3.2 The national economy in a global context

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 extent to which a fall in the exchange rate will lead to an increase in exports.

Students will be required to acquire knowledge and understanding of AD/AS analysis and should be provided with opportunities to use this analysis to explore recent and current economic behaviour. They should understand, and be able to analyse and evaluate, macroeconomic policy.

When applying and evaluating all the macroeconomic models in the specification, such as the circular flow of income and the multiplier process, students should be critically aware of the assumptions upon which these models are based and their limitations when investigating macroeconomic and global issues.

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 that the performance of the United Kingdom economy is influenced by its membership of the European Union (EU) and by external events in the international economy.

3.2.1 The measurement of macroeconomic performance

3.2.1.1 The objectives of government economic policy

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  • 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.

3.2.1.2 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.
 

3.2.1.3 Uses of index numbers

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  • 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'.

3.2.2.1 The circular flow of income

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  • 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 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.

3.2.2.2 Aggregate demand and aggregate supply analysis

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  • 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 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.

3.2.2.3 The determinants of aggregate demand

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  • 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 AD and how global events affect economic performance.

3.2.2.4 Aggregate demand and the level of economic activity

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  • 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.

Students will not be required to calculate the value of the multiplier using the marginal propensity to consume or the propensities to withdraw. However, they should be able to calculate the value of the multiplier from an initial change in injections and the resulting change in national income.

3.2.2.5 Determinants of short-run aggregate supply

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  • 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.
 

3.2.2.6 Determinants of long-run aggregate supply

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  • 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.

It is assumed that the long-run AS curve is vertical.

3.2.3 Economic performance

3.2.3.1 Economic growth and the economic cycle

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  • 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 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.
  • How demand-side and supply-side shocks, including those that occur in the global economy, affect domestic economic activity.

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 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.

3.2.3.2 Employment and unemployment

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  • The main UK measures of unemployment, ie the claimant count and the Labour Force Survey measure.
  • The terms seasonal, frictional, structural and cyclical unemployment.
  • How employment and unemployment may be determined by both demand-side and supply-side factors.
  • How changes in the rest of the world affect employment and unemployment in the UK.

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

3.2.3.3 Inflation and deflation

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  • The concepts of inflation and deflation.
  • Demand-pull and cost-push influences on the price level.
  • 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.

3.2.3.4 The balance of payments on current account

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  • The importance of international trade for an economy such as the UK.
  • The current account comprises trade in goods, trade in services, income flows and transfers.
  • The meaning of a deficit and a surplus on current account.
  • The factors that influence a country’s current account balance such as productivity, inflation and the exchange rate and economic activity in other countries.

Students should be aware that the current account is only one part of the balance of payments but knowledge of the other parts of the account is not expected.

3.2.3.5 Possible conflicts between macroeconomic policy objectives

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  • How negative and positive output gaps relate to unemployment and inflationary pressures.
  • 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.

3.2.4 Macroeconomic policy

3.2.4.1 Monetary policy

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  • Monetary policy involves the central bank taking action to influence the manipulation of 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 bank rate.
  • How changes in the exchange rate affect aggregate demand and the various macroeconomic policy objectives.

Students do not need to know how interest rates and the exchange rate are determined but they do need to know how changes in interest rates and the exchange rate affect macroeconomic performance.

3.2.4.2 Fiscal policy

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  • 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 difference between direct and indirect taxes.
  • The difference between progressive, proportional and regressive taxes.
  • The relationship between the budget balance and the national debt.

Students should be aware of the main taxes in the UK and the main categories of government spending, eg spending on defence, health, education and welfare.

Students should appreciate that governments may deliberately run budget deficits and surpluses to try to influence aggregate demand but they are not required to understand the arguments relating to the pros and cons of balancing the budget or attempting to limit the size of the national debt.

3.2.4.3 Supply-side policies

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  • 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.
  • Supply-side policies include measures such as government spending on education and training, cuts in income and corporation tax, welfare reform, and industrial policy.

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