Booklet 5 - The national economy-economic performance

• Inflation is a sustained increase in the general price level of goods leading to a fall in the purchasing power of money
• Disinflation occurs when the rate of inflation is falling
• Deflation is a decrease in the average price level
• Demand pull inflation occurs when aggregate demand is growing at an unsustainable rate leading to increased pressure on scarce resource.
• If there’s excess demand producers are able to increase the price of their product and achieve bigger profit margins because demand is greater than supply
• Demand pull inflation becomes a threat when an economy has experienced a boom with GDP rising faster than long run trend growth of potential GDP
• Demand-pull inflation is more likely when there is more likely when there is full employment of resources and SRAS is inelastic
• Demand-pull inflation diagram:

  
• Cost-push inflation occurs when firms respond to rising costs, by increasing prices to protect their profit margins
• Costs might rise because:

  • increase in prices of raw materials
  • Rising labour costs
  • higher indirect taxes- e.g sugar tax/ increase in VAT
  • A fall in the exchange rate
  • Monopoly employers/ profit push inflation
• Profit-push inflation is where dominant firms use their market power (at whatever level of demand) to increase prices well above costs.
• Cost-push inflation diagram:

  
• What could cause a fall in demand for Uk exports:

  1. Recession in Europe
  2. falling quality of Uk exports
  3. Uk losing access to markets. e.g EU/Brexit
  4. Overseas government imposing trade barriers e.g tariffs
• What could cause the rise in demand for Uk imports:

  1. Recovery in Uk markets- increased consumer confidence
  2. rise in Uk inflation rates as imports are cheaper
  3. sales drive by overseas firms to develop Uk markets
  4. UK government may remove trade barriers
• Demand for sterling is therefore derived from the demand for UK exports
• The supply of sterling comes from the demand by domestic households firms and government as they exchange their £s for foreign currency
• SPICED:

  1. Strong
  2. Pound
  3. Imports
  4. Cheap
  5. Exports
  6. Dear
• WPIDEC:

  1. Weaker
  2. Pound
  3. Imports
  4. Dear
  5. Exports
  6. Cheap
• Higher interest rates encourage Hot money to be moved into a currency because a good rate of return can be achieved
• Advantages of strong pound:

  • cheaper imports for consumers
  • Lower production costs for producers
  • lower inflation
  • interest rates may be lower
• Advantages of a weak pound:

  • Exports Cheap
  • Decrease in trade deficit
  • increase in economic growth
  • Exports cheaper so more competitive
  • increase business confidence in investment
• Disadvantages of a Strong Pound:

  • increase in trade deficit
  • slower economic growth
  • Impacts upon business confidence and capital investment.
  • reduced business investment
• Disadvantages of weak pound:

  • Imports more expensive
  • increase in inflation
  • increase in production costs
  • interest rates may increase
• Balance of payments (BOP)- records all financial transactions between the UK and the Rest of the World
• The current account (BoP) measures:

  • countries exports and imports
  • Trade in goods(visible balance)
  • Trade in services (Invisible Balance) e.g insurance and services
  • Primary investment incomes e.g. dividends, interest and migrants remittances from abroad
  • Net transfers- international aid
• If there is a deficit on the Balance of payment- Imports>Exports
• Surplus on current account on balance of payments means- exports>imports
• Balance of payments must balance in order to maintain a stable economy.
• Causes of a deficit on the current account:

  • real incomes have been rising therefore buy more imports
  • inflation so imports become cheaper
  • quality of goods may be poor
  • Recessions in countries of trading partners
  • lack of productive capacity of domestic firms
  • overvalued exchange rates
• Consequences of balance of payments deficits:

  • it Will become difficult for country to borrow from overseas as countries realise the unlikelihood of being repaid
  • Small deficits won’t be Seen as a threat as there is confidence in strength of our growing economy so countries lend as we are able to repay
• If government increases the interest rate to attract short term financial investment then exchange rate will increase- therefore demand for exports fall and demand for cheaper imports will increase the deficit will WORSEN. Also consumers pay higher prices for mortgages and loan repayments
• Policies to cure a current account deficit that are associated with protectionism:

  • tariffs on certain imports
  • quota limits for selected imports
  • subsidies to selected producers
• Policies that directly influence the exchange rate:

  • sell reserves of domestic currency (supply of £)
  • changing domestic interest rates (demand for £)
• Policies that will reduce the deficit immediately:

  • Sell reserves of domestic currency
  • changing domestic interest rates
• Policies that may reduce the deficit within 18 months:

  • Protectionist policies ( tariffs, subsidies, quotas)
  • reduce corporation tax/income tax
• Policies that may reduce the current account deficit in the longer term:

  • Freeze the level of minimum wage
  • Invest more in education
  • research and development
• Reducing interest rates may create other problems such as a rise in inflation, increased borrowing and consuming more goods and services. Will cause increase in aggregate demand with outward shift and therefore demand pull inflation
• If we freeze the level of minimum wage and the levels of inflation rise, the population of people earning minimum wages standard of living to decrease as their wages are unable to rise with the rising levels of inflation. AD shifts to the left and reduced economic growth
• Investing more in education may not reduce current account deficit as they’re are not enough trained teachers in the uk
• Tariffs may not reduce the current account deficit as if one country puts a tariff on another country’s exports they will retaliate and put tariffs on your exports