As Macroeconomics Notes 2023 Syllabus C
As Macroeconomics Notes 2023 Syllabus C
As Macroeconomics Notes 2023 Syllabus C
Topic 1 GDP:
It is the total money value of all final goods and services produced within geographical
boundaries of a country over a year.
5 Includes earned incomes e.g., wages, rent etc., but excludes transfer payments e.g.,
pensions, unemployment benefits etc.
GDP to GNP/GNI (Gross National Product/ Gross National Income) GDP + Net
property/Factor income from abroad. We add incomes earned by domestic citizens
from abroad and subtract incomes earned by foreigners domestically.
An economy may be an open economy which has four sectors i.e., households, firms,
government and international trade sectors. For an open economy there will be a
difference between values of GDP and GNP/GNI as mentioned above.
For a closed economy which does not have international trade sector, value of GDP and
GNP/GNI will be then same as there will be NO inflows of money from and outflows of
money to other countries.
Depreciation is the wear and tear and causes loss in value of a fixed asset
Topic 3:
Nominal GDP is calculated at current year prices and includes inflation in it.
Whereas Real GDP is calculated at base year prices and has been adjusted for inflation.
Real GDP =
Nominal GDP/ Deflator (Current year Price index/Base year Price index)
Example:
Topic 4
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2 Income method:
In this we add up the rewards of factors of production i.e. rent, wages, interest, profits
(distributed and undistributed), dividends etc.
Transfer payments such as pensions, unemployment benefits, scholarships etc. are not
counted because they are unearned incomes and merely transferred from earners to
non-earners.
3 Expenditure method:
We add up all expenditure by domestic citizens during a year on output produced. This
is aggregate demand(AD
AD = C + I + G+ (X – M)
We ADD,
Subsidies as the reduce the price below the actual value of output
We subtract
Indirect Taxes as they raise the price above what was the value of output
Imports value is taken because they were not produced in the geographical boundaries
of the countries
If done properly
Difference between GDP and market prices and GDP at basic prices or factor cost:
GDP at market prices is simply the value of output at current year’s prices.
Whereas GDP at basic prices or factor cost is the actual payment made to the 4 factors
of production for making the output i.e., rent, wages, interest and profits.
GDP at market prices + Subsidies – Indirect taxes becomes GDP at basic prices or
factor cost.
This is because subsides reduce market price below the actual payment to factors of
production and indirect taxes raise the market price above the actual payment to
factors of production.
Topic 5:
Before we analyze how incomes flow through households, firms, govt and international
economy, we need to understand various models of economies and their respective
sectors. We need to understand the concept of injections and withdrawals from the
circular flow.
Sectors of an economy:
C, S I G, T M
As consumption is the original injection than generates the circular flow of incomes in
an economy, we will not treat it as a separate injection.
Types of Economies:
There are only two sectors in a closed economy with no government and they are
Households and Firms
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I (Injection)
S (Withdrawal)
There will be three sectors in such an economy i.e., Households, Firms and Govt. There
will no international trade sector (Net Exports).
I + G (Injections)
S + T (withdrawals/leakages)
There be Households, Firms and International trade sectors, but no government in such
an economy.
I + X (Injections)
S + M (Withdrawals)
This is the real world model with all 4 sectors Households, Firms, Govt and International
trade existing in it.
I + G + X (Injections)
S + T + M (Withdrawals)
Let’s analyze how incomes and money flows through the above-mentioned economies
via circular flow model in the diagram below.
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As seen in the above diagram households provide factor services to the firms and
receive rewards for those services i.e., rent, wages, interest and profit. These rewards
are spent by households on buying goods and services from firms. If the factor rewards
are equal to spending economy will be in equilibrium as circular flow of incomes will
stay at the same level. However, households save some of the earning which are
channeled through banks to firms again, hence in a 2-sector closed economy if S = I,
economy is in equilibrium and so on for 3 sector and 4 sector economies equilibrium is
where injections are equal to the withdrawals.
Injections (J):
Exports (X)
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J=I+G+X
Withdrawals (W)
Imports (M)
W=S+T+M
Equilibrium is when
Injections = Withdrawal
I+G+X=S+T+M
If W > J = AD falls -> Incomes/profits/employment falls, S+T+M falls till J=W back to
equilibrium (READ AGAIN FOR A2)
AD = C + I + G + (X-M)
Shifts of AD curve:
Consumption:
Govt spending:
Govt may change its’ spending due to political reasons and economic conditions e.g.
more spending during recession and election, need for public and merit goods etc.
Net Exports:
Exchange rate: if exchange rate falls, demand for exports will rise due to cheaper
exports. Demand for imports will fall as they seem expensive. X-M will increase and AD
shifts to right and vice versa. Protectionism (use of trade barriers e.g., tariffs, quotas
and export subsidies etc.)
If there is an increase in protectionism, X-M will increase and AD shifts to the right and
vice versa. Relative quality of exports and imports: Inflation and deflation also affect X-
M component of AD.
It is the total supply or output of all goods and services produced in a country over a
year.
1 Profit
effect:
When price level rises, more firms start to supply as their cost of production is being
covered now.
3 Misinterpretation effect:
When price level rises, firms misinterpret the rise in prices with an increase in demand
for their products and start supplying more.
NOTE: AD and AS curves do NOT shift due to changes in price level. There is only a
movement along the curves called extension (for fall in price level) and contraction (for
rise in price level).
Note: The reasons are exactly the same as micro shifts of supply curve (RIWINTS
factors)
I indirect taxes
W wages
I interest rates
T technology
S subsidies
National income in short run is determined by interaction of AD and short run AS curves.
Note any changes in AD and/or AS will affect price level and real output as it was the
case in microeconomics market price and quantity.
Q Explain using AD and AS curves, how an increase in money supply and a decrease in
cost of inputs will affect national income and price level? (8)
K/U 2 Marks
National income is the total value of all final goods/services produced within the
geographical boundaries of a country over a year. Price level is the inflation level in the
country.
Application 6 marks
3 for graph
3 for explanation
Money supply increase due to more spending by govt compared to the taxes they take
or due to more printing of currency etc. will increase peoples’ incomes and hence AD
curve will shift to the right due to more consumption. This will also inject more
investment into AD.
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Decrease in cost of inputs will reduce firms’ cost of production. This will increase AS
because firms will be able to produce more. Refer to figure below;
As seen in the figure, initial equilibrium was at E0 and price level was P0 and real output
was at Y0. As a result of increase in money supply AD curve shifts to the right and due
to lower cost of inputs AS supply curve shifts to the right. Now Price level remains at P0
and national income/ real output increased to Y1.
Long run AS curve is initially perfectly elastic as economy is below full employment (or
inside their PPC). Then it becomes inelastic as the economy reaches close to full
employment (or close to its’ PPC) as there is a shortage of resources e.g., skilled
workers or fertile lands etc. At the end it becomes perfectly inelastic as we are on full
employment (On PPC). This will give us a three-stage long run aggregate supply (LRAS)
curve.
In both sweeping and vertical LRAS curves the shifting factors are the same as PPC
shifting factors or in other words, government supply side policies.
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Unit 2
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Price Stability
Inflation: It is the constant rise in general price level of goods and services in an
economy over a year.
Note: does not mean every product is becoming expensive. The representative basket
of goods and services is becoming expensive.
Degrees of inflation:
Hyperinflation: When price level rises very rapidly e.g., 20%, 100s%, 1000% and no limit.
This is very dangerous for an economy
High inflation reduces the real value of money or its purchasing power as consumers
can buy less with the same amount of money.
Disinflation:
This is when price level rises at a slower rate e.g., from 8% in year 1 to only 2% in year 2.
It means prices are still rising, but at a slower rate. It is not to be confused with
deflation.
Causes/types of inflation:
Demand-pull inflation:
Any injection in the components of AD i.e. C+I+G+(X-M) may cause AD to rise and if AS
cannot rise. There will be demand-pull inflation.
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As seen in the graph, initial equilibrium was E0, price level was P0 and GDP was Y0. As
AD rises to AD1, price level remained P0 as economy was below full employment, only
GDP increased to Y1. A further increase in AD from AD1 to AD2, caused price level to
rise from P0 to P1 as economy was nearing full employment, while real GDP increased
by more amount from Y1 to Y2.
Further rise in AD from AD2 to AD3, caused a greater increase in price level from P1 to
P2, whereas real GDP increased by lesser amount from Y2 to Y3 as economy has
reached full employment.
Further rise of AD from AD3 to AD4, only causes rise price level from P2 to P3 and there
is no increase in real GDP.
Consumption:
Incomes rise
Population rise
Investment:
Subsides by govt
Govt spending:
Political reasons
Net Exports:
Exchange rate depreciate/devalue: Reduced exchange rates will reduce export prices,
demand for exports will rises. Imports will become expensive, their demand will
Cost-push inflation:
This is due rise in input (Factors of production) costs, this will increase cost of
production, AS falls and price level rises.
1 R raw material prices: Expensive raw materials will cause an increase in cost of
production, AS falls and inflation occurs.
2 I indirect taxes: Rise.. cost will rise, AS falls and cost-push inflation occurs
4 I interest rates: If rise.. Cost of borrowing rises… cost of production rises and cost-
push inflation
5 N natural disasters:
8 Wage-Price spiral
Workers feel the real value of their income has fallen as they can afford less goods and
services even with the higher wage due to rise in prices. They demand more wages
again and this cycle continues causing more and more inflation until govt index links
their wages i.e., wages will be increased according to rise in inflation.
PPP Q) Explain how a fall in exchange rate of a country can cause both cost-push and
demand-pull inflation? (8)
App: 6 M
3 M for cost-push:
Devalued exchange rate means cost of imported items especially raw materials will
rise. Domestic firms importing raw materials will experience increase in cost of
production. AS will fall and cost-push inflation will occur as firms will pass the rise in
cost in form of higher prices.
Graph: Discretionary
Fall in exchange rate will make exports cheaper, demand for exports will rise in
international market due to increased international competitiveness.
Imports will become expensive and demand for will falls. X-M component of AD will
increase, causing demand-pull inflation if AS cannot rise.
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Q) Explain the difference in Cost-push and demand-pull inflation and one reason why
each may occur? (8)
APP 6 marks
A rise in wages due to trade union pressure or minimum-wage law will raise cost of
production, AS will shift to let and cost-push inflation will occur as producers will pass
on some of the risen to consumers.
Graph
Let’s take govt spending for example. It may increase due to recession and high
unemployment in the economy and govt will rise its’ spending to increase AD. They may
also spend more to gain popularity closer to general elections or be providing more
merit and public goods to raise living standards etc. All of this will shift AD to the right
and if economy is near or on full employment, demand-pull inflation will occur.
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1 Selecting a current year, i.e. it is the one we are measuring inflation for
2 Selecting a base year, i.e. the year with which prices of other years are compared
Should not be too far in the past Should be a normal year (No growth/recession)
Current year price/base year price * 100 (in base year all products have 100 as index
number)
Problems/limitations of CPI
1) Substitution Bias
For example, let’s say burgers are included in the CPI while hot dogs aren’t. When
the price of burgers increases, people will eat more hot dogs instead (because they
become relatively cheaper). However, because the index is based on a fixed basket
of goods, it does not take this into account. Instead, it simply assumes that people
will continue to eat burgers and pay the higher price. As a result, the increase in the
cost of living reported by the index is higher than the actual increase, because it
ignores the fact that consumers may switch to cheaper hot dogs instead.
2) Representation of Novelty
The representation of novelty in the CPI results in a temporary distortion of the
actual cost of living after the introduction of new products. The reason for this
is that people have a wider variety of goods or services to choose from,
whenever new products are introduced. However, for products to be included in
the CPI, they need to be bought consistently and in significant quantities
(usually for several years). Therefore it may take multiple years before new
products or innovations are included in the basket and thereby represented in
the CPI. Other indicators, such as the GDP deflator represent these changes
more quickly and accurately.
To give an example, let’s assume Tesla releases an affordable flying car next
year. Flying cars are obviously much faster than regular cars, so many
consumers abandon road traffic within a few weeks. However, the new flying
cars will not be included in the CPI at this point. It will take several months or
years of consistent consumer purchases before they will become part of the
fixed basket.
Problems:
If inflation rate is higher in the country compared with its’ trading partner countries,
export prices will become expensive, demand for exports will fall. Import prices will fall
and demand for imports will increase. This can lead to current account deficit if demand
was elastic.
Domestic currency will depreciate causing cost-push inflation as this will lead to
expensive imported raw materials.
This is the cost of reprinting menus and brochures etc. due to constant rise in price
level. b) Shoe-leather costs rise:
People keep moving their savings from one bank to another searching for higher
interest rate to protect the real value of their saving c) Businesses may start hoarding
(store goods to sell later at higher price)
Individuals on fixed incomes lose the real value/ purchasing power of their money and
become poorer in real terms e.g., pensioners, unemployed receiving benefits etc.
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Whereas those owning property, assets, shares, gold etc. will benefit from rise in the
value of their assets during inflation. Hence rich become richer and income gaps widen.
The function most adversely affected is store of value as people lose the value of their
savings in real terms during high inflation. They lose confidence in money and may
switch to gold or other currencies for savings.
Money’s function of means of deferred payments also gets affected by high inflation as
people stop lending in terms of money as they receive back their loan less in real terms.
Medium of exchange function also gets affected by high inflation as heavy amounts of
money may be required for even small transactions so people switch towards barter
and other currencies.
The function of unit of account may only get affected if inflation is too hyper and
numbers become enormous
Benefits of inflation:
2 Govt’s debt burden from domestic loans falls as they have to payback less in real
terms
3 Borrowers gain during inflation as they pay back less in real terms
4 Asset owners gain from rise in the value of their fixed assets.
Evaluation:
Whether inflation is always harmful will depend on The comparative rate of inflation
with other countries Whether it is demand pull or cost push inflation
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Whether the inflation was expected or unexpected Whether its stable or hyper
inflation
Q) Discuss if external consequences of inflation can ever be more serious than its
internal consequences? (12)
Analysis 8 M, Ev = 4 mark
If inflation rate is higher in the country compared with its’ trading partner country’s
export prices will become expensive, demand for exports will fall. Import prices will fall
and demand for imports will increase. This can lead to current account deficit if demand
was elastic.
Domestic currency will depreciate causing cost-push inflation as this will lead to
expensive imported raw materials.
Menu/shoe-leather costs
Evaluation:
External consequences may be more serious if inflation is above the trading partners’
inflation rate. They will be serious if economy is an open one e.g. (the one that relies
more on international trade). If closed economy, internal consequences will be greater.
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To conclude which effect will be greater will depend on the rate of inflation e.g., hyper is
more dangerous and cause of inflation e.g., cost push is more dangerous as it causes
unemployment as well.
1 Govt policy decisions e.g., fiscal and monetary policy will be wrong and there will be
poor results
2 Trade unions will negotiate wrong level of wage and may later realize that. This may
result in strikes and production delays.
3 Lenders and borrowers will find themselves locked into wrong contracts and may
have loss of real value of money as a result
4 Firms may price their products in accordance with inaccurate figures of inflation and
may end up over or under pricing.
Topic: Deflation:
Good deflation:
● Improvement in technology
● Increased productivity of workers
● More educated/trained workforce and improved efficiency
● Subsidies by the govt
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As seen in the figure, short run AS shifts to the right Price level falls, but real GDP rises.
This is showing growth of economy through greater efficiency and more output.
There will be jobs created, peoples’ incomes and living standards will improve. It is
indicating an advanced and more productive economy. Current Account might go into
surplus as exports will be cheaper and imports expensive.
Bad deflation:
This type of deflation can lead to a downward multiplier effect on an economy i.e. job
losses occur and they cause further job losses due to fall in demand.
Deflation results in increased purchasing power, hence lenders gain as they receive
back their loans higher in real terms. Borrowers lose as they have to payback more in
real terms. Govt’s debt burden increases
Firms keep cutting prices to increase AD, but consumers keep delaying purchase hoping
for prices to fall further. Economy may go down into a slump.
Evaluation;
Deflation is bad if it is due to fall in AD, but very good for the economy if due to increase
in AS. Secondly if it is a short-term, it is not harmful, but if it continues over a long
period, it becomes harmful. It will also depend on rate of deflation in trading partner
countries. If it is even lower in other countries, current account will go into deficit.
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Unit 3
Government uses various policies to achieve these aims. These are policies are mainly
divided into demand-side policies and supply-side policies.
They are Fiscal policy and monetary policy which also includes exchange rate policy.
In Fiscal policy government uses changes in taxation and govt spending to achieve its’
macroeconomic objectives. In other words, government uses its’ budget.
A Budget Deficit is when government expected revenue from taxes etc. are less than its’
planned expenditures.
A Budget surplus is when government expected revenue from taxes etc. are more than
its’ planned expenditures.
Let’s understand the two tools of fiscal policy well before learning its’ application by the
government.
Taxes
The average tax rate is the total tax paid divided by taxable income. While marginal tax
rates show the amount of tax paid on the next/additional income earned, average tax
rates show the overall share of income paid in taxes. They can be calculate using the
following formulas;
1 To generate revenue:
Taxes are the primary source of revenue for most governments. Among other things,
this money is spent to improve and maintain public infrastructure, including the roads
we travel on, and fund public services, such as schools, emergency services, and
welfare programs.
2 To provide subsidies
3 To reduce consumption of demerit goods like alcohol and production of external costs
like pollution
Government Spending
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Government spending refers to money spent by the public sector on the acquisition of
goods and provision of services such as education, healthcare, social protection, and
defense
1 To provide public goods like street lights and national defense which are not provided
by the private sector due to their characteristics of non-excludability and non-rivalry
which cause a free rider problem
3 To provide merit goods such as education and healthcare as they are under
consumed due to information failure in private sector
Govt may use expansionary fiscal policy if there is a recession and unemployment is
high. There is low economic activity.
Reduced taxes will increase disposable incomes, consumption will increase, and firms
will increase investment to meet the increase in demand. Govt spending will also inject
in AD. AD will rise. This will result in reduced unemployment and GDP/economic growth
will increase.
However, increased income maybe spent on imports of luxury goods worsening the
current account of BOP. Rise in AD, not matched by increased Aggregate supply as the
economy was on or near full employment, will cause demand-pull inflation.
Monetary policy:
When govt changes interest rates and/or money supply to achieve its’ macroeconomic
objectives. Exchange rate is sometimes also used.
Reduced interest rates will reduce cost of borrowing and return on saving. People will
save less and borrow more, consumption will rise. Firms will also investment more. AD
will rise.
Unemployment will fall and economic growth/GDP will rise. However, Demand-pull
inflation might occur and BOP current account will worsen.
As seen in the above figure (1), expansionary fiscal policy boosts AD and the AD curve
shifts to the right causing economic growth and generating employment as real GDP
rises from Y0 to Y1, however there will be inflation as price level rises from P0 to P1.
Increased incomes will be spent on imports causing a current account deficit.
As seen in the above figure (2), contractionary fiscal policy reduces AD and the AD curve
shifts to the left causing a fall in economic growth and caused employment as real GDP
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fell from Y0 to Y1, however there will be reduced inflation as price level fell from P0 to
P1. Reduced incomes will mean less imports and a reduced current account deficit.
If the economy is in recession and unemployment is high and economic growth is low.
Govt will devalue their currency.
Devaluation will make exports cheaper and their demand will rise. Imports will become
expensive and their demand will fall leading to BOP current Account surplus. Ad will rise
Unemployment will fall and economic growth will increase. However demand-pull
inflation will occur if AS cannot match increase in AD.
Note … in contractionary policy explanation means use your own skills to reverse the
argument.
1 Future confidence:
If firms and people are confident about future, an increase in direct taxes may not deter
Investment and spending and vice versa.
2 Time lags:
A . Recognition lag:
Sometimes it may take govt a little longer to realise the recession has set in or inflation
has started rising beyond the safe limits
B. Implementation lag:
Govt ministers will hold meeting and take time in deciding the right rates of taxes and
govt spending
C. Affectivity lag:
Govt spending such as on education and health may produce results in very distant
future
3 Political interferences:
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Fiscal policy is often used for political purposes rather than sound economic logic. For
example, politicians may increase spending near elections to gain popularity.
They may avoid an unpopular tax especially income tax that was needed for economic
improvement.
4 Unreliable data:
GDP and CPI are themselves prone to error, hence policies designed on basis of such
data may be inaccurate
If people and firms feel govt will retract/change the tax rates back again. They will save
the extra disposable income rather than increase spending.
1 Time lags:
It is faster than fiscal policy but still there are time lags. Change in interest rate may
affect the economy in 12 to 16 months.
2 Unreliable data:
GDP and CPI are themselves prone to error, hence policies designed on basis of such
data may be inaccurate
3 Future confidence:
If firms and people are confident about future, an increase in interest rates may not
deter Investment and spending and vice versa.
This will increase skills and productivity of workers and potential growth will result.
Long run AS will shift to the right
2) Subsides:
3) Privatization:
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Private sector will be more efficient due to profit motive and there will be greater
competition. More use of advance technology.
This is done through Deregulation: This is when govt makes laws on new business set
up e.g., licensing requirements easy, hence AS increases.
Government can either use their own resources or encourage private sector to develop
advance technology through more research and development. This will make firms
more productive and Long run AS curve will shift to the right
6) Trade union reforms: govt reduces their power of going on strike etc. to ensure
smooth production
7) Development of infrastructure:
Government can develop hard infrastructure like roads, bridges and soft infrastructure
like schools and hospitals. This will reduce firms’ distribution costs and increase their
profitability causing expansion in the economy’s productive potential.
Government can reduce direct taxes like income tax to create incentive for current
workers to work more hours and those who were not joining labor force due to high
taxes may join now. Reduction in corporation tax on firms’ profits will also leave more
retained profit for firms’ expansion.
9) Free trade
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The above figure shows result of supply side policies. It will shift long run AS. Govt can
achieve all its’ aims if it is able to use demand side policies (AD shifts out) along with
supply side policies in the long run.
These policies will increase AS and all the aims will be achieved in the long run however,
they are costly and there will be an opp cost of govt spending. The benefit will only
materialize in the long run.
2 Demand-pull inflation:
Increase in either government spending or investment by private sector firms will cause
demand-pull inflation in short run due to injections of G and I before increasing long run
aggregate supply (LRAS)
3 Brain drain:
The highly trained and skilled workers may leave the country and all the expenditure on
their training may become a wasted effort
4 Free trade may result in closure of some infant and sunset industries as they will not
be able to withstand the competition from cheap and good quality imports, causing
unemployment in short run
Unit 4
The gains from international trade are based on the theories of absolute and
comparative advantage.
Assumptions:
1 Only 2 country
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4 Free trade
Absolute advantage:
When a country can produce more of a product than the other with same amount of
resources.
X should specialize in Food production and Y on clothing. This will result in gains for the
world as well as the 2 countries when they trade.
CX 30 & 15 60 Or 0
CY 10 & 20 0 Or 40
World
Output 40 & 35 60 Or 40
Gains
From specialization 20 F 5C
As seen from the table the world has gained 20 food and 5 extra units of clothing from
specialization. Both countries will also gain if they trade at a mutually beneficial
exchange rate. If this exchange rate lies between their opportunity cost ratios.
Comparative advantage:
It is when a country can produce a good at a lower domestic opportunity cost than the
other i.e., the country has to give up less of a good to produce the other.
For example, country X may be more efficient in producing both coffee and tea
compared with country Y, nevertheless there are benefits for both countries and the
world from specialization and trade.
As seen from the figure, X is more efficient in both Tea and coffee than Y. It has
absolute advantage in both goods.
Country X has lower domestic opp cost in Coffee and has comparative advantage in it.
Country Y has lower domestic opp cost in Tea and has comparative advantage in it.
Trade is only possible when exchange rate is between the domestic opportunity cost
ratios i.e., between 1 and 3 teas for each coffee and between 0.3 and 1 coffee for each
tea
It is a curve that shows all possible combinations of quantities of imports a county can
trade with given volume of exports at a mutually beneficial exchange rate.
Country X TPC
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4 Rate of exchange may not fall between the domestic opportunity cost ratios
Topic: Protectionism:
Methods of protection:
1 Tariffs:
These are indirect taxes imposed on imports. They can be specific e.g. 1$ per barrel of
oil or ad-velorum, i.e., specific percentage of price of the product.
Benefits:
1 They raise the price of imports and make domestic goods/services more competitive.
This will protect domestic employment.
2 Revenue for govt increases which can be spent on merit and public goods etc.
Problems:
2 Retaliation by other countries i.e. other countries will also use protectionism against
our exports
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2 Quotas:
Benefits:
Problems:
2 Retaliation
3 Export subsidies:
They will reduce the cost of producing exports and exporting firms can supply more at a
lower price. Their international competitiveness will increase.
Benefits:
1 Demand for exports will increase and current account will improve
Problems:
1 Retaliation
2 They are costly for govt and there will be an opportunity cost of other areas of govt
spending
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4 Embargoes:
These are complete or partial ban on trade with a country due to political reasons.
5 Exchange control:
Govt sets a limit on how much foreign currency is available for international
transactions. This automatically reduces the amount of imports.
This is when a country sets a limit on exports of particular commodities. This can be
done to keep supply of a necessity good e.g. rice within the country or to keep an
essential raw material for domestic industries.
1 Tariffs more effective when demand is price elastic and quotas more effective when
inelastic
2 Exchange rate of the country will also determine the effectiveness of protectionism.
Benefits:
Some industries are newly set up and cannot face cheap and quality imports
competition. They need to be protected so that they can achieve economies of scale
and develop their comparative advantage.
Some industries have come to an end of their tenure. They should be protected so that
mass unemployment does not occur and workers can be trained in another skill.
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3 To prevent dumping:
This is when some countries’ firms sell at a very low price in international market, even
at loss to capture international markets for those goods. This is anticompetitive and
monopolies form as a result, hence countries should protect against dumping.
Strategic industries are important for survival of a country e.g. basic food and weapons
etc. These should be protected in case trade relations suffer so that the country does
not run out of basic necessities.
If a country is facing trade deficit, they will use protectionism to reduce this deficit. This
also helps in appreciating domestic currency.
Problems of protectionism:
1 Consumer choice will reduce and their welfare will decrease worldwide
2 Countries will have to be self-sufficient and may not specialise on a narrow range of
goods. This will hinder the development of their comparative advantage
3 Transfer of new ideas and technology will reduce as free trade allows easy movement
of technology in the world
4 Reduced choice of raw materials for domestic firms. If there was free trade, they
could have imported raw materials from other countries if they were not available
locally.
5 Countries may not be able to benefit from their “factor of endowment” by specialising
in those
As countries use more protection, they tend to specialise less and worldwide out falls.
Countries are not benefiting from absolute and comparative advantage
Benefits:
Problems:
4 Strategic industry may not survive and create shortage of basic foods etc.
Analysis 8 Marks
Up to 4 why justified
Anti-dumping argument
As discussed above protectionism has some benefits for local firms’ survival and as an
anti-dumping measure, but free trade benefits of comparative advantage and
specialisation are a major opportunity cost.
To sum up, economics only justifies protecting domestic industries in case of proven
dumping, sunset, sunrise and strategic industries protection. Other than this free trade
is always to be preferred due to its’ global benefits and resulting efficiency. Protection is
to be used for short-term only and removed as soon as possible.
If TOT moved from 106 to 104… Still favourable but deteriorated. If TOT move from 96
to 98 … Still unfavourable but improved
Influences of TOT:
1 Inflation/deflation:
Inflation > other trading partner countries. Exports will become expensive and imports
will become cheaper. TOT will improve.
Deflation will make exports cheaper and imports will become expensive. TOT will
worsen (for the question mention an offsetting factor)
If Currency appreciates/revalues export prices will rise and imports prices will fall, TOT
will improve (unless deflation occurs)
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Protectionism raises the price of imports and reduces the price of exports. TOT will
worsen unless there is an offsetting factor such as rise in inflation
APP 6 marks
Analysis 8 marks
Up to 4 why beneficial;
Fall in TOT means relative prices of exports are less than prices of imports. Cheaper
exports will increase country’s international competitiveness and demand for exports
will rise. Imports will become expensive and their demand will fall. If demand for
exports and imports is elastic current account will become surplus.
Injection of X-M will boost AD, resulting in economic growth and reduced
unemployment. Country will experience a rise in GDP.
Fall in terms of trade may not be beneficial if demand for imports and exports is
inelastic due to contractual obligations. Current account may go into deficit in short run.
This will reduce AD, unemployment will rise and GDP will fall.
If demand for export and imports Was elastic, AD will rise to injection X-M. This may
cause demand pull inflation if AS cannot increase.
Evaluation:
In the light of above discussion a fall in TOT maybe harmful for a country in short run as
demand for X+M tends to inelastic and current account deficit increases. However,
when J curve effect takes place in the long run and Marshall-Lerner condition is met.
Economy benefits from current account surplus, lower unemployment and higher GDP.
Unit 5
Balance of Payment:
It is a record of money inflows from exports, investment etc. and outflows for imports,
investments etc. for a country over a year.
It has 3 accounts namely current account (AS Topic), capital and financial account (A2
Topic)
It is the most frequent transactions Between one country and the rest of the World. It
has 4 sections,
a) Trade in goods:
We record the inflows and outflows of Money from exports/imports of tangible Goods.
For example Pak sells sweaters to UK For 10,000$ (outflows) Debit (Inflows) Credit
10,000
We record the inflows/outflows From rewards of factors of Production. These are arned
Incomes e.g.,
Rent
Wages
Interest
Profit
D) Secondary Incomes
These are unearned incomes e.g., Gifts of cash, charity, Govt Spending on overseas
embassies etc.
Current account deficit is when inflows from exports and transfers are greater than
inflows for imports and transfers.
Current account surplus is when inflows from exports and transfers are less than
inflows for imports and transfers.
Note: If one component of current account e.g., trade in services is in deficit, it does not
mean the whole current account will be in deficit. This is because current account has 3
other sections too and their joint surplus can outweigh the deficit in trade in services
and may turn the whole of the current account into surplus and vice versa.
Problems:
1 Deficit of current account means more outflows than inflows. X-M component of AD
falls, this will reduce AD and unemployment will rise. Economic growth will fall due to
reduced money supply.
2 Currency will depreciate and this will make imported raw materials expensive causing
cost push inflation.
3 A deficit large enough that makes the whole BOP deficit, will put pressure on Govt
reserves and they might deplete.
Benefits:
2 Deficit may be short term for a year or 2 and not large enough to make BOP overall
deficit. There is no major cause of concern
Benefits;
1 A surplus will boost X-M part of AD. AD will rise causing economic growth as money
supply increases. Unemployment will reduce as local industry is expanding.
2 Exchange rate will appreciate making imported raw materials cheaper and reducing
cost push inflation
Problems:
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1 X-M rise will boost AD, if AS doesn’t rise, demand-pull inflation will occur
2 Surplus of one country is the deficit of another. Other countries may retaliate AND use
protectionism against this country’s exports.
3 A surplus for short term may not be very beneficial. A small surplus will not make the
whole BOP surplus and reserves will not increase.
When price/value of one currency rises in terms of another. It can buy more units of
another currency e.g., 1£ = 2$.
When price/value of one currency falls in terms of another. It can buy less units of
another currency e.g. 1£ = 1$.
Demand for UK imports will increase and demand for UK exports will decrease. Current
account becomes deficit.
When £1 = $1
Demand for UK imports will decrease and demand for UK exports will increase. Current
account becomes surplus.
This is when demand and supply of currency in FOREX market determines the rate of
currency and there is no govt intervention
I Inflation Rate: If inflation rate in pak > other trading partners. Pakistani Exports will
become expensive and their demand will fall. Demand for RS will and it will depreciate’
and imports will become cheaper and their demand will rise. As a supply of RS will
increase and RS will depreciate and vice versa.
I Interest rate: If interest rate in Pak > Other countries, hot money will flow in to
Pakistani banks. Demand for RS will rise and cause appreciation of RS and locals will
also save in domestic banks and supply of RS will fall, exchange rate will appreciate and
vice versa.
I Investment prospects: If better than other countries, more firms invest in Pakistan and
RS demand rises and RS appreciates. Pakistani firms will also invest locally and supply
of RS will fall, RS will appreciate and vice versa
S Speculation: This is when people invest in currencies to make short term gains. If
speculators feel RS is going to appreciate, they will buy RS and RS will appreciate.
Speculators who already have RS, will not sell and supply of RS will fall, causing
appreciation and vice versa.
E Economic growth domestic: If Pak experiences economic growth, demand for luxury
imports will rise as incomes have risen. This will increase the supply of RS in
international market and RS will depreciate.
E Economic growth international: If the world experiences economic growth, demand for
domestic exports will rise as incomes have risen. This will increase the demand of RS in
international market and RS will appreciate.
Depreciation:
When currency depreciates, export prices fall and import prices rise. It should increase
demand for exports AND reduce demand for imports and current account should go
into a surplus. However, it does not happen in short run. This is because PED for
exports and imports tends to be inelastic in short run due to signed contracts for
exports and imports.
However, in long run when Marshall-Lerner condition is met i.e., joint sum of elasticity of
demand for exports and imports becomes greater one. Now current account will
become surplus in long run.
Appreciation:
When currency appreciates, export prices rise and import prices fall. It should increase
demand for imports AND reduce demand for exports and current account should go
into a deficit. However, it does not happen in short run. This is because PED for exports
and imports tends to be inelastic in short run due to signed contracts for exports and
imports. However, in long run when Marshall-Lerner condition is met i.e., joint sum of
elasticity of demand for exports and imports becomes greater one. Now current
account will become deficit in long run.
Unemployment:
It is when people are willing and able to work, but cannot find a job.
Unemployment Rate:
Labour force:
1 Frictional unemployment:
A. Search/voluntary unemployment: This is when people leave a job and take their time
looking for a better job
C. Casual unemployment: Some jobs are of such nature that workers keep getting
unemployed between jobs e.g., actors, authors, supply teachers etc
2 Structural unemployment:
This is when demand for a whole industry’s products falls. This could be due to;
a. Technological unemployment
This is due to change in technology and workers skills become outdated e.g., word
processors made typists unemployed
Handicrafts in certain countries became less popular causing unemployment for related
workers
c. international unemployment:
d. If declining industries are located in a particular region, there will be long term
regional unemployment
This can be due to trade union influence or imposition of a minimum wage law by the
govt. Firms will make some workers redundant as their cost has risen.
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As seen in the above figure, if minimum wage law or trade unions enforce a higher wage
than the market wage, L to L1 workers will lose their jobs and from L1 to L2 will be the
level of unemployment
4 Cyclical/Mass/Keynesian/demand-deficient unemployment:
Labour demand is derived demand i.e., labour is demanded for the products they make.
During a recession/slump demand for final products falls causing workers being made
redundant.
As seen in the above figure, fall in AD will make firms cut the number of workers hired. If
workers resist wage cuts through trade unions, level of unemployment will be from L to
L1. Even if they don’t resist wage cuts there will be unemployment from L to L2 workers.
Problems
Individuals:
Short run problems for individual workers are fall in incomes and living standards
Long run problems are deskilling i.e., loss of skills and reduced chances of re-
employability.
Benefits:
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Firms:
Problems
Benefits:
Firms will not face trade union pressure, hence pay lower wages and become more
competitive
Economy:
Problems
Govt tax revenue will fall from both direct and indirect taxes and they will have to spend
more on unemployment benefits. This will result in a budget deficit and need for
borrowing may emerge.
Low incomes will lead to low savings and low investment causing a fall in growth and
development
Benefits:
Reduced production will result in low external costs e.g., pollution etc.
Measurement of unemployment
Advantages
● Relatively cheap
● Very quick to calculate
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The more widely used measure is a labour force survey as per International Labour
Organization’s (ILO) definition of unemployment. Data collection authorities conduct
surveys at different places and time periods to collect information about employed,
unemployed, wage rates and working conditions etc. frequently.
Problems
Economic Growth: This is when real GDP rises over time. It can be actual or potential
growth.
Economic Growth:
Concepts:
2020 = 103 B $
2019 = 100 B $
3% Economic Growth
A country with more natural resources will have greater supply of energy sources and
their cost of production will fall causing PPC and LRAS (Long run AS) curves to shift
outwards causing potential growth
This will increase workers skills and productivity. They will be able to handle latest
technological equipment and more efficient working will cause a shift of productive
potential
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Physical capital refers to hard infrastructure like roads, bridges and communication
networks etc. If Gross investment on physical capital is greater than its’ depreciation
(wear and tear). Economy will experience economic growth due to reduced distribution
costs and quicker movement of resources and finished products.
Latest technology developed would reduce processing time and increase potential
output
This could be possible in short run through positive net migration i.e., immigration into
the country of skilled workers is greater than emigration out of the country or reduced
school leaving age and increased retirement age. In the long run this may happen due to
change in population structure resulting in a larger % of younger people in the country.
Larger work force will shift the PPC outwards.
Economic growth is the rise in Real GDP over time. It is measured by the formula
Economic growth maybe actual when previously unemployed resources are employed
and there is a movement from inside PPC towards PPC. It is linked
Why Beneficial:
There will be Fiscal dividend, i.e. govt will receive more tax revenue from both direct and
indirect taxes due to more incomes, profits and consumer spending. While their
spending on unemployment benefits and income support schemes will be lower. Govt
budget will become surplus.
Govt can spend this extra amount on education and health. This will increase workforce
skills and productivity, reduce absenteeism and improve GDP further. They can spend
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more on infrastructure which will reduce distribution costs, efficiency will increase
causing further growth.
If actual growth is greater than potential growth, unemployment will fall and incomes
and living standards will rise.
If some of the increased output is exported and local people citizens also prefer local
goods, Balance of payment current account will improve.
Country will prosper and its’ sovereignty will increase in the world.
Extra production may result in negative externalities such as pollution, congestion etc.
This may reduce the living standards.
Non-renewable resources such as oil, gas maybe depleted by careless usage and future
comparative advantage will fall.
Increased incomes maybe spent on importing luxury consumer goods which may turn
current account of BOP into a deficit.
If growth results in uneven distribution of income, only few may experience improved
living standards and majority may not be better off.
If growth was due to more multi-national companies setting up in the country, in long
run economic growth may fall as they will send profits home and may leave to cause
massive unemployment.
During actual economic growth AD rises and if AS cannot increase as the economy was
near or on full employment demand pull inflation might occur.
Evaluation:
Whether economic growth is beneficial will depend on the relevant costs and benefits
involved and how much value people attach to them.
Govt may aim for “Constrained optimization” i.e. growth is achieved keeping
sustainability, levels of environmental hazards to low level and income distribution more
even in mind. Hence it is subjective whether growth is always considered beneficial.