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Other places to get started:

• Micro Topics by spec - Paper 1 and Paper 3
• Macro Topics by spec - Paper 2 and Paper 3

Recommended websites:

• Physics and Maths Tutor - Current spec past papers
• Zaha Blog - Old past papers, good for MCQs
• Tutor2u - Add this onto your search when looking for information online
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Specification Reference - Micro

This uses the AQA specification from here. You should read through it and then come to here to discover the topics you want more information on.

Economic methodology / Economic Problem

• PPFs

Individual economic decision making (Y2)

• Consumer Behaviour - Utility
• Imperfect information
• Behavioural Economics

Price determination in a competitive market

• Demand
• Supply
• Elasticities
• Determination of equilibrium market prices
• Connections between markets - Types of demand

Production, costs and revenue

• Specialisation and division of labour
• Law of diminishing returns and returns to scale?
• Costs of production
  • Types of costs
• Economies of Scale
• Profit, accounting, normal and supernormal
• Technological change
  • Creative destruction

Market Structures (Perfect competition, imperfectly competitive markets and monopoly) (Y2)

• Types of markets
• Objectives of firms
• Price Discrimination
• Dynamics of competition
  • SR and LR benefits of competition
  • Non-price competition
  • Creative destruction
• Contestable Markets
• Static efficiency
• Dynamic efficiency
• Consumer and producer surplus

The Labour Market

• Demand for labour, MRP
• Influences upon the supply of labour
  • Monetary non-monetary factors
• Imperfectly competitive labour markets - Summary
  • Monopsony
  • Trade Unions
  • NMW
  • Discrimination

Distribution of wealth (Y2)

• Income / Wealth inequality
• Poverty

The market mechanism, market failure and government intervention in markets

• How markets and prices allocate resources
  • The price mechanism
• The meaning of market failure
• Externalities
• Types of goods
  • Public / Quasi-public
  • Private goods (basically not public)
  • Merit and demerit goods
• Market imperfections
  • Imperfect / asymmetric information
  • How monopolies can lead to market failure
  • How immobility of factors of production can lead to market failure
• Competition Policy
  • General principles of UK / EU competition policy
  • Costs / Benefits of such policies
• Public vs Private ownership and deregulation
  • Privatisation
  • Deregulation
  • Regulatory Capture
• Government intervention in markets
  • Market failure provides an argument for government intervention
• Government Failure
  • Occurs when intervention causes a misallocation of resources
  • Can be due to insufficient information or conflicting objectives
  • Can lead to unintended consequences

Production Possibility Frontier

Production Possibility Frontiers show what an economy is capable of producing and the opportunity cost between two goods.

Demand

Demand for a good or service is the quantity that purchasers are willing and able to buy at a given price level in a given period of time.

The basic law of demand is that demand varies inversely with price. Lower prices make products more affordable for consumers.

Factors affecting Demand

All of the following factors will cause a shift in demand.

• Price of substitutes
• Price of complimentary goods
• Income
• Advertising
• Tastes / fashions

Types of Demand

Derived Demand

Demand for a factor of production which derives not from the good itself, but for the good it produces.

• Labour, capital
• plane pilots and planes.

Joint demand

Demand for goods which are interdependent, such that they are demanded together. Complementary goods.

• Bikes and bike helmets

Composite Demand

Demand for a good that has multiple uses.

• Water
• Steel
• Wheat

Competitive Demand

Demand for goods that are in competition with eachother. Rival goods.

• Xbox vs Playstation

Supply

Supply is the quantity of a good or service that a producer is willing and able to supply onto the market at a given price in a given time period.
The basic law of supply is that as the price of a product increases, businesses expand supply to the market.

The profit motive

If the market price rises following an increase in demand, it becomes more profitable for businesses to increase output.

Causes of a shift in supply

1. Changes in the cost of Production

• Lower unit costs mean that a business can supply more at a lower price. Supply increases.
• Higher unit costs cause an inward shift of supply, e.g a rise in wage rates or raw materials.

2. A fall in exchange rate causes an increase in prices of imported goods and raw materials. Supply decreases.
3. Advances in production technologies. Supply increases.
4. Favourable weather conditions. Supply increases.
5. Taxes, subsidies and government regulations.

• Indirect taxes cause an inward shift of supply.
• Subsidies cause an outward shift of supply.

Types of supply

Joint Supply

When the production of one product leads to the creation of another (a by-product)

• Cows for beef and leather.

Competing Supply

A resource that can be used in the production of more than one product.

• Land could be used to produce 1 crop instead of another.

The 4 Factors of Production

Land - Raw materials available from mining, fishing, agriculture Capital - A manufactured item used to aid production, such as machines, factories and computers Labour - Human workers who are involved in producing the good Enterprise - The individual or business who take the initiative to set up a business, and come up with new ideas / innovations.

Examples

Land

• Oil
• Coal
• Fish
• Fruit, vegetables, meat
• Real estate - Land to build factories

Labour

• Workers
• Management

Capital

• Machines
• Hammers, spades, drills
• Tractors
• Computers, phones
• Factories
• Public infrastructure - roads etc.

Changing the factors of production

You can increase the factors of production by either increasing the quality or quantity of one of the factors.
Changing a factor of production will have a long run effect.

Land

1. Increase

• Discovery of new resources

2. Decrease

• Depletion of non-renewable resources

Labour

1. Increase

• Net immigration (more workers)
• Education and training (more skilled workers, able to work more efficiently)

2. Decrease

• Net emigration (less workers)
• Less skilled workers

Capital

1. Increase

• Investment into capital
• New technologies

2. Decrease

• Reduction of investment into capital (machines will break, and need to be replaced)

Enterprise

1. Increase

• Education and training (more educated people have better ideas)

The Price Mechanism

The price mechanism is the means by which decisions of consumers and businesses interact to determine the allocation of resources.
It does not necessary lead to a equitable distribution of resources, and can lead to market failure.

Functions of the price mechanism

Signalling

The price adjusts to demonstrate where resources are required or not required.

An increase in the price of coffee may make producers switch to make more coffee, and may cause consumers to consume less coffee / use a substitute.

Rationing

Higher prices man that only those willing and able to pay are included in the demand. This means when there is a shortage, raising the price will reduce demand.

Allocation

Prices allocate scarce resources among competing uses.

Incentives

When the price of a product rises, quantity supplied increases as businesses respond.

Examples

A taxi firm raises fares at its busiest times by as much as 5x the normal fare. Taxi drivers and customers are notified of the changes by mobile phone. What will result from this policy?

• A - It will be less likely that there is a market equilibrium
• B - Potential customers will have less perfect information?
• C - The market surplus will become a shortage
• D - The supply of taxi rides will become more price elastic.

D - Taxi drivers are more willing to supply rides during higher price times, so the supply will increase in response to price.

Short Run vs Long Run

Short Run - At least one factor of production is fixed

Long Run - All factors of production are variable

Consumer Surplus

The difference between what consumers are willing to pay, and the actual market price

Here, there is a consumer that is willing to pay £4, while the market price is £1. This means they have a consumer surplus of £3 - The good is worth £3 more to them than what they paid for it. The area shown is all consumer surplus.

Producer Surplus

The difference between what a supplier would be willing to sell at, and the actual market price

Here, the supplier would be willing to sell at 20p for a given output level, so they have a surplus of 80p when selling at the actual price of £1. The area shown is all producer surplus

The consumer surplus + the producer surplus is known as welfare. If there is a loss in consumer surplus and producer surplus, this is a welfare loss.

Specialisation

• Concentrating resources on a product or task
• Happens within businesses
• Can happen within a country, such as Bangladesh for textiles
• For specialised countries, they export the good they produce

Advantages

• Increased output. They can focus on being good at making a few goods / services. It is easier to focus on a single product and purchase the components required than to manufacture the components yourself. Fewer areas of expertise are required
• Cheaper products / costs of production. Focusing on one good allows you to produce it at scale, which means you can reduce production costs. You can do this by buying special machines that are more efficient that would not have been worth the investment before.

Disadvantages

• Less demand. Producing a smaller range of products means there are less customers want one of your goods so you may struggle to sell as many products as you could produce.

• Vulnerability. You are vulnerable to changes in wants of consumers. You are also more vulnerable to any laws that may be made, such as if you are producing tobacco. It may also make economies / businesses that depend on you vulnerable. If you go out of business there could be a lack of supply in a good, though this only applies for large businesses.

Division of Labour

Division of labour occurs when the production process of a good is broken down into various small tasks.

Advantages

• Increased output - Because of the repetition, a worker improve at a greater speed at a particular task. This means workers can produce more goods in the same amount of time.
  • The worker has to move around less, so they can spend more time doing the same job instead of walking around or switching tools.
• Less waste - Workers doing the same task repeatedly are less likely to forget something or make a mistake - Their job is simpler. Additionally, they will become more experienced so they will make less mistakes

Disadvantages

• Boredom. Workers get bored doing the same task over and over. In Henry Ford's case, this meant he had to pay workers more to compensate.
• Workers could not produce the product alone. This means it would be difficult for them to get another job, as they are unlikely to find another job in an area they are familiar with. If they created the whole good, they would be able to produce that good or component of it elsewhere.

Elasticities

Measures of elasticity measure how responsive one thing is to a change in another. For example, PED, which measures how Demand varies with price.

Elastic

If an elasticity is elastic, it has a magnitude of greater than 1. For example, 1.5, 2, 3, -3, -6, etc.

This means that it is very responsive to the change.

For example, for PED, a PED value of -2 would mean that consumers are very sensitive to a change in price.

Inelastic

If an elasticity is inelastic, it has a magnitude of less than 1. For example, 0.2, 0.4, -0.3 etc.

This means that it is not very responsive to the change.

For example, for PED, a PED value of -0.2 would mean that consumers are not sensitive to a change in price.

Price Elasticity of Demand

Price elasticity of Demand measures how responsive Demand when price is varied.

\( PED = \frac{\%\Delta QD}{\%\Delta P} \)

PED is almost always negative, since for most goods, price and demand are inversely proportional. (If something costs more, then you buy less.).

Sometimes we drop the minus sign, since its usually obvious anyway.

Factors that affect PED

• Necessity or Luxury
• Percentage of Income
• Width of market - How many substitutes
• Time (over a long time, people will be more able to switch products)

Examples of Elastic PED goods

• Luxury brands / handbags
• Restaurants
• Netflix / Disney+

Examples of Inelastic PED goods

• Houses
• Bread / milk
• Fuel

Perfectly Inelastic Demand

The more inelastic a good is, the more it looks like an 'I' / the more vertical it is. Perfectly inelastic demand means that consumers will always a fixed quantity, regardless of price / supply.

Perfectly Elastic Demand

The more elastic a good is, the more flat it is. Elastic goods are very responsive to changes in price. Perfectly elastic means below the demand curve everything is purchased immediately, and above nothing will be purchased. An example of a perfectly elastic demand curve is commodities / wheat (before regulations). The demand is perfectly elastic, at the market price. Anything above the market price won't be purchased because there are so many other sellers selling at market price.

Income Elasticity of Demand - YED

Income elasticity of demand measures how responsive Demand is when income is varied.

\(\text{YED} =\frac{\%\Delta QD}{\%\Delta Y}\)

Y stands for income.

<---- -2 ---- -1 ----- 0 ----- 1 ----- 2 ------>
       Inferior        |     Normal    | Luxury

Inferior Goods

Inferior goods have a YED of less than 0. This means that when people's incomes increase, they buy less of the good.

For example:

• Own-brand goods

Normal Goods

Normal goods are ones that increase slightly when people incomes increase. They will buy more, but not necessarily a lot more.

For example:

• Branded goods

Luxury Goods

Normal goods are ones that increase significantly when people's incomes increase. They will buy a lot more. They will increase % the amount they buy by more than double their increase in income.

This makes sense for things like holidays, as if someone gets a 10% income rise, all of that income is not being used, so they will have a lot more to spend on luxuries. Also bear in mind that this would be a 20% increase in luxury goods (assuming they have YED of 2), which won't be all of their spending, so it will not be 20% of what they are spending.

• Holidays
• Hotels

Cross Elasticity of Demand

Cross elasticity of demand compares how the demand of one product varies with the price of another product.

\(\text{XED} =\frac{\%\Delta \text{QD of Product A}}{\%\Delta \text{P of Product B}}\)

<---- -2 ---- -1 ----- 0 ----- 1 ----- 2 ------>
      Complimentary    |       Substitutes    

Complimentary Goods

When XED is negative, the two goods are complimentary.

Strong Compliments - Bike + Bike Pump (e.g -2) Weak Compliments - Steak and rice (e.g -0.2)

Substitutes

When XED is positive, the two goods are substitutes (in competition)

Close Rivals - Iphone vs Samsung (e.g 2.5) Weak Rivals - Apples and oranges (e.g -0.4)

Price Elasticity of Supply

Price elasticity of supply measures how the supply of a product varies with its price.

\(\text{PES} =\frac{\%\Delta QS}{\%\Delta P}\)

• Always positive

Elastic supply is better because the company can be responsive to a market in order to maximise profit.

Factors that impact PES

• Capacity utilisation - How close to full capacity is a firm/market operating.
  If there is lots of spare capacity, then supply will be elastic.
• Availability of stock - If there is a lot of spare stock then supply will be
  elastic and vice versa.
• Availability of raw materials - If raw materials are in short supply, this is
  likely to cause supply to be inelastic.
• Time - Over time, supply will be more elastic since firms are able to respond
  to higher prices by investing in more capital

Perfectly Inelastic Supply

Perfectly inelastic supply means that a fixed amount will be supplied regardless of the price level. An example could be the supply of the crown jewels - their price can vary but the quantity supplied won't change, there is always a fixed quantity of 1. Another example is carbon credits - there are a fixed amount given by the government and then firms have to compete for a fixed supply.

Perfectly Elastic Supply

Perfectly elastic supply means that supply will supply an infinite amount of good above/at a certain price level, but nothing below it. An example of perfectly elastic supply is imports - The world supply of a good has a fixed price, and changes in demand in a particular are insignificant compared to the world supply.

Public Goods

Main Characteristics

Non-excludability

Benefits derived from pure public goods cannot be confined to those who have paid for it. Non-payers can enjoy the benefits of consumption at no financial cost to themselves - The free-rider problem.

Non-rival consumption

Each party's enjoyment of the good does not diminish others' enjoyment

Non-rejectable

The collective supply of a pure public good for all means that it cannot be rejectable by people. An example is a national nuclear defence system or major flood defence projects.

Pure Public Goods

Pure public goods have all the properties of a public good

• Streetlights
• National Nuclear defence system

Quasi-public goods

Quasi-public goods have only some of the properties of a public good.

Public Beach

1. Rivalry - Some spots better than others, if the beach is full people will get worse spots.
2. Non-excludable: No requirements to enter the beach.

Wifi Zone

1. Rivalry: Connection gets worse as more people connect
2. Non-excludable: anyone can connect

Parks

1. Rivalry: Benches / better spots get used up
2. Non-excludable: anyone can enter

Economies of Scale

EOS - Economies of scale
MES - Minimum efficient scale
DOS - Diseconomies of scale

Internal Economies of Scale

Internal economies of scale are experienced when a firm becomes larger. They cause the average cost of production to fall as output increases.

Purchasing

Purchasing economies of scale mean that a firm is able to by in bulk, and therefore the average cost per unit is smaller.

Technical

E.g self-checkouts. Larger firms can invest in more technologies that reduces their costs.

Managerial

Using specialised staff who are better at the job. They are able to divide labour more and have more experience in their positions, since they can do a single job more efficiently than having to do multiple, since there is more of that job to be done in a large firm.

Risk-bearing

They are able to expand into new areas and bear the costs if they fail, so they are more likely to take risks, which may result in bigger profits, while having little actual risk to them.

Financial

Large firms are able to get lower interest rates on loans, since they can borrow bigger amounts and are more reliable than smaller firms.

Marketing

Large firms can divide their marketing budgets across larger outputs, so the average cost of advertising per unit is less than a smaller firm's.

External Economies of Scale

External economies of scale occur outside a firm but within an industry.

• Transport networks / infrastructure
• Suppliers relocate closer to firms, decreasing costs
• Influx of human capital / skilled workers.

An example of this is silicon valley.

External economies of scale involve changes outside of the business, such as the expansion of the industry which the firm is a part of. They lower unit costs for many/all firms.

Diseconomies of Scale

When firms get too big, costs can increase - They are no longer in the efficient section of the graph.

Control

Harder to control standards and how the business is run at a low level. You cannot visit every store of Starbucks by yourself regularly.

Communication

Harder to communicate messages in the firm as there are far more people to communicate the message to.

Alienation of workers

When workers are working in a large corporation they can feel alienated as they as an individual are not important to the business. It can cause a loss of morale and decrease productivity.

Internal Politics

Shareholders may have differing opinions on what should be done vs CEO and managers.

Judgements

The extent to which a firm will experience diseconomies of scale depends on how fast the firm grows. A firm growing too fast could mean the firm does not have time to develop systems and processes in order to manage the diseconomies of scale.

Market Failure

Allocative Efficiency - Where consumer satisfaction is maximised. At the equilibrium.

Market Failure - Occurs when the free market mechanism fails to allocate resources in an efficient manner.

Negative Externalities - A cost that is external to the market transaction and thus is not reflected in market prices. Something created but not paid for by the market that is a negative.

Primark Cotton T-shirt example

Private Costs

A cost incurred by an individual as part of its production or other economic transactions.

The firm's private costs:

• Cost of growing cotton
• Cost of manufacturing the t-shirt
• Shipping costs
• Rent of stores
• Wages of store staff

The consumer's private costs:

• Price of the t-shirt

External Costs

A cost that is associated within economic an transaction that is borne by a third party. This third party is often the government.

• Health services to pay for pollution / health issues
• Unemployment from fishing
• Cost of bringing in more water / cost of cleaning up water

Pollution Example

MPC - Marginal Private Cost
MSB - Marginal Social Benefit
MSC - Marginal Social Cost (MPC + Marginal External Cost)
Welfare Loss - Loss to society, filled in on diagram

Negative Production Externality

MSC > MPC

Negative Production - Pollution Example

MSC > MPC

In this example, pollution is used as an example of a negative production externality. Pollution has a negative effect when it is produced, therefore it is a negative production externality. The social cost of producing pollution is higher than the private cost (MSC > MPC), therefore firms overproduce, producing the amount that is good for them, and not at the level which is good for society. The MSC curve is to the left of the MPC curve since that is like the supply curve, but is more costly than the MPC curve, therefore it is to the left.

When there is a negative production externality, we want to reduce production in order to maximise social welfare. (This makes sense, as less pollution is good). However no pollution would not be truly best for society because this would mean having to shut down lots of power stations, and leave many without power, and then likely there would be shortages of water and food.

The filled in area represents the welfare loss because of the market failure.

Other examples

• Cheap clothes
• Flights

Negative Consumption - Smoking Example

MSB < MPB

In this example, smoking is used as an example of a negative consumption externality. Smoking has a negative effect when consumed. This is because they lead to health problems which will then have to be paid for by the country's healthcare system, and may lead to workers having more sick days and working less. The social benefit of smoking is less than the private benefit of smoking. Therefore people consume more cigarettes than they should. The MSB curve is like a demand curve. If consumers consumed based on the MSB then they would consume less, i.e a shift to the left of the MPB.

When there is a negative consumption externality, we want to decrease consumption in order to maximise social welfare. However no smoking may be worse overall for the society as no money / business is gained from the sale of cigarettes (and the taxes come with it).

The filled in area represents the welfare loss because of market failure.

Other examples

• Cars

Positive Production - Training in transferable skills Example

MSC < MPC

In this example, training in transferable skills is used as an example of a positive production externality. Training in transferable skills is done by individual firms, but increases the skill of the worker. This means that there is a gain for all firms in future who hire the same worker. If all firms are training their staff, then all firms will gain from other firms' training of workers. The private cost of training is more than social cost (MPC > MSC), this means that firms do not train workers as much as they should, because it costs them more than it costs society. The MSC curve is to the right of the MPC curve because they are like supply curves, where the costs of production are lower for society compared to the private cost, so MSC is to the right of MPC.

When there is a positive production externality, we want to increase production of the good in order to maximise societal welfare.

Positive Consumption - Education Example

MPB < MSB

In this example, education is used as an example of a positive consumption externality. Education has a positive effect when consumed, since all firms that later hire that worker will have a more skilled worker that is more productive and efficient. The MPB of education is lower than the MSB since more education results in higher expected wages, but does not account for the increased productivity gained by the firms that you work for. This is why MSB is higher than MPB. MSB is like a demand curve, and we want consumers to demand education more, as it provides a greater benefit than they receive.

When there is a positive consumption externality, we want to increase demand to maximise social welfare.

The filled in area represents the welfare loss because of the market failure.

Government Intervention

Sometimes the free market mechanism fails to allocate resources efficiently (Market Failure).

In order to solve the market failure, the government can intervene through various ways.

Government Failure

• Government Failure occurs when an intervention leads to a deeper market failure, or worse, a new market failure
• Intervention creates further inefficiencies, a missallocation of resources and a loss of economic / social welfare

1. Policies may have damaging long-term consequences for the economy or society
2. Policies may be ineffective in meeting their stated aims
3. Policies may create more losers than winners

• Can happen if a policy decision fails to create enough of an incentive to change people's behaviour

Possible Causes

• Political Self-interest
• Policy myopia - Quick fixes
• Regulatory Capture
  • Where regulation is designed / influenced by the group it is targetting
• Information failure
• Disincentive effects
• High enforcement / compliance costs
• Conflicting policy objectives
  • Minimum carbon price vs UK competitiveness
• Bureaucracy / Read tape
  • Costs of enforcement may hurt enterprise and incentives
• Unintended consequences
  • Black markets
  • Bank bail outs -> causes moral hazard
  • People circumvent new laws

Indirect Tax

A payment that is levied on a good / service by the government.

Positives

• Generates revenue for the government to spend on solving market failure -> Hypothecation
• Encourages consumption of other products that have less of a negative impact - Such as more sustainable fashion or healthier food
• Financial intervention tends to be more effective than other methods such as advertising, since people change their purchasing decisions based on price signals.
• if set correctly, the tax will solve the market failure and internalise the negative externality (The 1st and second party will pay the externality) and create a socially optimal outcome.

Negatives

• If set incorrectly, can be government failure
• Penalises people who don't over consume
• Indirect taxes are regressive. This means low income earners pay more tax, as a % of their income compared to high income earners.
• An indirect tax will be less effective on inelastic products.
• Difficult to place monetary values on MEC, this involves using judgements. If set incorrectly

Depends upon / Judgments

• The PED of the product. If the PED is inelastic, then a change in price won't cause much of a change in demand, and so the tax will be ineffective.

Incidence of tax

Elastic

When demand is elastic, consumers are sensitive to price changes, so the firm pays most of the tax, in order to maximise their profits.

Inelastic

When demand is inelastic, consumers are insensitive to price changes, so the firm pushes the tax onto consumer to maximise profit.

Minimum Price

A minimum price is set by the government to limit the price to a certain price level. It must be set above the market equilibrium price or it will have no effect.

The market equilibrium was at PQ, but after the intervention it creates a disequilibrium. Supply is at Q2 but demand is at Q1. This means that firms are willing to supply more than people are demanding, so there is likely to be a surplus.

Positives

• Reduce consumption of a negative product

Negatives

• Creates disequilibrium
• No revenue generated for the government
• Could create illegal markets
• Depends upon elasticity

Examples

• Alcohol (In Scotland)
• Agriculture (In EU) - Ensures that there is always spare supply and enough food for everyone. Some argue farmers' incomes are too low.

Maximum Price

A maximum price is set by the government to limit the price to a certain price level. It must be set under the market equilibrium price or it will have no effect.

The market equilibrium was at PQ, but after the intervention it creates a disequilibrium. Supply is a Q1 but demand is at Q2. This means that there is more people willing to purchase at that price than there are firms willing to supply, so there is likely to be a shortage.

Positives

• More affordable to LIC
• Ensure affordability of necessity

Negatives

• Creates disequilibrium
• Excess demand
• Firms leave the market
• Lack of investment

Examples

• Energy market (Gas & electric)
• Water
• Rental

Subsidy

A payment made to firms from the government in order to decrease the cost of production and increase supply of a good / service.

Examples

• Education
• Farming
• Free school meals
• Bike scheme
• NHS
• Public transport
• Electric cars
• Leisure centre

Positives

• If set correctly will correct market failure and create a socially optimal outcome. The market will operate efficiently.
• The third party will receive an increased benefit of consumption / production
• Products become more affordable to lower income consumers (progressive). For example, education is fully subsidised by the government
• A price incentive is more effective than other methods such as advertising

Negatives

• Subsidies are expensive
• Government failure will occur if the subsidy is set too high or low (because where to set it is based on a value judgement)
• Firms can be inefficient, as they rely on the subsidy and therefore don't seek to lower costs, since the subsidy will give them sufficient profit.
• Not all of the subsidy is passed on to consumers
• The impact of the subsidy will depend upon the elasticity of demand.

Judgements

• If PED is inelastic, the reduction in price won't make much difference in demand, and firms won't lower their prices much.

Diagrams

With a subsidy, we want to increase quantity since there is a positive externality that is unaccounted for in the price.

Positive Production

In order to correct a positive production market failure, we add a subsidy, adding a new line with the subsidy, which decreases the price and increases quantity.

Positive Consumption

A positive consumption diagram is more complicated, we can move the quantity to the correct level, but the price will not be at the socially optimal level.

Regulation

Laws that are implemented to encourage or discourage the production or consumption of a good or service.

Examples

Consumption

• Age restriction
• Smoking indoors ban
• Driving licenses
• Pictures on packaging
• Products not on show
• Gambling restrictions
• Education until 18

Production

• Quotas / limits on production of some products
• Environmental Laws
• Employment, such as National Minimum Wage
• Health and safety laws

Positives

• Regulations are backed by the law, there are consequences if they are broken
• Widely used and proven to be effective, such as the smoking ban indoors.
• If used correctly, they create a socially optimal outcome
• Not regressive

Negatives

• Can lead to the creation of an illegal marketplace
• Opportunity cost in enforcing regulations. Must be policed, which is expensive
• Deterrent must be large enough, to discourage individuals / firms from breaking the regulations
• If fines / deterrents are set incorrectly, this is a form of government failure
• Environmental regulation - difficult to prove who has broken the regulation.

Market Structures Intro

Market structures characterise how some markets behave. They are:

• Perfect Competition
• Monopolistic
• Oligopoly
• Monopoly

As well as an alternative model: Contestable Markets

Common topics

The types of profit

Barriers to entry

Barriers to entry are factors that prevents new entrants into a marketplace.

Examples:

• Economies of Scale, e.g Marketing
• Strong Branding
• Scope of products
• High start-up costs
• Technology / Capital
• High market share
• Copyright / patents / trademarks

Profit Maximisation

This means firms try to maximise profit. This point is at MR=MC

Efficiency

Static efficiency

Efficiency at a particular point in time (productive and allocative)

Dynamic Efficiency

Requires SNP in LR - Monopoly, Oligopoly

The development of new products and more efficient processes that improve productive efficiency in the LR.

Profit

Accounting Profit - Total Revenue - Total Costs
Super-normal Profit (SNP) - The amount of profit above normal profit

Normal Profit

Normal profit is the minimum amount of profit required to remain in a marketplace.

If the profit falls below this, then the firm will leave the marketplace and switch to the next best alternative market (provided there are low barriers to exit / low sunk costs).

The Role of Profit

Profit plays an important role in the market economy.

• Profit is the reward to shareholders and owners of a business
• Profit creates incentives for enterprise / innovation
• Profit attracts more firms to an industry, increasing competition
  • This decreases prices in the LR, as firms compete on price
  • This leads to increased choice as there are more products from different firms to chose from
  • Super-normal profit is competed away in the LR
• Profit in the LR allows for Research & Development
  • This leads to dynamic efficiency
  • This leads to lower prices and higher quality products in the LR
  • Increased productivity -> economic growth
• Lack of profit in a industry will cause firms to leave the industry
  • This means profit helps signal where more or less supply is needed in an industry, helping to achieve allocative efficiency
• Higher profit enables wages to rise
• Profit can be taxed via corporate tax to allow the government to gain revenue
• Profit can allow firms to build up a buffer against an economic downturn

Profit Evaluation

• Profit can drive firms to cut corners, for example:
  • Dumping waste / excess pollution
  • Underpaying workers
• Profit can cause firms to take too many risks, i.e 2008
• Profit can lead to inequality especially if firms have monopoly/monopsony power
  • It can allow market abuse, such as undercutting competitors to drive out competition
• Firms may have other objectives

Perfect Competition

Perfect competition is an ideal, unrealistic marketplace, useful to compare real marketplaces to.

Characteristics

1. No barriers to entry / exit
2. Many buyers and sellers
3. Homogenous products
4. Price Takers
5. Super-normal profit in the SR only
6. Mobile factors of production - can change marketplaces easily, e.g shifting from a carrot farmer to a potato farmer
7. Profit maximiser
8. Productively and allocatively efficient
9. Perfect Knowledge - For buyer and seller.

Demand shifting right

This could happen due to changes in trends, etc.

At first, in the SR, the firm makes super-normal profit as the market price of the product rises and the firm is able to charge a higher price than its costs.

However, in the long run, SNP is competed away as new firms enter the market in order to get in on the SNP. Supply shifts right due to new firms entering the market, and the price returns to its original level.

Monopolistic

Characteristics

• Low barriers to entry
• Many buyers and sellers
• SNP in SR only
• Differentiated products
• Price Maker

Examples

• Local takeaway - (Chinese, chippy, Italian food, Pizza, Kebab)
• Estate Agent

SR

In the SR a monopolistic firm can behave like a monopoly - the diagram is the same.

LR

However, in the LR, other firms see there is super normal profit, and since there is only low barriers to entry, other firms are able to enter the market and compete away the SNP.

Oligopoly

An oligopoly is a market structure where a few firms dominate, so they are highly interdenpedent.

Characteristics

• High barriers to entry
• A few firms dominate / high concentration ration
• Profit maximisation
• Interdependence between firms
• Non-price competition
• Strong branding exists
• Collusion likely

Examples

• Mobile phone networks
• Supermarkets
• Car manufacturers
• High street banks
• Film studios

Non-price competition

In an oligopoly, firms will engage in non-price competition, since if they lower prices, they are likely to enter a price war.

Examples:

• Marketing / Branding
• Loyalty schemes
• Promotions
• Quality
• Convenience

Kinked Demand Curve

The kinked demand curve demonstrates why there is non-price competition. Since there is interdependence, the other firms in the oligopoly will react rapdly to price changes.

If one firm drops their prices, the rest will follow, which leads to demand not increasing by much (Moving in the inelastic region).
If one firm raises their prices, the rest will keep their prices the same, and consumers will switch to other firms, causing a big drop in demand (moving in the elastic region).
This means that the most logical thing to do is keep the price the same.

Discontinuous MR

In oligopoly, there is a gap in MR between the two MC curves. This is because between these two cost curves, firms will not change their price. This is because if they raise prices, they will lose more customers and profit in comparison to keeping prices the same.
Alternatively, lowering prices would likely result in a price war, which would also mean lower profits.

Collusion

Collusion is where firms cooperate in their pricing and output policies. Firms are incentivised to collude because it allows them to eliminate risk, and gain the best outcome. (Prisoner's Dilemma)

Tacit Collusion

• Legal
• Firms follow a market leader / copy a large rival
• No communication occurs between the firms

Examples: Aldi price matching, Apple Airpods -> Galaxy pods.

Evaluation of the oligopoly model

• There are many examples of price competition - e.g Aldi
• Examples of new entrants to oligopolies - e.g Telsa, Disney+ (Large backing firm)
• Does not explain how firms arrive at the original price
• Does not account for the fact firms can test price changes to see if other prices react

Monopoly

A monopoly is a market structure where a single firm dominates, so they can abuse their market power.

Legal monopoly - 25% market share
Economic monopoly - 40% market share

Characteristics

• Very high barriers to entry
• Price makers
• SNP in SR and LR
• Profit maximiser
• One firm dominates / very high concentration ratio
• Large Economies of Scale
• Likely to abuse market power

Examples

• Tesco - legal monopoly
• Microsoft
• Blu-tac

Abuse of market power

A monopoly firm can use its market power to abuse various parties

Consumers

Raise prices above market equilibrium, since consumers have no alternative. They can also reduce output to create scarcity and raise the price of their product.

Rival firms

Lower prices below market equilibrium and make losses until the other firm is forced to leave the market

Suppliers

Refuse to buy raw materials unless they drop their prices - since suppliers depend on the firm for profit.

Natural Monopoly

In some cases, competition decreases efficiency, for example:

• Railways
• Water provision
• Electricity - National grid

Characteristics

• Extremely high capital cost to set up
• Duplication is unnecessary and wasteful
• Competition does not benefit the consumer

Costs fall in the LR due to Economies of Scale, but do not increase due to Diseconomies of Scale.

The Law of Diminishing returns does not apply to Natural Monopolies because there is so much Capital, that you can keep adding variable factors to it.

Price Discrimination

Price discrimination is a way to reduce consumer surplus and turn in into producer surplus.

You can eliminate consumer surplus with first degree price discrimination, in an auction. This allows you to extract the highest price from every consumer.

Types

First degree - Different price to each individual consumer (perfect price discrimination)
Second degree - Different price to different groups of customers
Third degree - Different price in each country

Consequences of Price Discrimination

• Increased profits redistribute income from consumers to producers
• Output will be larger -> Greater Economies of Scale
• Higher revenue -> Potential for greater SNP -> More R&D / Dynamic efficiency

Effect on Consumers

• Loss of welfare - Consumer surplus disappears in 1st degree price discrimination
• Inequitable - Some consumers have to pay more than others
• If profits reinvested, consumers may get LR benefits, such as increased efficiency -> lower costs and prices
• Lower prices might mean poorer consumers may be able to afford the product

Examples of second degree price discrimination

• Adult vs Child tickets
• Insurance -> age, no claims
• Train -> Peak and off-peak
• Flights -> School holidays / when you book

Why can train passengers be charged more for peak travel

Peak travellers are travelling as a necessity, so their demand is inelastic, so they can raise prices without losing many customers. On the other hand, off-peak is usually leisure travel, so it is elastic, and if prices are raised, demand will fall quickly.

Uber Surge pricing

Uber varies it prices a lot depending on:

• Time
• Demand
• Rain / weather
• Amount of available drivers / supply
• Location

Contestable Markets

The Contestable Market model suggests that even if there are high costs to entering the market, this does not matter unless these cannot be recovered upon exiting the market.

The contestable markets model proposes that:

• The number of firms is not the most important factor, instead it is the absence of barriers to entry and sunk costs
• Contestable markets are assumed to have free entry to new firms and free exit for incumbents and new entrants
• Free entry assumes that all firms and new entrants have access to the same technology
• New firms are not prohibited from entry by incumbents exploiting unachievable economies of scale (This means a natural monopoly is not contestable)

Entry to a market is usually costly to the entering firm, but the firm can still be contestable if these costs can be recovered when exiting the market.

Sunk Costs

Sunk costs are the costs that you pay to enter the market, but cannot recover when exiting the market.

Capital is the biggest sunk cost. This is because of the value of capital depreciates over time, meaning that you cannot recover the same amount of money that you paid for the capital when selling it.

However this can be avoided by renting the capital instead of purchasing it. This means that you do not have to pay the cost of the depreciation.

For example, in the Airline market, if you purchase a new plane, it will lose value rapidly first, and you will not be able to sell it for as much as you paid for it. However, if you rent the plane, you do not have to resell, and the cost of rent will be a part of your costs of production, and factored into your price.

So, by renting, markets become more contestable.

Hit and Run

A contestable market allows hit and run, allowing new firms to enter, compete away SNP then leave the market. Barriers to exit prevent hit and run.

If the industry becomes contestable, then the incumbent(s) fearing new firms will reduce their prices. This means that firms don't even have to enter the market to eliminate SNP, unlike in the other models.

Incumbents also strive to be productively efficient in order to deter new entrants - the lower they costs are, the harder it is to compete with them.

Point A

Point of profit maximisation, without contestability

Point B

• Fear of entry drives firms to increase output
• This causes a reduction in prices and the firm becoming more efficient as well as more supply
• This benefits consumers

Costs for Firms

FC - Fixed Costs - Costs that do not change depending on output, e.g Rent
VC - Variable Costs - Costs that change depending on output, e.g Raw materials
TC - Total Costs = FC + VC
AC (ATC) - Average Cost \(= \frac{TC}{Output}\)
MC - Marginal Costs - Cost for an extra unit of output

Revenue

AR - Average Revenue \(= \frac{TR}{Output}\)
MR - Marginal Revenue - Addition to revenue per extra unit produced
TR - Total Revenue \(= Output \times Price = AR\)

Productive Efficiency at Q

Average Costs decrease as quantity increases, but then increase again due to the Law of Diminishing returns, as shown in the table

Law of Diminishing Returns

Additional variable factors of production such as Labour after an optimal point will lead to decreasing marginal returns.

In the table, this begins at an output level of 3, and in the diagram, the optimal point is beyond Q (productive efficiency)

This is because after an optimal point additional workers will get in eachother's way and become less productive.

The Labour Market

The labour market is dictates wage and quantity of workers, much like regular markets dictate price of a good and supply of the good.

Key Concepts

• Demand
• Supply
• Labour Market Failure

Demand for Labour

Demand for labour is derived. This is because it is demanded for what it can produce, rather than for the thing itself.

What determines the demand for Labour

• Demand / Expected demand for a product / service
• Productivity of a worker
• Wage rate / price of labour
• Complementary labour costs, such as National Insurance and pensions
• Substitutes, such as capital

MRP - Measuring demand for Labour

MRP is the change in total revenue from employing one extra worker.

\(\text{MRP} = \text{Marginal Product} \times \text{Marginal Revenue}\)
\(\text{MRP} = \text{Productivity} \times \text{Price}\)

Factors that influence MRP

MRP for a single firm

MRP for an industry

MRP can shift due to two factors:

By MP - Training and development to improve productivity
By MR - Change in price of product being produced

WED - wage elasticity of demand

Wage elasticity measures how response demand for labour is to a change in wage.

\(WED = \frac{\%\Delta\text{ in DL}}{\%\Delta\text{ in W}}\)

Inelastic - Rising wages will not greatly impact on the demand for labour
Elastic - Rising wages will have a large impact on the demand for labour

Factors that affect WED

• Ease of substitution for capital
• Elasticity of the product, since it is a derived demand
• Proportion of labour cost in relation to total cost. If a high proportion of total cost is labour, it is more likely for demand for labour to be elastic.
• Time

Inelastic WED - Pilot

Pilot's WED is inelastic because they are difficult to replace with capital -> People would not fly in a plane without a pilot. Additionally, they are a necessity for airlines, so they will raise prices rather than shutdown.

Elastic WED - Cashier

Cashier's WED is elastic because they can easily be replaced with capital (self-checkouts).

Supply of Labour

Individual Supply of Labour

Income effect

The income effect is where a rise in wages makes people feel better off and therefore they may not feel a need to work as many hours.

Substitution effect

As wages rise the opportunity cost of leisure rises. This means that the cost of every hour taken for leisure rises, as this time could have been spent earning money. As wages rise, the substitution effect may lead to more hours being worked.

Diagram

Each individual has an optimum amount of income. E.g, £1,110 optimum

Once an individual is making more than this, they will experience the income effect more than substitution effect.

Evaluation

Assumes that everyone can change their hours easily - Many people have fixed-hour contracts and cannot easily change their hours.

Labour Supply for an economy

Change in Income

If average income is high/rising labour supply may decrease, because more people retire early and reach their optimal earnings.

Change in population

Population increases lead to a greater labour supply.

Change in expectations

• Life expectancy
• Pension age

Wage elasticity of supply of labour

Wage elasticity of supply of labour measures how responsive supply of labour is to a change in wage.

\(WES = \frac{\%\Delta\text{ in SL}}{\%\Delta\text{ in W}}\)

Factors that impact WES

Training and qualifications

A high level of training and qualifications means that it takes a long time for people to gain these qualifications, so it is not entirely driven by wage -> makes it more inelastic

Skill

A high level of skill required for -> Inelastic because fewer people have those skills, so workers are more scarce.

Vocation

If people desire a particular job, such as Nurse, or paramedic, the industry will attract workers regardless of the wage, because its what people aspire to do.

Time

Over a longer time, people can train / gain qualifications needed for higher paid jobs.

Labour market failure

Labour market failure is where the free labour market fails to properly allocate resources.

Perfectly competitive Labour Market

• Many buyers and sellers
• Workers have no influence on wage
• Perfect information
• Employers and workers free to enter in LR
• No individual firm can influence the market
• Doesn't exist

Monopsony

A Monopsony is a labour market dominated by a single buyer of labour. This prevents a perfect labour market because a single firm has influence over the labour market.

ACL - Average cost of Labour = \(\frac{\text{Total wage costs}}{\text{Number of workers employed}}\)
MCL - Marginal cost of labour - Addition to cost from employing 1 more worker

NHS Example

The NHS is a Monopsony employer for Nurses. MCL for a Monospony is very high/steep because every time you attract new workers with a higher wage rate, the firm must increase the wages of all existing workers to match.

In a competitive labour market the wage would be Wc and the quantity employed Qc. This would mean no profit as AC=AR. However, the monopsony uses the fact that it is the main employer to maximise profit (MC=MR) to limit employment to X and although there should be a higher wage, the monopsony pushed wages down to Wm since the workers don't have a choice but to accept the wage (they cannot lose workers, since there are no other firms able to hire them).

Solution to Monopsony

A monopsony can be partially solved by a trade union.

Collective bargaining allows the trade union to get a higher wage for its workers, moving the wage close to the competitive wage.

Effectiveness of a trade union against a monopsony

• Union density
• WED/WES
• Public support

Trade Unions

A group of workers who join together to maintain and improve their conditions of employment including their pay.

Collective Bargaining - A process where wages and other conditions of employment are negotiated and agreed upon by a union(s) with an employer(s)

A trade union bargains for a higher wage for all of its workers, creating a price floor on labour at WT. However - this can cause unemployment as firms have to reduce costs after their costs raise - they do this by firing some workers, so Q -> Q1. This unemployment may be mitigated by increasing labour productivity, such as workers agreeing to work harder. Sometimes workers will work harder due to their higher pay.

A trade union also creates a disequilibrium as there is excess supply of workers: more workers are willing to work at the wage WT than the firm demands.

What affects the amount of unemployment a trade union creates

• WED -> The more inelastic WED is, the less responsive firms are to changes in wage, so they will fire fewer workers.
• Amount wages have increased -> A smaller wage will mean firms will have fewer costs to recover
• Density of union membership -> If fewer people in the company are in the trade union then the wage will apply for fewer workers so costs have not increased as much.
• Legislation of unions -> More legislation will mean that unions will achieve a lower WT.

National minimum wage

A national minimum wage is a wage that almost all workers are paid.

Positives

• Living standards improve
• More equal distribution of income
• Increase in labour supply
• Reduced discrimination
• Increased worker productivity (more motivated by higher pay)
• The government has to pay less in benefits

Negatives

• May increase unemployment
• UK firms become less competitive (higher costs)
• Smaller businesses are impacted more
• Increased inflation

Evaluation

There is evidence that NMW does not cause unemployment, especially if you increase productivity.

Regional National Minimum Wage

London / SE could have a higher minimum wage due to higher living costs

However:

• People could emmigrate to higher paid areas
• Unfair to be paid differently for the same job
• Increases income equality / legislates divide
• Hard to administrate

Discrimination in the Labour Market

Where groups of workers are treated differently to other workers in the same job regarding pay and employment.

Wage discrimination - Paying workers different wage rates for doing the same job

Conditions required

• Requires employers to be able to identify and separate different workers supplying the same type of labour.
• This is possible when workers differ in their knowledge of the labour market and their ability to shop around employers.

Example

MRP is the perfect labour market. MRP₁ is the perceived MRP of the discriminated group. They are seen as less productive than they actually are, so they are employed less Q₁ instead of Q, and paid less W₁ instead of W.

Solutions

• Legislation
• Voluntary commitments

Firm's Objectives

Firms can have a range of different objectives. In Economics, we assume this is Profit Maximisation but this may not always be the case.

Principal Agent Problem / divorce of ownership from control

This is where the people who own the business (shareholders) are not the ones controlling it (managers). This means that the managers may not act in the best interests of the shareholders. For example, it may be beneficial for managers to increase revenue as it looks good for them, and they may be rewarded with high bonuses / pay raises. In comparison, profit maximisation would be more desirable for shareholders because that will mean higher dividends.

Profit Maximisation

Where firms try to maximise profit by operating at MR=MC (i.e producing another good would have a higher cost than revenue).

Advantages

• More profits to reinvest into Research & Development, new capital / expansion.
• Pay dividends to shareholders
• Lower costs -> lower prices
• Profit is the reward for risk-taking enterprises

Disadvantages

• Might not know where MC=MR is
• Scrutiny from regulators / investigators

Profit Satisficing

Profit Satisficing is where profits are sacrificed in order to satisfy key stakeholders

Which key stakeholders would firms want to satisfy

• Consumers -> may boycott if unreasonable prices
• Workers -> may go on strike if wages are too low / government intervention
• Government -> unhappy if there are unfair working conditions / prices too high for consumers
• Environmental groups -> may cause government intervention if cutting costs causes high pollution / damage to the environment.

Revenue Maximation

Revenue maximisation is where you try to maximise revenue, by operating at MR=0

Advantages

• Economies of scale -> larger output will mean greater economies of scale
• Predatory pricing -> drive out competition

Sales Maximisation (Growth)

Sales maximisation is where you sell as many of your good/service as possible until you have zero profit.
Sales maximisation occurs are AR=AC

Advantages

• Economies of scale - This objective will grow the firm the quickest
• Lowest price without making a loss
• Beneficial for managers (Principal Agent Problem)
• Flood the market - Develop loyalty, then change objectives later.

Other Objectives

Survival

If competition is harsh, the firm's only objective may be to make sure it survives - such as charging competitive prices while saving profit.

Public Sector

Public Sector firm's goal is to maximise consumer welfare. They operate when consumer welfare gained = AC. They have allocative efficiency.

Corporate Social Responsibility

Acting ethical - e.g donating to charities, using green energy, to generate good publicity for the company in an effort to increase loyalty of consumers.

Distribution of Income

Wealth - Property, Shares, Pensions
Income - Wages, Salaries, investment income, income from self-employment

Causes of wealth inequality

1. Inheritance
2. Marriage - Wealthy people marry other wealthy people
3. Income inequality - High earners have higher savings than can be invested
4. Chance - lottery

Causes of income inequality

1. Wealth inequality - E.g property can earn income
2. Household composition - Number of people in the household working
3. Level of skills and qualifications
4. Difference in earnings - Full time vs Part time, availability of overtime

Measuring Equality

Equality - Measurable - How evenly resources are distributed
Equity - Not measurable - Fairness, do people have the same opportunities

Lorenz Curve

The lorenz curve shows the level of inequality on a country

Gini coefficient = \( \frac{A}{A+B} \)
0 -> Perfect equality
1 -> Perfect inequality
Lower Gini coefficient -> less equality

Inequal country - e.g Brazil

The curve is far from the Lorenz curve, this country has high inequality and a high Gini coefficient

Equal country - e.g Czech Republic

The curve is close to the Lorenz curve, this country has low inequality and a low Gini coefficient

Why has the Gini coefficient been increasing in the UK?

• Reduction in top-rate tax
• Increase in regressive taxes - VAT
• Real wages have stagnated - Wages have not kept up with inflation
• Benefits / JSA have not kept up with inflation
• Inequality of opportunity exists - High proportion of Oxbridge graduates from privileged backgrounds get the best paid jobs
• Increase in single-parent households

Poverty

Absolute Poverty

When people's income is too low for them to afford basic necessities such as food shelter or warmth.
Even in developed countries such as the UK, there are undernourished or homeless people.

Relative Poverty

When people are poor compared to others. The Relatively poor may not be able to afford a certain standard of living.

Causes of Poverty

• Unemployment - Households with no employed people
• Low wages - Workers in unskilled employment earn low wages, since their MRP is low
• Sickness / Disability - People dependent on sickness / disability benefits have relatively low income
• Ageing population - State benefits are the main income for the elderly. Becoming less relevant as people build up pensions
• Increase in tax / reduction of benefits
  • 1973 - VAT 8%
  • 2022 - VAT 20%

Policies to reduce poverty

• National minimum wages
  • Encourages people to work and gives them higher pay
• Cutting bottom rate of tax
  • Makes tax less regressive and gives more incentive to work
• Exploiting trickle-down economics
  • Some economists argue that higher spending by the rich will stimulate the economy, benefiting everyone.
• Increasing the retirement age
  • Gives more time for people to save and reduces the time they are dependent on welfare.

Increasing benefits

The direction of incentive effects created by increasing welfare is controversial.
Free market economists argue it will cause voluntary unemployment, Keynesian economists think increased government spending will stimulate AD, and create jobs

Tax credits

Tax credits are benefits paid through the tax system.
The idea is that this creates incentives to work whilst reducing child poverty

Behavioural Economics

A method of economic analysis that applies psychological insights into human behaviour to explain how individuals make choices and decisions.

Normally in economics we assume all agents are acting rationally

Rational Decision Making

A decision that an allows an economic agent to maximise their objective, by setting marginal benefit of an action to its marginal cost.

Factors that rational agents consider

• Value
• Need
• Satisfaction - Marginal Utility
• Price
• Comparison to substitutes

Anchoring

A cognitive bias describing the human tendency when making decisions to rely too heavily on the first piece of information offered (the anchor). Individuals use an initial piece of information when making subsequent judgements.

Social Norms

Forms or patterns of behaviour considered acceptable by a society or a group within that society.

Restricted Choice

Offering a limited number of options so that they are not overwhelmed by the complexity of the situation. If there are too many decisions, people may make a poor decision / no decision.

Bounded Rationality

Bounded rationality is the theory that there is only so much information we can consider when making decisions. These decisions are rational given the limited choice and awareness of the situation, but often don't maximise total utility, because people don't want to spend ages considering every option.

It could be argued that this is rational behaviour, as some things aren't worth spending the time thinking about. For example, It may be more rational to eat the same cereal every day rather than spend 5 minutes considering what activites you are likely to do, and what nutrients would be most optimal for your day.

The increase in technology has made information more widely available than ever, giving a greater amount of information, but this means that its almost impossible to read all of the information and weigh everything up against eachother in a reasonable time. It could be argued that the availability of information leads to more use of rules of thumb.

Rules of Thumb

The theory of bounded rationality suggests that people make decisions on basic rules of thumb. This means that they use their previous experience to make a best-guess on the actual best option. For example, some people may use the rule of thumb that more expensive goods will be higher quality, when this isn't necessarily the case.

Consequences of Bounded Rationality

Given that agents with bounded rationality don't fully consider all the options and information, it means that we can use Choice Architecture to influence people's decisions. This includes nudges.

Irrational behaviour

In economics we often assume that individuals are rational, but this is not always the case. Irrational agents make decisions that don't maximise utility.

Irrationality can lead to market failure, loss of welfare or individual consequences like addiction.

Types of irrational behaviour

Cognitive Bias

A mistake in reasoning or in some other mental thought occurring as a result of using rules of thumb or holding onto one's preferences and beliefs, regardless of contrary information.

Rule of thumb - A rough and practical method that can be easily applied when making decisions

Herding effect

Following other peoples behaviour because you assume it is correct

Sunk cost fallacy

Continuing to invest in something because you have already invested / lost in it.

Discrimination

Disliking people for irrational reasons

Nudges

Factors that encourage people to think and act in a particular way that comply with desirable social norms

Choice Architecture

A framework setting out different ways in which choices can be presented to consumers, and the impact of that presentation on consumers' decision making.

E.g Amazon prime showing free now for 1 month.

Default Choice

An option that is selected automatically unless an alternative is specified

Examples:

• Organ donation - Opt out
• Private pensions - Opt out

Examples

• "The hospital will not lose $125 if you show up"
• "64.5% had declared their income tax on time"

Positives

• People who care strongly are still able to make a decision
• Can influence people to make decisions that are better for the economy
• Cheaper, less opportunity cost

Negatives

• Manipulation - unethical
• Illusion of choice

Shoves

Restrictions imposed by regulators and/or laws that restrict an individual's freedom to behave in certain ways. Breaking a sanction can lead to punishments.

Mandated Choice

People are required to make a decision by law.

Examples

• Can't buy cigarettes under 18
• Can't buy alcohol under 18

Positives

• More effective than nudges
• Proven to work
• More likely to create a measurable outcome

Negatives

• Underground / black market
• Expensive to enforce - opportunity cost

Marginal Utility

The satisfaction received from consuming a good or service

Marginal Utility - The additional utility gained from consuming an extra unit of a good or service

The law of diminishing marginal utility states that the more units of a good are consumed the lower the utility from consuming those additional units.

Specification Reference - Macro

This uses the AQA specification from here. You should read through it and then come to here to discover the topics you want more information on.

The measurement of macroeconomic performance

• The macro objectives and their conflicts
• Macro-economic indicators
  • Unemployment - Claimant Count / ILO
  • Inflation - CPI & RPI
  • Balance of Payments
• Using index numbers
• Uses of national income data
  • Purchasing power parity (PPP)?

How the macroeconomy works, circular flow of income, AD, AS

• The circular flow of income
• Aggregate Demand
• Aggregate Supply
• Long run aggregate supply
  • Classical LRAS
  • Keynesian LRAS

Economic performance

• Economic growth and the economic cycle
  • LR vs SR growth
  • Long run trend rate of economic growth
  • Costs / Benefits of economic growth
  • Concepts of the economic cycle, identifying current phase of economic cycle
  • Positive and negative output gaps
  • Causes of changes in economic phase
• Employment and unemployment
  • Measures of unemployment Claimant Count & ILO
  • Types of unemployment
  • Consequences of unemployment
  • Real wage unemployment
  • Natural rate of unemployment

Inflation and deflation

• Inflation and deflation
  • Inflation, deflation and disinflation
  • Demand pull and cost push
  • Fisher's equation MV=PQ
  • The effect of expectations
  • Consequences for individuals and the economy
• Conflicts between macro objectives
  • Negative and positive output gaps relate to unemployment and inflationary pressures
  • SR and LR Philip's Curve
  • How economic policies may be used to reconcile the policy conflicts in SR & LR

Financial markets and Monetary Policy

• The structure of financial markets and financial assets
  • Characteristics and functions of money
  • Narrow and broad money
  • Types of markets
    • Money market
    • Capital market
    • FOREX
  • The role of financial markets in the wider economy - TODO
  • Debt vs. equity - TODO
  • Bonds
    • The reason for the inverse relationship between IR and bond prices
• Commerical banks and investment banks
  • Different types of banks
  • Main functions of a commercial bank
  • Structure of a commericial bank's balance sheet
  • Objectives of a commerical bank - here
    • Liquidity
    • Profitability
    • Security
    • Potential conflicts between these objectives
  • How banks create credit
• Central banks and monetary policy
  • The main functions of the central bank
  • Monetary policy
    • That monetary policy involves the central bank taking action i.e IR, money supply, ER
    • The current objectives of monetary policy set by the government
    • The role of the Monetary policy committee
    • How changes in ER affect AD and various macro objectives - TODO
    • The transmission mechanism
    • How the BoE can influence growth of money supply (Quantative easing)
• Regulation of the financial system
  • Regulation of the financial system in the UK
    • PRA, FPC, FCA
  • Why a bank might fail
    • Risks of lending long term
    • Risks of borrowing short term
  • Liquidity and capital ratios
  • Systemic risk
  • Moral hazard

Fiscal Policy and supply-side policies

• Fiscal Policy
  • Involves government spending, taxation and budget balance
  • Fiscal policy for can be usedful for both micro and macro
  • How fiscal policy can influence AD
  • How fiscal policy can influence AS
  • How government spending and taxation can affect the pattern of economic activity
  • Types and reasons for government expenditure
  • Why governments impose taxes
  • Direct vs indirect taxes
  • Progressive, proportional and regressive taxes
  • Principles of taxation, such that taxes should be equitable
  • The role and relative merits of different UK taxes
  • Relationship between budget balance and national debt - TODO
  • Cyclical and structural budget deficits / surpluses
  • Consequences of budget deficits and surplus
  • That we have lots of debt
  • The role of the Office for Budget Responsibility
• Supply-side policies
  • The difference between supply side policies and supply side improvements
    • Supply side changes often come from the private sector, i.e technology improvements, investment
  • How supply side policies such as tax changes designed to change personal incentives, may increase potential output of economy and increase growth
  • The role of supply side policies in reducing the natural rate of unemployment
  • Free market supply side policies
    • Tax cuts
    • Privatisation
    • Deregulation
    • Labour market reforms
  • Interventionist policies include
    • Spending on education & training
    • Investment in research and development
    • Supply side policies can have micro and macro effects

The international economy

• Globalisation - TODO?
  • The causes of globalisation
  • The consequences of globalisation for less-developed and more developed countries
  • The role of multinational corporations in globalisation
• Trade
  • Comparative and Absolute Advantage
    • This shows specialisation can increase total output
  • Other benefits of trade, such as economies of scale
  • The reasons for changing patterns of trade between the UK and the rest of the world
  • The nature of protectionist
    • Tariffs, quotas, export subsidies
    • Causes and consequences of countries adopting protectinist policies
  • The main features of a customs union
  • The main characteristics of the Single European Market (SEM)?
  • The role of the WTO - TODO
• The balance of payments
  • Components of the balance of payments
  • The meaning of a deficit and surplus on the current account
  • Factors that influence a country's C/A
    • Productivity
    • Inflation
    • Exchange Rate
  • Consequences of investment flows between countries
  • Policies that could be used to correct a balance of payments deficit / surplus
  • Expenditure switching / expenditure reducing policies?
  • The conflicts that these policies could have on other macro objectives
  • Significance of a deficit / surplus for an individual economy
  • The implications for the global economy of a major economy or economies with imbalances deciding to take corrective action. ?
• Exchange rate systems
  • Freely floating
  • How governments can intervene the exchange rate
  • Advantages of fixed / floating ER systems.
  • Advantages / disadvantages for a country joining a currency union such as the eurozone
• Economic growth and development
  • The difference between growth and development
  • The main characteristics of less developed countries
  • Main indicators of development including the Human Development Index (HDI)
  • Factors that affect growth and development, such as investment, education, training
  • Barriers to growth and development
  • Policies tht might be adopted to promote growth and development
  • The role of aid and trade in promoting growth and development

Macro-Economic Objectives

These are the goals that the government has in terms of managing the economy.

• Steady and sustainable growth
• Full employment - 3% or less
• Inflation - 2% (±1%)
• Sustainably improve current account position

Circular flow of Income

The circular flow of income is a model that represents how national income flows around an economy.

Injections

Money that flows into the circular flow of income that can cause national income to grow.

• Investments
• Government Spending
• Exports

Withdrawals

• Savings
• Tax
• Imports

Sectors

• A 2 sector model is simplified and only includes Households and Firms (the model above).
• A 3 sector model includes the government, showing tax and government spending
• A 4 sector model includes international trade

National income changes

\(Injections = Investments + Government Spending + Exports\)
\(Withdrawals = Savings + Tax + Imports \)

• If injections = withdrawals then the national income stays the same.
• National income will increase if injections > withdrawals
• National income will decrease if injections < withdrawals

Calculating GDP

GDP Can be calculated in three different ways. These a different lines on the diagram:

• Output Method
  • Measure the total value of goods and services produced by firms
• Income Method
  • Measure the total amount of income received from firms -> households
• Expenditure Method
  • Measure the total amount of expenditure, households -> firms (AD is the formula for this)

All three of these are equal and will give the same answer.

Multiplier Effect

The multiplier effect of the final impact of an injection on an economy.

\(\text{Multiplier} = \frac{1}{MPW}\)

MPW - Marginal Propensity to Withdraw (leakage) - What proportion of money given to the economy will be leaked.

\(\text{MPW} = \text{MPS} + \text{MPI} + \text{MPT}\)

MPS - Marginal Propensity to Save - What proportion of the money will you save if given £100 MPI - Marginal Propensity of Imports
MPT - Marginal Propensity of Tax

Propensity - What proportion of money given to you will go to something.

The Multiplier Effect Process

The government injects £200m in a project to build thousands of affordable new homes

• £200m in extra demand in the economy
• Many businesses benefit directly, such as building supply industries, archetects.
• Constructing new homes means wages and profits flow in the circular flow of income

Will the extra incomes stay inside the circular flow of income?

• If yes, the multiplier effect is likely to be strong and resultant impact on GDP quite large

If the value of the multiplier is 1.5, then the final impact is £300m If the value of the multiplier is 1.25, then the final impact is £250m

Multiplier effect example

Assume that for each £100 of extra income

• 10% (0.1) is saved (S)
• 20% (0.2) is taken in taxation (T)
• 20% (0.2) leaks from the economy due to imports (M)

The money repeatedly circulates the economy until it is completely leaked out.

• £200m injection ->
  • £20m saved
  • £40m taxed
  • £40m imports
• £100m extra GDP ->
  • £10m saved
  • £20m taxed
  • £20m imports
• £50m extra GDP...

\(\text{Multiplier} = \frac{1}{0.1 + 0.2 + 0.2} = \frac{1}{0.5} = 2\)

So the effect of investment of £100m will be \(£100\text{m} * 2 = £200\text{m}\)

Simple Multiplier

The simple multiplier only considers savings. The only leakage is saving. Taxes and imports are ignored.

\(\text{Multiplier} = \frac{1}{1-\text{MPC}} = \frac{1}{\text{MPS}}\)

Causes of a high Multiplier

• The economy has plenty of spare capacity (i.e a negative output gap) to meet higher AD
• Marginal Propensity to import and tax is low
• High propensity to consume any extra income (i.e low propensity to save)
• New infrastructure projects often have higher multiplier effect

Aggregate Demand

The total demand for all goods and services within an economy in a given time period.

\(AD = C + I + G + (X-M)\)

C - Consumer spending (70% of AD in the UK)
I - Investment
G - Government spending
(X-M) - Exports minus imports (Negative in the UK)

Factors that cause consumer spending to rise or fall

• Interest rate - The reward for saving and cost of borrowing

If the interest rate increases this will impact on consumer spending and cause it to decrease because people save more and borrow less.

Wealth

An accumulation of assets over time

Wealth can be made up various different components such as:

• Property
• Savings
• Pension
• Investment

If wealth increases, so will consumer spending.

Consumer Confidence

The degree of optimism consumers have about the current state of the econmy and their own financial situation.

When consumer confidence is high, this will mean more consumer spending.

Direct Tax

A fall in income tax will lead to an increase in disposible income for households, this will translate into an increase in consumer expenditure.

Aggregate Supply

Aggregate supply is the total quantity of output supplied in an economy, at a given price level and time period.

SRAS

In the short-run, firms may have little flexibility when it comes to changing their inputs. If they need to change output in the short run they may need to increase the amount they use their resources, such as paying workers overtime.

Impact of the £ decreasing in value against the $

If the £ loses value in comparison to the dollar, then oil will increase in price. Oil is an essential commodity, so this will lead to SRAS shifting left.

The result of this is the economy shrinking and inflation in the SR.

Factors that can shift SRAS

• Changes in unit labour costs
  • Firms agreeing to paying higher wages
  • Falling worker productivity
• Commodity prices
  • Changes in raw material costs
  • Could be affected by exchange rate
• Government taxation and subsidy
  • Changes to producer taxes and subsidies levied by the government, such as a rise in VAT will cause higher costs and an inward shift

Classical LRAS

In the long run LRAS will increase due to increases in the quantity or quality of the four factors of production. This shows the classical LRAS, see also the Keynesian LRAS.

Factors that cause shifts in LRAS

• Expanding the labour supply
  • Improving incentives for people to search for and accept new jobs
• Increase the productivity of labour and capital
  • Investing in training and edcuation of the labour force
  • Improvements in technology / capital
• Investment in infrastructure
• Explore / discover new sources of raw materials.

• LRAS curve is perfectly inelastic
• Economic output stays the same regardless of price level (in LR)
• Economic output / unemployment only changes in the LR due to shifts in LRAS
  • AD has no impact in LR
• The LRAS shifts right due to increases in the quality or quantity of the 4 factors of production.

Economic Cycle

An economy goes through various stages

Stages of the Economic Cycle

Boom

Unemployment is low, consumers / businesses are spending. The economy is growing.

Downturn

Unemployment is rising. The economy is contracting

Recession

Unemployment is low. The economy has been contracting for atleast 2 quarters (6 months).

Recovery

Unemployment starts to decrease. The economy starts to grow.

Economic Cycle and Trend Growth

The trend growth diagram shows how SR growth goes up and down with the economic cycle, but the LR growth is different.

LR growth - Increase in 4 factors of production, e.g population

SR growth - Due to current position in economic cycle

Positive output gap

A positive output gap occur during booms. The economy is producing "above" the maximum capacity - it is unsustainable.

• Low unemployment
• High consumer spending
• High inflation

Negative output gap

A negative output gap occur during recessions. The economy is producing below the maximum capacity.

• High unemployment
• Low consumer spending
• Low inflation

Unemployment

Those individuals who are 16 to 66 who are willing and able to work, though are not currently in employment.

Macro Objective - Achieve "Full employment"
Full employment - Unemployment at 3% or less

\(\text{Unemployment Rate} =\frac{\text{People Working}}{\text{People able to work}}\)

Example:
1.64 million unemployed 32.5 million in work

UK = \(\frac{\text{1.64 million}}{\text{32.5 million}}\) = 4.8%

Economically Inactive

• Students
• Disabled
• Pensioners
• Not actively seeking a job
• Under 16
• Retired
• Asylum seekers
• Discouraged Workers

Measuring unemployment

Claimant count

The number of people claiming job-seekers allowance each month. Used to be used but no longer used by the ONS.

It is straight forward to compile
However, it may be inaccurate because

• People have too much pride to claim / enough wealth already
• It doesn't recognise people who have been raising children and are looking to return to the workforce as unemployed
• Excludes people who aren't eligible to claim JSA (e.g people with no permanent address)
• Doesn't include people who are unemployed but choose not to claim.

ILO - Labour Force Survey

Measures the percentage of the workforce who are without a job but are available for work, and actively seeking employment.

This measure involves a labour force survey.

• Considered to be more accurate than the claimant count method
• It is the international standard and therefore makes comparisons between economies more accurate

Drawbacks:

• The data relies on a sample of the population. It will not be fully representative
• Doesn't represent underemployment, those who have jobs, but are qualified to do more skilled work. They are settling for what they can get.
• Doesn't include the hidden unemployed. These people who have been out of work for a long time, who are seeking work. They are classified as discouraged workers.

Types of unemployment

Frictional Unemployment

Individuals that are between jobs, for example transferring from one sector to another. This tends to be a short term situation.

Structural Unemployment

Individuals who have left one sector due to it contracting, but do not have the skills to move into another that is expanding. This is due to occupational immobility.

Cyclical Unemployment

Unemployment that arises due to an economic downturn or onset of a recession.

Demand-deficient Unemployment

Arises due to AD being low within an economy. Easily rectified by boosting AD.

Seasonal Unemployment

Some jobs are linked into certain times of the year, such as the tourist industry during the summer will need less workers in the winter.

Consequences of Unemployment

For individuals

• Fall in earnings, even if claiming benefits
• Fall in their standard of living (relative poverty)
• Loss of status
• Stress that can lead to health issues
• The longer they are unemployed, the less employable they become

For the economy

• Unemployment represents an opportunity cost to an economy. Lost output cannot be regained. The economy is operating inefficiently.
• The government will have to increase their spending in order to pay for JSA. They will also receive less money (from taxes). This can lead to a deficit.

Positives of high unemployment

• Firms may be able to lower their wages and find it easier to recruit staff
• Downward pressure on inflation

Depends on

• The rate of unemployment (If unemployment is high, it is harder to get a job)
• How long individuals have been unemployed for
• The type of unemployment

Voluntary Unemployment

Involuntary Unemployment - Individuals made unemployed due to a recession / demand deficient unemployment
Voluntary Unemployment - Individuals who are unwilling to accept the going wage rate or the type of job available.

Real wage Unemployment - The wage rate is above the equilibrium leading to firms reducing the amount of workers they employ.

Causes

• Generous unemployment benefits, making accepting a job less attractive
• High marginal tax rates, which reduce effective pay
• Unemployed hoping to find a job more suited to their skills / qualifications
• Some jobs too tedious, e.g. Fruit picking / Security guard

Solutions

• Reduce unemployment benefits
• Reduce income tax
• Better information / easier to find a matching job
• Retrain to the job they want to do, e.g. Nurse, Teacher (fill skills gaps)

NAIRU

NAIRU - Non-accelerating rate of inflation

NAIRU the level of unemployment above which there will be inflation (labour market tightening). This is shown on the diagram - Moving AD past NAIRU will cause the price level to increase - i.e. inflation.

Decreasing NAIRU

• Training and Education
  • To fill skills gaps
• Net migration for skilled workers
• Reduce trade union power
  • To stop wages increasing
• Reduce benefits and income tax

Inflation

Inflation is a sustained rise in the average price of goods and services over a given time period.

Inflation means thee is a fall in the purchasing power of money. To beat inflation you need to invest and get higher returns than the inflation rate, or spend your money.

Macro Objective (UK) - 2% (±1%)

Disinflation - Reduction in inflation
Deflation - Sustained decrease in the average price of goods in services over a given time period

Types

Demand-Pull Inflation

Caused by excess aggregate demand.

• Often linked to a money and credit boom
• Economy close to full capacity
• Positive output gap.

Cost-Push Inflation

Inflation initiated by rising costs of production. For example:

• Rising wage costs in the labour market
• Increasing raw material and component costs from domestic and overseas suppliers.
• Rising import prices, often due to a falling exchange rate -> increasing import costs.

Money Stock

• Availability of credit
• The amount of current in circulation

Quantity Theory of Money - Fisher Equation

\(MV = PQ\)

Variable - Variable in SR and LR Constant - Constant in SR

Measuring inflation

Consumer Price Index

• Survey 40,000 households in order to research the most commonly purchased goods
• Create a basket of goods that contains 700 products to represent the economy
• Attach weightings to these goods based on their importance and how frequently they are purchased.

Limitations of CPI

• Not fully representative of some households - 14% of CPI is motoring costs
• Spending patterns - Single people have different spending patterns compared to those with children
• Quality - The CPI does not take into account changes in quality. Prices could rise but also be accompanied by higher quality, which would not be inflation.
• Slow to respond - CPI is slow to respond to new products and services. The CPI basket is changed every year but only a few items fall in / come out

Retail Price Index

Calculated in a similar way but includes more factors such as mortgage interest payments and council tax.

Expectations

When inflation becomes high, people expect it, meaning that they demand higher wages, and firms keep raising their prices because they can get away with it. This leads to inflation being "baked-in" to the economy.

See the philips curve for an example

Consequences of Inflation

Inflationary Noise

When inflation is high, it becomes difficult to compare prices / products since all prices are rising. Price signals also become less effective. Purchasing decisions become more complicated.

Menu Costs

Firms have to continually update their price list. This increases their admin costs as they have to update websites / catalogues.

Shoe Leather Costs

Individuals and firms don't want to hold on to their money since in real terms, it will lose value. Therefore they seek out the best interest rates from banks, even if it means frequently moving their money.

Fiscal Drag - Even at low inflation rates

The burden of tax can increase if tax brackets are not raised in line with inflation. If a worker gets a pay rise in line with inflation, this could push them into the next tax bracket, which would mean they are earning less money in real terms.

Business Confidence

If inflation is accelerating or fluctuating, it is difficult for businesses to plan for their future, so they will be less inclined to invest.

Loss of international competitiveness

Businesses can experience a loss in international competitiveness as rival economies could have more stable economies in comparison.

Depends Upon

The size of effects will depend upon:

• The amount of inflation
• Whether the inflation rate is stable or volatile
• Whether the inflation is anticipated / predicted

Positives

Since the Macro Objective is 2%, there must be some benefits.

Warning:

I am not very sure about these. Points 4. and 5. I found on the internet and seem to make sense, but weren't in lesson. no. 1 I don't understand, and no 2 and no 3 and the same if you actually expand them.

Benefits include:

• Indicator of stable growth
• Could be overstated by Measurement
• Avoiding a deflationary period.
• Low inflation encourages people to invest their money
• Firms are able to decrease people's wages, employees would be very unlikely to accept a pay cut

Deflation

A sustained fall in the average price of goods and services over a given time period.

Consequences of Deflation

Holding back spending

Consumers may postpone spending - they expect prices to fall in the future.

Debts increase

The real value of debt rises with deflation and higher real debts can be a big drag on consumer confidence. For example, for a mortgage.

Lower profit margins

Lower prices can mean reduced revenues and profits for businesses. This can lead to shedding labour causing higher unemployment. Higher unemployment means less customers so you shed more labour and get stuck in a cycle.

Can make exports more competitive

Deflation can make exports more competitive eventually, but it often comes at a cost in the short term.

Solving Inflation

Balance of Payments

The Balance of Payments records money flows into and out of the country in a given time period.

What is it made of

Three parts:

• The Current Account - The largest part
  • Trade in goods and services
  • Income
  • Transfers
• The Financial Account
  • F.D.I
  • Hot Money
• The Capital Account
  • Land

Flows of money between economies

Credit: The current account is credited when money flows into it from abroad

Debit: The current account is debited when money flows out from the UK to abroad.

Exports -> Credit
Imports -> Debit

Current Account

Total Trade

Records the value of exports and imports of goods and services.

Examples:

• Credit: Exporting weapons to other countries.
• Debit: Importing cars

Total Trade negative -> Deficit
Total Trade positive -> Surplus

Investment Income

Records the value of flows of income from investments in the form of interest, profit and dividends.

Examples:

• Credit: Marks and Spencers having stores abroad and bringing profit back to the UK.
• Debit: McDonalds having restaurants in the UK and then sending money back to the US.

Transfers

Records the transfers of money made and received by the government and individuals, e.g Remittances and payments to the IMF.

Examples:

• Credit: Individuals sending money back to the UK from abroad.
• Debit: Individuals sending money back to the Philiphines from the UK.

Problems with a Current Account Deficit

• A C/A deficit means you have more imports than exports.
• A C/A deficit is not usually considered as important as the other objectives.
• AD = C + I + G + (X-M) so if net exports are falling, AD is shifting left.

This could cause a reduction in growth or recession, which also means higher unemployment.

Evaluation of C/A deficit

• Inflation reduced / falling
• ER will depreciate, which may cause an automatic correction
• Other components of AD may be rising, which may mean overall there is growth.

Solving a C/A deficit

Expenditure Reducing

This method involves reducing the number of imports by generally reducing (luxury) consumption.

• Increase IR (contractionary monetary)
• Increase Income tax (contractionary fiscal)

However:

• Decreases economic growth
• Increases unemployment
• The problem with a C/A deficit is reduced AD, but contractionary policy further reduces AD -> Government failure
• Higher IR means borrowing more expensive
  • LICs affected more -> more inequality
• Income taxes will impact LICs more

Expenditure Switching

Switching import consumption to domestic consumption.

• Protectionism / Tariffs
  • May lead to retaliation
  • Distorts the market, second best option
• Supply Side policies
  • Education and training
    • Opportunity cost and time lag
  • Deregulation
    • Risk to health and safety as well as environmental risks

Economic Growth & Development

Economic growth is the increase in real GDP while economic development includes any improvements in the economy.

• Economic Growth
• Economic Development

Economic Growth

One of the macro objectives is steady and sustainable growth.

Positives of economic growth

• More jobs
• Higher living standards
• Increased tax revenue
• Increased funds for infrastructure
• Rising wealth, which can be used to reduce poverty

Negatives of economic growth

• Risk of demand-pull inflation
• Could be limited growth with rising inequality
• Over-exploitation of scarce finite resources

Judgements

It depends on the sustainability of the growth. For example:

• Renewable energy
• Selective logging
• Recycling
• Pollution / environmental damage

Economic Development

Economic Development includes everything in economic growth, as well as:

• Increase in living standards
• Increase in educational standards
• Improved healthcare
• Improved infrastructure
• Diversification of the economy

Most of these will lead to economic growth in the LR.

Economic Structure

Primary Production

This is normally the majority of undeveloped economies E.g Niger

• Agriculture
• Fishing
• Mining

Secondary Production

This is normally the majority of mid-level developed countries. E.g China

• Manufacturing

Tertiary Production

This is normally the majority of highly developed countries. E.g U.K, U.S.A

• Services

Sectorial Analysis

The world bank compares the proportion of GDP contributed by the agriculture, industrial and service sectors. This is used as a way of telling if a country is developed. More tertiary and less primary and secondary.

Rostow's Stages of Economic Growth

Rostow argues that all economies pass through five stages on their road to full economic development.

• Traditional
• Transitional
• Take-off
• Drive to Maturity
• High mass consumption.

Stages

Traditional

Traditional economies are largely dependent upon subsidence.

Transitional to take off

Growing surplus leads to an expansion in investment. Higher investment promotes greater growth while rising incomes feed into AD. There is growth in the secondary sector.

Take off

Expanding AD, employment opportunities and growing incomes would lead to the development of infrastructure, human and physical capital associated with a mature economy.

High mass consumption

Lots of consumption within an economy which provides sustained demand for the outputs of a developed economy.

The most crucial part of the model is take off. The implication is that additional savings/investment could set off a chain reaction of development. This culminates in sustained economic development.

Low Developed Countries

Factors of an LDC

• Large primary sector / Agriculture
• High unemployment
• Low level of human capital
• Lack of experts
• Low standard of living
• High level of Poverty
• Poor healthcare
• Poor education
• Poor infrastructure
• Weak institutions

How can LDCs develop?

Supply side policies

Supply side policies will increase growth and development.

However, they are very expensive and take a long time, so this may not be viable for LDC.

Join a trading bloc

Joining a trading bloc could reduce costs of production and increase exports.

However, if a country is very small, infant industries may suffer. Furthermore, an LDC may have to bend to the will of a larger nation.

Reduce IR

• Increases spending / AD
• Lower ER -> exports more competitive

Borrow from the I.M.F

The LDC could borrow from the International Monetary Fund.

However, this means they will have to pay back a large amount of interest, and there are normally additional conditions which are not beneficial to the LDC.

F.D.I (Foreign Direct Investment)

The LDC could get investment from another country.

However this is normally expected to be back in some way, e.g political favours. It can result in exploitation and kill off infant industries (the investing country will want their large firms to be able to move into the country).

O.D.A (Overseas development assistance / Foreign Aid)

Foreign Aid is intended to help stimulate growth and development in the LDC. It is intended to kick start the "take-off" stage.

It can be argued that developed nations will receive a benefit from the LDC developing, as they will gain a trading partner.

There are also humanitarian reasons for foreign aid. This can include helping to alleviate poverty and address income inequality. It can help solve market failure such as lack of healthcare or education within the LDC.

O.D.A Was designed to help countries achieve development goals.

Alternative reasons behind O.D.A

Polictical motivation. For example the USA donates foreign aid to Pakistan. In exchange, they are able to use military facilities in Pakistan.

It can also encourage trade between countries. The UK gave foreign aid to India, partly due to understanding the importance of India as a trade partner now and in future.

Reasons why countries don't benefit from O.D.A

Some countries are at such a low stage of development (not close to take off), that they are unable to benefit from foreign aid. They don't have the resources and the institutions in place to use it effectively.

Bad governance in some countries, such as corruption means the % of aid reaching its intended purpose is minimal.

Barriers to development

The following things prevent a country from developing from these measures.

• Corruption
• Clauses, e.g Russia forced Cuba to buy its imports after it gave O.D.A
• Specific projects are poorly chosen
• Lack of human capital
• Poor infrastructure
• Weak institutions - Lack of sound legal system.

Countries who went from LDC -> HDC quickly

• South Korea - Good policies
• U.A.E - Oil
• Qatar - Oil
• Saudi Arabia - Oil

Keynesian LRAS

The Keynesian model of LRAS is an alternative model of the standard LRAS curve.

• As AD shifts to the right the economy grows and unemployment falls.
• LRAS is elastic up until the curve. This is because of spare capacity in the economy.
• As AD reaches the curve, this then leads to a rise in price level - No spare capacity so firms are having to compete for labour.
• The price level rises from this point onwards as the labour market begins to tighten

Tightening of the labour market

• Small pool of labour remaining with skills, so firms increase ways to attract them to work for them.
• This drives up inflation

Philips Curve

The Philips curve shows the relationship between unemployment and inflation.

SR Philips Curve

In the short run, the Philips curve shows that inflation is inversely proportional to unemployment. This means that if you try to reduce unemployment, inflation will increase.

As unemployment reduces from 6% -> 2%, inflation rises from 1% -> 6%
This is due to demand pull inflation / tightening of the labour (rising wages).

Stagflation

Stagflation is where unemployment and inflation is high at the same time. It can occur when there are supply side shocks. These cause cost push inflation, regardless of unemployment levels. One example of stagflation is when Trade Unions were extremely strong, causing cost push inflation.

LR Philips Curve

However, in the long run, the philips curve is perfectly inelastic. I.e Unemployment has no effect on inflation in the LR. This is because the level of unemployment will always return to the Natural Rate of Unemployment in the long run.

In this example, the LRPC curve is shifting left. This could be because benefits and income taxes were reduced (supply side policy).

Natural Rate of Unemployment

• Where unemployment will always return to in the LR.
• LRPC sits at NRU.
• Unemployment below NRU is made up of voluntary unemployment.

To reduce NRU you must decrease voluntary unemployment.

Demand side policies in the LR

In order to see the effect of demand side policies on the

• A -> B
  • Government seeks to reduce unemployment via demand policies, such as lowering IR
  • Unemployment reduces from 5% -> 3%
  • But inflation raises to 4% due to demand-pull inflation / tightening of the labour market
• B -> C
  • Firms and Workers realise they are falling for money illusion
  • In real terms they are no better off than not working / firms not making real profits
  • Firms reduce their number of staff, workers return to benefits
  • Unemployment returns to 5%
  • However, now expectations of 4% are built into the economy
    • Firms keep raising prices
    • Workers demand pay raises
  • So 4% inflation stays, at the original rate of unemployment

Government Bonds

Government bonds are how the government takes loan. They are also known as gilts. They sell "bonds" which pay the owner a certain amount every year and when the bond expires, the government pays the fully amount back to the owner. This makes them very safe investments.

Coupon - The guaranteed fixed annual interest payment, normally divided into two 6-month payments.

\(\text{Yield} = \frac{\text{Annual coupon payment}}{\text{Current market price}} \times 100\%\)

If the market price of a bond increases, the yield will decrease (since it has the same coupon, but is more expensive)

A higher yield means it is more desirable.

Worked Example

50 year bond with maturity value $100 and a guaranteed yearly interest payment of £2.50. 5 years after issue the second hand price falls to £50. What is the yield before and after?

\(\text{Yield Before} = \frac{2.50}{100} \times 100\% = 2.5\%\)

\(\text{Yield After} = \frac{2.50}{50} \times 100\% = 5\%\)

Monetary Policy

The use of economic instruments such as:

• Interest Rate
• Exchange Rate
• Supply of money (Quantitative Easing)

in order to achieve macro-economic objectives

Expansionary Monetary Policy

• Fall in normal and real interest rates
• Measures to expand supply of credit -> Loans
• Depreciation of the exchange rate

Expansionary monetary policy shifts AD to the right.

Benefits:

• Grows economy
• Reduces unemployment

Negatives:

• Increases inflation
• Current account position gets worse

Contractionary Monetary Policy

• Higher interest rates on loans and savings
• Tightening of credit supply (loans harder to get)
• Appreciation of the exchange rate

Contractionary monetary policy shifts AD to the left.

Benefits:

• Reduces inflation
• Current account position improves

Negatives:

• Shrinks economy
• Increases unemployment

Money Supply / Quantitative Easing

Quantitative easing involves increasing the money supply.

Originally, to do this, the central bank would just print money, however, this was difficult to control.

Since 2008, there is a new way.

• Central bank creates money
  • Virtually add money to their own account
• Central bank buys bonds
  • Buys from banks such as HSBC, Natwest, Santander
  • These banks have a large influx of cash, making banks more liquid
• Banks have lots of cash, so they lend to make profit through interest
  • Lots of banks compete to lend money
  • Lower interest rate
• Causes businesses and consumers to borrow money
  • Consumer spending and Investment increases
  • Aggregate Demand increases
• Unemployment decreases and Economic growth increases

Drawbacks of Quantitative Easing

• Causes demand-pull inflation
• Worsens the C/A balance deficit
  • More credit means more purchasing of luxury imports
• Asset bubbles
  • Spike in property prices
  • Eventually people realise that it cannot rise anymore
  • Bubble pops, everyone tries to sell
  • Price drops rapidly
• Larger gap between rich and poor

Monetary Policy Committee

The main objective of the monetary policy committee is inflation 2%.

Factors under Consideration

The monetary policy committee's 9 members are presented with lots of information that influences their decision.

• Financial Markets
  • Share prices - Indicating investor confidence
  • Household wealth
  • Consumer confidence
• The International Economy
  • Including the US, Europe and Asia. Trends in ER of £ against $ and €.
• Money and Credit
  • Bank lending and consumer credit figures analysed
• Demand and output
  • Consumption and planned investment survey figures
  • Rate of Real GDP growth
• The Labour Market
  • Figures of unemployment - Indicates demand-pull vs cost-push inflation
• Costs and prices
  • Manufacturer surveys of input costs and factory gate prices used as in indicator of whether firms are passing inflation onto consumers

Problems with accurately forecasting inflation

• CPI has multiple issues
• External shocks can occur at any time
  • Pandemic
  • Russia's invasion of Ukraine

Transmission Mechanism

Fiscal Policy involves the use of government spending, direct and indirect taxation in order to achieve macro-economic objectives.

Changes in fiscal policy affects both aggregate demand and aggregate supply.

Fiscal Policy also includes supply side policies

Public Sector Businesses

Public Sector Businesses are owned and operated by the government. The private sector is privately owned.
Examples:

• NHS - largest employer
• Met Office
• Channel 4
• Network international
• Royal Mail (Only 30%)
• Eurostar

UK Government spending

• Social protection - £231 billion
• Healthcare - £141
• Education - £99 billion
• Defence - £45 billion

Sources of Income

• Income tax - £170 billion
• National Insurance - £115 billion
• VAT - £133 billion

Spending

Current Spending - SR Spending

Spending in order to keep day-to-day things running:

• Paying NHS Workers
• Drugs used in healthcare
• Road maintenance
• Army logistics supplies

Capital Spending - LR Spending

Spending on new public infrastructure.

• Construction of new motorways
• New equipment in the NHS
• Flood defence schemes
• Extra defence equipment

Earning

Direct tax is levied on income, wealth and profit.

• Income tax
• Inheritance tax
• National Insurance Contributions

Indirect taxes are taxes on spending.

• Duties on fuel, cigarettes and alcohol
• VAT

Crowding Out

The crowding out view is that a rapid increase in government spending / borrowing may steal scarce productive resources from the private sector, and end up in the public sector, where there is lower efficiency. This view is a classical view.

• To cover budget, the government borrows money
• To do this it sells bonds to private sector, which raise its revenue.

In order to get institutions to buy bonds, it might mean having to raise the interest rate.

• But raising the interest rate increases saving / reduces investment.
• This means more firms will save and lend their money since interest rates are higher
• But also, the cost of borrowing increases for firms, meaning it is harder for them to invest, so investment reduces

AD = C + I + G + (X-M)

Government spending increases, but investment decreases, so no actual growth in AD occurs.

Supply side policies shift LRAS to the right. They are subset of fiscal policies.

Policies

Education and training

• Improves Labour - more skilled workforce
• Improves Enterprise - more education means more ideas
• Unemployment decreases
• Economic growth
• Occupational mobility

Drawbacks

• Takes a very long time to cause a shift in LRAS
• Very costly
• Can widen the gap between the rich and the poor. Those who are not educated are disadvantaged in the job market, and if they get a job, they are likely to be paid less.

Privatisation

• Improves Capital - More investment
• Improves Enterprise - Innovation
• Economic Growth
• Decreases inflation

Drawbacks

• If it is a natural monopoly, such as tap water, it will not be very competitive and the costs are mostly fixed (e.g pipes). A monopoly would likely end up having cheaper prices.
• The goal of some industries shouldn't be profit - For example healthcare, the objective is to make people better, not earn as much money as possible.
• Regulation may be needed to control the monopoly power if it was not owned by the government - it may be easier / cheaper to just keep a government-owned monopoly.
• Fragmentation - For example trains, train tickets would have to be negotiated with each train company you travelled with.

Reduce unemployment benefits and income tax

• Labour - encouraged to work
• Unemployment decreases
• Economic growth
• Current Account worsens
• Inflation increases

Drawbacks

• Gap between poor and rich becomes larger
• Those unemployed and unable to get a job because of their skills will not be incentivised to get a job and will only be hurt by the policy.

Deregulation

• Land - natural resources allowed to be exploited
• Unemployment decreases
• Inflation decreases

Drawbacks

• Regulations could be in place for the safety of workers. Removing these regulations could cause increased injury and hence increased cost for the healthcare system.
• Regulations could be put in place to force the firm to pay for its negative externalities. Removing this regulation would cause the cost to be paid by the government elsewhere.

Infrastructure Investment

• Improves Land
• Improves Labour - occupational mobility
• Inflation decreases
• Economic Growth increases
• Current Account improves

Drawbacks

• Usually very expensive
• Normally takes a long time to be completed and hence shift LRAS to the right

Immigration

• Improves Labour - more workers
• Inflation decreases

Drawbacks

• May take away jobs from native workers, who then need to be paid unemployment benefits.
• May cause wages to decrease as there is more competition and firms have a greater choice.
• May reduce incentives to develop technologies to improve the productivity of each worker, since it is cheaper to hire more labour. This could lead to a lower living standard than if net migration was not increased.

Restriction of trade union activity

• Improves Labour
• Inflation decreases

Drawbacks

• Less safe working conditions - Trade unions lobby for safe working conditions and restricting them could reduce this.
• Cannot overcome unfair wages - cannot bargain for higher wages
• Less job security, and hence lower consumer confidence. If workers are in a trade union, they will feel more secure and hence be likely to save less and spend more

Exchange Rate

Hot Money

When the base rate in the UK increases, this makes it more attractive to investors who want the highest interest rates possible, so this will cause "hot money" to flow into the UK. This results in demand shifting right since investors are buying the pound.

Figure 1

The same shift also occurs when exports increase, as other countries are buying the pound in order to purchase UK goods / services.

Figure 2

When the base rate in the UK decreases, this makes it less attractive to investors who want the highest interest rates possible, so this will cause "hot money" to flow out of the UK. This causes supply to shift right as investors sell the pound.

The same shift also occurs when imports increase, as UK companies sell the pound and buy foreign currencies, in order to purchase imports.

Floating Exchange Rate

An exchange rate which is determined solely by the market forces of supply and demand.

Benefits

• Reduced need for currency reserves
  • No target exchange rate so no need for central bank to hold large reserves
• Partial correction for a trade deficit
  • Floating exchange rates can help when the balance of payments is in disequilibrium. In a large C/A deficit it applies downward pressure on the exchange rate

Factors that impact the value

• Base Rate
• The demand for imports and exports
  • High exports -> demand shifts right, value increases
  • High imports -> supply shifts right, value decreases
• Inflation -> Increases demand for imports as domestic goods are becoming expensive

Partial correction of C/A deficit

A current account deficit in simple terms means that Imports > Exports.
This means that there is a large supply of £ since UK companies sell the pound to buy foreign currencies.
This means that the value of the £ will drop, which in turn makes exports more competitive, helping to balance out the C/A deficit. This is the partial correction.

Depends upon

Partial correction of C/A deficit will only work when imports and exports are elastic.

This is known as the Marshall-Lerner Condition - The value of net export's elasticity must be greater than 1 in order to benefit from devaluation of the ER.

Elastic Scenario

£1 = $1.80 -> £1 = $1.60

Exports - Increase in quantity and value since they are more competitive

Imports - Decrease in quantity and value since they are more expensive

Therefore, C/A deficit improves

Inelastic Scenario

£1 = $1.80 -> £1 = $1.60

Exports - Stays similar, inelastic means no benefit from being more competitive

Imports - Get more expensive, but inelastic, so quantity stays similar.

Therefore, C/A deficit worsens

Fixed Exchange Rate

When the value of a currency is pegged to the value of another currency. E.g Yuan to $
For example, the Chinese government pegged the Yuan to the dollar.

Example peg, 7 Yuan to $1

If the value of the dollar increases then the Chinese Central Bank will intervene by selling their reserves of the $ to buy the Yuan. This causes the $ to fall in value and the Yuan to rise in value. They will meet at 7 Yuan = $1

If the value of the dollar falls, then the Chinese Central Bank will intervene by selling their reserves of the Yuan to buy the $. This causes the Yuan to fall in value and the $ to rise in value. They will meet at 7 Yuan = $1

Benefits

• Trade and Investment
  • Currency stability can promote trade because of less currency risk
• Used as a way of controlling inflation.
  • Causes deflation if pegged to a low level
• Can fix high to reduce the cost of imports
  • Reduces the cost of production and inflation.
• Less need for hedging
  • Hedging is insurance against currency fluctuation. It is a type of insurance
• Countries have to focus in which they can improve their competitiveness without depreciating their ER, these tend to be more long run in nature.
  • Have to use supply side policies etc.

Winners / Losers from China pegging ER low

Winners

1. Consumers (in the US)
   • They get cheaper goods and services
2. Tourists (US->China)
3. Large imports
   • E.g. Apple, cheap manufacturing

Losers

1. US firms who export to China
2. US Domestic producers - Cannot compete

Drawbacks of a Fixed ER

• More likely that there is currency speculation / speculative attack.
  • This when currency traders buy up a fixed currency hoping that the central bank will run out of reserves
  • Trader in one bank buys up currency
  • Central bank responds by selling reserves of local currency
  • Other banks join the speculative attack
  • They hope that the central bank runs out of local currency reserves
  • They can then sell it off for profit, and causes a massive drop in ER for the country
  • Small countries are more vulnerable
• Don't have free control of monetary policy - have to keep in mind peg

Managed Exchange Rate

An exchange rate system that allows the ER to fluctuate between an upper and lower ER value. It is also known as hybrid or semi-floating

With a managed exchange rate, the central bank only intervenes when the value of the ER goes above the upper value, or below the lower value.

A - Sell reserves of £ and buy $ B - Buy £ using reserves of $

Money

Functions of money

• Medium of exchange
  • Goods and services can be traded more efficiently using money compared to bartering
  • Allows of specialisation and division of labour
• Store of Value
  • Money is an Asset whose value can be retrieved in future
  • Transfers purchasing power between time periods
• Unit of account
  • Allows you to express the value of good in a clear and meaningful way
• Standard of deferred payment
  • Money must be acceptable and seen as holding its future value

Characteristics of Money

• Portable
• Divisible
• Durable
• Limited in supply
• Acceptable to majority
• Difficult to forge

Types of Markets

Money Markets - Short term lending / borrowing

Financial institutions who wish to borrow or lend on a short term basis, provides liquidity

Capital Markets - Bonds & Shares

Primary

Initial sale:

• The Government selling bonds
• Firms raising funds through initial sale of shares

Secondary

• Trading existing bonds
• Trading shares on London Stock Exchange

Forex Markets - Currency Exchange

Foreign exchange markets - Trading currency

Spot Transaction - Buying foreign/local currency now

Forward Transaction - Buying in future (e.g. in 2 months)

Business Finance

How businesses raise money for growth and investment.

Key Sources of Business Finance

Debt Finance

Debt Financing means borrowing money from an outside source, with the promise of paying back the borrowed amount, plus the agreed-upon interest at a later date.

• Bank Loans
• Bank Overdraft
• Credit Cards
• Mortgages
• Peer to Peer lending
• Corporate Bonds

Equity Finance

Raising money by selling shares of your business.

• Angel Investors - Dragon's den
• Venture Capital - Investment bank
• Stock Market Listing - Initial public offering
• Crowdfunding

Banks

Retail Banks

• High Street banks
  • HSBC
  • Barclays
  • Lloyds

Retail bank model

Consumers put savings / deposits into the bank. As a reward for this, they get an interest rate of 3%.

The retail bank then gives out loans / mortgages / credit cards, lending out that money at a higher interest rate than they gave to the consumer.

The retail bank earns money by acting as an intermediary between lenders and borrowers.

Investment Banks

A financial institution undertaking financial advisory work.

• JP Morgan

• Goldman Sachs

• Help companies raise finance by selling shares or bonds

• Trade in shares, bonds and other financial assets

• Advise on mergers and Corporate Restructuring

Many banks have Retail and Investment branches.

Systemic Risk

The potential for failure or distress from one large banks to trigger the collapse of other large banks and the entire financial system.

There is systemic risk from banks lending to each other (Money Markets) since a bank may not repay debt to another bank, which the other bank requires to continue operation.

Bank Balance sheet

Bank Liquidity and Capital

Banks have a conflict between profitability and liquidity.

Liquidity is important as it protects a bank against bad debt, debt which has been defaulted.
Debt is promised to the bank, so it counts as an asset, but the asset can lose all its value if the borrower defaults.

However, banks want to be profitable, so they can grow, pay their employees more and increase market share. In order to be profitable, you have to make investments / loans, which are risky. These are harder to convert back to cash when needed, so the bank becomes less liquid as all their assets are harder to convert to cash.

Banks need to strike a balance between liquidity, so they don't go bankrupt, while being as profitable as possible.

Secured vs Unsecured Loans

Secured loans are loans where the bank can take an asset if the borrower defaults. These have much lower interest rates because the bank has to take much less risk, and so they don't have to charge higher interest rates to compensate for borrowers defaulting.

Secured loans are less risky.

Liquidity Ratios

A liquidity ratio is the ratio of liquid assets held by a bank to their overall assets. Banks need to hold enough to cover expected demands from consumers withdrawing deposits.

• After the 2008 Financial Crisis, the Basel Agreement was introduced which required Commercial Banks to keep enough liquid assets such as cash and government bonds to get through a 30-day market crisis
• May refer to a reserve assets ratio for a bank which a bank must maintain to prepare for a sudden increase in withdrawals
• A high liquidity ratio may limit the amount of lending that a business is able to do because it must maintain more cash

Capital Ratios

Measures funds against riskier assets that could be vulnerable in a crisis.

A healthy ratio is 1:1

The EU runs stress tests to check if banks have enough capital buffer to weather difficult economic scenarios.

Credit Creation

When banks give out loans, it creates credit in the economy.

The banks balance sheet before a loan looks like this

After credit creation

You can see that it creates assets for the bank, as well as new liabilities. The bank now has loans, which are worth money, as well as the consumer having money available.

Credit Creation diagram

When people take out loans, they either put the money in the bank, in which case it goes to the bank, or they spend it, and it ends up in another bank / the same bank. So banks create credit.

2008 Financial Crisis

In the 2008 financial crisis people speculated heavily in the housing market, which eventually crashed due to banks giving out sub-prime mortgages while credit rating agencies still gave them "AAA" ratings.

Videos

Short: https://www.youtube.com/watch?v=eD9ry2Lgglw Longer: https://www.youtube.com/watch?v=GPOv72Awo68&t=479s

1. Interest rates were low and investors were looking for something with better returns
2. House prices had been rising steadily for many years, so mortgages were safe as if the borrower defaulted, you could still sell the house for a good price and not lose out.
3. Mortgages were bundled up into securities and sold to investment banks
4. The investment banks then sold shares in the securities to customers.
5. The Securities were rated by a credit rating agency - gave investors confidence
6. Insurance was available against the mortgages going bust (credit default swap) - further decreasing the perceived risk
7. As far as investors could tell, it was low risk and high reward.
8. However, due to the sharp increase in demand for mortgages, banks started giving out sub-prime mortgages
   • Sub-prime mortgages were mortgages that the borrower could not afford, and included sharp increases in interest rates every year. Banks knew that borrowers would default.
   • Banks did not care that they were sub-prime because they sold them on and were not responsible for them.
9. Credit rating agencies continued to give them AAA ratings because they were paid for by the banks.
10. Investment banks didn't care about the quality of the mortgages because they sold them to investors, and they didn't bear the risk.
11. Borrowers began to default on their loans.
12. The influx of houses on the housing market caused the bubble to burst, causing the house price to drop
13. More people defaulted as they realised there was no reason to continue paying when they were paying more than the price of the house for the mortgage.
14. The mortgage insurance companies did not have enough reserves, so went bust.
15. The government had to bail out banks because otherwise consumers would lose their houses and savings - too big to fail

Financial Market Failure

Moral Hazard

When a person or organisation takes more risks because they know they are covered by insurance.

For example, Banks in 2008 acted knowing that governments would bail them out if necessary.

Asymmetric Information

When one individual / party has much more information than the other party, and uses that to exploit the other party.

In 2008 Banks sold mortgages that were sub-prime and sold them as "AAA". In 2008 Banks gave out mortgages with fine-print that would cause the interest rate to jump rapidly every year, and knew that the buyers would not be able to pay.

Speculation

A risky action in which a person or organisation tries to predict what will happen to the price of an asset and buys or sells accordingly to make a profit.

• People in 2008 made the assumption that house prices would continue to climb.

"Too big to fail"

When the systemic risk is so large that they would bring other banks down / the whole financial system down. The government has to intervene and bail them out or people would lose their houses and savings.

Financial Regulation

After 2008, the Bank of England was given powers to ensure the stability of the financial markets and prevent 2008 occurring again.

Interventions

• "Stress-test" -> Check capital ratios to ensure they could survive 30 days of economic turmoil
• Can ask Commercial Banks and Lenders to increase capital buffer in difficult economic circumstances
• FPC can make recommendations to PRA and FCA
• FPC can recommend changes in regulation
• Ask to look at unregulated markets

Reasons for Regulatory changes

• Proactive instead of reactive
• Reduce likelihood of future financial crash
• Monitor activity more closely and have an early warning system
• Can take actions to risks of a crisis that might happen

Evaluation

• Regulatory capture - Paid for by firms, incentive to not regulate. Conflict of interest.
• Undermined by standards not being international - lenders may just move abroad to countries with less strict regulations.

Benefits of Deregulation

• Credit increases, increasing AD, due to higher investment and consumer spending
• Living standards increase - easier to get a mortgage and more jobs
• Profits for banks - create jobs
• Draws business into the UK - lower regulations will make the UK more internationally attractive since banks could make higher profits

Functions of the central bank

• Issues notes and coins
• Financial Stability
  • Regulate the financial market
• Inflation Targeting
  • Base rate
• Banker for the government - handles tax receipts and some items of government expenditure
• Commercial banks hold reserves at the central bank
  • Store of liquid assets used to balance out day-to-day transactions between banks. Decided each month in advance
• Manages the exchange rate
• Quantitative Easing
• Lender of Last resort

Lender of last resort

The Bank of England will lend to banks if there are no other banks willing to lend money, and they are short of cash.

Advantages

• Prevents systemic risk
  • Reduces risk of bank failing and creating domino effect
• Increased financial stability
• Increases confidence in financial system
  • Consumer spending and investment increases, AD increases
• Firms' and Consumers' savings are protected
• Banks able to seek more profit - Increases AD
• Encourages B.O.E to use multiple tools such as regulation to control the market.

Disadvantages

• Banks likely to take bigger risks
  • Larger moral hazard
• Banks encourages to be less liquid
• Reactive - larger opp. cost.

Judgement

Needs to be used in combination with other factors:

• Stress tests
• Regulation
• Reserves

International Trade

F.S - Financial Services
C.F - Cut Flowers

Absolute Advantage

Absolute advantage is where one country can produce a good at a lower unit cost compared to another. This is normally shown by a greater total capacity, since that leads to higher efficiency (EOS).

According to this theory of trade, the UK will not trade with Kenya.

Comparative Advantage

Comparative advantage is where one country can produce at a lower opportunity cost to another.

According to this theory of trade, the UK will trade with Kenya.
Opportunity cost of producing F.S in the UK is 1 (1:1) Opportunity cost of producing F.S in Kenya is 2 (2:1)

This means that the UK gives up less cut flowers per financial service, and therefore it makes sense for the UK to produce financial services and Kenya to produce cut flowers, and then trade.

Protectionism

Protectionism refers to government policies that restrict international trade to help domestic industries. Protectionist policies are usually implemented with the goal to improve economic activity within a domestic economy, but can also be implemented for safety or quality concerns.

Winners

• Governments - Through tax revenue from tariffs
• Domestic Firms
• Workers - More jobs
• Protected industries, such as agriculture

Losers

• Consumers (Higher prices)
• Firms that import lots of goods and services

Examples of Protectionism

• Tariffs - Import taxes
• Quotas - Limits on how many imports of a certain good are allowed in
• Embargoes - A total ban on an import good
• Intellectual property laws
• Preferential procurement policies
  • Governments favour local producers for infrastructure projects etc.
• Export subsidies - Payments to encourage domestic products by lowering their costs
  • Common Agricultural Policy in the EU
  • Cotton subsidies for US Farmers

Benefits

• Infant Industry Argument
• Sunset Industry Argument
• Protecting Strategic industries
  • Agriculture
  • Military
• Anti-dumping duties
  • Dumping is where they are sold for export at less than the market price in the country being exported to.
    • India complained of China and Thailand dumping bus and truck tyres
    • Anti-dumping duties prevent prices from crashing, and can be prevented with Quotas

Infant Industry Argument

The Infant Industry argument is the argument that some industries can have a comparative advantage but just need time to grow first, but they need protecting in the meantime.

Certain industries possess a possible comparative advantage but have not yet exploited economies of scale. Short-term protectionism allows the "infant industry" to develop its comparative advantage at which point the protection can be relaxed, leaving the industry to trade freely on the international market.

For example, South Korea put a bubble around their Car Industry by putting high tariffs on car imports (In the 1970s).

This means that domestic consumers purchase South Korean cars instead of imported cars since they are cheaper. After a while (2010s), South Korean Car manufacturers have grown larger and now have Economies of Scale. South Korea then removes the bubble of protection around them since they are now able to rival global firms. If there was never a bubble around them, they would be unlikely to have been able to compete with global competition and gone bust.

Sunset Industry Argument

The Sunset Industry Argument is the argument that you can protect declining industries with protectionism. This usually occurs in developed countries.

Steel in the UK

Steel is going into decline in the UK, but it used to be a large industry. By putting tariffs on imported steel, it allows steel manufacturers in the UK to keep being competitive. This is good as it prevents structural unemployment, but it also means that steel becomes more expensive.

Alternatives

Alternatively, instead of protectionism, you could use Education and Training to retrain workers into an industry with a skills gap.

Tariffs

A tariff is a tax placed on imports. It is set per unit. For example the UK government could put a tariff of £5 per kilogram of beef imported into the UK. If the market price for beef in the UK without trade is £40, this is what the diagram would look like.

A - Represents the conversion of consumer surplus back to producer surplus (for domestic producers)
B - Gain in tariff revenue for the government (tariff per unit (£5) * Q2->Q4)

Shaded Area - Loss in welfare / deadweight loss

Extension in domestic supply after tariff is added is X->Y

Y->Z Represents the disequilibrium between domestic supply and demand after a tariff has been added. This means that the quantity of imports is Q2->Q4, filling the disequilibrium.

Free Trade / Liberalisation

Free Trade is the opposite to protectionism.

A - Conversion of producer surplus to consumer surplus
B - Gain in consumer surplus

A + B = Total gain in consumer surplus

Reasons for Free Trade

• Lower prices, reduced inflation
• More innovation
• Sunset industry argument poor way to sustain unemployment
  • Costly and unsustainable way to sustain unemployment, use Education and Training instead
• Loss of economic wealth
  • Tariffs create deadweight loss
• Protectionism is regressive
  • Higher prices from tariffs hit those on lower incomes harder
  • Tariffs are usually placed on food and clothes
• Protectionism causes inefficiencies
  • Firms protected from competition don't have an incentive to reduce costs. This leads to even higher costs
• Trade wars
  • Placing tariffs on imports from one country may cause them to place import tariffs on your country, and you may then retaliate with more tariffs.
• Protectionism is a "second-best" approach to correctly a country's C/A balance
  • Should use supply side policies instead
  • Can be counted as government failure

The Changing Pattern of Trade

From the 1880s to the 1950s, the majority of trade occurred between North and South (Uk, Germany -> Africa, South America)

But from the 1950s, trade now mainly flows between developed nations (North-North)

Why

• Lots of trade deals between big countries
  • EU - Free trade / no tariffs
• Newly industrialised countries - MINT, BRIC
  • These disrupt trade and northern countries are trade with China instead

Example Question

The UK has seen significant changes in its pattern of trade with the rest of the world in terms of what we write and with whom. The UK's current account deficit widened from £29.1bn in 2011 to £100.2bn in 2015. The deficit in 2015 was 5.4%, the largest annual deficit as a percentage of GDP since records began in 1948.

Explain the possible reasons for changes in the pattern of trade between the UK and the rest of the world.

Trading blocs

The UK used to trade with developing nations for raw materials and there were not many trade agreements. However, over time the EU has grown significantly, a trading bloc with no tariffs, allowing free trade within the block. This meant that the UK increased trade within the EU and decreased trade with southern countries. This is because consumers choose cheaper products which come from the EU since there are no tariffs, and firms also trade with the EU because there are no tariffs, which means they can make more profit. Southern countries are not part of the EU, so they are left out of the free trade agreement.

Economic Integration

The process of blurring the boundaries that separate economic activity in one nation state to another (Removing barriers to trade).

Examples of barriers to trade

• Tariffs
• Product standards
  • In the EU they have the same standards for all countries
• Quotas
• Employment laws
  • Free movement of workers
• Subsidies

1. No tariffs on goods and services between members
   • NAFTA - North American Free Trade Area
   • USA, Canada and Mexico
   • Causes manufacturing to move to mexico
2. Same tariffs on products / service
   • ASEAN / Mercouser
3. Free movement of goods, services, capital and labour
   • Single European Market
4. Similar / Same Fiscal policies
   • E.U common subsidies
5. Single currency
   • Euro zone
6. Same country
   • US - States merged to become one country

Customs Union

A customs union is a group of countries who join together and agree to have free trade between them, and the same tariffs on other countries.

Trade Creation - Benefit

For example, Uruguay joins a Customs Union, and switches from Australian wine to Argentinian wine, which is cheaper.

• The country moves from a more expensive producer to a lower cost producer
• Costs of production decrease

Trade Diversion - Drawback

For example, Uruguay used to buy lamb from New Zealand, but now a tariff is levied on NZ by the Customs Union. The customs union would want to levy this tariff, since Brazil produces lamb, but it is more expensive than NZ lamb. However it is less expensive than the NZ lamb with the tariff, so Uruguay switches to Brazillian lamb.

• The country moves from a cheaper producer to a more expensive producer
• Costs of production increase

Advantages vs Disadvantages

Depends upon

• Size of economy and level of negotiating power
• Could negatively influence infant industries, especially if you are small / less developed economy
• The amount of Creation vs Diversion

World Trade Organisation

The World Trade Organisation is responsible for trying to promote and regulate free trade agreements between countries. All almost countries are a member of the WTO.

Ideal Trade

According to the WTO, ideal trade would be:

• Non-discriminatory
  • Countries are not allowed to have informally have free trade with one country but strong protections against another
  • Everything agreed between countries should be formal
• Free from barriers - no protectionism
• Predictable
  • So that countries can foster investment and job creation and businesses can flourish
• Promoting fair competition
  • The WTO will allow for "fair" competition, e.g allow Infant Industries to grow
  • Protectionism only when needed then taken away
• For trade to be beneficial to developing countries
  • Allow special provisions for developing countries

Roles & Functions of the WTO

• Set and enforce rules on international trade
• Resolve Trade Disputes
  • WTO steps in instead of countries retaliating against eachother i.e tariff war
• Provide a forum for negotiating trade liberisation
  • Gives a way for multi-country agreements to simultaneous reducing of protectionism
    • Negotiations take place in Geneva
• Monitor trade liberalisation
  • Make sure free trade agreements are honored
• Increase transparency of the decision making process
  • Member states understand how the decision has come about
  • Member states can critique the WTO for their decisions
• To help developing countries fully benefit from global trade
• Cooperate with other major economic institutions e.g I.M.F

Criticism

The WTO has been criticised for benefitting developed countries more as Free Trade benefits developed countries much more than LDCs.

Human Development Index

The Human Development Index is a measure of development.

It uses three key criteria:

• Average life expectancy
• Education Index
  • Mean years of school
  • Expected years of school
• Income Index (GNI at PPP)

The HDI is a number between 0 and 1. A higher number is more developed.

Drawbacks of H.D.I

• Doesn't show regional differences
• Slow to respond / doesn't update often enough to show short term changes
• GNI does not show welfare, depends how the government spends it, e.g military

Improvements to the H.D.I

These factors if added to the H.D.I it could make it more accurate.

• Distribution of Income (Included in Human Poverty Index)
• Level of environmental degration
• Freedom / Political Freedom
• Happiness

Top Countries

0.961 - Switzerland 0.959 - Norway 0.955 - Iceland

Globalisation

A process by which the world's economies are becoming more closely integrated

Multi-national Corporations

• Apple (USA)
• KFC (USA)
• Starbucks (USA)
• Amazon (USA)
• M&S (UK)
• Walmart (USA)
• Aldi (Germany)
• Google (USA)
• B.P (UK)

The majority of multi-national corporations come from HDCs (especially the US).

Reasons for Foreign Direct Investment / Multi-national corporations

Multi-national corporations invest in other countries, so they are a form of F.D.I.

There are multiple reasons for investing in another country:

• Market seeking
  • Seeking to expand their demand / number of possible customers
  • E.g Google
• Efficiency seeking
  • Seeking lower costs
  • E.g Apple gains cheap manufacturing from China
• Resource seeking
  • Seeking resources that are scarce / not available in the country of origin
  • E.g B.P drilling for oil across the world.

Why the speed of globalisation has increased

• Technology change
  • Communication technology has allowed cheap and easy transfer of information between the head office and global sites
• Revolution in transportation via containerisation
  • Firms can pack products on site, reducing costs of sea transport
• Trade has becoming more liberal as protections have been lifted due to the work of the World Trade Organisation
• Deregulation of financial markets around the world

Drawbacks of globalisation

More susceptable to external shocks:

• Covid
• War in Ukraine
• Oil prices
• 2008 Financial Crash

Unemployment and deindustrialisation occurs as MNCs move production out of developed countries into newly industrialised countries.

• Causes structural unemployment

Access to protected markets is restricted, so it is not a level playing field (Protectionism)

Impact on LDCs

Impact on the Balance Of Payments

• Initially, credit due to large investment, e.g $20m
• Eventually, debits due to profits paid back to headquarters
  • Year 1 -> $50,000
  • Year 5 -> $10m

Benefits of F.D.I and MNCs in an LDC

• Creation of jobs
• Skills and training provided for workers
• Increase in tax revenue
• Access to capital and dynamic efficiency

Potential costs for an LDC

• Capital intensive production techniques - few jobs created
• Top jobs imported in with the company
  • CEOs, CFO, CTOs are all based in the home country, only low paying jobs given in the LDC
• May have to cut taxes to attract MNCs
• Negative externalities, e.g pollution
• Infant Industries cannot compete with MNCs.

15 Mark answer

Same as essay but no evaluation or judgement.

• Intro
• Diagram
• Analysis (x4)

25 Mark Essay

• Introduction - Define key points
• Diagram - Draw a relevant diagram
• Analysis (x4) - Use economic theory to give one side of an answer, agree with the question / a positive response
• Evaluation (x3) - Give balance to the answer. Negatives, why you don't agree
• Judgement (1 or 2) - Depends upon... back up with facts.

Definitions / Intro

Current Spending - Spending to keep day to day things running, such as paying NHS staff
Capital Spending - Spending on new public infrastructure and investments.

Fiscal policy involves the use of government spending, direct and indirect taxes to affect the achievement of macro objectives.

Analysis

Subsidies

• Allow businesses to expand
• AD shifts right
• Firms can hire more people - unemployment down
• ??? spending
• Economy grows.
• Relate to diagram.

Reduce direct taxes - e.g Income Tax

• More disposable income
• AD shifts right
• unemployment down
• Economic growth

Reduce indirect taxes - e.g VAT

• SRAS shifts right
• AD expands due to SRAS shifting.
• Economic growth
• Unemployment down

Supply side policy - e.g Infrastructure Investment

• LRAS shifts to the right
• Economy grows
• Unemployment down
• Current account improves since the UK will be more competitive with other countries
• Inflation decreases since costs of production decrease

Evaluation

Expensive

• High opportunity costs
• Government debt

Takes a long time

• Especially supply side policies like education

If interest rates are high

• People will save rather than spend

Judgements

• Depends on where the AD curve is on the keynesian LRAS curve.

(You don't need to draw this many AD lines in the exam)

If there is no spare capacity, then policies that affect AD, such as cutting direct tax, will be ineffective.

You could also mention:

• depends on interest rate
• amount of national debt
• type of fiscal policy

Evaluate the view that strict rules and regulations are essential to create a more stable economy

Analysis

• Details of 2008. How it happened, market failure -> needs regulation to stop
• Systemic Risk - Banks are interconnected because they loan money to eachother. If one fails they could all fail and cause a collapse of the financial system.
• Stress Test - Can the banking sector survive for 30 days of shock -> Capital Ratio
• FPC is proactive rather than reactive. This makes the economy more stable as crisis are less likely and less severe. Less opportunity cost and less damage to consumer confidence

Evaluation

• Government Failure - Regulatory Capture
  • The FPC gets money from the firms it regulates which means there is a conflict of interest
• Countries with less regulation get boosted AD as banks move to them.
• Free market means more innovation and growth, which means they could recover from economic shocks better
• Other factors have a greater effect on stability, such as government spending, competence of Central Bank.

Judgement

• To be effective, the regulations need to be international
  • Otherwise, banks will move to countries with less regulation
  • Banks are still interdependent across countries
• Trade off / Opportunity cost
  • Little regulation -> higher AD and faster growth, higher risk of financial crash
  • Strict regulations -> low risk of financial crash, lower AD

June 2020 Econ P2 Planning

Essay 1

Explain possible causes of a falling budget deficit

Position in the economic cycle: In a boom, the government is likely to reduce government spending as AD no longer needs boosting. Furthermore, spending too much in a boom could lead to crowding out. This is where the government borrows in order to spend -> this drives up the interest rate, which makes the cost of borrowing higher, reducing the incentive for firms to invest. Furthermore in a boom, the government is likely to have more tax revenue as AD is higher.

Decrease in unemployment: A decrease in unemployment, will mean that more people are working. This will not only mean that AD shifts right -> more spending -> more tax revenue, but also, the government will not need to pay as much in welfare and JSA payments, which could cause a falling budget deficit.

Growth in the economy: As the economy grows (AD/LRAS diagram), the real gdp is greater, which means that the government has more tax revenue from VAT since there is more consumer spending.

To what extent do you agree that reducing the budget deficit is more important to the UK macro performance than the C/A deficit on the BoP

High budget deficit will mean a increase of the national debt, which not only will increase the opportunity cost of future years, but will mean that future generations pay for current spending. Reducing the budget deficit will decrease the burden on future generations and mean that in future taxes won't have to be raised to pay for the accumulated debt.

A C/A deficit may not be harmful to economy if the economy is growing (AD/AS), as the main impact of a C/A deficit is that net exports is negative, detracting from AD, however if consumer spending and other components are growing, this isn't a large issue, so in this case a budget deficit is more important.

Not reducing the budget deficit could mean that in future the cost of borrowing increases. This is because the more the UK government borrows, the less confidence bond-purchasers have in the UK government. Running a consistently high budget deficit could mean that in an economic shock, or recesssion, the government is not able to borrow when it is most needed. Government borrowing can be said to have an opportunity cost of borrowing in future. Borrowing too much can mean deeper recessions a greater impact on the economy than just reducing government spending initially. This suggests that reducing the budget deficit is more important than reducing the C/A deficit.

Crowding out.

C/A deficit could indicate that the UK only has a comparative advantage in very few small sectors. This means that a C/A deficit could indicate an issue with the structure of the UK economy, and that the UK needs to invest in more supply side policies to become more efficient. Once the UK becomes more efficient, its C/A balance should improve which will mean that the government has succeeded at improving the UK economy, which not only benefits the C/A balance, but also will have the result of reducing inflation, and lowering the cost of living and raising the standard of living for the UK due to a more efficient economy. This would make improving the C/A deficit a good indicator of macro-economic performance.

Trying to reduce the budget deficit could lead to government failure, as the government doesn't want to spend as it will be seen as failing its macro-economic objectives, even in a recession where higher government spending is needed. The budget deficit is more likely to follow booms/recessions rather than indicating whether the government is properly managing debt and its finances. This would make a budget deficit a poor indicator of macro-economic performance.

Reducing the C/A deficit will lead to increase in AD, as in order to reduce the C/A deficit, net exports must be increased. An increase in AD would lead to growth and a reduction in unemployment. Additionally, reducing C/A may involve creating trade deals with other countries, which may lead to trade creation, where the UK is able to switch from one more expensive country to a cheaper one, since tarrifs have now been removed. This would mean cheaper imports which could shift the AS curve right, leading to further growth.

Whether the budget deficit is more important as an objective depends upon whether they are used in conjunction with other objectives. Both objectives are subject to failure if relied upon solely. For example, a C/A deficit could be solved by a large devaluation of the exchange rate, but this would be a solution through the "second best" approach, and would not actually improve the competitiveness of performance of the UK economy. Similarly, reducing a budget deficit is only really desirable in a boom / normal economic times, and if governments don't increase spending during a recession this could lead to less growth and worse economic performance. If reducing the budget deficit is only a goal during a boom, then it is likely to be more important than reducing the C/A deficit, as the C/A deficit could simply be an indicator than the UK is a rich country and hence has a large number of luxury imports.

Essay 2

Explain how demand side and supply side shocks might increase unemployment in an economy

Evaluate the view that the main objectives of the UK government macroeconomic policy can be achieved without conflicting with eachother

Education and Training can increase the supply of skilled labour in an economy, (keynesian LRAS / AD), which increases the spare capacity in an economy, reducing the costs for firms and hence reducing inflation, increasing employment and increasing growth. Lower costs of production should also lead to

Infrastructure Investment can increase geographic mobility of labour, which will decrease costs for firms, shifting LRAS right (classical LRAS / AD diagram), which will reduce inflation, increase growth reduce unemployment.

Expansionary monetary policy such as decreasing the IR can lead to an increase in AD. If an economy has spare capacity, such as in a recession, then (keynesian LRAS / AD with spare capacity), then this will not cause inflation, increase growth and employment.

Supply side policies such as Education & Training cost a large amount of money and this money will have to come from somewhere -> Most likely this is through higher taxes, such as VAT, which are regressive. This means that the distribution of income will worsen when supply side policies are used. Furthermore, many of the most highly paid dodge tax, which means they are not paying for the supply side policies, instead the burden of tax ends up impacting the poorest most, further worsening the distribution of income.

Supply side policies such as education and training cause a large growth in government spending. If these are used correctly, they will be used when there is not much spare capacity in the economy. However, due to the large time lag of these investments, AD will shift right immediately, whereas LRAS will not shift for likely many years. This could lead to temporary demand-pull inflation.

Decreasing IR can lead to a reduction of saving and increase of spending, increasing AD. However, if IR are kept high for too long, this can lead to consumers have very little savings and borrowing large amounts. An economic shock such as a spike in oil prices could cause the BoE to increase IR, which could lead to consumers defaulting on their loans, including their mortgages. This could cause a recession and hence a fall in consumer confidence.