EC1B5 Revision Dashboard

GDP is the market value of all final goods and services produced within a country's borders during a specific time period.

• Market value: prices aggregate apples and aircraft. Non-market goods (clean air, unpaid care) are excluded. Imputed rent for owner-occupiers is a notable exception.
• Final goods only: avoids double-counting. A car counts once; the steel inside does not separately. Value added at each stage sums to the final price.
• Within borders (territorial): a Toyota built in the UK counts in UK GDP even though Toyota is Japanese. Contrast GNP/GNI which follows owner nationality: \(GNP = GDP + \text{Net Factor Income from Abroad}\).
• Time period — it is a flow: a house built in 2024 counts in 2024 GDP; its resale in 2025 does not.

GDP vs GNP/GNI — practical difference

Ireland: GDP >> GNP because multinational profits counted in Irish GDP are mostly repatriated. Philippines: GNP > GDP because millions of Filipinos work abroad and remit income home. The distinction matters for understanding where income is actually earned vs where it is produced.

Every transaction creates a sale, a purchase, and income for factors of production. So Production = Expenditure = Income is an accounting identity.

1. Production / Value-Added Approach

Sum value added across all firms: \(VA = \text{Revenue} - \text{Intermediate Inputs}\). Prevents double-counting; allows sectoral decomposition (agriculture / manufacturing / services). National statistics offices use this to track where growth originates.

2. Expenditure Approach

Most widely used in macroeconomics. Imports subtracted because C, I, G include spending on foreign-produced goods — subtracting M isolates domestic production.

3. Income Approach

Sum: wages and salaries + gross operating surplus (profits, rents) + mixed income (self-employed) + net taxes on production. Must equal expenditure; statistical discrepancy is reconciled by national statisticians.

Summing all sale prices gives £9.10 — 2.6× too high. Value added prevents this double-counting by only recording the net addition at each stage.

Equilibrium: injections (I+G+X) = leakages (S+T+M). This rearranges to the national saving identity.

Nominal GDP uses current prices. If prices double and output stays constant, nominal GDP doubles — misleading. Real GDP uses constant base-year prices, so changes reflect quantity changes only.

Chain-weighting (modern practice)

Fixed base years become stale — computers were tiny in any 1990 base year but enormous by 2000. Chain-weighting updates price weights each period. More accurate but the levels cannot be meaningfully summed across components — a technical nuance that catches students out.

Worked example

Nominal +31% = real +5% + inflation ~25%. The deflation step is essential for comparing output over time or across different countries' price levels.

Why they diverge: GDP per capita reflects both participation rate and hours per worker, not just productivity. France and the US have similar GDP per hour but the US has higher GDP per capita because Americans work longer hours — a choice about leisure vs income, not an efficiency difference.

The rule of 70

A 1pp difference in growth rate, compounded over 100 years, means the difference between a 2.7× and 7.2× improvement in living standards. This is why growth rates matter enormously for long-run welfare.

Converting GDP at market exchange rates misleads because price levels differ across countries. PPP asks: what can income actually buy locally?

Why market FX misleads: a haircut costs $10 in the US but $1 in India. Converting Indian incomes at market rates makes Indians look poorer than they really are in terms of real consumption possibilities.

Balassa-Samuelson effect

Richer countries have higher price levels, especially for non-traded services. Mechanism: productivity growth in traded goods (manufacturing) raises wages throughout the economy via labour mobility. Higher wages raise costs of haircuts, restaurants — non-traded services become expensive. So rich countries look cheaper in PPP terms than market FX implies.

Big Mac Index

The Economist's crude PPP proxy: if a Big Mac costs $5 in the US and £3 in the UK, the implied PPP rate is £0.60/$. If the actual rate is £0.80/$, the pound appears overvalued by ~25%. Crude (tax differences, non-traded ingredients vary) but intuitive and widely cited.

When to use which measure

Penn World Tables: the standard academic dataset for cross-country PPP comparisons. Uses ICP surveys across 180+ countries. Major revisions can substantially change estimated relative incomes — India's GDP was revised ~40% down after the 2005 ICP. Illustrates PPP data limitations, especially in economies with large informal sectors.

Human Development Index

UNDP's HDI combines: income (log GDP/capita) + health (life expectancy) + education (mean and expected years of schooling). Cuba and Sri Lanka score far higher on HDI relative to GDP than Gulf petrostates — they invest heavily in health and education. HDI captures dimensions GDP misses entirely.

India vs USA — a PPP illustration

India nominal GDP/capita (2023) ≈ $2,600. PPP-adjusted ≈ $9,000. Still well below US ($81,000) but the gap is meaningfully smaller than market FX implies. The Balassa-Samuelson effect and large informal sector explain much of the price-level difference.

Note how PPP adjustment reduces the apparent gap between developing and rich countries — but a large real difference in living standards remains.

Pre-industrial: productivity gains raised population rather than per-capita income, because land was fixed. Extra people → diminishing returns → income back to subsistence.

Evidence: the Black Death

Black Death (1347–51) killed ~30% of Europe's population → labour scarcity → real wages roughly doubled. Then population recovered and wages fell back. A catastrophe could only temporarily raise living standards — classic Malthusian reversal.

Escape mechanisms

• Demographic transition: rising incomes eventually lower fertility (children become costly rather than cheap labour). Breaks the loop.
• Industrialisation: capital and fossil fuels removed the land constraint — land became far less important as a factor.
• Institutions: property rights and contract enforcement enabled sustained capital accumulation and innovation at scale.

Capital per worker evolves according to:

s = saving rate, δ = depreciation rate, n = population growth, g = technology growth. The term (δ+n+g)k is break-even investment — needed to keep k constant as capital depreciates, population grows, and technology advances.

Steady state

At k*, output per actual worker grows at rate g (technology). Key insight: capital accumulation alone cannot sustain permanent per-capita growth — only technological progress can.

Comparative statics

Unconditional convergence — not observed

The basic Solow model predicts all countries converge to the same income level. This is not observed globally — Africa and rich OECD have not converged.

Conditional convergence — observed ✓

Countries converge to their own steady states (which differ because s, δ, n, A differ). Controlling for steady-state determinants, countries below their own k* grow faster. This is what data show. The key empirical implication of Solow.

Solow treats technology A as exogenous. Endogenous growth theory asks: where does A come from?

AK model (Romer 1986)

If knowledge spillovers mean social returns to capital are constant, permanent growth is possible without exogenous A. Learning-by-doing creates non-rival knowledge that others can use for free.

Non-rivalry of ideas

Physical capital is rival: one firm using a machine excludes others. Ideas are non-rival: the formula for a vaccine can be used simultaneously by everyone. Non-rivalry creates increasing returns at aggregate level — sustaining growth without diminishing returns hitting a ceiling.

Romer (1990) — expanding variety

Firms invest in R&D to create new varieties of intermediate goods. More varieties → higher productivity → growth. Policy implication: innovators can't capture all spillover benefits → underinvestment in R&D → government subsidies may be justified. Patents create incentives but also monopoly distortion — a second-best solution.

Schumpeterian growth

Growth through creative destruction: new innovations make old ones obsolete (smartphones killed film cameras). Aghion-Howitt: growth rate depends on probability of innovation × improvement per innovation. Implies: competition and market size matter for innovation incentives.

LD slopes down because diminishing MPL — each additional worker adds less output as capital is fixed in the short run. At high employment, MPL is low.

Shifts in labour demand

Monopsony — a complication

If a firm is the dominant employer (NHS in some UK regions), it faces an upward-sloping LS — must raise wages to attract more workers. Profit-maximising rule: \(MRP_L = MC_L\) where MC_L > W. Monopsonist hires less and pays less than competitive equilibrium. A minimum wage can increase employment in a monopsonistic market — key justification for moderate minimum wages (Dube, Lester, Reich 2010).

Workers maximise utility over consumption C and leisure ℓ, subject to budget constraint \(C = W(T - \ell)\).

Substitution effect (always raises supply)

When W ↑, opportunity cost of leisure ↑ → substitute away from leisure toward work.

Income effect (reduces supply)

When W ↑, effectively richer → demand more leisure (normal good) → work less.

Backward-bending supply curve

At low wages, SE dominates → LS slopes up. At high wages, IE can dominate → LS bends backward. Empirically: SE tends to dominate for low-earners; IE can dominate for high-earners and secondary earners in high-income households.

Reservation wage

Minimum wage a worker accepts to enter employment. Set by: unemployment benefits, non-labour income, home production value, preferences. If W < w_R → stays out of labour force (not unemployed). Higher UI generosity raises w_R → longer unemployment durations (moral hazard).

Efficiency wages (Shapiro-Stiglitz 1984)

Firms voluntarily pay above-market wages to deter shirking. If fired, workers lose the wage premium — so they work hard. Equilibrium includes unemployment as a "discipline device." Also: higher wages attract better applicants (adverse selection), reduce costly turnover. Prediction: positive relationship between wages and effort — empirically verified.

Insider-outsider theory

Employed workers (insiders) have bargaining power because replacing them is costly (training, disruption). Insiders negotiate wages above market-clearing, preventing unemployed outsiders from undercutting them. Structural unemployment can persist even with willing workers.

Nominal wage rigidity / loss aversion

Workers resist nominal wage cuts even when they would accept equivalent real cuts via inflation (Bewley 1999, surveys). Nominal cuts feel like a personal loss (loss aversion, Kahneman-Tversky). This explains why recessions cause unemployment rather than simply lower wages — firms cut employment rather than cut nominal pay.

Diamond-Mortensen-Pissarides (Nobel 2010): matching is costly and time-consuming. Matching function: \(M = m(U, V)\) — matches per period given unemployment U and vacancies V. Job-finding rate f = M/U; vacancy-filling rate q = M/V.

Boom: low U, high V (top-left). Recession: high U, low V (bottom-right). A rightward shift of BC signals worse matching efficiency — observed in US post-COVID where both U and V were elevated simultaneously, suggesting sectoral mismatch after pandemic restructuring.

Benefits

• Insurance against income loss — smooths consumption during job search.
• Better matching: workers can wait for well-suited jobs → higher quality employment.
• Automatic stabiliser: supports aggregate demand in recessions.

Costs (moral hazard)

• Raises reservation wage → longer unemployment durations.
• Katz & Meyer (1990): 10% higher replacement rate → 1–2 weeks longer US spell.
• Krueger & Mueller (2010): job search intensity falls as benefit generosity rises.

Danish flexicurity model

Denmark combines easy hiring/firing + generous UI (~90% replacement, 2 years) + intensive active labour market policies (retraining, job search support). Low structural unemployment despite high benefits — because job-finding rate f remains high. Suggests the design of UI system matters as much as the level.

Credit demand (downward sloping)

Firms invest until MPK = r. High r → fewer investment projects are profitable → less investment demand. Households borrow less at high r (consuming today is costlier).

Credit supply (upward sloping)

High r → saving more attractive → more funds supplied. Banks' willingness to lend also depends on capital adequacy and risk appetite.

• Information production: banks specialise in screening borrowers and monitoring loans — lower information costs than individual savers lending directly.
• Liquidity transformation: savers want liquid deposits (withdraw anytime); borrowers want long-term loans. Banks bridge this mismatch.
• Diversification: pool many deposits, make many loans — diversify idiosyncratic borrower default risk.
• Payments services: current accounts, cards, transfers — reduce transaction costs throughout the economy.

Bank balance sheet

Assets: loans, securities, reserves. Liabilities: deposits (demand + term), wholesale funding. Equity absorbs losses first. Leverage = Assets/Equity — a ratio of 20 means a 5% fall in asset value wipes out equity entirely (insolvency).

Banks are inherently fragile due to maturity mismatch: short-term liabilities (deposits that can be withdrawn anytime), long-term illiquid assets (mortgages that can't easily be sold). If all depositors withdraw simultaneously, even a solvent bank can fail.

Two equilibria

• Good equilibrium: depositors trust the bank; only those with genuine liquidity needs withdraw. Bank survives, all are better off than under barter.
• Bad equilibrium (bank run): each depositor fears others will run → rationally runs first → self-fulfilling panic → bank fails even if fundamentally solvent.

Bank runs are coordination failures — individually rational but collectively destructive. The role of expectations is crucial: the bad equilibrium is triggered by beliefs, not fundamentals.

Solvency vs illiquidity

Illiquid but solvent: good assets, cannot immediately convert to cash. Central bank lender-of-last-resort resolves this (Bagehot rule: lend freely at penalty rate against good collateral). Insolvent: assets worth less than liabilities. Requires recapitalisation, restructuring, or resolution. Policy must distinguish these — bailing out insolvent banks creates moral hazard.

Solutions to runs

• Deposit insurance (FDIC, FSCS): guarantees deposits up to a limit → removes incentive to run regardless of others' behaviour. Creates moral hazard → must be paired with supervision.
• Lender of last resort: central bank provides emergency liquidity to illiquid-but-solvent banks. BoE acted decisively in 2008 (unlike 1930s Fed which let banks fail).
• Capital requirements: more equity → more loss absorption → lower default risk → reduces likelihood of runs.

Shadow banking = credit intermediation outside the regulated banking system: money market funds, repo markets, CDOs, hedge funds, investment banks. By 2007 it was larger than traditional banking in the US.

• Not covered by deposit insurance or lender of last resort — vulnerable to runs.
• Repo market: short-term secured borrowing backed by securities. A "run on repo" (refusal to roll over) forces fire sales → price collapse → systemic crisis. The 2008 equivalent of a classic bank run.
• Dodd-Frank (2010) brought more shadow banking under oversight. But higher bank capital requirements push some risk back into the shadows — regulatory arbitrage is persistent.

Financial accelerator (Bernanke 1999)

Asset price falls → collateral values fall → borrowing constraints tighten → investment falls → further asset price falls → amplifying spiral. Financial conditions amplify rather than simply transmit shocks. Explains why financial crises produce deeper recessions than ordinary demand shocks.

Three functions

• Medium of exchange: eliminates the double coincidence of wants in barter. Without money, you need someone who wants exactly what you have and has exactly what you want. Money decouples buying and selling in time and space. With 1,000 goods: barter needs 499,500 price pairs vs money needs only 999.
• Store of value: moves purchasing power across time. Inflation erodes this. Any asset stores value, but money's advantage is liquidity — readily exchanged without loss.
• Unit of account: common unit for prices, debts, contracts. Simplifies economic calculation enormously.

Forms of money

Monetary aggregates (UK)

• M0 / Monetary base (H): notes + coins + bank reserves at BoE. Central bank controls directly.
• M1: currency + demand deposits.
• M4: M1 + savings accounts + other bank deposits. Most "money" is bank deposits, not physical cash — banks create deposits when they lend.

Defined as inflation >50% per month (Cagan 1956). Always involves extreme money creation. Germany 1923: prices doubled every 3.7 days. Zimbabwe 2008: 89.7 sextillion % per year.

Mechanism — fiscal dominance

Olivera-Tanzi effect: inflation erodes the real value of tax receipts collected with a lag. Higher inflation → lower real revenues → larger deficit → more printing. Vicious cycle.

End of hyperinflation

Requires a credible fiscal reform. Germany 1923: Rentenmark issued (backed by land), new independent Reichsbank, reparations renegotiated. Hyperinflations end abruptly once the fiscal problem is solved — expectations change overnight when the cause is removed. This proves hyperinflation is always ultimately fiscal, not purely monetary.

Anticipated inflation costs

• Menu costs: firms must update prices, menus, catalogues — costly though small in rich economies.
• Shoe-leather costs: people hold less cash (earn nominal return = 0) → more trips to bank, more time managing money.
• Tax distortions: nominal capital gains and interest taxed as if real — inflation creates phantom gains subject to tax.
• Unit of account confusion: harder to distinguish relative price changes from general price level movements.

Unanticipated inflation costs

• Redistribution: debtors gain (debt is in nominal terms); creditors lose. Erodes savings of those on fixed incomes (pensioners).
• Long-term contract disruption: wages, rents, bonds set in nominal terms become distorted.
• Investment uncertainty: volatile inflation makes long-term investment riskier → lower capital formation.

Costs of deflation (often worse)

• Debt deflation (Fisher 1933): falling prices raise real value of nominal debt → debtors cut spending → further deflation → spiral.
• Postponed demand: if prices fall, buy tomorrow — collapses current demand, especially for durables.
• ZLB problem: cannot cut nominal rates below ~0; real rates rise during deflation → extremely contractionary. Japan's "lost decades" illustrate all three.

Open market operations (main tool)

Buy/sell government bonds to add/drain reserves. OMO purchase: CB buys bonds → injects reserves → banks have more liquidity → short-term rates fall.

Policy rate / Bank Rate

The rate at which the CB lends to commercial banks — acts as a ceiling in a corridor system. Setting Bank Rate (BoE), Federal Funds target (Fed) anchors short-term market rates.

Interest on reserves (IOR)

Post-2008: CBs pay interest on reserves. This sets a floor for overnight market rates. Key tool when reserves are abundant (floor system).

QE and unconventional tools

• QE: buy long-term bonds → compress term premium → lower long-term yields directly. BoE bought £895bn of gilts 2009–2022.
• Forward guidance: commit to keeping rates low until conditions are met. Shifts entire yield curve through expectations.

Bank of England (2014): how money is actually created

"Whenever a bank makes a loan, it simultaneously creates a matching deposit in the borrower's bank account, thereby creating new money." Money is created endogenously by bank lending — the central bank accommodates reserve needs after the fact.

Textbook money multiplier vs reality

Where rr = reserve ratio. If banks hold 10% reserves, £1 new reserves → £10 new deposits. But this is misleading in practice:

• Banks don't lend out all excess reserves — they hold buffers.
• Money creation is demand-driven: banks create deposits when making loans, not the reverse.
• Post-2008: Fed expanded reserves from $45bn to $3tn via QE. Inflation did NOT surge — banks accumulated reserves (paid IOR). The simple multiplier story broke down completely.

UK 2021–23 inflation — case study

CPI peaked at 11.1% (October 2022). Main drivers: global energy prices (Russia-Ukraine war), supply chain disruptions (COVID legacy), tight labour markets. BoE raised Bank Rate from 0.1% to 5.25% in under two years — fastest tightening cycle in 30 years. Debate: domestic demand vs imported supply shocks? Core services inflation remained sticky, suggesting demand factors too. Illustrates limits of inflation targeting facing supply-side shocks.

• Co-movement: output, consumption, investment, employment, and hours all move together. Unemployment moves opposite to output (Okun's law: 1pp rise in unemployment ≈ 2pp output gap widening).
• Investment is most volatile: investment falls ~3× more than GDP in recessions. Non-durable consumption is most stable. Durables are intermediate.
• Leading indicators: housing starts, stock prices, and consumer confidence fall before recessions begin. Employment is a lagging indicator.
• Persistence: expansions and contractions continue once started. Recessions average ~11 months (NBER). Output gaps take 5+ years to close in severe recessions.
• International synchronisation: large economies' cycles spill over via trade and financial channels. Global recessions occurred in 2008–09 and 2020.

Okun's law

When output grows 2pp above potential, unemployment falls ~1pp. Useful for calibrating how much growth is needed to reduce unemployment meaningfully.

Real Business Cycle (Kydland-Prescott 1982)

Fluctuations are efficient responses to technology shocks. A bad TFP shock (A↓) lowers VMPL → labour demand falls → workers voluntarily choose leisure (substitution effect in labour supply — work less when productivity is low). Markets clear; unemployment is voluntary. Policy implication: monetary policy is ineffective; fiscal policy is distortionary. Criticism: requires implausibly large TFP shocks; doesn't explain why productivity falls in service recessions.

Keynesian (Keynes 1936)

Fluctuations driven by shifts in aggregate demand — often from "animal spirits" (investor confidence), consumer sentiment, or coordination failures. With sticky wages/prices, demand shocks change output not just prices. Unemployment is involuntary — workers willing to work at market wage cannot find jobs. Implies: fiscal and monetary stabilisation policy is effective and desirable.

Monetary/Financial (Friedman-Schwartz, Bernanke)

Monetary contractions and credit squeezes cause recessions. Friedman: Great Depression caused by Fed allowing M1 to fall 30% in 1929–33. Bernanke: bank failures destroy "information capital" of lending relationships — firms with good projects can't borrow. Financial accelerator (see W5): asset price falls → collateral falls → borrowing tightens → investment falls → further asset falls.

Flexible wage scenario

Rigid wage scenario

Evidence

During 2008–09, US nominal wages barely fell despite massive unemployment — consistent with downward rigidity. UK used furlough scheme (2020) to avoid mass layoffs — firms paid to hoard workers rather than cut wages. State-level US minimum wage studies (Dube, Lester, Reich) find no detectable employment loss near borders — consistent with monopsonistic market and rigidity.

Y* = potential output — what the economy can produce at the NAIRU with normal factor utilisation. Grows over time with technology and factor supply. The output gap is negative in recessions, positive when overheating.

• Negative output gap → deflationary pressure (workers accept lower wages; firms discount).
• Positive output gap → inflationary pressure (wage-price spiral possible).

Problem: potential output is unobservable and must be estimated. Large revisions occur — 2008 recession permanently reduced estimated potential output in most OECD countries. This matters enormously for policy: if the output gap is misjudged, both fiscal and monetary policy may be badly calibrated.

IS-LM with a ZLB

When rates hit zero, the LM curve becomes horizontal (liquidity trap). Fiscal expansion (IS shifts right) works fully — no crowding out via higher r. Monetary expansion (shift LM right) is ineffective at the ZLB — LM was already flat. This reverses the usual relative effectiveness of the two policies at the ZLB.

Theoretical modifiers

• Taxes: reduce multiplier — fraction of income taxed, reducing induced spending.
• Imports: reduce multiplier — induced spending partly on foreign goods (leaked abroad).
• Crowding out: G borrowing raises r → private I falls. Offsets fiscal expansion.
• Ricardian equivalence: forward-looking households save debt-financed tax cuts → multiplier approaches zero.

Empirical estimates

General finding: multipliers are larger when (a) economy is in recession, (b) monetary policy accommodates (ZLB), (c) economy is relatively closed. Smaller when above potential, rates rise, or debt is high.

1. Interest rate channel

↓ policy rate → ↓ short market rates → ↓ long-term rates (via expectations) → ↓ borrowing cost for firms and households → ↑ investment and durable consumption.

2. Asset price / Tobin's q channel

Lower rates → higher equity and bond prices → household wealth ↑ → consumption ↑ (wealth effect). Also: if stock price / replacement cost of capital (Tobin's q) > 1, firms invest more.

3. Exchange rate channel

Lower domestic rates → capital outflow → currency depreciates → exports cheaper for foreigners, imports more expensive → NX ↑ → GDP ↑. (See Week 9 for full mechanism.)

4. Credit channel (Bernanke-Blinder)

Lower rates improve bank profitability and borrower net worth → banks more willing to lend → investment rises beyond direct rate effect. Especially powerful when financial conditions are tight (post-crisis).

5. Expectations / confidence channel

If CB credibly signals rates will stay low, long-term rates fall today (expectations hypothesis of yield curve). Also: a rate cut can boost animal spirits — signals CB believes economy is ready to grow.

Why ZLB matters

If neutral rate is 2% and inflation target is 2%, normal cut space ≈ 4%. In 2008 and 2020, the Fed needed more than 4pp of cuts. With rates at zero, conventional tools are exhausted.

Quantitative Easing

CB buys long-term bonds using newly created reserves. Goal: lower long-term yields by increasing demand, reducing term premium. Also signals commitment to future low rates. BoE bought £895bn of gilts 2009–2022.

Forward guidance

• Delphic: "we forecast rates will remain low" (informational, not binding).
• Odyssean: commitment contingent on outcomes. Carney 2013: "we will not raise rates until unemployment falls below 7%." Shifts yield curve through expectations. More powerful but erodes credibility if not kept.

Negative interest rates

Sweden, Japan, ECB pushed overnight rates below zero. Aim: make reserve holdings costly → incentivise lending. Limits: banks reluctant to pass negative rates to retail depositors (fear of cash hoarding). Insurance companies and pension funds face severe difficulties matching long-term liabilities.

Discretionary tools

• G ↑ (government purchases): direct effect on GDP via expenditure identity. Multiplier depends on spare capacity, monetary response, trade openness.
• T ↓ (tax cuts): raises disposable income → C ↑. Multiplier < G multiplier because some saved (Ricardian concern).
• Targeted transfers: unemployment benefits, food vouchers directed to liquidity-constrained households with high MPC — high bang-per-buck.
• Public investment: infrastructure, R&D can raise both short-run demand (multiplier) and long-run supply (potential output). IMF (2014) estimates multiplier >1.5 for productive public investment.

Automatic stabilisers

Change automatically with the cycle without new legislation:

• Progressive income tax: income falls in recession → taxes fall more than proportionally (bracket effects). Buffers income falls.
• Unemployment insurance: automatically rises as unemployment rises. Maintains consumption of job-losers.

Automatic stabilisers are fast (no lag), well-targeted, and self-reversing. Preferred over discretionary policy for smoothing fluctuations, especially for small open economies where discretionary policy may be offset by exchange rate appreciation.

September 2022: Chancellor Kwarteng announced £45bn unfunded tax cuts without OBR forecast. Bond markets panicked immediately: 10-year gilt yields surged 150bp in days; £/$ hit record low. UK pension funds using LDI strategies faced margin calls — BoE had to buy gilts emergency to prevent financial collapse. Mini-budget reversed within weeks; Chancellor resigned. Lesson: fiscal credibility matters — bond vigilantes are real. A government that appears to ignore debt sustainability can face a market crisis rapidly, regardless of the technical merits of the policy.

Multipliers are larger: below potential output, at ZLB, in closed economies, when targeting high-MPC households. Smaller: above potential, when monetary policy offsets, when debt sustainability concerns trigger rising interest rates.

Absolute advantage: produce more output per unit of input than another country. Comparative advantage: lower opportunity cost of producing a good. Even if Country A is better at everything, both benefit from specialisation if opportunity costs differ.

Gains from trade and distribution

Trade raises aggregate welfare — allows consumption beyond the PPF. But creates losers in import-competing sectors (Stolper-Samuelson theorem: trade lowers returns to the scarce factor). In the US, trade with China caused ~2m manufacturing job losses 1999–2011 (Autor, Dorn, Hanson 2013). These concentrated losses create political pressure for protectionism even when aggregate gains are positive. The distributional problem is real — aggregate gains don't automatically compensate the losers.

Tariffs — costs and benefits

• Protect domestic producers in import-competing industries.
• Raise consumer prices — a transfer from consumers to producers and government.
• Reduce allocative efficiency and total welfare.
• Invite retaliation — trade wars lower global welfare (1930s Smoot-Hawley).
• May be justified for infant industries, national security, or as negotiating leverage — but rarely in general equilibrium.

The nominal exchange rate e is the price of one currency in terms of another. Convention matters — always specify the direction.

Determination of e — supply and demand

Demand for £: foreigners buying UK exports + foreign investors buying UK assets. Supply of £: UK residents importing + UK investors buying foreign assets. Shifts: interest rate differentials (UIP), inflation differentials (PPP), risk appetite, CA flows.

Marshall-Lerner condition and J-curve

A depreciation improves NX only if export + import price elasticities sum to >1. If elasticities are low initially (trade volumes don't adjust quickly), depreciation first worsens NX — the J-curve effect. Import prices rise faster than export volumes adjust. Over time (months to years), volumes respond and NX improves. This is why currency devaluations don't immediately fix trade deficits.

E measures relative price competitiveness. E = 1 → PPP holds (identical baskets cost the same). E > 1 → domestic goods relatively expensive; E < 1 → domestic goods relatively cheap.

Relative PPP

If UK inflation is 5% and US is 2%, sterling should depreciate ~3% to maintain relative purchasing power. PPP holds approximately over long horizons (10+ years) but poorly in the short run — exchange rates overshoot and are driven by capital flows, not just goods prices.

Uncovered Interest Parity (UIP)

Expected returns on domestic and foreign assets must be equal (otherwise riskless arbitrage). If UK rates are 2pp higher than US, the pound is expected to depreciate 2% to equalise returns. Links monetary policy, interest rates, and exchange rate expectations. In practice: UIP fails in the short run (excess returns / forward premium puzzle) but holds better over longer horizons.

Real interest parity

With perfect capital mobility, real rates equalise internationally. Small open economies are rate-takers in the global capital market.

A country cannot simultaneously maintain all three of:

Must give up one. Eurozone: capital mobility + fixed rate (euro) → no independent monetary policy. UK: capital mobility + independent policy → floating pound. China: fixed rate + independent policy → capital controls.

Optimum Currency Area (Mundell 1961)

Countries benefit from a common currency if: high labour mobility, high economic integration, symmetric shocks, fiscal transfers possible. The eurozone fails some criteria — labour mobility is low, shocks are asymmetric (German exports vs peripheral tourism), fiscal transfers are politically limited. Explains why Greece, Spain, Portugal struggled without exchange rate adjustment in 2010–15 — they needed depreciation but couldn't devalue within the euro.

Fixed vs floating — trade-offs

Case for fixed: reduces exchange rate uncertainty → facilitates trade/investment; disciplines monetary policy; useful for small open economies. Case for floating: automatic adjustment to shocks; monetary policy autonomy; no need to defend with costly reserve intervention.