet is always the long-run equilibrium.
Thus, we are in long-run equilibrium to begin.
Now say that the Fed pursues expansionary monetary policy. In this case, the aggregate demand
curve shifts to the right from aggregate demand curve 1 to aggregate demand curve 2. The
intersection of short- run aggregate supply curve 1 and aggregate demand curve 2 has now
shifted to the upper right from point A to point B. At point B, both output and the price level
have increased. This is the new short-run equilibrium.
But, as we move to the long run, the expected price level comes into line with the actual price
level as firms, producers, and workers adjust their expectations. When this occurs, the short-run
aggregate supply curve shifts along the aggregate demand curve until the long-run aggregate
supply curve, the short-run aggregate supply curve, and the aggregate demand curve all intersect.
This is represented by point C and is the new equilibrium where short-run aggregate supply
curve 2 equals the long-run aggregate supply curve and aggregate demand curve 2. Thus,
expansionary policy causes output and the price level to increase in the short run, but only the
price level to increase in the long run.

Figure %: Graph of a contractionary shift in the AS- AD model

The opposite case exists when the aggregate demand curve shifts left. For example, say the Fed
pursues contractionary monetary policy. For this example, refer to . Notice that we begin again at
point A where short-run aggregate supply curve 1 meets the long-run aggregate supply curve and
aggregate demand curve 1. We are in long-run equilibrium to begin.
If the Fed pursues contractionary monetary policy, the aggregate demand curve shifts to the left
from aggregate demand curve 1 to aggregate demand curve 2. The intersection of short-run
aggregate supply curve 1 and the aggregate demand curve has now shifted to the lower left from
point A to point B. At point B, both output and the price level have decreased. This is the new
short-run equilibrium.
But, as we move to the long run, the expected price level comes into line with the actual price
level as firms, producers, and workers adjust their expectations. When this occurs, the short-run
aggregate supply curve shifts down along the aggregate demand curve until the long-run
aggregate supply curve, the short-run aggregate supply curve, and the aggregate demand curve
all intersect. This is represented by point C and is the new equilibrium where short-run aggregate
supply curve 2 meets the long-run aggregate supply curve and aggregate demand curve 2. Thus,
contractionary policy causes output and the price level to decrease in the short run, but only the
price level to decrease in the long run.
This is the logic that is applied to all shifts in aggregate demand. The long-run equilibrium is
always dictated by the intersection of the vertical long-run aggregate supply curve and the
aggregate demand curve. The short-run equilibrium is always dictated by the intersection of the
short-run aggregate supply curve and the aggregate demand curve. When the aggregate demand
curve shifts, the economy always shifts from the long-run equilibrium to the short-run
equilibrium and then back to a new long-run equilibrium. By keeping these rules and the
examples above in mind it is possible to interpret the effects of any aggregate demand shift in
both the short run and in the long run.
Shifts in Aggregate Supply in the AS-AD Model
Shifts in the short-run aggregate supply curve are much rarer than shifts in the aggregate demand
curve. Usually, the short-run aggregate supply curve only shifts in response to the aggregate
demand curve. But, when a supply shock occurs, the short-run aggregate supply curve shifts
without prompting from the aggregate demand curve. Fortunately, the correction process is
exactly the same for a shift in the short-run aggregate supply curve as it is for a shift in the
aggregate demand curve. That is, when the short-run aggregate supply curve shifts, a short- run
equilibrium exists where the short-run aggregate supply curve intersects the aggregate demand
curve. Then the aggregate demand curve shifts along the short-run aggregate supply curve until
the aggregate demand curve intersects both the short-run and the long-run aggregate supply
curves. Once the economy reaches this new long-run equilibrium, the price level is changed but
output is not.
There are two types of supply shocks. Adverse supply shocks include things like increases in oil
prices, a drought that destroys crops, and aggressive union actions. In general, adverse supply
shocks cause the price level for a given amount of output to increase. This is represented by a
shift of the short-run aggregate supply curve to the left. Positive supply shocks include things
like decreases in oil prices or an unexpected great crop season. In general, positive supply shocks
cause the price level for a given amount of output to decrease. This is represented by a shift of
the short-run aggregate supply curve to the right.

Figure %: Graph of a positive supply shock in the AS- AD model

Let's work through an example. For this example, refer to . Notice that we begin at point A
where short-run aggregate supply curve 1 meets the long-run aggregate supply curve and
aggregate demand curve 1. Thus, we are in long-run equilibrium to begin.
Now say that a positive supply shock occurs: a reduction in the price of oil. In this case, the
short-run aggregate supply curve shifts to the right from short-run aggregate supply curve 1 to
short-run aggregate supply curve 2. The intersection of short- run aggregate supply curve 2 and
aggregate demand curve 1 has now shifted to the lower right from point A to point B. At point B,
output has increased and the price level has decreased. This is the new short-run equilibrium.
However, as we move to the long run, aggregate demand adjusts to the new price level and
output level. When this occurs, the aggregate demand curve shifts along the short-run aggregate
supply curve until the long-run aggregate supply curve, the short-run aggregate supply curve,
and the aggregate demand curve all intersect. This is represented by point C and is the new
equilibrium where short-run aggregate supply curve 2 equals the long-run aggregate supply
curve and aggregate demand curve 2. Thus, a positive supply shock causes output to increase and
the price level to decrease in the short run, but only the price level to decrease in the long run.

Figure %: Graph of an adverse supply shock in the AS- AD model

Let's work through another example. For this example, refer to . Notice that we begin at point A
where short-run aggregate supply curve 1 meets the long run aggregate supply curve and
aggregate demand curve 1. Thus, we are in long-run equilibrium to begin.
Now say that an adverse supply shock occurs: a terrifying increase in the price of oil. In this
case, the short-run aggregate supply curve shifts to the left from short-run aggregate supply
curve 1 to short-run aggregate supply curve 2. The intersection of short-run aggregate supply
curve 2 and aggregate demand curve 1 has now shifted to the upper left from point A to point B.
At point B, output has decreased and the price level has increased. This condition is called
stagflation. This is also the new short- run equilibrium.
However, as we move to the long run, aggregate demand adjusts to the new price level and
output level. When this occurs, the aggregate demand curve shifts along the short-run aggregate
supply curve until the long-run aggregate supply curve, the short-run aggregate supply curve,
and the aggregate demand curve all intersect. This is represented by point C and is the new
equilibrium where short-run aggregate supply curve 2 equals the long-run aggregate supply
curve and aggregate demand curve 2. Thus, an adverse supply shock causes output to decrease
and the price level to increase in the short run, but only the price level to increase in the long run.
This is the logic that is applied to all shifts in short-run aggregate supply. The long-run
equilibrium is always dictated by the intersection of the vertical long run aggregate supply curve
and the aggregate demand curve. The short-run equilibrium is always dictated by the intersection
of the short-run aggregate supply curve and the aggregate demand curve. When the short-run
aggregate supply curve shifts, the economy always shifts from the long-run equilibrium to the
short-run equilibrium and then back to a new long-run equilibrium. By keeping these rules and
the examples above in mind, it is possible to interpret the effects of any short-run aggregate
supply shift, or supply shock, in both the short run and in the long run.
Conclusions from the AS-AD Model
This section has served a number of purposes. First, we covered how and why the short-run
aggregate supply curve shifts. Second, we reviewed how and why the aggregate demand curve
shifts. Third, we introduced the mechanism that moves the economy from the long run to the
short run and back to the long run when there is a change in either aggregate supply or aggregate
demand. At this stage, you have the ability to use the highly realistic model of the
macroeconomy provided by the AS-AD diagram to analyze the effects of macroeconomic
policies. This will prove to be the most powerful tool in your collection for understanding the
macroeconomy. Use it wisely!

A2 Macroeconomics / International Economy

Fiscal Policy

The government’s handling of its own spending, taxation and government borrowing are the key
components of fiscal policy. In this note we delve deeper into some aspects of fiscal policy
drawing on the concepts covered at AS level.
What is Fiscal Policy?
Fiscal policy involves the use of government spending, taxation and borrowing to influence
both the pattern of economic activity and also the level and growth of aggregate demand, output
and employment. A rise in government expenditure, or a fall in the burden of taxation, should
increase aggregate demand and boost employment. The size of the resulting final change in
equilibrium national income is determined by the multiplier effect. The larger the national
income multiplier, the greater the change in national income will be.
However fiscal policy is also used to influence the supply-side performance of the economy. For
example, changes in fiscal policy can affect competitive conditions individual markets and
industries and change the incentives for people to look for work and for companies to invest and
engages in research and development. Government capital spending on transport infrastructure
and public sector investment in education and health can also have a direct but unpredictable
effect in the long run on the competitiveness and costs of businesses in every industry.
Government Spending
Government spending can be broken down into three main categories:
 ○ General government expenditure - consists of the combined capital and current
spending of central government including debt interest payments to holders of
government debt
○ General government final consumption - is government expenditure on current goods
and services excluding transfer payments
○ Transfer payments – transfers are transfers from taxpayers to benefit recipients through
the working of the social security system. The total welfare bill now exceeds £140 billion
per year
Government Spending and Fiscal Policy Objectives
The Treasury has outlined the main goals of fiscal policy to be the following:
○ Equity concerns: To ensure that government spending and taxation impact fairly within
and across generations – fiscal policy should be equitable to current and future
generations
○ Funding government spending: To meet the government’s spending and tax priorities
without a damaging rise in the burden of government debt
○ The benefit principle: This principle seeks to ensure that those who benefit from public
services such as the benefits from education, health and transport also meet as far as
possible the costs of the services they consume
○ Macroeconomic stability: Fiscal policy in the UK is now designed to support monetary
policy in ‘smoothing the path of aggregate demand over the economic cycle’ and in
contributing to an environment of sustainable growth and stable inflation – this is the
main macroeconomic objective of fiscal policy. Gordon Brown has introduced two fiscal
rules to support this objective
With the total level of government spending rising above £480 billion in 2004, much concern has
been given to the actual results from this level of public sector spending. In particular the size of
the state sector has been criticised by those who claim that public sector spending is open to a
high level of waste and lack of efficiency. The media often talk of the need for the public
services to “deliver” value for money in terms of meeting people’s needs and wants.
Successive governments have striven to improve the efficiency with which public services are
provided. This has included the widespread use of contracting-out and competitive tendering
where private sector businesses compete with the public sector for the contracts to provide
services such as NHS catering, laundry and cleaning services, together with maintenance of the
road network and aspects of the prison service. The government has also introduced value for
money audits for each major government spending department together with a huge and
growing number of performance targets.
A2 Macroeconomics / International Economy
FThe Phillips Curve

The essence of the Phillips Curve is that there is a short-term trade-off between unemployment
and inflation. But the original Phillips Curve has come under sustained attack – in particular
from monetarist economists, and when we consider the data for unemployment and inflation in
Britain over the last fifteen years, we will find that the nature of the trade-off has certainly
changed for the economy and others as well.
The basic Phillips Curve idea – economic trade-offs
In 1958 AW Phillips from whom the Phillips Curve takes its name plotted 95 years of data of
UK wage inflation against unemployment. It seemed to suggest a short-run trade-off between
unemployment and inflation. The theory behind this was fairly straightforward. Falling
unemployment might cause rising inflation and a fall in inflation might only be possible by
allowing unemployment to rise. If the Government wanted to reduce the unemployment rate, it
could increase aggregate demand but, although this might temporarily increase employment, it
could also have inflationary implications in labour and the product markets.
The key to understanding this trade-off is to consider the possible inflationary effects in both
labour and product markets arising from an increase in national income, output and employment.
The labour market: As unemployment falls, some labour shortages may occur where skilled
labour is in short supply. This puts extra pressure on wages to rise, and since wages are usually a
high percentage of total costs, prices may rise as firms pass on these costs to their customers
Other factor markets: Cost-push inflation can also come from rising demand for commodities
such as oil, copper and processed manufactured goods such as steel, concrete and glass. When an
economy is booming, so does demand for these components and raw materials.
Product markets: Rising demand and output puts pressure on scarce resources and can lead to
suppliers raising prices to widen profit margins. The risk of rising prices is greatest when
demand is out-stripping supply-capacity leading to excess demand (i.e. a positive output gap)
Explaining the Phillips Curve concept using AD-AS and the output gap
Let us consider the explanation for the trade-off using AD-AS analysis and the concept of the
output gap. In the next diagram, we draw the LRAS curve as vertical - this makes the
assumption that the productive capacity of an economy in the long run is independent of the
price level.
We see an outward shift of the AD curve (for example caused by a large rise in consumer
spending) which takes the equilibrium level of national output to Y2 beyond potential GDP Yfc.
This creates a positive output gap and it is this that is thought to cause a rise in inflationary
pressure as described above. Excess demand in product markets and factor markets causes a rise
in production costs and this leads to an inward shift in short run aggregate supply from SRAS1 to
SRAS2. The fall in supply takes the economy back towards potential output but at a higher price
level.

So this might help to explain the Phillips Curve idea. We could equally use a diagram that uses a
non-linear SRAS curve to demonstrate the argument. The next diagram shows the original short-
run Phillips Curve and the trade-off between unemployment and inflation:
The NAIRU
Milton Friedman, who criticised the basis for the original Phillips Curve in a speech to the
American Economics Association in 1968, introduced the concept of the NAIRU. It has been
further developed by economists both in the United States and the UK. Leading figures
developing the concept of the NAIRU in the UK include Sir Richard Layard and Prof. Stephen
Nickell at the LSE. Nickell is now a member of the Monetary Policy Committee involved in the
setting of interest rates.
The NAIRU is defined as the rate of unemployment when the rate of wage inflation is stable.
The NAIRU assumes that there is imperfect competition in the labour market where some
workers have collective bargaining power through membership of trade unions with employers.
And, some employers have a degree of monopsony power when they purchase labour inputs.
According to proponents of the concept of the NAIRU, the equilibrium level of unemployment is
the outcome of a bargaining process between firms and workers. In this model, workers have in
their minds a target real wage. This target real wage is influenced by what is happening to
unemployment – it is assumed that the lower the rate of unemployment, the higher workers’
wage demands will be. Employees will seek to bargain their share of a rising level of profits
when the economy is enjoying a cyclical upturn.
Whether or not a business can meet that target real wage during pay negotiations depends partly
on what is happening to labour productivity and also the ability of the business to apply a mark-
up on cost in product markets in which they operate. In highly competitive markets where there
are many competing suppliers; one would expect lower mark-ups (i.e. lower profit margins)
because of competition in the market. In markets dominated by monopoly suppliers, the mark-up
on cost is usually much higher and potentially there is an increased share of the ‘producer
surpluses that workers might opt to bargain for.
If actual unemployment falls below the NAIRU, theory suggests that the balance of power in the
labour market tends to switch to employees rather than employers. The consequence can be that
the economy experiences acceleration in pay settlements and the growth of average earnings.
Ceteris paribus, an increase in wage inflation will cause a rise in cost-push inflationary
pressure.
The expectations-augmented Phillips Curve
The original Phillips Curve idea was subjected to fierce criticism from the Monetarist school
among them the American economist Milton Friedman. Friedman accepted that the short run
Phillips Curve existed – but that in the long run, the Phillips Curve was vertical and that there
was no trade-off between unemployment and inflation.
He argued that each short run Phillips Curve was drawn on the assumption of a given expected
rate of inflation. So if there were an increase in inflation caused by a large monetary expansion
and this had the effect of driving inflationary expectations higher, then this would cause an
upward shift in the short run Phillips Curve.
The monetarist view is that attempts to boost AD to achieve faster growth and lower
unemployment have only a temporary effect on jobs. Friedman argued that a government could
not permanently drive unemployment down below the NAIRU – the result would be higher
inflation which in turn would eventually bring about a return to higher unemployment but with
inflation expectations increased along the way.
Friedman introduced the idea of adaptive expectations – if people see and experience higher
inflation in their everyday lives, they come to expect a higher average rate of inflation in future
time periods. And they (or the trades unions who represent them) may then incorporate these
changing expectations into their pay bargaining. Wages often follow prices. A burst of price
inflation can trigger higher pay claims, rising labour costs and ultimately higher prices for the
goods and services we need and want to buy.
This is illustrated in the next diagram – inflation expectations are higher for SPRC2. The result
may be that higher unemployment is required to keep inflation at a certain target level.
The expectations-augmented Phillips Curve argues that attempts by the government to reduce
unemployment below the natural rate of unemployment by boosting aggregate demand will have
little success in the long run. The effect is merely to create higher inflation and with it an
increase in inflation expectations. The Monetarist school believes that inflation is best controlled
through tight control of money and credit. Credible policies to keep on top of inflation can also
have the beneficial effect of reducing inflation expectations – causing a downward shift in the
Phillips Curve.
The long run Phillips Curve
The long run Phillips Curve is normally drawn as vertical – but the long run curve can shift
inwards over time

An inward shift in the long run Phillips Curve might be brought about by supply-side
improvements to the economy – and in particular a reduction in the natural rate of
unemployment. For example labour market reforms might be successful in reducing frictional
and structural unemployment – perhaps because of improved incentives to find work or gains in
the human capital of the workforce that improves the occupational mobility of labour.
What has happened to the inflation-unemployment trade off for the UK?
The disappearing Phillips Curve
Conventional economic wisdom suggests that rising real GDP growth and falling unemployment
will lead to higher inflation and, furthermore, that any attempt to hold activity above its
sustainable long-run level indefinitely is likely to result in inflation accelerating. But, over the
last decade, inflation has been both subdued and stable, while the unemployment rate has fallen.
Any positive relationship between economic activity and inflation has all but disappeared.
Charles Bean, Chief Economist of the Bank of England, speech given in November 2004
The evidence is that the supposed trade-off for the UK has improved over the last ten to fifteen
years. Indeed since the early 1990s, Britain has enjoyed a long period of falling unemployment
and stable, low inflation. The next table provides some supporting data for this view.
Factors that might explain the improved trade-off
No single factor on its own is sufficient to explain the changing (or improving) trade-off. Some
of the key ones are highlighted and explained below:
1. The flexibility of the UK labour market - A more flexible labour market has increased
the size of the labour supply and a reduction in trade union power has reduced the
collective bargaining power of many workers. Falling long-term unemployment is a
sign of a reduction in structural unemployment rates. We can be pretty certain that the
NAIRU (the non accelerating inflation rate of unemployment) has come down. Although
the NAIRU is not something we can observe and measure directly, it is estimated that the
NAIRU has fallen from nearly 10% of the labour force in 1992 to around 5% in the last
few years.
2. Benefits of immigration – although the precise effects of the economic effects of labour
migration are very hard to quantify with any accuracy, a rise in the size of inward
migration, from the ten EU accession countries and elsewhere, may have helped to
relieve labour shortages in some sectors of the economy and therefore help to control
upward pressures on wage inflation.
3. The effect of credible inflation targets: The use of inflation targets which were
introduced in1992 has helped to reduce inflation expectations. For Britain, the adoption
 of inflation targets has been an important step in establishing a credible monetary policy
framework as a way of “embedding” low-inflation in the British economy.
4. Low inflation in the global economy: External economic factors are important too! For
a decade or more, cost and price inflation in many parts of the global economy has been
on a downward path. Indeed the buzz word has been the threat of deflation in many
developed countries. The rapid advance of globalization has increased the intensity of
competition between nations and reduced the prices of many imported products. The
pricing power of manufacturing businesses in a huge number of international markets has
been greatly diminished by the pressures of globalisation. It has become much harder to
make price increases “stick” when there so many competing suppliers in different
countries.
5. Technological change and innovation has raised labour productivity and cut production
costs across many different industries. This fundamental change in the supply-side of the
British and international economy has been a key factor keeping inflation low even
though unemployment has been falling.
6. Increased competition in domestic and international markets – the British economy
has been affected greatly by the process of deregulation in many domestic markets and
by the increased competitive pressures that come from the globalisation of the world
economy. There is strong evidence that shifts in comparative advantage may have
worked in our favour in recent years. According to research from the Bank of England,
the international terms of trade – that is the price of the goods and services we export
relative to the price of those we import – has moved in Britain’s favour. That means that
if the earnings of people in work were merely to rise in line with the price of UK output,
the purchasing power of UK workers – who buy imported goods as well as goods
produced here – would nevertheless be rising. That in turn has reduced the pressure for
higher wages. This is known as the real-product wage effect. Cheaper imports increase
the real purchasing power of the wages earned by people living and working in the UK.

Why does a change in the Phillips Curve / NAIRU matter?

Our focus here is the possible consequences for the operation of government macroeconomic
policy.
Setting interest rates: Firstly a reduction in the NAIRU will have implications for the setting of
short term interest rates by the Monetary Policy Committee. If they believe that the labour
market can operate with a lower rate of unemployment without the economy risking a big rise in
inflation, then the Bank of England may be prepared to run their monetary policy with a lower
rate of interest for longer. This has knock-on effects for the growth of aggregate demand as
lower interest rates work their way through the transmission mechanism.
Forecasts for economic growth: Secondly the trade-off between unemployment and inflation
affects forecasts for how fast the economy can comfortably grow over the medium term. This
information is a vital for the government when it is deciding on its key fiscal policy decisions.
For example how much they can afford to spend on the major public services education, health,
transport and defence. Forecast growth affects their expected tax revenues which together with
government spending plans then determine how much the government may have to borrow (the
budget deficit).
Key Points
• The potential for a short run trade off between unemployment and inflation continues to
exist! If aggregate demand is allowed to grow well above an economy’s potential output,
then unemployment will fall but there is a risk of rising inflation
• Changes in inflation expectations alter the position of the short run Phillips Curve in the
x-y axis space – a fall in expectations of inflation causes a downward shift of the SRPC
• Monetary policy is probably most influential in affecting expectations of inflation – the
success of the BoE since 1997 has influenced the unemployment-inflation trade off for
the UK. Low global inflation rates have also had the effect of reducing inflation
expectations.
• Supply side policies that raise productivity and increase potential output can help to cause
an inward shift in the long run Phillips Curve
• There has been a fall in the NAIRU in the UK over the last fifteen years because of a
decline in the equilibrium rate of unemployment
• By most estimates, the UK has a lower NAIRU than most of the twelve countries inside
the single currency (Euro Zone). The NAIRU is probably around 5% of the labour force
• Although unemployment has remained low, some external factors have kept inflationary
pressures in check (including the strong exchange rate and falling commodity prices)
A2 Macroeconomics / International Economy
Monetarism and the Quantity Theory of Money

In this section we consider briefly the main principles of the monetarist theory of inflation and
the role that monetary policy can play in stabilising prices and output in an economy.
The basics of monetarism
The key features of monetarist theory are as follows:
○ The main cause of inflation is an excess supply of money leading to in the words of
Monetarist Economist Milton Friedman, “too much money chasing too few goods”. We
will see graphically how this can lead to a build up of inflationary pressure in an
economy.
○ Tight control of money and credit is required to maintain price stability
○ Attempts by the government to use fiscal and monetary policy to “fine-tune” the rate of
growth of aggregate demand are often costly and ineffective. Fiscal policy has a role to
play in stabilising the economy providing that the government is successfully able to
control its own borrowing.
○ The key is for monetary policy to be credible – perhaps in the hands of an independent
central bank – so that people’s expectations of inflation are controlled.
A simple way of explaining how a surge in the amount of money in circulation can feed through
to higher inflation is shown in the next flow chart.
Excess money balances held by households and businesses can affect demand and output in
several directions. Consumers will often increase their own demand for goods and services
adding directly to aggregate demand (although a high proportion of this extra spending may go
on imports).
Secondly some of the excess balances will be saved in bonds and other financial assets, or
invested in the housing market. An increase in the demand for bonds causes a downward
movement in bond interest rates (there is an inverse relationship between the two) and this can
then stimulate an increase in investment.
Similarly money that flows into housing will push house prices higher, and we know understand
quite well how a booming housing market stimulates consumer wealth, borrowing and an
increase in spending.
The Quantity Theory of Money
The Quantity Theory was first developed by Irving Fisher in the inter-war years as is a basic
theoretical explanation for the link between money and the general price level. The quantity
theory rests on what is sometimes known as the Fisher identity or the equation of exchange.
This is an identity which relates total aggregate demand to the total value of output (GDP).
MxV=PxY
Where
1. M is the money supply
2. V is the velocity of circulation of money
3. P is the general price level
4. Y is the real value of national output (i.e. real GDP)
The velocity of circulation represents the number of times that a unit of currency (for example a
£10 note) is used in a given period of time when used as a medium of exchange to buy goods and
services. The velocity of circulation can be calculated by dividing the money value of national
output by the money supply.
In the basic theory of monetarism expressed using the equation of exchange, we assume that
the velocity of circulation of money is predictable and therefore treated as a constant. We also
make a working assumption that the real value of GDP is not influenced by monetary variables.
For example the growth of a country’s productive capacity might be determined by the rate of
productivity growth or an increase in the capital stock. We might therefore treat Y (real GDP) as
a constant too.
If V and Y are treated as constants, then changes in the rate of growth of the money supply will
equate to changes in the general price level. Monetarists believe that the direction of causation is
from money to prices (as we saw in the flow chart on the previous page).
The experience of targeting the growth of the money supply as part of the monetarist experiment
during the 1980s and early 1990s is that the velocity of circulation is not predictable – indeed it
can suddenly change, partly as a result of changes to people’s behaviour in their handling of
money. During the 1980s it was found that direct and predictable links between the growth of the
money supply and the rate of inflation broke down. This eventually caused central banks in
different countries to place less importance on the money supply as a target of monetary policy.
Instead they switched to having exchange rate targets, and latterly they have become devotees of
inflation targets as an anchor for the direction of monetary policy.
Measuring the money supply
There is no unique measure of the money supply because it is used in such a wide variety of
ways:

M0 (Narrow money) - comprises notes and coins in circulation banks' operational balances at
the Bank of England. Over 99% of M0 is made up of notes and coins as cash is used mainly as a
medium of exchange for buying goods and services. Most economists believe that changes in the
amount of cash in circulation have little significant effect on total national output and inflation.
At best M0 is seen as a co-incident indicator of consumer spending and retail sales. If people
increase their cash balances, it is mainly a sign that they are building up these balances to fund
short term increases in spending. M0 reflects changes in the economic cycle, but does not cause
them.

M4 (Broad money) is a wider definition of what constitutes money. M4 includes deposits saved
with banks and building societies and also money created by lending in the form of loans and
overdrafts.

M4 = M0 plus sight (current accounts) and time deposits (savings accounts).

When a bank or another lender grants a loan to a customer, bank liabilities and assets raise by the
same amount and so does the money supply. Again M4 is a useful background indicator to the
strength of demand for credit. The Bank takes M4 growth into account when assessing overall
monetary conditions, but it is not used as an intermediate target of monetary policy. Its main
value is as a signpost of the strength of demand which can then filter through the economy and
eventually affect inflationary pressure.

A2 Macroeconomics / International Economy

International Trade - BRICS

The BRICs
BRIC is a term used to refer to the combination of Brazil, Russia, India, and China – and,
according to a major piece of research from Goldman Sachs, a US investment bank, these are
four countries that are likely to become major if not dominant players in the global economy
over the next twenty to thirty years. The Goldman Sachs forecast for size of GDP is as follows:
Largest economies in 2003 Largest economies in 2025 Largest economies in 2050
USA USA China
Japan China USA
Germany Japan India
UK Germany Japan
France India Brazil
China UK Mexico
Italy France Russia
India Russia Germany
Brazil South Korea UK

2000-05: BRICs contributed 28% of global economic growth

2005: BRICs had 15% share of global trade, double the level of 2001
2005: BRICs held 30% of global reserves of gold and foreign currency
2005: BRICs received 15% of global foreign direct investment and took 3% of FDI outflows
Since 2003, their stocks markets have increased by approximately 150%

Projected real growth in GDP, GDP per capita and working age population: 2005-50 (%
per annum)
Source: PriceWaterhouseCoopers
GDP in US $ GDP per capita GDP GDP GDP at GDP at market
terms at PPPs (PPP (PPP market exchange rates
terms) in terms) in exchange in 2050
2005 2050 rates in 2005
% change pa % change pa US=100 US=100 Percentage Percentage of
of US level US level
India 7.6 4.3 30 100 6 58
Indonesia 7.3 4.2 7 19 2 19
China 6.3 3.8 76 143 18 94
Turkey 5.6 3.4 5 10 3 10
Brazil 5.4 3.2 13 25 5 20
Mexico 4.8 3.3 9 17 6 17
Russia 4.6 3.3 12 14 5 13
S. Korea 3.3 2.6 9 8 6 8
Canada 2.6 1.9 9 9 8 9
Australia 2.6 2 5 6 5 6
US 2.4 1.8 100 100 100 100
Spain 2.3 2.2 9 8 9 8
UK 1.9 2 16 15 18 15
France 1.9 2.1 15 13 17 13
Italy 1.5 1.9 14 10 14 10
Germany 1.5 1.9 20 15 23 15
Japan 1.2 1.9 32 23 39 23

The new workshop of the world – China

A huge amount of discussion has been generated in recent years with the phenomenal growth of
the Chinese economy. The basic statistics of her growth are staggering although such rapid
expansion in output and investment is inevitably creating social, environmental, economic and
political pressures along the way. Production of factory goods in China has surged by 5-10 per
cent a year for over a decade and China now contributes an estimated seven per cent of global
manufacturing production. Since the mid 1990s, nearly £280 billion of foreign direct investment
has found its way into the Chinese economy. China has developed a huge comparative advantage
in the production of motherboards for personal computers and in many other areas of
manufacturing, the economy is poised to reap the benefits of high foreign direct investment and a
large jump in spending on research and development. R&D spending in China increased from
just 0.6% of GDP in 1996 to 1.1% in 2001.
China joined the World Trade Organisation in December 2001.
Annual growth in export and import volumes 2000 2001 2002 2003 2004 2005 2006

China 25.3 6.9 25.7 28.2 22.7 19.4 21.7

World 12.2 0.2 3.5 5.4 10.4 7.5 9.3
Australia, Japan, Korea and New Zealand 12.3 -2.9 7.1 8.1 12.8 6.8 8.3
OECD Europe (inc the UK) 11.6 2.6 1.5 2.6 6.9 5.1 7.3
NAFTA 11.5 -3.8 1.1 2.8 9.4 6.4 7.1
Source: OECD World Economic Outlook, data for 2006 is a forecast