OCR 585 June 2010 Exam: Tutor2u's Revision Toolkit For The Pre-Release Materials For The June 2010 Sitting

OCR 585 June 2010 Exam
Tutor2u’s Revision Toolkit for the
Pre-release Materials for the June 2010 Sitting
Geoff Riley
Head of Economics, Eton College

OCR Unit F585 June 2010 Pre-release Revision Toolkit
Contents
Introduction to the Case Study..................................................................................................................3

Extract 1: Longest and deepest recession since 1930s..............................................................................8
Extract 2: Fiscal Rules Broken..................................................................................................................31
Extract 3: Fixers and Floaters..................................................................................................................36
Extract 4: The Return of Protectionism...................................................................................................47
Extract 5: Making Economic Growth and Development Sustainable.......................................................55
Exam Practice – A Selection of Suggested Questions..............................................................................67
Opportunities for diagrams to support your analysis and evaluation.....................................................70
Suggestions for further reading and research.........................................................................................71
Page 2
Introduction to the Case Study

This is a brief commentary on the introductory section of the stimulus material
Economic cycles Extract 1:
Towards the end of 2009 many developed The early part of the pre-release case study
economies began to emerge from recession, as focuses on the nature of the recession in the UK.
the ‘green shoots’ of recovery appeared. Most You will be able to use your knowledge and
commentators expected the same would be true understanding of the causes and consequences
for the UK economy, but official data showed a of changes in the economic cycle. And also how
continued reduction in total output. The UK events in one or more overseas countries can
economy had experienced its longest and affect our own macroeconomic performance.
possibly its deepest recession since the 1930s.
Extract 2:
Fiscal policy rules
The second extract concentrates on the impact
Policy rules, in both the UK and the European of the financial crisis and recession on
Union (EU), came under pressure as a result of government finances and the impact of changes
the impact of the recession on public in fiscal policy on aggregate demand and supply.
expenditure and tax revenues. Though different Many governments have abandoned their fiscal
in their nature, both the UK fiscal rules and those rules – are they right to do so? What are some of
of the EU’s Stability and Growth Pact were the key possible consequences of the huge rise
broken. What had been seen as guarantees of in public sector borrowing and debt?
‘fiscal prudence’ came to be seen by some as a
‘fiscal straightjacket’.
Extract 3:
Currency systems and economic cycles
To fix or to float? Why does the choice of
Unsurprisingly in the recession, some countries’ exchange rate regime affect the impact of
exchange rates came under pressure too. In internal and external economic shocks on
Central and Eastern European economies, the indicators of performance such as output, jobs,
choice of exchange rate regime appeared to inflation and trade? The 3rd extract has a special
have implications for the key macroeconomic focus on the situation facing some of Europe’s
indicators – the ‘floaters’ recording generally newer member states.
better macroeconomic performance than the
‘fixers’.
Extract 4:
A fragile recovery for the world economy
The 4th extract has a global focus and in
The recovery in global economic growth in 2009 particular the fears that persistent recession and
was fragile for a number of reasons. One of weak recovery is causing many countries to
these was the dramatic rise in protectionism. It consider and actually introduce a growing
was not just the increase in tariffs that number of protectionist policies. Is the current
threatened a recovery in world trade, but the wave of globalisation now heading into reverse?
much more serious impact of domestic subsidies. This extract encourages you to analyse and
Anti-dumping cases lodged with the World evaluate the economic and social effects of
Trade Organisation (WTO) increased by 31.5% import protectionism.
from 2008 to 2009.
Page 3
Extract 5:
Copenhagen
The end of the recession for some economies The final extract focuses on environmental
coincided with an ambitious global summit in economics and the best strategies for nations
Copenhagen in December 2009 to seek wanting to create agreements and make
agreement on limiting carbon emissions. The progress in making growth and development
aim of this agreement was to make future more sustainable against the background of the
growth and development more sustainable. costs of global climate change.
Inevitably, there was disagreement between
developed and developing countries about what
targets should be set and, in particular, what
assistance should be made available to the
developing world to help it to meet these
targets.
Towards the end of 2009 many developed economies began to emerge from recession
Economic growth in a selection of OECD countries

Real GDP, precentage change from previous period, Constant Prices
5 5
4 4
3 3
2 2
1 1
Percent
0 0
-1 -1
-2 -2
-3 -3
-4 -4
-5 -5
06 07 08 09 10
Australia United Kingdom Spain

Germany United States France
Source: Reuters EcoWin
Our chart shows updated growth figures for six countries including the UK. The 2010 forecast is from
the latest World Economic Outlook from the OECD. We will come back to the growth data shown in
Extract 1 of the case study in the next section. For the moment focus on the speed with which many of
these countries fell into recession and the depth of the fall in output in 2009. The pace of the likely
recovery in 2010 – in most cases the expected rebound in national output (GDP) is slower than the
Page 4
growth achieved before the financial crisis and the recession. There are good grounds for expecting
weaker growth for some time after a deep recession – can you think of some?
Economic growth in a selection of countries 2008 2009 2010
World output 3.0 -0.8 3.9

Advanced economies 0.5 -3.2 2.1
United States 0.4 -2.5 2.7
Euro area 0.6 -3.9 1
Germany 1.2 -4.8 1.5
France 0.3 -2.3 1.4
Spain 0.9 -3.6 -0.6
Japan -1.2 -5.3 1.7
United Kingdom 0.5 -4.8 1.3
Newly industrialized Asian economies 1.7 -1.2 4.8

Emerging and developing economies 6.1 2.1 6.0
Africa 5.2 1.9 4.3
Russia 5.6 -9.0 3.6
Developing Asia 7.9 6.5 8.4
China 9.6 8.7 10
India 7.3 5.6 7.7
Brazil 5.1 -0.4 4.7
World trade volume (goods and services) 2.8 -12.3 5.8
Source: International Monetary Fund, Economic Outlook, February 2010, 2010 data are IMF forecasts
Our table above shows the extent to which a selection of countries and groups of economies has
suffered declines in output during the economic crisis:
1. World economy: World GDP fell last year – a global recession is highly unusual
2. Trade: The volume of world trade in goods and services collapsed by more than 12% in 2009 –
a sharp contraction in trade (de-globalisation) which affected many countries notably those
that are integrated into the world trading system and/or heavily dependent on exports as an
injection into their circular flows of income and spending. Germany and Japan for example
were hit hard by the severe fall in demand for exports of capital goods.
3. Australia: Not every developed country experienced recession – a good example is Australia.
The African continent also continue to grow although it suffered from a reversal of capital
flows from developed nations
4. BRICs: Overall, growth in emerging and developing countries fell from 6% in 2009 to 2% in
2010 (again no recession) but the pace of expansion is forecast to jump back up to 6% in 2010.
China and India among the BRIC nations have both managed to sustain growth similar to
previous rates of expansion.
Page 5
The UK recession in 2009 was deep by historical standards – from peak to trough of the economic
cycle, the real value of national output has fallen by more than 6% (a decline of 10% is often cited as a
benchmark for a depression). GDP growth for the UK in 2009 was -4.8% - a larger fall in output,
spending and incomes than that suffered by the Euro Area group of countries. In our next charts we
focus on the shape of the UK cycle – both in terms of the annual % change in real GDP and also the
actual level of real national output (GDP adjusted for changes in the general level of prices).
The Economic Cycle - Growth in UK National Output

Annual percentage change in GDP at constant prices
6 6
5 5
4 4
3 3
2 2
1 1
Percent
0 0
-1 -1
-2 -2
-3 -3
-4 -4
-5 -5
-6 -6
88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10
Source: UK Statistics Commission
Page 6
UK Real National Output

Quarterly value of real GDP
350 350
325 325
300 300
275 275
GBP (billions)
billions
250 250
225 225
200 200
175 175
150 150
80 82 84 86 88 90 92 94 96 98 00 02 04 06 08 10

T
he UK economy officially came out of recession in January 2010 – but there is the risk of a double-dip
recession later on in 2010.
Page 7
Extract 1: Longest and deepest recession since 1930s

For each of the following extracts we select passages from the pre-release materials and then provide
commentary and background analysis and discussion together with extra supporting charts. We
suggest some questions for discussion at the end of the toolkit and also outline opportunities for
including analysis diagrams in your answer on key issues raised by the five main extracts.
Extract 1 Text and Comments
“Exactly 12 months after the release of GDP figures which confirmed that the UK economy had
entered recession, there were high hopes that data for the third quarter of 2009 would confirm the
end of a period of falling GDP. These hopes were dashed when, in October 2009, it was announced
by the Office of National Statistics (ONS) that UK GDP in the third quarter of 2009 had fallen by
0.4% over the previous three months. The ‘green shoots’ of recovery had not yet emerged. Instead,
UK GDP had declined for six consecutive quarters making it the longest recession in the post-war
period and, possibly, the deepest if recovery did not begin by early 2010.”
Recession:
The fashionable definition of a recession is ‘two consecutive quarters of negative GDP growth’. The
National Bureau of Economic Research in the USA define a recession “as a significant decline in
activity spread across the economy, lasting more than a few months, normally visible in production,
employment, real income, and other indicators.” A depression is a persistent downturn in output and
jobs where an economy operates well below its productive potential and where there can be
powerful deflationary forces at work
Technically the UK economy’s entry into recession was confirmed in January 2009 after GDP fell by
1.5% in the last three months of 2008 after a 0.6% drop in the previous quarter. The UK exited the
recession in January 2010 when growth of 0.3% was recorded in GDP in the last quarter of 2009.
Green shoots:
Green shoots refers to evidence of a recovery in demand, production, incomes and jobs – i.e. a
turning point in the cycle. There are numerous possible signs of green shoots including the following:
 An upturn in consumer and business confidence

 A rise in spending by businesses on stocks (see the section on the stock cycle)
 A rise in demand for components and other factor inputs
 Evidence of an expansion in the hiring of new workers
 A rise in the total number of hours worked in the economy
 A fall in number of businesses operating with spare capacity
Some macroeconomic indicators are said to be lead indicators of the cycle – this means that they
start turning upwards ahead of a general rise in national output. Confidence measures are often
thought to be reliable lead indicators. Other green shoots may coincident – they move in line with the
different measures of GDP – examples include the demand for cash for retail transactions and levels
Page 8
of activity in the freight industry.
Some indicators tend to lag the economic cycle – they start to move in a favourable direction a while
after the trough of the recession has been passed. In previous recessions, the level of employment
and unemployment was considered a lagging indicator although, as we shall see in future sections,
the labour market has been less of a lagging indicator in the current cycle.
UK Economic Growth and Unemployment

Annual percentage change in GDP at constant prices, percentage unemployed
12.0 12.0
10.0 Unemployment (% of the labour force, LFS) 10.0
8.0 8.0
6.0 6.0
4.0 4.0
Percent
2.0 2.0
0.0 0.0
Real GDP (Annual % Change)
-2.0 Unemployment seems to have -2.0
peaked at a lower rate than in the
-4.0 -4.0
previous recession
-6.0 -6.0
-8.0 -8.0
90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10
Inevitably, commentators drew comparisons between macroeconomic performance in the UK and

other economies in the period 2008–2009. By November 2009, the UK was the only major global
economy not to have emerged from recession. The USA joined France, Germany and Japan in
recording positive economic growth in the third quarter of 2009. The euro area as a whole also
emerged from recession in the same period, ahead of the UK.
Macroeconomic performance refers to an assessment of how well a country is doing in reaching key
objectives of government policy.
1. Maintaining price stability (low, positive rates of inflation)

2. Increasing employment and reducing the scale of unemployment
3. Achieving a sustainable rate of economic growth
4. Improving the availability and effectiveness of public services
5. Achieving a degree of external balance in trade with other countries
6. Raising per capita incomes and avoiding excessive inequalities in income and wealth
Page 9
The Euro Area is a group of countries that have entered the single currency area, use the Euro as
their currency and have policy interest rates set for them by the European Central Bank. At present
there are sixteen member nations. These countries are:
Germany, France, Italy, Spain, Ireland, Netherlands, Finland, Luxemburg, Belgium, Austria, Slovakia,
Slovenia, Portugal, Greece, Cyprus and Malta
UK and Euro Area Growth

Annual percentage change in real national output
4 4
UK
3 3
2 2
Euro Zone
1 1
0 0
Percent
-1 -1
-2 -2
-3 -3
-4 -4
-5 -5
-6 -6
05 06 07 08 09
Source: EuroStat
Page 10
The next section of Extract 1 contains a lot of important macroeconomics both about the impact of
the recession, the response of UK firms and also the attempts to use stimulus policies to avoid a
hugely damaging slump or depression.
“Figs 1.1 and 1.2 below show that the UK economy was still in recession, despite the Bank of
England cutting interest rates earlier and more aggressively than the European Central Bank.
Economists believed this was due to the different impact that the financial crisis, which had
preceded the recession, had had on the UK economy.”
 The Bank of England started cutting interest rates in the Autumn of 2008 and – having
started the process of ‘monetary easing’ – it moved decisively with policy interest rates
dropping from 5.5% to just 0.5% in March 2009.
 The extract suggests that the BoE moved more aggressively than the European Central Bank
(ECB) – does the data in Fig 1.2 actually bear this out?
 Over the period November 2008 through to March 2009, the BoE moved from 5.5% to 0.5%
whereas the ECB dropped rates from 4.25% to 1.5% (a small drop) – but it continued cutting
to reach a base rate of 1% by the early summer of 2009.
 It is true that the change in nominal interest rates was greater in the UK – but it would be
wrong to exaggerate the difference. The European Central Bank sets interest rates for the
Euro Area as a whole and inevitably the rate setting process for a monetary union with
sixteen member nations is more difficult. Was there some inertia on behalf of the ECB? Or did
it reflect a different inflation target or a belief that the world economic crisis would affect the
Euro Area in a different way?
House Prices and Consumer Confidence

index of confidence (top pane) and average prices per month (bottom pane)
umer confidence indicator (fall indicates lower confidence)
5 5
0 0
Index of confidence
-5 -5
-10 -10
-15 -15
-20 -20
-25 -25
-30 -30
-35 -35
-40 -40
200000 200000
180000 180000
Average price in £s
160000 160000
140000 140000
120000 120000
100000 100000
Average House Price for UK (Halifax house price data)
80000 80000
03 04 05 06 07 08 09 10
Source: HBoS House Price Index and EcFin Consumer Confidence Data
Page 11
Lower interest rates are expected to cause a recovery in confidence and the housing market would be
a key area to look at for signs of a rebound in spending and activity.
 To what extent was the financial crisis affecting the UK in a different way to other EU
countries such as Germany and France? Two supporting arguments for this view are that
firstly, the UK has a larger financial services sector (e.g. banking, currency trading) and
secondly that the UK housing market that boomed to a great extent than in the European
Union. The sharp drop in profits and employment in financial services plus the steep
downturn in the housing market and high levels of consumer debt were all expected to make
the UK economy more vulnerable to the international downturn.
 In the chart above we see what has happened to average house prices in the UK and the
monthly index of consumer confidence. After many years of rising property values, the
housing industry fell into a slump from the autumn of 2007 onwards. Prices fell by more than
twenty-five per cent from peak to trough and there was also a sharp fall in measures of
construction industry activity such as new housing starts and employment in building.
Construction Sector Confidence and Housing Starts

Number of new houses started each month (top pane) and confidence (lower pane)
50000 50000
Number of housing starts
40000 40000
30000 30000
20000 20000
10000 10000
0 0
10 10
0 0
Index of Confidence
-10 -10
-20 -20
-30 -30
-40 -40
-50 -50
-60 -60
Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3
05 06 07 08 09
Monthly housing starts in England Construction Sector Confidence indicator
“Consequently, UK policies to stimulate growth had been less effective than the policies in other
developed countries. In addition, the behaviour of UK firms in the recession had made the recession
more prolonged, as evidenced by the massive reduction in stocks (inventories).”
What are the main policies used to stimulate growth?
1. Cuts in policy interest rates – the reduction in UK policy interest rates from 5.5% to 0.5%
Page 12
represents an attempt to use an expansionary monetary policy to stabilise confidence and

boost domestic and external demand in the UK economy.
2. Fiscal Stimulus policies – in common with many countries, the UK government has made
active use of fiscal policy measures in a counter-cyclical way to avoid a depression. We have
a special section on the economics of a fiscal stimulus later on in this toolkit – but briefly
these fiscal measures have included:
a. A temporary reduction in VAT from 17.5% to 15% (reversed as of January 2010)
b. A car scrappage scheme (The US and German governments have run similar
scrappage initiatives)
c. A boiler scrappage scheme
d. Bringing forward some government capital spending projects
e. Financial support for the banking system including the state taking a controlling
interest in banks such as Royal Bank of Scotland and Bradford and Bingley
f. The overall effect of these stimulus measures has been a large rise in the
government’s budget deficit which is forecast to reach 12% of national income in
2009-10.
3. QE: The Bank of England introduced a policy of quantitative easing in March 2009.
4. The Exchange Rate: Another important stimulus for the UK has been the depreciation of
sterling against a number of other currencies including the US dollar and the Euro (see the
section in this toolkit on the exchange rate and the UK economic cycle)
Page 13
Price Ratespending,
ofRecession
Interest (%)
The UK recession has been caused mainly by a sharp fall in consumer causes aand
investment fallexports
in investment demand by bu
Level
SRAS
AD1
AD2
Investment demand
AD3 ID2
Y3 Y2 Y1 I1 I2
Real National Income
Why might the behaviour of UK firms in the recession made the recession more prolonged?
GDP is a combination of all the economic activity of households (consumer spending), businesses and
government (e.g. public sector spending). Whilst the UK moved into recession, remember that:
1. Some industries and markets suffered a much sharper and prolonged downturn in demand
than the average (e.g. new car sales, building & construction, steel production)
2. Other industries experienced relatively little weakness in demand (e.g. grocery sales)
3. Several industries and markets benefited from a significant increase in demand (e.g. fast
food, domestic holidays, budget hotels, discount retailing)
Several themes have emerged about the general reactions of businesses in the UK economy during
the recession – here is a selection:
 Aggressive de-stocking: Many businesses responded promptly to the downturn in demand by

reducing short-term production and seeking ways to reduce their unsold products. They also
sought to cut demand for raw materials and semi-finished products such as components used
in manufacturing goods. Our next chart shows the extent of this de-stocking and it helps to
explain why the UK economy descended so quickly into a full-blown recession
 Price cuts: With demand falling and spare capacity rising, one way to shift unsold products is
to cut prices and offer deeper discounts to consumers. British businesses did this on a
frequent basis and this helps to explain much of the steep fall in inflation during 2009.
 Temporary shutdown of production: Highly cyclical industries such as construction and car
making reacted to the recession by scaling back production and in some case temporarily
closing down factories or operating with fewer shifts. A reduction in output can be shown by
Page 14
a movement back along the short-run aggregate supply curve

 Lay-offs and redundancies: This is an inevitable feature of a recession – but as our chart
below shows, the scale of new redundancies at the start of the downturn was very high
indeed. Businesses did not wait to see how bad the slump was going to be, they shed jobs
with speed helped by the UK having employment laws that make it easier and less costly to
make some workers redundant.
 Postponing capital investment projects: A key feature of the recession has been the large fall
in the real level of investment in new plant and equipment, buildings and other capital inputs.
Private sector capital spending has taken a big hit during the downturn and there are worries
that this will have a damaging effect on productivity and the economy’s capacity to supply
goods and services once recovery picks up
Taken together businesses in the UK responded quickly to the recession – unemployment started
rising almost as soon as the downturn started and it rose quickly although not to levels seen in the
last recession in the early 1990s. The de-stocking was a note-worthy feature and, whilst it looks
dramatic on a graph, there is a line of thought that this was a positive aspects of the recession –
because firms were in a better position to re-stock once demand started to pick up again.
Redundancies in the UK Economy

Monthly total
325000 325000
300000 300000
275000 275000
250000 250000
redundancies
225000 225000
200000 200000
175000 175000
150000 150000
125000 125000
100000 100000
Jan May Sep Jan May Sep Jan May Sep Jan May Sep Jan May Sep Jan May Sep
04 05 06 07 08 09
The monthly number of worker redundancies shot up in the final months of 2008
Page 15
Changes in stocks and the UK economic cycle

Evidence for the stock cycle in the UK
4 4
3 3
2 2
1 1
Real GDP Growth
0 0
Percent
-1 -1
-2 -2
-3 -3
-4 -4
-5 -5
-6 -6
4 4
3 3
2 2
1 1
£ (billions)
billions
0 0
-1 Change in the value of stocks -1
-2 -2
-3 -3
-4 -4
-5 -5
04 05 06 07 08 09
Notice the decision by UK businesses to cut production and attempt to off-load stocks
Value of UK Capital Investment Spending

Quarterly value of capital spending at constant 2003 prices, £ billion
65 65
60 60
55 55
GBP (billions)
50 50
billions
45 45
40 40
35 35
30 30
90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09
Capital investment spending has fallen much further than in the previous recession
Page 16
Focus on the UK car industry and stimulus policies
“This was most obvious in the car industry where assembly lines were simply closed down.”
The OCR stimulus material refers to the car industry – so we will focus on that now
Recession and the UK Car Market

Real spending on vehicles and consumer confidence
11.00 11.00
Spending on vehicles, constant Prices, SA, £bn
10.50 10.50
£ (billions)
billions
10.00 10.00
9.50 9.50
9.00 9.00
40 40
Net % of people saying that this is a good time to buy a car
Net balance
20 20
0 0
-20 -20
-40 -40
50 50
30 30
Percent
10 10
-10 -10
New passenger car registrations, annual% change
-30 -30
Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3
05 06 07 08 09
Source: SMMT and Nationwide Consumer Confidence Index
The UK motor industry was especially vulnerable to the recession:
 A new car is a major purchase often bought using unsecured credit deals – the recession
caused a steep fall in consumer confidence and the interest rates on unsecured loans became
harder to get and more expensive. The middle graph in the chart above displays how the
percentage of people saying that now was a good time to buy a car dipped from the middle
of 2007 onwards
Page 17
 Demand from household consumers for new vehicles slumped partly because consumers
decided not to take on extra debt with house prices falling and fears of rising unemployment
 Overseas demand for UK produced vehicles was affected by recession in the European Union
and also by the strength of sterling against the Euro in 2007-08 (the pound subsequently
started to depreciate)
 Many companies opted to cut-back or postpone their purchases of new fleet vehicles
By the start of 2009 new car registrations were thirty per cent lower than a year earlier and as the
chart below shows passenger car production slumped in the autumn and winter of 2008-09. Many
manufacturers opted to contract supply by temporarily closing down production lines or by running
extended working holidays. The aim was to scale back output so that it was more in line with demand
and to avoid an excessively high level of unsold cars (stocks).
United Kingdom Passenger Car Production

Monthly output figures for cars made in the UK
130000 130000
120000 120000
110000 110000
100000 100000
90000 90000
80000 80000
Number of
70000 70000
60000 60000
50000 50000
40000 40000
30000 30000
20000 20000
10000 10000
0 0
Jan Mar May Jul Sep Nov Jan Mar May Jul Sep Nov Jan Mar May Jul Sep Nov Jan
07 08 09 10
Passenger cars, for home market Passenger cars, for export
Source: Society of Motor Manufacturers and Traders
In December 2008 a press release from the Society of Motor Manufacturers and Traders spelt out the
problems facing the industry:
“The UK motor industry is facing unprecedented challenges and urgent action is now required. The
sector has seen falls in demand, extended plant closures and the first signs of redundancies in the
supply chain. Without swift action and the ability to access credit and finance, significant damage will
be done to the nation’s industrial capability – leaving the UK poorly equipped to take advantage of
any global growth when it returns.”
The statement hinted at what economists term a ‘hysteresis effect’ - where a recession can create
long-standing damage to the capacity of the industry through plant closures and business failures
(which reduces the size of the capital stock) and where structural unemployment within the industry
Page 18
and related supply-chain businesses can lead to a depreciation in the employable skills of affected
workers and the possibility of a permanent reduction in the available labour supply. Little wonder
that the UK motor industry pressed the government hard for some form of financial support. In the
spring of 2009 this arrived with the announcement of a car scrappage scheme.
Cash for clunkers
Under the terms of the UK car scrappage scheme, drivers of cars at least 10 years old could get
£2,000 off the price of a new vehicle. Half of the money is paid by the government and half by the
carmaker in question. In February 2010 the government announced an extension of the consumer
subsidy. Having put £400m into the scheme with a limit of 400,000 vehicles that can be scrapped, it is
estimated that the scrappage initiative has been responsible for about a fifth of all new UK car
registrations. Our chart below shows total UK consumer spending on new cars – notice the V-shaped
nature of the recession in 2007-2009 compared to the sustained fall in spending on new cars at the
time of the last major recession in the early 1990s.
UK Consumer Spending on Purchase of Motor Cars

Spending on motor cars at constant 2003 prices, seasonally adjusted, £bn per quarter
11 11
10 10
9 9
2003 GBP (billions)
8 8
billions
7 7
6 6
5 5
4 4
89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09
 Some critics of the scheme argued that many new cars bought will be imported reducing the
size of the multiplier effect from the stimulus and adding to the UK’s trade deficit in goods.
They also believe that the scheme has not been value for money as many of the new cars
would have been bought anyway without the effect of the incentive – it has simply brought
forward purchases of new cars to earlier in the economic recovery
 Supporters of the incentive scheme argue that new cars provide environmental benefits and
that it is vital to support UK car manufacturing and the supply-chain businesses that depend
on the final demand for new vehicles. UK-built engines and vehicles are exported to over 100
markets.
 The car scrappage scheme has undoubtedly provided a boost to the UK vehicle industry –
Page 19
although the weakness of sterling against the Euro has also played a part.
Officially a recession occurs when there are two successive quarters of negative GDP growth. You can
see this happened in the 3rd quarter of 2008. The worst quarter for growth was the 1 st quarter of 2009
when GDP fell by 3.5% in Germany and 2.5% in the UK. France and Germany edged out of recession
in the 2nd quarter of 2009 – whereas the UK was still seeing negative GDP growth.
The next section of Extract 1 considers the impact of the loosening of monetary policy by the Bank of
England and the European Central Bank – the extract provides the following chart and we have
updated this to take the numbers up to the spring of 2010.
Page 20
Interest Rates for the Euro Area and for the UK

Per Cent
6 6
5 5
Bank of England Rates
4 4
Euro Zone Interest Rates

Percent
3 3
2 2
1 1
0 0
Jan Mar May Jul Sep Nov Jan Mar May Jul Sep Nov Jan Mar May Jul Sep Nov Jan Mar
07 08 09 10
Policy interest rates in both the UK and the single currency area have remained the same since the
spring of 2009 and it is unlikely that this period of ultra-low interest rates will change in the near
term. Indeed there is an interesting argument about whether a central bank should commit itself to
maintaining low interest rates in order to have a stronger impact on business and consumer
confidence and prospects of a sustained recovery in demand and jobs.
Page 21
“Both monetary and fiscal policy in the UK should have helped promote economic growth or, at
least, reduced the impact of the recession. The Bank of England base rate was held at an historic
low of 0.5% from March 2009. In addition, the Bank effectively created money by buying £125
billion of government bonds back from the private sector: a policy known as quantitative easing.”
This section of Extract 1 refers directly to the Bank of England’s policies of lower interest rates (also
known as policy rates) plus the new policy of quantitative easing (QE) introduced in March 2009 when
the recession was already underway.
Economic effects of lower interest rates
Can ultra-low interest rates prevent a slump? In theory cutting nominal interest rates close to zero
provides a big monetary stimulus to the economy:
1. Mortgage payers have less interest to pay – increasing their effective disposable income
2. Cheaper loans should provide a possible floor for house prices in the property market
3. Businesses will be under less pressure to meet interest payments on their loans
4. The cost of consumer credit should fall encouraging the purchase of big-ticket items such as a
new car or kitchen
5. Lower interest rates might cause a depreciation of sterling thereby boosting the
competitiveness of the export sector
6. Lower rates are designed to boost consumer and business confidence
But some economists argue that in current economic circumstances, the usual transmission
mechanism for monetary policy may have broken down and that cutting interest rates has little
impact initially on demand, production and prices. Several reasons have been put forward for this:
1. The unwillingness of banks to lend – most banks are cutting the size of loan books
2. Banks have been reluctant to pass base rate cuts onto consumers and there is little incentive
to lend when interest rates are at such low levels
3. Low confidence – people are not prepared to commit to major purchases – recession has
made people risk averse as unemployment rises. Weak expectations lower the effect of
interest rate changes on consumer demand – i.e. there is a low interest elasticity of demand.
4. Huge levels of debt still need to be paid off including £200bn on credit cards
5. Falling asset prices – and expectations that property prices will continue to fall
The Liquidity Trap
In the 1930s, John Maynard Keynes referred to a liquidity trap effect – a situation where the central
bank cannot lower nominal interest rates any lower and where ‘conventional’ monetary policy loses
its ability to impact on spending. The Nobel prize-winning economist Paul Krugman has defined the
liquidity trap as “a situation in which conventional monetary policy loses all traction.” When interest
rates are close to zero as they are in the UK, the USA and in the Euro Zone, people may expect little or
no real rate of return on their financial investments they may choose instead simply to hoard cash
rather than investing it. This causes a fall in the velocity of circulation of money and means that an
expansionary monetary policy appears to become impotent. This means that different approaches
are called for in order to stabilise demand in an economy on the verge of a depression
Page 22
The Cost of Borrowing Money in the UK Economy

Per cent, source: Bank of England
20.0 20.0
Overdrafts
18.0 18.0
Credit cards
16.0 16.0
14.0 14.0
12.0 12.0
Percent
10.0 10.0
8.0 8.0
6.0 Mortgage rates 6.0
4.0 4.0
Base Interest Rates (set by BoE)
2.0 2.0
0.0 0.0
Jan May Sep Jan May Sep Jan May Sep Jan May Sep Jan May Sep Jan May Sep Jan
04 05 06 07 08 09 10
Source: Bank of England
Quantitative easing
Under the programme of quantitative easing, the Bank of England has bought up to £200 billion of
assets - mainly gilts (i.e. government bonds) financed by the issuance of new central bank reserves.
According to the Bank “the aim of quantitative easing is to boost the supply of money, push up a wide
range of asset prices and facilitate finance through the capital markets, thus raising demand in the
economy. “ In short the key aim in the short term has been to lower some long term interest rates
including the yield on government bonds and also to free up the supply of finance available for
business loans and mortgages. This will then affect components of aggregate demand including
capital investment by small and medium sized businesses.
Quantitative easing is best described as an “unconventional” approach to monetary policy working

by changing the quantity of bank reserves and money in circulation rather than directly changing the
cost of borrowing money.
Page 23
Interest Rates on 10-year UK Government Bonds

per cent
5.50 5.50
5.25 5.25
5.00 5.00
4.75 4.75
4.50 4.50
4.25 Quantitative easing programme started here 4.25

Percent
4.00 4.00
3.75 3.75
3.50 3.50
3.25 3.25
3.00 3.00
2.75 2.75
Jan Mar May Jul Sep Nov Jan Mar May Jul Sep Nov Jan Mar
08 09 10
Our chart above shows the daily yield (interest rate) on ten year government bonds – one of the key
interest rates in the financial markets. The launch of QE did help to bring down bond yields and
although they have tended to rise during 2009 and into the early months of 2010, much of this is due
to fears of accelerating inflation and the huge rise in the scale of the UK government’s budget deficit.
The Deputy Governor of the Bank of England, Charles Bean, said in a recent speech that the Bank
estimates that the policy of QE has kept long term interest rates nearly 1 per cent lower than they
might otherwise have been during 2009. Perhaps the full effects of this on the supply and cost of
business and mortgage finance will only be seen as 2010 unfolds – remember that changes in any
macroeconomic policy are subject to uncertain time lags.
“Monetary policy was eased by the fall in the value of sterling: sterling’s effective exchange rate
Page 24
index had fallen by 15% since the start of recession and it had fallen almost 19% against the US$.”
It is important to realise that movements in the exchange rate – the purchasing power of one
currency against another – forms part of monetary policy. We have seen big changes in the value of
the pound (sterling) in foreign exchange markets over the last two to three years.
Euro - Sterling Exchange Rate

Value of one Euro, daily closing exchange rate
0.975 0.975
0.950 0.950
0.925 0.925
0.900 0.900
Pence per Euro1
0.875 0.875
0.850 0.850
0.825 0.825
0.800 0.800
0.775 0.775
0.750 0.750
0.725 0.725
08 09 10
 The effective exchange rate index (EERI) measures the overall value of sterling against a
basket of other currencies, the basket is weighted according to the relative importance of
trade with a given country or area. So the EERI for the UK is heavily weighted towards the
Euro and the US dollar since more than 70% of our trade is conducted in these currencies
 You can see from the next chart that the sterling index was on a downward path from late
2007 onwards and that the currency depreciation accelerated in the final three months of
2008. Since then sterling has stabilised using the EERI measure although it has moved around
quite a bit against individual currencies
 The key point is that during 2008-1010 sterling has fallen in value compared to pre-recession
levels and that this currency depreciation ought to have provided a boost to the economy.
Page 25
Dollar-Sterling Exchange Rate

US dollars per £1, daily closing exchange rate
2.2 2.2
2.1 2.1
2.0 2.0
1.9 1.9
1.8 1.8
GBP/USD
1.7 1.7
1.6 1.6
1.5 1.5
1.4 1.4
1.3 1.3
Jan Mar May Jul Sep Nov Jan Mar May Jul Sep Nov Jan Mar May Jul Sep Nov Jan Mar
07 08 09 10
Economics effects of a depreciation in the exchange rate
A fall in the currency represents an expansionary monetary policy and can be used as a counter-
cyclical measure to stimulate demand, profits, output and jobs. It ought to bring about an
improvement in the balance of trade and, through higher export sales, drive higher demand and
output in industries that serve export businesses – the so-called ‘supply-chain’ effect.
Economists at Goldman Sachs have estimated that a 1% fall in the exchange rate has the same effect
on UK output as a 0.2 percentage-point cut in interest rates. On this basis, the 25% decline in sterling
in 2008 was equivalent to an additional cut in interest rates of between 4 and 5 percentage points –
this at a time of domestic and global economic weakness. Without the depreciation in sterling at this
time, the recession in the UK would have been much deeper.
In brief, a cheaper currency provides a competitive boost to an economy and can lead to positive
multiplier and accelerator effects within the circular flow of income and spending
Depreciation of sterling also has the effect of increasing the value of profits and income for UK
businesses with investments overseas. And it is a boost to tourist and farming industries. For farmers,
CAP payments are made in Euros, so a lower £/Euro exchange rate increases the sterling value of
farm subsidies.
Some of the benefits of a weaker currency happen in the near term; but there are also some
potential gains in the medium term. For many years the UK economy has been criticised for over-
consumption and under-investment with the economy being unbalanced and too dependent on
borrowing.
Not all of the effects of a cheaper currency are positive – here are some downsides and risks:
Page 26
 A weak currency can make it harder for the government to finance a budget deficit if
overseas investors lose confidence. When investors take their money out, this is known as
capital flight.
 Depreciation increases the cost of imports – e.g. rising prices for essential foodstuffs, raw
materials and components and also imported technology. This can cause an inward shift of
SRAS (and has inflationary risks) and might also affect long-run productive potential.
Weak global demand has dampened the beneficial effects of a lower currency – it is harder to
export when key markets are in recession and, as the table below shows, some of the
economies of the UK’s main trading partners have been in deep recession in 2009. If the price
elasticity of demand for exports and imports is low, a depreciation of the exchange rate may
initially cause a worsening of the balance of trade in goods and services.
Using an expansionary fiscal policy
“Fiscal policy was also loosened. The rise in the UK budget deficit (Fig. 1.3) was not just a cyclical
rise, as might be expected in a recession. There were discretionary increases in public expenditure
and a cut in VAT, adding to the structural (rather than cyclical) nature of the deficit.”
Figures 1.3 shows the government budget balance but you need to take a close look at the 3 rd data
point in this chart! From April 2007 through to 2008 the government borrowed £33bn and this
increased to £84bn in the 2008-09 financial year. On a quick glance it appears that borrowing actually
fell in 2009-10 but the data covers only six months – a period when we know the UK economy was
deep in recession. Borrowing in those six months totalled £78bn and the figures worsened still further
in the next six months leading to an annual budget deficit of over £170bn.
It is not unusual for the government to run a budget deficit. Indeed deficit financing is the norm and
budget surpluses are rare for the UK – the last one was in 2000 as a result of a one-off payment of
over £20bn from the telecommunications companies following the auction of 3G spectrum licences.
In a recession government spending commitments rise and tax revenues take a hit.
Page 27
Net Government Debt and UK Budget Surplus/Deficit

65 65
Net UK government debt as % of GDP
60 60
net debt as % of GP
55 55
50 50
45 45
40 40
35 35
30 30
20 20
Public sector finances - surplus on current budget £bn per month
15 15
£ monthly (billions)
10 10
5 5
billions
0 0
-5 -5
-10 -10
-15 -15
-20 -20
Jan May Sep Jan May Sep Jan May Sep Jan May Sep Jan May Sep Jan May Sep
05 06 07 08 09 10
UK Government Spending and Taxation

Measured as a percentage of national income (09-10 is a forecast from the OECD)
55.0 55.0
52.5 52.5
50.0 50.0
47.5 47.5
Per cent of GDP
Total Government Spending

45.0 45.0
42.5 42.5
Total Tax Revenue

40.0 40.0
37.5 37.5
35.0 35.0
90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10
Source: OECD World Economic Outlook
What are discretionary increases in government spending?
Page 28
These are increases in government spending independent of the state of the economic cycle. For
example the government might decide to increase investment spending on new roads, or bring
forward higher spending on overseas aid or front-line NHS services.
What is a structural budget deficit?
A structural budget deficit is the level of government borrowing with an adjustment made for the
effects of the business cycle. In the most recent recession UK national output has fallen by 6% so we
would expect the budget deficit to rise. But even when the cycle is adjusted for, the UK entered the
downturn with a structural deficit estimated by the OECD to be between 3-4% of GDP (see the chart
below). The structural deficit is now estimated to be closer to 10% of GDP and this gives an indication
of the size of the fiscal problem facing the current and any future government.
UK Government Borrowing
Borrowing as a percentage of GDP, data for 2010-11 is a forecast from the OECD
8.0 8.0
6.0 6.0
4.0 4.0
Government borrowing
2.0 Cyclically adjusted borrowing 2.0
0.0 0.0
Per cent of GDP
-2.0 -2.0
-4.0 -4.0
-6.0 -6.0
-8.0 -8.0
-10.0 -10.0
-12.0 -12.0
-14.0 -14.0
-16.0 -16.0
90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11
Source: OECD World Economic Outlook
As a result of the huge rise in government borrowing the level of debt interest payments has soared –
indeed in 2010-11 it is forecast that the UK government will spend more on repaying interest to
holders of bonds and other loans than it will spend on education.
The economics of a fiscal stimulus and the fiscal multiplier
The fiscal multiplier measures the final change in national income that results from a deliberate
change in either government spending and/or taxation. Several factors affect the likely size of the
fiscal multiplier effect.
1. Design: i.e. the important choice between tax cuts or higher government spending. Recent
evidence from the OECD is that multiplier effects of direct increases in spending are higher
than for tax cuts or increased transfer payments.
2. Who gains from the stimulus? If tax reductions are targeted on the low paid, the chances are
Page 29
greater that they will spend it and spend it on British produced goods and services. But how
soon will they get any benefit from reductions that they notice?
3. Financial Stress: At present, fiscal policy is operating in highly unusual and uncertain times.
Uncertainty about job prospects, future income and inflation levels might make people save
their tax cuts. On the other hand if consumers are finding it hard to get fresh lines of credit,
they may decide to consume a high percentage of a boost to their disposable incomes.
4. Temporary or permanent fiscal boost: Expectations of the future drive behaviour today ...
most of us now expect taxes to have to rise in the coming years. Will this prompt a higher
level of household saving and a paring back of spending and private sector borrowing?
5. Monetary policy response: In the jargon, does monetary policy accommodate the fiscal
stimulus (i.e. there are no offsetting rises in interest rates)? Consider a situation in 2010-2011
when the Bank of England holds policy interest rates close to 1% even if inflationary pressures
are rising - this will drive down real interest rates and perhaps boost demand still further. But
the central bank has an inflation target to consider and the Bank may start to raise interest
rates and limit the impact of the fiscal boost.
6. The availability of credit: If fiscal policy works in injecting fresh demand into the economy,
we still the banking system to be able to offer sufficient credit to businesses who may need to
borrow to fund a rise in production (perhaps for export) and also investment in fixed capital
and extra stocks.
7. Openness of the economy: The more open an economy is (i.e. the higher is the ratio of
imports and exports to GDP) the greater the extent to which higher government spending or
tax cuts will feed their way into rising demand for imported goods and services, lowering the
impact on domestic GDP.
Crowding out
The “crowding-out hypothesis” is an idea that became popular in the 1970s and 1980s when free
market economists argued against the rising share of national income being taken by the public
sector. The crowding out view is that a rapid growth of government spending leads to a transfer of
scarce resources from the private sector to the public sector. For example, if the government chooses
to run a bigger budget deficit, the government will have to sell debt to the private sector and getting
individuals and institutions to purchase the debt may require higher interest rates. A rise in interest
rates may crowd out private investment and consumption, offsetting the fiscal stimulus.
Crowding in
Some Keynesian economists argue that in a deep recession, large fiscal deficits crowd-in rather than
crowd-out private sector investment. In the aftermath of an economic shock, many countries operate
with spare capacity that puts big downward pressure on business profits and jobs. Well-targeted
timely and temporary increases in government spending can absorb the under-utilised capacity and
provide a strong multiplier effect which then generates extra tax revenue. In 2009 we have seen a
spectacular fall in private sector borrowing – government deficits provide a counter-weight to this.
And the fact that real interest rates on ten-year government bonds remain at low levels suggests that
there isn’t an immediate funding crisis for most western Governments who have chosen to use a
fiscal stimulus as a counter-cyclical policy. Much of the funding for the borrowing – at least in the
short term – will come from the rising savings of the private sector of rich advanced nations. Some
countries have experienced a fiscal crisis – Greece is the most recent example.
Page 30
Extract 2: Fiscal Rules Broken
“The state of the UK public finances aroused much debate at the end of 2009. The Chancellor of the
Exchequer, Alistair Darling, said that it made economic sense for government borrowing to
increase as it had done during the recession. Other politicians accused the Government of being
‘irresponsible’ in its use of fiscal policy. The fiscal rules, which had governed fiscal policy since 1997,
had been breached. Alistair Darling argued that it would be ‘perverse’ to apply the fiscal rules
strictly given the severity of the recession and argued that the ‘rules’ needed to be flexible. Whilst
he conceded that the ‘golden rule’ and the ‘sustainable investment rule’ would be broken, he
stated that the principles underlying the conduct of fiscal policy (credibility, flexibility and
transparency) would remain in place.”
Fiscal policy has become a crucial issue in the British economy in the last few years – extract 2
focuses on the way in which fiscal policy can be used in managing aggregate demand in the
aftermath of external shocks and domestic recession. Read through the extract paragraph above – I
feel the key points are as follows:
 Why does it make economic sense to increase borrowing during a recession?

 What are the fiscal rules used by the government and have they been ditched?
 Why are credibility, flexibility and transparency important in the handling of fiscal policy?
1/ Extra borrowing during a recession
In a recession there is an automatic rise in government borrowing providing that the government is
prepared to allow the automatic stabilisers to work. This is because a contraction in demand and
output leads to a fall in employment and less revenues from income tax and national insurance. In a
downturn, business profits tend to suffer causing a reduction in tax revenues from corporation tax.
And a decline in the real level of consumer spending leads to lower tax receipts from value added tax
and other indirect taxes on the goods and services we buy. The result is that a recession causes a
general fall in total tax revenues.
The second cause of borrowing is that in a downturn, unemployment rises and the incomes of those
families hit by the recession are cut – leading to an increase in state spending on welfare benefits.
Higher government spending and weaker tax revenues together cause an automatic increase in the
budget (fiscal) deficit. This is known as the automatic stabilisers at work. Recent evidence from the
OECD suggests that allowing the fiscal automatic stabilizers to work might help to reduce the
volatility of the economic cycle by up to 20 per cent. The strength of the automatic stabilizers is
linked to the size of government spending as a % of GDP, the progressivity of the tax system and how
many welfare benefits are income-related. Automatic stabilizers help to provide a cushion of
demand and support output during a recession.
The key issue then becomes how much extra borrowing a government is prepared to allow over and
Page 31
above cyclical changes in the fiscal deficit. The UK government along with many others in the Group
of 20 countries (G20) has opted to make active use of increased borrowing as a way of stabilising the
economy. The result has been a huge rise in the size of the annual budget deficit which has broken
the Labour government’s previous fiscal rules.
UK Government Budget Balance as a share of GDP

As a percentage of GDP, 2010 is an OECD forecast
5.0 5.0
2.5 2.5
0.0 0.0
-2.5 -2.5
PERCENT
-5.0 -5.0
-7.5 -7.5
-10.0 -10.0
-12.5 -12.5
-15.0 -15.0
90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11

2/ The Fiscal Rules
The Labour government introduced two key fiscal policy rules
(i) The Golden Rule:

Over the business cycle, the Government will borrow only to invest and not to fund
current government spending. The Golden Rule commits the government not to borrow
in the medium run except to finance investment. Current tax revenue has to pay for all of
current spending, once cyclical fluctuations are averaged out.
(ii) The Sustainable Investment Rule:

Government net debt as a percentage of GDP will be held over the economic cycle at a
stable and prudent level (thought to be close to 40% of GDP)
Both of these rules have been broken as a result of the recession. In effect the government has
abandoned them and the debate in the years to come will be how to restore public sector finances
to a sustainable level. Either state spending must fall and/or taxes must rise. In addition, there is also
a borrowing rule for countries wanting to join or already members of the European single currency:
European Monetary Union Borrowing Rule

Countries inside the Euro Area are required to restrict their borrowing to less than 3% of GDP in any
one year. The recession has meant that this rule has had to be relaxed as most EU governments
have chosen to increase borrowing as part of a fiscal stimulus programme. This is covered in the next
section of Extract 2.
Page 32
3/ Credibility, flexibility and transparency in fiscal policy
Here is my brief interpretation of what these terms mean:
 Credibility – the government’s plans for fiscal policy need to be credible for the financial
markets.
o Each year in the Budget statement the Chancellor provides macroeconomic forecasts
and estimates for state spending, tax revenues and the annual budget deficit. The
government is reliant on investors to provide the funds to purchase the new issues
of government debt (such as ten year bonds / gilts).
o Unless the markets believe that the fiscal numbers add up and that the government
has a credible plan to keep borrowing and debt under control, there is a danger that
investors will either move their money elsewhere or will demand a higher interest
rate on government bonds as a reward for their risk.
o The credibility (or otherwise) of fiscal policy plans has become a hugely important
issue in the last two years with some worries emerging that the UK government may
lose its AAA rating from the credit agencies such as Standard and Poors and
Moody’s. In 2009 the UK government announced a plan to halve their budget deficit
over the next four years.
 Flexibility – I take flexibility to mean the ability of the government to use different parts of
fiscal policy in a flexible way as macroeconomic circumstances change.
o When the Bank of England changes policy interest rates as part of monetary policy,
this is often seen as a ‘blunt instrument’ of policy affecting consumers and
businesses in different ways.
o In contrast, changes to fiscal policy can be targeted to impact on a certain group of
households or perhaps a specific industry. For example the introduction of the car
and boiler scrappage schemes, the removal of stamp duty on houses priced under
£250,000 (designed to give specific help to first-time buyers in the property
markets), tax relief on research and development in emerging ‘green industries’.
Other examples include specific funding for regional infrastructural spending and
Investment allowances for small firms.
o Flexibility also may require existing fiscal rules to be interpreted in a more relaxed
way when an economy is hit by special factors, but this raises questions about why
we have these fiscal rules in the first place. Too high a level of government
borrowing risks damaging the credibility of fiscal policy among domestic and
international investors and in the financial markets.
 Transparency - taxpayers should understand how the tax system works and should be able
to plan their tax affairs with a reasonably degree of certainty. Taxes should also be difficult to
evade and should not be too difficult or expensive to collect.
Equity and effectiveness?

Three aspects of fiscal policy are mentioned in extract 2 but perhaps there are other important
criteria for the handling of fiscal policy? The extracts make no mention of the possible importance of
equity effects that come from tax and government spending decisions. And there is heated debate
among economists about the effectiveness of fiscal policy as an instrument of demand management
and in driving improvements to the supply-side of the economy.
Budget deficits in Euro Area countries
Page 33
This next section of the extract looks at the growing budget fiscal deficits of countries inside the Euro
Area. As we mentioned above, nations inside the single currency are expected to keep tight control
of their government borrowing – limiting the annual deficit to no more than 3% of GDP. In the event,
the depth of the recession in Europe has caused many EU nations to way exceed this cap.
The extract mentions both the figures for the annual budget deficit (the amount a government needs
to borrow in any one year to cover their own spending) and also for public sector debt i.e. the total
accumulated government debt that has yet to be repaid.
“Members of the euro area had also struggled to meet the fiscal rules set under the European
Union’s Stability and Growth Pact (SGP). The European Commission produced macroeconomic
forecasts for each member state of the European Union in November 2009 (Fig. 2.1).
France’s budget deficit was forecast by the European Commission to be 8.3% of GDP by the end of
2009, over two and a half times the limit set by the SGP. The budget deficits for Spain and Greece
were forecast to be even greater at 11.2% and 12.7% of GDP respectively.
The European Commission said that: “the average budgetary position in the EU had gone from –0.8%
of GDP in 2007, the best position in 30 years, to –2.3% in 2008, the year when the financial crisis
turned into a full-blown economic crisis. That figure is expected to treble to –6.9% in 2009 and to
increase further to –7.5% in 2010.
Public debt is set to increase by more than 20 percentage points of GDP in the same period, and to
continue rising even after the deficits start coming down.” On the basis of the budget deficits
experienced by some member states, the European Commission put some countries under its
Excessive Deficit Procedure (EDP), setting targets for the reduction in deficits over a number of
years.”
Key points from this section of the extract:
 Forecasting: The EU Commission produces macroeconomic forecasts for each member state
– it might be worth thinking about why these forecasts are useful. And also why forecasts are
nearly always wrong!
 The UK is not the only country to have seen very large rises in government borrowing – Spain
and Greece are singled out as having particular deficit and debt problems and both of these
countries remain firmly in the news as your prepare for this paper.
 Spanish and Greek Deficits: What might explain why Spain and Greece experienced much
higher budget deficits than France? Connect the passage in the extract with Fig 2.1below
which takes five indicators of macroeconomic performance.
 Spain: Spain is forecast to have an 11.2% budget deficit in 2009 compared to 8.3% for France
– this might be explained because:
o Forecast economic growth in 2009 was much lower for Spain – the recession was
deeper than for France.
o The rate of unemployment in Spain in 2009 is nearly twice that of France
o Spain in forecast to experience a year of (mild) price deflation with CPI inflation of
minus 0.4%.
o These three factors together can explain the higher budget deficit. A deeper
recession and sharply higher unemployment hits tax revenues. As does negative
inflation since this will affect revenues from ad valorem indirect taxes and may also
lead to wage cuts which reduce revenues from income tax
 Greece: Greece is forecast to have the highest budget deficit of those countries shown with a
Page 34
gap of 12.8% of GDP between government spending and tax receipts. Yet - judging from the
forecast data in the table - the Greek economy is least affected by the recession (real GDP
falls by just 1.1%) and unemployment (measured as a % of the labour force) remains lower
than France. Consumer price inflation is also positive so the effects of deflation of tax
revenues ought to have been avoided. So why such a huge fiscal deficit?
o One of the answers comes from a larger shadow economy in Greece compared to
other countries. Tax avoidance and tax evasion may be endemic in this country
causing tax revenues to be lower for a given level of GDP.
o Another explanation comes from the surge in Greek government spending in the
years prior to the global financial crisis. Greece unexpectedly made it into the Euro in
2001 just before Euros came into circulation. The Greek government was then able
to borrow money at much lower interest rates than it had been used to and many
largely uncontrolled local state spending projects were given the go-ahead causing
the fiscal deficit to rise and public sector debt to climb. Greece has traditionally had a
large public sector compared to the rest of her economy. The country also has one of
the most generous state pension systems among the 30 OECD countries with
pensions of 96% of pre-retirement earnings available to the newly retired.
o The Economist magazine has written recently that “Greece has a long history of fiscal
trouble. It has spent half of the past two centuries in default.... when it became the
12th country to join the euro in 2001; its public debt was more than 100% of GDP”.
Another quick look at the table above:
 Macroeconomic performance refers to a range of indicators – growth, inflation and

unemployment and the budget balance are domestic economic measures whereas the
current account deficit is an external objective/measure
 The data in Fig 2.1 is basically a snapshot and a forecast for four countries in a year of
recession – be careful reading too much into the numbers when asked to make contrasts – a
stronger assessment of the relative health of these four countries would require more years
of data and a chance to calculate average annual rates for inflation, growth and jobs.
 Consider some of the connections between these nations. They are all inside the European
Union although only three (France, Spain and Greece) share the same currency. How might a
recession in Spain affect the UK? If the Greek government suffers a fiscal crisis (as has
happened in the early months of 2010) how might this affect financial markets and the
economy of the UK?
Page 35
Page 36
Extract 3: Fixers and Floaters
Extract 3 focuses on the economic importance of countries having different exchange rate regimes and
also how many of Europe’s new member nations have been affected by the global financial and
economic crisis. We will go through the extract paragraph by paragraph by paragraph and then provide
some additional background information, analysis and evaluation.
“The news that the UK remained in recession in the third quarter of 2009 caused the sharpest
depreciation in the value of sterling on the foreign exchange markets in six months. On one day of
trading in October, sterling fell 1.5% against the euro.”
Why might news of continued recession cause a fall in the value of sterling?
1. Interest rate expectations: Currency traders / speculators might decide that a longer
recession increases the chances of the Bank of England keeping policy interest rates at very
low levels for the time being – this might cause an outflow of ‘hot money’
2. Fragility of UK economy: The foreign change market might see continued recession as a sign
that the UK economy is fragile and vulnerable to fresh international economic shocks (i.e. the
risk of a ‘double-dip recession’) and that this makes the UK a less attractive location for
portfolio investment in stocks and shares, bonds and property
3. Overvalued exchange rate? A lengthy recession might be an indicator that the pound
sterling remains ‘over-valued’ against leading currencies such as the US dollar and the Euro.
4. Fiscal deficits and risk of debt crisis: A deep recession will worsen government finances and
increase the risk of a possible sovereign debt default / lower credit rating. This might cause
some capital flight from an economy – as an investors move their money out of the UK, the
supply of sterling in currency markets increases leading to depreciation.
Page 37
Euro - Sterling Exchange Rate

Value of one Euro, daily closing exchange rate
0.96 0.96
0.95 0.95
0.94 0.94
0.93 0.93
0.92 0.92
Pence per Euro1
0.91 0.91
0.90 0.90
0.89 0.89
0.88 0.88
0.87 0.87
0.86 0.86
0.85 0.85
0.84 0.84
Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Jan Feb Mar
09 10
“The downturn in economic activity has also tested the exchange rate regimes of a number of
Central and Eastern European economies. Two of these, Slovakia and Slovenia, had joined the
euro. The other six Central and Eastern European economies which joined the EU in 2004 had
adopted either freely floating or fixed exchange rate regimes:
 Poland, the Czech Republic and Hungary operated freely floating exchange rates;
 Estonia, Lithuania and Latvia had a fixed exchange rate against the euro.
Those which adopted a fixed exchange rate regime appeared to have had most problems.”
Floating exchange rates

In a floating exchange rate system, the value of the currency is determined purely by
demand and supply. Trade flows and capital flows affect the exchange rate under a floating
system and there is no target for the exchange rate as part of monetary policy and no need
for intervention in the currency market by the central bank.
Fixed exchange rates

With a fixed exchange rate, the value of a currency is pegged and no fluctuations from the
central rate are permitted. The central bank may need to intervene in the foreign exchange
markets to buy or sell currencies to keep the agreed exchange rate at the fixed rate.
Occasional realignments of one currency against another may be allowed. If the currency
falls this is called devaluation; if the central peg for the currency increases this is called
Page 38
revaluation.
We are told in the extract (see below) that Europe’s new member states have a variety of exchange
rate systems in place. Poland, the Czech Republic and Hungary operates with a floating system.
Macroeconomic performance for those member states with floating exchange rates was mixed.
Poland’s GDP was forecast by the European Commission to grow over the whole of 2009 helped by
a 30% fall in the value of the zloty on the foreign exchange markets. On the other hand, Hungary
had to be bailed out by the International Monetary Fund (IMF) and the 10% fall in the value of the
forint did not prevent the recession from being severe. The experience of the Czech Republic was
better than Hungary, but weaker than Poland (see Fig. 3.1).
International Monetary Fund (IMF)
The International Monetary Fund is made up of 186 countries, which together strive for global
monetary co-operation, financial stability, the facilitation of international trade, as well as promoting
high employment and sustainable economic growth
Let us look a bit closer at the example of Hungary and Poland
Hungary
Hungary joined the EU single market in May 2004 and for several years enjoyed strong GDP growth
of 4 per cent or higher, large net inflows of foreign direct investment (FDI) and a significant rise in per
capita incomes. However much of the higher consumer spending was financed by borrowed money
and an asset price boom including property and stocks and shares proved unsustainable. Many
Hungarian consumers opted to borrow money in Euros at low interest rates and perhaps did not
understand the risks of doing this – especially the uncertain movements of the exchange rate.
 Hungarian inflation accelerated (3.9% in 2006 jumping to 7.9% in 2007 and 6.1% in 2008)
 And a positive output gap also led to growing current account deficit on the balance of
payments of more than 6% of GDP each year 2005-2008.
 The Hungarian government was also running a large budget deficit (10.4% of GDP in 2006)
 The economy was accumulating enormous external debts including consumers taking out
mortgages from foreign banks priced in Euros.
 A speculative attack on the Hungarian Forint led to devaluation against the Euro - making it
even more expensive for consumers to service their Euro-denominated debts. Economy
spiralled into a deep recession in 2009. Hungary was forced to seek emergency financial
assistance from the International Monetary Fund.
Page 39
Hungarian Forint against the Euro

Forint per Euro
320 320
310 310
300 300
290 290
280 280
EUR/HUF
270 270
260 260
250 250
240 240
230 230
220 220
08 09 10
Our chart above shows the daily value of the Hungarian forint against the Euro. The graph shows a
high level of currency volatility in 2008 and the early months of 2009. Hungary suffered an economic
crisis at this time and was forced to seek emergency financial help from the International Monetary
Fund (IMF). Between July 2008 and March 2009 the value of the forint fell from 229 forint = Euro 1 to
315 forint = Euro 1 – a depreciation of 38%. Since then the Hungarian currency has gradually
recovered some ground and is now more stable from day to day. But this near 40% devaluation in
the currency had a big effect on their economy.
In 2009 in Hungary
 Real GDP fell by 7%
 Exports of goods and services were down 15%
 External debt climbed to 132% of GDP
 Government debt rose to nearly 80% of GDP
Normally one might expect a floating exchange rate to provide a useful way of stabilising exports,
production and profits during an economic recession. The extract hints at this by saying that
countries with floating exchange rates may have had fewer economic problems during the recent
crisis. But this has not been the case with Hungary. Yes her currency did devalue giving her export
sector a competitive boost. But the fall in the currency came at a time of recession in Hungary’s main
export markets (other eastern European countries and established EU nations such as Austria and
Germany). So the beneficial effect of the lower exchange rate was weakened whilst the steep fall in
the purchasing power of the forint caused higher inflation, debt problems for people with loans
priced in Euros. And it also made the Hungarian economy less attractive for foreign investors at a
time when the Hungarian government needed to borrow huge sums to finance a fiscal deficit.
Poland
Poland’s economy has fared better than Hungary in recent years. Our chart below confirms that the
Page 40
Polish zloty did indeed fall sharply from the second half of 2008 through to the early months of 2009.
The growth rate fell from 5.4% in 2009 to 1.4% in 2009 but an outright recession was avoided. This
despite a 10% drop in the real value of Poland’s exports of goods and services (Poland’s main export
market is Germany and Europe’s biggest economy was deep in recession in 2009.).
Poland's Effective Exchange Rate Index

Index of the trade weighted value of the Polish currency - the Zloty
130 130
125 125
120 120
115 115
110 110
Index
105 105
100 100
95 95
90 90
85 85
Jan Apr Jul Oct Jan Apr Jul Oct Jan Apr Jul Oct Jan Apr Jul Oct Jan
06 07 08 09 10
Poland Macroeconomic Indicators 2008 2009 2010
Real GDP (% change) 5.0 1.4 2.5

Consumer spending (% change) 5.9 3.2 1.4
Investment (% change) 8.2 -1.5 2.3
Exports (% change) 7.0 -10.4 1.4
Imports (% change) 8.1 -15.3 1.0
Unemployment (% of labour force) 7.1 8.4 9.6
Budget balance (% of GDP) -3.7 -6.4 -7.8
Policy interest rate (%) 6.3 4.3 4.2
CPI inflation (%) 4.2 3.5 2.2
BoP Current Account (% of GDP) -5.1 -1.7 -2.3
It seems that Poland was able to avoid recession because
 The depreciation of her exchange rate helped to keep the economy competitive in the face
of a European-wide recession
 Policy interest rates were cut in 2009 – the Polish Central Bank was able to use interest rates
as a means of stabilising confidence and demand
 Consumer spending on goods and services continued to grow in real terms and this helped to
limit the negative accelerator effect on capital investment spending by businesses
 The Polish government allowed the budget deficit to widen to over 6% of GDP but this has
not created the same financial crisis seen in countries such as Greece, Ireland and Portugal
Page 41
 The cyclical rise in unemployment in Poland has been modest – indeed Poland now has one
of the lowest unemployment rates among EU countries. In March 2010 it was reported thata
growing number of German migrant workers are considering moving to Poland in search of
work – a reversal of the usual trends in migrant movement within the EU single market.
Poland - Growth, Unemployment and Inflation

GDP growth (top pane), Unemployment and inflation (bottom pane)
2.0 2.0
1.5 1.5
1.0 1.0
0.5 0.5
Percent
0.0 0.0
-0.5 -0.5
-1.0 -1.0
-1.5 -1.5
-2.0 -2.0
-2.5 -2.5
22.5 22.5
20.0 20.0
17.5 Unemployment rate (per cent) 17.5
15.0 15.0
Percent
12.5 12.5
10.0 10.0
7.5 7.5
Consumer price inflation (%)
5.0 5.0
2.5 2.5
0.0 0.0
02 03 04 05 06 07 08 09 10

The Baltic States and Fixed Exchange Rates
We now turn to the Baltic States and their recent experiences: Let us refer back again to the relevant
section of Extract 3.
Estonia, Lithuania and Latvia had all enjoyed a decade of high growth prior to the recession, in part
promoted by significant levels of foreign direct investment. However, the recession experienced by
these economies was deep and prolonged. In addition, since the onset of recession, Estonia, Lithuania
and Latvia experienced severe balance of payments problems, despite maintaining positive
balances on their current accounts. Potential investors feared that these economies might abandon
their fixed exchange rate against the euro, consequently capital inflows dried up and capital
outflows increased. There were several speculative attacks on the Estonian, Lithuanian and Latvian
currencies which made the problems of these economies worse.
We will go through this section piece by piece.
1/ High growth promoted by significant levels of foreign direct investment
Many new entrants to the EU single market attracted large amounts of inward investment both
before and straight after their accession to the EU. The Baltic States are very small in the context of
the EU as a whole. Think about what impact FDI inflows might have on their GDP growth rates and
how you might show this using an AD-AS diagram framework.
Page 42
2/ However the recession experienced by these economies was deep and prolonged
What brought an end to the super-fast growth of the Baltic States?
 These economies over-heated. Growth rates proved to be unsustainable and excess demand
led to a large rise in consumer price inflation and double-digit annual growth in wages.
 High relative inflation damaged the cost and price competitiveness of exporters in the Baltic
States and made imports look relatively cheap in comparison.
 Rising living standards led to a surge in consumer spending – much of which was spent on
imports causing the trade balances to move into deficit.
 Falling unemployment, rising incomes and high confidence caused a surge in the demand for
consumer credit. Excessive borrowing by households proved to be disastrous when the
global credit crunch engulfed the European economy.
 The fixed (or pegged) exchange rate against the Euro meant that countries such as Estonia
and Latvia did not have the option of devaluing their exchange rate to restore lost
competitiveness in overseas markets. (see the chart below to see the exchange rate)
 The overall result has been an exceptionally deep recession for these countries. To take
Estonia as an example. The economy was already in recession in 2008 (GDP fell by 3.6%) but
in 2009 national output collapsed by more than 13%, consumption was down 18% and
capital investment demand was 33% lower in just one year. Inflation dropped from 10% in
2008 to close to zero in 2009 (see Fig 3.1 for confirmation of this). From being one of
Europe’s fastest growing countries in 2004-07 Estonia is on the brink of a deflationary
depression.
Pegging to the Euro - Estonia and Latvia
Local exchange rates to the Euro, daily value
15.95 15.95
15.90 15.90
15.85 Estonian currency 15.85
15.80 15.80
EUR/EEK
15.75 15.75
15.70 15.70
15.65 15.65
15.60 15.60
15.55 15.55
15.50 15.50
15.45 15.45
0.725 0.725
Latvian currency
0.700 0.700
0.675 0.675
0.650 0.650
EUR/LVL
0.625 0.625
0.600 0.600
0.575 0.575
0.550 0.550
0.525 0.525
0.500 0.500
97 98 99 00 01 02 03 04 05 06 07 08 09 10
3/ Estonia, Lithuania and Latvia have experienced severe balance of payments problems, despite
maintaining positive balances on their current accounts.
(Important Note – there is an error in this sentence in the extract)
Page 43
None of the three countries mentioned have had current account surpluses in recent years. Indeed
one of the features of these three Baltic States is that their current account deficits have grown
considerably during the years when consumption and living standards were booming and high
inflation was making their economies less competitive). To support this I have included official data
from Euro Stat on the current account deficits and surpluses of a selection of EU countries in 2008.
Current account % of GDP)

Greece -14.6
Latvia -13.0
Portugal -12.1
Lithuania -11.7
Spain -9.6
Estonia -9.4
Hungary -7.1
Poland -5.1
Czech Republic -3.1
France -2.3
United Kingdom -1.6
Finland 3.0
Netherlands 4.8
Sweden 6.3
Perhaps the authors of the extracts were referring to a surplus in trade in services? Estonia for
example runs an annual trade deficit in goods, a large and rising service surplus and has a negative
balance for net earnings from overseas investments.
Back to the essence of the point which is about some of the countries suffering from “several balance
of payments problems” and the consequences for economic performance. To understand this bit,
think about the basic calculation of a country’s balance of payments. There are two main accounts to
consider, the current account and the capital account. The current account is made up of four
separate balances:
(i) Trade balance in goods

(ii) Trade balance in services
(iii) Net earnings from rents, interest, profits, and dividends from overseas investments
(iv) Net transfers between countries (such as foreign aid, cross-border transfers from
pension funds and worker remittances from migrant workers)
The capital (or financial) account tracks inflows and outflows of capital between countries and
includes the following balances
(i) Direct investment

(ii) Portfolio investment
(iii) Other financial flows (including short term banking flows between countries)
(iv) Changes in official reserve assets (including gold and foreign currency reserves)
In principle the current and capital accounts need to balance. Countries running sizeable current
account deficits have some freedom to operate with capital account deficits (for example they might
choose to increase their overseas investments to accumulate external assets). Countries
experiencing persistent current account deficits need to attract net inflows of capital if they are to
Page 44
balance their accounts, or they may have to run down their reserve assets or (in extreme
circumstances) seek emergency funding from the International Monetary Fund (IMF).
By the time the global financial crisis spread it was clear that the Baltic States of Estonia, Latvia and
Lithuania were living well beyond their means and running up big current account deficits that were
– for small open economies in turbulent times – completely unsustainable. A current account deficit
is manageable providing that a country can find sufficient external finance from overseas creditors.
But for these three countries, the mood of investors changed and as the extract suggests, capital
inflows not only started to dry up and began flowing out of these economies.
4/ Potential investors feared that these economies might abandon their fixed exchange rate
against the euro, consequently capital inflows dried up and capital outflows increased. There were
several speculative attacks on the Estonian, Lithuanian and Latvian currencies which made the
problems of these economies worse.
Investors came to the unsurprising conclusion that the Baltic States had over-valued exchange rates
and there were doubts about whether individual governments would be prepared to intervene in the
currency markets to defend existing currency pegs. Foreign exchange speculators tend to attack what
they perceive to be the weakest currencies in a region in the expectation that – by shorting the
currency (borrowing money to sell it and then buy it back again at a much lower price) – they can
make big profits in a short space of time.
The speculative attacks prompted central banks in these countries to raise interest rates in a bid to
defend their currencies. Higher interest rates proved to be the catalyst for the bursting of their
economic and financial bubble bringing about some of the worst recession conditions in the entire
European continent. Latvia suffered to the extent that – in the autumn of 2008 – it was forced into
asking for an IMF-led loan rescue package of 7.5bn euros which was agreed condition on the Latvian
government introducing severe fiscal austerity measures including sharp cut-backs in government
spending.
Page 45
Macroeconomic Indicators for Latvia

0 0
Trade balance (goods)
-50 -50
-100 -100
LVL (millions)
-150 -150
millions
-200 -200
-250 -250
-300 -300
-350 -350
-400 -400
20.0 20.0
17.5 17.5
15.0 15.0
12.5 Unemployment rate (%) 12.5
10.0 10.0
Percent
7.5 7.5
5.0 5.0
2.5 Consumer price inflation (%) 2.5
0.0 0.0
-2.5 -2.5
-5.0 -5.0
04 05 06 07 08 09 10
Balance of Trade in Goods Unemployment rate (%)
Consumer price inflation (%) [ar 12 months]
Estonia
Estonia is in a different situation to Latvia and Lithuania in the sense that it have an extremely low
level of government debt (indeed it does not issue long term government bonds) and therefore has
not suffered from the twin deficit problems facing countries such as Greece and Spain. Indeed
Estonia has offered financial help to Latvia as part of the IMF bail-out and the Estonian government
has applied to join the Euro Area some time in 2011.
In regard to extract 2 in this pre-release exam, it is interesting to note that during the crisis, the
Estonian government has opted not to introduce any specific fiscal stimulus programmes, Instead it
has decided to let the financial and economic crisis work its way through the economy preferring
instead to use the recession as a way of correcting many of the imbalances that had been created
during their boom years. Government spending has been cut and Estonians have had to accept
severe wage cuts as part of the process of adjusting to the recession. In the period 2002-07 budget
surpluses of 1.7% of GDP were achieved by Estonia, while its government debt is the lowest in the EU
at below 10% of GDP.
Page 46
Estonia's GDP Growth, Unemployment and Interest Rates

Annual % change in real GDP, unemployment rate %, inter-bank interest rates (%)
20 20
15 15
Economic Growth
10 10
Unemployment
5 5
Percent
Interbank Interest Rates

0 0
-5 -5
-10 -10
-15 -15
-20 -20
Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4
06 07 08 09
To round off this look at extract 3 we look at figure 3.1 below – a snapshot of three domestic
macroeconomic indicators for six of the newer member states of the EU.
Some key points from this data:
(i) GDP growth rates: There is a huge difference in growth rates in 2009. The three Baltic
States have suffered a collapse in output and were already in recession in 2008 so the
cumulative fall in output is much greater than shown in the table. Some issues to
consider might include:
a. What long term damage might be caused by such a large decline in national output
Page 47
in these countries?
b. Explain how the fall in output will affect employment and wages in these countries
(ii) Inflation rates: Two countries shown in Fig 3.1 were on the brink of price deflation in
2009 (Latvia and the Czech Republic). Indeed by the start of 2010 the Latvian economy
was already experiencing deflation.
a. Explain how a recession might cause a fall in the annual rate of price inflation
b. What are the likely causes of deflation in a country such as Latvia?
c. Identify some of the economic consequences of a prolonged period of price deflation
for countries such as Latvia or the Czech Republic
(iii) Unemployment rates: There is another sizeable gap between the highest and lowest
unemployment rates among the six countries shown. Although the Czech Republic has
suffered a recession as deep as the UK economy in 2009, it’s unemployment rate
remains relatively low compared to that of Hungary and Poland and well below the mass
unemployment existing in the Baltic States
a. Identify some of the economic and social costs of a high level of unemployment
b. What policy options are open to the Baltic States should they wish to give reducing
unemployment a high priority with their macroeconomic policies?
Page 48
Extract 4: The Return of Protectionism
When individual countries are in economic trouble the lobbying for protectionist policies nearly always
gathers momentum. And extract 4 focuses on this issue with particular reference to the ongoing trade
and currency disputes between the USA and China together with individual examples of protectionism
introduced during the downturn. Global Trade Alert’s latest report identifies no fewer than 192
separate protectionist actions since November 2008, with China as the most common target. Russia
has introduced the biggest number of protectionist measures since the crisis started - and of course
Russia is not a member of the WTO so it not bound by any commitment to reduce trade barriers.
This extract will provide good opportunities for you to analyse and evaluate the economic and social
costs and benefits of protectionism. And consider whether the wave of globalisation of the last twenty
years might be (perhaps temporarily) coming to an end. Are we heading for a period of de-
globalisation?
Extract 4 Passages and Comments
“Whilst it was good news that major developed nations were recovering from recession at the end of
2009, some of the policy reaction to the global downturn was worrying. It had become increasingly
apparent that there had been a return to economic nationalism during the recession. Tariffs and
quotas had been imposed by some countries on imports and restrictions had been placed on
takeovers of national firms by foreign capital.”
Protectionism / economic nationalism have many faces. This passage of extract 5 mentions three
examples of barriers to trade and the free flow of capital:
 Import tariffs (including anti-dumping measures)

 Import quotas (a non-tariff barrier to trade) and import licences
 Restrictions on foreign take-overs of domestic businesses
We will look at each of these in turn, but keep in mind that there are many other types of protectionist
measure available to national governments:
 Subsidies for national industries

 Stringent health and safety standards (such as India completely banning Chinese toys from the
market)
 Complex customs clearing procedures – for example Indonesia (mentioned in the extract
below) has limited the import route for over 500 different goods to six ports and the
international airports, including electronics, toys, food, shoes and clothing. Argentina imposed
licensing requirements on auto parts, textiles, TVs, toys, shoes, and leather goods.
 Calls to favour domestic products and companies in national economic stimulus packages
 Restrictions on international capital flows or immigration
 Credit/loan guarantees and investment tax allowances to favoured domestic businesses
 Preferential treatment to domestic firms via financial aid such as subsidies and bail-outs
 Using monetary policy / deliberate currency intervention to engineer a devaluation of an
exchange rate to give domestic producers a competitive boost
Page 49
What is driving the return towards protectionism?
1. Excess capacity in many domestic industries as a result of the global recession - leads to higher
costs and falling profits. The response is often to introduce subsidies. Subsidies proposed for
the auto industry have proliferated and total some $48 billion worldwide, mostly ($42.7 billion)
in high-income countries.
2. Reactions (retaliation) to perceived economic damage caused by trade distorting subsidies and
allegations of import dumping - "beggar thy neighbour" policies - e.g. EU tariffs on shoe
imports from China and Vietnam. Note the prisoners' dilemma aspect of protectionism - the
(short term) dominant strategy is to protect unilaterally
3. Credit crunch: There is a desire to increase the multiplier effects of fiscal stimulus programmes
and to control the flow of money around the world economy - just recently with Krafts bid on
Cadbury's there were calls in the UK for French-style financial protectionism via a "Cadbury's
Law"
4. Protectionism is a response to the failure of nations to agree other ways to reduce structural
trade imbalances - and the breakdown/failure of attempts to achieve a new multi-lateral trade
agreement post DOHA
Anti-dumping duties
This section of the extract focuses on the use of anti-dumping duties by developing and developed
countries against subsidised imports:
The return of protectionism was also evidenced by the number of anti-dumping cases brought to the
World Trade Organisation (WTO), up by one third. Of the 85 cases launched in the first half of 2009,
half were against China. More worrying still was the fact that 88 of the 104 anti-dumping cases in
the second half of the year were brought by developing countries against subsidised imports.
What is dumping?
Dumping is a form of price discrimination where an exporter chooses to selling good and services
abroad at a price below that charged in the domestic market. The price may be so low that it is below
the unit cost of production and typically the aims of dumping are to penetrate international markets,
get rid of stocks and improve cash-flow by offering price discounts. Some dumping can have predatory
objectives, namely inflicting material damage on the domestic suppliers in another country.
The WTO Anti-Dumping Agreement provides for anti-dumping investigations and possibly also anti-
dumping measures (i.e. counter-tariffs) in case a foreign company sells its products cheaper on one
export market than at home or on another export market. A company might be able to offer lower
prices abroad because it receives an export subsidy from its home country – this is frequently the main
cause of anti-dumping duties introduced by developing countries against the imports from advanced
economies.
Many developing countries complain that expensive subsidies in the developed countries prevent the
emerging market nations from reducing their dependence on commodity exports (where world prices
are volatile) and being able over the long run to diversify their economies into attractive locations for
manufacturing industry.
Page 50
China and anti-dumping duties
The extract mentions that China has been a focus of many anti-dumping duties. For example in
November 2009, The US Commerce Department imposed anti-dumping tariffs of up to 99% on imports
of Chinese tubular goods alleging that China had been selling its oil well pipes at prices that were much
lower than normal. But this can also work in the other direction! For example in February 2010, China
introduced anti-dumping duties on US chicken imports, after accusing American poultry firms of
exporting the meat at unfairly low prices.
China-US Trade Tensions
Barak Obama’s presidential campaign at the beginning of the global slowdown raised fears that the
USA would turn to protectionism as the spectre of job losses loomed. Obama was quoted as saying:
“China must change its currency practices. Because it pegs its currency at an artificially low rate,
China is running massive current account surpluses. This is not good for US firms and workers, and
not good for the world.”
This section of the extract focuses on the long-standing tensions and stresses between the United
States and China.
There is huge pressure within the United States for a response to what is perceived as being unfair
trade practices between many Chinese exporters and their US counterparts. At the heart of the
controversy are claims that China has manipulated their currency (called the renminbi or the Yuan)
keeping it low against the US dollar to make Chinese exports cheaper in US markets and making US
exports more expensive for Chinese buyers.
The US government believes that China’s sizeable current-account surplus and huge foreign-exchange
reserves suggest that the renminbi is undervalued even though the Chinese currency has appreciated
in nominal terms by more than 20% since China ended its fixed exchange rate regime against the US
dollar in mid-2005. Indeed the appreciation in the renminbi has done little to alter the scale of the
Chinese-US trade imbalance.
Complaints have grown that cheap Chinese goods continue to flow at high rates into the USA during
the recession threatening US jobs and undermining US recovery. The Chinese currency was argued to
be undervalued relative to its purchasing-power-parity rate. For example, the July 2009 Big Mac index
showed the yuan undervalued by 49% against the dollar
Page 51
Yuan-Dollar Exchange Rate and China-US Trade

Monthly USChinese Yuan
balance of trade/US Dollarwith
in goods exchange
China rate and balance of trade in goods
-5.0
-7.5 US trade balance with China ($bn per month) -7.5
-10.0
USD (billions)
-12.5 -12.5
billions
-15.0
-17.5 -17.5
-20.0
-22.5 -22.5
-25.0
-27.5 -27.5
8.50 8.50
8.25 8.25
China US $ exchange rate, Yuan per $1
8.00 8.00
CNY/USD
7.75 7.75
The fixed exchange rate ended in July 2005
7.50 7.50
7.25 7.25
7.00 7.00
6.75 6.75
02 03 04 05 06 07 08 09

Buy American provisions in the US fiscal stimulus
The US government’s fiscal stimulus package contained strong ‘Buy American’ provisions that limited
public sector spending to firms in the USA. In September 2009 the US government imposed 35%
tariffs on tyres imported from China – US$1.3 billion of tyres had been imported in the first six
months of 2009. China complained to the WTO and announced retaliatory tariffs on imports of US
car parts and chicken meat.
Here we see examples of the USA introducing protectionism (the tariff on tyres) and also linking their
fiscal policy recovery programmes to requirements to use locally sourced inputs in order to increase
the size of the fiscal multiplier effects from higher Federal spending. This is a form of economic
nationalism, in the same way that China’s alleged manipulation of their currency is designed to affect
the pattern of trade. The USA is not the only country to engage in this – in the UK the Royal Bank of
Scotland, HBOS and Lloyds TSB were all bailed out in 2008, and one part of the deal was that they
should raise the amount of lending to UK companies and individuals as a way of unfreezing the supply
of credit in the British economy.
Note here the extract mentions that China has already responded with retaliatory tariffs on car parts
and chicken meat. Game theory might be used here to explain why countries involved in a trade
dispute may decide to adopt a ‘tit for tat’ strategy when one country introduces import tariffs. The end
result is that nations can descend into a trade battle causing total trade to decline.
Such measures were not confined to the USA, however.
 French President, Nicolas Sarkozy, proposed a ‘strategic investment fund’ to fight off foreign
takeovers
Page 52
 Indonesia introduced licences to limit imports

 India and Vietnam introduced tariffs on steel
 Russia imposed tariffs of 30% on cars and 15% on farm machinery.
Let us consider the analysis of an import tariff. The standard tariff diagram is shown below. When
analysing a tariff remember to consider both the direct and indirect effects on consumers and
producers. A tariff raises the price of imported products and this will have a direct effect on
 Consumers of the product

 Exporters of the product from the importing economy
 Domestic suppliers of the product who have been given an artificial boost to competitiveness
 The government (or tariff implementing body) who raise revenue from import duties
But there are also indirect effects to consider – for example, the effect of a tariff on
 Producers of other products who use the import as a component (they face higher costs) -
tariffs on input goods adversely affect profitability and output higher up in the value-added
chain. The tariffs on steel mentioned in the extract might be an example of this
 The indirect effects on competition in the market and the incentives to be efficient
 The overall effects on the allocation of scarce resources
 The indirect effects of the tariff on the distribution of income – might import duties have a
regressive effect on the gap between higher and lower income groups?
Price
Domestic Supply
Deadweight loss of economic welfare from the tariff
Revenue from Tariff
Pw + Tariff
Pw + T
World Price
Pw
M
Domestic Demand
Qs Qs2 Qd2 Qd Output (Q)
“Just as the global economy emerged from recession, the dramatic rise in protectionism reduced the
volume of world trade seriously threatening the global recovery. Both the United Nations (UN) and
the Organisation for Economic Co-operation and Development (OECD), forecast that world trade
would fall by 15% during 2009 – the first decline for over 20 years.”
Page 53
This did indeed happen – in fact in 2009 world output shrank by 2% whereas there was a 14% decline
in the value of trade in goods and services together with a sharp fall in the level of capital flows
between countries. Our next chart provides confirmation of the shrinkage in trade flows. This is
evidence of de-globalisation.
However to aid your evaluation keep in mind that the rise of protectionist measures is not the only
reason for the contraction in world trade. The credit crunch is a major factor behind the events of
2009. Because of a freezing of trade credit, many exporters have found it difficult to get the finance
necessary to pay for making and then transporting products to overseas markets.
Another explanation comes from the vertical disintegration of global production – there is a
misconception that iPods are all made in China. Final assembly might take place there but the broader
manufacturing process including components takes place in more than a dozen countries. A slump in
demand for consumer durable products and capital goods (e.g. new machinery and technology) has hit
supply-chain industries causing a steep decline in intra-industry trade.
Part of your analysis and evaluation of the effects of protectionism and the global credit crunch causing
a slump in international trade might be to consider the impact on industries that provide the
infrastructure needed to allow trade to function. The downturn in trade has badly affected the global
shipping industry and reduced demand and profits for airline freight businesses. Ports have suffered
from weaker levels of activity and a lower demand for cross-border trade affects many other service
industries such as trade insurance. An example of the effect of de-globalisation in 2009 was a collapse
in freight rates for containers shipped from Asia to Europe. The Baltic Dry Index became a signal of the
broader impact of the global financial crisis and recession.
Quarterly Value of World Trade

4.50 4.50
4.25 4.25
4.00 4.00
3.75 3.75
US Dollars (thousand billions)
thousand billions
3.50 3.50
3.25 3.25
3.00 3.00
2.75 2.75
2.50 2.50
2.25 2.25
2.00 2.00
Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1
04 05 06 07 08 09
Export, EXPORTS,F.O.B. Imports, IMPORTS,C.I.F.
Page 54
World Freight Index - Baltic Dry (BDI)

Daily closing index
12000 12000
11000 11000
10000 10000
9000 9000
8000 8000
7000 7000
Index
6000 6000
5000 5000
4000 4000
3000 3000
2000 2000
1000 1000
0 0
04 05 06 07 08 09 10
Evaluation arguments on the economic impact of protectionism
Tariffs and other forms of import control can be justified as a response to dumping policies by overseas
producers and also on grounds of giving infant industries temporary protection as part of a strategy of
import substitution for developing countries. Import restrictions might also be defended on social
welfare grounds – for example limiting the negative externalities from the importation and
consumption of dangerous products. But many of the arguments in favour of protectionism only hold
up if the protectionism is temporary, rather than permanent, as the latter breed structural
inefficiencies. In the long run though it is generally accepted free trade is a better route to growth.
Some of the arguments against protectionism
1. A tariff only confers a short-term competitive advantage for one nation until those countries
affected decide to respond. There is a huge risk of retaliatory action leading to
a. Escalation of tariff wars (plenty of scope for this as average tariffs in the world are
lower than agreed bound tariffs at the last WTO agreement)
b. Subsidy races between national governments looking to protect their 'strategic'
industries - for industries laden with excess capacity, these subsidies impede exit and
delay adjustment. Even worse, subsidies may be linked to requirements that
companies to preserve domestic employment, even at the cost of shutting more
efficient plants abroad in developing countries.
c. Use of defective strategies for countries embroiled in a trade war - drawing from game
theory - break-down of a cooperative solution (tit for tat), e.g. Canada has matched the
subsidies the US gave Detroit auto makers to ensure that Canadian plants of American
producers would remain open.
2. Higher input costs for users of imports on which tariffs or quotas etc have been applied. e.g. A
month after India banned certain Chinese toys, it had to reverse it as prices rocketed
3. Protectionism distorts comparative advantage and goes against the principles of the gains
Page 55
from specialisation and free trade and exchange - a risk that protectionism will partially bring
an end to globalisation
4. Trade controls as a barrier to entry reduces incentives for productive and dynamic efficiency
by making markets less contestable leading to higher unit costs and (ultimately) a worsening of
consumer welfare
5. Inflationary consequences of import tariffs and restricting supply through quotas (higher
import prices can lead to an inward shift of SRAS)
6. Fiscal costs of subsidising domestic firms or subsidies offered to exporters (particularly at a
time of large focus on fiscal deficits at the moment)
7. There are co-operative ways of over-coming structural trade imbalances without resorting to
trade wars. A full-scale return to protectionism will bring about a further sharp fall in the
volume of world trade which ultimately will harm most countries engaged in international
trade and exchange. Likely in its wake to lead to a reduction in world economic growth and
lower trend growth rates - mutually beneficial trade is a positive-sum game.
Protectionism or protection? A tricky balancing act
Governments are expected to protect their citizens from negative outcomes such as job losses; but not
to resort to protectionism – this is a tricky balancing act! For example, were the actions of the Bank of
England to provide asset backed guarantees protectionism in the same way that Obama's tariffs on
Chinese tyres were?
Page 56
Extract 5: Making Economic Growth and Development Sustainable
The final extract centres on the economics of sustainable development and policies to reduce carbon
emissions and mitigate the impact of climate change. Climate change is one of the most important
issues of the next decades and has the potential to severely impact societies, economies and human
well-being be they developed or developing. What are likely to be effective, efficient and equitable
policies to limit global warming to 2°C above pre-industrial levels? The consensus is that this can only
be achieved with reasonable probability (>50%) if atmospheric greenhouse gas concentrations stabilize
at or below 450 ppm CO2e in the long term. How and who pays for the shift towards a low (or even
zero) carbon economy lies at the heart of much of this extract. Can the world develop a system similar
to the world trading system to bring down C02 emissions?
Extract 5 Passages and Comments
As the global economic slowdown and recession neared its end, governments of developed and
developing nations met in Copenhagen in December 2009 to seek an agreement to further limit
carbon emissions. The Copenhagen summit took place under the United Nations Framework
Convention on climate change. The major achievement under the UN Framework was the signing of
the Kyoto Protocol in 1997. This protocol set binding targets for the carbon dioxide emissions of the
major developed economies and established an important principle with respect to developing
economies. This principle was that developing economies would face a lower burden in reducing
emissions than developed countries.
This is an introductory section to the extract.
Targets: A key part of it is the idea of binding targets for reducing C02 emissions. A binding target
provides a means by which countries or groups of nations (such as the EU) can signal their intent to
introduce low-carbon policies. And it is part of the process of building trust over who will carry the
burden of CO2 reductions. Ahead of the Copenhagen Summit a number of countries announced new
unilateral targets for C02 emission reduction:
 USA: US President Obama pledged to cut emissions by 17% by 2020 and by 83% by 2050
 China: China has a new target to reduce the energy intensity of GDP by 40-45% by 2020
 India: The Indian Action Plan on Climate Change pledges the country to 8 national missions to
cut emissions in solar power, forestry, sustainable agriculture, and energy efficiency
 Brazil: Brazil already sources more than 80% of its power from renewable energy sources and
has pledged to reduce deforestation by 80% by 2020.
Development: The second key part of this paragraph is the principle built into Kyoto that developing
countries would face a lower burden in cutting emissions than richer advanced nations. C02 emissions
per person in 2007 (according to the World Resources Institute) were much higher in the developed
world – for example:
 Australia - 26 tonnes of C02 per person

 USA – 24 tonnes
 Japan – 11 tonnes
Page 57
 EU average (for 27 nations) – 10 tonnes

 China – 5 tonnes
 Brazil – 5 tonnes
 India – 2 tonnes
Economic growth – rising incomes – carbon emissions
As many of the emerging market economies continue to grow so too will C02 emissions per head as
people have more money to pay for a wider range of goods and services. The world’s poorest nations
(many of whom are expected to be hardest hit by the impact of climate change) argue that their future
development risks being curtailed if they are required to introduce binding C02 limits in the short term.
They lobby for investment in low carbon technologies first and then future commitments to meet
binding targets.
“The Copenhagen summit was the first step in agreeing a successor to the Kyoto Protocol, which
expires in 2012. The task ahead of the participants was monumental. According to the International
Panel on Climate Change (IPCC), to ensure that global temperatures were no more than 2% above
their pre-industrial levels would require a cut in global carbon emissions of 50% of 1990 levels by
2050. For rich developed nations it was estimated that this would require an 80% reduction in
emissions. According to the International Energy Agency, such cuts in emissions would require US$1
trillion a year in investment in cleaner technology. The World Bank estimated that, of this global
total, US$475 billion a year in investment was needed in developing countries.”
The Copenhagen Accord
This Copenhagen Accord contains three elements.

1. The first is recognition of the need to prevent global temperatures rising by more than 2
degrees Celsius above pre-industrial levels.
2. The second is a commitment by developed countries to give $30bn of aid between 2010 and
2012 to developing countries for investment in green technology and to mitigate the effects of
climate change. In addition, a goal was set of providing $100bn a year by 2020.
3. The third is for rich countries to give pledges on emissions reductions and for developing
countries to give pledges on reducing emissions increases. Developed countries’ pledges will
be scrutinised by the UN Framework Convention on Climate Change, while developing
countries will merely be required to submit reports on their progress in meeting their pledges.
But this is only an accord. It has no legal status
Investment in low-carbon technologies
Capital investment is needed in lower-carbon technologies for power and fuel – examples you might
write about include:
1. Wind power
2. Solar power
3. Hydro-electric power
4. Geo-thermal power
5. Wave (tidal) power
6. Bio-fuel production and usage
7. Nuclear power
Page 58
8. Carbon capture and storage - capturing emissions (e.g. from traditional coal or gas-fired
burning power stations) and burying them in non-atmospheric reservoirs
Options 1 to 6 are commonly known as sources of renewable energy and fuel. There was a flurry of
interest and investment in renewable energy sources when world oil and gas prices surged in 2007 and
2008. But the global economic recession has brought down the prices of fuels to less than half of what
they were a few years ago and the economic incentives for investment in clean energy appear to have
worsened because of the recession. Clean energy investment has suffered because:
 Prices for standard sources of energy have fallen back

 Renewable energy sources have low running costs but high fixed costs – without production on
a large scale it is difficult to achieve the economies of scale needed to bring down the unit
costs of supply and make renewable energy economically viable
 Dirty sources of energy remain cheap to get out of the ground and sell. The global recession
has brought down the price of carbon allowances (e.g. under the European ETS) and this has
sent a damaging price signal to those contemplating investing in alternative energy sources
 Many businesses who have looked to invest in clean energy projects suffered from the credit
crunch. BP for example cut investment from $1.4bn in 2008 to less than half of this in 2009
“Getting an agreement to reduce emissions was only one problem. How to ensure that countries met
their agreements was an even bigger issue. Breaking an international commitment to reduce carbon
emissions simply involves having to make bigger cuts in emissions in the next round of negotiations.
Economists have suggested that the issues surrounding reaching international agreements to bring
about a reduction in emissions can be explained in terms of a range of different market failures.”
This section focuses on some of the environmental market failure issues linked to attempts to find
effective, efficient and politically acceptable ways forward to cut emissions year on year.
There are many market failures connected to the climate change debate – these include:
 Externalities specifically greenhouse gas externalities and other emissions contributing to

global warming
 Missing markets for scarce environmental resources leading to the tragedy of the commons
 Other public goods issues with the environment including the free-rider problem from those
countries that opt to allocate resources towards cutting emissions
 Information asymmetries and other forms of information failure including information gaps
among consumers about the consequences of their consumption decisions for the
environment
 The impact of climate change and other environmental problems on the distribution of
income and wealth within and between countries
Market failure occurs when the price mechanism fails to deliver an efficient or equitable allocation of
resources. Allocative efficiency occurs when the price charged for a product equals the marginal social
cost of production. If a market does not price an externality correctly there is a loss of allocative
efficiency and this leads to a loss of economic and social welfare and can have severe distributional
consequences. Poorer people in both developed and developing countries are often those worse
affected by the consequences of climate change.
The standard externalities diagram might be used to show the external costs from pollution or the
social costs of coping with some of the effects of man-made climate change
Page 59
Externalities
Externalities are
are costs
costs or
or benefits
benefits inflicted
inflictedupon
upon aathird
third party
partyoutside
outside ofof aa market
market transaction,
transaction,
caused
causedbyby either
either under-
under-oror over-allocation
over-allocation ofof resources
resources to
to aaparticular
particular product.
product.
The Tragedy of the Commons
Environmental assets are public goods which are not usually exchanged on markets. Therefore no price
emerges to signal relative scarcity and change behaviour. There may be big free-rider problems for
resources that are exposed for all to use which leads to a suboptimal over-consumption of a resource –
the long term destruction of endowments is inevitable without government intervention.
The tragedy of the commons is when private firms try and exploit common goods, which leads to
overproduction of the good that is unsustainable - the result of individuals exploiting the resource for
their own (rational) self-interested aims (i.e. Private profit) can be a permanent depletion of the
resource for all. Examples f the tragedy of the commons include:
 Depletion of ocean fishery stocks

 Deforestation in Brazil and many other countries
 Over-extraction of ground-water
 Impact of rising population density
“Some countries, such as France, proposed that a failure to meet agreed targets should result in
trade sanctions and tariffs to provide countries with incentives to honour their commitments.
Developing countries, in particular, were opposed to such measures at a time of slow growth in
global trade. They argued that they lacked the capital to make the investments necessary to reduce
carbon emissions. Low levels of development made it difficult for them to reduce emissions. They
proposed that developing countries should receive increased capital flows from developed nations.
China called for the developed countries to contribute 1% of their GDP per year, about US$400
billion. The African Union asked for US$67 billion a year for Africa alone.”
This section links to extract 4 – it becomes difficult for countries to make progress in finding the finance
to push forward cleaner energy projects at a time of shrinking world trade and slower economic
growth. That said many countries have included specific environmental asset investments as part of
their fiscal stimulus programmes – both China and the United States are good examples of this.
Capital shortages?
The extract mentions that developing countries (in general) lack the capital to make the required
investments. Presumably this refers to the impact that lower per capita incomes has on the supply of
savings and loanable funds. And also less well developed financial institutions and systems for
allocating financial capital to environmental investments. The world’s leading finance houses certainly
have a role to play as asset managers in putting together project financing for the development of the
technologies in developing countries and in particular raising enough debt and equity capital to fund
clean tech companies.
Funds from within developing nations
The reality is that hundreds of billions of dollars are actually available to fund clean fuel and clean
energy technologies. There are many pension funds, private-equity investors, and hedge funds looking
for appropriate investments providing that they can produce a sufficiently attractive risk-adjusted rate
of return (the key to unlocking private sector investment). And the extract fails to mention to potential
Page 60
importance of funds from within developing nations that can be harnessed to make a difference –
many of the fast-growing developing countries with access to and exports of valuable primary
commodities or successful in exporting manufactured products to developed countries have created
sovereign wealth funds.
The poorest countries are rationed in terms of their pool of domestic savings – but there is huge scope
for the richer developing nations accumulating vast foreign exchange reserves to provide investment
funds for poorer countries. Some are already doing so, although the extract makes no mention of this.
Emissions reduction policies
If targets had been agreed at Copenhagen, individual governments would need to make policy
decisions on how best to achieve these targets. There are three options:
1. Regulation
2. Carbon-pricing
3. Subsidies
Regulation has a role to play, particularly where markets do not work well. But regulation on its
own, however, is unlikely to be able to deliver the reductions in carbon emissions the IPCC estimates
require. Economists generally argue that carbon pricing is a much more effective and efficient
method of reducing carbon emissions. The only large-scale attempt to use carbon pricing is the EU’s
Emissions Trading Scheme (ETS), set up in 2005. A study by the Massachusetts Institute of
Technology concluded that, in its first three years, the ETS had reduced carbon emissions by between
120 million and 300 million tonnes. This meant that emissions were 2–5% a year lower than they
would have been without the ETS. In comparison, regulation and subsidies are either ineffective or
subject to government failure. Most notable has been the policy to subsidise the production of crops
for bio-fuels in the USA which has raised global food prices, yet had little impact on carbon
emissions.
This section of the extract revolves around the main policy options for reaching C02 emission reduction
targets. Three main options are mentioned – we will go through each in turn:
Regulation:
“Regulation has a role to play, particularly where markets do not work well”
Governments in richer and poorer nations often like laws and regulations because on the surface they
appear to carry few costs and can change the behaviour and people and businesses without the
apparent distortion of market prices. Examples of regulations might include:
 EU laws on maximum C02 emissions for different makes of vehicle per km travelled.
 Brazil introducing regulations requiring industries to phase out the use of fossil fuels
 In the UK - tougher regulations on the energy efficiency of many household appliances, and a
possible phasing out of all lighting which does not use low-energy bulbs.
 Regulations requiring power companies to generate a certain % of the power they sell from
renewable sources
Regulations enforced properly can often act as a spur to innovation and investment by the private
sector of the economy. The joint ventures by leading EU car manufacturers to develop fuel efficient
engines are examples of when this can work. But regulation also carries risks and costs:
Page 61
 Dangers of regulatory capture (government failure) if policy if affected by lobbying from those
affected
 Monitoring: Monitoring emissions of polluters can be costly and difficult
 Penalties: Penalties for violations must be significant enough to dissuade firms from ignoring
legislation – often they are insignificant and do little to change behaviour
 Competitiveness – the burdens of regulation / red tape can increase costs and – if applied by
only one country – damage the competitiveness of domestic businesses and perhaps cost jobs
“Economists generally argue that carbon pricing is a much more effective and efficient method of
reducing carbon emissions.”
Economists like carbon pricing although they argue about which is the best approach for sending price
signals to both producers and consumers. The two main alternatives are
(i) Carbon trading such as that created by the European Union ETS
(ii) Introducing a carbon tax on goods and services
Carbon trading
Carbon trading seeks to create incentives to reduce pollution. The EU carbon trading scheme operates
through the allocation and trade of CO2 emissions allowances. It creates a market in the right to emit
C02 where one allowance represents one tonne of C02 equivalent. A cap is set on the emissions – this
creates the scarcity required for the market and allows a price to emerge. At the end of each year
businesses within the scheme are required to ensure they have enough allowances to account for their
installation’s actual emissions. There are heavy fines for those without such permits.
The aim of carbon trading is to create a market in pollution permits and put a price on carbon. In this
way, policy can help internalize some of the environmental costs of firms’ production and encourage
lower emissions to tackle climate change. In a cap and trade system, the volume of permits would
gradually decline. As the price of the permits rises, so the economics of investing in cleaner
technologies will change. The hope is that businesses will find ways of reducing c02 emissions in the
most efficient way possible – therefore mitigating the flow of c02 in the least-cost manner. Cap and
trade is designed to
 Reward efficiency – e.g. those businesses that are pollution efficient

 Reward action – e.g. investment in lower-carbon cleaner factories and production processes
 Reduce pollution without damaging the competitiveness of European businesses
A supply and demand diagram to show how emissions trading works might be as follows:
Page 62
Permit Price (Euro per tonne of C02) EU Carbon Trading Market in Theory
Supply 2012 Supply 2010
Price 2012
Demand 2012
Price 2010
Demand 2010
Cap Cap Quantity of Permits

2012 2010
Carbon offset schemes can also complement the trading scheme – for example the ETS can be used to
finance environmental projects in developing countries through the Clean Development Mechanism. A
recent article in the Economist mentioned projects such as a forestry project in Indonesia (to combat
deforestation) and wind turbines in India as examples.
The theory of carbon trading is quite straightforward but the EU scheme has come under attack from
many directions.
1. The system has suffered from government failure because of the over-allocation
of carbon quotas and national freedom to allocate carbon permits. Allowances
were handed out for free rather than being auctioned off
2. In recent times, the carbon price has collapsed with the effect of driving up the
demand for coal fired energy! – A dirtier fuel! (this is an example of the law of
unintended consequences)
3. Carbon prices have fallen further because of the recession hitting EU economy.
The recession has caused reductions in output in steel, paper, cement and glass
and a sharp decline in production has led to a sell-off of carbon credits
4. That has caused a big drop in the market value of carbon permits from Euro 35 to
Euro 9 - there is less incentive for companies to stop polluting and there are fears
for the future of many clean energy projects. Some economists have called for a
minimum price to be applied to the carbon market.
Put simply the current EU carbon price is too low to drive sufficient innovation and investment. Many
clean technologies need a very high carbon price to be economic and this has not yet happened. The
Copenhagen Summit did little to promote the expansion of international carbon trading schemes.
Page 63
Permit Price (Euro per tonne of C02) EU Carbon Trading Market in Theory
Supply 2012 Supply 2010
P2012
P2010 Demand 2010
Demand 2012
Cap Cap Quantity of Permits

2012 2010
Carbon taxation
A carbon tax is a specific tax on the consumption or production of goods and services which cause
carbon dioxide emissions. The main arguments for a carbon tax include:
1. A tax creates specific price on carbon – there is less uncertainty than emissions-trading
2. It is a classic way of internalizing externalities (i.e. making the polluter pay) - the tax would
raise the marginal cost of the cO2-emitting activities, up to the point that the marginal
social cost of abatement is equated to the marginal social benefit from these activities
3. Incentive for firms to lower emissions and for consumer behaviour to change
4. A tax can be phased in and can be revenue neutral (i.e. other taxes can be cut – perhaps
employment taxes)
5. Revenue generated can be “ring-fenced” and then recycled – i.e. spent on environmental
initiatives including research projects in low-carbon products
Carbon pricing is not a cost-free option – some of the tricky issues include:
 Who to tax and how much to tax when carbon emissions are difficult to measure?
 Costs of compliance (administration) and the risk of tax evasion
 Possible regressive effects on lower-income families (when carbon taxes are passed on in
prices) – for example if a carbon tax caused household energy bills to rise
 Less certainty about the effect on quantity of emissions than a trading scheme
 Countries that do not introduce a carbon tax may free ride on some of the benefits i.e. they
enjoy a reduction in CO2 emissions without imposing their own tax
 Would politicians be prepared to raise the carbon tax sufficiently high to reduce emissions?
Subsidies and the environment
“Regulation and subsidies are either ineffective or subject to government failure. Most notable has
been the policy to subsidise the production of crops for bio-fuels in the USA which has raised global
food prices, yet had little impact on carbon emissions.”
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Subsidies can be a positive force for good in reducing the cost of supplying renewable energies and in
providing consumers with incentives to switch to lower-carbon products. But as the extract mentions
they can also have unintended and costly consequences for the environment and for society as a
whole.
Bio- fuels: The move towards growing crops that can be used as bio-fuels in the developing world
shifted in production away from foods towards fuel and had a knock-on effect in world food markets.
High food price inflation created an enormous problem of food poverty and associated malnutrition in
many of the world’s poorer countries and also hit the real living standards of those in relative poverty
in advanced countries. It also provided windfall gains to farmers in rich countries and recent studies
have claimed that the use of bio-fuels has made little or no difference to total C02 emissions. The bio-
fuel subsidies are an example of government failure.
Global Food Prices

Weekly index, 2000 = 100
300 300
275 275
250 250
225 225
Index
200 200
175 175
150 150
125 125
100 100
05 06 07 08 09 10
Source: Economist Commodity Price Index
Other subsidies may have stronger environmental benefits
1.
Tax relief on research and development on second generation bio-fuels
2.
Payments to consumers for spending on energy efficiency such as home insulation
3.
Subsidy payments to farmers in developing countries to reduce deforestation
4.
Subsidies to encourage investment in wind turbines and solar power
5.
Direct subsidies to local authorities to provide charging points for electric cars
6.
The German government favours feed-in-tariffs as a way of stimulating investment in
renewable energies
China – the environment and sustainable growth
There is a lengthy section on China in the final section of extract 5. The extract raises a number of
important issues:
Page 65
China, the world’s largest emitter of greenhouse gases, is central to the achievement of any global
agreement on cutting carbon emissions. Previously, China has resisted cuts in its emissions, arguing
that it unfairly limited its economic development. It would seem that China is now more committed to
taking action to ensure sustainable development. It has moved away from the single minded pursuit of
economic growth. Part of the reason for this change in approach to economic development has been
the undeniable economic and social impacts from increasing air and water pollution in China. Another
is the financial capital it has received under the Kyoto Protocol to enable it to produce clean energy and
introduce cleaner technologies in general.
In addition, China can see benefits in a shift to more sustainable development. According to Hu Angang,
an economist at Tsinghua University, sustainable development provides: “a huge opportunity for China.
The country will become the largest renewable-energy market, bio-energy market, clean-coal market,
nuclear-power market, carbon-exchange market, environmental technology market, low-carbon
economy, exporter of low-carbon products and low carbon- technology innovator.” Because of its level
of development, China may lack the capital and technology to take advantage of these opportunities
for sustainability. However, it has an abundance of cheap labour and a political system which allows it
to take into account the long term benefits and costs of sustainable growth.
There is a lot in this final section. At the heart of the passage is a shift in the approach taken by the
Chinese government towards mitigation of the effects of climate change and a greater emphasis given
to sustainable development.
Page 66
China's Economic Growth Compared

Annual percentage change in real national output
15.0 15.0
12.5 12.5
10.0 China 10.0
7.5 7.5
India
5.0 USA 5.0

Percent
UK
2.5 2.5
0.0 0.0
-2.5 -2.5
-5.0 -5.0
-7.5 -7.5
00 01 02 03 04 05 06 07 08 09
Source: IMF
 Volatile weather: China has become increasingly aware of the impact that more volatile
weather patterns is having on its economy. That includes episodes of drought in the north west
and floods in the south east
 Major pollution problems: Including surface and coastal water pollution and overwhelming
evidence of the social costs of air pollution in many of China’s towns and cities and industrial
complexes
 Global influence: China’s rise as a global economic superpower (analysed for example through
the BRIC analysis developed by Jim O’Neill and his team at Goldman Sachs) also gives it a new
responsibility in international affairs.
 Energy dependence: China’s continued economic growth requires huge increases in supplies of
energy and many inside China’s political elite are worried about a growing dependence on
fossil fuels – there is a political imperative to diversify energy sources and find cost efficient
renewable sources - China plans to ramp up wind and solar power, so that they meet 20% of its
energy needs by 2020
 Funding: The Clean Development Mechanism has given China over $2bn already for
investment in cleaner energy and industrial processes and more money is expected from this
scheme. China also has huge foreign exchange reserves at her disposal after years of running
up big trade surpluses.
 Export potential: We tend to think of Western advanced nations dominating the flow of
investment and lower-carbon technology products exported from developed to developing
countries. China sees huge opportunities to develop and scale up their own domestic low
carbon technology and then export it to the West. These exports will be a source of future
growth and help to maintain GDP growth at or around the minimum 8 per cent target set by
the Chinese government. They will seek to create a comparative advantage in clean energy and
exploit the benefits – not least in creating millions of new jobs in ‘green industries’.
Add these together and China see’s long term political, social and economic benefits from lowering
Page 67
energy dependency and increasing energy efficiency (defined by the Chinese as energy consumed per
unit of GDP produced). A recent article in the Guardian reported that China could spend up to $600bn
on clean power over the next decade - or the equivalent of its entire military budget every year for
each of the next 10 years.
In March 2010 a BBC news article reported that
“China overtook the US during 2009 to become the leading investor in renewable energy technologies,
according to a new analysis. Researchers with the Pew Charitable Trusts calculate that China invested
$34.6bn (£23.2bn) in clean energy over the year, almost double the US figure. The UK emerges in third
place among G20 nations, followed by Spain and Brazil. Investing in clean energy can renew
manufacturing bases, and create export opportunities, jobs and businesses.”
This article cements one of the key points in extract 5 – that China regards a shift towards investment
in renewable energy as a stronger driver of long term economic growth because it boosts both
aggregate demand and long run aggregate supply. Expect China to become one of the world’s major
exporters of green technology in the years to come – it is moving well beyond being the workshop of
the world.
China, Gross Capital Investment

Investment at current prices
15.0 15.0
12.5 12.5
10.0 10.0
CNY (thousand billions)
thousand billions
7.5 7.5
5.0 5.0
2.5 2.5
0.0 0.0
78 80 82 84 86 88 90 92 94 96 98 00 02 04 06 08

Some of the policies introduced by the Chinese relate to strategies mentioned earlier in this extract:
1. Tighter vehicle fuel-efficiency targets
2. Subsidies for electric vehicles
3. Doubling the size of subsidies for renewable energy compared to those for coal
We can link this focus on sustainable development to the issues raised in Extract 2. China has launched
an enormous fiscal stimulus programme to keep her economy growing during the global financial crisis.
A total of 210bn Yuan of the stimulus money is earmarked for environmental protection projects and
improving energy efficiency.
Page 68
Exam Practice – A Selection of Suggested Questions
 The exam paper last two hours and that there are sixty marks available.
 In terms of allocating your time you have approximately 2 minutes per mark but keep in mind
that the higher marks are reserved for analysis and evaluation so don’t spend too long on the
shorter questions.
 You may also be eligible to receive extra time in the exam
 All questions are compulsory
Structure of the questions:
 Q1a – 4
 Q1b – 6
 Q1c – 10
 Q2a – 4
 Q2b – 6
 Q2c – 10
 Q3 – 20
Levels of response
(i) 4 mark questions require Levels 1/2 and tend to be ‘explain…’

(ii) 6 mark questions require Levels 1/2/3 and tend to be ‘analyse…’
(iii) 10 mark questions require Levels 1/2/3/4 and tend to be ‘comment on…’
(iv) 20 mark questions require Levels 1/2/3/4 and tend to be ‘discuss…’
Questions usually (but not always) follow the order of the extracts so potentially you could expect the
first 10 marks on Extract 1, 10 marks on Extract 2 etc… and 20 marks on the final extract. Best
Economists will be flexible in the exam and use, analyse and evaluate the full Economist’s toolkit of
concepts and ideas.
Here is our selection of questions for each extract – we hope they might be useful in preparing for the
exam and in stimulating discussion points about the pre-release materials.
Extract 1:
a. Explain the economic cycle

b. Distinguish between an recession and a depression
c. Explain the causes of an economic recession
d. Analyse the multiplier and the accelerator
e. Explain the ways in which a recession may come to an end
f. Using an aggregate demand and supply (AD/AS) diagram explain what can cause an
economy to experience a recession
g. Analyse two chosen macroeconomic policies to stimulate growth / recovery
h. Comment on the extent to which the Bank of England’s policy of ultra-low interest
rates has worked in stabilising the economy
Page 69
i. Define quantitative easing

j. Explain how quantitative easing works
k. Analyse the likely effects of quantitative easing on the UK economy using aggregate
demand and supply curves
l. Explanation how an economic recession can cause changes in government spending
and tax revenues
m. Analyse the effects of a rise in the discretionary budget deficit on the economy using
AD/AS and comment on the importance of the fiscal multiplier
n. If the UK had joined the euro, do you think the country would have fared better during
the recession?
o. Discuss the extent to which a recession on the supply-side of the economy is crucial in
determining the sustainability of a demand-led recovery?
Extract 2
a. Explain two possible relationships between the macro objectives shown in Fig 2.1
b. Explain the difference between a cyclical and discretionary budget deficit
c. Explain the difference between a budget deficit and the national debt
d. Comment on the limitations of using very low interest rates as a way of helping an
economy deep in recession
e. What will determine the size of the multiplier effects arising from the fiscal stimulus
policies introduced by the UK government
f. Analyse the possible “crowding-out” and “crowding-in” effects from higher
government spending and borrowing
g. Comment on why the government has introduced fiscal rules such as the Golden Rule
and Sustainable Investment Rule
h. To what extent have the UK and many other EU countries made the right decision in
choosing to break their fiscal rules during this recession?
i. Analyse the methods by which countries with large fiscal deficits can bring their
borrowing under control
Extract 3
a. Distinguish between fixed and floating exchange rates

b. Explain how exchange rates are determined in a floating exchange rate system
c. Explain the functions of the International Monetary Fund
d. Illustrate a depreciation of the pound on a supply and demand diagram. What are the
factors that could cause this?
e. Using an aggregate demand and supply diagram, analyse the likely effect of a
depreciation of the value of sterling against the dollar and the euro
f. Explain some of the possible benefits / problems of Euro membership for newer EU
states such as Slovenia and Slovakia
g. Analyse why ‘fixers’ such as Latvia and Estonia had worse economic performance than
‘floaters’ such as Poland and the Czech Republic during the recession
h. Explain some of the causes and effects of BOP / current account problems that have
affected countries such as Latvia and Lithuania
Page 70
Extract 4
a. Explain what is meant by protectionism

b. Explain two different methods of protectionism
c. Explain the role of the World Trade Organisation
d. Explain what is meant by dumping
e. Analyse the effects on the Chinese economy of an import tariff on car parts
f. Who gains and who loses from protectionism?
g. How can reducing trade barriers and thereby reducing the price of imports help a
developing country?
h. Analyse the possible effects of a revaluation of the Chinese yuan for (a) China and (b)
China’s trading partners
i. Analyse (using AD/AS) and the possible consequences of ‘world trade falling by 15%
during 2009’ – does this mean the end of globalisation?
j. “Tariffs and other forms of protectionism risk a country sacrificing medium-term
growth opportunities for near-term economic interests” Do you agree with this
statement?
k. Comment on the likely effects of a return to economic nationalism for the future
performance of the world economy
l. Discuss the extent to which less developed countries and more developed countries
should adopt policies to protect their domestic industry during a recession
Extract 5
a. Distinguish between economic growth and sustainable economic growth

b. Why might a rise in GDP result in a decline in human well-being?
c. Does it matter that the carbon price fluctuates with the business cycle?
d. Explain why the poorest African countries may find it difficult to finance investment in
alternative energy supplies
e. Analyse the benefits that might occur if developed nations agree to increase funds for
developing countries to investment in green technology
f. Discuss the methods that might be used to reduce carbon emissions
g. What incentives exist for countries to agree to tough pledges to reduce emissions?
h. Assess whether or not the EU emissions trading scheme has been a success so far
i. Compare the relative merits of a cap-and-trade scheme with carbon taxes
j. Why is tackling climate change politically difficult for (a) individual countries and (b)
the world as a whole? How is game theory relevant to your analysis?
k. What other alternatives are there to cap and trade and carbon taxes as means of
curbing emissions? Compare their relative merits
l. Comment on the decision by China to use investment in renewable energy to promote
economic growth and sustainable economic development
Page 71
Opportunities for diagrams to support your analysis and evaluation

This pre-release stimulus material provides lots of opportunities to use the economist’s toolkit of AS
and A2 concepts (both micro and macro!) and also to introduce diagrams into your writing. Here is our
selection of some of the diagram opportunities but I am sure you will be able to think of more!
Extract 1
 AD/AS diagram to show the causes and effects of the recession

 AD/AS diagram to show the effects of an external shock such as the credit crunch and/or a rise
in world oil and energy prices
 Economic cycle diagram to show the output gap at different stages of the business cycle
 AD/AS diagram to show the possible effect of the recession on long run aggregate supply and
the economy’s productive capacity
 A labour demand and supply diagram to illustrate the impact of recession on employment
Extract 2
 AD/AS diagram to show the effect of a fiscal stimulus programme and/or cuts in interest rates
on national income and prices
 Loanable funds diagram to show the possible effects of rising government borrowing on
interest rates / possible crowding out effects
Extract 3
 Supply and demand diagram to show the forces that might cause a currency to depreciate in
the foreign exchange market
 Phillips Curve diagram when discussing the inflation and unemployment rates achieved by six
of Europe’s newer member states
 AD/AS diagram to show the possible effects of significant levels of foreign direct investment
into economies such as Poland, Hungary
Extract 4
 Supply and demand diagrams to show the effects of import tariffs and export subsidies and
import quotas
 Game theory matrices showing possible pay-offs to co-operative and defective strategies when
countries become embroiled in a trade war
 AD/AS diagram to illustrate the possible effects on an economy when tariffs are introduced on
products such as steel, cars, car parts and foodstuffs
Extract 5
 Externalities and market failure diagram

 Supply and demand diagram to show the effect of a pollution tax on prices and output
 Supply and demand diagram to illustrate how a carbon trading market might work
Page 72
 AD/AS diagrams to show the effects of increased investment by developing countries such as
China on renewable energy projects
Suggestions for further reading and research
Extract 1: Longest and deepest recession since the 1930s
 BBC news articles on the global car industry

 BBC special reports on the global economy
 Businesses and the UK economic recession (Tutor2u blog articles)
 Guardian special articles on recession
 The story of the BRIC economies (Financial Times)
 Tutor2u blog articles on the UK economy
 UK economy – the recession (BBC news special reports)
 UK economy – the recovery (BBC news special reports)
 UK economy tracker (BBC news website)
 UK trade deficit widens to biggest in 17 months (BBC news, March 2010)
 Unemployment set to peak in 2010 (Guardian, December 2009)
Extract 2: Fiscal rules broken
 Bank of England halts quantitative easing (Guardian, February 2010)

 Economists back delay on government spending cuts (BBC news, February 2010)
 Economists urge swift action to reduce budget deficit (BBC news, February 2010)
 Forget cuts and keep spending, Brown told (Independent, February 2010)
 Guardian special articles on quantitative easing
 The cost of the financial meltdown: Deficits and spending (BBC news special report)
 Tutor2u blog articles on fiscal policy
 Tutor2u blog articles on Keynesian economics
 Tutor2u blog articles on monetary policy
 UK government finances (BBC Budget 2010 coverage)
 UK government spending (BBC Budget 2010 coverage)
Extract 3: Fixers and Floaters
 European Monetary Fund: What might it look like? (BBC news, March 2010)
 Greece faces devaluation, default or deflation. Next stop the IMF (Guardian, February 2010)
 Greece's government unveils major spending cuts (BBC news, December 2009)
 Guardian special articles on currencies
 Kaletsky on the benefits of a weak pound (Tutor2u Blog, March 2010)
 Latvia economy reels in recession (BBC news, February 2010)
 Latvia to seek support from the IMF (BBC news, November 2008)
 Lithuania's economy shrinks 12% (BBC news, April 2009)
 Poland launches economic stimulus package (BBC news, November 2008)
Page 73
 Revision presentation on fixed versus floating exchange rates (Tutor2u)

 The wider financial impact of southern Europe's Pigs (The Observer, March 2010)
 Tutor2u blog articles on exchange rates
Extract 4: The return of protectionism
 Buy America clause dangerous (BBC news, February 2009)

 China aims for 10pc growth and won't appreciate yuan (The Australian, December 2009)
 China and the other BRICs will rebuild a new world economic order (Observer, Jan 2010)
 China continues its unstoppable economic charge (Independent, January 2010)
 China to put duties on US chicken imports (BBC news, February 2010)
 China warns against protectionism (BBC news, February 2009)
 Economist Big Mac Index
 How to Buy American web site: http://howtobuyamerican.com/index.php
 Is China exporting its unemployment? (BBC World Business News, March 2010)
 Small island for sale (foreign takeovers and the UK economy) (Economist, March 2010)
 The dangers of trade protectionism (BBC news, February 2009)
 The US-China trade war is here (Business Week, December 2009)
 Tutor2u blog articles on the Chinese economy
 Tutor2u blog articles on trade and protectionism
Extract 5: Making economic growth and development sustainable
 BBC news special reports on the Copenhagen Summit

 Can we go 100% renewable? (BBC news, December 2009)
 Carbon trading – does it really reduce emissions? (BBC news, November 2009)
 China promises economic stimulus plan will protect environment (Guardian, June 2009)
 China steams ahead on clean energy (BBC news, March 2010)
 China 'unfairly seen as eco-villain' (BBC news, June 2009)
 China unveils emissions targets ahead of Copenhagen (BBC news, November 2009)
 China’s economy surges into 2010 (Tutor2u revision presentation, January 2010)
 China's climate policy shift (BBC news, September 2009)
 Copenhagen deal – key points (BBC news, December 2009)
 Copenhagen fails green investors (BBC news, December 2009)
 Economics and the environment: Down to earth index (Guardian, December 2009)
 Economists hail EU emissions trading success (Business Green, February 2010)
 EU announces climate change package (BBC news, November 2009
 European Climate Exchange
 Europe's failing carbon emissions trading system (The Ecologist, July 2009)
 GDP is a misleading measure of wealth
 Guardian special articles on carbon emissions
 Guardian special articles on emissions trading
 Revision presentation on market failure and the environment (Tutor2u)
 Tutor2u blog articles on environmental economics
 Wind farms and polluted skies: the great paradox of China (Guardian, August 2009)
Page 74
Page 75

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OCR 585 June 2010 Exam

Tutor2u’s Revision Toolkit for the

Pre-release Materials for the June 2010 Sitting

Head of Economics, Eton College

Introduction to the Case Study..................................................................................................................3

Introduction to the Case Study

Economic cycles Extract 1:

Economic growth in a selection of OECD countries

Australia United Kingdom Spain

Economic growth in a selection of countries 2008 2009 2010

World output 3.0 -0.8 3.9

Newly industrialized Asian economies 1.7 -1.2 4.8

The Economic Cycle - Growth in UK National Output

Source: UK Statistics Commission

UK Real National Output

Source: Reuters EcoWin

Extract 1: Longest and deepest recession since 1930s

Extract 1 Text and Comments

 An upturn in consumer and business confidence

of activity in the freight industry.

UK Economic Growth and Unemployment

10.0 Unemployment (% of the labour force, LFS) 10.0

Source: UK Statistics Commission

Inevitably, commentators drew comparisons between macroeconomic performance in the UK and

1. Maintaining price stability (low, positive rates of inflation)

UK and Euro Area Growth

House Prices and Consumer Confidence

Construction Sector Confidence and Housing Starts

What are the main policies used to stimulate growth?

represents an attempt to use an expansionary monetary policy to stabilise confidence and

 Aggressive de-stocking: Many businesses responded promptly to the downturn in demand by

a movement back along the short-run aggregate supply curve

Redundancies in the UK Economy

Changes in stocks and the UK economic cycle

Source: Reuters EcoWin

Value of UK Capital Investment Spending

Source: UK Statistics Commission

Focus on the UK car industry and stimulus policies

Recession and the UK Car Market

The UK motor industry was especially vulnerable to the recession:

United Kingdom Passenger Car Production

Cash for clunkers

UK Consumer Spending on Purchase of Motor Cars

Source: Reuters EcoWin

Interest Rates for the Euro Area and for the UK

Euro Zone Interest Rates

Economic effects of lower interest rates

The Liquidity Trap

The Cost of Borrowing Money in the UK Economy

6.0 Mortgage rates 6.0

Quantitative easing is best described as an “unconventional” approach to monetary policy working

Interest Rates on 10-year UK Government Bonds

4.25 Quantitative easing programme started here 4.25

Euro - Sterling Exchange Rate

Dollar-Sterling Exchange Rate

Economics effects of a depreciation in the exchange rate

Using an expansionary fiscal policy

Net Government Debt and UK Budget Surplus/Deficit

UK Government Spending and Taxation

Total Government Spending

Total Tax Revenue

Source: OECD World Economic Outlook