GCSE ECONOMICS (OCR)

Revision Guide: Unit 2

How the Economy Works

Name:
Form:
 What are the Economic Objectives of Government
There are 4 main macro-economic objectives of Governments. These are:

(1) Economic Growth

Ideally the economy will grow at a steady rate. We want the economy to grow at the highest rate
possible that is sustainable. An economy that grows too quickly in the short run may increase
inflationary pressures
Economic Growth needs to be sustainable. This means that it is achieved using renewable resources
and in a way that is environmentally friendly

(2) Low inflation/Price Stability

There is an acceptance that in a modern, dynamic economy prices are likely to rise over time
However high inflation is bad for the economy
The Government and the Monetary Policy Committee of the Bank of England set an inflation target
of about 2%. They intervene (using tools such as interest rates) if inflation looks like it is going above
(or below) this target level

(3) High employment/Low unemployment

Again, it is reasonable that there will always be a small amount of frictional unemployment as
workers move between jobs
However, a key aim of government is to keep employment as high as possible

(4) Balancing imports and exports: avoiding a large current account deficit
The government must ensure that there is not more money leaking out of the economy (to pay from
imports) than is coming into the country from the sale of exports

Clashes between economic objectives

It is often very difficult for a government to achieve all 4 economic objectives at once.

For example, in a recession, the government may try and stimulate demand. This will stimulate economic growth
and reduce unemployment. However it may also cause demand pull inflation and suck in imports, thus making the
current account deficit worse

Government policies

The government will use a range of economic policies to achieve these objectives. These will include:

(a) Fiscal Policy

(b) Monetary Policy
(c) Supply-Side policies
(d) Specific policies
(e) A combination of the above

These policies will be dealt with later in this revision guide

 Economic Issue 1
Economic Growth

Definition
Economic Growth can be defined as a rise in the productive capacity of the economy such that more output is being
produced. (An increase in the value of output of the economy measured by change in Real GDP)

How is Economic Growth Measured?

Economic Growth is measured by looking at the change in Gross Domestic Product (GDP)

GDP measures the VALUE of all goods and services produced in an economy over a period of time (usually a year).
For example if the Wood economy only made cakes and made 10 cakes at 5 each, the GDP would be 50

In order to accurately compare countries, it is necessary to take into account differences in population. To do this
GDP is divided between the population to give GDP PER CAPITA (per person). In reality this is only an average as it is
highly unlikely that the GDP is equally distributed between the population

Sometimes GDP rises and gives the appearance of economic growth. However this is just because prices have
increased (imagine if the prices of cakes rose to 10, GDP would look like it has doubled to 100 when in reality we
have made no more cakes than previously). To take into account inflation we often measure economic growth by
looking at REAL GDP PER CAPITA

What causes Economic Growth?

Economic growth can be demand-led or supply-led.

Demand led growth occurs when Aggregate Demand (total demand in the economy) rises. This may occur because:
incomes rise; taxes are cut; interest rates are cut; there are high levels of consumer and business confidence;
expectations are good.

Supply-led growth occurs when there is a rise in Aggregate Supply (total supply in the economy. This occurs because
there has been an increase in the QUANTITY and QUALITY of resources. For example: more investment increases the
capital stock; better education and training improves the quality and productivity of labour; the discovery of North
Sea Oil boosts land stocks; the support of banks and government schemes boost enterprise:

Causes of Economic Growth

Investment (Increases in Capital) should increase productivity meaning more goods and services can be
produced. May also reduce unit costs making goods more competitive in international markets
Changes in Technology should improve productivity meaning a higher value of goods and services can be
produced
A larger workforce may be achieved through immigration or through increased participation rates (people
working longer or in some cases just people working)
Education and Training (Increases in Human Capital) should make labour more productive
Natural Resources
Government Policies eg Monetary and Fiscal to manipulate the level of Aggregate Demand
What are the economic consequences (costs and benefits) of economic growth?
Economic Growth is usually regarded as a positive with benefits outweighing costs. However, some people argue
that there can be negative aspects of economic growth

The benefits of Growth The costs of Growth In reality it depends on

Higher GDP implies the country is It depends on how the EG is HOW the GDP rise is achieved ie:
richer and living standards are achieved. If it is through longer
higher working hours, living standards may Demand led or supply led?
be lower. Is it sustainable? Are
If the economy is producing more it inflationary pressures
is likely that more people are If economic growth is achieved by increasing?
employed. This reduces the costs of using non renewable resources this From renewable resources
unemployment and reduces will be unsustainable and will cause or non renewable resources
absolute poverty future economic problems How workers are
treated/workers rights
If GDP is rising, the government will Demand led growth can be
automatically be earning more tax unsustainable and may cause lead HOW the rise in GDP is distributed
revenue from existing tax rates. to demand pull inflation amongst the population
This may finance expenditure on
more public and merit goods In reality GDP may be unevenly
spread between the population
Supply led growth increases with the rich getting richer and no
productive capacity so may help benefit to the poor
bring down inflation
What economic policies can be used to address this?
Type of Policy What would you do?
Fiscal Policy To achieve demand-led growth:
Reduce direct and indirect taxes to stimulate
(Changes in Government Expenditure and Taxation) AD
Increase government spending on benefits etc
to stimulate demand
Increase spending on infrastructure (multiplier)
To achieve supply-led growth:
Reduce direct taxes to improve economic
incentives to work and to invest
Increase government expenditure on education
and training
To achieve demand led growth:
Monetary Policy Reduce interest rates: reduces saving;
encourages borrowing; makes mortgages
cheaper so increases peoples disposable
income; reduces exchange rates so makes
demand for exports rise
Money Supply is increased (through
quantitative easing) making it easier for banks
to lend to consumers and businesses to
stimulate consumer demand and investment
To achieve supply-led growth:
Reduce interest rates to stimulate investment
by firms (ie borrowing to buy new, more
productive capital)
Increase money supply; encourage the banking
sector to lend more money to new and existing
businesses to stimulate enterprise
Supply-Side Policies Classical Approach (not government intervention)
Privatisation and deregulation of markets
Get rid of minimum wage
Get rid of benefits
Reduce bureaucratic rules and costs that
businesses face
Keynsian approach: Government can help to stimulate
AS
More spending on merit goods like: education,
training, health
More spending on infrastructure (road, rail etc)
to make it easier for firms to set up and reduce
transport costs
Other In reality, there is likely to be a mix of the policies
mentioned above
EU grants may also be used to stimulate development
and growth in certain regions
 Economic Issue 2

Achieving high employment/reduced unemployment

Definition
Unemployment is defined as the number of people who are willing and able to work, and actively seeking work, but
unable to find jobs

How is Unemployment Measured?

(a) The Claimant Count: Traditionally unemployment has been measured by the number of people receiving
benefits. Some people think this underestimates unemployment because some people are too proud to
claim benefits or may be ineligible for some reason. Other people think it over estimates unemployment
because some people work but still claim benefits (benefit fraud)
(b) The International Labour Organisation (ILO) measure: This is the same measure as used across Europe and
other areas of the world so it makes international comparisons easier. The ILO measure looks at who is
claiming benefits but also looks at records of whether individuals are actively seeking work (ie job
applications)

What causes Unemployment?

Type of Unemployment Explanation
Cyclical Unemployment Unemployment caused by a general lack of demand
across the whole economy (ie recession) Labour is an
example of derived demand, so if there is no demand
for goods there is no demand for labour to make the
goods
Structural Unemployment Unemployment caused by a lack of demand for a
particular industries goods. For example a lack of
demand for UK coal will lead to unemployment
amongst UK miners
Regional Unemployment Unemployment that is particularly high in a given
region. This has been linked to structural
unemployment because when a particular industry is
concentrated in one region, the demise of the industry
will hit that region particularly hard
Frictional Unemployment When people are in between jobs. There may
physically be enough jobs for everyone BUT the jobs are
either in the wrong area or in the wrong occupation. It
takes time for people to re-train or re-locate
Classical Unemployment Unemployment caused by Trade Unions and Minimum
Wages. TUs and minimum wages have the effect of
creating wages that are above the market clearing free
market wage, thus causing excess supply of labour
Voluntary Unemployment Unemployment caused when workers are unwilling to
work at existing rates of pay. This is often made worse
by the tax and benefit system which may make it more
financially worthwhile not to work
Technological Unemployment Unemployment caused when new capital takes over
jobs that were previously done by workers, examples
include: Banking; Newspaper Printing
 What are the economic consequences (costs)
Costs to .... What are they?
Unemployed worker Reduced disposable income
Low self esteem/morale
Possibility of absolute and relative poverty
Over time lose skills and become increasingly
unemployable
Business May be less consumer demand for their
products when unemployment is high
(especially if they make income elastic normal
goods)
Although it may be easier and cheaper to
recruit labour. Skills may be lower if labour has
been out of work for a long time- may need to
spend money on re-training
Government Tax revenue falls from both direct taxes
(income tax) and indirect taxes (VAT)
Government expenditure on benefits (social
protection) will rise (opportunity cost)
If the government is spending more and
earning less it will contribute to a budget deficit
and may require further borrowing by the
government
The government may have to pay for some of
the social costs of unemployment (crime)
Society Increased crime rates
Increased social breakdown (divorce)
Increased alcohol/drug issues
Low engagement with education if perceive it is
pointless
The Economy Unemployment represents an unproductive use
of a scarce resource (labour opp cost))
The economy will be producing less GDP than it
is capable of
The longer labour is unemployed the more it
deteriorates in quality

What economic policies can be used to address unemployment?

Economic Policy How would it work?
Fiscal Policy Government Spending would increase:
To stimulate demand via the MULIPLIER effect
On specific projects- re training; attracting firms
to areas of high unemployment through
subsidies
Taxation would decrease
Lower levels of direct tax would increase the
incentive to work and give people higher
disposable incomes, thus increasing spending
Lower levels of indirect tax would stimulate
demand by making prices cheaper
Lower levels of business tax allow firms to
invest more money in new capital
Monetary Policy Interest rates would decrease:
Would reduce saving and encourage people to
spend, demand for goods increases demand for
workers
Would encourage people to borrow to finance
spending
Would make mortgage repayments cheaper,
giving people more money to spend
Would make it cheaper for firms to borrow to
finance investment and expansion
Would lead to a fall in exchange rates which
might make UK goods more competitive and
stimulate demand for exports
Money Supply would increase
More money is available from the banking
sector to finance consumption and investment
demand
Supply-side policies Remove the minimum wage
Cut benefits
Lower direct taxes on workers to encourage
incentives to work
Lower direct taxes on businesses
Remove unnecessary legislation and
bureaucracy
Specific policies Policies that match to specific types of unemployment
are likely to be more effective. Fiscal and monetary
policy will help with cyclical unemployment but will not
help other types

Regional: Regional Policy to attract new industries to an

area
Structural: As above and re-training of workers
Frictional: Re-training to improve occupational mobility
of labour; schemes to help workers physically re-locate-
eg support with housing and removal expenses
Classical: Reduce TU power; get rid of the minimum
wage
Voluntary unemployment: Reduce direct taxes (income
tax); reduce benefits
 Economic Issue 3
Reducing Inflation (ensuring price stability)

Definition
Inflation can be defined as a sustained rise in the general level of prices

The rate of inflation is the rate at which the general price level rises over time

Price Stability means that the general level of prices is kept constant or grows at an acceptably low rate over time.
How is Inflation Measured?
Inflation is now measured using the Consumer Price Index (CPI) which is the same as the rest of Europe

The government selects a basket of goods that represents the spending patterns of UK households.
It then weights the goods/services according to how important they are to spending patterns
Prices are measured at a range of outlets across the country
Inflation is then calculated

What causes Inflation?

Demand Pull Inflation Cost- Push Inflation
Inflation is caused when aggregate demand increases in Inflation is caused when firms costs of production rise.
the economy so that there is excess demand. Firms put their prices up to compensate for the rising
AD may rise for a number of reasons: costs of production. Costs may rise because:
Economic Boom Oil/Petrol prices rise
Tax cuts Primary commodity prices rise
Low interest rates Wage levels increase (perhaps the minimum
Income rises wage increases)
Consumer Confidence Government taxes increase
Business Confidence Government legislation imposes extra costs to
firms

What are the economic consequences (costs) of Inflation

Cost Explanation
Menu Costs Firms and the government have to spend time/money
changing menus/vending machines/parking
meters/published prices
Shoe-leather costs Consumers and businesses have to spend time finding
out where the cheapest prices are after a period of
 inflation
Income re-distribution problems Some people gain from inflation and some people lose
Gainers: People with loans; workers in strong trade
unions
Losers: People on fixed incomes (pensioners, people in
low paid, un-unionised jobs); savers
May cause a wage-price spiral When there is inflation, workers are worse off in real
terms. This will cause them to demand a wage
increase. However a wage increase will cause a firms
costs to rise again, fuelling further inflation. This cycle
may continue
It makes our goods uncompetitive abroad and will If UK inflation is higher than other countries, our goods
damage our current account will be priced more highly than other goods. This will
cause a reduction in the demand for our exports and an
increase in the demand for imports which are cheaper
Unemployment As a result of the above, there is less demand for UK
goods. Because labour is an example of derived
demand, it means that there is also less demand for
labour

What economic policies can be used to address this?

Policy How it would work?
Fiscal Policy To reduce demand pull inflation
Government expenditure would be cut to
reduce demand in the economy via the
multiplier effect
Direct taxes would rise. This would reduce
disposable incomes and deter people from
spending
Indirect taxes would rise. This would increase
prices and deter spending/demand
To reduce cost-push inflation
Lower direct taxes on business
Lower indirect taxes that have a big impact on
businesses-eg fuel tax

Monetary Policy To reduce demand pull inflation

Increase interest rates: encourages saving;
deters borrowing; reduces business demand for
investment; raises exchange rate so may
reduce the demand for exports
Reduce money supply: Makes it harder for
banks to lend money to consumers and
businesses
To reduce cost push inflation
Lower interest rates as most firms have loans
Supply-side policies Remove minimum wage
Lower business taxes
Other policies In the past prices and incomes policies have been tried.
This act like a maximum price on incomes and prices.
They did not really work!
 Economic Issue 4
Avoiding a large current account deficit

Definition
The current account measures the amount of money the country earns from selling exports the amount of money
that is spent on imports

A current account deficit means that more money is leaving the country to pay for imports than is entering the
country to pay for exports
How is Measured?
The current account is a section within the Balance of Payments. The current account looks at both goods (visible)
and services (invisibles)
What causes a current account deficit
A current account deficit is caused by a lack of competitiveness of UK goods. This will be caused by a range of
factors:

High UK wage costs compared to elsewhere means UK prices are higher

High levels of business tax in the UK increase costs and hence prices
Historically there have been low levels of investment , innovation and productivity in the UK- this means that
our goods are less good and more expensive
A strong pound (high exchange rate) has made our exports more expensive and imports cheaper)

In addition, as you UK has got more developed and richer, this has sucked in imports

There has also been a rise in imports of manufactured goods as, following the process of de-industrialisation, we no
longer have the capacity to produce these ourselves.
What are the economic consequences (costs)
A current account deficit is both the symptom of a problem and a cause of future problems:

SYMPTOM: A current account deficit suggests that the economy is not as productive, efficient and competitive as
foreign rivals (see above)

CAUSE:
If more money is leaking out of the economy to pay for imports GDP will fall
If we are buying imports and not selling exports, there will be a fall in demand for UK workers. This will
cause higher UK unemployment and may contribute to absolute and relative poverty in the UK
What economic policies can be used to address this?
Policy How will it work?
Fiscal Policy N/A
Monetary Policy Interest rates will be cut. This will lead to a fall in the
exchange rate, making UK goods more competitive
and imports more expensive/less competitive
Supply side policies Policies to reduce UK business cost: lower min wage;
lower business taxes; less legislation that firms have
to meet- eg health and safety legislation
Policies to promote efficiency, productivity and
investment
Other specific policies Could use protectionism- but retaliation is highly
likely!
Explain how the Government Earns and Spends its Money
 Government

(The Treasury)

GOVERNMENT REVENUE GOVERNMENT EXPENDITURE

Government Expenditure

Sometimes called Public Expenditure or Public Spending, this is spending by the government
The main areas of public spending are:
o Social Protection (Benefits and Pensions etc)
o Health
o Education

The main economic reasons for Government Spending

Reason Explanation
(1) To correct market failure/provide Market failure is the idea that a free market economy
may fail to produce some goods and services in sufficient
public and merit goods quantities
Public goods are goods such as defence and the police.
These would not be provided at all in a free market
because it is impossible to stop people from having them
if they dont pay (Non excludability) For this reason, it
is impossible to make profit from them
Merit goods are Good goods such as health and
education. They carry external benefits and are
important for economic growth. In a free market there
would be some private sector health and education but
not everyone would have access to it.

A large proportion of government spending occurs

because the government has to provide (and fund) the
goods and services that the private sector will not
produce in sufficient quantities
(2) To redistribute income In a free-market economy there will be huge inequality
of income. Those born into rich families will have access
to private sector health and education and are likely to
get richer and richer. On the other hand, people born
into poor families will not be able to afford education
and health and so are unlikely to get high paid jobs.
Without benefits they are likely to face both absolute
and relative poverty

The government uses its finances to try and redistribute

income. It does this by taxing those who can afford to
pay (see later) and using this money to help the poorest.
This will include:

Provision of benefits such as unemployment

benefit and housing benefit
Provision of council houses
Government provision of health and education
 so that everyone has a chance to better
themselves
(3) To help stabilise the economy and The economy will go through an economic cycle. The
government will use Government Spending as part of its
alter the levels of demand in the fiscal policy to try and minimise booms and
economy slumps/recessions. In particular the government may:

Increase government spending to stimulate

demand if we are in a recession and
unemployment is high
Reduce government spending to dampen
demand if we were in a boom and there was too
much demand pull inflation

Government Revenue

Most government revenue comes from Taxation. There are different types of taxes:

Type of Tax What is it? Examples

Direct Tax A tax that is levied on a particular Income tax
individual or business National Insurance Contributions
Corporation tax (tax on company
profits)
Indirect Tax A tax that is levied on a good or VAT
service Excise Duties- taxes on alcohol,
petrol, cigarettes etc

Reasons for Taxation

There are a number of economic reasons for taxation

Reason for Taxation Explanation

(1) To raise revenue Taxes provide the money necessary to fund public and
merit goods
(2) To help reduce market failure. In Some goods have external costs, these are costs imposed
on a third party- eg passive smoking
particular, to deter the consumption In a free-market economy, there will be over
and production of goods which have consumption and/or production of goods with external
external costs costs as individuals and firms only care about their
private costs and benefits when making decisions.
The government can impose a tax on a good or service in
order to deter its consumption.
Examples include: taxes on alcohol; cigarettes; road use

In reality, taxes are often not that effective in reducing

consumption because the demand for these products is
price inelastic. However critics argue that the tax at least
creates revenue that can be used to address the issue
 (3) To redistribute income As described above, incomes will be very unequally
distributed in a free market economy. The government
can use its tax and benefit policy to redistribute income

To do this the government needs to tax those people

who can most afford to pay it (progressive taxation)
(4) To stabilise the economy/alter levels Taxes are part of a governments use of fiscal policy.
of demand in the economy When demand is too high in the economy, the
government will increase taxes to address this

When demand is too low in the economy, the

government will reduce taxes to try and stimulate the
economy

Different tax structures

Taxes can be set up to work in different ways. A key issue is the structure of the tax.

Tax Structure Explanation Pros and Cons/Examples

Progressive Taxation As your income rises, you pay a bigger Pros: Fairer; can be used to re-
proportion of your income in taxation distribute income
Cons: Progressive taxes can have
a disincentive effect
Egs: Direct taxes like income tax
can be organised so that they are
progressive
Proportional Taxation As your income rises, you pay the Pros: Fair-ish; less of a
same proportion of your income in disincentive effect than a
taxation progressive tax
Cons: Some would argue that the
rich can afford to pay a bigger
proportion of their income

Regressive Taxation As your income rises, you pay a Pros: Less disincentive effects
smaller proportion of your income in Cons: UNFAIR!!!
taxation Example: VAT (and all indirect
taxes)- everyone pays the same
actual amount of tax but this will
vary as a proportion of their
income
What sorts of tax are best for the economy?

Over the last 20 years there has been a switch away from direct taxes and towards indirect taxes. Some people
argue that this is good, and others that it is bad

Advantages Disadvantages
Direct Taxes Are often more progressive Direct taxes are very visible-
This means that they are people notice them more
regarded as fairer and can be High rates of direct tax can
used to re-distribute income have a disincentive effect.
For example someone who
works hard to earn over
60K may be deterred if it
means they enter a much
higher tax band
High direct taxes on
businesses can add to costs
and contribute to UK firms
being uncompetitive
Indirect Taxes Less noticeable to us Are likely to be unfair as
Have less disincentive effects indirect taxes are regressive
therefore are less likely to
affect the supply side of the
economy and GDP

How does the government balance its budget?

It is important that the government tries to balance money coming in (Government Revenue) with money going out
(Government Spending)

Balanced Budget Government Spending = Government Revenue

Budget Deficit Government Spending is greater than Government
Revenue
Budget Surplus Government Revenue is greater than Government
Spending

If the government has a budget deficit, it will have to borrow money to finance this. It borrows money from private
individuals and financial institutions within the UK and outside of the UK.

The amount of money the government borrows each year is the Public Sector Net Cash Requirement (PSNCR) The
sum total of all previous borrowing that the government still has to pay back is known as the NATIONAL DEBT

Economists are divided about whether government borrowing/debt is a problem

YES! NO! IT DEPENDS

(1) It imposes a burden on (1) Spending on merit goods will (1) On WHAT the borrowing
future generations of tax lead to a rise in GDP. If the financed
payers who have to pay it country becomes richer, it (2) WHO the money was
back will easily be able to repay borrowed from
(2) If the money is borrowed the debt
from abroad, repayments (2) A lot of money is borrowed
involve money leaving the from within the UK so when
country it is paid back money is not
(3) It does not model financial actually leaving the country
prudence (living within you r (3) Future generations will
 means) benefit from investment in
(4) A lot of borrowing finances infrastructure, education,
dead weight spending that health etc
brings no benefits to future
generations

The Redistribution of Income

Income is redistributed by using progressive taxation and then using this money to fund means tested benefits.
This means benefits that you have to apply for and depend on you having very low wages/income

Some people agree with the redistribution of income and some disagree with it

Arguments for the redistribution of Arguments against the In reality it depends on:
income redistribution of income
It relieves absolute and relative Progressive taxes have disincentive HOW the income is redistributed- ie
poverty effects. They may deter people from
getting jobs or working harder. This (a) How progressive is the tax
If poor people are given money they will cause GDP in the economy to be system
spend a high proportion of it- this lower than it otherwise would be. (b) How rigorous is the
goes back into the economy and This will also mean that tax revenues approach for giving benefits?
creates demand for goods and jobs are lower.

Living standards will be increased The poor may be better off if the
because the poor will value the economy is allowed to grow as this
money more than the rich did will provide more jobs and greater
tax revenue to re-invest

Correcting Market Failure

As has been seen, a key reason for both taxation and government spending is to correct market failure, particularly
in relation to goods which have external costs and external benefits.

In the exam, you will need to be able to suggest and evaluate strategies for dealing with externalities

Examples Strategies Factors to consider when

evaluating
Goods with external costs Car use Taxes Will they work (diagrams)
Cigarettes Legislation (eg bans) Cost of the policy
Alcohol Subsidising alternatives Opportunity cost of the
Drugs Advertising campaigns policy
about the external costs Likely price inelastic
demand and implications
Possible disincentive
effects
Goods with external Education Subsidies Will it work?
benefits Health Public sector provision (eg Efficiency
Training in the case of health and Cost to the government
education OC to the government
Advertising campaigns
about the external benefits
 What Economic Policies does the Government Use?
The main government policies are:

Fiscal Policy
Monetary Policy
Supply-Side Policies
In addition the government may use specific policies

POLICY 1
Fiscal Policy

Main Policy Tools

Government Expenditure (G)

Taxation (T)
Fiscal policy is the deliberate manipulation of G and T by the government in order to achieve its macro-economic
objectives

More Information

Traditionally fiscal policy has been used to try and influence levels of demand in the economy (demand
management) Increasingly, G and T are also being used to try and influence the supply side of the economy

Please see the section on how the Government raises and spends money

How does the policy work?

Please see the section on the macro-objectives/issues that the government faces

Evaluating the Policy

There are a number of problems/issues with fiscal policy:

(1) There may be a time lag

(2) There are trade-offs. For example using fiscal policy to stimulate demand will increase GDP and reduce
unemployment BUT it may also cause demand-pull inflation and suck in imports, thus making the current
account worse
(3) The effect on the government budget. Expansionary fiscal policy (aimed at stimulating demand) will require
increasing government spending and reducing taxes. This will contribute to a budget deficit and will require
borrowing
(4) High levels of tax at times of boom, may affect the supply side of the economy and will cause disincentive
effects
 POLICY 2
Monetary Policy

Main Policy Tools

The Money Supply

The rate of interest (the price of borrowing money)

Monetary policy is policy that deliberately manipulates the money supply and the rate of interest in order to achieve
macro-economic objectives

More Information
Interest rate policy is the main feature of monetary policy in the UK
The main objective is to use interest rates to keep inflation to about 2%. Since 1997 it has been the
responsibility of the Monetary Policy Committee of the bank of England to do this
The MPC change the BASE RATE. This is the interest rate at which the Bank of England lends to other
commercial banks. If the base rate goes up, other banks tend to put their rates up too

Interest Rates- more detail

Interest rates are the reward to saving and the cost of borrowing- they can be seen as the price of money
There are many different interest rates in the economy because:

There are different rates between savings accounts and loan accounts. Banks make their money by charging
higher interest rates on loans than they give on savings
Different amounts of risk. Most banks will deter risky borrowers with high rates of interest. On the other
hand safe borrowers who are perhaps longstanding customers will be rewarded by lower interest rates
Competition- there are now lots of different ways to get credit from banks, building societies, supermarkets,
shops- interest rates will vary according to how much competition there is for that type of loan- eg car loans
Interest rates given on savings account will be higher if you have a bigger deposit and are less likely to take
out your money (eg you dont have a debit account). This is because the bank can make a lot of money from
loaning out your money! On the other hand, if you want ready access to your money you will not get such a
high interest rate

How does the policy work?

Different interest rates affect aggregate demand because they affect:
Borrowing
Saving
Mortgage repayments
The cost of borrowing for firms (for investment)
Exchange rates- a rise in interest rates will lead to a rise in exchange rates which causes a lack of demand for
UK goods as they are less competitive

Evaluating the Policy

Time lags
Commercial banks dont always pass on base rate cuts
Confidence if confidence is low demand may not increase
Trade offs (as with fiscal policy above)
Link between interest rate and exchange rate means that the MPC always has to consider the effect on
international competitiveness and trade
 POLICY 3
Supply-Side Policies

Main Policy Tools

Supply side policies are policies that are aimed at increasing the amount of aggregate supply in the economy.

The best way to do this is to find approaches that cause an increase in the QUANTITY and QUALITY of the factors of
production:
LAND
LABOUR
CAPITAL
ENTERPRISE
More Information
Classical (free market) economists believe that an important part of supply-side economics is to keep the
government out of business and to create as many incentives as possible and as much competition as possible

Keynsian economists believe that there is market failure. They believe that the government has a responsibility to
intervene to stimulate aggregate supply in the economy

How does the policy work?

How to increase the QUANTITY How to increase the QUALITY
Land Discovery of new resources Investment in new technologies,
eg farming methods
Labour Reduce direct taxes and benefits Improved education, health and
so that there is more incentive to training
go to work
Capital Offer subsidies to encourage Encourage more innovation and
investment R&D- either through subsidies or
Lower business taxes so firms by reducing the other costs
have more money to invest businesses face (taxes and
Create more competition (eg legislation such as health and
through privatisation) as this will safety)
spur on efficiency drives
Enterprise More business loans and Improved enterprise education in
grants/enterprise schemes; tax schools
allowances and relief for new
businesses
Evaluating the Policy
Theoretically, supply side policies avoid the trade offs that come with demand management policies. It is
theoretically possible to achieve improvements in all 4 macro-economic variables:

However: supply side policies take a long time to implement; they are often seen as putting efficiency ahead of
fairness (eg cutting benefits, reducing direct taxes); they may make the vulnerable more vulnerable!
There will also need to be enough demand in the economy to ensure that the available resources are utilised.