Table of Contents
Changes in the price level (contraction, extension in AD)..........................................................................3
5 factors affecting consumption (shift inwards/ outwards).......................................................................3
6 factors affecting investment..................................................................................................................5
Keynesian LRAS curve...............................................................................................................................9
Long run economic growth.....................................................................................................................10
Benefits of economic growth..................................................................................................................11
Costs of economic growth.......................................................................................................................12
Evaluation of economic growth..............................................................................................................13
Costs of unemployment..........................................................................................................................17
Benefits of unemployment......................................................................................................................19
Evaluation..............................................................................................................................................19
Policies to reduce unemployment...........................................................................................................19
Demand theories of inflation..................................................................................................................21
1) Quantity theory of money...................................................................................................................21
2) Keynesian demand-pull inflation.........................................................................................................22
Monetarist theory of money...................................................................................................................22
Cost-push inflation..................................................................................................................................23
How do changes in other countries affect UK inflation?..........................................................................23
Limiting factor: Inflation psychology.......................................................................................................24
Costs of high inflation for the performance of the macroeconomy and individuals.................................24
Benefits of low inflation for the performance of the macroeconomy and individuals..............................25
Policies to achieve low inflation..............................................................................................................26
Demand pull inflation:............................................................................................................................26
Cost push inflation:.................................................................................................................................27
Deflation consequences..........................................................................................................................27
The Phillips curve (original = SRPC).........................................................................................................29
Long run Phillips curve (Friedman’s theory).............................................................................................29
Current account......................................................................................................................................31
Causes and consequences of a current account deficit............................................................................32
Evaluation: a deficit may not necessarily be harmful..............................................................................33
Policies to reduce a current account deficit.............................................................................................36
Causes and consequences of a current account surplus...........................................................................38
Policies to reduce a current account surplus............................................................................................39
Financial account....................................................................................................................................40
Key constraints on economic growth and development..........................................................................42
,Arguments for Foreign Direct Investment (FDI).......................................................................................43
Human welfare.......................................................................................................................................44
How to sustain economic growth in the long run....................................................................................44
Rapid economic growth in Africa............................................................................................................45
Chinese reform challenges......................................................................................................................45
Trade vs aid............................................................................................................................................45
Trade in promoting economic growth and development.........................................................................46
David Ricardo’s comparative advantage.................................................................................................47
Gains of free trade..................................................................................................................................47
Arguments for protectionism:.................................................................................................................53
Methods of protectionism.......................................................................................................................54
Tariffs.....................................................................................................................................................54
Embargo.................................................................................................................................................54
Non-tariff barriers...................................................................................................................................55
Import quotas.........................................................................................................................................55
Trade subsidy.........................................................................................................................................55
History of the European Union................................................................................................................56
Pros and cons of monetary union............................................................................................................58
Causes of a currency depreciation...........................................................................................................60
Effects of a currency depreciation...........................................................................................................61
Causes of currency appreciation.............................................................................................................63
Effects of a currency appreciation...........................................................................................................63
Freely floating exchange rates................................................................................................................65
Pros and cons of a freely floating exchange rate.....................................................................................66
Fixed exchange rate................................................................................................................................67
Pros and cons of a fixed exchange rate...................................................................................................68
Managed exchange rate.........................................................................................................................69
Adjustable peg exchange rate.................................................................................................................69
The macroeconomy
To produce the flow of national output, the economy must possess a stock of human capital, together with stocks of
other factors of production: land and entrepreneurship.
National capital stock is the stock of capital goods, like buildings and machinery in the economy that has accumulated
over time and measured at a point in time
,Wealth is the stock of assets which have value at a point in time, as distinct from income which is a flow generated over a
period of time
National wealth is the stock of all goods that exist at a point in time that have value in the economy
National income/ output/ product is the flow of new output produced by the economy in a particular period
Capital consumption is the depreciation of the national stock and to maintain the size of the capital stock (in the absence
of population growth and technical progress), additional investment on replacements is needed. If this investment doesn’t
take place, negative economic growth occurs and the economy’s LRAS shifts inwards (or PPF).
Changes in the price level (contraction, extension in AD)
Trade effect (X – M) = change in the value of PL. If there is an expansion, price level decreases and makes exports more
competitive.
Wealth effect (C)
Interest effect (C, I, X-M) = interest rates will meet the inflation target. Lower interest rates stimulate higher consumption
and investment and reduces the value of exchange rate which boosts net exports.
Useful economics models
1) Harod-Domar model also suggests a higher capital stock increases economic growth
2) Neo-classical Solow growth model, an increase in capital per workers will lead to a rise in the steady rate
of growth. Workers will have access to improved capital machinery which in the long run will improve productivity
Aggregate demand
Aggregate demand = C + I + G + (X - M)
5 factors affecting consumption (shift inwards/ outwards)
Measured through the personal and household savings ration (realised or actual personal saving/ personal disposable
income) – personal includes firms like partnerships and charitable organisations
, Savings ratio increased from 9.1% in January 2020 to 26.5% in July 2020
Depends on the Marginal Propensity to Consume
Bring in the multiplier effect
1. Interest rates and the availability of credit
Rewards savers for sacrificing current consumption for greater reward. An increase in interest rates
encourages saving
The availability of credit
Other aspects of monetary policy like controlling bank lending can affect consumption
If credit is cheap and easy, people supplement current income by borrowing on credit created by the banking
system
However opposite effects occur like in the ‘credit crunch’ where interest rates rose and supply of credit
shrunk, with banks refusing to supply applicants with new credit
2. Level of income
Often called the Keynesian consumption theory. As income rises, although absolute consumption rises,
consumption falls as a fraction of total income, while fraction saved increases. Therein lies the cause of
recessions: too much saving and too little spending
Level of real disposable income affected by income tax and welfare benefits
Distribution of income
Rich people save a greater proportion of their income than poor people (MPC is less)
Household indebtedness also affects this
3. Expectations/ consumer confidence
Expected future income
People plan on the basis of a long-term view of their expected income. This is the life cycle theory of
consumption. Temporary fluctuations generally have little effect on forms of savings like contributions to
pensions and the purchase of life insurance.
Expectations of future inflation
Uncertainty caused by rising inflation increases precautionary saving and reduces consumption but may also
have the opposite effect as households may decide to bring forward consumption decisions by spending on
consumer durables thereby avoiding expected future price increases
People may also decide to borrow to finance house purchases if they expect property prices to appreciate at
a rate faster than general inflation as a ‘hedge’ against inflation
People prefer to buy physical assets in preference to saving through the purchase of financial assets
4. Wealth effect (asset prices)
House prices increase causing:
i. The wealth effect occurs – ‘feel good’ factor among property owners
Changes in the price level (contraction, extension in AD)..........................................................................3
5 factors affecting consumption (shift inwards/ outwards).......................................................................3
6 factors affecting investment..................................................................................................................5
Keynesian LRAS curve...............................................................................................................................9
Long run economic growth.....................................................................................................................10
Benefits of economic growth..................................................................................................................11
Costs of economic growth.......................................................................................................................12
Evaluation of economic growth..............................................................................................................13
Costs of unemployment..........................................................................................................................17
Benefits of unemployment......................................................................................................................19
Evaluation..............................................................................................................................................19
Policies to reduce unemployment...........................................................................................................19
Demand theories of inflation..................................................................................................................21
1) Quantity theory of money...................................................................................................................21
2) Keynesian demand-pull inflation.........................................................................................................22
Monetarist theory of money...................................................................................................................22
Cost-push inflation..................................................................................................................................23
How do changes in other countries affect UK inflation?..........................................................................23
Limiting factor: Inflation psychology.......................................................................................................24
Costs of high inflation for the performance of the macroeconomy and individuals.................................24
Benefits of low inflation for the performance of the macroeconomy and individuals..............................25
Policies to achieve low inflation..............................................................................................................26
Demand pull inflation:............................................................................................................................26
Cost push inflation:.................................................................................................................................27
Deflation consequences..........................................................................................................................27
The Phillips curve (original = SRPC).........................................................................................................29
Long run Phillips curve (Friedman’s theory).............................................................................................29
Current account......................................................................................................................................31
Causes and consequences of a current account deficit............................................................................32
Evaluation: a deficit may not necessarily be harmful..............................................................................33
Policies to reduce a current account deficit.............................................................................................36
Causes and consequences of a current account surplus...........................................................................38
Policies to reduce a current account surplus............................................................................................39
Financial account....................................................................................................................................40
Key constraints on economic growth and development..........................................................................42
,Arguments for Foreign Direct Investment (FDI).......................................................................................43
Human welfare.......................................................................................................................................44
How to sustain economic growth in the long run....................................................................................44
Rapid economic growth in Africa............................................................................................................45
Chinese reform challenges......................................................................................................................45
Trade vs aid............................................................................................................................................45
Trade in promoting economic growth and development.........................................................................46
David Ricardo’s comparative advantage.................................................................................................47
Gains of free trade..................................................................................................................................47
Arguments for protectionism:.................................................................................................................53
Methods of protectionism.......................................................................................................................54
Tariffs.....................................................................................................................................................54
Embargo.................................................................................................................................................54
Non-tariff barriers...................................................................................................................................55
Import quotas.........................................................................................................................................55
Trade subsidy.........................................................................................................................................55
History of the European Union................................................................................................................56
Pros and cons of monetary union............................................................................................................58
Causes of a currency depreciation...........................................................................................................60
Effects of a currency depreciation...........................................................................................................61
Causes of currency appreciation.............................................................................................................63
Effects of a currency appreciation...........................................................................................................63
Freely floating exchange rates................................................................................................................65
Pros and cons of a freely floating exchange rate.....................................................................................66
Fixed exchange rate................................................................................................................................67
Pros and cons of a fixed exchange rate...................................................................................................68
Managed exchange rate.........................................................................................................................69
Adjustable peg exchange rate.................................................................................................................69
The macroeconomy
To produce the flow of national output, the economy must possess a stock of human capital, together with stocks of
other factors of production: land and entrepreneurship.
National capital stock is the stock of capital goods, like buildings and machinery in the economy that has accumulated
over time and measured at a point in time
,Wealth is the stock of assets which have value at a point in time, as distinct from income which is a flow generated over a
period of time
National wealth is the stock of all goods that exist at a point in time that have value in the economy
National income/ output/ product is the flow of new output produced by the economy in a particular period
Capital consumption is the depreciation of the national stock and to maintain the size of the capital stock (in the absence
of population growth and technical progress), additional investment on replacements is needed. If this investment doesn’t
take place, negative economic growth occurs and the economy’s LRAS shifts inwards (or PPF).
Changes in the price level (contraction, extension in AD)
Trade effect (X – M) = change in the value of PL. If there is an expansion, price level decreases and makes exports more
competitive.
Wealth effect (C)
Interest effect (C, I, X-M) = interest rates will meet the inflation target. Lower interest rates stimulate higher consumption
and investment and reduces the value of exchange rate which boosts net exports.
Useful economics models
1) Harod-Domar model also suggests a higher capital stock increases economic growth
2) Neo-classical Solow growth model, an increase in capital per workers will lead to a rise in the steady rate
of growth. Workers will have access to improved capital machinery which in the long run will improve productivity
Aggregate demand
Aggregate demand = C + I + G + (X - M)
5 factors affecting consumption (shift inwards/ outwards)
Measured through the personal and household savings ration (realised or actual personal saving/ personal disposable
income) – personal includes firms like partnerships and charitable organisations
, Savings ratio increased from 9.1% in January 2020 to 26.5% in July 2020
Depends on the Marginal Propensity to Consume
Bring in the multiplier effect
1. Interest rates and the availability of credit
Rewards savers for sacrificing current consumption for greater reward. An increase in interest rates
encourages saving
The availability of credit
Other aspects of monetary policy like controlling bank lending can affect consumption
If credit is cheap and easy, people supplement current income by borrowing on credit created by the banking
system
However opposite effects occur like in the ‘credit crunch’ where interest rates rose and supply of credit
shrunk, with banks refusing to supply applicants with new credit
2. Level of income
Often called the Keynesian consumption theory. As income rises, although absolute consumption rises,
consumption falls as a fraction of total income, while fraction saved increases. Therein lies the cause of
recessions: too much saving and too little spending
Level of real disposable income affected by income tax and welfare benefits
Distribution of income
Rich people save a greater proportion of their income than poor people (MPC is less)
Household indebtedness also affects this
3. Expectations/ consumer confidence
Expected future income
People plan on the basis of a long-term view of their expected income. This is the life cycle theory of
consumption. Temporary fluctuations generally have little effect on forms of savings like contributions to
pensions and the purchase of life insurance.
Expectations of future inflation
Uncertainty caused by rising inflation increases precautionary saving and reduces consumption but may also
have the opposite effect as households may decide to bring forward consumption decisions by spending on
consumer durables thereby avoiding expected future price increases
People may also decide to borrow to finance house purchases if they expect property prices to appreciate at
a rate faster than general inflation as a ‘hedge’ against inflation
People prefer to buy physical assets in preference to saving through the purchase of financial assets
4. Wealth effect (asset prices)
House prices increase causing:
i. The wealth effect occurs – ‘feel good’ factor among property owners
