IGCSE Economics Basic Econonomic Problem

Unit 4; Government Policies

Aggregate Demand

This is the total demand in the economy.

It is made up of:

  • Consumption
  • Investment
  • Government Expenditure
  • Exports - Imports
Aggregate Demand
Figure 1: Aggregate Demand

Aggregate Supply

This is the total supply in the economy.

  • It is initially flat due to the ability to employ more resources (labour) and increase supply.
  • It becomes steeper & then vertical when the economy reaches full employment which means we cannot increase supply.
  • At this stage prices increase if AD increases (inflation)
Aggregate Supply
Figure 2: Aggregate Supply

Figure represents a simplistic model of an economy.


  • Imports represent money leaking out to other economies.
  • Taxation removes money from households and takes it out of the economy unless the Government spends it.
  • Savings by households represent money taken out & stored by banks (although its often lent for investment).


  • Exports by firms represent additional money coming into the economy
  • Government spending injects more money into the economy
  • Capital investment by firms (often borrowed).
Circular Flow of Income
Video 1.8

Government Aims

  • Full employment: having all the people who are able to work and looking for work in employment. Usually there will be some frictional unemployment existing.
  • Price stability: governments aim to keep inflation at a steady rate (around 2%). This allows firms and individuals to plan for the future more accurately.
  • Economic growth: increasing the output of the economy (Real GDP). In the long run they aim to push the PPB (Production Possibility Boundary) outwards.
  • Redistribution of Income: governments may aim to take money from the rich (through higher taxes rates) and give it to the poorer population (through unemployment and social benefit schemes).
  • Balance of Payments stability: keep imports and exports balanced swell as flows of finance.

Government Production

Governments may provide goods/services that are a natural monopoly (water/electricity).

Essential goods such as health care, education and police forces are often provided by the government.

Governments may provide merit goods such as public swimming pools, libraries and sports centres.

Government Employment

  • The government employs people in public sector jobs such as teaching, police and fire services, doctors, nurses and military personnel.
  • Through its employees it can set examples of good practise and restrict wage increases to limit inflation.
  • The government can also increase or decrease its number of employees to manipulate unemployment figures.

Monetary policy

Key Characteristics

This focuses on controlling changes in the money supply, interest rates & exchange rate.

  • Money Supply: changed by printing money & encouraging/discouraging lending by commercial banks. Increased money supply = Increased Aggregate Demand (AD).
  • Interest Rates: Central Bank raises or lowers these. Raised interest rates make saving more attractive and borrowing more expensive. This should lower AD & therefor firms are also likely to invest less.
  • Exchange Rates: these can be fixed to another currency (dollar) to control inflation or they can be floating.

Contractionary Monetary Policy: raising interest rates and reducing money supply to reduce AD.

Expansionary Monetary Policy: reducing interest rates and increasing the money supply to increase AD.

Video 1.8

Fiscal Policy

Key Characteristics

This focuses on changes in government expenditure and taxation.

  • Government Expenditure: increases in spending will increase AD, decreases in spending decrease AD.
  • Taxation: increases in taxation will leave people with less money to spend & so reduce AD.
  • Budget: the government has a surplus when it takes more money than it spends & a deficit when it spends more than it takes.

Reflationary Fiscal Policy: increasing gov spending and reducing taxation to increase AD.

Contractionary Fiscal Policy: reducing gov spending and increasing taxation to reduce AD.

Video 1.8

Market Orientated Supply Side Policies

  • Getting rid of red-tape and bureaucracy – oftentimes firms produce less than they ought to because they have so many forms and rules they have to follow. Getting rid of these makes it faster to produce, saving time and money.
  • Reducing the power of trade unions – trade unions keep wages high. Wages are a big part of a firms’ costs of production. If trade unions were made less important, firms could spend less on their workers by reducing the wage.
  • Changing laws and legislations – if previously firms were only allowed to supply a certain amount, then when this is changed they are free to produce more.
  • Reducing taxes on firms – this allows them to produce more at the same price.

Interventionist Supply Side Policies

  • Investment in healthcare – this makes the workforce able to produce more as they are healthier.
  • Research and Development – can lead to new ways of doing things, or the discovery of new production techniques like genetically modifying crops.
  • Investment in technology – combine harvesters do a lot more work, at a faster rate, than humans. Car plants in Tokyo are now almost all totally automated.
  • Subsidizing entire industries – this allows firms to spend money on the above, or to buy more factors of production which make them more productive.

Taxation Aims

  • To reduce income inequalities - we can take from the rich and give to the poor.
  • To increase government revenue in order to pay off debt
  • To increase merit and public goods and services
  • To reduce external and social costs caused by polluting firms

But taxation itself is a general term, as there are different types of taxes. In general we can identify:

  • Direct tax – a tax on income, profits or wealth
  • Indirect tax – a tax paid on the value of a good or service. For example, if you buy a meal at a restaurant, you will have to pay for the meal and for a tax (of around 13%) on the value of your meal. This is known as Value Added Tax (VAT).

Tax Systems

Progressive Taxation

With a progressive taxation system, citizens are put into ‘income earning bands’ and charged taxation according to these bands. The higher your income, the greater percentage of taxation that you need to pay on income in a particular bracket.

Regressive Taxation

Regressive taxation is the opposite to progressive taxation; the higher your income, the less percentage you pay in tax. Once again, citizens are allocated a tax band and must pay accordingly.

Proportional Taxation

In this case, citizens pay the same percentage in tax, regardless of their income. There are no tax bands – everyone pays the same % - for example 10%. If you earn $100 a year, you thus pay $10. If you earn $100 000 a year, you pay $100. Again, note that the amount each person pays is different but the percentage is the same.

Unit 4; Macroeconomic Indicators

Measuring Inflation

The Retail price Index (RPI)

  • This is a price index that shows the general change in prices over time as a %.
  • A hypothetical basket of goods and services which represents a normal households spending.
  • The items are ‘weighted’ to reflect the % of income spent on them.
  • Each month the prices of the goods and household spending patterns are monitored and the RPI is calculated.
  • The index has a ‘base year’ and the % change is measured from this.
Video: What is inflation?

Causes of Inflation

Cost-Push Inflation

  • Increases in wages & raw material costs push production costs up and result in higher prices.
  • If increases in wages are matched by an increase in worker productivity then unit costs should not rise.
  • A ‘wage spiral’ may occur when workers demand higher wages leading to higher prices & so workers then demand higher wages again & so on.

Demand-Pull Inflation

  • Excess demand (an increase in demand without an equal increase in supply) pulls prices higher.
  • Usually output can be increased to match demand but if there is full employment then extra workers cannot be employed to increase output. It could also be a shortage of a raw material that limits supply.


  • Increases in the money supply that are greater than increases in output (more money chasing same output).
  • Can be classed as demand-pull inflation.

Effects of Inflation

  • The value of money falls (each $ buys less). Hyperinflation may lead to loss in confidence of the currency.
  • Redistribution of income:
    • savers lose out as their savings lose ‘real’ value & borrowers gain as they repay less in ‘real terms’ than they borrowed.
    • People on fixed incomes (pensioners, students) see their real income fall unless it is ‘index-linked’ (linked to the changes in the rate of inflation).
  • Increased costs for firms: changing prices, labels, working out future costs.
  • Balance of Payments: increased prices make a country’s exports less desirable & imports seem comparatively cheaper. This can lead to further issues such as unemployment.

Measuring Unemployment

Measured as the % of the labour force who are willing & able to work and looking for a job.

Methods for measuring unemployment vary & generally the official rate is lower than the actual number of people looking for work.

Video 1.8 Outsourcing in the Philippines

Types of Unemployment

  • Frictional unemployment: people between jobs - tends to be short term.
  • Structural unemployment: industrial change over the long term can leave sectors of the labour force with skills that the economy no longer demands.
  • Seasonal unemployment: labour only demanded at certain times of the year (fruit pickers/ tour guides).
  • Cyclical unemployment: high unemployment in times of recession.
  • Immobility of labour: workers are generally fairly immobile (home, family) & only seek work in their region.
  • Technology: increases in technology have replaced some jobs and reduced number of workers in others.
  • Minimum wage: increased labour costs may force employers to hire less workers.

Effects of Unemployment

  • Increases in unemployment lead to higher costs for the Government (support & benefits) & at the same time less income for the Government (income tax). This could mean higher taxes for the working population or reduced spending on schools/hospitals/emergency services etc.
  • Increased unemployment means less output & so less goods and services for people to share.
  • Increased costs to society through higher crime rates, higher health bills (alcoholism/depression), increased rates of divorce.

Measuring Output

Gross Domestic Product (GDP)

Definition: The total value of the goods and services produced in an economy over a given time period.

This is the standard measurement but there are several variations that are used to provide a clearer picture of what is happening in the economy.

  • Nominal GDP: GDP valued using the current prices (no inflation consideration).
  • Real GDP: GDP that has had the effect of inflation removed.
  • Real GDP per capita: average Real GDP per person in the country. This allows any changes in the population size to be reflected.

Measuring Quality of Life

Human Development Index (HDI)

This is an index that takes into account 3 factors (each is an index itself):

  • Life expectancy index
  • Education index
  • Income index

It generates a score between 0 and 1. The closer to 1 the higher the quality of life.

It is considered a better measure of overall development then GNI or GDP because it takes into account social factors aswell as purely economic ones.

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