4.2 The national and international economy

This section of the specification is primarily about macroeconomics. However, students should understand that microeconomic principles underpin the behaviour of the macroeconomy. Understanding some aspects of macroeconomic behaviour requires that students have a firm grasp of related microeconomic principles, for example, understanding of price elasticity of demand is essential when analysing the impact of changes in the exchange rate on an economy.

Students should have a good knowledge of developments in the UK economy and government policies over the past fifteen years. They should also be aware of developments in the world economy, including the European Union, and how these have affected the UK. They are not required to have specific knowledge of economic developments in any individual country, other than the UK, but if this is needed, relevant data will be presented to students.

Students should recognise that there are a number of models demonstrating how the macroeconomy works and should appreciate that different economic models provide insights into different aspects of the behaviour of the macroeconomy. When using these models students should be critically aware of the assumptions upon which they are based and their limitations when they are used to make sense of real world phenomena. Furthermore, they should be prepared to propose, analyse and evaluate possible solutions to macroeconomic problems. They will be required to assess the impact and effectiveness of current government policies to deal with these problems, as well as considering alternative policies and approaches.

4.2.1 The measurement of macroeconomic performance

4.2.1.1 The objectives of government economic policy

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Additional information

  • The main objectives of government macroeconomic policy: economic growth, price stability, minimising unemployment and a stable balance of payments on current account.
  • The possibility of conflict arising, at least in the short run, when attempting to achieve these objectives.

Students should be aware that governments may also have other objectives of macroeconomic policy, such as balancing the budget and achieving an equitable distribution of income.

They should be aware that the importance attached to the different objectives changes over time.

4.2.1.2 Macroeconomic indicators

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  • Data which is commonly used to measure the performance of an economy, such as: real GDP, real GDP per capita, Consumer Prices and Retail Prices Indices (CPI/RPI), measures of unemployment, productivity and the balance of payments on current account.
 

4.2.1.3 Uses of index numbers

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Additional information

  • How index numbers are calculated and interpreted, including the base year and the use of weights.
  • How index numbers are used to measure changes in the price level and changes in other economic variables.

A detailed technical knowledge is not expected of indices such as the Retail Prices Index (RPI) and Consumer Prices Index (CPI), but students should have an awareness of their underlying features, for example, the concept of the ‘average family’ and a ‘basket of goods and services’.

4.2.1.4 Uses of national income data

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Additional information

  • The use and limitations of national income data to assess changes in living standards over time.
  • The use and limitations of national income data to compare differences in living standards between countries.
  • The importance of using purchasing power parity (PPP) exchange rates when making international comparisons of living standards.
 

4.2.2.1 The circular flow of income

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Additional information

  • What national income measures.
  • The difference between nominal and real income.
  • Real national income as an indicator of economic performance.
  • The circular flow of income concept, the equation income = output = expenditure, and of the concepts of equilibrium and full employment income.
  • The difference between injections and withdrawals into the circular flow of income.
  • The effect of changes in injections and withdrawals on national income.

Students are not expected to have a detailed knowledge of the construction of national income accounts.

4.2.2.2 Aggregate demand and aggregate supply analysis

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Additional information

  • Changes in the price level are represented by movements along the aggregate demand (AD) and aggregate supply (AS) curves.
  • The various factors that shift the AD curve and the short-run AS curve.
  • The factors which affect long-run AS and distinguish them from those which affect short-run AS.
  • Underlying economic growth is represented by a rightward shift in the long-run AS curve.
  • How to use AD/AS diagrams to illustrate macroeconomic equilibrium.
  • How both demand-side and supply-side shocks affect the macroeconomy

Students should be able to use AD and AS analysis to help them explain macroeconomic problems and issues. For example, they should be able to use AD and AS diagrams to illustrate changes in the price level, demand-deficient (cyclical) unemployment and economic growth.

Students should also understand how global economic events can affect the domestic economy.

4.2.2.3 The determinants of aggregate demand

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Additional information

  • What is meant by AD.
  • The determinants of AD, ie the determinants of consumption, investment, government spending, exports and imports.
  • The basic accelerator process.
  • The determinants of savings.
  • The difference between saving and investment.

Students will not be required to undertake calculations to illustrate the operation of the accelerator.

Students should understand how changes in net exports affect aggregate demand and economic performance.

4.2.2.4 Aggregate demand and the level of economic activity

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Additional information

  • The role of AD in influencing the level of economic activity.
  • The multiplier process and an explanation of why an initial change in expenditure may lead to a larger impact on local or national income.
  • The concept of the marginal propensity to consume and use the marginal propensity to consume to calculate the size of the multiplier.
  • Why the size of the marginal propensity to consume determines the magnitude of the multiplier effect.

Students will only be required to calculate the multiplier from the marginal propensity to consume.

Calculations from the marginal propensities to withdraw will not be expected.

4.2.2.5 Determinants of short-run aggregate supply

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Additional information

  • The price level and production costs are the main determinants of the short-run AS.
  • Changes in costs, such as: money wage rates, raw material prices, business taxation and productivity, will shift the short-run AS curve.
 

4.2.2.6 Determinants of long-run aggregate supply

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Additional information

  • The fundamental determinants of long-run AS such as technology, productivity, attitudes, enterprise, factor mobility, and economic incentives.
  • The position of the vertical long-run AS curve represents the normal capacity level of output of the economy.
  • The importance of the institutional structure of the economy in determining aggregate supply, such as the role of the banking system in providing business investment funds, should also be understood.
  • The Keynesian AS curve.
 

4.2.3 Economic performance

4.2.3.1 Economic growth and the economic cycle

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Additional information

  • The difference between short-run and long-run growth.
  • The various demand-side and supply-side determinants of short-run growth of real national income and the long-run trend rate of economic growth.
  • The costs and benefits of economic growth.
  • The impact of growth on individuals, the economy and the environment.
  • The concept of the economic cycle and the use of a range of economic indicators, such as real GDP, the rate of inflation, unemployment and investment, to identify the various phases of the economic cycle.
  • The difference between positive and negative output gaps.
  • The causes of changes in the various phases of the economic cycle, including both global and domestic demand-side and supply-side shocks.

Students should be able to use a production possibility curve and AD/AS diagrams to illustrate the distinction between short-run and long-run economic growth.

Students should understand that long-run economic growth occurs when the productive capacity of the economy is increasing and is a term used to refer to the trend rate of growth of real national output in an economy over time.

Students should be able to discuss the sustainability of economic growth.

Students should understand that a positive output gap occurs when real GDP is above the productive potential of the economy, and a negative output gap occurs when real GDP is below the economy’s productive potential.

Students should be able to discuss causes of cyclical instability such as: excessive growth in credit and levels of debt, asset price bubbles, destabilising speculation and animal spirits or herding.

4.2.3.2 Employment and unemployment

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Additional information

  • The main UK measures of unemployment, ie the claimant count and the Labour Force Survey measure.
  • The concepts of voluntary and involuntary unemployment.
  • The terms seasonal, frictional, structural and cyclical unemployment.
  • How employment and unemployment may be determined by both demand-side and supply-side factors.
  • The concept of, and the factors which determine, real wage unemployment.
  • The concept of, and the factors which determine, the natural rate of unemployment.
  • The consequences of unemployment for individuals and for the performance of the economy.

Students should appreciate that unemployment has a variety of causes and hence the appropriate policies to reduce unemployment depend on the cause.

They should understand that a negative output gap is linked to cyclical unemployment and that supply-side causes of unemployment affect the position of the long-run aggregate supply curve.

4.2.3.3 Inflation and deflation

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Additional information

  • The concepts of inflation, deflation and disinflation.
  • Demand-pull and cost-push influences on the price level.
  • Fisher’s equation of exchange MV = PQ and the Quantity Theory of Money in relation to the monetarist model.
  • The effects of expectations on changes in the price level
  • The consequences of inflation for both individuals and the performance of the economy.
  • The consequences of deflation for both individuals and the performance of the economy.
  • How changes in world commodity prices affect domestic inflation.
  • How changes in other economies can affect inflation in the UK.

Students should understand that deflation exists when the price level is falling, whereas disinflation is when the rate of inflation is falling.

Students should appreciate that deflationary policies are policies to reduce aggregate demand and do not necessarily result in deflation.

Students can use T instead of Q in the Fisher equation but using Q means that PQ is nominal national income and overcomes the difficulties associated with the inclusion of intermediate transactions.

4.2.3.4 Possible conflicts between macroeconomic policy objectives

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Additional information

  • How negative and positive output gaps relate to unemployment and inflationary pressures.
  • Both the short-run Phillips curve and the long-run, L-shaped Phillips curve.
  • The implications of the short-run Phillips curve and the long-run, L-shaped Phillips curve for economic policy.
  • How economic policies may be used to try to reconcile possible policy conflicts both in the short run and the long run.

Students should be able to use macroeconomic models, including the AD/AS model, to analyse the causes of possible conflicts between policy objectives in the short run and long run. They should be able to discuss approaches to reconciling these conflicts and the monetarist/supply-side view that the major macroeconomic objectives are compatible in the long run.

The L-shaped Phillips curve is also known as the vertical long-run Phillips curve.

4.2.4 Financial markets and monetary policy

4.2.4.1 The structure of financial markets and financial assets

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Additional information

  • The characteristics and functions of money.
  • Definitions of the money supply and the distinction between narrow money and broad money.
  • The difference between the money market, the capital market and the foreign exchange market.
  • The role of financial markets in the wider economy.
  • The difference between debt and equity.
  • Why there is an inverse relationship between market interest rates and bond prices.

Students should know that ways in which firms raise finance include: issuing shares, issuing corporate bonds and borrowing from a bank.

Students should know the terms coupon and maturity in relation to government bonds and be able to calculate the yield on a government bond.

4.2.4.2 Commercial banks and investment banks

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Additional information

  • The difference between a commercial bank and an investment bank.
  • The main functions of a commercial bank.
  • The structure of a commercial bank’s balance sheet.
  • The objectives of a commercial bank, ie liquidity, profitability and security.
  • Potential conflicts between these objectives.
  • How banks create credit.

Students should be aware of the differences between a commercial bank and an investment bank but they do not need a detailed knowledge of the activities and functions of an investment bank. They should also be aware that many banks are engaged in both investment banking and commercial banking activities and that this may increase systemic risk.

Students should be aware that there are other institutions that operate in financial markets but they do not need to know about their activities or their functions.

Students will not be required to calculate the credit multiplier.

4.2.4.3 Central banks and monetary policy

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Additional information

  • The main functions of a central bank.
  • That monetary policy involves the central bank taking action to influence interest rates, the supply of money and credit and the exchange rate.
  • The current objectives of monetary policy set by the government.
  • The role of the Monetary Policy Committee of the Bank of England (MPC) and how it uses changes in bank rate to try to achieve the objectives for monetary policy, including the government’s target rate of inflation.
  • The factors considered by the MPC when setting the bank rate.
  • How changes in the exchange rate affect aggregate demand and the various macroeconomic policy objectives.
  • The monetary policy transmission mechanism, including the relationship between changes in interest rates and the exchange rate.
  • How the Bank of England can influence the growth of the money supply.

Students should understand current and recent instruments of monetary policy such as: quantitative easing, Funding for Lending and forward guidance.

Students should understand how the MPC of the Bank of England uses changes in bank rate to try to achieve the objectives for monetary policy, including the government’s target rate of inflation.

4.2.4.4 The regulation of the financial system

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Additional information

  • Regulation of the financial system in the UK, eg the role of the Bank of England, the Prudential Regulation Authority (PRA), the Financial Policy Committee (FPC) and the Financial Conduct Authority (FCA).
  • Why a bank might fail, including the risks involved in lending long term and borrowing short term.
  • Liquidity ratios and capital ratios and how they affect the stability of a financial institution.
  • Moral hazard.
  • Systemic risk and the impact of problems that arise in financial markets upon the real economy.

An in-depth knowledge of the PRA, FPC and the FCA is not expected but students should appreciate their role in trying to maintain the stability of the financial system.

Students will not be required to calculate liquidity or capital ratios.

4.2.5 Fiscal policy and supply-side policies

4.2.5.1 Fiscal policy

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Additional information

  • Fiscal policy involves the manipulation of government spending, taxation and the budget balance.
  • Fiscal policy can have both macroeconomic and microeconomic functions.
  • How fiscal policy can be used to influence aggregate demand.
  • How fiscal policy can be used to influence aggregate supply.
  • How government spending and taxation can affect the pattern of economic activity.
  • The types of and reasons for public expenditure.
  • Why governments levy taxes.
  • The difference between direct and indirect taxes.
  • The difference between progressive, proportional and regressive taxes.
  • The principles of taxation, such as that taxes should be equitable.
  • The role and relative merits of different UK taxes.
  • The relationship between the budget balance and the national debt.
  • Cyclical and structural budget deficits and surpluses.
  • The consequences of budget deficits and surpluses for macroeconomic performance.
  • The significance of the size of the national debt.
  • The role of the Office for Budget Responsibility.

Students should be able to assess the economic significance of changes in the level and distribution of both public expenditure and taxation.

They should be able to discuss the issue of the budget balance and be able to evaluate the possible economic consequences of a government running a budget deficit or budget surplus.

They should be able to assess the impact of measures used to rebalance the budget.

4.2.5.2 Supply-side policies

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Additional information

  • The difference between supply-side policies and supply-side improvements in the economy.
  • How supply-side policies can help to achieve supply-side improvements in the economy.
  • How supply-side policies, such as tax changes designed to change personal incentives, may increase the potential output of the economy and improve the underlying trend rate of economic growth.
  • How supply-side policies can affect unemployment, the rate of change of prices and UK external performance, as reflected in the balance of payments on current account.
  • The role of supply-side policies in reducing the natural rate of unemployment.
  • Free market supply-side policies include measures such as: tax cuts, privatisation, deregulation and some labour market reforms.
  • Interventionist supply-side policies include measures such as: government spending on education and training, industrial policy, subsidising spending on research and development.
  • Supply-side policies can have microeconomic as well as macroeconomic effects.

Students should recognise that supply-side changes in the economy often originate in the private sector, independently of government, eg through productivity improvements, innovation and investment.

Students should recognise that supply-side policies can involve government intervention to deal with market failures such as short-termism, as well as policies to improve economic incentives and the operation of markets.

4.2.6 The international economy

4.2.6.1 Globalisation

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Additional information

  • The causes of globalisation.
  • The main characteristics of globalisation.
  • The consequences of globalisation for less-developed and for more-developed countries.
  • The role of multinational corporations in globalisation.
 

4.2.6.2 Trade

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Additional information

  • The model of comparative advantage.
  • The distinction between comparative and absolute advantage.
  • The model shows that specialisation and trade can increase total output.
  • Other economic benefits of trade, such as the ability to exploit economies of scale and increased competition.
  • The costs of international trade.
  • The reasons for changes in the pattern of trade between the UK and the rest of the world.
  • The nature of protectionist policies, such as: tariffs, quotas and export subsidies.
  • The causes and consequences of countries adopting protectionist policies.
  • The main features of a customs union.
  • The main characteristics of the Single European Market (SEM).
  • The consequences for the UK of its membership of the European Union (EU).
  • The role of the World Trade Organisation (WTO).

Students should be able to use a simple numerical example to illustrate the principle of comparative advantage and the associated benefits of trade.

Students should be able to use a diagram to illustrate the effects of imposing a tariff on imports.

Students should be able to discuss the arguments for and against the UK’s membership of the EU.

4.2.6.3 The balance of payments

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Additional information

  • The difference between the current, capital and financial accounts on the balance of payments.
  • The current account comprises trade in goods, trade in services, income flows and transfers.
  • The meaning of a deficit and a surplus on the current account.
  • The factors that influence a country’s current account balance such as productivity, inflation and the exchange rate.
  • The consequences of investment flows between countries.
  • The policies that might be used to correct a balance of payments deficit or surplus.
  • Expenditure-switching and expenditure-reducing policies.
  • The effect policies used to correct a deficit or surplus may have upon other macroeconomic policy objectives.
  • The significance of deficits and surpluses for an individual economy.
  • The implications for the global economy of a major economy or economies with imbalances deciding to take corrective action.

Students should have a detailed knowledge of the structure of the current account of the balance of payments but only need a general appreciation of the other sections of the balance of payments account.

Students should appreciate the difference between foreign direct investment (FDI) and portfolio investment.

4.2.6.4 Exchange rate systems

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  • How exchange rates are determined in freely floating exchange rate systems.
  • How governments can intervene to influence the exchange rate.
  • The advantages and disadvantages of fixed and floating exchange rate systems.
  • Advantages and disadvantages for a country of joining a currency union, eg the eurozone.
 

4.2.6.5 Economic growth and development

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Additional information

  • The difference between growth and development.
  • The main characteristics of less-developed economies.
  • The main indicators of development, including the Human Development Index (HDI).
  • Factors that affect growth and development, such as: investment, education and training.
  • Barriers to growth and development, such as: corruption, institutional factors, poor infrastructure, inadequate human capital, lack of property rights.
  • Policies that might be adopted to promote economic growth and development.
  • The role of aid and trade in promoting growth and development.

Students should appreciate the links between this and other parts of the specification, such as: globalisation, trade, the determinants of economic growth and inequality.

Students should be able to compare market-based strategies and interventionist strategies for promoting growth and development.