AQA Year 13 MACRO KNOWLEDGE ORGANISER Financial Markets & Monetary Policy

Characteristics of money Types of financial market

Money – anything generally accepted in payment of a debt; removes the needs Money market: short-term, highly liquid debt
to barter, avoiding the double coincidence of wants securities including instruments like Treasury bills, commercial paper, and
Characteristics of money: acceptable to all, portable, durable, easily certificates of deposit; includes banks, financial institutions, and
divisible, not able to be counterfeited and scarce in supply. corporations seeking short-term financing or investments.
The Four Functions of Money Capital market: long-term debt and equity securities,
including stocks, bonds, and real estate investments; includes primary (new
Medium of exchange –money facilitates transactions between buyer and
issue of shares) and secondary (existing bonds/shares are traded
seller; specialisation and the division of labour requires a means of
Foreign exchange market: currencies are bought and
exchanging goods and services; money promotes this.
sold; facilitates international trade and investment
Unit of account - a nominal unit of measure used to value/cost/price
products, assets, debts, incomes and spending Types of financial asset
Store of value – an asset that holds value over time
Financial assets are a type of asset that represents a claim to a future cash
Standard for deferred payment – the accepted way in each market to settle
flow or a stream of payments, such as:
debt
Stocks: Represent ownership in a company and pay dividends to
Money supply definitions shareholders.
Bonds: A debt instrument that pays interest to the bondholder.
Money supply: the total quantity of money that is available for
Mutual funds: A pool of investments managed by a fund manager and
transactions. It is typically categorised into different monetary aggregates
offers diversification to investors.
based on liquidity and accessibility.
Exchange-traded funds (ETFs): Similar to mutual funds but are traded on
• Narrow Money (M1): M1 represents the most liquid components of the
exchanges like stocks.
money supply. It includes physical currency (coins and notes) and
Derivatives: Instruments whose value is based on the value of an
checking deposits in banks. M1 is used for day-to-day transactions.
underlying asset, such as options and futures.
• Broad Money (M2, M3, etc.): Broader monetary aggregates include
M2, M3, and beyond, which incorporate illiquid assets. These
Digital money
aggregates encompass a wider range of savings and time deposits, as
well as other near-money substitutes. Digital money, also known as electronic money or digital currency, refers to a
• Broad money includes savings accounts, time deposits, and other forms form of currency that exists solely in electronic or digital form.
of near-money assets. It is increasingly used for transactions and includes, digital wallets,
Liquidity: highly liquid assets are easy to convert to cash cryptocurrencies, central bank digital currencies and pre-paid cards
AQA Year 13 MACRO KNOWLEDGE ORGANISER Role of financial markets
Role of financial markets Inverse relationship: bonds prices & yields
Financial market: buyers and sellers come together to trade financial There is an inverse relationship between market interest rates and bond prices.
assets, such as stocks, bonds, currencies, and derivatives. The main goal A bond is a loan, repaid when the bond matures; it pays annual interest (the coupon);
of a financial market is to match buyers and sellers to efficiently allocate bonds can be traded after issue
Example: Tutor2u issues a £1,000 bond with £80 annual interest to investors to be
financial capital to its most productive uses helping to increase repaid in 2028 the date of maturity
economic growth. • Yield = £80 interest/market value of bond = 8%
Key roles: • Interest is paid annually on a set date such as June 1st to bond holders and interest
• To facilitate saving by businesses/households - secure place to store is fixed at £80 per year
money and earn interest • Bonds are traded in the market so the price can and does change
• To lend to businesses/consumers • This changes the implied % yield on a bond e.g if the price rose to £2,000, then the
yield falls to £80/£2000 = 4%; if the price fell to £500 then the yield rises to
• To allocate funds to productive uses; allocate capital to where the
rate of return relative to risk is highest Commercial & Investment Banks
• To facilitate the final exchange of goods/services (e.g contactless
payment) Commercial banks: provide traditional banking services such as accepting
• To provide forward markets to allow economic agents to insure deposits, making loans, and offering checking and savings accounts. They
against price instability and hedge against possible risks focus on providing financing to consumers and small businesses.
• Banks are licensed deposit-takers providing a range of savings accounts
• To provide a market for equities, allowing business to raise new
• They are licensed to lend money and create money via new bank loans, overdrafts
capital and mortgages
• To provide information about the prices of financial assets • Charges a higher interest rate on loans (or other assets) than the rate it pays out on
deposits (or other liabilities) to pay the operating expenses of a bank and helps
Equity v debt them to make a profit
Equity represents ownership in a company, entitling shareholders to a • Commercial banks are heavily regulated by governments,
proportional share of profits and voting rights. Investment banks: Specialise in underwriting securities, M&A advisory,
• Equity does not need to be repaid and carries higher risk, but trading, research, and asset management.
potentially higher returns through dividends and capital gains. • Operate in capital markets.
Debt involves borrowing money that must be repaid with interest over a • They focus on providing financial services to corporations, institutional investors
and high-net-worth individuals.
specified period. • They are subject to some regulations, often less stringent than commercial banks,
• Debt holders do not have ownership rights but have a priority claim on often with a focus on securities and financial market operations.
assets in case of bankruptcy, making it a lower-risk investment with • They are typically investment firms with no physical branches and a focus on
fixed returns. providing advice and services.
AQA Year 13 MACRO KNOWLEDGE ORGANISER Commercial banks
Functions of a commercial bank Objectives of commercial banks
• Accepting deposits: commercial banks offer safe and easily accessible Liquidity v Profitability:
deposit accounts, including savings accounts, checking accounts, and  Striking the right balance between liquidity and profitability can be
fixed deposits. challenging. While maintaining high liquidity ensures safety, it may
• Providing loans: they extend credit to individuals and businesses for reduce potential profits. Banks must decide how much liquidity to hold.
various purposes, such as mortgages, business loans, and personal  Sometimes a central bank will impose minimum liquidity requirements
loans. on banks such as a cash/deposits ratio
• Payment services: commercial banks facilitate payment and fund Profitability v Security:
transfer services through checks, electronic funds transfers, and online  Pursuing higher profitability often involves taking on more risk, which
banking. can jeopardise the security of customer deposits.
• Safekeeping of valuables: some commercial banks offer safe deposit  Balancing these objectives is crucial for long-term sustainability
boxes for customers to store valuable items securely.
How the banks create money
• Currency exchange: they provide foreign exchange services to facilitate Fractional reserve system: banks create credit by using the fractional reserve
international trade and travel. system, where they are required to hold only a fraction of their deposits as
Balance sheet of commercial bank cash / liquid reserves and can lend out the rest.
Assets: Money multiplier effect: when banks lend out a portion of the funds
 Cash and Reserves: funds held in the central bank or as cash on hand deposited with them, these funds are deposited in other banks, creating a
 Loans and Advances: money lent out to borrowers. chain reaction of lending and increasing the money supply.
 Investments: securities held by the bank, such as government bonds or Credit creation process: as banks make loans, they effectively create new
corporate bonds. money in the form of additional deposits. This process multiplies the initial
Liabilities: deposit and contributes to economic activity measured by GDP
 Deposits: funds held in customer accounts. Limitations on money creation
 Borrowings: funds borrowed from other financial institutions. • Market forces – the profitable lending opportunities to businesses and
 Capital: the bank's equity, including shares and retained earnings households can often fluctuate for example at different stages of the
cycle
Money or credit creation by commercial banks • The risks of lending including default risk from the borrower
Banks create credit by agreeing loans to businesses and households. When a • Regulatory policies such as minimum capital reserve requirements as
bank makes a loan, it credits their bank account with a deposit of the size of part of regular bank stress tests
the loan. At that moment, new money is created. They do not need to attract • Monetary policy - level of policy interest rates set by the Bank of
deposits from savers initially England influences total demand for loans
AQA Year 13 MACRO KNOWLEDGE ORGANISER Central banks and monetary policy
Main roles of a central bank Central Bank = the government's bank
Monetary policy: Central banks set interest rates and control the money Issuing government bonds: Central banks can issue and sell government
supply to influence the economy. bonds on behalf of the government to finance its budget and borrow
Financial stability: Central banks work to ensure the stability of the money.
financial system by regulating banks and other financial institutions Managing government debt: Central banks can help governments manage
Managing the currency: Central banks print and issue currency, manage its their debt by buying and selling government bonds in the market, helping
value, and oversee its distribution. to stabilize prices and maintain liquidity.
Lender of last resort: Central banks act as a lender of last resort, providing Providing advice: Central banks often provide economic and financial
emergency loans to banks and other financial institutions during times of advice to governments, helping them to make informed decisions about
crisis. fiscal policy and other issues.
Financial supervision: Central banks supervise the financial system to
ensure that financial institutions are operating safely and following Bank base rate
regulatory requirements. Base rate: main interest rate set by a nation’s central bank; the rate of
Research: Central banks conduct economic research and analysis to inform interest charged to commercial banks if they must borrow from the central
their policy decisions. bank when short of liquidity; market interest rates often take their cue from
Examples: Bank of England, ECB, the Fed in USA changes in the Base Interest Rate
Market interest rates: rates for savings, bank overdrafts, mortgages, credit
Lender of last resort
cards, pay day loans etc.
Lender of last resort: role central banks play in times of financial distress.
When other financial institutions are unable to provide loans, the central Responsibility for monetary policy
bank steps in to lend money to banks/financial institutions.
The central bank makes decisions on base rates & QE to meet its remit; in
• Central banks provide emergency loans to financial institutions in times
the UK the Bank of England has to aim to meet the 2% inflation target in the
of crisis to prevent their collapse and limit systemic risk.
medium term. REVIEW: Monetary policy from Year 12!
• They also provide short-term loans to banks at a slightly higher interest
Decisions affect the main economic indicators and can affect the exchange
rate than the market rate - the discount window.
rate (higher interest rate leads to appreciation ceteris paribus)
• They require collateral from financial institutions as a condition for
Bank reserve requirements: the central bank can change the amount of
lending. This helps to mitigate the risk of default.
money banks must have in reserve to ensure banks have enough liquidity to
• Central banks are known as the lender of last resort due to their ability
meet the needs of their customers; the UK does not have these but sets
to provide loans in times of crisis, which can help to prevent financial
'stress tests' to check the banks are prepared for a financial shock/crisis
panics/loss of reputation
AQA Year 13 MACRO KNOWLEDGE ORGANISER Regulation of the financial sector
Why regulation is important FPC
Preventing systemic risk: Financial regulation helps to reduce the risk of a • Identifying systemic risks: The FPC assesses the financial system to identify potential risks
major financial crisis by requiring financial institutions to maintain that could threaten its stability. .
adequate capital and liquidity, and by limiting risky activities. • Setting policy tools: Once systemic risks are identified, the FPC has the authority to
Protecting consumers: Financial regulation protects consumers from recommend or set specific policy tools to address these risks. These tools can include
capital requirements for banks, leverage ratios, liquidity requirements, and more.
fraud, predatory lending, and other harmful practices.
• Stress testing: The FPC conducts stress tests to assess how well the financial system and
Ensuring fair competition: Financial regulation promotes fair competition individual institutions can withstand adverse economic conditions and shocks.
in the financial industry by preventing anticompetitive behaviour and
unfair pricing practices. Why commercial banks can fail
Promoting financial stability: Financial regulation helps to prevent the Run on the bank – depositors panic and withdraw money leaving the bank with
kind of market instability that can lead to economic downturns and insufficient liquidity to meet all its customers' demands
recessions. Credit crunch – bank may be unable to borrow from other banks overnight
Financial regulation bodies in the UK Toxic debt - losses from bad debt/loan defaults reduces bank's credit rating; its
The Bank of England
share price falls
The Prudential Regulation Authority (PRA)
The Financial Policy Committee (FPC) Arguments for and against allowing bank failures
The Financial Conduct Authority (FCA)
FCA Bank failures …. Bail-outs help to...
• Encourage market  Prevent systemic risk
• Regulation and supervision: The FCA is responsible for regulating financial
institutions. It sets regulatory rules and standards for these firms, conducts discipline​  Protect depositors
prudential supervision, and ensures that they comply with applicable regulations. • Promote competition  Prevent the negative
• Consumer protection: The FCA ensures that financial products and services are • Avoid moral hazard externalities from financial
fair, transparent, and not misleading. • Protect taxpayers​ market failure
• Market supervision: The FCA actively monitors financial markets to identify risks
and emerging issues Liquidity and capital ratios
Liquidity ratios: used to assess a bank's ability to meet its short-term financial obligations
PRA
and maintain sufficient liquid assets to cover withdrawals and unexpected funding needs
• Prudential supervision: The PRA is responsible for prudential supervision involves Cash Reserve Ratio (CRR): mandates that banks maintain a certain percentage of their
assessing and ensuring the financial soundness of financial institutions to prevent total deposits in the form of cash or deposits with the central bank.
financial instability. Capital Adequacy Ratio: measures the proportion of a bank's risk-weighted assets (RWA)
• Setting and enforcing prudential standards: The PRA enforces standards to ensure to its total capital, expressed as a percentage; it ensures that a bank's capital is sufficient
that financial firms can withstand economic and financial shocks. relative to its risk exposure.
AQA Year 13 MACRO KNOWLEDGE ORGANISER The Financial Sector – the need for regulation
Market failure in the financial sector: asymmetric information Market failure: speculation and market bubbles
Asymmetric information: one party in a transaction has more information Speculation: buying assets (e.g. stocks or real estate) with the expectation
than the other which can lead to of profiting from price increases, rather than from the asset's intrinsic value.
• Adverse selection: occurs when individuals with hidden information Market bubbles: when asset prices rise significantly above their
about their riskiness (e.g., borrowers with poor credit history) are more fundamental values due to speculation and irrational exuberance; bubbles
likely to seek financial products (e.g., loans), leading to higher default often burst, leading to market crashes and financial instability.
rates for lenders. Market failure: market rigging
• Moral hazard: arises when one party, typically after a transaction, has an Market rigging: the manipulation of financial markets to gain unfair
incentive to behave differently because of incomplete information e.g. advantages.
borrowers may take on excessive risks if they believe they won't bear the • Examples include insider trading (trading based on non-public,
full consequences of their actions. material information), market manipulation (e.g., pump-and-dump
Market failure in the financial sector: externalities & systemic risk schemes), and collusive behaviour among market participants to
Externalities: spillover / third-party effects that affect parties not directly distort prices.
involved in a transaction: • Monopoly power is usually assumed to damage consumer and social
• Negative externalities: financial institutions may engage in risky welfare.
practices (e.g., excessive lending) that can lead to systemic risks • Market rigging undermines market integrity and can lead to investor
affecting the entire economy e.g. GFC 2008 losses.
• Systemic risk: widespread failure of financial institutions leading to a Lack of regulation: inadequate or ineffective regulation of financial
domino effect and a widespread economic collapse. markets can lead to excessive risk-taking, fraud, and other forms of
• Positive externalities: a well-functioning financial sector can benefit the misconduct.
broader economy by efficiently allocating capital and promoting Financial crisis
economic growth. Financial crisis: major shock to financial markets, associated typically with
Market failure in the financial sector: moral hazard falling asset prices and insolvency amongst debtors which ramifies
Moral hazard: refers to the risk that one party may take on excessive risks throughout the financial system, disrupting the market’s capacity to
because they believe they are protected from the full consequences of their allocate financial capital.
actions. Includes currency crisis (sudden collapse of currency), external debt crisis
• It can arise when banks and financial institutions believe they will be (unable to fund a current account deficit), sovereign debt crisis
bailed out by the government in the event of a financial crisis. (government cannot pay interest on their debt), banking crisis (possible
• This can lead to reckless behaviour and excessive risk-taking. run-on banks) and broad financial crisis (combination of others).
AQA Year 13 MACRO KNOWLEDGE ORGANISER The International Economy: Globalisation
Globalisation Causes of globalisation
Globalisation: The deepening of relationships between countries, reflected • Containerisation and falling transport, freight and travel costs
in an increasing level of cross-border trade and investment and migration • Increasing influence of powerful corporations (MNCs/TNCs)
De-globalisation: a reversal of the process of globalisation • Lower trade barriers/trade liberalisation
Slower globalisation ('slowbalisation'): slowdown in the speed of • Increasing size and number of trading blocs
globalisation • More FDI flows between countries
Characteristics of globalisation • Greater labour migration and the emergence of a global labour force
• Rapid spread of technologies, manufacturing systems and management
• Increased trade in goods and services (more WTO members, China & techniques (knowledge transfers)
India, Russia); higher trade to GDP ratios • Faster communication and information flows and the emergence of new
• More capital transfers and capital liberalisation (MNCs/TNCs, FDI, markets, especially global media presence
foreign ownership of companies etc) • Improvements in infrastructure
• Global branding • Geopolitical change
• Greater specialisation and division of global labour force • New emerging markets
(outsourcing, offshoring….global sourcing and global supply chains)
• Labour migration (within and between countries) Benefits of globalisation
• Shifting balance of economic and financial power from developed
Economies of scale: Globalisation encourages both producers and consumers
world to emerging markets
to reap benefits from division of labour; greater productive efficiency
• De-industrialisation and structural unemployment in developed
More cost-reducing innovation: more competitive markets reduces the level
economies
of monopoly profits and can incentivise businesses to innovate
• Increased global media presence (internet); greater connectivity
Lower consumer prices/better quality: greater competition can drive down
• Greater investment spending on infrastructure & innovation; more
prices for consumers and may increase range and quality of goods available
integrated global supply chains
(increased consumer surplus)
• Increasing interdependency of economic agents (producers,
Faster economic growth: leads to higher per capita incomes and reduced
consumers, governments and enterprises)
extreme poverty in many lower income countries.
Multi or trans-national corporations (MNCs/TNCs) Freer movement of labour: helps to relieve skilled labour shortages &
Multi- or trans- national companies (MNCs or TNCs): companies that diversifies the workforce, promoting knowledge, technology & management
operate in more than one country. The head office might be in the USA, but practice transfers boosting innovation
the manufacturing factories in SE Asia, using raw materials from Africa, while Increased awareness: of the long-term global economic challenges from
final products are sold in markets across the world. climate change and the impact of wealth & income inequality
AQA Year 13 MACRO KNOWLEDGE ORGANISER Globalisation
Costs of globalisation Causes of de-globalisation
Rising inequality: the gains from globalisation are unequal leading to Protectionism: measures such as tariffs, quotas, and trade barriers may be
growing political and social tensions when inequality of income and used to shield domestic industries from foreign competition.
wealth increases; relative poverty may increase Economic Shocks: Economic downturns/recessions can lead countries
Environmental costs: threats to the global commons including to reduce their reliance on global trade, supply chains and investment.
irreversible damage to ecosystems, land degradation, deforestation, Changing Trade Agreements: countries might renegotiate or withdraw from
loss of bio-diversity and water scarcity trade agreements that were previously promoting globalisation e.g. Brexit
Macroeconomic fragility: in an inter-connected world, external shocks Environmental Concerns: concerns about climate change might lead to
in one region can rapidly spread to other centres (this is known as prioritisation of local production to reduce the carbon footprint associated
systemic risk) with long-distance trade.
Trade imbalances: increasing trade imbalances (both surpluses and Health Crises: global health crises, such as pandemics, disrupt travel, trade,
deficits) lead to protectionist tensions, more import tariffs and quotas and supply chains.
and a move towards managed exchange rates – this can then lead to Economic Nationalism: governments might adopt policies to protect
de-globalisation and slower growth domestic industries and jobs, even if it means reducing international trade
Jobs: Workers may suffer structural unemployment from out-sourcing Impact of globalisation on developed countries
of manufacturing to lower-cost countries and a rise in the share of
imports in GDP Benefits Costs
Tax avoidance: many large MNCs can find ways of avoiding corporation • Increased access to foreign • Job displacement/structural
tax and other taxes; the rich can also avoid tac using tax havens, markets unemployment
reducing the tax revenue of governments • Attraction of foreign investment • Rise in income inequality
Brain drains: a more mobile global workforce means some countries • Improved productivity and • Environmental degradation
suffer from emigration, losing their most productive workers. innovation

Systemic risk of negative global shocks Impact of globalisation on developing countries

A more interconnected world is at greater risk from negative economic shocks Benefits Costs
such as: • Increased access to global • Economic dependence such as
• pandemics • geo-political shocks primary product dependency
markets
• financial crises, • risks from terrorism, • Exploitation of labour and issues
• Increase in foreign investment
• currency crises commodity price volatility with emigration
• Increased access to knowledge
• natural disasters • unexpected changes in • Enironmental degradation
and technology
• extreme weather global interest rates
AQA Year 13 MACRO KNOWLEDGE ORGANISER Globalisation: MNCs
Multinational corporations (MNCs) Global value chains
Multinational corporations: businesses that base their manufacturing, Global value chain (GVC): the interconnected network of activities involved in
assembly, research and retail operations in several countries, e.g. Nike, the production and delivery of goods and services that are performed by
Apple, Vodafone, Netflix, Uber, Amazon, Facebook (Meta) Google and multiple firms, operating in different countries.
Samsung • In a GVC, different stages of production, such as design, research
How MNCs affect globalisation and development, manufacturing, marketing, and distribution,
are performed by different firms in different countries, with each
• Many MNCs have re-located manufacturing to countries with relatively firm adding value to the final product or service.
lower unit labour costs in order to increase their supernormal profits • The total trade value of parts and components for smartphones reached
and equity returns for shareholders nearly $490 billion in 2019 (WTO)
• Some MNCs are reshoring manufacturing as labour costs rise in many
emerging countries. Benefits of MNC for a country
• The pandemic caused some firms to shorten their manufacturing • Employment opportunities created by MNC where they operate,
supply chains and 'de-globalise' contributing to lower unemployment rates.
• MNCs bring investment, technology and expertise, which can stimulate
Importance of multinational corporations economic growth and development.
• Major contributors to FDI, often establishing subsidiaries in foreign • MNCs can facilitate innovation, knowledge and skills transfer to local
countries workers, enhancing productivity and competitiveness.
• Around two-thirds of global trade is conducted within multinational • MNCs generate tax revenue for governments through corporate taxes,
enterprises or their subsidiaries (WTO data) potentially boosting public finances
• Foreign affiliates of multinational corporations employ around 60 million
people worldwide (OECD data) Costs of MNC for a country
• In 2019, global trade in intermediate goods accounted for over 50% of • MNCs may also displace local businesses, leading to job losses in certain
total trade. TNCs are at the heart of the creation of global value chains. sectors or regions.
• Tax revenue losses from base erosion and profit shifting could be • Countries hosting MNCs may become dependent on foreign investment,
between $100 billion and $240 billion annually (OECD data) risking loss of control over key sectors of the economy.
• MNCs may exploit cheap labour in host countries, leading to suppressed
Emerging market MNCs
wages and poor working conditions for local workers.
MNCs do not just grow out from developed countries: they have grown out of • Some MNCs engage in aggressive tax planning strategies to minimize their
EM economies e.g. from China: China Mobile, TikTok, Huawei Technologies; tax liabilities (tax avoidance), which can reduce the tax revenue collected
from India: Infosys, Tata Group by host countries
AQA Year 13 MACRO KNOWLEDGE ORGANISER The International Economy: Trade
Why countries trade Comparative Advantage
• To increase the availability of resources, goods and services Comparative advantage: when one country can produce a good or service
• To increase choice for consumers/more product differentiation at a lower opportunity cost than another country. It considers where a
• To increase efficiency/reduce costs/reduce prices country is relatively more efficient or relatively less inefficient at producing
Good X Good Y
International specialisation
Country A 60 45
International specialisation: where countries/regions focus on producing &
exporting specific goods or services in which they have a comparative Country B 120 60
advantage, while importing other goods or services that they can acquire Before specialisation and trade, the countries can produce 180 of X and 105
more efficiently from trading partners. This specialisation allows countries to of Y. This assumes the labour input and other inputs are initially divided
allocate their scarce factor resources more efficiently, improve overall equally between the two countries.
productivity, and hopefully benefit from the gains of trade across borders Opportunity cost ratios
In country A, to get 60 more of X means giving up 45 of Y. The opportunity
Absolute advantage cost of 1X = 45/60 of Y = 0.75; the opportunity cost of 1Y = 60/45 = 1.34.
Absolute advantage: a country produces a good at a lower direct costs In country B, to get 120 more X means giving up 60 of Y. The opportunity cost
i.e. if a country using the same factors of production can produce more of of 1X = 60/120 = 0.5; the opportunity cost of 1Y = 120/60 = 2.
a product Country A has a lower opportunity cost than country B in the production of
Good X Good Y Y (1.34 compared to 2) while country B has a lower opportunity cost of
production of X (0.5 compared to 0.75).
Country A 20 10 Country A has a comparative advantage in Y and country B has a
Country B 5 15 comparative advantage in X.
The gains in output after specialisation
Together Countries A & B can produce 25 of good X and 25 of good Y
before specialisation. Good X Good Y
• Country A has an absolute advantage in the production of good X, Country A 0 90
while Country B has an absolute advantage in production of good Y.
Country B 200 20
• If they specialise where their absolute advantage lies, then A
produces 40 of X (but no Y) and B produces 30 of Y (but no X). By specialising in where their comparative advantages lie, their joint output
They have produced 15 more of X and 5 more of Y by specialising. They goes up from 180 to 200 of X and from 105 to 110 of Y. They can trade and
can trade and potentially share the gains made. potentially share these gains.
AQA Year 13 MACRO KNOWLEDGE ORGANISER Specialisation and trade
Mutually beneficial terms of trade Comparative advantage underlying assumptions
The two countries need to find a mutually beneficial terms of trade – in • No transport costs
other words, a trade of ood X for good Y that benefits both countries. If • No barriers to trade
they trade at 3:2 then both countries can benefit because • Homogenous goods
3:2 or 1.5X:1Y lies between the internal opportunity cost ratio for both • No economies of scale
countries. • No environmental costs
In A, the opportunity cost ratios were 1X:0.75Y and 1Y;1.34X • Perfect knowledge
In B, the opportunity cost ratios were 1X:0.5Y and 1Y:2X • Factor mobility between uses
A can now sell 1Y and receive 1.5X in exchange whereas before it received • All resources fully employed and all goods and services sold
1.34X Many of these assumptions do not hold in the real world, so the gains from
B can now sell 1X and receive 0.67Y in exchange whereas before it received trade may be less or more than the theory predicts
0.5Y Competitive Advantage
After trade and specialisation Competitive advantage: when your country/business has access to
technology or innovations that allow cheaper and/or more efficient
After both specialisation and trade, both countries are better off than before. production of goods. This gives a cost advantage and, therefore, a
Assuming country A exports 43Y to country B and imports 63X from country B price/quality advantage over competitors. It is a more appropriate trade and
Good X Good Y specialisation concept when considering highly differentiated manufacturing
goods, for example.
Country A 63 48 Using diagrams to show absolute and comparative advantage
Country B 137 62
Country A has 3X and 3Y more than before
Country B has 17X and 2Y more than before
Both have gained from specialising where comparative advantage lies and
then exchanging at a mutually beneficial exchange rate,, even though B has
the absolute advantage in the production of both goods.
David Ricardo
David Ricardo was one of the founding fathers of classical economics. He developed the
idea of comparative advantage. His basic rule: Specialise a country’s scarce factor resources A has absolute advantage in No gains from trade. A has comparative
in goods and services that they are relatively best at. This opens potential gains from Y and B has absolute Opportunity cost ratios are advantage iin X and B has
specialisation and trade which leads to improved economic welfare advantage in X the same. (Parallel) comparative advantage in Y
AQA Year 13 MACRO KNOWLEDGE ORGANISER Pattern of trade
Pattern of trade The UK's pattern of trade
Pattern of trade: the mix of goods and services that a country and imports Geographical
and exports in international trade; the range of countries it exports to and • Despite Brexit, 46 per cent of UK exports go to the European Union
imports from and 53 per cent of UK imports come from the European Union
Factors influencing the pattern of trade • 3.6 per cent of UK exports go to China and 13% of UK imports come
• Absolute and comparative advantages from China
• Factor endowments - the quantity and quality of the resources a • USA is largest single export market for UK with Germany 2nd
country has or has not got • Germany is biggest source of imports (12%), USA on 11% and
• Trading bloc and trade agreements Netherlands on 7.3%. (2023 data)
• Globalisation, trade liberalisation, protectionism & FDI flows Commodity
• Changes in world incomes and growth rates • The UK trades most in petroleum products; road vehicles;
• Exchange rate movements pharmaceutical products; industrial machinery; business services;
• De-industrialisation & the pace of economic development financial services (including insurance); telecommunications; cultural
Geographical pattern of trade and creative services.
Geographical pattern of trade: how businesses and consumers in other
countries trade with businesses and consumers in a country Pattern of trade and primary product dependency
Intra-regional trade: trade between countries in the same region Primary product dependency: where a country's economy heavily relies on
Gravity theory of trade: countries tend to trade most with other nations in the export of raw materials or primary products, such as agricultural goods,
closest proximity minerals, or energy resources.
Commodity pattern of trade Export earnings fluctuate with global commodity prices and demand
Commodity pattern of trade: the type of products (goods and services) leading to economic instability and hindering economic development.
traded internationally. It shows if a country has a dependence on primary v Examples include oil-exporting countries, agricultural exporters e.g. Cote
manufactured v service exports. As a nation develops complexity and d'Ivoire & cocoa and mineral-dependent countries e.g Zambia & copper
capabilities, they become capable of supplying and exporting a broader
Emerging markets and trade patterns
range of products
Emerging Market: an economy that cannot yet be classified as ‘developed’
The EU's pattern of trade and the USA & China
and is investing heavily in its productive capacity.
The EU trading bloc is a customs union and a single market which encourages
• Many EMs have followed a path of industrialisation built on rising
a high degree of intra-regional trade. 20 countries also share a currency, the
domestic and inward investment increasing their export capacity and also
Euro. Many countries have either of both China and the USA as a major
their demand for primary commodities, affecting trade patterns
trading partner because of their economic size.
AQA Year 13 MACRO KNOWLEDGE ORGANISER Protectionism
Types of restrictions on trade NTBs
Tariff: tax on imports (ad valorem or specific) Intellectual property laws such as patents and copyright protection
Quota: physical limit on the quantity of imports allowed Technical barriers to trade including labelling rules and stringent sanitary
Subsidy: payments by the government to reduce the costs of producers, standards. This raises product compliance costs for exporters
increases supply and reduces the price Preferential state procurement policies – where government favour local
Non-tariff barrier (NTB): barriers such as import quotas, tough producers when finalising contracts for state spending projects
environmental and product standard rules, trade embargoes and export Domestic subsidies – aid for businesses facing financial problems –for
subsidies example, subsidies for car manufacturers or loss-making airlines.
Rules of Origin: rules of the national source of the traded goods e.g. a Financial protectionism – when a government instructs state-owned banks
minimum % for locally-sourced components to give priority/cheaper loans to domestic businesses
Managed exchange rates – government intervention in currency markets
Impact of a tariff on a market to change the relative prices of imports and exports
Tariffs v quotas
Before the tariff, price is The impact of a quota is similar to a tariff; restricting supply of imports
P2; domestic demand is Q4 increases the market price. A quota that raises the price by the equivalent
and domestic supply amount as the tariff has the same welfare effects as a tariff except there is no
is Q3; imports are Q3Q4. gain in government tax revenue (areas 2+3+4 = net welfare loss)
After imposing the
Impact of subsidy on imports
tariff; new price is
P1, domestic Before the subsidy,
demand is Q2 and imports are
domestic supply is Q1Q2. Subsidy shifts
Q1: Q1Q2 of good domestic supply to
is imported. Consumer right. Imports fall to
surplus falls by Q2Q3. At the
area 1+2+3+4; producer subsidised price, more
surplus rises by area 1; domestic suppliers can
government tariff revenue compete with the
rises by area 3: net welfare world producers.
loss of areas 2+4.
AQA Year 13 MACRO KNOWLEDGE ORGANISER Reason for restrictions on trade/protectionism
Causes of protectionism Problems with protectionism
Higher prices for consumers: protectionist policies often lead to higher prices for
Protecting domestic industries: trade restrictions can shield domestic industries
imported goods due to tariffs or quotas.
from foreign competition, preventing job losses and maintaining national self-
sufficiency in critical sectors. Less choice for consumers: trade restrictions can limit or prevent some goods
being imported
National security: trade restrictions may be used to safeguard national security
interests; export of certain technologies or goods could be restricted to prevent them Lower living standards: living standards may fall as the availability
from falling into the wrong hands. and affordability of goods decreases; many protectionist measures reduce welfare
Diversify: an economy that is too dependent on one product. Over-reliance on protection: can lead to inefficiencies in supply, reducing
Infant industry argument: governments may protect emerging or "infant" industries competitiveness in the long term.
until they can compete internationally; tend to be temporary trade barriers, like Danger of retaliation/trade war: protectionist policies may strain diplomatic
subsidies or tariffs, providing domestic industries time to grow relations and lead to retaliation by trading partners.
Sunset industry argument: use tariffs to slow the decline of older sectors and limit Increase in income inequality: if trade restrictions benefit specific industries or
risks of structural unemployment. groups while imposing costs on others; they may also affect global income distribution
Anti-dumping measures: duties are imposed when foreign companies sell products by limiting opportunities for developing countries to export
below their production cost in the domestic market, harming domestic producers Shadow markets: incentives to by-pass controls
protecting local industries from unfair competition.
Environmental and health concerns: restrictions prevent the import of products Issues with free trade
that do not meet domestic environmental, health, safety and quality standards. Job losses: free trade can lead to job losses in industries where other
Balance of payments improvement: trade restrictions can be used to improve a countries have a comparative advantage; when cheaper imports flood the
country's balance of payments by reducing imports through tariffs or quotas can help market, this can lead to layoffs and unemployment.
reduce trade deficits that use up foreign currency reserves Wage suppression: free trade can lead to downward pressure on wages, as
Raise tax revenues: this is especially important for many developing countries who companies might move production to countries with lower labour costs.
have a limited domestic tax base).
Income inequality: free trade can exacerbate income inequality within
countries;
Benefits of protectionism
Trade barriers and inequality
• Domestic industries become more competitive with better products for consumers • Protectionism tends to benefit high-income earners and harm low-income
• Protects domestic industries and helps them grow; may create jobs earners because of higher prices are regressive
• Can protect jobs, prevent structural unemployment • Job losses caused by trade barriers also disproportionately affects low-income
• Governments can gain some tax revenue from tariffs workers, though jobs for some could be protected.
• Can be used to improve the current account balance on the Balance of Payments • Trade barriers can lead to less competition in certain sectors, allowing companies
• Can protect citizens from dangerous products, protect national security and help to have more pricing power; higher profits could be shared with workers via higher
promote self-sufficiency in strategic industries real wages.
AQA Year 13 MACRO KNOWLEDGE ORGANISER Trade agreements including customs unions and EU's SEM
Trading blocs Customs union
Trading bloc: regional economic groupings/regional trade agreements Free trade between members and the common external tariff (CET) cause:
RTAs i.e. groups of countries that trade more freely amongst themselves but Trade creation: removal of tariffs between members increases trade between
may set barriers against non-members businesses within the bloc; more gains from specialisation and trade; greater
Bilateral trade agreement: trade agreement between two countries exploitation of the bloc's countries' comparative advantages
Multilateral trade agreement: trade agreements between many countries or Trade diversion: the CET means trade may pivot away from the global lowest-
between a trading bloc and another country/trading bloc cost producers to the lowest cost producer within the bloc; trade is diverted
Types of trading blocs from outside to inside the bloc
Preferential Trading Area (PTA) such as trade agreements between the EU and Examples: the EU, Turkey & the EU
the less developed countries Trade creation diagram
Free trade area/agreement (FTA): free trade between members; tariffs and Before joining the customs union,
quotas removed; price is P1; domestic demand is
Customs union: free trade between members and a common external tariff (CET) Q2 and domestic supply is Q1:
on non-members Q1Q2 of good is imported.
Single (common) market: free trade and common policies on product regulation, After joining the tariff is removed;
and freedom of movement of the factors of production (capital and labour) and
new price is P2, domestic demand
of enterprises and services. The physical (borders), technical (standards) and
is Q4 and domestic supply is Q3;
fiscal (taxes) barriers are removed to allow free movement among the member
states – creates a ‘level playing field’ for trade by removing NTBs, which is imports increase to Q3Q4.
particularly useful for services trade Consumer surplus rises by area
Monetary union: members of the bloc share a common currency, central bank 1+2+3+4; producer surplus falls by
and interest rate e.g Eurozone area 1; government tariff revenue
falls by area 3: net welfare gain of
Free trade areas and rules of origin
areas 2+4.
A free-trade area eliminates tariffs, import quotas, and preferences on
most (if not all) goods and services traded between them. Single or common market
Examples: ASEAN, USMCA, EFTA, ACFTA Common/single market has free movement of goods, services, capital and
• Each member can set its own tariff on imports from outside the FTA labour and a common set of rules on standards reducing both tariff and non-
• FTA may be undermined by re-exporting so this is prevented by imposing tariffs on tariff barriers to trade
re-exports and enforce a ‘country of origin rule’ (i.e. a certain % of goods traded
Example: the EU single market
must originate from a member state to qualify for tariff-free internal trade)
• Rules of Origin: negotiating and establishing the rules of origin is complex and adds Brexit: the UK left both the EU customs union and single market and
to the costs of firms that trade negotiated an FTA with the EU called the Trade and Cooperation Agreement
AQA Year 13 MACRO KNOWLEDGE ORGANISER UK's membership of EU and Brexit
Brief History Costs of EU membership for UK
UK joined the European Economic Community in 1973 when it was Membership Fees: the UK made significant net financial contributions to
a customs union. The EU evolved and become more integrated with the the EU budget. These contributions were a source of contention,
establishment of the EU's Single Market (1993 onwards) and the particularly among those advocating for Brexit.
Eurozone (1999 onwards). It also enlarged, for example, many Eastern Loss of Sovereignty: EU membership necessitated the acceptance of
European countries joined in the 1990s. In 2016 the UK held the Brexit supranational laws and regulations, limiting the UK's ability to make
referendum and the UK voted narrowly to leave the EU. In 2020 the UK independent policy decisions in areas such as trade, agriculture, and
officially left the EU. competition policy.
Immigration and Freedom of Movement: Many citizens of member states
Benefits of EU membership for UK 1973-2020 came to live and work in the UK, leading to concerns about increased
immigration levels and pressure on public services, infrastructure, and
Access to the Single Market: the free movement of goods, services, wages.
capital, and labour facilitated trade and investment flows between the UK Trade Restrictions: Membership in the EU's Single Market also meant
and other EU member states, boosting economic growth. compliance with common external tariffs and trade policies, which could
Foreign Direct Investment (FDI): increase in UK's access to FDI from other limit the UK's ability to negotiate independent trade deals with non-EU
EU countries, as well as from outside the EU, contributing to job creation, countries.
technological advancement, and overall economic development. Regulatory Burden: While regulatory alignment with the EU facilitated
Trade Agreements: the UK benefited from the trade agreements trade, some businesses viewed EU regulations as burdensome and overly
negotiated collectively by EU member states with other countries and bureaucratic, potentially stifling innovation and competitiveness
regions, providing enhanced market access for British goods and services.
Brexit
Regulatory Alignment: EU membership entailed adherence to common
standards and regulations, which reduced non-tariff barriers to trade and The benefits and costs above can largely be reversed for the pros & cons of
compliance costs for UK businesses, particularly in sectors heavily Brexit. 2016-2020: Uncertainty about the type of Brexit the UK would choose
integrated with the EU market. and what type of trade agreement the UK would make with the EU created
Regional Development Funds: The UK received funding from various EU economic uncertainty deterring business investment. 2020: The UK agreed
programs aimed at promoting regional development, infrastructure the TCA with the EU – a free trade agreement. Research estimates the UK
projects, and research and innovation initiatives in less economically economy is about 4-5% smaller than it would have been. Tax revenue is
developed areas. estimated to be about £40bn less per year. Many SMEs are finding it costly to
Access to immigrant labour: EU immigrants filled skills gaps and adhere to UK & EU sets of standards after leaving the EU's SEM and some
contributed positively to the public finances alignment with the EU is creeping back in..
AQA Year 13 MACRO KNOWLEDGE ORGANISER Trading agreements and WTO
Trading blocs: advantages World Trade Organisation
Increased Trade: RTAs lead to increased trade among member countries, The key functions of the WTO are:
boosting economic growth. More trade creation & gains from trade Negotiation: facilitating trade negotiations among member countries to
Efficiency Gains: by reducing trade barriers, resources are allocated more reduce trade barriers.
efficiently; more dynamic efficiency and tech transfer Dispute Settlement: resolving trade disputes through a rules-based system
Economies of Scale: larger markets allow for economies of scale, reducing Monitoring: monitoring trade policies and practices of member countries to
production costs. ensure they comply with WTO rules.
Political Cooperation: RTAs can promote political cooperation and peace Technical Assistance: providing technical assistance to developing countries to
among member countries; pooled sovereignty can increase global influence help them participate in global trade.
Trading blocs: disadvantages Possible conflict between trading blocs and the WTO
Trade Diversion: RTAs can lead to trade diversion, where members start Trade Discrimination: RTAs may discriminate against non-members,
trading more with each other but less with non-members. potentially violating WTO's most-favoured-nation principle.
Complexity: compliance with different rules and regulations within the Trade Diversion: if RTAs lead to trade diversion, they can be seen as contrary
RTA can be complex and expensive for businesses; may be some to the WTO's goal of reducing trade barriers globally.
diseconomies of scale Inconsistent Rules: conflicting rules between RTAs and WTO agreements can
Exclusion: non-member countries can face trade disadvantages, create legal and practical challenges.
potentially causing international tensions. Preferential Treatment: WTO rules generally favour non-discrimination, while
Inequality: may benefit more efficient states at expense of weaker ones RTAs provide preferential treatment to member countries.
Loss of Sovereignty: deeper integration may require members to cede Dispute Resolution: disputes can arise when WTO and RTA rules conflict,
some sovereignty in trade policy. requiring resolution mechanisms to reconcile differences.
Factors influencing the potential success of a trading bloc Challenges faced by the WTO
• Economic size of the bloc Multilateral Negotiations Gridlock: there have been numerous disagreements among
• Number of members in the bloc member countries on various issues such as farm subsidies and special treatment for
• How integrated the bloc is developing countries.
Rise of Bilateral and Regional Agreements: done outside the framework of the WTO.
• The flexibility and willingness to change over time as global economic
leading to a complex web of overlapping trade rules and regulations.
balance of power alters Diverging Development Goals: developing and developed countries have differing
• The unity of purpose within the member states priorities and expectations from the WTO.
• The strengths and weakness of the economies of members Digital Trade and E-Commerce: the rapid growth of digital trade and e-commerce presents
• How evenly the benefits of membership are spread across the challenges for the WTO, as existing trade rules and agreements may not adequately cover
members these areas.
AQA Year 13 MACRO KNOWLEDGE ORGANISER Balance of Payments
Balance of Payments Capital account on the Balance of Payments
The capital account:
A country’s balance of payments account records all the flows of money between the
residents of that country and the rest of the world. It has three key parts: • Records financial transactions that involve the acquisition or disposal of
• Current account non-financial assets, such as real estate, patents, and copyrights,
• Capital account between a country and the rest of the world.
• Financial account • It also includes capital transfers, which involve the transfer of assets for
Export (X) = a UK produced good or service sold overseas resulting in an INFLOW of specific purposes, like debt forgiveness.
income to the UK; it is a CREDIT or positive on the UK current account on the balance
of payments; an injection into the circular flow Financial account on the Balance of Payments
Import (M) = an overseas produced good or service purchased by UK citizens resulting The financial account:
in an OUTFLOW of income from the UK; it is a DEBIT or negative on the UK current a/c • Records transactions related to financial assets and liabilities, including
on the BoP; a withdrawal from the circular flow
Net exports = X-M
foreign direct investment (FDI), portfolio investment, banking flows (such
Trade balance as hot money) and changes in foreign exchange reserves.
• If the value of X exceeds the value of M, there is a trade surplus (net injection, • It details how a country's residents and entities interact with foreign
boost AD) assets and liabilities.
• If the value of M exceeds the value of X, there is a trade deficit (net withdrawal,
reduces AD) The balance of payments always balances
• If the value of M equals the value of X, there is an equilibrium in trade or balance As a set of accounts all debits must be matched with credits.
in trade • Any deficit on the current account will be offset by a surplus on the
capital & financial accounts.
Current account on the Balance of Payments • A ‘balancing item' ensures any discrepancy between current account,
Current Account: The current account records the transactions related to a capital account and financial account is solved.
country's trade in goods, services, primary and secondary income
Trade Balance: The balance of trade accounts for the difference between Current account deficit v budget deficit
the value of a country's exports and imports of goods BE CAREFUL NOT TO CONFUSE THESE DEFICIT TERMS!
Services balance: The balance in trade for services, such as tourism, Current account deficit: when the value of exports is less than the value of
financial services, transportation, and consulting. imports in goods, services, primary and secondary income; a net withdrawal
Primary Income: Income includes net flows of earnings from investments, from the circular flow (X<M); AD shifts left, ceteris paribus, slowing growth.
such as dividends, interest, and profits, Budget deficit: when the government spends more than it receives in tax
Secondary income: Net transfers of money or goods between countries, revenue; a net injection into the circular flow (G>T); AD shifts right, ceteris
such as foreign aid, remittances from expatriates, and gifts. paribus, encouraging growth
AQA Year 13 MACRO KNOWLEDGE ORGANISER Balance of Payments
Current account deficit Causes of a current account deficit
Current account deficit: The value of exports of goods and services, Long term causes (often structural): low rates of capital investment which
investment incomes and transfer inflows is lower than spending on limits the overall productive capacity and cost competitiveness of key export
imported goods and services, investment income outflow and outward industries; relatively high cost & price inflation contrasted with trade
transfers. partners; weaknesses in non-price competition such as branding &
• A net outflow of income from a country’s circular flow (X<M) innovation; long-term decline of previously dominant export sectors such as
• A current account deficit can be a sign of economic weakness, as it deindustrialisation in manufacturing, decline in extractive sectors, loss of
means that the country is relying on borrowing from abroad to finance comparative advantage
its consumption. Consequences of a current account deficit
• However, a current account deficit can also be the result of strong
economic growth or investment in importing new capital goods. • Fall in AD since (X-M) is negative –
leading to fall in real output (Y1 to
Financing a current account deficit Y2), slower GDP growth
To finance a current account deficit, a country needs to: • Drag on GDP growth might then
• Attract inflows of FDI, portfolio investments, hot money, savings which lead to weaker investment & jobs
may need higher interest rates or better rates of return • Possible negative multiplier effect
• Use up foreign currency reserves • Large external deficit likely to lead
• Sell assets/property to foreign investors to a depreciating exchange rate
• Find ways to increase its international competitiveness
Causes of a current account deficit
Cyclical causes of current account deficit: when an economy is booming, Does a current account deficit matter?
rising real incomes boost consumer spending increasing demand for It depends on:
imports, causing a wider trade deficit; and vice versa in an economic • its size relative to GDP • what has caused it
downturn • its persistence • how easy it is to finance it
Structural causes of current account deficit: arise from supply-side Current account surplus
weaknesses such as relatively low capital investment, low productivity &  Net injection into economy • Inflationary if there is no spare capacity
research and businesses not operating at the cutting edge of innovation  Positive export multiplier effects • Creates trade deficits elsewhere in world which
Short run causes (often cyclical): fall in value of exports, a boom in  Trade surplus allows net exporting may need correcting, more protectionism
consumer spending or a broader economic boom (more imports); an of capital • Pressure on currency to appreciate
 Trade surplus enables additions to • If surplus is due to high saving/low consumption,
appreciation of the exchange rate (less price competitive as exports prices
foreign currency reserves. SoL may not be as high as it could be
rise and import prices fall)
AQA Year 13 MACRO KNOWLEDGE ORGANISER Correcting a current account deficit
Reducing a current account deficit Supply-side policies
Correcting a deficit may require: • Infrastructure projects in improving transport networks, telecoms to
• Deflationary policies to reduce AD and spending on imports increase supply-side capacity and productive efficiency
• Depreciation/devaluation of the currency: to restore price • Incentives to promote enterprise/start-ups/new export businesses
competitiveness • Privatisation/deregulation to increase productivity & efficiency
• Direct controls: on imports via tariffs, quotas etc. • Investment in education to improve a country’s human capital
• Supply-side improvements: to improve both price and non-price • Protecting property rights to drive a faster rate of innovation/ideas
competitiveness • Tax incentives to attract foreign direct investment from companies who
subsequently export goods and services
Expenditure-switching policies
Expenditure-switching policies: policies designed to change the relative Effectiveness of different policies
Depends on the root causes of the current account deficit
prices of exports and imports.
• If consumer boom caused it, then deflationary policies may work well
• An exchange rate depreciation can improve the price competitiveness
• If it is a structural deficit, then supply-side policies work better
of exports and make imports more expensive when priced in a domestic
• If it is a lack of price competitiveness, a depreciation may work well
currency
• A tariff can make imported goods relatively more expensive than Will a depreciation/devaluation improve the trade deficit?
domestic ones. A depreciation reduce export prices and increase import prices; this could
• Lower relative inflation makes exports more competitive relative to increase net export demand and the trade deficit improves.
imports BUT the response to these relative price changes depends on the PED for X
Expenditure-reducing policies and PED for M. According to the Marshall-Lerner condition, the absolute
Expenditure-reducing policies: contractionary monetary and fiscal policies value of the sum of the PED for X + PED for M must be greater than or equal
designed to lower real incomes and aggregate demand and thereby cut to 1 for a depreciation to improve the current account.
the demand for imports. J-curve effect
• Higher direct taxes In the short run, PEDs are low,
• Cuts in real government spending on welfare trade deficit worsens; but over
• Cuts in real government spending on public services time the PEDs rise and the
• An increase in interest rates to lower demand for credit and increase Marhsall-Lerner condition is met.
saving The J-curve shows the time lag
These deflationary polices might a conflict with other macroeconomic between a depreciation or
objectives such as maintaining low unemployment and ensuring a steady devaluation and an improvement
rate of economic growth. in the trade balance.
AQA Year 13 MACRO KNOWLEDGE ORGANISER Balance of Payments
Causes of current account surplus Global trade imbalances
• Strong competitive advantage Trade imbalance: when a country has a current account deficit or surplus that
• Persistent excess of savings over investment (savings glut) is greater than 3% of its GDP
• High global prices for an exported commodity
Main causes of global trade imbalances
• High levels of net investment inflows
• Differences in savings and investment
• Cyclical: a recession leading to fewer imports
• Exchange rates – may be over- or under-valued
Effects of a current account surplus • Differences in productivity and competitiveness
• Allows a country to run deficit on the financial account of the balance • Government protectionist policies (e.g. tariffs, export subsidies)
of payments • Structural factors (e.g. demographics, resource endowments)
• Surplus foreign currency can be used to fund investment in assets • Global supply chains
located overseas. • Net capital flows (can affect exchange rates
• Some current account surplus countries have large sovereign wealth • Cyclical factors (e.g. boom sucks in more imports
funds which can be used to invest in assets at home or overseas. Consequences of global trade imbalances
• Stronger exchange rate since high export sales leads to an increase in
• Deficit countries run up large external debts and are reliant on foreign
demand for a nation’s currency
capital. This risks political opposition to domestic assets being bought
• May cause inflation (higher AD; exporting firms competing for
by overseas MNCs
resources bidding up costs; inflow of liquidity into banking system)
• Deficit countries might decide to switch towards using protectionist
Policies to correct a trade surplus: reflation (boost AD, redcue S),
policies promoting the rise of economic nationalism
revaluation of currency (Marshall-Lerner condition must hold; may be an
• Surplus countries are saving more than they spend, thereby
inverse J-curve effect, remove barriers to trade to increase imports)
depressing global aggregate demand and growth
Importance of the Balance of Payments • Surplus nations might be under-consuming (thus affecting living
• Trade imbalances can lead to economic instability or reflect it standards) and allocating domestic scarce resources to exporting
• Persistent deficits can constrain economic growth and overseas
encourage more protectionism • Deficit countries may use deflationary policies to correct the deficit,
• Current account deficits can cause a currency depreciation, affecting slowing growth
import prices, inflation, and investor confidence. Global trade imbalances can lead to increased economic volatility,
• A surplus can provide a source of savings and investment heightened protectionism, and potential disruptions to global economic
• A deficit may indicate that a country is borrowing heavily to finance stability, hindering sustainable economic growth and cooperation among
its consumption, which can be unsustainable in the long term nations.
AQA Year 13 MACRO KNOWLEDGE ORGANISER Exchange rates
Exchange rate FOREX market diagrams
Exchange rate: the price of a currency in terms of another. It is determined
by demand and supply in FOREX markets Equilibrium exchange rate: the rate which equates demand and
supply for a particular currency against another currency. Changes
Bilateral exchange rate: one currency in terms of one other currency. eg £1
in the equilibrium exchange rate happen when there are changes
= $1.05 in currency demand and supply
Multilateral exchange rate: one currency in terms of a group of other
Impact of an increase in exports or Impact of an increase in imports or
currencies e.g. effective or trade-weighted index = a weighted average
inward investment – demand for outward investment – supply shifts
exchange rate expressed as an index (Base year =100) currency shifts right right
Real effective exchange rate is adjusted for relative inflation rates
Factors influencing the demand for a currency
Demand for a currency is an inflow of money into an economy. Demand for
currency is derived from the need to have currency to buy exports, inwards
investment, etc.
• Buying exports of goods and services
• Overseas portfolio inflows into property, shares and bonds
• Hot money flowing into a country’s banking system
• Inflows of foreign direct investment (FDI) Impact of a fall in interest rates Impact of speculation – if currency is
• Speculative buying of a currency by market traders – demand shifts left and supply appreciating, speculators may buy in =
shifts right (double shift) demand shifts right
Factors influencing the supply of a currency
Supply of a currency is an outflow of money into an economy. The supply of
a currency is determined by domestic demand for imported goods and
services from abroad, outwards investment etc. Economic agents sell their
currency to get the currency they need for these international transactions
• Domestic spending on imported goods and services
• Outflow of portfolio flows in property, shares and bonds
• Hot money flowing out of a country’s banking system
• Outflows of foreign direct investment (FDI)
• Speculative selling of a currency by market traders
AQA Year 13 MACRO KNOWLEDGE ORGANISER
Exchange rate systems
Types of exchange rate systems Currency board
• Freely floating • Semi-fixed (adjustable/crawling peg) • A currency board: country's domestic currency is fully backed by a foreign
• Managed floating • Fully fixed (hard peg) Currency board (hard peg) reserve currency or specific foreign asset, typically held in a fixed exchange
Freely floating exchange rate rate relationship.
• Domestic currency is issued only when there are corresponding foreign
• Currency value is set purely by demand and supply of the currency i.e.
currency reserves to back it up, and the currency in circulation is fully
market forces.
convertible into the foreign reserve currency at the established fixed
• Currency can either appreciate (rise) or depreciate (fall)
exchange rate.
• No intervention by central bank
• The currency board must hold foreign currency reserves equal to the total
• There is no target for the exchange rate
amount of domestic currency in circulation.
• The external value of currency is not an explicit target of monetary
Exchange rate terms
policy; interest rates are not set to influence the value of the currency)
Depreciation (currency falls in value in a floating system) v devaluation
Managed floating exchange rate
(currency's value is deliberately reduced in a fixed system)
• Central bank gives freedom for market exchange rates on a day-to-day Appreciation (value rises in a floating system) v revaluation (currency increased
basis, supply and demand factors drive the currency’s value in a fixed system)
• Central bank may intervene occasionally
• Buying to support a currency (selling their FX reserves or selling Advantages of floating exchange rate systems
to weaken a currency (adding to their FX reserves) Independent Monetary Policy: Interest rates and QE decisions can be used
• Currency becomes a key target of domestic monetary policy to influence domestic economy, not constrained by exchange rate
• Higher exchange rate to control inflationary pressures considerations.
• “Managed depreciation” to improve competitiveness & trade balance Shock Absorption: Free-floating exchange rates allow countries to absorb
Fixed exchange rate external economic shocks more effectively to help rebalance the economy.
• Central bank pegs the currency value to one or more currencies Reduced Speculative Attacks: Since exchange rates are determined by
• The central bank must hold enough foreign exchange reserves to market forces, speculative attacks on a currency are less likely
intervene in currency markets when needed to maintain the fixed Automatic ‘correction’ of trade imbalance: If a country is running a large
currency peg trade deficit, its currency's depreciation can over time make its exports more
• Pegged rate becomes the official rate price competitive and imports more expensive, leading to a narrowing of the
• There might be unofficial trades in shadow currency markets deficit.
• Adjustable peg: occasional realignments may be needed (must be Currency reserves: The central bank does not need to hold large foreign
officially sanctioned with the agreement of the IMF) leading to either a currency reserves because there is no specific currency target, financial
devaluation or revaluation capital can flow freely across countries seeking the best returns
AQA Year 13 MACRO KNOWLEDGE ORGANISER Exchange rate systems & the Terms of Trade
Disadvantages of floating exchange rate system EXTENSION: Terms of Trade
Exchange Rate Volatility: this causes uncertainty for businesses reducing The terms of trade measures the rate of exchange of one product for
international trade and investment. another when two countries trade.
Currency Risk: Volatility introduces currency risk for businesses and
investors. Terms of Trade Index (ToT) = 100 x Average export price index / Average
Inflation Pass-Through: Exchange rate fluctuations can lead to changes in import price index
import prices, which can impact domestic inflation.
If a country can buy more imports with a given quantity of exports, its
Loss of Exchange Rate as a Policy Tool: While countries gain monetary
policy autonomy, they lose the ability to manage the exchange rate as a terms of trade have IMPROVED. If the ToT index falls, this is said to be a
deliberate policy tool. DETERIORATION as fewer imports can be bought for every export sold.
Advantages of fixed exchange rate systems The terms of trade fluctuate in line with changes in export and import
Price Stability: A fixed system provides price stability helping control prices. The exchange rate and the rate of inflation can both influence the
inflation; provides a predictable environment for businesses and consumers. direction of any change in the terms of trade:
Reduced Exchange Rate Risk: Fixed exchange rates eliminate the currency
• A depreciation will cause a DETERIORATION in the ToT
risk associated with fluctuating exchange rates.
• An appreciation will cause an IMPROVEMENT in the ToT
Discipline on Monetary Policy: constrains a country's central bank from
pursuing an independent monetary policy. This can prevent excessive money
supply growth and associated inflationary pressures.
EXTENSION: Changes in the terms of trade
Foreign Investment: A stable exchange rate can attract foreign investment.
because there is less risk associated with currency fluctuations. Standard of living: improvement in ToT makes imported food, medicines,
Disadvantages of fixed exchange rate system etc; a long term decline in the ToT would reduce the standard of living
Lack of Flexibility: a fully fixed system cannot respond to external economic Technology and capital goods: improvement in ToT makes imports of
shocks. Interest rate may be needed to keep exchange rate fixed rather than technology/capital more affordable; but a deterioration in the ToT has
affect domestic economic indicators the reverse effect
Balance of Payments Issues: Persistent imbalances can lead to pressures on Prebisch-Singer Hypothesis: ToT are likely to deteriorate over time for
the currency peg. primary product producers because there is a low YED for primary goods,
Speculative Attacks: Fixed exchange rate systems can be vulnerable to while productivity in production rises; implications for developing
speculative attacks if investors believe that the currency is overvalued or if countries that are primary product dependent if it holds.
there are concerns about the country's ability to maintain the peg. Price competitiveness: Deterioration in ToT may not be a concern if it is
Dependence on Reserves: To maintain a fixed exchange rate, a country caused by a depreciation that increases international price
needs to have sufficient foreign exchange reserves. competitiveness
AQA Year 13 MACRO KNOWLEDGE ORGANISER International competitiveness
International competitiveness Being internationally uncompetitive
International competitiveness: sustained ability to sell goods and services • Larger trade deficit constraining economic growth and lowering the standard
profitably at competitive prices in a foreign country of living
International price competitiveness: producing goods/services at lower • Economic decline/stagnation as industries cannot compete effectively: more
price than international competitors structural unemployment as uncompetitive industries may shed jobs
International non-price competitiveness: producing goods/services that • Income inequality may grow as a lack of competitiveness can exacerbate
are better quality, better designed, have faster delivery, better after-sales income inequality because some industries decline while others thrive.
service…than international competitors
Measures of international competitiveness A lack of international competitiveness can cause a wider trade
Relative unit labour costs: ULCs are the labour cost per unit of output; a deficit, increasing unemployment with negative multiplier effect and
measure that takes into account the costs of employing workers and their slower economic growth
productivity Strategies to improve international competitiveness
Relative export prices: if a country’s exports become cheaper relative to its
• Stable macroeconomic environment
competitors, it becomes more price competitive • Competitive exchange rate
The global competitiveness index: an indicator that takes into account a • Low & stable inflation
whole range of factors that influence both price and non-price • Strong financial & legal institutions
competitiveness • Competitive tax environment
Benefits of international competitiveness • Investment in human capital; more education & training; better
• Stronger trade performance (trade surplus/smaller deficit) healthcare
• Export-led growth (multiplier effect) increasing real • Inward migration of skilled workers
incomes; higher standard of living • Improvement in management to boost worker productivity
• Increased research and development (R&D) and innovations
• Lower unemployment
• Market competition to raise productivity
• Increase in FDI
• Support enterprise; make it easier to start up a business; reduce
Diagram shows export-led rise in business red tape
AD from AD1 to AD2 with export • Investment in critical infrastructure (transport, energy,
multiplier effect AD2 to AD3; real communication networks)
GDP increases from Y1 to Y3, but • Balanced growth across economy’s regions
there may be some demand-pull • Use of supply-side policies to increase productivity, incentives and
inflation competition
AQA Year 13 MACRO KNOWLEDGE ORGANISER Measures of development
Growth v Development Other measures of development
Economic growth: increase in the value of total output of goods and Gini Coefficient: Measures income inequality within a country, indicating
services produced by an economy over time the distribution of income and wealth
Economic development: improvement in the overall standard of living and Gender Inequality Index: Evaluates gender disparities in health, education,
quality of life of the population; it involves both an increase in the and economic participation
quantity and quality of those goods and services.; it also includes social Multidimensional Poverty Index (MPI): Considers factors such as health,
and environmental progress; increases the freedom & opportunities of education, and living standards to assess poverty and deprivation in
individuals. multiple dimensions e.g. child mortality, access to water & cooking fuel,
So, economic growth is a necessary but not sufficient condition for sanitation etc.
economic development. While growth can help increase incomes, Environmental Sustainability Indicators: Evaluates a country's impact on
development also encapsulates cultural and human values, e.g. self- the environment e.g carbon emissions, natural resource depletion, and
esteem not just material well-being pollution.
Measures of development Human Poverty Index (HPI): Focuses on severe deprivation in health,
The UN's Human Development Index (HDI) education, and standard of living, emphasizing the most disadvantaged
• Health – life expectancy at birth populations.
• Education – mean years of schooling and expected years of schooling Social Progress Index (SPI): Measures various aspects of well-being,
• Living standards – GNI per capita at PPP including basic human needs, foundations of well-being, and opportunity.
Each dimension is measured on a scale from 0 to 1, with 1 being the Sustainable development goals (SDGs)
highest achievement. The HDI combines these values by taking the 1. No Poverty 10. Reduced Inequality
geometric mean of the three. Each is given the same importance 2. Zero Hunger 11. Sustainable Cities & Communities
HDI Values 3. Good Health & Well-being 12. Responsible Consumption &
• Very high for HDI of 0.80 and above • Medium from 0.550 to 0.699 4. Quality Education Production
• High from 0.70 to 0.799 • Low below 0.550 5. Gender Equality. 13. Climate Action
6. Clean Water & Sanitation 14. Life Below Water
Is the HDI a good measure of development? 7. Affordable & Clean Energy 15. Life on Land
HDI is holistic, simple, useful for policy guidance, good for global 8. Decent Work & Economic Growth 16. Peace, Justice, & Strong Institutions
comparisons 9. Industry, Innovation, & Infrastructure 17. Partnerships for the Goals
But it does not cover all elements of development progress, the data may The SDGs are designed to be universally applicable and are meant to be achieved by
not always be accurate, giving equal weighting to each element may fail to 2030. They serve as a framework for governments, organisations, businesses, and
allow for a country's development priorities, hides regional, income and individuals to work collectively toward a more sustainable, equitable, and
prosperous future for people and the planet.
educational inequalities;
AQA Year 13 MACRO KNOWLEDGE ORGANISER Less developed countries & barriers to development
Main characteristics of less developed countries
• Low per capita income
• High levels of poverty and inequality
The Harrod-Domar model
• Limited infrastructure for transportation, communication, and electricity
stresses the importance of
networks, for example
savings and investment. The
• Limited human capital - a less educated/skilled workforce, with lower
rate of economic growth
levels of literacy and numeracy
depends on:
• Dependence on primary commodities: rely on exporting primary
•Level of national saving (S)
commodities, such as agricultural products or natural resources, rather
•Productivity of investment
than manufactured goods
(capital-output ratio)
Rate of growth of GDP =
Primary product dependency & the 'resource curse' savings ratio / capital output
• Primary product dependency: when a country has a high dependence ratio
on extracting & then exporting primary commodities, making The model suggests that a higher savings ratio leads to an increased
it vulnerable to volatile global prices and terms of trade rate of investment (in a closed economy), thereby helping to building
• Export-commodity-dependent country: when more than 60 per cent of the capital stock of a country as a result,
its total merchandise exports are composed of primary commodities. increasing output through a rise in productive capacity (LRAS)
• Prebisch-Singer Hypothesis (PSH): over the long run, real prices of
primary commodities such as coffee decline relative to prices of Volatile commodity prices
manufactured goods such as cars because primary products have a lower Volatile commodity prices can cause uncertainty; it is unpredictable for
income elasticity of demand. a commodity producer what will happen to export earnings and the
• Resource curse/Dutch disease/Petrocurrency effect: a natural terms of trade over time; uncertainty also deters investment.
resource/natural gas/oil find attracts inward investment causing the When prices fall unexpectedly: When prices rise unexpectedly:
currency to appreciate and making other industries such Fall in export earnings Rise in export earnings
as manufacturing less internationally price competitive Trade deficit Economic growth
Fall in revenue/profits for Inflation pressure
Savings-Investment Gap producers Trade surplus
Savings gap: in low-income countries, extreme poverty and weak financial Loss of government revenue Appreciation of currency
markets makes it hard to generate enough savings to fund capital investment Unemployment Income inequality
projectsthat could boost development Depreciation of currency Increase in government revenue
AQA Year 13 MACRO KNOWLEDGE ORGANISER Barriers to development
Human capital gap Weak institutions & corruption
Human capital: the knowledge, skills, experiences, and abilities possessed Weak institutions: when the legal, financial and political institutions are
by individuals in a population that can be used to produce economic value. not well-established
Human capital gap: the difference between the skills, knowledge, health, Problems with weak institutions: more difficult to establish property rights;
and other attributes of a workforce and the level required to support harder to access to credit & finance – may have to use informal financial
sustainable economic growth and development sector; less say in how the economy is run - may not have a democratic vote
Problems with human capital gaps: Corruption: the abuse of public office for private gain – it can include, bribery
• Hinders labour productivity growth of public officials when contracts are negotiated, bribery at customs facilities,
• Reduces innovation and technological progress money laundering, misappropriation of aid flows; illegal tax evasion
• Holds back increases in entrepreneurship Problems with corruption: deters foreign investment by increasing the
• Can deter foreign investment cost/risk of doing business; more allocative inefficiency - public resources are
• Reduces economic resilience to shocks diverted for private gain; political lobbying can sway government decisions;
Infrastructure gaps more persistent income & wealth inequality and reduced progress cutting
extreme poverty; loss of trust - a breakdown of social capital; poorer human
Infrastructure gap: when the available infrastructure resources / development outcomes because less tax revenue is collected
investments do not fully meet those infrastructural needs adequately Absence of property rights
Infrastructure projects are important and add to both AD and LRAS in an Property rights: need to be clearly defined e.g. identifying and titling land
economy, often with high multiplier effects rights, protection of intellectual property, preventing illegal poaching, having
Problems with infrastructure gaps: the right to start & own a business, enables use of digital identity
• Higher costs for businesses – this causes higher prices – therefore programmes; helps prevents the Tragedy of the Commons
hitting real incomes for consumers Failing to establish property rights deters entrepreneurship, R&D and
• Lower geographical mobility of labour causing higher structural innovation, reduces investment that may boost agricultural productivity,
unemployment limits wage growth that could lead to greater tax revenue for development
• Less attractive to FDI (slower economic growth in the long run) projects, allows deforestation and other depletion and degradation of natural
• Economy more vulnerable to effects of climate change especially risks resources
from natural disasters
• Impact on human development – including having access to safe and Other development barriers
reliable water and sanitation services Demographic issues, capital flight, foreign currency gaps, high levels of external
• Can damage export competitiveness debt; country is land-locked with bad neighbours; conflict/civil war; poor
• Can contribute to ender inequalities governance/political unrest; the geography of the country; too reliant on
natural resource
AQA Year 13 MACRO KNOWLEDGE ORGANISER Policies for growth and development
Market-based policies Interventionist strategies
• Trade liberalisation – remove some of the tariff and non-tariff barriers • Managed exchange rates – to increase stability/certainty helping to
to trade more openly REVIEW: topics of free trade, protectionism, increase investment and inflation control REVIEW: Topis of exchange
tariff model.... for advantages/disadvantages rate systems and effects of a depreciation or appreciation
• Promotion of FDI - attract resource-seeking, efficiency-seeking and/or • Infrastructure development – public sector investment can crowd in
market-seeking FDI by cutting corporate taxes, making country more private investment; improves labour mobility, efficiency of supply
attractive to business, reducing business risks.. to boost AD and LRAS, chains, productivity, information between buyers and
with multiplier) REVIEW: topic of investment sellers... REVIEW: Supply-side policies
• Removal of government subsidies to increase incentives to • Promoting joint ventures with global companies – helps knowledge,
innovate REVIEW: Topic of subsidies technology & skill transfers by offering tax advantages/breaks and
• Floating exchange rate systems to allow currency to find its market streamlining opportunities for businesses REVIEW Economies of scale
value; may depreciate or appreciate depending on whether it was over • Buffer stock schemes – help reduce commodity price volatility but
or undervalued in its fix; frees up use of interest rates to benefit the often a case of government failure REVIEW Minimum and maximum
domestic economy REVIEW: Topis of exchange rate systems and prices
effects of a depreciation or appreciation Other development strategies
• Microfinance schemes provide extremely poor people with small loans • Industrialisation – the Lewis model – move underemployed rural workers into
(microcredit) to help them engage in productive activities or to grow urban manufacturing to increase productivity growth
their tiny businesses. They can help the poor increase their income, • Development of tourism – injects income in from abroad
build businesses and reduces vulnerability to external shocks via • Development of primary industries – diversify to a range of primary products
microinsurance. • Fairtrade schemes
• Privatisation – REVIEW: topic of privatisation • Aid – humanitarian/emergency/financial - may need paying back
• Debt relief – or debt forgiveness; frees up tax revenue from debt interest
Interventionist strategies
costs
• Development of human capital - investment in education; skills Role of aid and trade
development programmes; healthcare initiatives; adult education course:
• Aid provides immediate relief and support to countries facing economic
entrepreneurial support; gender equality policies; infrastructural
challenges, helping to address urgent needs such as healthcare, education,
improvements – more schools, easy access to education REVIEW: Supply-
and infrastructure development but can lead to more debt
side policies • Trade facilitates long-term sustainable growth by fostering the exchange of
• Protectionism – infant industry protection; export subsidies to promote goods and services, encouraging specialisation, and promoting investments,
trade, anti-dumping, diversification, less primary product thereby stimulating economic development and improving living standards
dependent REVIEW: topics of free trade, protectionism, tariff model over time.
AQA Year 13 MACRO KNOWLEDGE ORGANISER Fiscal policy: public spending
Public spending Disadvantages of higher public spending
Public spending: spending by the government to influence AD Resource crowding out: when the economy is operating at full
Current spending: government consumption G = spending on the say-today capacity and the growth of the public sector causes a shortage of resources
costs of running public services e.g. wages of teachers, energy bills for in the private sector
hospitals; directly affects AD; does not include transfer payments
Financial crowding out: expansion
Transfer payment: payment made or income received in which no goods or
of the state sector financed
services are being paid for, such as a benefit payment or pension
by increased government
Capital spending: government investment in the economy’s infrastructure
borrowing can cause an increase in
e.g. building hospitals & housing, new roads/railways
demand for loanable funds (D1 to
Factors in the changing size & composition of public spending D2)which pushes up interest rates
Demographics – ageing populations increase the demand for healthcare (r1 to r2)and crowds out private
Rising incomes – public services typically have a high YED so if real incomes sector investment
grow there is an increase demand for public services
Expectations – as technology improves, expectations of better Disadvantages of higher public spending
health/education/infrastructure/wifi increase
• Government sector is not profit-motivated, so an increasing role for the
Times of crisis – people expect the government to bail out banks or support
state could reduce productivity growth and economic growth
businesses and jobs in a pandemic, help households with energy bills in a
• Rising national debt – successive budget deficits increase the size of the
cost-of-living crisis etc
national debt which increases the debt servicing costs (debt interest) so
Advantages of higher public spending as % of GDP less is available to spend on public services
• Adds to AD increasing short run growth • May mean higher taxes and/or more austerity required in future
• Helps economy recovery from recession (with fiscal multiplier effects) • Restricts freedom of choice – 'nanny state' - anti-free market
• If government invests can add to AS and long run growth philosophy that private sector allocated resources more efficiently
• Can 'crowds in' private sector investment if government improves • Less government spending can ease demand-pull inflation pressures
transport/communications/energy networks which increase private
Impact of government spending on inequality
sector's efficiency;
• Government spending on healthcare and education can also increase • Spending on welfare benefits can help reduce poverty and inequality; caps
labour productivity in the long run on welfare have the opposite effect
• Can help reduce income inequality and poverty • Low-income households tend to benefit disproportionately from public
• Can help reach net zero environmental targets spending on housing, healthcare and education
AQA Year 13 MACRO KNOWLEDGE ORGANISER Fiscal policy: Taxation
Taxation Changes in indirect taxes
Direct tax: a tax on income/wealth e.g. income tax, employee NICs, • Reducing VAT could encourage increased spending if cost savings are passed
corporation tax, capital gains tax on to consumers; could boost confidence
Indirect tax: a tax on spending e.g VAT, excise duties • Reducing excise duties on tobacco, alcohol etc. Could increase consumption
Progressive tax: a tax that takes a higher proportion of income from those of goods that have negative consumption externalities; net welfare loss
on higher incomes • Reducing regressive taxes would reduce income inequality
Proportional tax: a tax that takes the same proportion of income whatever • Reducing import tariffs can boost the gains from trade but exposes businesses
the level of income to more competition from abroad
Regressive tax: a tax that takes a lower proportion of income from • Lower indirect taxes can reduce cost-push inflation
those on higher incomes • Lower indirect taxes can reduce shadow market activity & bootlegging
Changes in direct taxes • Reducing indirect taxes may reduce government revenue and weaken public
finances
• Reduction in income tax and NICs – increases real disposable • NB: Analysis can be reversed for increases in indirect taxes
incomes, increases consumption, AD rises, short run economic
Laffer curve
growth, but there may be demand-pull inflation; could suck in
imports causing a deterioration in the current account balance Laffer Curve: the relationship between
• Lower direct taxes can increase incentives to work, save and invest tax rates and government revenue.
• Lower direct taxes may attract more immigration and help fill skills At very high tax rates, people are
gaps disincentivised to work/save/invest,
• Lower corporation tax increases the retained profits of businesses there may be more tax
which could be re-invested; higher investment adds to AD with avoidance/evasion/ possible brain drain,
multiplier effect and LRAS. so a cut in the tax rate (T1 to T2) could
• Lower direct taxes may encourage more entrepreneurship, R&D and generate economic growth and increase
innovation; increase dynamic efficiency tax revenue (R1 to R2)
• Lower direct taxes could attract more FDI (less corporation tax) Tax burden
• Lower direct taxes, which are usually progressive, could increase
income and wealth inequality Tax burden: the total tax revenues (direct and indirect) as a percentage of GDP.
• Lower direct taxes could reduce government revenue depending on • Rising tax burden increases government revenue, helps reduce government borrowing,
redistributes income/wealth (if progressive taxes are higher), allows more investment in
the impact on the supply-side of the economy; higher budget public goods and helps address externalities
deficit, National Debt could rise • However, it also may constrain growth, reduce disposable incomes, increase tax
NB: Analysis can be reversed for increases in direct taxes avoidance/evasion, reduce competitiveness and curb incentives to work
AQA Year 13 MACRO KNOWLEDGE ORGANISER Fiscal policy: government borrowing and debt
Fiscal policy Financing government borrowing
Automatic stabilisers: automatic fiscal changes as the economy moves • If government revenue is less than government spending, it has to borrow
through stages of the business cycle e.g. the fall in tax revenues during a to make up the difference
recession or an increase in state welfare benefits when unemployment • Government issues bonds/Treasury bills = IOUs
is rising; help smooth the trade cycle • It has to pay interest on its debt (debt servicing costs)
Discretionary fiscal policy: fiscal policy decisions determined by government • Interest on bonds is called the,bond yield
macroeconomic priorities • The yield on the bond varies inversely with the price of bonds
Counter-cyclical fiscal policy: Keynes argued fiscal policy should be • Some bonds are index-linked (just over25% in UK) and the interest
expansionary in recession and contractionary in a boom. increases payable with inflation
Fiscal (budget) deficit v National Debt Fiscal rules
Budget deficit or fiscal deficit: the annual amount the Fiscal rules: restrictions on fiscal policy set by the government to constrain
government borrows to make up the gap between its income (mostly tax its own decisions on spending and taxes
revenue) and its spending. A net injection into the circular flow G>T; it is a UK government's main fiscal rules are:
flow • National Debt should be on course to fall as a % of GDP in five years' time
National debt (public sector net debt): a stock of the total accumulation of • Public sector borrowing should not exceed 3% of GDP in five years' time
budget deficits (government borrowing) that is still to be repaid • Some types of welfare spending should stay below a pre-specified cap
Cyclical fiscal deficit: government borrowing related to the trade cycle – in The Eurozone's fiscal rules allow countries with excessive borrowing to
a recession government spending rises and tax revenues fall; should go reduce their debt on average by 1% per year if it is above 90% of gross
when economy returns to trend growth rate domestic product (GDP), and by 0.5% per year on average if the debt pile is
Structural fiscal deficit: government borrowing that remains when between 60% and 90% of GDP
economy is at full capacity; tax and welfare reform may be needed Factors influencing the size of the budget deficit and size of the National Debt
Government borrowing v household borrowing Budget deficit factors:
• State of the economy (cyclically part higher in recession, more spent
Govt finances not like a household’s or an individual business’s finances supporting incomes & jobs, less tax revenue as more unemployed, less
because: consumer spending, lower profits)
• Government decisions are big enough to influence whole economy • State of the housing market (affects stamp duty revenues)
• Fiscal policy can, and should, be used counter-cyclically • Political priorities
• Governments do not ‘die’ so any debts can be paid off in future • Unplanned events (Economic shocks, global pandemic..)
• Government can borrow to invest; interest is then paid by those National Debt factors:
benefiting from the investment in future – this can be considered • Size and persistence of budget deficit (which adds to the National Debt)
intergenerationally much fairer than borrowing for current spending) • Government policy choices on tax and public spending