Thursday, May 3, 2012

How To Study Unit 2: Managing the Economy (Edexcel) Effectively?

After many years of critical coaching, thorough observation and some analysis, I managed to arrive at a conclusion of why many candidates fail to perform in Unit 2: Managing the Economy and perhaps also in Unit 4: The Global Economy. As all of you are aware, these two units are classified as macroeconomics and they have a distinct feature that separates them from the other two which are Unit 1: Competitive Markets-How They Work and Why They Fail and Unit 3: Business Economics and Economics Efficiency

My experience tells me that generally students do either very well in Microeconomics or excel in Macroeconomics. Frankly, I seldom come across candidates that are good in all the units. It is either they are good in Unit 1 and 3 or Unit 2 and 4. HOWEVER, students that exhibit sharp understanding of Macroeconomics (Unit 2 and 4) usually do not have much problems coping with Microeconomics (Unit 1 and 3). It is always those who seem to have a promising start in Unit 1 that end up struggling along the way up to Unit 4

Why is that so? These are the following reasons:

Unit 1 and 3 tend to have ‘more memorising’ elements. It works wonder if you rot-memorise. You may even get away with distinction by memorising terms/ definitions despite not having any proper understanding/ appreciation of the terminologies. As a matter of fact, many of these keywords do repeat themselves in the exam e.g. production possibility frontier, opportunity cost, PED, XED, YED, PES, taxation, subsidy, market failure, government failure, productive efficiency, allocative efficiency, profit maximisation, revenue maximisation, sales maximisation and many more. In Unit 1, almost every question carries definition mark. We have about 15 questions (8 MCQs and 7 in data response) and that may be a whooping 12/13 marks just for definitions. While I don’t deny that Unit 2 and 4 do test candidates on definitions, they somehow carry lesser marks/ weightage/ appear with lesser frequency. Even if they do, they may appear in many bewildering forms that often require candidates to do some critical thinking. Consider real GDP per capita, real GDP growth, annual real GDP growth, nominal GDP, GDP at current prices, real GDP, GDP at constant prices etc. Sometimes, they may appear in the form of phrase such as ‘sterling’s trade-weighted index’ or ‘government spending increasing only 0.5% in real term’ and students have to use their understanding to gauge the meaning of the phrase. Conclusion is, memorising does not work that well in Macroeconomics

In Unit 1 and 3, candidates do not have to explain how things work/ transmission mechanism and that is why answers are so much shorter. The beauty is, the type of questions that can be asked seem to be ‘limited’. Do more past year papers and you will undeniably agree with me. They are repetitive and the questions just manipulate themselves in different phrasings. In Macroeconomics, situations may not go that smooth. There are ‘endless’ possibilities of how macroeconomic variables affect one another. For instance, house prices can affect price level, economic growth, global trade, employment level, public finances and many more. Using LOGIC combined with some economic theories, you will have to explain how those variables are affected and perhaps argue why they may not be affected too at the same time. The combinations are just too great. Here, memorising will not work and not at all. However, I don’t imply that macroeconomics is necessarily harder. It just functions differently. It is equivalent to telling directions. There are just too many ways for you to move from point A to point B and you must be a good direction-informer

Besides, do take note that ALL Economics textbooks of all level are organised in such a way where candidates are exposed to the concept of GDP, inflation, balance of payments, unemployment, fiscal policy, monetary policy, supply side policies etc when it is crystal clear that examinations test us far beyond that. They want us to know the TRANSMISSION MECHANISMS but they never taught that to us, at least not in a direct way

Here, I will organise your revision for Unit 2: Managing the Economy in the most systematic way which will definitely enhance your understanding in the shortest time. How fast you improve and much of information you can grab will have to depend on you yourself. Please bear another thing in mind. It will not be sufficient reading what I’m about to post. Use it. Practice the newly earned-skills

Basic transmission mechanisms:

1. Economic growth leads to lower unemployment
Growth --> rising income per capita --> greater spending into the economy --> AD for goods and services increase --> more manpower needed à lower unemployment

2. Economic growth leads to higher inflation
Growth --> increase in wages/ bonuses --> greater spending into the economy --> increase in AD --> price level increases --> demand-pull inflation

3. Economic growth leads to the worsening of current account deficit
Growth --> increase in wages/ bonuses --> UK people have high marginal propensity to import --> rise in imports and assume exports unchanged --> worsening of the current account deficit

4. Economic growth leads to income inequality
Growth --> wages for low/ middle class earners will usually increase but at a slower rate --> probably worse off after adjustment for inflation, student loan repayments, income tax and NICs (National Insurance Contributions) --> rich people may be subjected to higher income tax BUT there are other non-income gains that are taxed at much lower rate e.g. capital gain and share dividends --> widening income inequality

5. Growth leads to deterioration of environment
Growth --> increase in wages --> greater AD for goods and services --> more lands cleared to give way for residential homes, business parks and factories/ more cars on the road --> deforestation and rise in global warming

 6. Lower unemployment leads higher growth
Low unemployment --> AD for goods and services will increase --> higher real output --> growth

7. Lower unemployment leads to higher inflation
Low joblessness --> greater spending into the economy --> AD shifts rightward --> price level increases --> demand-pull inflation

8. Lower unemployment leads to worsening of current account deficit
Low joblessness --> unemployed people now have income to spend --> UK people have high marginal propensity to import --> rise in imports and assuming exports unchanged --> current account deficit widens

9. Lower unemployment leads to deteriorating environment
Fewer jobless people --> greater spending into the economy --> more lands to be cleared to construct houses, leisure areas and factories/ more cars and busses on the roads --> deforestation and emission of CO2

10. Lower unemployment reduces income inequality
Fewer unemployed people --> jobless people now have income and assume that their income is more than their previous benefits and UK government implements progressive taxation --> narrowing the gap between the rich and poor

11. Lower unemployment leads to higher inflation 
Fewer jobless people --> total expenditure into the economy increases --> AD shifts rightward --> increase in price level --> higher demand-pull inflation 


12. High inflation leads to lower growth
Supposed that the inflation creeps beyond the targeted level of CPI 2% +/- 1% --> Bank of England may consider an increase in base rate --> if this happens, cost of borrowing will increase --> lower consumption and investment --> fall in AD à lower growth

13. High inflation leads to increase in unemployment
Increase in inflation à falling real income --> limiting the spending ability of households --> AD for goods and services will fall --> fewer workers needed

14. High inflation leads to the worsening of current account deficit
Increase in production costs --> less competitive pricing --> export prices increase and assuming import prices unchanged --> fall in demand for British manufactured goods --> widening current account deficit

15. High inflation leads to widening income inequality
Rise in price level --> wages growth rate is usually lower than the rate of inflation --> falling real income --> consumers/ households are priced-out --> every pound purchases lesser goods and services

17. High inflation leads to less deterioration of environment
Increase in price level --> falling real income --> limiting the ability of households to spend elsewhere --> fall in AD for goods and services --> factories operate shorter hours and economic activities come to a slowdown --> less severe congestion, deforestation and flights --> improve the conditions of the environment


18. Large current account deficit leads to lower economic growth

Huge current account deficit --> imports of goods outweigh exports of goods --> net withdrawal from the UK’s circular flow of income --> falling net exports/ resulting in net imports --> AD shifts leftward -- lower real output --> faltering growth

19. Large current account deficit leads to lower inflation

Rising current account deficit à imports of goods are greater than exports of goods à net withdrawal from the circular flow of income à falling (X-M) --> AD shifts leftward --> price level falls --> lower inflation for the UK economy

20. Large current account deficit leads to rising unemployment

Huge current account deficit --> indicator that British people have high marginal propensity to import (M increases) and at the same time UK manufactured goods are losing its price competitiveness (X falling) --> decline in factory orders both from domestic and international market --> factories no longer need so many manpower as before --> retrenchment --> rising unemployment

21. Large BOP deficit leads to improvement in the environmental condition

Large BOP deficit is due to the ongoing current account deficit --> imports of goods far outweigh exports of goods --> demand from both domestic and international market falling --> greater spare capacity e.g. heavy equipments are not in used and factories dispose lesser waste, thrash and smog --> cleaner environment within UK

22. Large BOP deficit leads to increase in income inequality

Huge current account deficit --> imports greater than exports --> falling factory orders both from domestic and international market --> factories will need to get rid of surplus of workers --> those retrenched will fall into greater poverty

More to come, stay tune!! Remember, you don't have to study textbooks. It is incredibly sufficient if you're able to understand transmission mechanisms alone. LOGIC is the word. Please don't rot memorise

Now, let's roll for demand management policies


Fiscal policy

1.  Increase in government spending leads to economic growth
Larger budget e.g. building of new schools and hospitals --> direct injection into the circular flow of income --> increase in AD --> rise in real output -->economic growth

2. Increase in government spending leads to falling unemployment
The UK government spends more money onto public sector e.g. enlargement of existing departments and build more roads and bridges --> create jobs e.g. teachers, surgeons and nurses in NHS, road builder etc --> lower unemployment within UK

3. Increase in public sector expenditure leads to rising inflation
Direct injection into the circular flow of income --> government spending is a component of AD --> AD shifts to the right à price level increases --> demand-pull inflation

4. Increase in budget deficit leads to larger current account deficit
Greater budget deficit is an indicator that the UK government has increased its spending --> AD shifts rightward --> economic growth --> rise in income --> UK people have high marginal propensity to import --> import of foreign goods increases --> assuming exports unchanged --> widening of current account deficit

5. Increase in public sector spending leads to deterioration of environment
Larger budget to construct schools, hospitals, roads and bridges, sports complex etc à clearing up of lands/ deforestation à worsening the environmental condition

6. Increase in public sector spending leads to falling income inequality
Larger budget e.g. financial support to help key workers to climb onto the property ladder, Minimum Income Guarantee for pensioners, New Deal programmes for long term unemployed, Jobseekers Allowance etc --> people who are unemployed have some incomes to sustain themselves while some are moved into labour market --> narrowing income inequality/ reducing cases of relative poverty

7. Reduction in income tax leads to economic growth
Lower income tax --> higher take-home pay à more money to spend into the economy --> rise in consumption --> AD shifts rightward --> rise in real GDP --> growth

8. Lower income tax leads to falling unemployment rate
Lower income tax --> higher disposable income --> more money to spend into the economy --> AD for goods and services will increase --> more manpower needed --> lower unemployment

9. Lower business tax leads to higher inflation
Slash in corporation tax --> higher retained profits --> firms are more likely to increase investment e.g. purchase of capital equipments, build new factories etc --> injection into the circular flow of income --> AD increases --> increase in price level --> inflation

10. Lower business tax and income tax leads to worsening of current account deficit
Lower business tax --> higher retained profits --> more likely to invest/ enlarge operations --> purchase of more raw materials, intermediate goods and capital equipments from abroad --> assuming exports constant --> worsening the current account deficit

11. Slash in income tax leads to deterioration of environment
Lower income tax --> higher take-home pay --> households have more money to splash into the economy --> AD for goods and services increase --> More supermarkets, banks, pubs, housing areas, parks etc will be built --> worsening the environmental condition

12. Cut in income tax leads to falling income inequality
Reduction in income tax for lower/ middle income people --> allow for higher disposable income --> reducing the gap between the rich and poor

Next comes the monetary policy

 MONETARY POLICY

1. Lower interest rate leads to higher growth
Slash in base rate --> cheaper cost of borrowing --> more households will borrow and spend (cars, properties, flat screen TVs etc) while companies seize opportunity to invest due to higher rate of return on capital --> increase in AD --> rise in real output à growth

2. Lower interest rate leads to lower unemployment
Fall in repo rate --> fall in cost of borrowing --> people will spend more money (cars, furniture, foods and drinks etc) and companies will increase their investment (new factories, outlet, operation centre etc) --> more manpower needed to produce goods and services --> falling unemployment

3. Lower interest rate leads to rising price level
Cut in overnight rate --> cheaper borrowing --> more people and firms spend into the economy à AD shifts rightward --> price level increases --> inflation

4. Lower interest rate leads to narrowing of the current account deficit
Falling interest rates --> less attractive to save money in UK due to lower return on savings --> outflow of hot money e.g. short term funds --> supply of pound increases in exchange for other currencies --> value of pound falls --> exports artificially cheap while imports artificially expensive --> reduction in the balance of trade --> cutting down size of current account deficit

5. Lower interest rate leads to worsening of environmental condition
Cheap borrowing --> households splash more money into the economy e.g. buying properties, cars, dine more often outside while companies invest by building new factories --> clearing up of lands to give ways to development and growth à greater air, water, and noise pollution

6. Lower interest rate leads to reduction in income inequality
Households increase spending into the economy --> AD for goods and services increases --> more manpower needed to produce output --> job creations --> people on long term unemployment may return to job markets

SUPPLY SIDE POLICIES/ MICROECONOMICS REFORM (some other syllabus)


1. Lower income tax leads to higher economic growth
Workers get to keep higher portion of their income --> create an incentive to work harder/ longer hours/ taking up second piece of job --> more potential output produced --> higher economic growth

2. Reform to income tax leads to lower unemployment
Unemployed people realise that take-home-pay has increased --> larger gap between disposable income and benefits from staying unemployed --> creates incentive to enter into labour market --> lower unemployment

3. Lower income tax leads to lower inflation
Higher take-home-pay --> creates an incentive to be more productive at work place --> increase in output --> high overhead costs are spread over greater output --> lower unit costs --> pass on to economy --> falling price level --> lower inflation

4. Fall in income tax leads to narrowing of BOP deficit
Higher disposable income --> creates an incentive to be more productive --> rise in output --> lower unit costs --> competitive pricing --> assuming other factors constant, exports will increase --> narrowing the balance of trade/ current account deficit

5. Trade union reform leads to higher economic growth
Weaker trade union --> lesser industrial disputes --> more productive working days in a month/ year --> more potential output produced --> higher growth

6. Labour union reform leads to lower inflation
Unions have lesser power to bargain for high wages that are not met by equivalent rise in productivity --> wages cost kept low --> prices of goods and services do not increase --> lower cost-push inflation

7. Weaker trade union leads to fall in unemployment
Trade unions have less power to bargain for absurd wages --> wage costs are kept low --> companies will have greater tendency to demand for more workers --> job creations --> lower unemployment

8. Weaker labour union leads to falling BOP deficit
Lesser strikes and more productive working days and wage costs are kept low --> costs are spread over more output --> lower unit costs --> competitive pricing --> assuming other factors constant, exports will rise --> narrowing BOP deficit

9. Better education and training leads to higher growth
UK government increases spending onto education and training --> professors are financially rewarded, more research grants for universities, improvement in education system, more schools, greater range of vocational programmes introduced like carpentry, IT skills, tailoring and cooking class --> more productive and skilled workforce --> increase in potential output --> growth

10. Better education and training leads to lower inflation
UK will have more productive and skilled manpower --> efficiency at workplace increases --> increase in potential output --> costs are spread wider --> lower unit costs --> pass on to the economy --> lower inflation

11. Better education and training leads to lower unemployment
UK will have more knowledgeable workers and those that undergone training will have better skills --> value for money if firms recruit them --> reduce frictional (time taken to land on new job) and structural unemployment (due to change in structure of economy)

12. Better education and training leads to shrinking BOP deficit
UK will have more educated and skilled workers \--> productivity at workplace increases --> more output produced --> lower unit costs --> rise in competitiveness --> higher exports, assuming imports constant --> BOP deficit narrows

13. Privatisation leads to economic growth
More new private firms are established --> the spirit of competition has led to more innovation e.g. methods to increase output and employees are more likely to be productive to keep their jobs --> higher potential output à growth

14. Privatisation leads to fall in inflation
More new private firms are created --> fierce competition and assuming other factors constant --> prices will be kept low and also there will be an incentive to reduce costs so that price reduction will not affect their profit margin --> lower inflation

15. Privatisation leads to narrowing of current account deficit
More private firms are created and assuming other factors constant --> more competitive environment --> have the incentive to keep prices low and at the same time pursue efficiency measures to preserve margins of profit/ incentive to produce quality goods --> export prices become competitive and assuming imports unchanged --> BOP deficit shrinks

16. Deregulation leads higher growth
Reduction in the barriers to entry --> more private enterprise set up --> more potential goods and service produced --> growth

17. Deregulation leads to lower inflation
Government efforts to create a more competitive environment --> lower barriers to entry --> more firms competing to enlarge their market share --> prices of goods and services are kept low --> falling inflation

18. Deregulation leads to shrinking deficit in the balance of trade
Greater competition --> firms try to hold down prices --> competitive pricing for exports of goods and services --> reduction in current account deficit

19. Reducing state welfare benefits lead to higher growth
The opportunity cost of staying unemployed has increased --> greater incentive for jobless people to enter the labour market and assuming other factors constant --> more output à growth is achieved

20. Reducing welfare benefits lead to lower inflation
More jobless people will have the incentive to enter the labour market --> supply of labour increases --> wages will be suppressed à wages cost fall --> lower prices --> inflation is reduced

21. Cut in welfare benefits leading lower unemployment
Long term unemployed finds that it is more financially rewarding to be in labour market than at home --> more of them try to look for jobs and assuming other factors constant --> fall in the number of jobless people

22. Lower benefits lead to falling current account deficit
Gap between new benefits and disposable income increases --> creates an incentive to look for work --> increase in labour supply into certain industries will keep market wages low --> low unit costs --> improve competitiveness --> exports of goods and services increase --> reduction in BOP deficit

23. Employment subsidies leading to higher growth
Government provide grants e.g. wages and training are paid by the state --> private firms in theory are encouraged to provide more regular training for their workers --> rise in productive potential --> growth

24. Employment subsidies leading to lower unemployment
Companies are given financial subsidies --> creates the incentive/ provided with more budget to enlarge their base of employees --> new vacancies are created -->  more people are absorbed into labour market --> lower joblessness

25. Employment subsidies leading to lower inflation
Wages are subsidised by government --> keep operating costs low and assuming other factors constant --> companies may pass on some of the cost savings in the form of lower price --> falling inflation

26. Subsidies leading to reduction in size of current account deficit
Operations are partially subsidised by government e.g. training, wages, purchase of raw materials etc --> able to operate in a larger scale leading to various economies of scale --> cheaper unit costs --> greater competitiveness --> falling current account deficit

Some more advanced TRANSMISSION MECHANISMS:

1. Increase in government spending may lead to lower growth (possible? YES, 2 ways)
A. Rise in public expenditure --> greater budget deficit --> more borrowing from the private sector by selling gilts --> due to the attractive returns and since they are government-backed --> bought by private companies --> lesser money to invest --> possibility of lower growth and is known as crowing out effect

B. Surge in public spending --> the increasing need to borrow for more money --> creates competition with the private sectors for money --> interest rate is bid up --> higher cost of borrowing --> falling in private investment --> economic growth may be muted and is known as crowding out effect

2. Rise in exports which may lead to widening current account deficit (What?? YES, 4 ways)
A. Surge in exports --> demand for sterling increases to facilitate transactions --> pound appreciates --> British-made goods become less price competitive --> demand for exports fall --> current account deficit widens

B. Rise in exports --> revival in the manufacturing sector --> increasing the need to sustain/ enlarge the operations --> purchase of more capital equipments usually from Germany and Japan --> may worsen current account deficit

C. Rise in exports --> revival of the beleaguered manufacturing sector --> more people are absorbed into employment --> total spending onto imported goods may increase since UK people have high marginal propensity to import --> worsening the balance of trade

D. A rise in exports, assuming imports are constant --> (X-M) will increase --> AD shifts rightward --> price level increases --> demand-pull inflation --> UK goods less price competitive --> falling demand from major trading partners like USA, France, Germany and Italy --> widening of the current account deficit

3. Collapse in house prices will lead to rising unemployment

A Falling house prices --> negative wealth effect/ falling equity --> people reduce their spending into the economy/ build up their savings --> falling AD for goods and services --> less manpower is needed --> rising unemployment --> through negative multiplier effect, unemployment may increase much more

B. Tumbling property market --> housing firms have less incentive to increase their portfolio --> reduction in the number of bricklayers needed and workers from construction related industries e.g. machinery, raw materials etc will be retrenched too --> rising unemployment

Well candidates, as you can see the list of transmission mechanisms may go on and on and on and that is why I strongly recommend you all to comprehend how the flows work rather than memorising them as there could be easily hundreds of them. Study SMART pays!! :) Cheers

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