4EC / 3EC 2.

1
2018 - 2019 GOVERNMENT
AND THE ECONOMY

Revision Book
ECONOMICS
IGCSE
25. ECONOMIC GROWTH

A) MACROECONOMIC OBJECTIVES

Macroeconomics is the study of the economy as a whole. The government manages the
economy through policies intended to reach macroeconomic objectives:

" economic growth (= increase in the production level of the economy)

" low inflation (= limited increase in prices)
" low unemployment (= small number of people struggling to find a job)
" balanced current account (= selling as much to foreign countries as is being bought
from them)
" environment protection
" redistribution of income (= reducing poverty)

B) DEFINITION OF ECONOMIC GROWTH

An economy registers economic growth when the production of the economy increases. This
represents an increase in wealth that will be distributed as incomes:
" property owners: rents
" workers: wages
" financial assets owners: interests and profits

Incomes will be spent to buy the goods and services that have been produced.

CONSUMER PPF AND GROWTH

GOODS

PPF1 PPF2

CAPITAL GOODS

C) MEASURE OF ECONOMIC GROWTH

Growth is measured with the Gross Domestic Product (GDP) that sums up the country’s total
output (= production level) over a year.

The growth rate measures the percentage change in GDP over a period of time.

GDP NEW - GDP OLD

growth rate = × 100%
GDP OLD

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D) LIMITATIONS OF GDP AS A MEASURE OF GROWTH

a) inflation

Nominal GDP measures the production level of an economy at market prices. An increase in
prices may therefore lead to an increase in GDP while the volume of the production
(= quantity) has remained the same.

Real GDP adjusts GDP for inflation. The increase in the production level is calculated as if
prices had remained unchanged.

b) population

GDP cannot be compared between two countries if their population size is different.
Therefore, GDP per capita (= per head) is calculated as an average GDP per inhabitant.

GDP
GDP per capita = × 100%
population size

c) statistical errors

The statistical department of the government is in charge of establishing the national

accounts and measuring GDP. Errors may happen when gathering or processing data.

d) home produced goods / hidden economy

Goods or services that are not traded or illegally traded are not reported to the government
and do not contribute to the GDP measure.

e) interpretation

Economic growth means that the production level of the economy has risen and that there is
more income to distribute. But is does not mean that individual incomes are equally
distributed.

f) external costs

The GDP measure does not include possible external costs (resource depletion, pollution,
deteriorated work conditions…)

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E) THE ECONOMIC CYCLE

GDP ECONOMIC CYCLE

GDP
1) boom

2) downturn

4) recovery

3) recession

TIME

a) boom

The peak of the economic cycle is called boom.

" demand is strong
" GDP, which includes exports, is growing fast
" unemployment is low
" prices are likely to rise
" imports (= purchases of foreign goods) are likely to increase

b) downturn

After a boom, the economy eventually slows down, which represents a downturn.
" demand is weakening
" GDP is slowing down
" unemployment starts to rise
" prices hardly increase
" imports fall

c) recession

The bottom of the economic cycle is called recession. A strong and lasting recession is called
depression.
" demand is falling sharply
" GDP is flat or even declining
" unemployment increases sharply (mass unemployment)
" prices are flat or even falling (deflation)
" imports are at a minimum

d) recovery

After a recession, the economy may experience an upswing called recovery.

" demand starts to rise
" GDP is increasing
" unemployment starts to decrease
" prices slowly increase
" imports increase

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F) CONSEQUENCES OF GROWTH

a) employment J

As growth means an increase in the production level of a country, more workers will be
needed and unemployment is likely to fall.

b) standards of living J

Growth generates more income to be distributed and households can afford to spend more
on healthcare, education and leisure.

c) poverty, public services J

When the economy is growing, the tax revenue collected by the government will increase.
The government can spend more on healthcare, education, infrastructure (roads,
research…), public services and redistribution of incomes.

d) inflation L

Higher incomes may lead to a sharp increase in demand for goods and services and create
shortages: prices are likely to rise.

e) environmental damage L

Higher production levels may have been achieved at the cost of the environment (pollution,
resources depletion). Growth becomes unsustainable.

26. INFLATION

A) DEFINITIONS

Inflation corresponds to a general and persistent rise in prices.

Deflation corresponds to a fall in prices that happens when the economy significantly slows
down.

B) MEASURE OF INFLATION

Inflation is measured by the CPI (Consumer Price Index), a calculation that determines the
average price of a given basket (= list) of goods and services.

The inflation rate measures the percentage change in CPI over a period of time.

CPI NEW - CPI OLD

inflation rate = × 100%
CPI NEW

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C) TYPES OF INFLATION

a) demand-pull inflation

Prices may increase due to shortages when demand is strong and supply is too slow to
adjust. This may happen when there is:
" an economic boom with strong consumer and manager confidence
" tax cuts that increase disposable incomes
" a sharp increase in government spending (on infrastructure, public services…)
" a sharp increase in exports (= demand from foreign countries)

b) cost-push inflation

When businesses are facing higher costs, they decrease their output levels, which may cause
shortages pushing prices up. Businesses pass on the increase in costs on to consumers.

c) money-supply inflation

When consumers, businesses or the government can borrow money to finance further
purchases, demand will increase, creating shortages and pushing prices up. An increase in
the supply of money (= coins + notes + amounts on bank deposits including loans) may
therefore lead to inflation. This may happen when interest rates (= the cost of borrowing
money) fall.

D) CONSEQUENCES OF INFLATION

a) purchasing power L

If incomes remain the same, their purchasing power falls with inflation: the cost of living
rises.

b) wages L

With inflation, workers may ask for a pay rise in order to maintain their purchasing power.
But this increases production costs and will contribute to stronger inflation. Besides,
conflicts between workers and businesses may appear.

c) exports L

If a single country experiences inflation, the goods they sell abroad become relatively more
expensive for foreign countries and exports are likely to fall.

d) uncertainty / consumer and business confidence L

Inflation brings uncertainty and makes it difficult for businesses to plan future production
levels. Consumers are expected to spend less as they are cautiously saving money.
Businesses reconsider their investment projects and innovate less. This contributes to slow
down the economy.

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27. UNEMPLOYMENT

A) DEFINITIONS

Unemployment corresponds to those who are without a job but who are actively seeking work
at the current wage rate.

Employment corresponds to those who carry out at least one hour’s paid work in a week or
who are participating in training schemes or help in family businesses.

B) MEASURE OF UNEMPLOYMENT

a) surveys

The Labour Force Survey (LFS) is carried out according to the method of the International
Labour Organisation (ILO).

b) claimant counts

Summing up all those who are claiming for a Jobseeker’s allowance enables to get a measure
that is probably lower than actual unemployment level as some will not be entitled to an
allowance or do not claim any.

C) TYPES OF UNEMPLOYMENT

a) cyclical (demand-deficient) unemployment

During a downturn or a recession in the economic cycle, demand falls and businesses slow
down production. They need less workers and may lay off staff.

b) structural unemployment

" sectoral unemployment

lay-offs in a declining industry

" technological unemployment

lay-offs due to a declining industry impacting a whole region that was specialised in that
activity. Unemployment will be enhanced by:

9 geographical immobility as workers are reluctant to move to regions where more

jobs are available.

9 occupational immobility as workers may not be skilled to switch to an activity

where jobs are available

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 c) seasonal unemployment

Lay-offs relating to a slowdown in activity linked to a season / weather (tourism, agriculture).

d) frictional

Short-term unemployment when people are between two jobs.

D) CONSEQUENCES OF UNEMPLOYMENT

a) output (GDP) L

Unemployment means that some resources in the economy are left unused and wasted: the
economy is not working at its full potential

b) poverty L

Less people will earn an income and some might face falling living standards and poverty. In
addition, people may suffer psychologically from being unemployed, which lowers social
welfare.

c) government budget L

The government will pay more benefits to those being unemployed but collects less taxes
during the economic slowdown, the budget will deteriorate and public services may be
restricted because of a lack of financing.

d) consumer / business confidence L

Consumers may spend less as they anticipate that they might lose their job. Demand is likely
to fall and business will be cautious about hiring workers and investing in capital (machinery
and technology).

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28. BALANCE OF PAYMENTS ON THE CURRENT ACCOUNT

A) DEFINITIONS

Exports are goods and services sold to foreign countries.

Imports are goods and services purchased from foreign countries.

The record of all transactions relating to international trade is called balance of payments
which is split into two parts:

1. the current account shows the value of all the goods and services traded with
foreign countries and the income that have been paid countries and the incomes
that have been paid between the countries;

2. the financial and capital accounts record flows of money relating to savings and
financial operations.

A current account deficit (< 0) occurs when the value of imports and incomes entering the
country is superior to the value of exports and incomes leaving the country.

A current account surplus (> 0) occurs when the value of imports and incomes entering the
country is inferior to the value of exports and incomes leaving the country.

Visible trade is the trade (exports and imports) of goods. The balance of trade or visible balance
is the difference between the exports of visibles and imports of visibles.

Invisible trade is the trade of services and payment of incomes (primary incomes) and
government transactions (secondary income).

The exchange rate is the value of a currency expressed in terms of an other currency.
(£1£ = €1.12 as of 10/9/2018)

B) THE RELATIONSHIP BETWEEN THE CURRENT ACCOUNT AND THE EXCHANGE RATE

a) Impact of a change in the exchange rates on the current account balance

If exchange rates increase, exports become more expensive for foreign countries and they
are likely to decrease. Imports become cheaper and they are likely to increase. The current
account balance will deteriorate.

b) Impact of a change in the current account balance on the exchange rates

A surplus in the current account means that exports have been superior to imports. Foreign
countries will have demanded the domestic currency to pay for the goods and services sold
to them. This will lead to a shortage of the domestic currency pushing the exchange rate up.

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C) REASONS FOR DEFICITS OR SURPLUSES

a) quality of domestic goods

The reputation of goods produced in a country can lead to a significant volume of exports
leading to a surplus.

b) price of domestic goods

Low inflation may account for a relatively lower price compared to countries with higher
inflation. This boosts exports and improves the balance of the current account.

c) changes in exchange rates

Lower exchange rates may account for relatively lower prices compared to other countries.
This boosts exports and improves the balance of the current account.

D) IMPACT OF A CURRENT ACCOUNT DEFICIT

a) leakages from the economy

If a country imports a significant proportion of their goods and services being consumed, it
becomes dependent on the other economies. This leads to a significant outflow of money to
other countries and a loss in income.

b) inflation

High imports may lead to inflation when the prices of imports increase. This can contribute
to an increase in production costs that will reduce supply and contribute to domestic
inflation.

c) competitiveness

A current account deficit could reveal a loss in attractiveness of domestic goods. They could
relate the lack of innovation or quality.

d) funding the deficit

An economy will need to use their reserves of foreign currencies to pay for imports. if these
are insufficient they will have to borrow. These loans need to be paid back with interests,
which can become expensive.

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29. PROTECTION OF THE ENVIRONMENT

A) BUSINESS ACTIVITIES THAT DAMAGE THE ENVIRONMENT

" mining
" power generation
" chemical processing
" agriculture
" construction
" visual pollution
" noise pollution
" air pollution
" water pollution

B) GOVERNMENT INTERVENTION TO PROTECT

a) taxes (taxing goods with negative externalities, external costs)

Taxes raise the price of polluting goods and demand for taxed goods and services is likely to
fall. The related tax revenue can help to develop innovation in less polluting activities.

b) subsidies (goods with positive externalities, external benefits)

Grants can be given as an incentive to develop less polluting activities. The price of these
good and services will fall and their demand is likely to increase.

c) regulation and fines

Projects may be blocked, goods and services may be prohibited, guidelines and codes of
practice may be suggested: specialist agencies are in change of tracking those who break
environment laws and impose financial penalties (= fines) to reduce the profits of polluting
businesses.

d) polluting permits

Permits set a maximum level of pollution that will be allowed over a period of time. They can
be traded between firms if not fully used up.

e) park provisions

National parks can be established to preserve wild life.

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30. REDISTRIBUTION OF INCOME

A) REASONS FOR INCOME INEQUALITY

" education, skills, shortages in the labour market

" welfare system (government paying benefits for those who are retired, sick,
unemployed…)

" wealth distribution through inheritances

B) TYPES OF POVERTY

a) absolute poverty

people struggling to satisfy basic needs (eating, shelter, healthcare, education…)

b) relative poverty

people having lower incomes than the average or median income level

C) REASONS TO REDUCE POVERTY

" raising living standards

" contributing to growth (healthier, well-educated, productive workforce)

" ethical reasons, common welfare

D) GOVERNMENT INTERVENTION TO REDUCE POVERTY AND INCOME INEQUALITY

a) progressive taxation

The burden of taxation lies more heavily on the rich: the tax rate is higher on high incomes,
they pay proportionately more than low-income earners.

b) redistribution through benefit payments

In a welfare system, the citizen and businesses pay contributions that will help those in need
(unemployed, sick elderly…)

c) investment in education and health

Education helps people to find a job and to be better informed on how to lead healthier
lives. Mortality rates can be lowered through improved diet and housing.

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31. FISCAL POLICY

A) DEMAND-SIDE POLICIES AND THEIR AIMS

The government can use different tools called macroeconomic instruments to achieve
macroeconomic objectives:

" rate of taxation

" level of government expenditure
" rate of interest
" level of debt in banks

A change in these instruments may impact aggregate demand, GDP, unemployment, inflation,
the balance of the current account, environment protection and the distribution of incomes.

B) THE GOVERNMENT BUDGET AND THE PUBLIC DEBT

The government collects a tax revenue by imposing wealth and income (direct taxes) or
expenditure (indirect taxes). They also can tax economic activities with negative externalities
(polluting activities, consumption of harming products…).

The tax revenue can be used:

" to pay for public services (justice, defence, policing, education, healthcare, culture….)
and infrastructure (transportation and information networks)

" to be redistributed to those in need (allowances, benefits…)

Every year, the government plans how much is going to be spent and how much is going to be
collected. These plans are published in the government is the budget.

At the end of the year:

" if the tax revenue has been superior to the government expenditure, there is a budget
deficit: the government has to borrow the difference. All the loans that have not yet
been paid back contribute to the public debt. They will have to be paid back in the
future with interests

" if the tax revenue has been superior to the government expenditure, there is a budget
surplus: the government can pay back previous loans in order to reduce the public debt

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C) THE FISCAL POLICY

a) instruments

The government will use the tax rates in order to impact the disposable incomes for
households and thereby consumption and aggregate demand. The level of government
expenditure can also be used to impact aggregate demand directly.

b) expansionary fiscal policy

WHEN? when GDP is low (recession) to stimulate the economy and trigger a
recovery

HOW? lower tax rates

higher government expenditure

IMPACT J AD Þ
J GDP Þ
L inflation Þ
J unemployment à

c) contractionary fiscal policy

WHEN? when the economy is overheating and needs to be slowed down as strong
aggregate demand has led to shortages and inflation

HOW? higher tax rates

lower government expenditure

IMPACT L AD à
L GDP à
J inflation à
L unemployment Þ

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32. MONETARY POLICY

A) THE ROLE OF THE CENTRAL BANKS

Central banks are administrations that:

" regulate the banking system

" lend to banks if they need cash and give them the ability to grant new loans to their
clients (households, businesses, even governments)
" set interest rates

Their aim is to strengthen the financial system, to control inflation and to stabilise an
economy’s currency.

B) MONETARY POLICY

a) instruments

The Central Bank can change the level of interest rates by setting the base rate at which they
lend money to banks. Banks will take the base rate as a reference for the rates they set for their
clients. This impacts the cost of loans and will encourage or discourage households and
businesses to borrow money in order to finance further spending.

The Central Banks may also control money supply by monitoring the ability of banks to grant
loans. With quantitative easing, the Central Bank may buy financial assets (=valuables) from
banks. This extra cash can be used by the bank to grant more loans to their clients.

More and cheaper loans impact aggregate demand in the economy as they enable higher
consumption by households, investment by businesses and government expenditure. More can
be spent today to be paid back later.

b) expansionary (loose) monetary policy

WHEN? when GDP is low (recession) to stimulate the economy and trigger a
recovery

HOW? lower interest rates

increase in money supply

IMPACT J AD Þ
J GDP Þ
L inflation Þ
J unemployment à

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c) contractionary (tight) monetary policy

WHEN? when GDP is overheating and needs to be slowed down as strong aggregate
demand the economy and trigger a recovery

HOW? lower tax rates

higher government expenditure

IMPACT L AD à
L GDP à
J inflation à
L unemployment Þ

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33. SUPPLY-SIDE POLICIES AND GOVERNMENT CONTROLS

A) SUPPLY-SIDE POLICIES AND THEIR AIMS

Supply-side policies aim at increasing aggregate supply, the total amount being provided in an
economy as measured by GDP.

B) INSTRUMENTS OF SUPPLY-SIDE POLICIES

a) in the labour market

WHEN? when the aim is to improve productivity

HOW? by limiting labour legislation and reducing the power of labour legislation in
order to increase flexibility in the labour market

IMPACT L work conditions may deteriorate, workers will be less protected

b) in the market for goods and services

WHEN? when the aim is to increase competition

HOW? by privatising companies that belonged to the public sector in order to

improve competitive pressure, by contracting out activities to private
businesses and by deregulating the markets and simplifying administrative
procedures

IMPACT L businesses may dominate their market and increase prices

c) public investment

WHEN? when the aim is to stimulate production in the long run

HOW? by investing in education and training, transportation and ITC networks,

research and development and by lowering taxes on incomes as an incentive
for entrepreneurs

IMPACT L effect will take long to show

L opportunity cost

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34. RELATIONSHIP BETWEEN OBJECTIVES AND POLICIES

A) CONFLICTING AIMS: UNEMPLOYMENT / INFLATION

PROBLEM high unemployment

POLICY expansionary demand-side policy

9 lowering taxes and increasing government expenditure
9 reducing interest rates

IMPACT J AD Þ
J GDP Þ
J unemployment à

L inflation Þ

PROBLEM high inflation

POLICY contractionary demand-side policy

9 raising taxes and reducing government expenditure
9 lowering interest rates

IMPACT J inflation à

L AD à
L GDP à
L unemployment Þ

B) CONFLICTING AIMS: ENVIRONMENTAL PROTECTION / GROWTH

PROBLEM environment deterioration

POLICY taxes and fines

legislation making investments in environmentally friendly production
methods compulsory

IMPACT J environmental protection

L GDP à
L unemployment Þ
L inflation Þ

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C) CONFLICTING AIMS: GROWTH / CURRENT ACCOUNT BALANCE

PROBLEM recession

POLICY expansionary demand-side policy

IMPACT J GDP Þ
J unemployment à

L higher imports deteriorating the current account balance

PROBLEM strong current account deficit

POLICY contractionary demand-side policy to reduce imports

IMPACT J lower imports improving the current account balance

L GDP à
L unemployment Þ

D) CONFLICTING AIMS: GROWTH / PUBLIC FINANCES

PROBLEM recession

POLICY expansionary fiscal policy

IMPACT J GDP Þ
J unemployment à

L higher government expenditure likely to increase budget deficit and

public debt

PROBLEM significant budget deficit, public debt

POLICY contractionary demand-side policy (austerity)

IMPACT J lower government expenditure

L GDP à
L unemployment Þ
L public services deteriorate

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