EDEXCEL ECONOMICS (A) KNOWLEDGE ORGANISER: THEME 2 Aggregate demand AD

The Aggregate Demand Curve Factors that shift the AD curve

AD curve: shows the relationship between the level of real planned Changes in real income and employment: When the economy is growing and
expenditure and the general price level in an economy inflation is stable, people’s real incomes increase as does their job security. This
AD = C + I + G + X – M gives people the disposable income and confidence to spend more. Consumption C
A fall in the general price level (PL) causes an extension of AD increases, boosting AD. Higher C may lead to more investment I as businesses
(movement along the AD curve, higher real Y). expand to meet the higher consumer demand.
A rise in the PL causes a contraction of AD (movement along AD Changes in consumer & business confidence (Keynes’ ‘animal spirits’): When
curve, lower real Y). there is high consumer and business confidence in the economy, both consumption
The relationship is INVERSE because: C and investment I demand grow. Confidence is affected by a multitude of factors –
• Real income effect: As the price level falls, the real value of economic news, market sentiment, policy changes etc.
income rises, consumers can buy more; higher consumption C Changes in household wealth – the 'wealth effect': When assets prices increase,
(the real money balance effect) then people begin to feel wealthier. Homeowners see similar houses to theirs
• Balance of trade effect: A fall in the relative price level of a increasing in value; shareholders see the value of their holding go up. This gives
country could make foreign-produced goods more expensive, households more confidence to spend rather than save and encourages them to
causing a rise in exports, X and a fall in imports, M. take out more loans, secured against their higher valued assets. C increases adding
• Interest rate effect: If price inflation is low this might lead to a to AD. (Negative wealth effect does the opposite)
reduction in interest rates and so there is less incentive to save Changes in monetary policy: Lower interest rates make saving less attractive and
and consumption C rises; the exchange rate could also borrowing cheaper, so consumers are more likely to spend; mortgage holders may
depreciate and improve net exports (X-M). also find their mortgage interest payments fall giving them more spending income;
AD and shifts in AD businesses are more likely to invest because borrowing costs are lower and saving
any retained profit gives a lower return.
AD slopes downwards to the right.
Changes in fiscal policy: The government can increase its own consumption G
and/or public investment I. It can fund this via more government borrowing.
• Any change that causes AD to
Cutting income tax can boost C; cutting indirect taxes such as VAT can cause
increase other than a change in
consumer confidence to rise; cutting corporation tax may encourage more I. All
the PL shifts AD to the right
these can cause AD to increase.
from AD1 to AD3
• Any change that causes AD to Changes in the exchange rate and in the global economy: a depreciation reduces
decrease other than a change export prices and increases import prices so net exports rise; global growth can
in the PL shifts AD to the left also boost net exports (X-M)
from AD1 to AD2 NB: reverse the chains of reasoning for all factors for decreasing AD
EDEXCEL ECONOMICS (A) KNOWLEDGE ORGANISER: THEME 2 Aggregate supply AS – (Neo)Classical
The Aggregate Supply Curve – (Neo)Classical Factors that shift the SRAS curve
Short run aggregate supply SRAS: total planned output when the general Changes in wage costs: if firms can pay lower real wages, this reduces their
price level can change but the prices and productivity of factor inputs are costs of production making them more willing to supply.
held constant. In the short run, the SRAS curve is assumed to be upward Changes in productivity: if labour become more productive ie more output per
sloping labour input, this increases the efficiency and more can be supplied
Movements along the SRAS Curve: A change in the price level brought Changes in unit labour costs: Unit labour costs = labour cost per unit of
about by a shift in AD results in a movement along the short run AS curve. output. If wages fall relative to productivity growth, then ULCs fall,
If AD rises, there is an extension of SRAS; if AD falls there is a contraction reducing costs to businesses, so they will be prepared to supply more.
of SRAS. Changes in commodity, energy and raw material costs: if the cost of buying raw
Shifts in SRAS materials, energy and other commodities needed for production fall, production
costs fall and SRAS shifts right.
SRAS slopes upwards to the
Changes in education/skills: improved education and training boosts skills and
right; as SRAS1 curve
occupational mobility, which helps increase productivity, reducing the costs of
• Any change that causes
production and increasing SRAS.
SRAS to increase other than a Changes in indirect taxes & subsidies: if indirect taxes are cut and/or government
change in the PL shifts SRAS to subsidies are increased, this reduces the costs of production and SRAS shifts
the right from S1 to AD3 right.
• Any change that causes Changes in the exchange rate: an appreciation decreases import prices; if a
SRAS to decrease other than a country is a net importer of energy, raw materials and components, this
change in the PL shifts SRAS to decreases the costs for many businesses and SRAS shifts right
the left from SRAS1 to SRAS2
Changes in regulation: if the government reduces the red tape and bureaucracy
Shifts in LRAS for businesses, this reduces their costs and SRAS shifts right.
Long run aggregate
Long supply (LRAS)
run aggregate supply LRAS: total planned NB: reverse the chains of reasoning for all factors for decreasing SRAS
output when both prices and average wage Factors that shift the LRAS curve
rates can change – it is a measure of The LRAS represents the economy’s productive potential, ie. its maximum
a country’s potential output and the concept is
https://www.tutor2u.net/economics/store/minister-for-employment- output given its resources. LRAS is located at the economy’s full employment
labour-markets linked to the production possibility frontier. level of output. There is no spare capacity. It shifts when there is:
In the long run, the LRAS curve is assumed to • Change in the quantity of resources (land, labour, capital & enterprise)
be vertical (i.e. it does not change when the • Change in the quality of resources
general price level changes). • Technological progress
EDEXCEL ECONOMICS (A) KNOWLEDGE ORGANISER: THEME 2 Aggregate supply AS - Keynesian
The Keynesian Aggregate Supply Curve Shifts in the Keynesian AS
There is no distinction between the Shifts in AS (where full employment
short run and long run for AS in income Yfe increase):
the Keynesian model. The Any change that causes the
Keynesian AS curve is curved. productive potential of the economy
Below Y1 AS is very elastic; the (full employment income) to rise will
economy has lots of spare capacity shift the AS right (and vice versa).
and any increase in AD can easily be (The same factors that cause the
met without inflation classical LRAS to shift).
Between Y1 and Yfe the AS
becomes less elastic: there is less
spare capacity; increase in AD can Classical v Keynesian views
be met, but costs to businesses For Yfe and above, the AS is Classical economists believe in the self-adjusting nature of markets, where
start to increase as firm compete for perfectly inelastic; there is no
wages and prices are flexible, and the economy naturally tends toward full
skilled labour and other spare capacity; an increase in AD employment. They argue that government intervention is often
scarcer resources; some inflation will cause inflation not growth counterproductive.
Keynesian economists emphasise the role of aggregate demand and argue that
Shifts in Keynesian AS markets may not always self-adjust efficiently, especially during recessions.
Shifts in AS (with no change in full They advocate for government intervention, such as fiscal policies, to manage
employment income Yfe): demand and stabilise the economy.
Any change that causes the costs of
production in the economy to Summary of key factors that shift the AS in the long run
fall or rise will shift the AS curve Factors that increase the economy’s productive potential, or its full
'up' or 'down' respectively. employment level of output. These are the same factors that shift the
(The same factors that cause the production possibility frontier to the right:
• Changes in government
classical SRAS to shift). However, • Technological advances regulations
there is no increase in the • Changes in relative productivity • Demographic changes and
productive potential of the • Changes in education & skills migration
economy. • Competition policy
EDEXCEL ECONOMICS (A) KNOWLEDGE ORGANISER: THEME 2 Equilibrium levels of real national output
Equilibrium national income (Classical) Equilibrium national income (Keynesian)

• The short run • Equilibrium national output

equilibrium national level is the output where AD
output level is the output = AS at Y1.
where AD = SRAS. • If AD is high enough then
• The long run equilibrium the equilibrium can be at
level of national output the full employment level of
is where the AD = LRAS, income (where the AS
at Y1. is vertical)

Increases in AD and AS
Increases in AD and SRAS

AD increases from AD1 to AD2. The AS increases from AS1 to AS2. The
AD increases from AD1 to AD2. SRAS increases from SRAS1 to equilibrium equilibrium national output
The equilibrium national output SRAS2. The equilibrium national national output increases from Y1 to increases from Y1 to Y2. The price
increases from Y1 to Y2. There is output increases from Y1 to Y2. Y2. There is some demand-pull level falls from PL1 to PL2 suggesting
some demand-pull inflation as the The price level falls from PL1 to PL2 inflation as the price level rises from some disinflation or deflation
price level rises from PL1 to PL2. suggesting some disinflation or PL1 to PL2.
deflation
NB: Decreases in AD and/or AS would results is changes in equilibrium national income too.
Students need to identify the original and final equilibrium coordinates.
EDEXCEL ECONOMICS (A) KNOWLEDGE ORGANISER: THEME 2 The Multiplier
The Multiplier Other multiplier formulae
The multiplier effect occurs when an initial injection into In a closed economy with no government: k = 1/MPS
the circular flow causes a bigger final increase in real national income. In a closed economy with a government k = 1/(MPS + MPT)
This injection of demand might come for example from a rise in exports In an open economy with a government k = 1/(MPS + MPT + MPM) or 1/MPW
X, investment I or government spending G. Where MPS = marginal propensity to save, MPT = marginal propensity to tax, MPM = marginal
propensity to import and MPW = marginal propensity to withdraw
The multiplier process Factors influencing the size of the multiplier
The multiplier effect arises because one agent’s spending is another High multiplier value Low multiplier value
agent’s income. When a spending project creates new jobs for • Economy has plenty of spare capacity • Economy is close to full capacity
example, this creates extra injections of income and demand into a • Propensity to import and tax is low • Rising demand causes inflation
country’s circular flow. • High propensity to consume any • Higher inflation causes rising
The negative multiplier effect occurs when an initial withdrawal or extra income interest rates
leakage of spending from the circular flow leads to knock-on effects The size of withdrawals (S, T, M) from the circular flow is a major factor in
and a bigger final drop in real GDP. determining the size of the multiplier.
Showing the multiplier effect in a diagram
The multiplier coefficient
Initial increase in AD from AD1 to AD2
The multiplier coefficient itself is found by:
increases real GDP from Y1 to Y2.
Final change in real GDP / Initial change in AD
It then kicks off a multiplier effect which
Example: If the government increased spending by £5 billion but this
increases AD further to AD3 and real GDP rises
caused real GDP to increase by a total of £12 billion, then the
to Y3
multiplier would have a value of 12/5 = 2.4
Investment multiplier – initial change from I
Multiplier formula Fiscal multiplier – initial change from G or
government borrowing
Multiplier k = 1/(1 - MPC) where the MPC = the marginal Export multiplier – initial change from X
propensity to consume Evaluation of multiplier
MPC = change in consumption/change in income = change in C/change • Difficult to know exact size of multiplier - hard to measure
in Y • Takes time for multiplier process to feed through to real GDP – time lag
Initial change in injections x k = final change in national Y • Economists disagree over its size
Example: if investment increases by £100bn and the MPC = 0.8, the • Long run multiplier effect is likely higher for developing economies than for
final increase in real GDP will be £100bn x 1/(1-0.8) = £500bn developed ones; infrastructure projects often have higher multiplier effects
EDEXCEL ECONOMICS (A) KNOWLEDGE ORGANISER: THEME 2 Causes of economic growth
Short run v long run growth Factors that can constrain growth
Long run growth: an increase in potential output There are many factors that can constrain growth; some may be more significant in
Short run growth: an increase in real GDP, driven by an increase in AD developing economies than developed ones. Some examples are: economic shocks
that draws unemployed resources into use. (e.g. pandemic, Brexit, financial crisis), poor macroeconomic management, political
instability, poor productivity growth, lack of investment, inadequate infrastructure
Factors which cause short run economic growth (transport, energy and communication networks), small export base/primary product
Any event or policy that increase components of AD (i.e. C+I+G+X-M) dependency, shortage of human capital, brain drain, poor access to finance, high
stimulates an extension in AS and uses up some unemployed food prices, weak financial and legal institutions etc.
resources; movement from a point inside the economy's PPF to a point
on the PPF. International trade and export-led growth
Export led growth: a significant part of the expansion of real GDP, jobs and per capita
Factors which cause long run economic growth
incomes flows from successful exporting of goods and services
The productive potential of the economy increases if there is an
Exports are an injection into the circular flow and may also stimulate more
increase in:
investment, another injection. Industries supporting the increase in exports e.g.
• The quantity of the factors of production
logistics will also grow (an export and investment multiplier effect)
• The quality of the factors of production
Balanced growth
• There is a technological advance
Balanced growth: when output and the capital stock grow at the same rate. Also
There is an outward shift of the economy’s PPF or LRAS shifts right.
refers to balanced expansion of components of aggregate demand and/or the
Examples could be:
different sectors in an economy
Land (natural resources): finding and mining a new cobalt find;
reclaiming land from the sea; fertilising agricultural land Output gaps
Labour/enterprise (human resources): immigration to increase Negative output gap: actual GDP is below potential GDP. This means that there is
quantity and quality (filling in skills gaps); education & training spare capacity in the economy. Some resources are not fully employed. We would
Capital (man-made resources): investment increases quantity but expect some unemployment. There is not enough demand in the economy for all
also quality as new technology is integrated resources to be fully utilised.
Positive output gap: actual GDP is above potential GDP. This puts resources in the
Actual v potential output economy under strain. Demand growth exceeds supply growth. Firms may find it
Actual output: the current level of production (real GDP) in an hard to recruit workers with the right skills and they may find they have to compete
economy. Some resources may be unemployed. for other resources, such as raw materials, that are in short supply. This puts
Potential output: the economy's productive capacity or the largest upwards pressure on wages and other costs and may lead to inflation. Consumers
output that could be produced, given the prevailing state of may buy more imports if domestic suppliers cannot meet their demand, increasing
technology and stock of available resources. the trade deficit.
EDEXCEL ECONOMICS (A) KNOWLEDGE ORGANISER: THEME 2 Output gaps
Negative output gap Negative output gap
Using the classical AD/AS Using the Keynesian AD/AS model:
model: • Equilibrium income is at Y1, where
• Equilibrium income is at AD=SRAS. This is the actual output.
Y1, where AD=SRAS. This • Yfe represents the economy's
is the actual output. potential output or full employment
• Yfe represents the income
economy's potential • The gap between Y1 and Yfe is the
output. negative output gap
• The gap between Y1 and • An increase in AD to AD2 reduces the
Yfe is the negative output size of the negative output gap
gap There are some unemployed resources. A rise in AD could from Y1Yfe to Y2Yfe
help close the gap Difficulties measuring the output gap
Positive output gap Measuring the output gap in an economy is challenging:
• It involves determining potential output, which is not directly observable
Using the classical AD/AS • It is influenced by evolving factors like technological changes and demographic
model: shifts
• Equilibrium income is at • Accurate data on current output levels is often subject to revisions
Y1, where AD=SRAS. This • Economic uncertainty means it is hard to make precise measurements
is the actual output. Sustainable growth
• Yfe represents the • Growth which can continue into the long run
economy's potential • Growth without using up non-replaceable resources
output. • No natural resources depletion or degradation (environmentally-friendly)
• The gap between Y1 and • Growth which does not compromise future generations
Yfe is the positive output Inclusive growth
gap. • Growth where all citizens experience an increase in their income/living standard
• Income inequality does not cause some groups to miss out on the benefits of
A positive output increases the competition for scarce resources;
growth
wages and other business costs start to rise, SRAS will shift left
• Most economists do not believe that the benefits of growth will 'trickle down'
until the economy returns to Yfe. (Cost-push inflation)
from rich to poor without government intervention
EDEXCEL ECONOMICS (A) KNOWLEDGE ORGANISER: THEME 2 Trade cycle (the economic or business cycle)
Trade cycle Causes of an economic slowdown
Trade cycle or economic cycle, also known as a business cycle, refers • Interest rate rise: central banks might respond to an increase in inflation by raising interest
to the fluctuation of economic activity in an economy over time. rates to cool down the economy, reduce AD growth and prevent excessive inflation.
It involves alternating periods of expansion and contraction in real • Tighter fiscal policy: government may put up taxes or cut public spending to improve public
finances, reducing AD growth/
economic output, employment, and other key economic indicators.
• A slowdown in global economic growth or the emergence of trade tensions can negatively
Economic cycles are characterised by several key phases: impact a country's exports and economic prospects.
Rapid Expansion (Boom) - Slowdown - Peak - Recession - Trough - • Global geopolitical events can slow growth.
Economic Recovery
Causes of a recession
The trade cycle A recession is typically marked by two consecutive quarters of negative real GDP
growth.
• Lower consumer confidence as disposable incomes decrease
• Fall in business confidence: less investment; job loss
• Higher unemployment: as businesses lay off workers, consumer confidence falls
• Negative demand/supply-side economic shocks eg a credit crunch, a sudden rise in energy
prices, a trade shock
• Poor choice of macroeconomic policy: eg too much austerity; keeping interest rates too high for
too long
Causes of an economic recovery
An economic recovery is the phase of the business cycle that follows a recession
where national output recovers to where it was before a recession.
Phases of the trade cycle
economic events in other countries.
Boom – a period when the rate of growth of real GDP is fast and • Cuts in interest rates (monetary policy): to stimulate AD
higher than the long run trend • Fiscal stimulus: such as tax cuts or an increase in government spending or borrowing
Slowdown – a weakening of the rate of growth; real GDP is still rising • Business and consumer confidence may increase boosting AD
but at a slower rate • Positive demand/supply-side shock eg a fall in energy prices
• More rapid global growth: boosts exports and economic prospects
Recession – a period of at least six months when an economy suffers
a fall in real GDP Causes of a boom
Recovery – a phase after recession when real GDP starts to rise and A boom occurs when the economy is growing at an unsustainable rate
unemployment begins to fall • Over confidence: 'animal spirits' cause a rapid increase in AD when there is
Depression – a prolonged downturn where real GDP falls by at least little/no spare capacity
10% • Loose fiscal and/or monetary policy; allows AD to grow too rapidly
EDEXCEL ECONOMICS (A) KNOWLEDGE ORGANISER: THEME 2 Trade cycle & economic shocks
Features of a recession Economic shocks
Falling real GDP: a sustained decline in a country's GDP over at least Economic shock: unexpected and significant events that lead to a sudden and
two consecutive quarters (six months). Economic output shrinks as substantial impact on key indicators, such as GDP growth, inflation, unemployment,
businesses produce less, consumers spend less, and investment interest rates, and exchange rates.
declines. Demand-side shock: a sudden change in AD
Rising unemployment: businesses reduce production and cut back Supply-side shock: a sudden change in AS
on hiring, leading to job losses and a rise in cyclical unemployment. Positive shock: a shock that boosts the economy
Disinflation: falling demand and a weaker labour market often lead Negative shock: a shock that causes a recession or increase in unemployment or
– perhaps with a time lag – to a reduction in the rate of price inflation
inflation. External shock: a shock that comes from global events outside the economy
Reduced business investment: businesses tend to scale back their Internal shock: a shock that comes from within an economy
investment during a recession because of weak or falling demand. Demand & supply side shocks
Risk to government finances: government borrowing and national Demand-side - negative Supply-side - negative
debt may rise as government spends to support the economy. • Economic downturn in a major trading • Steep rise in energy and/or commodity/raw
partner material prices
Economic scarring • Unexpected tax increases/cuts in welfare • Lockdown due to a pandemic
Economic scarring: can reduce the medium/long run potential output • Financial crisis causing a credit crunch • Natural disasters
of the economy • Bigger than expected rise in unemployment • Unexpected breakthroughs in production
• Businesses may scrap unused/obsolete capital (NB: Opposite for positive AD shocks) technology (could be positive)
• Workers who lose their jobs may also lose some skills reducing their (NB: Opposite for positive AS shocks)
productivity (labour hysteresis) Examples of shocks
• Increase in business failures Global financial crisis 2007-9; pandemic; volatile global energy & commodity prices;
• Fall in the financial capacity to lend
slowdown in China; climate change & extreme weather events; increased
Depression v recession protectionism, Brexit, currency volatility etc
An economic depression is a more severe and prolonged economic Evaluation of shocks
downturn than an economic recession. Impact of the economic shock depends on:
• It can persist for several years • The size of the shock & the scale of the shock (regional, global?)
• Unemployment rates can reach very high levels and remain elevated for an • Likely multiplier effects (positive/negative depending on the shock)
extended period. • How temporary/permanent the shock is
• Long-term unemployment and underemployment are common features • Who the winners and losers are
• Depressions can include severe banking and financial crises, with widespread • How effectively the government responds to the shock
bank failures, credit contractions, and disruptions to the financial system. • Opportunities v threats created by the shock
EDEXCEL ECONOMICS (A) KNOWLEDGE ORGANISER: THEME 2 Impact of Economic Growth
Benefits of economic growth Costs of economic growth
Economic growth can lead to benefits for all economic agents – Economic growth can lead to costs that affect all economic agents –
consumers, producers, workers & the government consumers, producers, workers & the government
Higher standards of living: growth often leads to higher per capita Inflation: rapid growth can lead to demand-pull and cost-push inflation,
incomes, which in turn can improve the standard of living for a nation's eroding real purchasing power and potentially leading to economic
citizens. instability.
Greater profits for firms: allows expansion and can create jobs Environmental costs: fast growth of GDP can lead to overexploitation of
Job creation: growth can help reduce unemployment rates and provide scarce non-renewable natural resources, causing resources degradation
individuals with greater financial stability. and depletion, compromising sustainability.
Reduced poverty: growth increases access to education, healthcare, and Income inequality: benefits of growth may disproportionately accrue to
necessities leading to progress in reducing extreme poverty and certain segments of the population, leading to increased income &
improvements in human development outcomes (HDI Index) such as wealth inequality as measured by the Gini Coefficient.
higher life expectancy. Financial instability: if rapid growth is fuelled by excessive borrowing
Greater income equality: more jobs, less poverty reduce inequalities and and speculative investment, this can result in financial bubbles and
the associated social problems. subsequent crashes.
Increased government revenue: A growing economy generates higher Wider trade deficit: rapid growth means consumers/businesses will buy
tax revenues – a fiscal dividend - that can then be used to fund better from abroad if home supply cannot grow fast enough increasing
public services such as education & healthcare. imports.
Investment opportunities: growth attracts domestic and foreign Sacrificing current consumption: the opportunity cost of producing
investment leading to innovation, increased productive capacity (LRAS), more capital goods to boost productive capacity is a loss of the
and further job creation. production of consumer goods.
Improvement in environment: more efficient, green and cleaner Human costs: growth may lead to less leisure time or more
technology is used. stress/mental health issues for workers.
Kuznets curve Kuznets curve diagrams
Kuznets curve suggests that economic inequality tends to increase during the
early stages of economic development, but then decreases as a country
becomes more developed.
Environmental Kuznets curve suggests that environmental pollution tends to
increase as a country's income increases during the early stages of economic
development, but then decreases as a country becomes more developed.
EDEXCEL ECONOMICS (A) KNOWLEDGE ORGANISER: THEME 2 Possible macroeconomic objectives & conflicts
The main macroeconomic objectives Phillips curve
Objectives are the aims or goals of government policy
The Phillips Curve is an
• Sustainable and balanced economic growth (% change in real GDP)
economic model that shows
• Environmental protection: growth needs to be sustainable
the possible inverse non-
• Price stability: control of cost and price inflation (eg via an inflation
linear relationship between
target)
the unemployment
• High employment rate, low unemployment, reduced inactivity in the
rate and the rate of inflation
labour market
• Improved productivity, international competitiveness
• Sustainable overseas trade balance in goods and services/Balance of Explaining the Phillips curve:
Payments current account in equilibrium Trade-off between inflation and unemployment
• Improved public services, sustainable government finances (both At A: when unemployment is high, inflationary pressures in
borrowing and debt) an economy tend to be weak; there is lots of spare capacity (negative
• More equitable final distribution of income and wealth - greater income output gap) in the economy, so reducing unemployment does not put
equality much upward pressure on wages and prices
• Improved national well-being/higher standard of living At B: as unemployment falls further, then wage pressures and price
The government can also set other goals such as net zero, targets for pressures may start to accelerate – the gradient of the curve steepens
reducing child poverty, new house building etc If unemployment falls even lower, the risk of a significant increase in
Objectives can change over time depending on the economic (& political) inflation goes up - the output gap is likely to be positive and factor
context markets are experiencing shortages
Macroeconomic conflicts or trade-offs Challenges to the Phillips curve
It can be difficult for all macroeconomic objectives to be met at the same time – Stagflation – when both unemployment and inflation are high (a
there are trade-offs, improving one may worsen another. For example: stagnant economy with inflation)
• Faster growth can fuel demand-pull inflation and widen a deficit on the The short run Phillips curve could shift out if expectations of inflation
current account; income inequality may rise if the growth is not inclusive increase, or inwards if expectations of inflation decrease
• Low unemployment can increase real wages and cause cost-push inflation Some monetarist economists do not believe the inflation-unemployment
• Polices to reduce inflation can slow growth and cause unemployment trade-off exists in the long run (the long-run PC Is vertical), meanwhile
• Reducing government borrowing and the national debt can slow growth and Keynes though it was possible to have differing levels of unemployment
cause living standards to stagnate at the same inflation rate.
EDEXCEL ECONOMICS (A) KNOWLEDGE ORGANISER: THEME 2 Demand-side policies – fiscal policy
Demand-side policies Public spending
Demand-side policies: policies that aim to manipulate aggregate demand (AD) to Public spending: spending by the government to influence AD.
achieve the macroeconomic objectives. Current spending: government consumption G = spending on the say-
Fiscal policy: use of taxation, government spending and government borrowing today costs of running public services e.g. wages of teachers, energy bills
to influence the economy. for hospitals; directly affects AD.
Monetary policy: use of interest rates and the money supply to affect AD – run Capital spending: government investment in the economy's
by the independent Bank of England in the UK. infrastructure e.g. building hospitals & housing, new roads/railways etc

Fiscal policy: taxation Using demand-side fiscal policy to influence the economy
Direct tax: a tax on income/wealth e.g. income tax, employee NICs, corporation Increasing public spending adds to the G component of AD (same shift as
tax, capital gains tax in diagram on income tax cut; if government increases its spending on
Indirect tax: a tax on spending e.g. VAT, excise duties capital projects, this increases the I component of AD (and in the long-
Progressive tax: a tax that takes a higher proportion of income from those on term, if successful, could also shift AS to the right)
higher incomes.
Proportional tax: a tax that takes the same proportion of income whatever the Government borrowing
level of income. Budget deficit or fiscal deficit: is the annual amount the government
Regressive tax: a tax that takes a lower proportion of income from those borrows to make up the gap between its income (mostly tax revenue)
on higher incomes. and its spending. A net injections into the circular flow G>T; it is a flow
Using demand-side fiscal policy to influence the economy National debt (public sector net debt): a stock of the total
Initial equilibrium at Y1 and PL1. accumulation of budget deficits (government borrowing) that is still to
Government cuts income tax, stimulating a be repaid.
rise in consumer spending which shifts AD Balanced budget: G=T
from AD1 to AD2, ceteris paribus. Budget surplus: a net withdrawal from the circular flow G<T; the
Real GDP increases from Y1 to Y2. Short government may be able to pay back some of its debt.
run economic growth, helps to close the
negative output gap, drawing unemployed
resources into use, but there may be some
Using demand-side fiscal policy to influence the economy
demand-pull inflation (PL1 to PL2). Increasing the budget deficit is a net injection into the economy; it adds
A fiscal multiplier effect could further to AD; if the government borrows to invest this also adds to AD (and can
stimulate AD growth and real GDP may
add to AS too). AD shifts right as in the diagram.
increase further.
A fiscal multiplier may kick in further stimulating growth.
EDEXCEL ECONOMICS (A) KNOWLEDGE ORGANISER: THEME 2 Demand-side policies – monetary policy
Demand-side monetary policy Using demand-side monetary policy to influence the economy
Demand-side monetary policy: use of interest rates, changes in the money • If deflation is a threat, the BoE
supply and/or changes in the exchange rate to affect AD – run by the can cut interest rates to boost AD
independent Bank of England (BoE) in the UK. from AD1 to AD2, increasing the
Bank base rate: the main interest set by the Bank of England; it is the rate at price level from PL1 to PL2 and
which commercial banks can borrow from the BoE increasing real GDP (Y1 to Y2)
• If inflation is above target, the
Market interest rates: rates of interest available to borrowers and savers which BoE can increase interest rates to
vary depending on risk, amount borrowed/saved, access to savings etc; they reduce AD from AD2 to AD1,
typically follow the Bank base rate up/down reducing the price level from PL2
Quantitative easing or QE: the BoE's asset purchase scheme to increase the to PL1, but this could slow growth
money supply (It is called quantitative tightening or QT when it is reversed) as real GDP falls (Y2 to Y1) and
cause some unemployment
Inflation target
Inflation target: in the UK CPI inflation target = 2% +/- 1 % point Bank of England Monetary Policy Committee (MPC)
Monetary policy adjusted AD to control inflation, meet the target and achieve
Central bank: the monetary authority and major regulatory bank in a
price stability
country. A central bank is responsible for operating monetary policy and
Nominal v real rate of interest: nominal is the actual rate paid; real rate is the
maintaining financial stability e.g. the UK's BoE
nominal rate adjusted for inflation. E.g. nominal = 5%, inflation rate = 3%, real
The MPC consists of nine members who meet eight times a year to set
rate is approximately 2%
Monetary policy transmission mechanism the base rate and decide if QE (or QT) is needed. The Governor of the
Bank has the casting vote.
How interest rate changes feed through to AD and influence inflation:
• Higher interest rates raise the cost of borrowing, which slows consumer spending Factors considered by the BoE MPC when making bank base rate decisions
C and business investment I. • Rate of growth of real GDP and the estimated size of the output gap
• This reduces AD aggregate demand for goods and services, which in turn eases • Forecasts for price inflation
upward pressure on retail prices. • Rate of growth of wages and other business costs
• Higher interest rates lead to an appreciation of the currency making imports • Movements in a country’s exchange rate
cheaper which then helps to reduce inflation. • Rate of growth of asset prices such as house prices
• Higher interest rates increase the return on savings, which encourages saving and • Movements in consumer and business confidence
helps to reduce inflationary pressures from excess aggregate demand. • External factors such as global energy prices and inflation in other
• Central banks might also think that an increase in the cost of borrowing sends a countries
message to businesses and unions when negotiating pay settlements. • Financial market conditions including the rate of growth of credit / money
EDEXCEL ECONOMICS (A) KNOWLEDGE ORGANISER: THEME 2 Demand-side policies – monetary policy
Quantitative easing (QE) Using QE to influence AD and the economy
Quantitative easing or QE: the BoE's asset purchase scheme to increase the • The GFC caused a prolonged
money supply (It is called quantitative tightening or QT when it is reversed). QE: recession and interest rates were
• increases the supply of money in the banking system brought down to a very low level but
there was still a fear of deflation
• encourage commercial banks to lend at cheaper interest rates to small & • The BoE began to QE to boost AD
medium sized businesses from AD1 to AD2 because interest
• is a form of expansionary monetary policy rates could not really be cut more,
• has been used as a technique to stimulate aggregate demand at a time helping to increase the price level
when nominal interest rates have fallen to historically low levels from PL1 to PL2 and promoting
economic recovery in real GDP (Y1 to
How QE works Y2)
Central bank creates new money electronically to make large purchases of
assets (bonds) from the private sector Expansionary v contractionary monetary policy
• Commercial banks receive cash from BoE asset purchases, and this Expansionary (reflationary/looser): cut interest rates, increase the money
increases their liquidity and might encourage them to lend out to supply via QE to stimulate AD growth to prevent deflation; a depreciation /
devaluation on the currency can boost AD too
customers which will help to stimulate an increase loan-financed
Contractionary (deflationary/tighter): raise interest rates, decrease the money
consumption C & investment I
supply via QT to slow AD growth and help control inflation; an appreciation /
• Increased demand for government bonds increases the market price of revaluation on the currency can slow AD too
bonds.
Some strengths and weaknesses of demand-side policies
• Higher bond price causes a fall in the yield on a bond (there is an inverse • Monetary and fiscal policy can conflict as well as complement each other
relationship between bond prices and yields). e.g. government pursued austerity in 2010 (tighter fiscal policy) while BoE
• Lower bond yields/long term interest rates may cause the currency to loosened monetary policy
depreciate, which can increase net exports (X-M) • Time lags: some fiscal policy can affect AD quite quickly e.g. a cut in
• Those who have sold bonds may use the extra cash to buy assets with income tax, but changes in the base rate take 18-24 months to influence
relatively higher yields such as shares of listed businesses and corporate inflation
bonds; if asset prices rise this can create a positive wealth effect on C • Interest rates have less impact because home ownership is low in the UK
When has QE been used and more mortgage holders fix their interest rate than in the past
Many countries have used QE e.g UK, USA, Japan, Eurozone...particularly after the Global • Loosening fiscal policy to boost AD can increase the budget deficit and
Financial Crisis 2007-9 and during the pandemic. National Debt, especially if growth does not pick up
The UK did £375bn of QE 2009-12, £60bn after Brexit vote in 2016, BoE further increased QE • Both fiscal and monetary demand-side policies can have an impact on the
in COVID up to a total of £895bn by March 2021 distribution of income; there may be winners and losers
EDEXCEL ECONOMICS (A) KNOWLEDGE ORGANISER: THEME 2 Supply-side policies: market based
Supply-side policies (SSPs) Problems with market-based SSPs
Supply-side policies: policies that focus on increasing the supply of goods and services in Income inequality: tax cuts that may benefit high-income earners and
an economy to encourage greater productivity and faster economic growth. reductions in social safety nets can lead to a wider wealth/income gap.
Main aims of SSPs Reduced social safety nets: Critics argue these policies can lead to reduced
• Improve incentives to work and invest in people’s skills (human capital) public services, including healthcare, education, and welfare programmes and
• Increase labour and capital productivity may increase poverty
• Increase occupational and geographical mobility of labour Underinvestment in public goods: underinvestment in critical public goods like
• Increase capital investment and research and development spending infrastructure, healthcare, and education may cause slower long-term
• Promote contestability and stimulate innovation (dynamic efficiency) economic growth.
• Encourage start-ups and expansion of new businesses especially those with Market failures: free markets are not perfect and can lead to market failures,
significant export potential/promote economic diversification such as externalities (costs or benefits imposed on third parties) and public
• Improve price & non-price competitiveness in global markets goods problems (goods with non-excludable and non-rivalrous consumption).
• Improve the trend rate of sustainable growth of real GDP to help support Financial instability: deregulation and lack of oversight in financial markets can
improved living standards & better regional economic balance contribute to financial instability e.g. prior to GFC.
Market-based SSPs SSPs in the AD/AS model
Market-based SSPs remove unnecessary government intervention to free up
markets, competitive forces & incentives to increase the long run trend growth rate
Tax cuts: lowering income, corporate, and capital gains taxes provides individuals and
businesses with more disposable income and greater after-tax profits, thereby
incentivising work, investment, and entrepreneurial activities.
Deregulation/privatisation: reducing regulations/bureaucratic red tape
can lower compliance costs and make it easier for firms to operate, expand, and innovate.
Firms may enter markets to make them more contestable/competitive. Private ownership
may increase competitiveness via the profit-incentive.
Trade liberalisation: reducing trade barriers, such as tariffs and quotas, can stimulate
international trade and stimulate investment in exports; promotes international
competitiveness. In the classical model, In the Keynesian model,
Intellectual Property protection: strong intellectual property rights protection encourages
successful SSPs shift LRAS to the successful SSPs shift AS to the
innovation and entrepreneurship by ensuring that creators and inventors can profit from
their ideas and inventions. right (LRAS to LRAS1); allows AD right (AS to AS1); also allows AD
Labour market reform: more flexibility to reduce costs of hiring and firing; opening up to to grow faster without inflation to grow faster without inflation
inward skilled migration; reducing trade union power. pressure building pressure building
EDEXCEL ECONOMICS (A) KNOWLEDGE ORGANISER: THEME 2 Supply-side policies: interventionist
Interventionist SSPs Problems with interventionist SSPs
Interventionists SSPs: interventionists believe the government can directly Bureaucracy and inefficiency: government intervention can lead to
intervene to improve the long-term supply-side of the economy. bureaucratic inefficiencies, which may slow down economic processes and
result in the misallocation of resources.
Types of interventionist SSPs Crowding out private sector: interventions, e.g. those involving public
Investment in infrastructure: government investment in capital such as the ownership/control of industries, may crowd out private investment and
transport, energy & communication networks in the economy, building more social entrepreneurship.
housing, which can also help private sector businesses. Reduced incentives: high taxation and extensive regulation can reduce
Interventions to reduce poverty: enables those on very low incomes to find work individuals' and businesses' incentives to work, invest, and innovate.
and contribute to the economy more fully; opportunities for more Ineffective redistribution: high levels of taxation can lead to capital flight and
entrepreneurship and improved labour productivity if skills are built up. tax evasion, undermining the intended redistribution.
Provision of key public and positive externality goods: government can invest in Costly and inefficient state enterprises: state-owned enterprises can become
human capital by providing healthcare and education/training; spending on public inefficient and financially burdensome, as they may not operate with the
goods such as defence and internet provision can improve security and same degree of cost-efficiency and innovation as private companies.
communication encouraging more investment and FDI.
Investment in ideas: the government can help fund R&D projects that lead to Examples of market-based & interventionist SSPs
more innovation, dynamic efficiency and competitiveness at home and abroad.
State ownership of key businesses: nationalisation of, for example, water, energy • Privatisation – Royal Mail in 2016 (Channel 4 has been proposed)
& transport industries can help an economy develop and, if provided • Deregulation of the UK retail energy market
effectively, can encourage private sector businesses to invest and grow. • Creation of new 8 Free Ports and Regional Enterprise Zones
Policies to tackle labour market failure: the government can provide more • Tax free childcare: £500 every 3 months (up to £2,000 a year) for each child
education/training to increase occupational mobility, use regional policy to • Creating 20 Institutes of Technology, roll-out of T Levels, new National Skills Fund
improve geographical mobility & set up an immigration system that ensures skills • Unemployment: Kickstart scheme for long term unemployed, Apprenticeship
gaps and labour shortages are not a problem. Levy on Firms
• Reforms to the UK immigration system (moving to a points-based system)
Ideas for evaluation of market-based & interventionist SSPs • Super-deduction tax incentive for business capital investment (125% tax
allowance)
Time lags: there is often a significant short-term cost (opportunity cost) while the
• Major infrastructure projects (+ creating the new UK Infrastructure Bank)
benefits come through in the long term, especially for interventionist SSPs.
• Lower Thames Crossing, London Super-Sewer
Income distribution: interventionist SSPs often reduce inequality, while market-based • Funding for rollout of electric vehicle charging infrastructure
SSPs may increase it; there may be winners and losers depending on which economic • UK Gigabit Programme and the Shared Rural Network.
agents' perspectives are being considered. • Relaxation of planning for renewables (off-shore wind) / UK Emissions Trading
Potential for government failure: unintended consequences as government lacks Scheme
perfect information.