ECONOMICS 2.1 Government & The Economy
ECONOMICS 2.1 Government & The Economy
ECONOMICS 2.1 Government & The Economy
Population ● Population growth must be taken into account when analysing growth patterns
changes ● E.g if GDP grows by 2.8% and the population also rises, this increase in population
will offset the growth in GDP
● GDP will therefore be difficult to calculate
● To overcome this problem, changes in GDP per capita can be calculated (GDP /
size of population)
Statistical ● The gov collects millions of documents for firms, individuals, etc…
errors ● Errors are made because the information has been entered inaccurately or left out
● Therefore, the true value of GDP is never really known
The value of ● Some goods and services are not traded and therefore economic activity is not
home produced recorded
goods ● E.g in undeveloped countries, people rely almost on their own produce to live. It is
not traded and therefore not recorded
● As a result, if such activities are not recorded, the value of national income is
underreported
External costs ● GDP doesn’t take into account the external costs
● As a result, GDP does not measure how these costs impact on the well-being of
society
Boom ● During a boom, GDP is growing fast because the economy is performing well
● Existing firms will be expanding and new firms will be entering the market
● Demand will be rising, jobs will be created, wages will be rising and profits made by
firms will be rising
● However, prices may also be rising
Recession or ● Demand will start to fall for many goods and services - particularly non-essentials
depression ● Unemployment rises sharply, business confidence is very low, bankruptcies rise
and price become flat
● Prices of some things may even fall
Recovery ● Businesses and consumers regain their confidence and economic activity is on the
increase
● Demand starts to rise, unemployment begins to fall
● Prices start to rise again
Standards of ● Increases in GDP mean that on average people have more income - with more
living disposable income, people can buy more goods and services
● Also, as the economy grows, it is possible to spend less time working - because of
improvements in efficiency
● Also, people can live longer - can buy healthier diets
Poverty ● Rapid economic growth reduces poverty (creates new jobs taken by the poor)
● Growing economy means gov collects more tax revenue - gov can spend more on
healthcare, education and provision for poor - reducing poverty
Productive ● Economic growth raises productive potential - meaning a country can produce
potential more goods and services
Inflation ● If economic growth is too fast, the economy may overheat - causing inflation
Environment ● Economic growth leads to more pollution - e.g as economies grow, more cars are
purchased and more flights are taken
● Also, EG uses up non-renewable resources such as oil - once they are used up,
they cannot be replaced - meaning that future generations will have fewer
resources (called unsustainable growth)
2.1.26 Inflation
Key terms:
What is inflation?
● Inflation: general and continuing rise in prices, measured as a rate (%)
● Deflation: a fall in prices OR an economic slowdown (a period of time where
aggregate demand is falling)
● Aggregate demand: total demand in the economy from consumers, businesses, the
government and foreign buyers
Types of inflation:
Demand-pull inflation:
● Demand-pull inflation: inflation is caused by increased (too much) demand in the
economy
KEY CONCEPT: Monetarists believe that inflation may be caused when households, firms
and the government borrow money from banks to fund extra spending.
● This adds to the money supply because there are now more bank deposits (the
borrowed money increases bank balances).
● The extra money lent creates more demand and prices are driven up.
● This type of inflation is likely to occur if interest rates are low
● This is because borrowing is likely to increase when interest rates are low
Wages ● When prices rise, workers will want higher wages to compensate for their loss of
purchasing power
● So inflation may lead to higher wages, but it is not automatic (depends on employer/
time frame)
● Potential spiral: inflation occurs → firm increases wages → firm increases prices
because costs have gone up → higher wages
Exports ● When prices rise domestically, firms will find it harder to sell goods overseas (price of
exports rise) → demand for exports falls → balance of payments is affected
negatively
● Fall in demand for exports could lead to job loss domesticall
Unemployment ● Inflation means aggregate demand is rising → firms want to increase output since
prices are increasing (more revenue!) → more workers are needed to produce these
goods → reduction in unemployment
● There is a tradeoff between inflation and unemployment
Shoe leather ● When prices change frequently consumers & firms spend more time looking for the
costs lowest price/best value → all of this walking around wears out the leather on your
shoes! (metaphorically…)
Uncertainty ● If inflation is high and varying, firms do not know what prices will be in 3 or 6 months
time → making predictions becomes difficult
○ Will investments be wise?
● It’s not ideal for businesses to make long term (financial) decisions, when inflation is
changing prices rapidly in the short term
Business and ● Consumers may feel anxious about high inflation → less willing to borrow money,
consumer more likely to save ‘just-in-case’ (which means less spending!) → lower aggregate
confidence demand→ potentially few jobs/higher unemployment
● Businesses may postpone growth plans or reduce spending → less likely to take
risks → less economic growth
● Hyperinflation: prices spiral out of control, increase by 100s or 1000s of %, can
destabilise a country
Investment ● Investment requires spending large sums in hopes of future returns (earning that
money back and more!)
● Uncertainty leads to low business confidence, which means investment projects are
likely to be postponed/cancelled. → negative impact on economic growth &
employment
2.1.27 Unemployment
Key terms:
Unemployment: when those actively seeking work are unable to find a job
Types of unemployment:
Type Explanation
Structural This type of unemployment happens as a result of changes in the structure of an economy
Unemployment ● Sectorial unemployment: an industry is in decline (coal, video rental stores)
● Technological unemployment: when workers are replaced by machines
● Regional unemployment: unemployment rates can differ by region
Seasonal Some workers only work part of the year (usually due to weather)
Unemployment
Frictional It occurs when people are unemployed as they move from one job to another
unemployment
IMPACT OF UNEMPLOYMENT ON…
Output ● If people are unemployed, the productive potential of a country is not being fully
exploited
● Levels of output are lower than they could be
● This means that the national income and living standard will be lower
● However, if most of the unemployment is a result of new technology being
introduced, output might not fall. Output could actually increase if productivity rises.
Use of scarce People who are out of work do not make any contribution to production, which is a waste of
resources resources and results in lower levels of national income
Poverty ● High unemployment means higher rate of poverty because less people are earning
money and supporting their family
● When people are unemployed their incomes fall as state benefits tend to be lower
than wages
Gov spending ● In most developed countries, when people are unemployed they are entitled to
on benefits receive financial benefit from the state
● If unemployment levels rise, the government has to allocate more money to
unemployment benefits, which incurs an opportunity cost
● Money could be spent on education, healthcare, etc
Tax revenue ● If unemployment rises, tax revenues will fall because most taxes are related to
income and spending
● This means the government has less to spend and may have to cut public services
● Instead, it may borrow more, which will increase national debt or it may have to
increase tax rate
Consumer ● During periods of high unemployment, consumers lose confidence because they
confidence think that they will get laid off or fired
● This will result in consumers spending less money in order to save it
● Also their income falls because state benefits are generally lower than wages.
Business ● When firms lay off workers, they have to pay them redundancy money
confidence ● The remaining workers may be demotivated because they may fear to be the next
● A firm will be left with spare capacity when laying off people and there is likely to be
a fall in demand
● Sales fall when unemployment rises (people have less to spend)
● These events reduce confidence of business decision makers - as a result, they
may cancel investments)
Society ● Mainly local communities workers are employed by a same big firm , if the big firm
closes then it will cause everyone to have less money
● Therefore this will cause the small firms to struggle which means that the
environment will be worse as the economy is poor
○ Individuals might doubt themselves if they get unemployed
○ Unemployment could also lead to crime and raise stress levels
2.1.28 Balance of Payments on Current Account
Key terms:
● Current account balance: difference between total exports and total imports
● Current account balance = value of exports into a country - value of imports
Quality of domestic ● If a country has a reputation for high quality domestic products, it is likely to
goods enjoy high/rising sales from overseas. (eg. wine or olive oil from Spain) →
Increasing demand for exports → higher current account balance
● This also means people of that country will prefer their own high-quality
products, so imports for that product will be low →high current account balance
Quality of foreign ● If goods and services from overseas are superior to domestic products →
goods Increasing demand for imports → lower current account balance
● ** Less demand for home-produced goods could mean lower domestic output
and higher unemployment rates
Price of domestic If domestic goods and services increase in price (due to inflation perhaps) → demand
goods from overseas buyers will fall → lower current account balance
Price of foreign If foreign goods and services area cheaper than those produced at home → increased
goods demand for imports → lower current account balance
Exchange rates Exchange rates affect prices, which will impact demand for imports and exports, which
between countries affects the current account balance.
Low demand ● A country with a high CA deficit may be struggling to sell their goods abroad, due to
for exports low quality or high prices
● This can lead to slow economic growth and high unemployment
● This may also suggest a structural weakness in the economy, that they may not be
able to effectively compete internationally
Funding the ● Foreign currency is needed to pay for the rising quantity of imports
deficit ● It may be necessary to borrow foreign currency (interest!)
● This can be offset with a surplus in the capital account
2.1.29 Protection of the Environment
Key terms:
Power ● Damages the environment if electricity is produced with fossil fuels (coal/oil)
generation ● Fossil fuel plants release: release of hot/dirty water, solid waste, ash, & result in
noise and visual pollution. Worst effect is releasing greenhouse gases
● Nuclear power stations also represent a danger of radioactive waste
Chemical ● Necessary because: chemicals are used in daily life- fuels, paints, cleaning
processing supplies, pesticides, plastics, glues, adhesives, refrigerants.
● Creating chemicals can harm the environment
○ Refineries & chemical processing plants produce HAPs (hazardous air
pollutants) → cause cancer/health problems
○ Some chemical processes release VOCs (volatile organic compounds) into
the air → cause asthma, lung & heart problems
Agriculture ● Use of pesticides and fertilisers: helpful for improving crop yields, but with rainwater
they can pollute rivers & seas and kill aquatic life
● Factory farming is emits huge amounts of greenhouse gases
● Deforestation also results in huge CO2 emissions and destroys wildlife habitats
Construction ● Produces more waste material than any other industry which uses up resources
and causes disposal problems
● Causes of air pollution: land clearing, operation of diesel engines, demolition,
burning/working with toxic materials
○ Also produces lots of dust, which can cause respiratory problems
● Causes of water pollution: Diesel and oil, paint, solvents, cleaners and other
harmful chemicals and construction waste and dirt can be washed into water
systems
WAYS BUSINESSES DAMAGE THE ENVIRONMENT
Visual pollution ● Business activity results in something physical that looks unattractive
● Eg. Giant office buildings, bright illuminated signed, wind farms, overflowing skips, litter
Noise pollution ● Business activity results in excessive noise, causes a disturbance to everyday life
● Eg. jet engines, loud music from bars, machinery/tools, commercial traffic sounds
Air pollution ● Burning fossil fuels: emissions from vehicles, airplanes, etc
● Emissions from factories & other business activities: manufacturing & processing
businesses discharge harmful greenhouse gases
● Agricultural activities: pesticides, fertilisers, ammonia are all byproducts of agricultural
activity.
Water pollution ● Most harmful substances find their way into waterways as a result of business activity:
○ Industrial waste: manufacturing requires water, and waste water is sometimes
dumped into nearby waterways.Most gov's have regulations forcing businesses to
treat the water before dumping it, but it can still be dangerous
○ Marine and ocean dumping: waste materials from shipping, oil leaks, and waste
from the land can pollute the ocean; waste from some countries is dumped directly
into the sea.z
○ Sewerage: sewage in most developed countries is treated before it reaches the
sea, but untreated sewage is harmful (disease, human waste, pharmaceutical
drugs, plastic, etc)
● Marine life is threatened by water pollution. Pollution can also threaten humans' access to
clean drinking water
Taxation Cost imposed on businesses who ● Adv: emissions reduced, green jobs created, tax
create externalities revenue goes to the gov (to fund green projects)
● Disadv: represents a cost to businesses
Subsidies Gov offers grants, tax allowances, ● Adv: firms respond to financial incentives
financial incentive ● Disadv: opportunity cost for the government, can
lead to complacency (low effort from firms)
Regulation Laws: regulations, guidelines, codes ● Adv: sets clear expectations for all firms
of practice, ‘rules’ ● Disadv: hard to monitor/enforce, opportunity cost
Gov agencies check on firms for gov resources creating & enforcing laws
Fines Financial penalty for firms & ● Adv: firms are usually very responsive to financial
individuals who break environmental penalties because they reduce profit
laws ● Disadv: not effective if they aren’t large enough
Pollution Gov issued doc that allows firms to ● Adv: incentivises firms to reduce emissions in
permit discharge a certain amount of order to profit from sale of the permit
polluting material ● Disadv: pollution is being allowed; variables
include cost and number of permits issued
Park Gov establishes protected ● Adv: wildlife, historical sites, scenery, unique land
provision national/state parks to & water features are protected
preserve/protect nature ● Disadv: opportunity cost of land & gov resources
2.1.30 Redistribution of Income
Key terms:
● Income inequality: differences in income that exists between the different groups of
earners in society, that is, the gap between the rich and the poor
Where people do not have enough resources to meet all of Poverty that is defined relative to existing living
the basic human needs standards for the average individual
● People are fighting to survive (no adequate food, ● Those in relative poverty are at the bottom of a
water, shelter, education, sanitation, etc) nation’s income scales (their income falls short
● Often no income, they live in search of of the average standard of living)
food/basic needs ● Calculation of the EU: those living at 60% or
● Levels are low in developed countries due to the less of the median national income, so it varies
government providing basic welfare payments between countries
and programmes for the needy ● This is always present, even in developed
● An estimated 702 million people live in absolute societies
poverty (9.6% of world population)
REASONS TO REDUCE POVERTY & INEQUALITY
Meet basic ● About 10% of the world population are at risk of starvation, especially those who
needs are children. (3.1 million children died of starvation in 2011).
● Malnutrition increases the risks of other diseases, making people more likely to die
of treatable illnesses.
● If absolute poverty is eliminated, basic needs are met, which would lead to less
death from starvation and more healthy children
Raise living ● Although relative poverty will always exist (mathematically) the living standards will
standards rise as income rises
● Those in relative poverty are more likely to become ill and have lower life
expectancy, likely due to: poorer housing, less nutritious diets, reduced access to
healthcare. They are also likely to have lower self-confidence and less control over
their lives and less choice.
● Reduce poverty → higher living standards → more educated population → boost
economic growth → more employment, more income, more tax revenue for gov
Ethical reasons ● Many believe people and governments have a moral obligation to reduce poverty
● It’s seen as a moral duty of both people and governments to help reduce poverty →
reduce human suffering, ensuring people have happier healthier lives
Expansionary Fiscal Policy: Goal is to stimulate the economy (increase aggregate demand)
Stimulate economic ● Increased gov spending → more jobs in the public sector → lower unemployment
growth rates & higher aggregate demand
● Increased gov spending on infrastructure roads, schools, airports) → factors of
production become more mobile → increased productivity
● Cut taxes → households have more disposable income → higher aggregate
demand → suppliers produce more to meet demand
Reduce ● increased gov spending → funds towards hiring + public sector workers or funding
unemployment infrastructure projects that require contracted labour → reduced unemployment
● Increased gov spending or tax cuts - increase aggregate demand → suppliers
boost production to meet demand - additional workers are hired for the increase in
production
Contractionary Fiscal Policy: Goal is to cool off the economy (decrease aggregate demand)
Reduce inflation ● Reduce gov spending → less gov funding for education, healthcare, infrastructure,
etc → fewer public sector jobs → less AD
● Raise taxes → consumers have less disposable income → less aggregate demand
→ less inflation
Reduce current ● Higher taxes or reduced gov spending → reduced aggregate demand → reduce
account deficit demand for imports → lower current account deficit
Protect the ● Higher taxes on polluting businesses → discourage 'non-green' economic activity
environment
2.1.32 Monetary Policy
Key terms:
Inflation ● Monetarists believe inflation happens due to money supply growing too quickly
● To reduce inflation - slow down speed of money supply
● To do this, you would raise interest - which will mean borrowing levels fall - money supply
stops growing so fast
● This will reduce AD(aggregate demand) in economy
Unemployment ● Lowering interest rates will incentivise firms and individuals to take out loans & take more
risks
● Therefore spending increases, so aggregate demand increases
● More workers are hired so that businesses can increase supply to meet high demand
Economic ● Monetary policy can be used to influence the natural economic cycle
growth ● Eg. interest rates are lowered to encourage spending, stimulate the economy and lift a
country out of recession (most countries did this after the 2008 crash)
The current ● To reduce a CA deficit: increase interest rates → lower aggregate demand → less
balance demand for imports
● However, if interest rates are raised, this may also increase the exchange rate, making
exports more expensive and imports cheaper, resulting in a larger CA deficit
● So how can we know how the CA will be affected by higher interest rates? Factors
include:
➔ The strength of link between interest rates & exchange rates: If strong link, higher
interest rates will raise exchange rates. Exports become expensive & imports
cheaper - bad for current balance
➔ Income Elasticity of Imports: If demand for imports were income elastic, higher
interest rates would reduce demand, improving the current balance
➔ Price Elasticity of demand for imports & exports: If both are price elastic and
exchange rates rise when interest rates do, imports would be cheaper and
exports would be more expensive. This would worse the current balance
THE MECHANISM BY WHICH INTEREST RATES CHANGES AFFECT CONSUMERS AND FIRMS
Supply Side Policies: Government measures designed to increase aggregate supply in the
economy (tend to be ‘business friendly’ and increase economic growth)
1. PRODUCTIVITY
Generally improve the productivity of production factors → resources are used more
effectively so potential of economy can be increased
- Improve Flexibility: Previously, it was believed that workers were inflexible. Trade
Unions were an obstacle to this change (forced up wages and resisted the
introduction of new working practices/technology)
- U.K 1980s, legislation to remove trade union power so labour markets could
work more freely (fewer strikes related to wages & less disruption)
- Training & Education: Quality of workforce will increase with more training and
education. Labour productivity will increase therefore so will aggregate supply
- SS Policies promote more competition. This will pressure firms to be more
cost effective and innovative, raising productivity (privatisation & deregulation
play a role in this aim)
- Productivity can increase with more investment. By purchasing technology
and updating facilities, efficiency will improve
- Competition: Some Supply Side Policies aim to promote competition, giving firms
incentive to innovate and cut costs, raising productivity.
2. TOTAL OUTPUT
In this example, the country will be able to produce greater quantities (capital & consumer
goods) when SS policies are used to increase aggregate demand
1. Privatisation
● Helps to break up state monopolies, reduce inefficiencies and promote competition (Private sector = profit
to survive) → Competitive pressure should improve quality and choice
● Public services were contracted out (Eg. meals & cleaning services in schools/hospitals)
● State monopolies become private → consumers might be exploited = price increases and poor quality
services (water supply & energy distribution)
2. Deregulation
● This relaxes laws and rules the government uses to control the market
● This reduces: Excessive paperwork, obtaining unnecessary licences, having lots of committees to approve
a decision, various ‘trivial’ rules that slow down business development
● Inadequate/insufficient regulations may cause problems as business are left unchecked (Eg, Financial
crisis, food safety recalls)
5. Infrastructure Spending
● Gov. invest more in infrastructure to improve economic growth & aggregate supply
○ Improve transportation and communication systems → better geographic mobility; easier
distribution of goods
○ Improve education & healthcare → improve quality of human capital which benefit firms
(Eg. Building roads will allow for trade for many years into the future)
Even if a government favoured the use of FISCAL POLICY to reduce inflation, there is still
negative effects:
1. Higher taxes and low government spending = unemployment (eg. if consumption falls
because of higher taxes, businesses will see a fall in demand for their products - may
react by cutting production and laying off workers / Lower government spending
means that some services are likely to be cut - teachers/nurses/and more must be
laid off)
2. People may suffer from poorer government services after the cuts in expenditure (eg.
waiting times rise, facilities worsen, etc)
● Moneta Policy: if interest rates are lower, people will borrow and spend more / firms
invest more
○ Businesses will develop new products, expand and set up new ventures -
extra investment will drive economic growth
○ They may also use quantitative easing to stimulate growth - helping increase
money supply = increase in aggregate demand
Possible Trade-Off
● These policies may go too expansionary: economy may overheat - firms will not be
able to meet the rising aggregate demand and respond by raising their prices instead
of producing more = demand pull inflation
○ stimulating economy too much = inflation so there’s another trade-off between
these factors
● Inflation is more likely to be caused if their is limited capacity in the economy / factors
of production are immobile
○ If firms have nearly in full capacity and don’t have enough resources =
inflation more likely to occur
● However, SUPPLY SIDE measures are business friendly so they’ll help firms
increase supply (eg. government training schemes = skilled labour to helps firms
meet rising demand
In developed countries where environmental issues are more pressing, governments use:
legislation, fines and pollution permits to protect the environment
● HOWEVER, many restrict business development - it is difficult to find the right
balance in this trade-off
Possible Trade-Off
● Reducing inflation by raising interest rates = CA Balance will worsen for a period of
time
○ Although, the impact of price changes for demand of Imports and Exports will
depend on their elasticity