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AS MACROECONOMICS NOTES
Unit 1 Macroeconomics (National income accounting)
National income measures include;
GDP (Gross Domestic Product)
GNP (Gross National Product)
NDP (Net Domestic Product)
NNP (Net National Product)
Topic 1 GDP:
It is the total money value of all final goods and services produced within geographical
boundaries of a country over a year.
What GDP includes/excludes:
1 Only money value
2 Produced in a particular period e.g., a year
3 Produced within the boundaries of the country including MNCs output
4 Official trades only (Excludes hidden/black economy)
5 Includes earned incomes e.g., wages, rent etc., but excludes transfer payments e.g.,
pensions, unemployment benefits etc.
Topic 2 Refining GDP:
GDP to GNP/GNI (Gross National Product/ Gross National Income) GDP + Net
property/Factor income from abroad. We add incomes earned by domestic citizens
from abroad and subtract incomes earned by foreigners domestically.
An economy may be an open economy which has four sectors i.e., households, firms,
government and international trade sectors. For an open economy there will be a
difference between values of GDP and GNP/GNI as mentioned above.
For a closed economy which does not have international trade sector, value of GDP and
GNP/GNI will be then same as there will be NO inflows of money from and outflows of
money to other countries.
From GDP to Net Domestic Product
GDP – Depreciation on capital
Depreciation is the wear and tear and causes loss in value of a fixed asset
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NNP/NNI (Net National Product/Net National Income)

GNP – Depreciation on capital. This is referred to as national income
NYd (Disposable National Income)
NNP – Direct Taxes (such as Income tax) + Transfer payment

Topic 3:
Nominal VS Real GDP:
Nominal GDP is calculated at current year prices and includes inflation in it.
Whereas Real GDP is calculated at base year prices and has been adjusted for inflation.
Calculating Real GDP:
We use deflator formula to calculate real GDP,
Real GDP =
Nominal GDP/ Deflator (Current year Price index/Base year Price index)
Example:
2019 Nominal GDP = 100 million $
2020 Nominal GDP = 120 million $
Inflation Rate in 2019 was 10%
Deflator = 110/100 = 1.1 …
Real GDP = 120/1.1 = 109.09 million $
Topic 4
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2 Income method:
In this we add up the rewards of factors of production i.e., rent, wages, interest, profits
(distributed and undistributed), dividends etc.
Transfer payments such as pensions, unemployment benefits, scholarships etc. are not
counted because they are unearned incomes and merely transferred from earners to
non-earners.
3 Expenditure method:
We add up all expenditure by domestic citizens during a year on output produced. This
is aggregate demand (AD)
AD = C + I + G+ (X – M)
Consumption + Investment + Govt spending + Net export i.e., Exports - Imports
We ADD,
Subsidies as the reduce the price below the actual value of output
Exports value is added as they were produced in the country
Unsold stocks value
We subtract
Indirect Taxes as they raise the price above what was the value of output
Imports value is taken because they were not produced in the geographical boundaries
of the countries
If done properly
National income = national output = national expenditure
Difference between GDP at market prices and GDP at basic prices or factor cost:
GDP at market prices is simply the value of output at current year’s prices.
Whereas GDP at basic prices or factor cost is the actual payment made to the 4 factors
of production for making the output i.e., rent, wages, interest and profits.
GDP at market prices + Subsidies – Indirect taxes becomes GDP at basic prices or
factor cost.
This is because subsides reduce market price below the actual payment to factors of
production and indirect taxes raise the market price above the actual payment to
factors of production.
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Topic 5:
Circular flow of money in an economy (closed and open economies):
Before we analyze how incomes flow through households, firms, govt and international
economy, we need to understand various models of economies and their respective
sectors. We need to understand the concept of injections and withdrawals from the
circular flow.
Sectors of an economy:

Households Firms Government Net exports (X-M)

Consumption Investment Government Exports
Spending
X
Saving Taxes Imports
C, S I G, T M
As consumption is the original injection than generates the circular flow of incomes in
an economy, we will not treat it as a separate injection.
Types of Economies:
2 sector (No govt) closed (no international trade)
There are only two sectors in a closed economy with no government and they are
Households and Firms
I (Injection)
S (Withdrawal)
3 Sector closed economy:
There will be three sectors in such an economy i.e., Households, Firms and Govt. There
will no international trade sector (Net Exports).
I + G (Injections)
S + T (withdrawals/leakages)
3 Sector open economy (Includes international trade)
There be Households, Firms and International trade sectors, but no government in such
an economy.
I + X (Injections)
S + M (Withdrawals)
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4 sector open economy

This is the real world model with all 4 sectors Households, Firms, Govt and International
trade existing in it.
I + G + X (Injections)
S + T + M (Withdrawals)
Let’s analyze how incomes and money flows through the above-mentioned economies
via circular flow model in the diagram below.
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As seen in the above diagram households provide factor services to the firms and
receive rewards for those services i.e., rent, wages, interest and profit. These rewards
are spent by households on buying goods and services from firms. If the factor rewards
are equal to spending economy will be in equilibrium as circular flow of incomes will
stay at the same level. However, households save some of the earning which are
channeled through banks to firms again, hence in a 2-sector closed economy if S = I,
economy is in equilibrium and so on for 3 sector and 4 sector economies equilibrium is
where injections are equal to the withdrawals.
Injections (J):
Investment (I) by firms on;
1 Capital goods (machinery, roads)
2 Finished and semi-finished goods
Govt spending (G)
Exports (X)
J=I+G+X
Withdrawals (W)
Net Savings (S):
Savings – borrowing/dissaving (taking out of past savings)
Net Taxes (T):
Taxes – transfer payment (unemployment benefits)
Imports (M)
W=S+T+M
National income equilibrium/disequilibrium and return from disequilibrium to
equilibrium:
Equilibrium is when
Injections = Withdrawal
I+G+X=S+T+M
Disequilibrium is when J > W or W > J
If J > W = AD rises -> Incomes/profits/employment rises
S + T + M = W all rise till J=W back to equilibrium
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If W > J = AD falls -> Incomes/profits/employment falls, S+T+M falls till J=W back to
equilibrium (READ AGAIN FOR A2)
Withdrawals and injections diagrams
Withdrawals
Savings increase with income and are negative if income is less than consumption.
Therefore, savings curve will start from negative and it will slope upwards with the rise
in income as shown in the figure below;

As seen in the figure, below income level Y0, spending is more than income hence
saving curve starts from negative. This is called dissaving. At Y0, there is neither saving
nor dissaving as income is equal to spending. After Y0 level of income, saving is
positive as income is more than spending.
With the addition of other withdrawals like taxes and saving in a three and four sector
economy. The withdrawals curve shifts upwards from W2 to W3 and W4.
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Injections
Injections on the other hand are not dependent on national income as exports depend
on foreigners’ incomes, government spending depends on political and social
objectives and investment depends on businesses’ future expectations. As a result,
injections are taken as fixed with respect to changes in national income.
In a 2-sector economy, there is only one injection of investment (I), but with the addition
of government spending (G) and exports (X) in a 3 and 4 sector economy, the injections
(J) curve will shift upwards from J2 to J3 and J4 as shown in the diagram below;

In a 4-sector economy, national income equilibrium is at Y0 where W=J as shown in the

diagram below;

At Y1, J > W by area c to d, national income will rise. At Y2, W > J by area a to b, national
income will fall. At Y0, J = W, hence national income is in equilibrium with no tendency
of change.
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Changes in national income equilibrium

1. Increase in equilibrium national income
Equilibrium national income will change with the change is injections and withdrawals.
Income will move to a higher equilibrium if any injection increases or withdrawal falls.
Increase in injections
A rise in injections will result in an increase in production, income and spending, hence,
will cause a rise in GDP from Y0 to Y1 as shown in figure below;

Decrease in withdrawals
A decrease in withdrawals from W0 to W1, will increase national income as shown
below;
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2 Decrease in equilibrium national income

An increase in any of the withdrawals or a decrease in any of the injections will
decrease national income
Decrease in injections

Increase in withdrawals

Links between injections and withdrawals

There is an indirect link between savings and investment, taxation and govt spending,
and exports and imports through banks, govt and international trade.
If more money is saved, banks will have more money available to lend for investment to
firms. If tax receipts are higher, govt can spend more and lastly, if imports are more,
foreigners’ incomes will rise and they can buy more of our exports.
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These links however, do not guarantee that S=I or G=T or M=X. This maybe due to
banks lending more or less than savings deposited with them, govt might spend more
of less than tax revenue and so on for exports and imports. Therefore, planned
injections may not equal planned withdrawals.
Business Cycle:
These are the stages an economy through over time through changes in real GDP. They
happen automatically over time.

Economic Growth: This is when the real GDP rises over time.
Boom: When real GDP rises rapidly
Recession/downturn: When real GDP falls for at least 6 months or two quarters
Slump/trough: When real GDP keeps falling over an extended period of time
Symptoms:
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Topic 6 Very important:

Aggregate demand (AD): It is the total demand/spending on goods and services
produced within a country over a year.
AD = C + I + G + (X-M)
C = consumption I = investment G = govt spending X – M = Net Exports (Exports value
– imports value)
Why does AD curve slope downward? (MCQs)

This is due to three effects:

1) Real income (purchasing power) effect:
If price level falls, real income rises due to more purchasing power. People
increase consumption and it results in more AD and vice versa.
2) International trade effect:
When price level falls, exports will become cheaper and their demand will
increase in international market. This will increase the value of X-M and
consequently AD will extend and vice versa.
3) Interest Rate effect:
When price level falls, people can buy more and demand for loans falls. Banks
will reduce interest rate. This will increase consumption and investment causing
AD to extend and vice versa.
Shifts of AD curve:
This is because of changes in one or more components of AD i.e., C + I + G + (X-M).
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Consumption:
Consumption is affected by changes in incomes, Direct taxes, Interest rate, Population
and future confidence of consumers etc.
Investment: (firms spending on capital goods)
It is affected by changes in interest rate, subsidies, future confidence for firms,
population etc.
Govt spending:
Govt may change its’ spending due to political reasons and economic conditions e.g.
more spending during recession and election, need for public and merit goods etc.
Net Exports:
The changes in net exports component can be due to changes in;
Exchange rate: if exchange rate falls, demand for exports will rise due to cheaper
exports. Demand for imports will fall as they seem expensive. X-M will increase and AD
shifts to right and vice versa. Protectionism (use of trade barriers e.g., tariffs, quotas
and export subsidies etc.)
If there is an increase in protectionism, X-M will increase and AD shifts to the right and
vice versa. Relative quality of exports and imports: Inflation and deflation also affect X-
M component of AD.
Topic 6 Aggregate supply:
It is the total supply or output of all goods and services produced in a country over a
year.
Short Run Aggregate Supply:
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SRAS curve slopes upwards due to 3 effects

1 Profit effect:
As price level rises, firms have more incentive of earning profit, hence they supply more.
There is an extension on AS curve from point a to b. and vice versa.

2 Cost coverage effect:

When price level rises, more firms start to supply as their cost of production is being
covered now.
3 Misinterpretation effect:
When price level rises, firms misinterpret the rise in prices with an increase in demand
for their products and start supplying more.
NOTE: AD and AS curves do NOT shift due to changes in price level. There is only a
movement along the curves called extension (for fall in price level) and contraction (for
rise in price level).
Shifts of Short run AS curve:
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Note: The reasons are exactly the same as micro shifts of supply curve (RIWINTS
factors)
R raw material prices
I indirect taxes
W wages
I interest rates
N natural disasters / good weather
T technology
S subsidies
Topic 7 National income determination in Short Run:
National income in short run is determined by interaction of AD and short run AS curves.

Note any changes in AD and/or AS will affect price level and real output as it was the
case in microeconomics market price and quantity.
Q Explain using AD and AS curves, how an increase in money supply and a decrease in
cost of inputs will affect national income and price level? (8)
K/U 2 Marks
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National income is the total value of all final goods/services produced within the
geographical boundaries of a country over a year. Price level is the inflation level in the
country.
Application 6 marks
3 for graph
3 for explanation
Money supply increase due to more spending by govt compared to the taxes they take
or due to more printing of currency etc. will increase peoples’ incomes and hence AD
curve will shift to the right due to more consumption. This will also inject more
investment into AD.
Decrease in cost of inputs will reduce firms’ cost of production. This will increase AS
because firms will be able to produce more. Refer to figure below;

As seen in the figure, initial equilibrium was at E0 and price level was P0 and real output
was at Y0. As a result of increase in money supply AD curve shifts to the right and due
to lower cost of inputs AS supply curve shifts to the right. Now Price level remains at P0
and national income/ real output increased to Y1.
Topic 8 Long Run Aggregate Supply (LRAS):
Long run AS curve is initially perfectly elastic as economy is below full employment (or
inside their PPC). Then it becomes inelastic as the economy reaches close to full
employment (or close to its’ PPC) as there is a shortage of resources e.g., skilled
workers or fertile lands etc. At the end it becomes perfectly inelastic as we are on full
employment (On PPC). This will give us a three-stage long run aggregate supply (LRAS)
curve.
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Another school of thought in Economics believe that an economy is always on full

employment level i.e., operating on its’ PPC. This will make the long run aggregate
supply (LRAS) curve perfectly inelastic.
Three-stage LRAS curve

Vertical LRAS curve

In both 3 stage and vertical LRAS curves the shifting factors are the same as PPC
shifting factors or in other words, government supply side policies.
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Unit 2
Price Stability
Inflation: It is the constant rise in general price level of goods and services in an
economy over a year.
Note: does not mean every product is becoming expensive. The representative basket
of goods and services is becoming expensive.
Degrees of inflation:
Mild/creeping inflation: 1% to 2% and is good for the economy
Hyperinflation: When price level rises very rapidly e.g., 20%, 100s%, 1000% and no limit.
This is very dangerous for an economy
High inflation reduces the real value of money or its purchasing power as consumers
can buy less with the same amount of money.

Disinflation:

This is when price level rises at a slower rate e.g., from 8% in year 1 to only 2% in year 2.
It means prices are still rising, but at a slower rate. It is not to be confused with
deflation.
Causes/types of inflation:
Demand-pull inflation:
It is due rise in AD and AS cannot be increased as economy is on full employment. Too
much money chasing too few goods.

Any injection in the components of AD i.e. C+I+G+(X-M) may cause AD to rise and if AS
cannot rise. There will be demand-pull inflation.
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As seen in the graph, initial equilibrium was E0, price level was P0 and GDP was Y0. As
AD rises to AD1, price level remained P0 as economy was below full employment, only
GDP increased to Y1. A further increase in AD from AD1 to AD2, caused price level to
rise from P0 to P1 as economy was nearing full employment, while real GDP increased
by more amount from Y1 to Y2.
Further rise in AD from AD2 to AD3, caused a greater increase in price level from P1 to
P2, whereas real GDP increased by lesser amount from Y2 to Y3 as economy has
reached full employment.
Further rise of AD from AD3 to AD4, only causes rise price level from P2 to P3 and there
is no increase in real GDP.
Factors causing rise in AD and demand-pull inflation:
Consumption:

Direct taxes reduced

Incomes rise
Population rise
Interest rate reduce
Investment:
Interest rates reduce
Future confidence increases
Subsides by govt
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Govt spending:
When govt needs to provide more merit/public goods
When unemployment is high
Political reasons
Net Exports:
Exchange rate depreciate/devalue: Reduced exchange rates will reduce export prices,
demand for exports will rises. Imports will become expensive, their demand will
fall. X-M will increase and demand-pull inflation will occur
Use of protectionism (trade barriers)
Quality of exports and imports
Cost-push inflation:
This is due rise in input (Factors of production) costs, this will increase cost of
production, AS falls and price level rises.

Factors causing cost-push inflation:

1 R raw material prices: Expensive raw materials will cause an increase in cost of
production, AS falls and inflation occurs.
2 I indirect taxes: Rise.. cost will rise, AS falls and cost-push inflation occurs
3 W wages: Rise … cost rises… AS fall… Inflation rise
4 I interest rates: If rise.. Cost of borrowing rises… cost of production rises and cost-
push inflation
5 N natural disasters:
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6 T technology worsens or shift to old technology.. cost rise… AS falls.. inflation

7 S removal of subsidies: Cost rise… AS fall ..Price level rise
8 Wage-Price spiral
Perhaps the most important cause of cost-push inflation is when workers in an
economy demand higher wages and it’s granted by the firms. This results in higher cost
of production for firms and they pass on some of this rise in cost to consumers in form
of higher prices.
Workers feel the real value of their income has fallen as they can afford less goods and
services even with the higher wage due to rise in prices. They demand more wages
again and this cycle continues causing more and more inflation until govt index links
their wages i.e., wages will be increased according to rise in inflation.

PPP Q) Explain how a fall in exchange rate of a country can cause both cost-push and
demand-pull inflation? (8)
K/U: ER + Cost-push +demand-pull define
App: 6 M
3 M for cost-push:
Devalued exchange rate means cost of imported items especially raw materials will
rise. Domestic firms importing raw materials will experience increase in cost of
production. AS will fall and cost-push inflation will occur as firms will pass the rise in
cost in form of higher prices.
Graph: Discretionary
3 M for demand-pull inflation:
Fall in exchange rate will make exports cheaper, demand for exports will rise in
international market due to increased international competitiveness.
Imports will become expensive and demand for will falls. X-M component of AD will
increase, causing demand-pull inflation if AS cannot rise.
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Q) Explain the difference in Cost-push and demand-pull inflation and one reason why
each may occur? (8)
K/U 2 marks cost-push + demand-pull inflation (define)
APP 6 marks
3 marks for cost push
A rise in wages due to trade union pressure or minimum-wage law will raise cost of
production, AS will shift to let and cost-push inflation will occur as producers will pass
on some of the risen to consumers.
Graph
3 marks for demand-pull inflation:
It may occur due to any injection in components of AD i.e., C+I+G+(X-M)
Let’s take govt spending for example. It may increase due to recession and high
unemployment in the economy and govt will rise its’ spending to increase AD. They may
also spend more to gain popularity closer to general elections or be providing more
merit and public goods to raise living standards etc. All of this will shift AD to the right
and if economy is near or on full employment, demand-pull inflation will occur.
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Topic: interpreting inflation from graphs

1 In which year inflation rate was highest? 2015

2 which year deflation started? 2016
3 When was the price level/ price of good highest? 2016
4 When was the price level/price of good lowest? 2009
Topic: How is inflation measured?
We use a consumer price index (CPI) to measure inflation. It is a measure of year on
year changes in price level in index form.
Steps in constructing CPI
1 Selecting a current year, i.e. it is the one we are measuring inflation for
2 Selecting a base year, i.e. the year with which prices of other years are compared
Should not be too far in the past Should be a normal year (No growth/recession)
3 Make an imaginary basket of goods/services consumed by an average family. 300 to
600 goods
4 Give an index number to goods in the basket
Current year price/base year price * 100 (in base year all products have 100 as index
number)
5 Assign weights to items in the basket
Weights= Expenditure on good/total expenditure * 100
This is to reflect the importance of the good in family’s budget
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6 Make a weighted index:

We multiply weights * index number = WI
7 Calculating CPI and inflation:
CPI = £ WI/ £W (sigma)
Inflation = CPI 2 – CPI 1 / CPI 1 * 100

CPI = 10,950/100 = 109.5

Inflation = 109.5 – 100 / 100 * 100 = 9.5 %
Problems/limitations of CPI

1) Substitution Bias

The substitution bias causes certain increases in price to be overstated because it

ignores the presence of substitutes. More specifically, the reason for this is that
not all prices change proportionately. While some prices may rise from one year to
the next, others may fall, and some of them won’t move at all. Now, consumers
respond to these changes by buying more of the goods that become relatively
cheaper and less of those that become relatively more expensive. That is, they
substitute some of the more expensive goods for cheaper alternatives. However,
because the CPI is calculated with a fixed basket of goods, it cannot include this
effect (i.e., it just assumes that people continue to buy the more expensive goods
instead of switching to cheaper ones). Hence, an increase in the price of a good in
the index may be overstated.

For example, let’s say burgers are included in the CPI while hot dogs aren’t. When
the price of burgers increases, people will eat more hot dogs instead (because
they become relatively cheaper). However, because the index is based on a fixed
basket of goods, it does not take this into account. Instead, it simply assumes that
people will continue to eat burgers and pay the higher price. As a result, the
increase in the cost of living reported by the index is higher than the actual
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increase, because it ignores the fact that consumers may switch to cheaper hot
dogs instead.

2) Representation of Novelty
The representation of novelty in the CPI results in a temporary distortion of the
actual cost of living after the introduction of new products. The reason for this
is that people have a wider variety of goods or services to choose from,
whenever new products are introduced. However, for products to be included in
the CPI, they need to be bought consistently and in significant quantities
(usually for several years). Therefore it may take multiple years before new
products or innovations are included in the basket and thereby represented in
the CPI. Other indicators, such as the GDP deflator represent these changes
more quickly and accurately.

To give an example, let’s assume Tesla releases an affordable flying car next
year. Flying cars are obviously much faster than regular cars, so many
consumers abandon road traffic within a few weeks. However, the new flying
cars will not be included in the CPI at this point. It will take several months or
years of consistent consumer purchases before they will become part of the
fixed basket.

3) Effects of Quality Changes

The effects of quality changes cannot always be accurately represented
because the quality is extremely hard to measure. If the quality of a good
deteriorates from one year to the next, the value of this good decreases even if
its price remains the same. This essentially has the same effect as an increase
in price (i.e., consumers receive less value per dollar). The CPI does not take
these changes into account by default. However, the US Bureau of Labor
Statistics (BLS) updates the basket regularly to reflect changes in quality.
However, despite sophisticated measures and scientific methods (e.g., hedonic
quality adjustment), it is extremely difficult to measure and include quality
changes in the basket accurately.

For example, the quality of computers constantly increases due to

technological progress. Therefore, the consumer price index has to be adjusted
on a regular basis to reflect these changes. However, there is no bulletproof
method to measure the increase in quality (or its value), which makes it difficult
to include the value increase in the consumer price index accurately.
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Topic Problem and benefits of inflation:

Problems:

1 International Trade problems:

If inflation rate is higher in the country compared with its’ trading partner countries,
export prices will become expensive, demand for exports will fall. Import prices will fall
and demand for imports will increase. This can lead to current account deficit if
demand was elastic.

Domestic currency will depreciate causing cost-push inflation as this will lead to
expensive imported raw materials.

2 Businesses: a) Rise in menu costs

This is the cost of reprinting menus and brochures etc. due to constant rise in price
level. b) Shoe-leather costs rise:

People keep moving their savings from one bank to another searching for higher
interest rate to protect the real value of their saving c) Businesses may start hoarding
(store goods to sell later at higher price)

3 Groups and individuals:

Individuals on fixed incomes lose the real value/ purchasing power of their money and
become poorer in real terms e.g., pensioners, unemployed receiving benefits etc.

Whereas those owning property, assets, shares, gold etc. will benefit from rise in the
value of their assets during inflation. Hence rich become richer and income gaps widen.

4 Effects on functions of money

The function most adversely affected is store of value as people lose the value of their
savings in real terms during high inflation. They lose confidence in money and may
switch to gold or other currencies for savings.

Money’s function of means of deferred payments also gets affected by high inflation as
people stop lending in terms of money as they receive back their loan less in real terms.
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Medium of exchange function also gets affected by high inflation as heavy amounts of
money may be required for even small transactions so people switch towards barter
and other currencies.

The function of unit of account may only get affected if inflation is too hyper and
numbers become enormous

Benefits of inflation:

1 Mild inflation of 1% to 2% is ideal for an economy as AD is just above AS, there is

profit motive for firms to buy raw materials at a lower price and sell the finished product
at a higher price.

Firms expand to meet increase in demand and create employment opportunities.

2 Govt’s debt burden from domestic loans falls as they have to payback less in real
terms

3 Borrowers gain during inflation as they pay back less in real terms

4 Asset owners gain from rise in the value of their fixed assets.

Evaluation:

Whether inflation is always harmful will depend on The comparative rate of inflation
with other countries Whether it is demand pull or cost push inflation

Cost push inflation is more harmful as it causes unemployment as well

Whether the inflation was expected or unexpected Whether its stable or hyper
inflation

Q) Discuss if external consequences of inflation can ever be more serious than its
internal consequences? (12)

Analysis 8 M, Ev = 4 mark

Up to 4 for external (international trade)

International Trade problems:

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If inflation rate is higher in the country compared with its’ trading partner country’s
export prices will become expensive, demand for exports will fall. Import prices will fall
and demand for imports will increase. This can lead to current account deficit if
demand was elastic.

Domestic currency will depreciate causing cost-push inflation as this will lead to
expensive imported raw materials.

Up to 4 for internal consequences:

Menu/shoe-leather costs

Income gaps increase

Lenders lose and borrowers gain

Savers lose if inflation rate is higher than interest rate

Evaluation:

External consequences may be more serious if inflation is above the trading partners’
inflation rate. They will be serious if economy is an open one e.g. (the one that relies
more on international trade). If closed economy, internal consequences will be greater.

To conclude which effect will be greater will depend on the rate of inflation e.g., hyper is
more dangerous and cause of inflation e.g., cost push is more dangerous as it causes
unemployment as well.

Topic: Problems if inflation figures were incorrect:

1 Govt policy decisions e.g., fiscal and monetary policy will be wrong and there will be
poor results

2 Trade unions will negotiate wrong level of wage and may later realize that. This may
result in strikes and production delays.

3 Lenders and borrowers will find themselves locked into wrong contracts and may
have loss of real value of money as a result

4 Firms may price their products in accordance with inaccurate figures of inflation and
may end up over or under pricing.
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Topic: Deflation:

It is the constant fall in the general price level over a year.

Good deflation:

This is due to increase in aggregate supply as a result of more efficiency in the

economy. This may be due to

• Improvement in technology
• Increased productivity of workers
• More educated/trained workforce and improved efficiency
• Subsidies by the govt

As seen in the figure, short run AS shifts to the right Price level falls, but real GDP rises.
This is showing growth of economy through greater efficiency and more output.
There will be jobs created, peoples’ incomes and living standards will improve. It is
indicating an advanced and more productive economy. Current Account might go into
surplus as exports will be cheaper and imports expensive.
Bad deflation:
This is due to fall in AD in an economy due to fall in incomes possibly caused by a
recession.
This type of deflation can lead to a downward multiplier effect on an economy i.e. job
losses occur and they cause further job losses due to fall in demand.
Deflation results in increased purchasing power, hence lenders gain as they receive
back their loans higher in real terms. Borrowers lose as they have to payback more in
real terms. Govt’s debt burden increases
 30

Firms keep cutting prices to increase AD, but consumers keep delaying purchase
hoping for prices to fall further. Economy may go down into a slump.
Evaluation;
Deflation is bad if it is due to fall in AD, but very good for the economy if due to increase
in AS. Secondly if it is a short-term, it is not harmful, but if it continues over a long
period, it becomes harmful. It will also depend on rate of deflation in trading partner
countries. If it is even lower in other countries, current account will go into deficit.
 31

Unit 3
Government Macroeconomic policies:
A Government’s major macroeconomic objectives are to solve the major macroeconomic
problems such as inflation, unemployment, low or negative economic growth, balance of
payments disequilibrium, income inequalities and sustainability etc.
Government uses various policies to achieve these aims. These are policies are mainly
divided into demand-side policies and supply-side policies.
Topic: Demand-side policies
They are Fiscal policy and monetary policy which also includes exchange rate policy.
In Fiscal policy government uses changes in taxation and govt spending to achieve its’
macroeconomic objectives. In other words, government uses its’ budget.
A government budget is a document that presents a governing body's anticipated
revenues and proposed spending for a fiscal year.
A Budget Deficit is when government expected revenue from taxes etc. are less than its’
planned expenditures.
A Budget surplus is when government expected revenue from taxes etc. are more than
its’ planned expenditures.
Let’s understand the two tools of fiscal policy well before learning its’ application by the
government.
Taxes
Note: We have already done them in microeconomics (direct, indirect, progressive
regressive, proportional etc.)
Average Rate of Tax (art) and Marginal Rate of Tax (mrt):
The average tax rate is the total tax paid divided by taxable income. While marginal tax
rates show the amount of tax paid on the next/additional income earned, average tax
rates show the overall share of income paid in taxes. They can be calculate using the
following formulas;
art = total tax / total income
mrt = change in tax / change in income
Reasons for taxation:
 32

Why does a government impose taxes?

1 To generate revenue:
Taxes are the primary source of revenue for most governments. Among other things,
this money is spent to improve and maintain public infrastructure, including the roads
we travel on, and fund public services, such as schools, emergency services, and
welfare programs.
2 To provide subsidies
3 To reduce consumption of demerit goods like alcohol and production of external costs
like pollution
4 To reduce balance of current account deficit
Government Spending
Government spending refers to money spent by the public sector on the acquisition of
goods and provision of services such as education, healthcare, social protection, and
defense
Government spending can be in form of current expenditure which is recurring e.g.,
salaries and uniforms of military and other public sector workers etc. It is also in form
of capital investment on projects such as roads, hospitals (hard and soft infrastructure)
etc.
Reasons for government spending:
1 To provide public goods like street lights and national defense which are not provided
by the private sector due to their characteristics of non-excludability and non-rivalry
which cause a free rider problem
2 To provide subsidies to newly set up businesses, declining businesses, export-
oriented businesses. Subsidies are also given to help consumers afford necessities as
they reduce the prices
3 To provide merit goods such as education and healthcare as they are under consumed
due to information failure in private sector

Expansionary Fiscal policy: (main topic)

Govt may use expansionary fiscal policy if there is a recession and unemployment is
high. There is low economic activity.
Govt will reduce taxes and increase their spending.
 33

Reduced taxes will increase disposable incomes, consumption will increase, and firms
will increase investment to meet the increase in demand. Govt spending will also inject
in AD. AD will rise. This will result in reduced unemployment and GDP/economic growth
will increase.
However, increased income maybe spent on imports of luxury goods worsening the
current account of BOP. Rise in AD, not matched by increased Aggregate supply as the
economy was on or near full employment, will cause demand-pull inflation.
Contractionary fiscal policy:
During high inflation,
Raise taxes and reduce Govt spending……..
Monetary policy:
When govt changes interest rates and/or money supply to achieve its’ macroeconomic
objectives. Exchange rate is sometimes also used.
When AD is low, unemployment is high and GDP is low.
We will use expansionary monetary policy.
Interest rate will be reduced and money supply will be increased.
Reduced interest rates will reduce cost of borrowing and return on saving. People will
save less and borrow more, consumption will rise. Firms will also investment more. AD
will rise.
Unemployment will fall and economic growth/GDP will rise. However, Demand-pull
inflation might occur and BOP current account will worsen.
Contractionary policy will be used during high inflation.
Interest rate will increase and money supply will be reduced….
Graph for expansionary (figure 1) /contractionary fiscal/monetary policy (Figure 2):
 34

As seen in the above figure (1), expansionary fiscal policy boosts AD and the AD curve
shifts to the right causing economic growth and generating employment as real GDP
rises from Y0 to Y1, however there will be inflation as price level rises from P0 to P1.
Increased incomes will be spent on imports causing a current account deficit.
As seen in the above figure (2), contractionary fiscal policy reduces AD and the AD
curve shifts to the left causing a fall in economic growth and caused employment as
real GDP fell from Y0 to Y1, however there will be reduced inflation as price level fell
from P0 to P1. Reduced incomes will mean less imports and a reduced current account
deficit.
Exchange rate devaluation / revaluation:
If the economy is in recession and unemployment is high and economic growth is low.
Govt will devalue their currency.
Devaluation will make exports cheaper and their demand will rise. Imports will become
expensive and their demand will fall leading to BOP current Account surplus. Ad will rise
Unemployment will fall and economic growth will increase. However demand-pull
inflation will occur if AS cannot match increase in AD.
Same graph as expansionary fiscal/monetary policy
If economy is facing high inflation, govt will revalue the currency….
Note … in contractionary policy explanation means use your own skills to reverse the
argument.
Limitations of fiscal policy
1 Future confidence:
If firms and people are confident about future, an increase in direct taxes may not deter
Investment and spending and vice versa.
 35

2 Time lags:
Fiscal policy especially govt spending is slow to operate.
A . Recognition lag:
Sometimes it may take govt a little longer to realise the recession has set in or inflation
has started rising beyond the safe limits
B. Implementation lag:
Govt ministers will hold meeting and take time in deciding the right rates of taxes and
govt spending
C. Affectivity lag:
Govt spending such as on education and health may produce results in very distant
future
3 Political interferences:
Fiscal policy is often used for political purposes rather than sound economic logic. For
example, politicians may increase spending near elections to gain popularity.
They may avoid an unpopular tax especially income tax that was needed for economic
improvement.
4 Unreliable data:
GDP and CPI are themselves prone to error, hence policies designed on basis of such
data may be inaccurate
5 Future policy reversals:
If people and firms feel govt will retract/change the tax rates back again. They will save
the extra disposable income rather than increase spending.
Limitations of monetary policy:
1 Time lags:
It is faster than fiscal policy but still there are time lags. Change in interest rate may
affect the economy in 12 to 16 months.
2 Unreliable data:
GDP and CPI are themselves prone to error, hence policies designed on basis of such
data may be inaccurate
3 Future confidence:
 36

If firms and people are confident about future, an increase in interest rates may not
deter Investment and spending and vice versa.
Topic Supply-side policies:
These are aimed at increasing Aggregate supply of goods/services through greater
efficiency.
1) Education and training of labor
This will increase skills and productivity of workers and potential growth will result.
Long run AS will shift to the right
2) Subsides:
3) Privatization:
Private sector will be more efficient due to profit motive and there will be greater
competition. More use of advance technology.
4) Reducing barriers to entry / Contestable markets development
This is done through Deregulation: This is when govt makes laws on new business set
up e.g., licensing requirements easy, hence AS increases.
5. Investment in research and development (RND)
Government can either use their own resources or encourage private sector to develop
advance technology through more research and development. This will make firms
more productive and Long run AS curve will shift to the right
6) Trade union reforms: govt reduces their power of going on strike etc. to ensure
smooth production
7) Development of infrastructure:
Government can develop hard infrastructure like roads, bridges and soft infrastructure
like schools and hospitals. This will reduce firms’ distribution costs and increase their
profitability causing expansion in the economy’s productive potential.
8) Reducing direct taxes
Government can reduce direct taxes like income tax to create incentive for current
workers to work more hours and those who were not joining labor force due to high
taxes may join now. Reduction in corporation tax on firms’ profits will also leave more
retained profit for firms’ expansion.
9) Free trade
 37

The above figure shows result of supply side policies. It will shift long run AS. Govt can
achieve all its’ aims if it is able to use demand side policies (AD shifts out) along with
supply side policies in the long run.
Limitations of Supply side policies:
1 Long run effect and opportunity cost:
These policies will increase AS and all the aims will be achieved in the long run however,
they are costly and there will be an opp cost of govt spending. The benefit will only
materialize in the long run.
2 Demand-pull inflation:
Increase in either government spending or investment by private sector firms will cause
demand-pull inflation in short run due to injections of G and I before increasing long run
aggregate supply (LRAS)
3 Brain drain:
The highly trained and skilled workers may leave the country and all the expenditure on
their training may become a wasted effort
4 Free trade may result in closure of some infant and sunset industries as they will not
be able to withstand the competition from cheap and good quality imports, causing
unemployment in short run
 38

Unit 4
International Trade and Protectionism
The gains from international trade are based on the theories of absolute and
comparative advantage.
Assumptions:
1 Only 2 countries
2 Only 2 goods (Food and clothing)
3 Zero transport cost
4 Free trade
5 Constant opportunity cost i.e. straight line PPC
Topic Absolute and comparative advantage:
Absolute advantage:
When a country can produce more of a product than the other with same amount of
resources.

It can be seen country X has absolute advantage in Food and Y on clothing.

X should specialize in Food production and Y on clothing. This will result in gains for the
world as well as the 2 countries when they trade.
 39

Before specialization After Specialization

½ resources for both goods
Food Clothing Food Clothing
CX 30 & 15 60 Or 0
CY 10 & 20 0 Or 40
World
Output 40 & 35 60 Or 40
Gains
From specialization 20 F 5C
As seen from the table the world has gained 20 food and 5 extra units of clothing from
specialization. Both countries will also gain if they trade at a mutually beneficial
exchange rate. If this exchange rate lies between their opportunity cost ratios.
Comparative advantage:
Very little international trade is based on absolute advantage and comparative
advantage explains the gains from trade for the rest of world trade.
It is when a country can produce a good at a lower domestic opportunity cost than the
other i.e., the country has to give up less of a good to produce the other.
For example, country X may be more efficient in producing both coffee and tea
compared with country Y, nevertheless there are benefits for both countries and the
world from specialization and trade.

As seen from the figure, X is more efficient in both Tea and coffee than Y. It has
absolute advantage in both goods.
 40

Although country Y is inefficient comparatively in both goods, but is less inefficient in

Tea. Hence it should specialise in Tea. Country Y will also gain if it specialises in the
good where it is most efficient i.e. coffee.

Country X has lower domestic opp cost in Coffee and has comparative advantage in it.
Country Y has lower domestic opp cost in Tea and has comparative advantage in it.
Mutually beneficial Exchange rate:
Country Specialise and export opp cost will trade for
X Coffee 1C = 1T More than 1T
Y Tea 1T = 0.3C More than 0.3C
Different Exchange rates and suitability for both countries

Trade is only possible when exchange rate is between the domestic opportunity cost
ratios i.e., between 1 and 3 teas for each coffee and between 0.3 and 1 coffee for each
tea
Topic= Trading possibility curve (TPC):
It is a curve that shows all possible combinations of quantities of imports a county can
trade with given volume of exports at a mutually beneficial exchange rate.
Country X TPC
 41

Limitations of Comparative and absolute advantage:

1 Only 2 goods is an unreal assumption
2 Only 2 countries is also unreal
3 Constant opportunity cost and homogenous resources is not a reality
4 Rate of exchange may not fall between the domestic opportunity cost ratios
5 Overtime comparative advantage may change due to changes in international demand
patterns
Topic: Protectionism:
It is the use of policies by government to protect domestic industry from international
competition through intervention in international market forces (demand and supply).
Methods of protection:
1 Tariffs:
These are indirect taxes imposed on imports. They can be specific e.g. 1$ per barrel of
oil or ad-velorum, i.e., specific percentage of price of the product.

Benefits:
1 They raise the price of imports and make domestic goods/services more competitive.
This will protect domestic employment.
2 Revenue for govt increases which can be spent on merit and public goods etc.
 42

Problems:
1 If demand is inelastic, tariffs will not be very effective
2 Retaliation by other countries i.e. other countries will also use protectionism against
our exports

Extended diagram of Tariffs

At World supply WS (without Tariff) and price PW. Only 0Q1 domestic firms were able to
sell. Domestic demand was 0Q2. Level of imports was Q1 to Q2.
As Tariff shifted world supply curve to WS1 and price increased to PW1. Now from Q1
to Q3 local firms can supply extra and domestic demand fell from Q2 to Q4 reducing
consumer choice. Imports reduced to Q3 to Q4.
CS was initially a pw d. After tariff it was a PW1 b. The loss in CS was PW PW1 b d.
Domestic PS was initially c PW f. After tariff it was c PW1 g. Govt Tax revenue was H
and I
2 Quotas:
 43

This is the physical limit on quantity of imports of a particular type.

Benefits:
1 Reduction in imports will increase demand for local goods
2 Effective even when demand is inelastic
Problems:
1 No tax revenue unless govt sells quota licences
2 Retaliation
3 Export subsidies:
They will reduce the cost of producing exports and exporting firms can supply more at a
lower price. Their international competitiveness will increase.
Benefits:
1 Demand for exports will increase and current account will improve
2 More employment in export oriented industries
Problems:
1 Retaliation
2 They are costly for govt and there will be an opportunity cost of other areas of govt
spending

4 Embargoes:
These are complete or partial ban on trade with a country due to political reasons.
5 Exchange control:
Govt sets a limit on how much foreign currency is available for international
transactions. This automatically reduces the amount of imports.
6 Voluntary Export Restraints (VERS):
 44

This is when a country sets a limit on exports of particular commodities. This can be
done to keep supply of a necessity good e.g. rice within the country or to keep an
essential raw material for domestic industries.
Effectiveness of protectionism (Evaluation):
1 Tariffs more effective when demand is price elastic and quotas more effective when
inelastic
2 Exchange rate of the country will also determine the effectiveness of protectionism.
3 Country may be a part of a trade zone e.g. EU, NAFTA etc.
Topic: Benefits and problems of protectionism:
Benefits:
1 Sunrise/infant industry argument:
Some industries are newly set up and cannot face cheap and quality imports
competition. They need to be protected so that they can achieve economies of scale
and develop their comparative advantage.
2 Declining/sunset industry argument:
Some industries have come to an end of their tenure. They should be protected so that
mass unemployment does not occur and workers can be trained in another skill.
3 To prevent dumping:
This is when some countries’ firms sell at a very low price in international market, even
at loss to capture international markets for those goods. This is anticompetitive and
monopolies form as a result, hence countries should protect against dumping.
4 To protect strategic industries:
Strategic industries are important for survival of a country e.g. basic food and weapons
etc. These should be protected in case trade relations suffer so that the country does
not run out of basic necessities.
5 To improve balance of trade:
If a country is facing trade deficit, they will use protectionism to reduce this deficit. This
also helps in appreciating domestic currency.
6 To prevent domestic unemployment
7 To prevent entry of a demerit good in the country
Problems of protectionism:
 45

1 Consumer choice will reduce and their welfare will decrease worldwide
2 Countries will have to be self-sufficient and may not specialise on a narrow range of
goods. This will hinder the development of their comparative advantage
3 Transfer of new ideas and technology will reduce as free trade allows easy movement
of technology in the world
4 Reduced choice of raw materials for domestic firms. If there was free trade, they
could have imported raw materials from other countries if they were not available
locally.
5 Countries may not be able to benefit from their “factor endowment” by specialising in
those products for which their factors of production were suitable
6 Global output falls:
As countries use more protection, they tend to specialise less and worldwide out falls.
Countries are not benefiting from absolute and comparative advantage
Topic: Benefits and problems of free trade:
Benefits:
1 Consumer choice will increase
2 Development of their comparative advantage
3 Global output rises
4 Transfer of new ideas and technology
5 Choice of raw materials for domestic firms
6 Countries may be able to benefit from their “factor of endowment” by specialising in
those products for which their factors of production were suitable
Problems:
1 Sunrise/infant industry may not survive
2 Declining industries will go out of business and create mass unemployment
3 Dumping may take place
4 Strategic industry may not survive and create shortage of basic foods etc.
5 Balance of trade may worsen in short run
6 domestic unemployment may rise
7 Demerit goods may be imported
 46

Q) Discuss if protecting domestic industries from international competition can ever be

justified given the benefits of free trade? (12)
Analysis 8 Marks
Up to 4 why justified
Sunrise/sunset industry argument
Anti-dumping argument
Balance of payments current account improvement
Up to 4 why not justified
Reduced consumer choice
Hinders (limits) Development of comparative advantage
Transfer of new ideas and technology may not be easy
List some others
Up to 4 Evaluation (1 for conclusion)
As discussed above protectionism has some benefits for local firms’ survival and as an
anti-dumping measure, but free trade benefits of comparative advantage and
specialisation are a major opportunity cost.
To sum up, economics only justifies protecting domestic industries in case of proven
dumping, sunset, sunrise and strategic industries protection. Other than this free trade
is always to be preferred due to its’ global benefits and resulting efficiency. Protection
is to be used for short-term only and removed as soon as possible.
 47

Topic Economic integration / Trade blocs:

When countries merge their economic affairs and act like one big country without trade
barriers and easy movement of resources between countries.
Levels of Economic integration:
 48

Topic Terms of trade:

It is the relative price of exports and imports in index form.
TOT = Export price Index/Import price index * 100
Base Year = 100/100* 100 = 100
Example Export prices increased by 20% and import prices fell by 10 %
120/90 * 100 = 133.33
Mcqs = If TOT > 100 (Favourable)
If TOT < 100 = (unfavourable)
If TOT moved from 106 to 104… Still favourable but deteriorated. If TOT move from 96
to 98 … Still unfavourable but improved
Influences of TOT:
1 Inflation/deflation:
Inflation > other trading partner countries. Exports will become expensive and imports
will become cheaper. TOT will improve.
Deflation will make exports cheaper and imports will become expensive. TOT will
worsen (for the question mention an offsetting factor)
2 Exchange Rate Appreciation/revaluation and Depreciation/devaluation:
If Currency appreciates/revalues export prices will rise and imports prices will fall, TOT
will improve (unless deflation occurs)
3 Use of protectionism/free trade:
Protectionism raises the price of imports and reduces the price of exports. TOT will
worsen unless there is an offsetting factor such as rise in inflation
Q) Explain why a countries TOT change? (8)
TOT define, Formula K/U 2 m
APP 6 marks
3 factors for 2 each
TOT effects on economy:
 49

Q) Discuss if a fall in TOT is always beneficial for an economy? (12)

Analysis 8 marks
Up to 4 why beneficial;
Fall in TOT means relative prices of exports are less than prices of imports. Cheaper
exports will increase country’s international competitivene ss and demand for exports
will rise. Imports will become expensive and their demand will fall. If demand for
exports and imports is elastic current account will become surplus.
Injection of X-M will boost AD, resulting in economic growth and reduced
unemployment. Country will experience a rise in GDP.
Up to 4 why not beneficial
Fall in terms of trade may not be beneficial if demand for imports and exports is
inelastic due to contractual obligations. Current account may go into deficit in short run.
This will reduce AD, unemployment will rise and GDP will fall.
If demand for export and imports Was elastic, AD will rise to injection X-M. This may
cause demand pull inflation if AS cannot increase.
Evaluation:
In the light of above discussion a fall in TOT maybe harmful for a country in short run as
demand for X+M tends to inelastic and current account deficit increases. However,
when J curve effect takes place in the long run and Marshall-Lerner condition is met.
Economy benefits from current account surplus, lower unemployment and higher GDP.
HW: discuss if a rise in tot is always beneficial for a country? (12)
 50

Unit 5
Current Account of Balance of Payments and Exchange Rate
Balance of Payment:
It is a record of money inflows from exports, investment etc. and outflows for imports,
investments etc. for a country over a year.
It has 3 accounts namely current account (AS Topic), capital and financial account (A2
Topic)
Current Account (Important)
It is the most frequent transactions Between one country and the rest of the World. It
has 4 sections,
a) Trade in goods:
We record the inflows and outflows of Money from exports/imports of tangible Goods.
For example Pak sells sweaters to UK For 10,000$ (outflows) Debit (Inflows) Credit
10,000
Pak buys cars from
Japan for 20,000$ 20,000
Balance of trade In goods: 10,000$ Deficit
b) Trade in services: We record the inflows/outflows From Export/import of Services
For ex, Pak student in UK University 20,000
Pak bank service Used by Americans 15,000
Balance of trade In services: 5,000$ Deficit
Balance of trade in goods and services: 15000$ Deficit
C) Primary income Transfers:
We record the inflows/outflows From rewards of factors of Production. These are
earned
Incomes e.g.,
Rent
Wages
Interest
 51

Profit
Incomes balance: 20,000$ Surplus
D) Secondary Incomes
These are unearned incomes e.g., Gifts of cash, charity, Govt Spending on overseas
embassies etc.
Secondary incomes balance 5,000$ Surplus
Current Account Balance 10,000 $ surplus

Current account surplus is when inflows from exports and transfers are greater than
outflows for imports and transfers.
Current account deficit is when inflows from exports and transfers are less than
outflows for imports and transfers.
Note: If one component of current account e.g., trade in services is in deficit, it does not
mean the whole current account will be in deficit. This is because current account has 3
other sections too and their joint surplus can outweigh the deficit in trade in services
and may turn the whole of the current account into surplus and vice versa.
Causes of imbalance (deficit/surplus) in current account:
• Overvalued exchange rate. ...
• Economic growth. ...
• Decline in competitiveness/export sector. ...
• Higher inflation. ...
• Recession in other countries. ...
• Borrowing money. ...
Current Account Deficit Problems and benefits:
Problems:
1 Deficit of current account means more outflows than inflows. X-M component of AD
falls, this will reduce AD and unemployment will rise. Economic growth will fall due to
reduced money supply.
2 Currency will depreciate and this will make imported raw materials expensive causing
cost push inflation.
3 A deficit large enough that makes the whole BOP deficit, will put pressure on Govt
reserves and they might deplete.
 52

Benefits:
1 AD fall will reduce demand-pull inflation
2 Deficit may be short term for a year or 2 and not large enough to make BOP overall
deficit. There is no major cause of concern
3 If economy was experiencing economic growth and needed to import lots of
technology and raw materials etc. The short-term deficit will convert into long run
surplus as more can be exported in future
4 Living standards of local people rise due to high quality imports

BOP Current account surplus problems and benefits:

Benefits;
1 A surplus will boost X-M part of AD. AD will rise causing economic growth as money
supply increases. Unemployment will reduce as local industry is expanding.
2 Exchange rate will appreciate making imported raw materials cheaper and reducing
cost push inflation
Problems:
1 X-M rise will boost AD, if AS doesn’t rise, demand-pull inflation will occur
2 Surplus of one country is the deficit of another. Other countries may retaliate AND use
protectionism against this country’s exports.
3 A surplus for short term may not be very beneficial. A small surplus will not make the
whole BOP surplus and reserves will not increase.
Topic Definitions and measurement of Exchange Rates: (Important)
It is the price/value of one currency in terms of another e.g., 1£ = 1.5$.
Exchange rate appreciation:
When price/value of one currency rises in terms of another. It can buy more units of
another currency e.g., 1£ = 2$.
Exchange rate depreciation:
When price/value of one currency falls in terms of another. It can buy less units of
another currency e.g. 1£ = 1$.
 53

Exchange rate changes and effect on exports and imports’ prices:

Example $150 (T Shirt) 150/1.5 = 100£
When £1 = 2$ 150/2 = 75£
Demand for UK imports will increase and demand for UK exports will decrease. Current
account becomes deficit.
When £1 = $1
Price of T shirt will be 150/1 = £150
Demand for UK imports will decrease and demand for UK exports will increase. Current
account becomes surplus.
Exchange Rate Systems / How Exchange rate is determined:
There are 3 systems: (Fixed and managed exchange rates in A2 macroeconomics)
1) Free-floating Exchange rates:
This is when demand and supply of currency in FOREX market determines the rate of
currency and there is no govt intervention
Factors influencing Free-Floating Exchange rate: (III SEE)
I Inflation Rate: If inflation rate in pak > other trading partners. Pakistani Exports will
become expensive and their demand will fall. Demand for RS will decrease and it will
depreciate’ and imports will become cheaper and their demand will rise. As a supply of
RS will increase and RS will depreciate and vice versa.
I Interest rate: If interest rate in Pak > Other countries, hot money will flow in to
Pakistani banks. Demand for RS will rise and cause appreciation of RS and locals will
also save in domestic banks and supply of RS will fall, exchange rate will appreciate and
vice versa.
I Investment prospects: If better than other countries, more firms invest in Pakistan and
RS demand rises and RS appreciates. Pakistani firms will also invest locally and supply
of RS will fall, RS will appreciate and vice versa
S Speculation: This is when people invest in currencies to make short term gains. If
speculators feel RS is going to appreciate, they will buy RS and RS will appreciate.
Speculators who already have RS, will not sell and supply of RS will fall, causing
appreciation and vice versa.
E Economic growth domestic: If Pak experiences economic growth, demand for luxury
imports will rise as incomes have risen. This will increase the supply of RS in
international market and RS will depreciate.
 54

E Economic growth international: If the world experiences economic growth, demand for
domestic exports will rise as incomes have risen. This will increase the demand of RS in
international market and RS will appreciate.

J Curve Effect: (A2 topic, but needed in AS too for evaluation)

An appreciation or depreciation of currency effects current account of balance of
payments differently in short and long run.
Depreciation:
When currency depreciates, export prices fall and import prices rise. It should increase
demand for exports AND reduce demand for imports and current account should go
into a surplus. However, it does not happen in short run. This is because PED for
exports and imports tends to be inelastic in short run due to signed contracts for
exports and imports.
However, in long run when Marshall-Lerner condition is met i.e., joint sum of elasticity of
demand for exports and imports becomes greater than one. Now current account will
become surplus in long run.
Appreciation:
When currency appreciates, export prices rise and import prices fall. It should increase
demand for imports AND reduce demand for exports and current account should go
into a deficit. However, it does not happen in short run. This is because PED for exports
and imports tends to be inelastic in short run due to signed contracts for exports and
imports. However, in long run when Marshall-Lerner condition is met i.e., joint sum of
elasticity of demand for exports and imports becomes greater one. Now current
account will become deficit in long run.
 55

Impact of exchange rate changes on the economy AD/AS analysis:

56
 57

Topic: Government policies to correct current account deficit/surplus;

There are 2 broad-based policy measures govt can use to correct imbalances in the
current account of balance of payments and these are Expenditure-switching policies
and Expenditure-dampening policies.
1 Expenditure-switching policies:
This is when govt tries to switch the expenditure of domestic citizens towards
domestically produced products and also tries to switch expenditure of foreigners
towards local products as well.
Expenditure-switching policies include;

• Devaluation of domestic currency (part of monetary policy already covered)

• Protectionism (includes trade barriers e.g., tariffs and quotas already covered)
• Supply-side policies (already covered)
Devaluation:
A govt will devalue their own currency to make exports cheaper, hence making them
more internationally competitive so that foreigners buy more of their exports. If demand
for exports and imports is elastic, it will improve current account balance, reduce
unemployment and accelerate economic growth.
Similarly, imports will become expensive as domestic currency can buy less of foreign
currencies, hence people will switch towards cheaper locally produced goods.
This policy will be successful only if;

• Marshal Lerner condition is met i.e., the joint demand for exports and imports is
greater than 1
• Other countries do not devalue their currencies more than the home country’s
currency
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• No retaliation by other countries in form of tariffs etc. otherwise our exports will
not be cheaper and they will not gain international competitiveness
• Rise in Inflation rate does not offset the devaluation
Protectionism:
Imposing tariffs, quotas and bans on imports will reduce imports and giving exporters
subsidies will make them cheaper and more competitive in the international market.
This policy will be successful only if;

• The demand for exports and imports is elastic

• The other countries do not retaliate and impose tariffs and quotas on our exports
• The country is not part of a trading bloc such as EU, BRICKS etc.
• Local firms have the capacity of supplying according to the rise in demand for
domestic products i.e., supply is elastic
Supply-side policies
Govt can reduce cost of production and increase aggregate supply through education
and training, subsides, developing infrastructure etc. This will make domestic output
more competitive in the international market and current account of balance of
payment will improve.
There are certain limitations of these policies such as

• They are costly and there is opportunity cost of other areas where govt could
spend
• They take a long time and AS only shifts to the right in long run
• Brain drain might occur as educated workers may leave the country for high pay
in other countries
• Demand-pull inflation will occur in short run due to injection of govt spending
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Unit 6 Unemployment (Also includes Economic Growth)

Unemployment:
It is when people are willing and able to work, but cannot find a job.
Unemployment Rate:
No unemployed / labour force * 100
Labour force:
It includes both employed and unemployed
Labour force participation rate:
Labour force / Population of working age * 100
Topic= Types/causes of unemployment:
1 Frictional unemployment:
A. Search/voluntary unemployment: This is when people leave a job and take their time
looking for a better job
B. Seasonal unemployment: When people are made redundant during off-season as
there is a temporary switch in consumer expenditure e.g., tourism
C. Casual unemployment: Some jobs are of such nature that workers keep getting
unemployed between jobs e.g., actors, authors, supply teachers etc
Note govt does not worry too much about this
2 Structural unemployment:
This is when demand for a whole industry’s products falls. This could be due to;
a. Tech nological unemployment
This is due to change in technology and workers skills become outdated e.g., word
processors made typists unemployed
b. Change in fashion, taste, trends etc.
Handicrafts in certain countries became less popular causing unemployment for related
workers
c. international unemployment:
When an imported good/service replaces a local product
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d. If declining industries are located in a particular region, there will be long term
regional unemployment
3 Classical/real wage unemployment:
This can be due to trade union influence or imposition of a minimum wage law by the
govt. Firms will make some workers redundant as their cost has risen.

As seen in the above figure, if minimum wage law or trade unions enforce a higher wage
than the market wage, L to L1 workers will lose their jobs and from L1 to L2 will be the
level of unemployment
4 Cyclical/Mass/Keynesian/demand-deficient unemployment:
Labour demand is derived demand i.e., labour is demanded for the products they make.
During a recession/slump demand for final products falls causing workers being made
redundant.

As seen in the above figure, fall in AD will make firms cut the number of workers hired. If
workers resist wage cuts through trade unions, level of unemployment will be from L to
L1. Even if they don’t resist wage cuts there will be unemployment from L to L2 workers.
Topic: Consequences of Unemployment
Problems
Individuals:
Short run problems for individual workers are fall in incomes and living standards
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Long run problems are deskilling i.e., loss of skills and reduced chances of re-
employability.
Depression and crime rates may rise
Benefits:
Leisure time and possibility to retrain and improve their employability
Firms:
Problems
There will be fall in spending hence AD and sales will reduce
Benefits:
Easy availability of skilled/unskilled workers
Firms will not face trade union pressure, hence pay lower wages and become more
competitive
Economy:
Problems
Govt tax revenue will fall from both direct and indirect taxes and they will have to spend
more on unemployment benefits. This will result in a budget deficit and need for
borrowing may emerge.
Low incomes will lead to low savings and low investment causing a fall in growth and
development
Country will produce inside its PPC, hence inefficiency
Benefits:
Reduced production will result in low external costs e.g., pollution etc.
Both demand-pull and cost push inflation will reduce
Measurement of unemployment
Most governments use two main measures of unemployment.

• Claimant Count measure

• Labour survey measure
Claimants mean number of people who have claimed unemployment benefits
Rate of unemployment: Claimants/Claimants + Employed * 100
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Advantages

• Relatively cheap
• Very quick to calculate
• Inactive population will be excluded from the unemployed
Problems

• Government manipulation may occur to understate unemployment figures for

political reasons
• Government may change rules of eligibility e.g., one must be unemployed for
more than 4 weeks to qualify for benefit claim
• Some unemployed people may choose not to claim benefits as they may have
other sources of income such as family support
• There may be lack of information or lack of job centers, hence many unemployed
will not be counted as they were not registered with a Human Resource
Development Center (HRDC)
• This measure may not be useful in developing countries like Pakistan
Labour survey measures
The more widely used measure is a labour force survey as per International Labour
Organization’s (ILO) definition of unemployment. Data collection authorities conduct
surveys at different places and time periods to collect information about employed,
unemployed, wage rates and working conditions etc. frequently.
The questionnaires are used to cover

• Household size and structure

• Accommodation details
• Demographics like age, sex, qualifications, marital status and ethnicity etc.
To be qualified as unemployed an individual has to be;

• Without a paid job

• Available to start work within 2 weeks
• Searching for work or waiting to start a job already obtained
Benefits

• Government cannot manipulate the figures easily

• International comparisons are easier as it is based on internationally accepted
definition
• More info is obtained about qualification levels of job seekers
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Problems

• False information provided by public

• Reliability of figures depends on the number of times the surveys were conducted
in a year
• Reliability depends on the skills of surveyors and equipment available for
recording the data
• Expensive and time consuming
• Sampling errors and bias as data is collected from only a sample to represent the
whole population
• Inactive population is also included e.g., those on training or completing
education and those who are not actively seeking work
Economic Growth:
Economic Growth: This is when real GDP rises over time. It can be actual or potential
growth.
Economic Growth:
Real GDP 2 – Real GDP 1 / Real GDP 1 * 100
Real GDP 2 (Current year) and Real GDP 1 (Previous year)
Concepts:
2020 = 103 B $
2019 = 100 B $
3% Economic Growth
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Actual Economic Growth

Potential Growth:
It is when economy’s productive potential increases. This is linked to outward shift of
PPC and outward shift of long run aggregate supply. This occurs in long run due to
increase/improvement in quantity and/or quality of resources.

The above graph shows potential growth through shifts of PPC and LRAS curves and
Actual growth through shift of AD curve and movement from a point “u” inside PPC to
the point “B”.
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Reasons for Actual growth:

Causes of shift In AD i.e. Expansionary Fiscal and Monetary policies
Fiscal = Taxes reduce and Govt spending increase
Monetary = Money supply increase and/or Interest rates decrease and/or exchange rate
devaluation
Reasons for Potential growth:
All the factors that shift PPC outwards.
Govt uses supply-side policies
Some of these are explained below
Causes of potential economic growth
1 Exploration of new oil, gas, etc.
A country with more natural resources will have greater supply of energy sources and
their cost of production will fall causing PPC and LRAS (Long run AS) curves to shift
outwards causing potential growth
2 Use of fertilizers, hybrid seeds, modern technology etc.
This will increase agricultural productivity leading to potential economic growth
3 Education and training of labour (human capital investment or soft infrastructure)
This will increase workers skills and productivity. They will be able to handle latest
technological equipment and more efficient working will cause a shift of productive
potential
4 Investment in physical capital
Physical capital refers to hard infrastructure like roads, bridges and communication
networks etc. If Gross investment on physical capital is greater than its’ depreciation
(wear and tear). Economy will experience economic growth due to reduced distribution
costs and quicker movement of resources and finished products.
5 Research and development of new technology
Latest technology developed would reduce processing time and increase potential
output
6 Increase in labour force
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This could be possible in short run through positive net migration i.e., immigration into
the country of skilled workers is greater than emigration out of the country or reduced
school leaving age and increased retirement age. In the long run this may happen due to
change in population structure resulting in a larger % of younger people in the country.
Larger work force will shift the PPC outwards.
Consequences of economic growth
Q) Discuss if economic growth is always beneficial for an economy? (12/20)
Economic growth is the rise in Real GDP over time. It is measured by the formula
Real GDP2 – Real GDP1/Real GDP1 * 100
Economic growth maybe actual when previously unemployed resources are employed
and there is a movement from inside PPC towards PPC. It is linked
with AD rise. Whereas potential economic growth is when quantity/quality of resources
increases and there is a shift of PPC outwards. It is linked with outward shift of Long
run AS.
Why Beneficial:
There will be Fiscal dividend, i.e. govt will receive more tax revenue from both direct and
indirect taxes due to more incomes, profits and consumer spending. While their
spending on unemployment benefits and income support schemes will be lower. Govt
budget will become surplus.
Govt can spend this extra amount on education and health. This will increase workforce
skills and productivity, reduce absenteeism and improve GDP further. They can spend
more on infrastructure which will reduce distribution costs, efficiency will increase
causing further growth.
If actual growth is greater than potential growth, unemployment will fall and incomes
and living standards will rise.
If some of the increased output is exported and local people citizens also prefer local
goods, Balance of payment current account will improve.
Country will prosper and its’ sovereignty will increase in the world.
Problems of economic growth
Extra production may result in negative externalities such as pollution, congestion etc.
This may reduce the living standards.
Non-renewable resources such as oil, gas maybe depleted by careless usage and future
comparative advantage will fall.
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Increased incomes maybe spent on importing luxury consumer goods which may turn
current account of BOP into a deficit.
If growth results in uneven distribution of income, only few may experience improved
living standards and majority may not be better off.
If growth was due to more multi-national companies setting up in the country, in long
run economic growth may fall as they will send profits home and may leave to cause
massive unemployment.
During actual economic growth AD rises and if AS cannot increase as the economy was
near or on full employment demand pull inflation might occur.
Evaluation:
Whether economic growth is beneficial will depend on the relevant costs and benefits
involved and how much value people attach to them.
Developed countries may consider economic growth harmful if it is causing pollution
and sustainability problems, whereas developing countries may attach higher value to
monetary growth and incomes.
Govt may aim for “Constrained optimization” i.e., growth is achieved keeping
sustainability, levels of environmental hazards to low level and income distribution more
even in mind. Hence it is subjective whether growth is always considered beneficial.