PATRIK I.

LEVAI #IStandWithCEU

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ECONOMICS
THEME 2
SUMMARY
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MEASURES OF ECONOMIC PERFORMANCE
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GDP: the sum of all goods and services produced in a country in a year
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Economic Growth:
2 meanings:
Actual Economic Growth: increase in real incomes or GDP
Potential Economic Growth: increase in the productive capacity (hard to measure accurately)
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Increase in GDP, a sign that a country is experiencing:
• increasing incomes
• increasing output
• increased spending
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but: does not mean better standard of living :
• may be working for longer
• more work pressures
• higher cost of living eg. mortgage payments
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• pollution likely to increase,
• other social costs also can increase
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Other national income measures
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GNP: GDP + income recieved from abroad – income claimed by non-residents
• GNP may be less than GDP if much of income from production flows to foreigners (firms/persons)
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GNI: GDP + income paid into country by other countries, eg. interest, dividends
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Evaluation of growth figures depend on:
• how much of output is self-consumed (does not appear in GDP)
• methods of calculation & reliability of data
• is money spent on warfare or on education and health?
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Purchasing power parities (PPPs):
When values are expressed in accordance with the amount that the currency will buy in the local
economy.
• good for international comparisons - if cost of living is high, PPP value of GDP will be lower
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Limitations of using GDP to compare living standards between countries and over time
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• If output is self-consumed, bartered (traded without price system), or if tax is not declared
after sales – national income will not reflect true standard of living
• Informal economy: eg. charity shops are an output of service but have no income that shows up
• Income distribution: sometimes a large part of income is earned by very few people - this makes
the mean income higher - so doesn’t reflect real standard of living for most people
• Consumer and capital spending: spending on investment goods is good for the future but not for
the present living standards
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Inflation
A sustained increase in prices, measured by a change in a weighted index of prices, eg. CPI
Deflation
A fall in the general level of prices, i.e. negative inflation
Disinflation
A fall in the rate of inflation (rising less steeply, slower)
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Limitations of using the CPI (Consumer Price Index) to measure inflation
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• Does not include housing costs, eg. rent or mortgage interest repayments
• CPI measures cost of living for an average household – top and bottom 4% and pensioners not
included
• Only 57% of households respond to the CPI survey
• List of 650 items only changes 1/year but tastes and fashions change faster
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RPI as an alternative measure
RPI (retail price index) is an index to measure inflation
–> includes housing costs eg mortgage interest repayments.
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The Causes of Inflation
2 types:
Demand-pull: AD shifts to right, caused by: increased consumption, investment, govt. spending and
increased exports
Cost-push: AS shifts to left, caused by: increased production costs, eg. rise in wages or fall in
exchange rate (makes imports more expensive)
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Monetarists believe inflation is caused by increase in money supply above the rate of increase in real
output.
Inflation can be controlled by controlling the money supply, eg. either directly or through interest
rates.
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The Effects of Inflation
For Consumers:
• Makes savings less attractive as real value of them is falling because prices are rising
• Fixed-income people’s purchasing power falls as prices rise
• Those with debt benefit because real value of debt falls compared to rising prices
For firms:
• Exports become expensive, imports become cheap so national firms lose international
competitiveness, and the balance of payments worsens
• Causes uncertainty which leads to decrease of investment in capital goods
• Foreign investment might decrease, as eg. the pound is devaluing, so who would want to invest
in it?
For Government:
• Cost of borrowing falls, as real interest rate is reduced
• Provides cushion against deflation, which would otherwise lead to underinvestment and
reduced spending
For workers:
• Some workers expect high wages, but firms do not feel confident about paying higher costs, this
might lead to unemployment
• Some say high wage inflation will force companies to employ more people as everyone expects
higher wages
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Employment and Unemployment

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Level of unemployment: number of people out of work
Rate of unemployment: proportion of the workforce
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Measures of unemployment
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Claimant count:
Number of people claiming Jobseeker’s Allowance or other benefits like Universal Credit
• Does not represent the full picture of unemployment -
• many eligible do not claim benefits and there’s tight criteria, eg. having made certain number of
NI contributions or ‘signing on’ every 2 weeks
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UK Labour Force Survey:
Measure of unemployment of those out of work in last 4 weeks and ready to start in next 2 weeks
• More inclusive than claimant count -
• quarterly telephone survey of 80,000 households
• over age of 16
• but: survey data 6 weeks out of date when published (every month)
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Distinction between unemployment and underemployment
• Some people do not work enough hours to have the pay they would like or are in jobs that do not
pay as much as they expect given their qualifications
• Underemployment became important after the 2008 crisis, between 2008 and 2012 it increased
50%
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So figures for unemployment may be misleading, as under employment is taken into account, jobs
market experienced a significant downfall after 2008
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Changes in the rates of employment, unemployment and inactivity
Employment is affected by these factors:
• School or compulsory training leaving age
• Number of school leavers entering higher education
• Net migration - the difference between immigration and emigration
• Availability of jobs - higher levels of employment if there are more jobs
• Level of taxes and benefits - if taxes on income are high or benefits are too good, it is a
disincentive for people to work
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Inactivity
A measure of people of working age who are unwilling or unable to work.
• 20% in the UK. Majority are students in higher education.
• It can make levels of unemployment look lower than they really are, as these people do not
feature on the unemployment figures.
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The causes of unemployment
Two very different views:
• Classical view:
- “Real wage unemployment” - wages are kept artificially above market-clearing wage
- If people would accept a lower wage rate, they could find jobs
- Unemployment is a short term problem and the best solution is Laissez Faire
If people accept lower wages, firms will not have to charge
such high prices as the costs of production decrease (i.e.
wages), so workers will find lower wages acceptable because
the costs of living have decreased.
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• Keynsian view:
- “Demand-deficient or cyclical unemployment” - caused by lack of aggregate demand (AD) in
economy eg. in a recession
- Economy can be in equilibrium, even though not everyone has a job
- needs fiscal or monetary stimulus to fix
If people do not spend and save too much, there will be fewer
job opportunities because firms will need less people as the
demand has fallen. Losing jobs will cause even less spending,
so the vicious circle continues
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Other reasons for demand-deficient unemployment
• Lack of business confidence in economy
• Slow rates of productivity growth in relation to other countries
• External shocks, eg. oil price rises - oil is imported and demand is price inelastic so there will be less
spending inside the UK
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Other types of unemployment
• Structural unemployment:
A measure of workers who lose jobs in a declining industy (eg. in agriculture) and do not have the skills
to join other industries
• Frictional unemployment:
Measures people moving from one job to another.
• Seasonal unemployment:
People who have jobs only at certain times of the year, eg. ski instructors
- Should be addressed by developing mobility of labour: improvement in skills + improvement in
geographical mobility
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The higher the level of skills in the labour workforce, the more flexible workers will
be in case of a change in requirements.
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The Effects of Unemployment
To Consumers:
• lower incomes, lower standard of living
• unseen cost: people out of work lose morale, bad for family members
To Firms:
• People spend less, so they will have to have lower prices and so make less profit
• Workers may be willing to work harder to stay in their jobs
To Workers:
• Workers without work may have their skills become obsolete, out of date, eg. because of new
tech.
To Government:
• Has to pay more benefits, could spend it on something else (opportunity cost)
• Will receive less tax
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To society as a whole:
• opportunity cost: the economy could be producing more but it isn’t
• can lead to crime, civil unrest
• when people are busy, tends to have positive social effects
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Balance of Payments
It is a record of payments between one country and the rest of the world. Comprises the current,
financial and capital accounts. The most significant is the current account.
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The Current Account
The current account records trade in goods, trades in services, investment income and current transfers.
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• Trade in goods and services:
- Trade in goods: the movement of tangible products across international borders, eg. pharma
and cars export and foodstuffs import in UK
- Trade in services: movement of intangible output, eg. banking and insurance export and foreign
holiday import in UK
• Investment income and current transfers:
- Investment income: interest, profit and dividends that are rewards for capital investment in
another country, eg. British person buys shares in US company - dividends appear as positive
figure on current account
- Current transfers: movement of funds for which there is no corresponding trade in goods and
services, eg. taxes paid to the EU
• Current account deficits and surpluses:
- Surplus: when more money flows in than flows out, eg. Germany (exports large number of
high-value goods)
- Deficit: outflows greater than inflows, eg. Spain, UK
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Financial and Capital Accounts
• Financial account: records money flows for investment purposes - FDI (assets, companies); and
‘hot money’ - speculative movement of money between countries as exchange and interest rates
change
• Capital account: puts the other two accounts in balance by recording changes in net assets
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What happens to the current account of the balance of payments when interest rate rises:
I) exchange rate usually also rises
II) exports become less competitive
III) imports become more competitive
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Current account imbalances
• Not necessarily a problem – as long as it can be funded:
- sign that living standards are rising
• Problem, when reserves of foreign currencies begin to run low:
- might mean that the currency falls in value - inflationary (imports become more expensive)
- country is becoming uncompetitive (rising costs relative to trading partners)
- can cause unemployment
- can cause tax increases to stop people spending too much
Interconnectedness of economies through international trade
Countries become independent, interreliant for income (exports) and for resources, goods and
services (imports)
Effect:
• If one country/area suffers with weak demand this has a direct effect on other countries
The cost of a current account imbalance is only siginificant if it is unsustainable -
Sustainability: the needs of the present are met without compromising
the ability of future generations to meet their own needs

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AGGREGATE DEMAND AND SUPPLY
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Aggregate demand: The total planned expenditure on goods and services produced domestically
Aggregate supply: The total planned output of goods and services domestically
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When price levels increase - inflation
When output increases - economic growth
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Aggregate demand (AD)
The characteristics of AD
AD = Consumption (C) + Investment (I) + Government spending (G) +
Exports–Imports (Net trade) (X-M)
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The AD Curve is downward-sloping
not because ‘people buy more things when they are cheaper’
Reasons:
I) Lower prices in economy mean increased intl. competitiveness - so more exports, fewer imports
- meaning net exports are higher at lower prices
II) At higher price levels interest rates are likely to be raised by monetary authorities. This will
cause decrease in investment (a component of AD) and an increase in savings (taking out of
the economy, leakage)
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Consumption (C)
Main component of AD (approx. 60%)
Measures the amount that consumers which to spend at various price levels rather than save (C or S).
• The higher the income after tax (disposable) the more people are likely to spend
• but spending gets slower as incomes rise (saving increases)
other factors that make people want to spend and not save:
• Confidence, in job security and future income prospects
• Interest rates - higher i.r. leave consumers with less money to spend after housing costs and
increase cost of hire purchase
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Investment (I)
An increase in capital stock. (approx 10-15% of AD)
Creating assets that will generate income in the future.
Gross investment:
Total amount of investment, without calculating for depreciation of assets. (eg. wears out, becomes
obsolete technology)
Net investment:
Takes into account the fall in value of capital assets. More useful measure, but depreciation is hard
to measure.
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Influences on investment
• Confidence
• Changes in the rate of economic growth
• Business expectations
• Competitors
• Government incentives and regulations
• Interest rates: rising interest rates makes firms less likely to borrow, but some say interest rates
do not change investment that much (interest elasticity of demand for investment is low)
• Demand for exports - eg. a low exchange rate or surging demand in target country
• Access to credit - how keen banks are to lend
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Keynes believed it is not rational thinking that makes people invest or sell in capital and stock
markets, but an animal instinct. Animal spirits: People buy and sell impulsively not calmly, this
makes markets move.
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A change in investment changes the level of AD, vica versa.
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Government expenditure (G)
As a component of AD only approx 25%
A large part of government spending is paid out as transfer payments — movement of spending power
from taxpayers to other consumers (so features as consumption)
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Main influence:
• Trade cycle: In a boom, high economic growth, government expenditure falls — less demand for
benefits. Revenue from taxes increase. Effect: Govt. to run a budget surplus.
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The Government can manipulate AD by overspending (deficit), when there is a slowdown.
Also: taxing more heavily in boom can help put breaks on economy.
Fiscal policy:
The deliberate manipulation of government spending and taxation in order to influence the level of AD.
If loose or expansionary: Rise in government spending or fall in taxation; or spending is rising
more quickly than taxation.
• National debt:
Accumulation of budget deficits over the years.
Long-term cost for future generations.
Short run – there is some flexibility with the balance of government’s accounts
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- Keynes views fiscal policy as a powerful tool to shift AD.
- Classical economists believe overspending is just like printing more money – causes inflation.
Nowadays there is a consensus that government sometimes has to stimulate the circular flow
through fiscal policy
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Net trade (X – M)
Exports: an injection into the circular flow of income.
Imports: outflow
Exports – Imports = Net exports
• If value of imports is greater — negative value, eg. in UK
Reasons why the value of net exports might change:
• Level of real income
• Change in the exchange rate:
- if pound is strong, imports become cheaper, exports more expensive
- in short run, price elasticity of demand for exports tends to be low - as contracts are in place for
specific prices
- price elasticity of demand low for eg. oil – lack of substitutes
• Changes in global economy:
- eg. recession in USA means they buy less exports from UK
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Levels and not rates - levels might not fall but slower increase means exports rise more slowly.
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If any of the AD components rises or imports fall curve shifts to right.
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Aggregate supply (AS)
The characteristics of AS
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Aggregate supply is the amount that firms are willing to produce at various price levels.
Influenced by:
• Productivity, changes according to:
- Costs of production
- Level of investment
- Availability and efficiency of factors of production
- Supply-side policies
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Distinction between movement along and shift of AS curve
Movement:
Average price level changes.
eg. if AD shifts to right and AS is relatively inelastic, firms are willing to produce more at higher
prices
Shift:
Change in costs of production.
• Cost of raw materials
• wages
• exchange rates
• indirect tax rates
Change in productive potential.
eg. labour market better educated or improved technology
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Relationship between short-run and long-run AS
Short-run:
Shifts occur because costs of production change. Overall productive capacity remains
unchanged.
Short-run changes might feed through to long-term.
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Long-run:
Productive potential of firms whan all factors are variable.
For Classical: Long-run curve is vertical
For Keynsian: idea that there can be spare capacity or output gap even in the long run, markets
do not clear.
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• Short-run ‘supply-side shocks’ shift the short-run AS
curve. eg. oil price or exchange rate changes
• Quality or quantity of factors of production feed
through into shift in long-run AS
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Short run impact is a change in production costs;
long-run change is a new level of potential output. 

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Short-run AS
Shifts occur when costs of production change. Not the amount they are willing and able to produce.
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External shocks -
Cause AS to shift up or down rather than right or left.
eg. cost of workers.
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Short-run shifts include:
• Cost of raw materials and energy:
In UK, these are imported, so if there is a global increase in demand for oil, costs of
production increase in UK. (oil is a major production cost)
• Changes in exchange rates:
eg. if Euro falls in value relative to pund, costs fall in UK so AS will increase.
• Changes in tax rates:
Increase in indirect taxes will mean an increase in costs. eg. Rise in VAT makes prices go
up, as firms try to pass on extra costs to consumer.
Increase in tax = decrease in AS curve.
Decrease in tax, eg. petrol prices = increase in AS
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Long-run AS
Classical view:
In the long-run, economy will operate at full capacity, there will be no unemployed resources.
AS curve vertical. If there are unemployed resources, prices of these fall so surplus disappears.
Keynsian view:
Equilibrium level out output can occur below the full employment level of output.
AS curve has 3 distinct sections:
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1. Blue part: Spare capacity. Economy can increase output without cost pressures.
• There are unused resources: eg factories not working at full capacity; or there is
unemployed labour
• In this section, AD increases (eg. fiscal policy) and equlibrium real output would increase –
without causing price level increase
2. Pink part: Bottlenecks. Some constrictions in supply chain cause cost and wage pressure buildup.
• eg. a certain type of labour, when short in supply – haves its price go up
• If AD increases in this section, economy will still grow but there will be some inflation
–> Effects on the production costs
3. Red part: Full Capacity. All viable workers have work, so if firms want to attract them, they have
to offer higher wages.
• Here if AD increases, short-run maybe some extra spending, but long-term: increased
inflation, no increased output.
• Classical view says this Red part is the only one that occurs, meaning the economy cannot be
in equilibrium while there is unemployment. If there is: Govt. mismanagement or short-term
failure
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Factors influencing long-run AS
Shifts to the right can be caused by several factors -
Labour market:
• Changes in relative productivity:
Productivity is output per unit of input. If it increases relative to main trading partner countries,
productivity gap said to be closing. Costs of production are becoming less expensive.
• Changes in education and skills:
Increased education spending means a workforce will produce more output per worker.
Education increases the value of the potential output. Not all education achieves this end.
• Demographic changes and migration:
Birth rate, life expectancy and net migration all influence firms’ costs.
• Increases in health spending:
Workers will have fewer days off sick and will be active for longer.
However, spending on health might be absorbed into wage increases for the health staff.
Also, majority of healthcare is spent on the elderly or the very young.
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Product market:
• Technological advances:
Innovation and investment in new ideas reduces cost for firms.
• Changes in Government regulation:
Deregulated industries cause an increase in competition.
• Competition policy and reduction in barriers to intl trade:
As a country opens up to more trade, competition drives down prices.
so: as Globalisation develops, AS increases.
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NATIONAL INCOME
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The circular flow of income
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Distinction between income and wealth:
Wealth: the sum of all assets in an economy. A stock concept. Has no direct impact on circular flow.
eg. Housing, Stocks, Shares, Capital assets.
“The Wealth Effect”:
The effect on incomes or spending when asset values change.
eg. if your property increases in value, you are more confident to spend; or take out a loan based
on increased wealth. Causes the circular flow to increase when the loan is spent.
Income: A flow concept.
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Injections and withdrawals
3 types of injections into circular flow:
• Investment (I) (increase in the capital stock)
• Government spending (G)
• Exports
All magnified by the multiplier.
3 types of withdrawals from circular flow:
• Savings (S)
• Tax (T)
• Imports (M)
These determine the size of the multiplier.
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Equilibrium levels of real national output
AD-AS meeting point: equilibrium
When there is a shift in AS or AD:
• If prices were higher than the new equilibrium
– prices would fall because supply > demand; lots of unsold goods, services
• If prices were lower than new equilibrium
– prices would rise because supply < demand; shortages
• Worldwide recession, fall in AD:
– falls in prices
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The multiplier
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The multiplier ratio is the ratio of a change in equilibrium real income to the injection
that brought it about. Shows the change in total income as compared to initial
injection.
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The most important factor determining the size of multiplier is the size of withdrawals
from the circular flow (saving, taxes, imports)
!MPW (marginal propensity to withdraw) is the sum of MPT (tax), MPS (save) and MPM
(import)


MPW + MPC = 1
MPC = marginal propensity to consume
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Multiplier = (1 – MPC)
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The importance of the multiplier:
• If any change occurs in spending, final impact on incomes will be much greater
than initial impact.
• The greater the leakages, the smaller the multiplier.
• The larger the value of the multiplier, the greater the shift in AD.
• Can be both in positive or negative direction.
• eg. increase in leakages will have larger negative impact on AD according to the
size of the multiplier
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ECONOMIC GROWTH
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Actual economic growth: An increase in real GDP
Potential economic growth: An increase in capacity in the economy
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Factors which could cause economic growth
• An increase in one of the components of Aggregate Demand (C, I, G, X-M)
- Consumption, investment, government expenditure or net trade (X-M)
eg.
– Increased consumption – may be because increased confidence or availability of credit.
– Increased investment – may be because level of growth itself is increasing (increases it too)
– Government spending – on education or healthcare might cause growth
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• An increase in Aggregate Supply (AS)
- May be because costs of production fall
- eg. labour markets cheaper, because of immigration or increased birth rate
- May be because of supply-side policy
- eg. deregulation (removes constraints that limit competition)
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A right shift in AD only raises prices not GDP if AD curve crosses vertical part of AS curve.
A right shift in AS has no effect if AD curve is crossing on its horizontal part.
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Potential economic growth
Can only occur when the vertical part of AS curve shifts to the right, increasing the amount the
economy could produce.
so: potential economic growth increases when PPF curve shifts outwards.
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for Evaluation:
Economic growth is useful when it’s inflation adjusted, i.e. real / constant values.
If nominal / current values are given – point out that figures are distorted by inflation.
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Export-led economic growth
An increase in the export component of AD (X).
Can often acount for more than 50% of AD, - eg. China
Problem is:
Export-led growth makes exporters vulnerable to changes in demand in other countries or exchange
rates. – Factors outside of their control
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Constraints on growth
• Absence of efficient capital markets: eg. unavailability of credit; asymmetric information
• Government instability: eg. incompetency, lack of transparency, lack of ability to attract inward
investment – because of war, political tension
• Labour market problems: shortage of skilled labour, brain-drain (poor countries) or fall of birth
rates (rich countries) – most effectively solved with increased immigration
• External constraints: eg. lack of access to world markets because of tariffs; or fear of terrorism in
target market country

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Output gaps
The difference between actual and potential GDP or growth in GDP.
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If the economy is growing faster than the trend, positive output gap, pressures grow:
• Tight labour markets
• Wage pressures
• Shortages of raw materials
• Inflationary pressures
! • Raised interest rates by Bank of England’s Monetary Policy Committee
If the economy is growing below trend, negative output gap, spare capacity in economy:
• possible cut in interest rates
• less likely to cause inflation
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Difficult to estimate the size of the output gap,
as not all unemployed resources would have
same impact if they were employed.
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Trade / business cycle
Stages: Boom, Slowdown, Recession, Recovery, Boom
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Impact of Economic Growth
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Benefits:
Consumers:
• Increased incomes and wealth
• Can afford to save
• More confidence
• Increased spending
• Wages rise – as firms try to keep workers
Firms:
• More revenue and profit
• Can take on more workers
• More likely to invest
• Increased future growth prospects
Governments:
• More Income Tax, VAT, Capital Gains Tax + more Corportation tax
• Less spending on unemployment benefits
• Healthier fiscal position
Current and future living standards:
• Total incomes rising – makes people feel better-off
• Decreased poverty rate
• Increased employment, wages
• Government more likely to spend on merit goods, eg. libraries
• Firms may use cleaner technology – so increases health
• Rising standards of living – as lon as costs of living do not increase at same rate
• Growth of asset value – eg. houses and shares
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Costs:
Income inequality:
• Unwaged and unskilled less likely to benefit from increased incomes, but may trickle-down
• Likely to be short-term unemployment for those with worse labour market flexibility
Environmental problems:
• Depletion of natural resources
• External costs: - eg. carbon emmissions or other form of pollution – but governments can use
increased tax revenue to clean up environment and enforce control measures
Balance of payments problems on current account:
• Higher incomes will mean more imports, but if growth is export-led current account improves
Bottleneck in economy:
• If there is little spare capacity, factors of production rise in price, - eg. skilled labour or fuel
• Monopoly power might develop – higher barrier to entry of new firms onto market
Social dislocation and stress
• Increased pay leads to increased responsibilities and expectations
Problems of rapid growth:
• bad planning or corner cutting or bad worksmanship
• can cause short-term spikes in prices
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Macroeconomic objectives and policies
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Objectives
• Economic Growth (rise in real GDP)
• Reduction of unemployment
• Control of Inflation
• Balance out the Current Account of the Balance of Payments
• Protection of Environment
• More equal distribution of income
The order of priority varies between countries.
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Demand-side Policies
A deliberate manipulation of AD by the government to achieve macroeconomic objectives.
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The 2 types of demand-side policies:
• Monetary policy: decisionmaking using monetary instruments – Interest Rates and Quantitative
Easing
• Fiscal policy: government’s managagement of Spending and Taxation – to change total level of
spending in economy
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Monetary policy instruments:
Bank of England’s Monetary Policy Committee (MPC) targets inflation as its focus. Independent from
government. Current inflation target at 2%.
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• Interest Rates:
- Sets off chain reactions in economy, ‘transmission mechanisms’ – so AD shifts, changes
demand – works through consumption
- Consumers spend and save according to interest rates – eg. Affects mortgage payments
- Investment is sensitive to interest rates – high rates mean fewer projects seem worthwhile
- Net Exports also affected – as interest rates change cost of production and exchange rates
(in same direction) – so relative productivity is also affected

• Quantitative Easing (QE):

- Bank of England purchases financial assets, – eg. Pension funds, insurance
- designed to inject money into economy
- Asset prices rise – spending increases
How it works:
I) As asset prices rise: asset holders (businesses, households) portfolios increase in value
and liquidity (easier to transfer into cash) – They feel wealthier and have more money
available
II) Leads to Increased spending – boost of AD
III) Consumers and businesses more likely to take on debt as lowered yields (lower interest
rates) reduce cost of borrowing
Some factors dampen QE’s effect –
• As banks’ assets increase in value, they may be more willing to lend –– but: nowadays more
concerned about financial health, so less willing to lend

 PATRIK I. LEVAI #IStandWithCEU

Exiting QE as economy recovers

• QE asset purchases by Bank of England will be resold in money markets
- tightetning of monetary policy
- easy credit less available
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Fiscal policy instruments:
The manipulation of taxes and government spending to influence level of demand in economy.
Expansionary policy: Cutting Tax or Raising Government Spending – AD rises
Contractionary policy: More Taxes than Government spending – AD rises more slowly
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Budget deficit and surplus:
• Budget/Fiscal Deficit:
The amount by which government spending exceeds revenues. Expansionary fiscal policy.
- Pumps spending power into economy – sometimes at expense of spending power in the
future
- Multiplier magnifies the effect of this boost –
- eg. builds hospital and pays by borrowing – when workers and building materials are bought,
incomes produced will be re-spent, creating new incomes – how the multiplier works.
- Keynsians think government should spend to get out of recession
• Budget/Fiscal Surplus:
The amount by which tax revenues exceed government spending. Contractionary fiscal policy.
- Takes spending power out of the economy – with negative multiplier effects
- During times of boom – government should curb spending to reduce inflationary pressures
- Puts government accounts in better position
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Direct and indirect taxation:
• Direct tax: Impact on AD as people feel worse or better off – as planning is based on disposable
income (income after tax) – might not have immediate effect – but compounded effect of
expectations and confidence –
• Indirect tax: Impact on AS as it affects amount that firms are willing to sell at a certain price –
eg. many firms absorb effect of rise in VAT – short-run left shift in AS curve (decrease)
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Strengths and weaknesses of demand-side policies
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Monetary policy
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• Shorter time-lag than fiscal policy – but estimated that interest rate changes take up to 2 years to
have an impact
• Further time delays – as many mortgage holders have fixed-rate contracts, so impact on spending
is delayed
• Affects both small and large firms
• Rise in interest rates worsens income distribution
• Raises the cost of production – when the cause of inflation to be corrected could be an increase in
them too – so it doesn’t alwasys cure, it exacerbates it
• When commodity prices rising – people in debt are affected by rising interest rate
• First round of QE in 2009 increased real GDP 1–2% and inflation by 0.75–1%
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 PATRIK I. LEVAI #IStandWithCEU

Fiscal Policy
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• Implemented in Annual budget – but some room for menoeuvre in autumn pre-budget
- so: Time lag in decision-making
• Many tax changes cannot beign til start of new fiscal year in April, sometimed 1–2 years ahead
- so: Implementation lag
• So effect doesn’t become apparrent immediately
• When government expands spending – people increase their pay demands – so wages increase –
increases costs and not outputs
• Crowding-out effects of increased spending:
- eg. if government builds new hospital, less scope for private hospital nearby which could provide
the same service
- eg. if government runs deficit, needs to raise finance – so when credit is less readily available –
private iniciative damaged
• Expansionary fiscal policy can cause inflation as it can act like printing money, bonds being very
liquid (easy to turn into cash)