The Market System

1 - The Economic Problem

Goods – things that are produced in order to be sold

Finite – having an end or a limit

Infinite – without limits

 Basic economic problem – allocation of anation’s scarce resources

between competing resources that represent infinite wants
 Scarce resources – amount of resources available when supply is
limited
o What to produce
o How to produce
o For whom to produce
 Opportunity cost – value forgone of the next best alternative
 Expenditure – spending by a government, usually a national
government
 Production possibility curve – a line showing the different combinations
of two goods that an economy can produce given that all resources are
used up
 Capital goods – those purchased by firms and used to produce other
goods such as factories machinery, tools and equipment
 Consumer goods – those purchased by households such as food,
confectionery, cars, tablets, and furniture
 Economic growth – increase in the level of output by a nation
 Factors that shift the PPC outwards:
o New Technology
o New resources
o Education and Training
o Improved efficiency
 Factors that shift the PPC inwards:
o War
o Natural factors (storms, etc)
o Migration of workers overseas

2 - Economic Assumptions
 Consumers aim to maximise benefit – choosing goods with high quality and low
price
 Maximize – to increase something such as profit, satisfaction or income
as much as possible
 Businesses aim to maximise profits
 Revenue – money that a business earns over a period of time,
especially from selling goods and services
o Set the highest possible price that the market can stand
o Purchase resources with high quality and low price
 Reasons why consumers may not maximise benefit:
 o Brand loyalty
o Peer pressure from friends or society
o Difficulty quantifying benefit from consumption
o Lack of information
 Reasons why businesses may not maximise benefit:
o They are non-profit organizations
o They operate as social enterprises – companies, organizations, and
businesses
o Different employees who are delegated tasks may not take the best
decisions
o Other business objective (e.g. maximise consumer satisfaction)
o Lack of information

3 - The Demand Curve

Demand curve – line drawn on a graph that shows how much of a good that
will be bought at different prices.

Demand schedule – table of the quantity demanded of a good at different

price levels, which can be used to calculate the expected quantity
demanded

Effective demand – amount of a good people are willing to buy at given

prices over a given period of time supported by the ability to pay.

Shift in the demand curve – movement to the left or the right of the entire
demand curve when there is a change in any factor affecting demand except
the price

4 - Factors that May Shift the Demand Curve

Non-price determinants of demand:

 Advertising
 Fashion and Tastes
 Demographic changes
 Disposable income – income that is available to someone over a period
of time to spend; it includes state benefits but excludes direct taxes
 Cost of substitute goods – goods bought as an alternative to another
but perform the same function
 Cost of complement goods – goods purchased together because they
are consumed together

5 - The Supply Curve

Supply – amount that producers are willing to offer for sale at different
prices in a given period of time

Supply curve – line drawn on a graph which shows how much of a good
sellers are willing to supply at different prices

Shift in the supply curve – movement to the left or right of the entire supply
curve when there is any change in the conditions of supply except price
6 - Factors that May Shift the Supply Curve
Non-price determinants of supply:

 Technology
 Natural Factors
 Production costs
 Indirect taxes – taxes levied on spending, such as VAT
o Decreases consumption – amount of goods, services, energy, or
natural materials used in a particular period of time
 Subsidies – money that is paid by a government or organization to
make prices lower, reduce the cost of producing goods or providing a
services, usually to encourage production of a certain good

7 - Market Equilibrium
Equilibrium price – price at which supply and demand are equal

Market clearing price – price at which the amount supplied in a market

matches exactly the amount demanded

Total revenue – amount of money generated from the sale of goods

calculated by multiplying price by quantity

Excess demand – where demand is greater than supply and there are
shortages in the market

Excess supply – where supply is greater than demand and there are unsold
goods in the market

8 - Price Elasticity of Demand

PED – the responsiveness of demand to a change in price

Inelastic demand – change in price results in a proportionally smaller change

in demand

Elastic demand – change in price results in a proportionally greater change

in demand

Perfectly inelastic – where the PED is 0 and a change in price results in no

change in quantity demanded

Perfectly elastic – where the PED is infinity and an increase in price results
in 0 demand

Unitary elasticity – where the PED is -1 and a change in price results in a

proportionally equal change in quantity demanded

 Availability of Substitutes
 Degree of Necessity
 Proportion of Income spent
 Time frame

PED and revenue:

  When elastic, decrease price to increase revenue
 When inelastic, increase price to increase revenue

9 - Price Elasticity of Supply

PES – a measure of responsiveness of supply to changes in price

Inelastic supply – where changes in price result in proportionally smaller

changes in quantity supplied

Elastic supply – where changes in price result in proportionally greater

changes in quantity supplied

Perfectly inelastic supply – where a change in the price results in no change

in quantity supplied

Perfectly elastic supply – where any decrease in price results in the quantity
supplied becoming 0

Unitary elasticity – changes in price result in proportionally equal changes in

quantity supplied

 Access to and mobility of factors of production

o Raw materials – substances used to make a product
 Spare capacity
 Extra stock
 Time

10 - Income Elasticity of Demand

YED – a measure of the responsiveness of demand to changes in income

 Classifications of goods according to YED

o Normal good – those with a YED greater than 0
 Necessity – 0 < YED < 1
 Luxury – YED > 1
 Spending on luxury goods is a discretionary expenditure
(non-essential spending or spending that is not
automatic)
o Inferior goods
 YED and businesses
o Can predict when incomes will rise and fall and switch to producing other
goods
 Elasticity and governments
o Indirect taxes – governments tax products with inelastic demand, e.g.
 Value-added tax (VAT) - a tax on some goods and services –
businesses pay VAT on most goods and services they buy
and if they are VAAT registered, charge VAT on the goods
and services they sell
 Excise duty – government tax on certain goods, such as
cigarettes, alcoholic drinks and petrol that are sold in the
country
 o Subsidies – governments choose to subsidise goods with price inelastic
demand (steep demand curve) to cause a significant decrease in price

11 - The Mixed Economy

Economy – a system that attempts to solve the basic economic problem

Private sector – provision of goods and services by businesses owned by

individuals or groups of individuals

Public sector – government organisations that provide goods and services in

the economy

Private sector organizations

 Ownership:
o Sole trader – one person
o Partnership – two or more people
o Company – shareholders invest and choose a board of directors
 Shareholders – people or organizations that own shares in a
company
 Aims
o Survival
o Growth
o Profit maximization
 Companies pay shareholders a dividend – part of a company’s
profit that is divided among the people with shares in the
company
o Social Responsibility

Public Sector organizations

 Ownership
o Government departments own several services (e.g. NHS, armed forces)
o Government owns state-owned enterprises (SOEs). All assets and
liabilities belong to the state.
 Assets – things or resources belonging to an individual or
business that has value or power to earn money
 Liabilities – amount of debt that is owed or must be paid
o Local authority services provided by local councils
o Other public sector organizations ran by an expert/board selected by
Queen / government organizations
 Aims:
o Improve quality of services
o Allow for social benefits
o Efficiency by minimizing costs
o Profit (in some countries)

Mixed Economy – economy where goods are provided by both public and
private sectors
  What to produce – goods such as food, clothes, etc, public goods such as
education, street lighting, protection.
 How to produce – private firms produce consumer goods efficiently, public
sector provides public goods.
 For whom to produce – private sector produces for those who can afford the
goods, public goods free for everyone, supported by taxes
 Market failure – where markets lead to inefficiency
 Lack of information
 Lack of competition
 Missing markets
o Public goods – goods that are not likely to be provided by
the private sector
 Free rider – individual who enjoys the benefit of a good
but allows others to pay for it
 Non-rivalrous and non-excludable
o Merit goods – goods that are under-provided by the private
sector.
 Factor immobility
 Externalities

Market intervention against market failure:

 Businesses producing externalities can be regulated/fined

 Legislation prevents businesses from dominating the market
 State money used to provide public/merit goods
 Legislation forcing firms to provide more information about products
 Government helps keep some factors mobile, such as retaining workers

12 - Privatisation
Privatisation – act of selling a company or activity controlled by the
government to private investors

 Types of forms of privatization:

o Sale of nationalized industries – public corporations previously
part of the private sector that were taken into state ownership
o Contracting out
o Sale of land and property
 Reason for privatization
o Generate Income for government
o Public sector organisations were inefficient
o Reduce political interference
 Effects of privatisation
o Consumers
 Increased quality
 Reasonable prices
o Workers
 Large numbers made redundant
o Businesses
 Changed objectives – profit becomes more important
Increased investment
Mergers and takeovers of privatised firms -
 Takeover - act of getting control of a company by
buying over 50 per cent of its shares
 Hostile takeover – takeover that the company being
taken over does not want or agree to
 Diversification into new areas – if a company or economy
diversifies, it increases the range of goods or services it
produces
o Government
 Benefit from huge amount of revenue generated
 Business of the government can be focused upon more sharply
 Privatisation is expensive for advertising
 Criticism for state assets being sold off too cheaply

13 - Externalities
 External costs – negative spillover effects of consumption or
production – they affect third parties in a negative way.
o Noise pollution
o Air pollution
o Water pollution
o Overcrowding
o Traffic congestion
o Resource depletion
 External benefits – positive spillover effects of consumption or
production – they bring benefits to third parties.
o Education
o Healthcare
o Vaccinations
 Social cost = private costs + external costs
o Private costs – costs of an economic activity to individuals and
firms
o Social costs – costs of an economic activity to society as well as
the individual or firm
 Social benefit = private benefits + external benefits
o Private benefits – rewards of an economic activity to individuals
and firms
o Social benefits – benefits of an economic activity to society as
well as to the individual or firm
 Government policies to deal with externalities:
o Taxation
o Fines
o Subsidies
o Pollution Permits
o Government regulation
 Government and the Economy
25 - Economic Growth
 Macroeconomics – study of large economic systems such as those of a
country of area of the world
 Microeconomics – study of small economic systems that are part of
national or international systems
 Macroeconomic objectives:
o Economic growth – increase in the level of output by a nation
 National income rises: value of income, output, or
expenditure over a period of time
o Redistribution of income
o Controlling inflation
o Reducing unemployment
o Protection of the Environment
o Balance of payments
 Economic growth is measured with GDP – market value of all finished
goods and services produced in an economy in a period of time
(usually a year), an internationally recognized indicator of national
income. Limitations:
o Value of home-produced goods
o Informal/hidden markets
o Statistical errors
 o Does not measure living standards
 Amount of leisure time people have
 The way extra income is shared between the population
 Whether growth has resulted in pollution
 The quality of goods and services
o Population changes – use GDP per capita
o Inflation – use real GDP: growth rate – inflation rate
o External costs: doesn’t measure well-being of society
 The economic cycle:
o Boom – peak of the economic cycle where GDP is growth rate is at its
most.
o Downturn – stage of the economic cycle where GDP is growing but not as
fast as during a boom.
o Depression / slump– bottom of the economic cycle where GDP starts tto
fall with significant increases in unemployment
o Recession – a period of temporary economic decline during which trade
and industrial activity are reduced, generally identified by a decrease in
GDP in two successive quarters.
 Impact of economic growth:
o Employment: more people employed as more output produced
o Standards of living: higher
o Poverty: lower as more people are employed
o Productive Potential: Increased, PPC shifts outwards
o Inflation: possible overheat – demand rises too fast, causing prices
and imports to rise, a situation that governments may try to
correct by raising taxes and interest rates
o The environment: unsustainable growth – economic growth that is
not possible to sustain without causing environmental growth

26 - Inflation
 Inflation – a general and continuing rise in prices; rate at which prices
rise
 Aggregate demand – total demand in the economy, including
consumption, expenditure, investment, and exports minus imports
 Deflation – period where the level of aggregate demand is falling
 Rate of inflation is monitored by CPI (consumer price index) - a measure of
the general price level, excluding housing costs
 RPI (retail price index) - a measure of the general price level including
housing costs and council tax
 Types of inflation
o Demand-pull inflation: inflation caused by too much demand in
the economy relative to supply
o Cost-push inflation: demand caused by rising business costs
 Relationship between inflation and interest rates: monetarists believe that
when interest rates are low, inflation rises
 o Monetarists – economists who believe that there is a strong link
between growth and the money supply and inflation
 Impact of inflation
o Prices – purchasing power of money (amount of goods and services
that can be bought with a fixed sum of money) decreased, falling
living standards
o Wages – workers need to increase wage to compensate for lower
purchasing power
o Exports – high domestic inflation makes exports more expensive
o Unemployment – high inflation implies high aggregate demand, so
unemployment decreases
o Menu costs – costs to firms of having to make repeated price
changes
o Shoe leather costs – costs to consumers and firms of having to
search for new suppliers when inflation is high
o Business and consumer confidence – more anxious and cautious; lose
confidence and growth plans / product development postponed.
 Hyperinflation: very high levels of inflation; rising prices get
out of control
o Uncertainty – firms will not know what prices will be in the future so will
sign less contracts.
o Investment – uncertainty of future prices caused by inflation, lack of
business confidence causes cancellation / postponement of investment
projects

27 - Unemployment
 Unemployment – when those who are actively seeking work cannot find
a job
 ILO definition: does not have a job, wants a job, has sought work in the past 4
weeks, willing to start in the next 2 weeks, OR out of work, have found a job and
are waiting to start it in the next 2 weeks
 Types of unemployment
o Cyclical or demand deficient unemployment – unemployment
caused by a lack of demand due to a downturn in the economic
cycle
 Laying off – to stop employing someone as there is no work
for them to do
o Structural unemployment – unemployment due to a change in the
structure of the economy, such as the decline of an industry
 Technological unemployment
 Sectorial unemployment
 Regional unemployment
o Seasonal unemployment – unemployment caused when seasonal
workers, such as those working in the holiday industry, are laid
off as the season has ended
o Voluntary unemployment – unemployment resulting from one
choosing not to work
 o Frictional unemployment – temporary unemployment as people
move between jobs
 Impact of unemployment
o Output – falls, except if technology is used instead
o Use of scarce resources - wasteful
o Poverty – increases as people cannot sustain themselves anymore
o Government spending on benefits increases
o Tax revenue decreases
o Consumer confidence decreases
o Business confidence decreases – workers fear that they will be the next to
laid off, falling demand from unemployment as there is less to spend, less
risks and investments taken
o Society – impacts on local communities, stress, less likely to get married

28 - Balance of Payments on the Current Account

 The current account on the balance of payments
o Exports – goods and services that are sold overseas
o Imports – goods and services that are bought from overseas
o Balance of payments – a country’s record of all transactions
relating to international trade
o Current account – part of the balance of payments where all
exports and imports are recorded
o Capital and financial accounts – part of the balance of payments
where flows of savings, investment and currencies are recorded
 Current Account Deficits and Surpluses
o Current balance – difference between total exports and total
imports (visible and invisible)
o Current account deficit – where the value of imports exceeds the
value of exports
o Current account surplus – where the value of exports exceeds the
value of imports
 Visible and Invisible Trade
o Visible trade – trade of physical goods
 Balance of trade / visible balance – difference between
visible imports and visible exports
o Invisible trade – trade in services
 Primary income – income received by the loan of production
factors abroad
 Secondary income – government transfers to and from
overseas agencies such as the EU
o Relationship between the current account and exchange rates:
 Exchange rate – price of one currency in terms of another
 If the exchange rate gets stronger, exports become more expensive
and imports become cheaper
 A surplus on the current account causes a rise in the demand for the
country’s currency causing the currency to get stronger
 o Reasons for deficits and surpluses
 Quality of domestic goods
 Quality of foreign goods
 Price of domestic goods
 Price of foreign goods
 The exchange rate between countries
o Impact of a current account deficit:
 Leakages from the economy – domestic output and employment
levels are under threat
 Inflation – if imports prices increase, this will be counted in the CPI
so will affect inflation levels
 Low demand for exports – Might be struggling to sell goods and
services abroad.
 Funding the deficit – country needs foreign currency to pay for rising
quantity of imports, causing potential borrowing

29 - Protection of the Environment

 Business activity that damages the environment
o Mining
o Power generation
o Chemical processing
 HAPs (Hazardous air pollutants)
 VOCs (Volatile organic compounds)
o Agriculture
o Construction
 Ways that businesses damage the environment
o Visual pollution
o Noise pollution
o Air pollution
 Burning of fossil fuels
 Emissions from factories and other business activities
 Agricultural activities
o Water pollution
 Industrial waste
 Marine and ocean dumping
 Sewerage
o Government intervention to protect the environment
 Taxation
 Subsidies
 Regulation
 Fines
 Pollution permits
 Park provision

30 - Redistribution of income
 o Income inequality – differences in income that exist between the
different groups of earners in society, that is, the gap between
the rich and the poor. Reasons:
 Workers with talent tend to earn more
 People out of work, such as pensioners, receive lower incomes
 The extent to which government redistributes income
 People who own assets will enjoy additional income
o Lorenz curve – a graphical representation of the degree of income
or wealth inequality in a country
o Absolute Poverty – where an individual doess not have the
resources to all of their meet basic human needs
o Relative poverty – poverty defined in relation to existing living
standards for the average individual
o Reasons to reduce poverty and inequlity
 Meet basic human needs
 Raise living standards
 Ethical Reasons
o Measures to reduce income inequality:
 Progressive taxation – where the proportion of income paid
in taxes rises as the income of the taxpayer rises
 Regressive taxation – tax system that places the burden of
the tax more heavily on the poor
o Redistribution through benefit payments
o Investment in education and healthcare

31 - Fiscal Policy
 Policy instruments – tools governments use to implement their
policies, such as interest rates, rates of taxation, and levels of
government spending
 Fiscal policy – decisions about government spending, taxation and
levels of borrowing that affect aggregate demand in the economy
 Budget – government's spending and revenue plans for the next year
 Government revenue
o Taxation is imposed for the following reasons:
 To pay for public sector services
 To discourage certain activities
 Help control aggregate demand
 Redistribution of income
o Direct taxes – taxes levied on the incomes of individuals and firms
 Income tax – direct tax on income
 Social insurance tax – similar to income tax but for pensions,
benefits, and healthcare
 Corporation taxes – levied on profits made by limited companies
 Capital gains tax – levied on financial gains made when selling
assets at a profit
 Inheritance tax – paid on money that is inherited from people who
die
 o Indirect taxes – taxes levied on spending, such as VAT
 Sales taxes – taxes on spending. EU countries use value-added tax
(VAT) - tax on some goods and services, business pay value-
added tax on most goods and services they buy and if they
are VAT registered, charge value-added tax on the goods
and services they sell
 Duties – heavy taxes on a select range of goods, such as petrol,
cigarettes and alcohol
 Customs duties – taxes levied on imports.
 Council tax – collected by local authorities to help pay for local
services
 Business rates – collected by local authorities which contribute to
the provision of local community services
 Stamp duties – paid when buying certain assets such as houses and
shares
o Environmental taxes
 Landfill tax
 Climate change levies – paid mainly by suppliers of power
 Aggregates levy – tax on sand, gravel and rock, reduces the
environmental damage from quarrying
 Government expenditure
o Social protection –benefits, pensions, jobseekers allowances
o Health care – salaries of doctors and health workers, equipment
o Education – salaries of teachers, equipment for schools, student grants
o Defence – maintenance of the armed forcess
o Interest – on government borrowings, national debt
o Public order / safety – police force, fire services, prison service
o Social services – care of children, elderly, people with disabilities
o Other – transport, housing, industry, training, recreation, etc
 Fiscal deficits and surpluses
o Fisal deficit – amount by which government spending exceeds
government revenue
o Fiscal surplus – amount by which government revenue exceeds
government spending
 Impact of a fiscal deficit and fiscal surplus
o Fiscal deficits: National debt – total amount of money owed by a
country gets larger, more revenue spent paying off debt, future
generations burdened
o Fiscal surpluses: Surplus sued to spend on future provision of public
services, taxes could be lowered, payoff national debt
 Types of fiscal policy
o Expansionary fiscal policy – fiscal policy measures designed to
stimulate demand in the economy
o Contractionary fiscal policy – fiscal measures designed to reduce
demand in the economy
 Effects on macroeconomic objectives:
o Inflation – Contractionary FP can be used to reduce inflation.
 o Economic growth – Expansionary FP such as increases in government
expenditure which increases aggregate demand. Economic growth from
government investment in schools, transport links and airports
o Unemployment – expansionary FP reduces unemployment. Increases in
government expenditure and tax cuts stimulates demand, causing firms to
produce more, so hire more
o Current Account Deficit – contractionary FP reduces aggregate demand
which reduces the demand for imports
o Fiscal policy and the environment – environmental taxes raised help
reduce damage. Subsidies encourage environmentally friendly activities

32 - Monetary policy
 Monetary policy – use of interest rates and the money supply to
influence aggregate demand in the economy
 Money supply – amount of money circulating in the economy
 Differences in interest rates:
o Different banks charge different interest rates to stay competitive
o Rates get higher if money is borrowed without security
 Mortgage – a legal arrangement where money is borrowed
from a financial institution to buy land or a house; money is
paid regularly over a period of multiple years, and if regular
payments are not made then the lender has the right to take
the property and sell it to get their money back.
o High rates of interest – price of borrowing money - are charge to
credit card users.
 Role of the central bank in setting the interest rate:
o Implementing the MP (monetary policy) nad regulating the banking
system
o Acting as a lender of last resort to commercial banks
o Controlling inflation and stabilising a nation’s currency
o Setting interest rates
 Impacts of changing interest rates on macroeconomic objectives:
o Inflation – money supply grows too quickly, increased interest reduces
aggregate demand
o Unemployment – low interest rates cause more aggregate demand so
firms hire more
o Economic growth – affects aggregate demand, causing more output
o The current balance – lower interest rates cause more aggregate demand,
so higher imports. However, lower interest rates lead to less foreign
investment into domestic banks, so the value of the currency weakens
and more exports are sold, so higher exports as well. Depends on:
 Income elasticity of demand for imports
 Strength of the link between interest rate and the exchange rate
 Price elasticity of demand of both imports and exports
 Mechanism by which interest rate changes affects consumers and firms
o Consumers:
 Loans rise, more borrowing
  Mortgage payments fall, more money to spend
 Increased aggregate demand
 Spending encouraged rather than saving
o Firms:
 Interest payments on borrowings fall, profits increase
 Business confidence increased, stimulates investment
 Large proportions of investment are funded through borrowing so
returns on investment are higher
o Exchange rate: lower interest rate causes the less demand from foreign
investors so the exchange rate falls. This causes exports to become
cheaper and more demand for them, and imports become more
expensive, so less demand for them. Improves current balance
 Asset purchasing by central banks
o Quantitative easing: purchasing of financial assets such as
government by central banks from commercial banks, causing a
flow of money from central banks to commercial banks
o This extra cash can be used by commercial banks as a basis for making
new loans to consumers and businesses
o Doesn’t actual give commercial banks any cash, but more money is
created electronically, causing inflation

33 - Supply Side Policies

 Supply side policies – government measures designed to increase
aggregate supply in the economy
 Aggregate supply – total amount of goods and services produced ina
country at a given price level in a given time period
 Impact of supply side policies on productivity and total output
o Productivity
 Improving Flexibility – Criticism of labour unions for forcing up
wages and resisting the introduction of new practices and
technology. The government introduced anti-trade union legislation
– banned secondary picketing and closed shops
 Training and education – quality of workforce improves if more
education and training is received
o Privatisation and deregulation improve competition – pressure for firms to
be more innovative and cost effective
o More investment – if businesses purchase new technology, efficiency
improves
o Total output: increased productive potential, increased output causes
national income to rise, less chance of demand-pull inflation
 Impact of supply side policies on macroeconomic objectives:
o Privatisation
 Privatisation breaks up state monopolies and promotes competition,
as businesses have to make a profit to survive
 Services provided by the public sector are contracted out
 State monopolies may often become private monopolies
o Deregulation
  Excessive paperwork
 Obtaining unnecessary licenses
 Having lots of people or committees to approve decisions
 Various “trivial” rules that slow down business development
o Education and training – more worker productivity, more communication,
analysis, problem solving, causing more employability. However education
investment is expensive and returns on investment may not be seen for
many years.
o Policies to boost regions with high unemployment – government
selectively reforms labour markets and makes it easier for firms to “hire
and fire” people
o Infrastructure spending – productive potential increases if infrastructure is
improved – e.g. transport systems or broadband network
o Lower business taxes to stimulate investment – firms need to be confident
about the future and there need to be funds available for investment
 Tax profits decrease
 Cost of investment against tax can be offset – if something, such
as the cost or a sum of money, offsets another cost it has
the same effect of reducing or balancing it, so the situation
remains the same.
 Tax incentives encourage people to save more and buy shares (tax
relief/breaks)
o Lower income taxes to encourage working – high taxes reduce the
incentive to work and discourage people from developing businesses,
more people take holidays, retire earlier, refuse overtime, which reduces
output.
 Government controls – it can pass legislation to help protect the environment,
impose fines on firms, etc.
o Advantage – they reduce the exploitation of vulnerable group or sectors
o Disadvantage – they may impose costs on firms that might inhibit their
growth and development

34 - Relationships between Objectives and Policies

 Austerity – official action taken by a government in order to reduce the
amount of money that it spends or the amount that people spend
 Unemployment and inflation
o Monetary policy is used to reduce inflation, as interest rates can quickly
be raised, decreasing aggregate demand. However,
 Consumer and business borrowing is discouraged, fall in
consumption and investment, and reduced aggregate demand
 Higher mortgage payments, reducing spending power and
aggregate demand falls
 Firms incur higher interest charges – less investment and less
aggregate demand
 Firms discouraged from borrowing for investment so they lose their
competitive edge in foreign markets
  High inflation leads to stronger exchange rates so harder for firms to
sell abroad
o Fiscal policy used to reduce inflation:
 Higher taxes and low government spending results in
unemployment – higher taxes lead to less aggregate demand so
workers laid off; less government spending decreases aggregate
demand
 People suffer due to poorer government services
o Possible trade-off: When inflation was reduced, unemployment rises.
Supply side measures to reduce inflation may avoid unemployment, as
these measures increase supply rather than decrease demand. However,
they are slow to have an impact on the economy.
 Economic growth and inflation
o Expansionary fiscal policy and expansionary monetary policy can promote
growth
o Possible trade-off: They may be too expansionary, causing an overheating
of the economy and demand pull inflation, especially if there is limited
capacity in the economy or if factors of production are immobile.
However, supply side policies may be used as they are more business
friendly.
 Economic growth and Environmental Protection
o As there is more output it is more likely for there to be damage from
emissions
o Land taken for business development results in less wildlife
o Possible trade-off: Many people argue that the environment is a
worthwhile price to pay for less poverty and longer life expectancy and
improved living standards. Measures such as legislations, regulations,
fines and pollution permits can be used; however it may damage the
entrepreneurial spirit too much.
 Inflation and the current account on the balance of payments
o When inflation is high, prices rise so exports will be more expensive,
reducing demand and decreasing the current balance
o Consumers switch from domestic goods to imported goods, further
worsening it
o Monetary policy used to reduce inflation would lead to a strong exchange
rate which would decrease exports further and increase imports further,
worsening it
o Possible trade-off: A government reducing inflation will have to accept that
the current account may temporarily worsen.
 Contractionary fiscal policy should be used to decrease inflation as it
would decrease aggregate demand only and would not affect trade.
 Supply side policies would also avoid negative impacts as they are
business friendly and more output produced.