ECONOMICS WORKBOOK MARKETS IN ACTION UNIT F581 …
WORKBOOK ANSWERS
Edexcel A-level Economics A
Theme 2 The UK economy: performance and policies
This Answers document provides suggestions for some of the possible answers that might be given for the questions asked in the workbook. They are not exhaustive and other answers may be acceptable, but they are intended as a guide to give teachers and students feedback.
Topic 1
Measures of economic performance
Economic growth
1 D. (1 mark) Explanation: A, B and C are already included in per capita GDP; D (the quantity or quality of education provision) tends to increase economic wellbeing. NB Explanation is not required for mark.
2 Nominal GDP is the total output of goods and services produced by an economy in a given time period, not adjusted for inflation. (1 mark) Real per capita GDP is nominal per capita GDP adjusted for the effects of inflation. (1 mark)
3 B. (1 mark) Explanation: the Bank of England has been given an inflation target of 2% over the medium term (within a band of +/−1%). NB Explanation is not required for mark.
4 Per capita GDP is the total output of goods and services produced by an economy in a given time period divided by that country’s population. (1 mark)
5 Gross national income (GNI) is also known as GNP. GNI or GNP = GDP + net property income from abroad. Net income from abroad includes dividends, interest and profit flows from abroad, i.e. GNP includes the value of all goods and services produced by nationals of a country whether in that country or abroad. (2 marks)
Inflation
6 Deflation is a situation of a continually falling price level, or negative inflation. (1 mark)
7 Deflation is a situation of a continually falling price level, or negative inflation, e.g. in Japan inflation was −2% in 2010. Disinflation is a situation where the rate of inflation is falling, e.g. UK inflation fell from 7.2% in 1991 to 0.75% by 2000. (4 marks)
Employment and unemployment
8 Unemployment is when people are out of work and are actively seeking employment.
(1 mark)
9 Unemployment is when people are out of work and are actively seeking employment. The claimant count measures unemployment through the number of people claiming job seeker’s allowance. The ILO is a survey. It seeks to measure unemployment by counting the people who have been out of work and have been looking for work for at least 4 weeks and are ready to start work in the next 2 weeks. (2 marks)
Exam-style questions (multiple choice and short answer)
1 The current account of the balance of payments is an account identifying transactions in goods and services between the residents of a country and the rest of the world. It is made up of four components: trade in goods, trade in services, net primary income and secondary income. (2 marks)
2 The current account saw an improvement from a deficit of £93,165 million to a deficit of £78,959 million. Although the balance of trade in goods deteriorated to £137,448 million, there was an improvement on the trade in services balance to £111,562 million and smaller outflows on primary and secondary income payments. (4 marks)
3 D. (1 mark) Explanation: a decrease in exports will reduce receipts to the UK, hence the current account surplus will fall. NB Explanation is not required for mark.
4 The CPI and the CPIH are both indices which measure the price level in a country and are used to calculate inflation. The CPIH includes a measure of housing costs whereas the CPI does not. The CPI increased by 5.9% whereas the CPIH increased by 6.4%. (4 marks)
5 The CPI index remained unchanged at 100. This means CPI inflation was 0% between 2014 and 2015. (2 marks)
6 Inflation is the sustained increase in the average cost of living. Inflation occurs when the price level increases. Inflation can be measured by the consumer price index. This is an index covering a basket of around 650 goods that are weighted according to a typical household’s expenditure patterns. The CPI is then compared to the previous year at the same time and any increase in prices will highlight how much the price level and hence the cost of living (inflation) has gone up. (4 marks)
Exam-style questions (data response)
7 Example answer:
GDP per capita is a measure of the total output of goods and services in the economy, divided by the population number. In the UK, per capita GDP has grown by ‘only 2%’ since 2008 suggesting that economic welfare may have increased only very slowly over the last decade. One advantage of using GDP per capita is that it is easy to calculate from official government figures. The methodology for calculating GDP is well understood and it does not require a separate calculation. Governments across the world have agreed on standardised methodologies for calculating GDP and agreeing what activities to include. This also means it is a good comparison between countries so we can compare economic welfare growth in the UK against other countries.
Second, it is a good indicator of the state of the economy of a country. Higher GDP equates with higher economic wellbeing since it suggests that, on average, households can purchase more goods and services. Economists usually associate greater consumption with greater economic welfare. People with higher incomes can also contribute more to government revenues through tax payments. This can allow for more merit goods such as education and healthcare.
However, GDP per capita does not tell us anything about the distribution of income within a country. The bulk of income could be earned by an elite of wealthy individuals. Hence GDP per capita may give a false impression of the economy as really the majority of people may not have such a high income. The extract suggests that ‘a large share of the workforce has had no real wage increases for many years’ while the richest households ‘have seen much stronger income growth’. (10 marks)
A fully developed answer with clear definitions, good use of the extract for application, fully developed and applied analysis and well-applied evaluation.
8 Example answer:
‘Economic wellbeing’ is not a precise term but aims to provide a more comprehensive measurement of how well an economy is performing by including wider measurements of economic and social progress. Economic measures such as GDP and unemployment are supplemented by measures of healthcare, education, personal finance, transport and housing, as well as surveys of happiness.
In the extract, it states that total school spending fell by 8% in real terms between 2010 and 2018. This might mean that the UK will have a less well-educated/qualified workforce, which will have a direct negative impact on UK measures of national wellbeing since literacy and education standards are part of wellbeing measures. In addition, a less well-educated workforce will be less productive or less able to work in highly technical parts of the economy.
A cut in spending on welfare such as job seeker’s allowance and housing benefit will mean that the average incomes for those who receive benefits will fall. This will reduce the average incomes received by households in the UK and have a direct negative impact on measures of national wellbeing. It might also reduce mobility of labour, particularly for the frictionally unemployed. This could raise the equilibrium unemployment rate, leading to a further fall in national wellbeing.
However, the likelihood of all of these changes having such a significant effect on the overall UK HDI is unlikely. First, even though the extract suggests there has been a cut in per pupil spending which will impact current students, it does say that overall education spending ‘has been protected from the sharpest cuts’. Key elements of the educational system are likely to be maintained hence measured indices of development (such as the HDI) and other measures of ‘wellbeing’ are likely to be maintained.
Second, a cut in government spending is unlikely to be part of a long-term policy in most countries. The main motivation for these cuts is governments’ austerity programmes, as governments need to cut their budget deficit and reduce the growth of debt. However, in the long term, as the economy recovers, these policies may be moderated and spending on education and healthcare will be increased. (15 marks)
The student fully understands the material and has constructed a well-balanced piece of analysis and high-quality evaluation.
Topic 2
Aggregate demand
Aggregate demand
1 a Consumption is the total planned household expenditure on goods and services. It is one of the main components of aggregate demand in the UK. (1 mark)
b Investment is expenditure by firms on capital goods such as machinery or equipment used to manufacture other goods. (1 mark)
c Net trade is the value of exports minus the value of imports. OR The value of goods and services sold in exchange for foreign currency minus the value of goods and services bought with foreign currency. (1 mark)
Consumption (C)
2 Marginal propensity to save (MPS) is the change in household saving resulting from an increase in income. (1 mark)
(It can also be calculated as 1 – MPC (marginal propensity to consume) OR
change in saving/change in income.) (1 mark)
3 Average propensity to consume (APC) is the percentage of income spent (C/Y).
(1 mark)
4 The rate of interest is the cost of borrowing money. (1 mark) A change in interest rates
will have a direct influence on consumption. For example, a fall in interest rates will encourage people to borrow as it means the interest payments on loans or mortgages will fall. Hence, one would expect that the level of borrowing in the economy will increase. Consumption will also increase as a result of more money being available to consumers. In addition, the opportunity cost of saving will fall as consumers get a lower return on any savings held in banks. Therefore, savings will fall and consumption will rise. A rise in interest rates will have the opposite effect on consumption. (2+ marks)
Wealth is a stock and measures the value of a household’s assets minus its liabilities.
(1 mark) A change in wealth will also affect consumption. If the value of household wealth increases then consumers will tend to feel more confident. In addition, their ability to finance consumption through extracting wealth from their house by borrowing (mortgage equity withdrawal) will increase. So an increase in wealth will lead to an increase in consumption. (2+ marks)
Investment (I)
5 Investment is the purchase by firms of capital goods. (1 mark)
6 +10%. Calculation: investment is approximately £44,000 million in Q1 2014 Q1 and £40,000 million in 2012 Q2. Therefore ((44,000 − 40,000)/40,000)) ( 100 = +10%. (2 marks)
7 Lower interest rates make it easier to access finance because of lower monthly/yearly interest payments. This leads to more borrowing by firms.
In addition, lower interest rates mean that firms expect that more investment projects (marginal projects with a lower expected return) are now profitable. Following MEC theory, this implies profit-maximising firms will undertake more investment, leading to ceteris paribus an increase in investment. A fall in interest rates from r1 to r2 leads to investment increasing from I1 to I2. (6 marks)
[pic]
Government expenditure (G)
8 When an economy is in a recession, national income/output falls. This suggests that employment will fall. This will lead to a fall in income tax receipts as fewer people will be in employment. In addition, spending will tend to fall. So indirect tax receipts (e.g. VAT) will also fall. Therefore total tax receipts will fall. (2+ marks)
In addition, a fall in employment will probably be followed by a rise in unemployment. Hence government spending on job seeker’s allowance will rise. (2 marks)
These effects are known as automatic stabilisers.
Exam-style questions (multiple choice and short answer)
1 D. (1 mark) Explanation: it will reflect a rise in X or a fall in M. Both represent a
in AD. NB Explanation is not required for mark.
2 A. (1 mark) Explanation: a decrease in imports will reduce withdrawals so boost X − M and hence the expenditure measure of GDP. NB Explanation is not required for mark.
3 The exchange rate is the price of one currency in terms of another. (1 mark)
4 −15%. Calculation: the exchange rate in February 2014 was approximately 1.65;
in February 2018 it was 1.4: therefore ((1.65 − 1.4)/1.654)) ( 100 = −15.15%. (2 marks)
5 Knowledge, application and analysis (up to 6 marks):
• Define exchange rate: the price of one currency in terms of another. Application: the value of the pound has fallen by 15% between February 2014 and February 2018.
• A decrease in the value of the pound means that the price of UK goods falls in foreign markets; demand for them increases, meaning increased volume of X and hence a rise in AD.
• A decrease in the value of the pound means that the price of imported goods rises; hence there is a decrease in demand for imports which may be substituted for
UK-produced goods, leading to a decrease in M and a rise in AD.
Evaluation (up to 4 marks). Two separate points are needed with relevant use of context:
• Long-term contracts between companies mean that a fall in export earnings will not happen straight away. Export earnings may rise in the short run or stay the same.
• Exporting companies may choose to keep prices unchanged and receive higher profit margins.
• PED for exports and imports may be highly price inelastic. So some foreign countries/firms may take the hit of having to pay a higher price due to a better quality of goods. So export earnings may remain stable.
6 Knowledge, application and analysis (up to 6 marks):
• Define economic growth: increase in real GDP.
• Define balance of payments: record of transactions between the UK and the rest of the world. Current account includes exports minus imports of goods and services plus net income from abroad plus net transfers between residents.
• If growth is accompanied by an increase in domestic demand (C + I + G) then the increase in growth may be accompanied by a rise in imports as households, firms and government use their rising income to purchase more goods from abroad. In this case, the balance of payments might deteriorate.
• If growth is export led then the balance of payments might improve. (This could count as evaluation depending on how analysis is developed.)
Evaluation (up to 4 marks):
• Impact depends on the changes in the exchange rate over the time period. Since sterling depreciated sharply between 2014 and 2018, this will offset some of the effect.
• The extent of the change depends on the relative growth rates in the UK vs trading partners. If the UK grows by more than its trading partners, it is likely that the balance of payments will deteriorate. In 2018 the UK was starting to grow more strongly again, though growth in many trading partners was also picking up.
• The effect of an increase in domestic demand depends on the marginal propensity to import (MPM). In the UK this has remained very high despite the recession. The MPM means the effect of an increase in UK growth on the current account deficit will be magnified.
Exam-style questions (data response)
7 Nominal GDP is GDP measured in terms of money values, so it measures both the increase in the real GDP of the economy and the changes in the price of goods and services.
According to the extract, ‘nominal GDP increased by 0.7%’ in 2017 Q3, reflecting a ‘0.4% increase in real GDP and a 0.3% increase in prices’. Here, real GDP has actually risen by 0.4%, but nominal GDP has risen by 0.7% as it includes the effects of inflation, which increased by 0.3%. (4 marks)
8 A recession is when there are two consecutive quarters of falling real GDP. GDP is the total value of goods and services produced by the factors of production in an economy in a given time period. Real GDP is GDP adjusted for inflation.
In the extract we are told that output ‘fell by a cumulative 6.5%’ during the recession, suggesting that at some point there were at least two consecutive quarters of negative GDP growth. (4 marks)
9 Consumption had grown by only ‘0.1%’ in the third quarter of 2017. This was due to households reacting to the squeeze in their real incomes. The latter was caused by weak nominal income growth, coupled with an increase in inflation, caused largely by the depreciation of the pound. (4 marks)
10 Business investment growth (‘2% in Q3’) has been stable over the past year but weaker than in previous expansions. This appears to have been largely due to increased uncertainty arising as a result of Brexit. Uncertainty tends to result in reduced investment as businesses become less certain about future profits and are therefore unwilling to commit large current expenditure on new capital spending. (4 marks)
Topic 3
Aggregate supply
Short-run aggregate supply
1
[pic]
The SRAS is upward sloping because as prices rise, firms find it more profitable to increase production and thus will be incentivised to do so. This is because in the short run, wages and other input prices are assumed to be fixed. With fixed-cost inputs and higher-priced outputs, companies can increase profit by increasing production. Thus, as the price level increases in the short run, real wages (and other real costs) fall, giving the SRAS an upward slope. (4 marks)
2 The initial SRAS is SRAS1.
a SRAS3 (2 marks)
b SRAS2 (2 marks)
c SRAS2 (2 marks)
Each effect labelled correctly on the diagram (1 mark):
[pic]
3 AD/AS diagram showing:
• initial AD/AS curves and axes correctly labelled and initial equilibrium labelled
(1 mark)
• contraction (leftwards/inward shift) in SRAS (1 mark)
• new equilibrium correctly labelled showing a fall in the equilibrium level of real national output and an increase in the equilibrium average price level (1 mark)
[pic]
Further explanation: firms use oil for many purposes and it has few substitutes so demand is likely to be price inelastic. Oil price increases will also add to transport costs, pushing up costs of production for all firms. This means the increase in AS may be substantial. In the long run, households are also likely to see an increase in key costs of living (petrol and other goods’ prices). This may lead to a wage–price spiral, pushing up SRAS even further. (2+ marks)
Long-run aggregate supply
4 The short run is the period in which at least one factor of production is assumed to be fixed. Labour is usually assumed to be the variable factor of production. In the long run, all factors of production (land, labour, capital and enterprise) are variable. (4 marks)
The Keynesian and classical LRAS curves
5 Net investment is the increase in total investment spending minus any depreciation (wearing out of existing capital equipment). An increase in net investment will mean that the capital stock becomes greater. This means that there will be more machinery and other capital equipment with which to produce goods and services. Ceteris paribus, this will mean that the long-run aggregate supply curve for the economy shifts rightwards (as in the diagram below showing a classical LRAS). (4 marks)
[pic]
6 C. (1 mark)
7 At low levels of real output the LRAS curve is horizontal. With a high level of unemployment and a lot of ‘spare capacity’ in the economy, output can be increased without a rise in wages as more workers can be employed at the current wage rates and
a rise in the demand for raw materials and capital will not raise their price. Then at higher levels of output the LRAS starts to slope up as firms begin to experience rises in costs as they have to compete for increasingly scarce resources. The price level will rise to compensate for the higher costs. At the full employment level (maximum potential output), there is no spare capacity and the LRAS curve becomes perfectly inelastic. (4 marks)
[pic]
Exam-style questions (multiple choice and short answer)
1 A. (1 mark) Explanation: this would increase the price of imports, hence the costs of production would rise and SRAS would shift to the left. NB Explanation is not required for mark.
2 Labour productivity measures the output per worker per period of time. For example, GDP/total employment. (2 marks)
3 Knowledge, application and analysis (up to 6 marks):
AD/AS diagram showing:
• initial AD/AS curves, axes correctly labelled, vertical LRAS
• initial equilibrium correctly labelled
• increase (rightwards/outwards shift) in AD (new equilibrium correctly labelled showing an increase in the equilibrium average price level but no change in output, which remains at Qfe).
[pic]
Further explanation: a classical LRAS is drawn as vertical at the level of full employment. This is because classical economists believe the market is always self-equilibrating and therefore will always return to equilibrium, ultimately at the point where markets clear. An increase in AD from AD1 to AD2 will simply raise the price level from P1 to P2 (draw on diagram), but output will remain at Qfe.
Evaluation (up to 4 marks): the assumption of classical economists that markets always clear may not be valid in the real world, where contracts may be set for long periods of time or where unemployed resources might exist. This will mean the LRAS will not be vertical but may instead be upward sloping as argued by some Keynesian economists. This means that real output may increase, as well as the price level, at least up to the point of full employment.
4 Knowledge, application and analysis (up to 6 marks): two factors which might include:
• beneficial effects on economic growth, e.g. leading to increase in employment; increased income and corporation taxes
• beneficial effects on lower inflation
• beneficial effects on the balance of payments (increased competitiveness of exports leading to increase in X − M).
Also reward AD/AS diagram showing effects of LRAS shift to the right, increase in potential/trend output growth rate. (2 marks)
Evaluation (up to 4 marks):
• Time lag: training takes time to take full effect. Courses must be designed and implemented, then workers must put their skills into practice. Reforming the A-level specification was done extremely rapidly, but it still took more than 4 years from conception of the idea until the courses were first taught. Rapid policy changes may not be fully thought through and may have unforeseen effects.
• Demand-side approaches may be more immediate in their effects. Monetary policy may be changed monthly by the Monetary Policy Committee, though its effects might have long and variable time lags.
• Quality of training can be very varied. Poor-quality training may result in a deadweight welfare loss.
Topic 4
National income and macroeconomic equilibrium
National income
1 (4 marks)
[pic]
Injections and withdrawals
2 An increase in wages would result in an increase in households’ incomes. This would lead to an increased ability to consume more goods. Given we have assumed no leakages, all of the increased income would be spent on increased consumption.
The increase in consumption will require an increase in the output of goods and services. This will require an increase in the use of factors of production (land, labour and capital). In return, those factors will receive an increase in incomes (wages, rent, interest and profit). (4 marks)
3 C. (1 mark) Imports (a leakage) are not injections into the circular flow of income.
4 Income is a flow of factor incomes such as wages from labour or rent from the ownership of land. Wealth is a stock of financial or real assets such as property or ownership of land. Therefore, in the circular flow of income, income might be the wages that a firm pays to households. If households receive income, they might use it to acquire wealth. That wealth might take the form of property that households choose to purchase, the cash in their bank accounts or shares in firms. (4 marks)
The multiplier
5 Definition of the multiplier (1 mark), e.g. the multiplier formula.
Analysis of the multiplier (2 marks), such as:
• spending by one person becomes other people’s incomes
• the process continues until all extra income is leaked away
• its relevance to government spending, e.g. on hospitals
Explanation of the effects of leakages, e.g. tax, imports. Leakages will reduce the value of the multiplier because the money will be withdrawn from the circular flow of that country (e.g. leave it through purchases of imports or be withdrawn by the government through taxation). Such money will therefore not be available to spend on subsequent spending rounds in the economy. (4 marks)
6 Knowledge, application and analysis (up to 6 marks):
• Definition of multiplier: the extent of the final increase in national income can be shown with the multiplier formula:
K = 1 2
1 − MPC
• Calculation of the size of the multiplier (i.e. K = 4) using the data provided for Moravia.
• Analysis of multiplier:
– spending by one person becomes other people’s incomes
– process continues until all extra income is leaked away in savings, taxes or imports
– application to examples of investment spending
Evaluation (up to 4 marks):
• Discussion of the size of the multiplier (size and types of leakages), e.g. as applied to the example which has a high MPS of 0.25, but no other leakages as it has no taxation or imports. Contrast this with the UK which has low MPS but high MPM and MPT.
• The time-lag effects.
• The effect of the increase in AD on equilibrium income will depend on the shape of the AS curve. A steep AS (e.g. classical LRAS) means that the increase in AD will primarily lead to an increase in inflation and not real national income.
• Other things might not be equal, e.g. consumer confidence in Moravia might fall, leading to a rise in the MPS and a fall in the MPC.
Exam-style questions (multiple choice and short answer)
1 D: accelerator. (1 mark) (Note: the multiplier shows the effect of a change in one of the components of aggregate demand and the consequent final rise in national income, not the effect of a change in national income and investment, which is the accelerator.)
2 10 (2 marks):
K = 1 2
1 − MPC
Therefore: K = 1/(1 − 0.9) = 10
Exam-style questions (data response)
3 The phrase ‘real post-tax wages fell by 0.5%’ means that wage income (the income earned by labour) fell by 0.5% when adjusted for the effects of inflation. This means that inflation will have been 0.5% higher than any increase in wages, so the purchasing power of wage income fell. (4 marks)
4 Knowledge (2 marks): factors might include:
• real post-tax income growth falling
• consumer confidence/expectations of financial situation
• low savings ratio in the past suggesting stocks of wealth may be low so no positive wealth effect
One factor must be developed/explained.
Application (2 marks):
• real post-tax income falling by ‘0.5%’ in first quarter of 2008
• surveys suggest that households expect their financial situation to ‘weaken sharply over the next 12 months’; another indicator of income expectations is household spending on durable goods, such as cars and televisions
5 Government spending is an injection into the circular flow of income. (2 marks)
Possible mechanisms include: (up to 2 marks each)
• Increased government spending boosts incomes through higher benefits payments. These act as an injection to income, and this in turn boosts consumption from that extra income.
• This then has a multiplier effect through businesses and investment, and again through incomes paid to employees.
• Direct boost to consumption that the government brings as it purchases a range of goods and services. This will induce firms to produce more of these goods and services. This will lead to increased employment of workers, whose incomes will rise. This will in turn boost their consumption.
• Reference to multiplier effect as spending moves around the circular flow.
Reward the appropriate use of a circular flow of income diagram, showing an increase in G.
6 Knowledge, application and analysis (up to 6 marks):
• Circular flow of income diagram.
[pic]
• Definition of investment.
• Description of effects of fall in investment and annotation on diagram. (2 marks) Reduction in injections, for example (up to 2 marks each):
– reduced purchases of capital equipment
– reduced output by firms that buy and install the new machinery
– reduced incomes by firms producing the capital equipment
– leading to reduced employment
– leading to reduced income by households
– leading to reduced spending
Evaluation (up to 4 marks):
• The effects depend on the level of leakages: S, T or M.
• There are short-/long-run effects: a fall in investment may reduce the quality of the capital stock and decrease the productivity of labour and capital.
• The effects depend on how much capacity there is in the economy.
• Multiplier effects might depend on the confidence of households.
7 Knowledge, application and analysis (up to 9 marks):
• Definition of imports.
• Explanation that imports are a leakage from the circular flow of income.
• Explanation that fall in imports leads to increase in (X − M) so a rise in AD.
• Diagram showing AD shift to the right (1 mark) and changes in the equilibrium points.
(1 mark)
[pic]
• Growth:
– increase in AD (1 mark)
– via increase in (X − M) caused by fall in M (1 mark)
– multiplier effects (1 mark)
• Effects on national income (Y) and price level (P) must be clearly explained and marked on diagram.
• Further analytical marks for consequences for growth, e.g. through damaging effects of inflation. (2 marks)
Evaluation (up to 6 marks):
• Discussion of the size of the multiplier (size and types of leakages, e.g. applied to UK which has low MPS but high MPM).
• The time-lag effects.
• The effects depend on the shape of the AS curve (vertical LRAS vs flatter LRAS).
• Other things might not be equal, for example the pound might change in value.
Topic 5
Economic growth
1 Short-term real growth is measured by the percentage change in national output. National output is measured by gross domestic product. Real GDP growth is nominal GDP growth adjusted for inflation.
Long-term growth is shown by an increase in trend or potential GDP and this is illustrated by an outward shift in a country’s long-run aggregate supply curve (LRAS). (4 marks)
The business cycle and output gaps
2 A negative output gap occurs when actual output (measured by actual real GDP) is less than potential output. (2 marks)
3 A positive output gap occurs when actual output is greater than potential output. (2 marks) There will usually be inflationary pressures.
4 Two characteristics include:
• A decline in unemployment. (1 mark) An economic boom occurs when real GDP shows a sustained increase at or above the trend real GDP growth rate. This is likely to result in an increase in employment as firms hire more workers to produce the additional output. Hence unemployment will fall. (1+ marks)
• An increase in demand–pull inflation. (1 mark) Since an economic boom reflects
a sustained increase in AD at above trend real GDP growth, it is likely to result in bottlenecks developing and shortages in several markets. The excess of AD over AS
is likely to result in prices being driven up on a sustained basis. (1+ marks)
5 Real GDP is the value of goods and services produced by the factors of production of
an economy within a given time period (adjusted for the effects of inflation). (1 mark)
In 2009 Q1, GDP fell sharply by around 1.6%. (1 mark) In 2009 Q2, real GDP continued to fall (1 mark) but at a much slower rate of about 0.2%. (1 mark)
6 The output gap is the difference between actual GDP and potential GDP. (1 mark)
The figure suggests that in 2010 there was a large negative output gap (1 mark) of around 3% of GDP. (1 mark) The output gap narrowed between 2010 and 2017 (1 mark) and by the end of 2017 was around zero. (1 mark)
7 The output gap is the difference between actual and potential GDP. The output gap closed over the period and by the end of 2017 was around zero. Possible reasons for this might include:
• An increase in actual GDP growth over the period due to a recovery in any of the components of GDP (C, I, G, (X − M)). Give a plausible reason for the behaviour of any of those components (e.g. increased consumer confidence and rising employment saw a recovery in consumption).
• A fall in potential GDP growth as estimates for the productive potential of the economy were revised down.
We cannot tell which from the data as we are only given the figures for the size of the output gap. (4 marks)
8 AD/AS diagram (2 marks):
[pic]
Explanation (2 marks):
• An increase in actual output growth is indicated by the shifts of AD from AD1 to AD2 or to AD3, etc. Given the initial LRAS curve (LRAS1), the respective levels of output are Y1, Y2, etc.
• An increase in potential output growth is indicated by the rightward shift in LRAS from LRAS1 to LRAS2.
PPF diagram (2 marks):
[pic]
Explanation (2 marks): the PPF shows the maximum combination of two goods that an economy can produce when all resources are fully and efficiently employed. At output combination X, the economy is operating within its PPF. This indicates that there are unemployed resources, or that actual output is less than potential. A movement of the economy from point X to point Y shows an increase in the output of basic foods and exported crops, but without any shift in the PPF. This demonstrates actual economic growth with no increase in potential output. Potential output increases when the PPF
shifts outwards. This is shown by a movement from PPC1 to PPC2.
9 Example answer:
The financial system consists of a country’s banks, equity markets (markets for stocks and shares) and debt markets (markets in bonds). Economic growth is a (sustained) increase in real GDP. A more developed financial system should enhance economic growth in a number of respects. It should enable businesses to have better access to loans if they need them. This should facilitate additional investment, thus increasing AD (since AD =
C + I + G + (X − M)). This will increase actual real GDP growth as AD shifts to the right.
In addition, investment will improve the productive capacity of the economy and therefore might boost LRAS. This will boost potential GDP growth as well as actual GDP.
Furthermore, the financial system allows firms or individuals with spare cash to have a secure place to save their cash. This may encourage additional saving to fund investment. This should help to channel savings into investment, thereby supporting an increase in real GDP (GDP = C + I + G + (X − M)).
However, problems in financial systems will undermine the effectiveness of this process.
A weak financial system will disrupt this process of channelling savings to investment. Savers may be reluctant to place money with banks which they perceive as in danger of failing and may hoard it at home instead. In addition, weak banks may be unable to make loans to businesses, thereby restricting the amount of any new investment. Potential and actual economic growth would thus be undermined.
Marks will be awarded for other possible benefits (provided they are linked clearly to economic growth) such as: developed financial systems produce information about possible investments and allocate capital; they facilitate the trading, diversification and management of risk; they ease the exchange of goods and services.
The impact of economic growth
10 Households: economic growth should result in rising living standards for households as it should lead to a fall in unemployment, meaning that household incomes will rise. This in turn means that households will be able to consume more goods and services and potentially also enjoy more rewarding leisure time, using their higher incomes for engaging in activities. (4 marks)
Firms: economic growth should lead to an increase in the demand for firms’ products. This should create an increase in revenue, allowing for an increase in profits. If the firms expect the growth to be sustained, this might lead to an increase in investment and a further increase in these firms’ long-term profitability. (4 marks)
Government: economic growth will benefit the government as it will lead to an increase in government revenue. For example, as the economy grows, the firms’ sales and profits will grow. Other things being equal, this will lead to an increase in government revenue through receipt of VAT and corporation tax. In addition, firms might increase the number of employees they hire. This will cause an increase in income tax and national insurance receipts. (4 marks)
11 Possible costs include:
• Economic growth will possibly be accompanied by an increase in negative externalities such as pollution and congestion. We see this in parts of the UK which are already highly congested. Economic growth will result in more firms producing increased output with a consequential increase in pollution and noise (and other externalities) and more goods being transported. This will add negative externalities such as congestion and atmospheric pollution. (4 marks)
• If economic growth exceeds potential output growth for a prolonged period, it is likely to lead to an increase in inflation. The most likely type of inflation resulting from strong growth in AD is demand–pull inflation. This occurs when the economy is close to full capacity and AD shows a strong increase, pulling up prices in particular in those parts of the economy where there are capacity constraints. Inflation is generally thought to affect the price of goods and services in particular, but in the UK, house price inflation has been an acute problem, especially in areas where there is a shortage of residential property such as London and the South East. (4 marks)
Exam-style questions (multiple choice)
1 B. (1 mark)
Exam-style questions (data response)
2 Definition of economic growth: increase in real GDP. (1 mark)
Possible problems might include: (3+ marks)
• Low interest rates and a growing economy have already led to substantial house price inflation in the UK.
• It could lead to workers seeking higher wage demands as their own costs of living are also increasing. This could be a significant problem.
• Rapid economic growth might also cause a further deterioration in the UK’s current account deficit. Not only might rapid economic growth lead to an increase in demand–pull inflation, which will undermine the UK’s competitiveness and increase the price of exports, it might also lead to increased demand for imports from consumers benefiting from higher incomes.
3 Explanation of GDP growth: increase in real output produced by factors of production of an economy in any given time period. (1 mark)
Reasons might include (up to 2 marks each):
• unreliable data/revisions to past data which are collected from many sources
• recovery in GDP growth unpredictable or other unexpected development
• miscalculation
4 Knowledge, application and analysis (up to 9 marks):
• Definition of economic growth; distinction between actual economic growth and potential economic growth.
• Possible benefits: economic growth can increase employment in an economy as there is greater demand for goods and services, which leads to increased consumption of goods due to higher disposable incomes. An increase in C leads to an increase in AD. If the economy is growing faster than the population, then per capita incomes are rising, resulting in a better quality of life as people can afford more goods and services than they could before.
• There will be increased government revenues via its tax receipts as more people
are making more money, leading to increased spending on health and education.
An increase in productivity leads to an increase in AS.
• Increased investment into the economy results in greater confidence due to higher profits from firms. There will be more capital goods in the economy, which will lead to increased productivity and an increase in AS. Also the multiplier effect will be in evidence — multiple rounds of repeat spending associated with increased investment, leading to increased employment, leading to increased consumption.
Evaluation (up to 6 marks):
• Phillips curve: the higher the growth in employment in the economy, the greater the upward pressure there is on the price level (demand–pull inflation). Therefore, there will be higher inflation. The increase in the cost of living means that the standard of living does not increase by that much.
• GDP measurement issue: standard of living is not just associated with money; it could include access to clean water or green spaces. Economic growth can lead to degradation of the environment as more polluting resources are used. A poorer environment leads to a poorer quality of life.
Topic 6
Macroeconomic objectives and policies
The main macroeconomic objectives
1 Example answer:
Inflation is an increase in the average price level, as measured by the percentage increase of the CPI. Inflation can cause uncertainty for businesses and a fall in investment. This is partly because inflation might reduce consumer confidence and spending and so reduce aggregate demand. Export demand might also suffer as inflation increases costs and reduces competitiveness, which can lead to falling demand for exported goods and rising demand for imports. Falling confidence is likely to force firms to postpone capital investment.
Inflation can also create ‘shoe leather’ and ‘menu’ costs. Shoe leather costs are where firms and businesses need to make an additional effort to seek out the best deals. These costs are also called search costs, reflecting the increased time spent attempting to find the lowest available prices. Menu costs are costs associated with having to regularly
re-price products to bring them in line with general inflation.
In evaluation of this, provided the inflation is anticipated by firms they might be able to
plan ahead for its effects by hedging their costs. They might also not suffer any loss of competitiveness in the short run if the exchange rate falls to compensate for the increase in domestic prices.
In addition, the internet has increased the availability of information and considerably reduced the problem of search costs. Search engines and comparison sites have also made it much easier to access the cheapest product even at times of rapidly rising prices. (15 marks)
2 Knowledge, application and analysis (up to 9 marks):
• Definition of inflation (sustained increase in the general price level measured by the annual percentage change in an index such as the CPI or RPI).
• Understanding of distribution of income: how the GDP of a country is distributed among different groups (the highest percentile earners and the lowest percentiles, or other identified groups) of a country.
• Identification of groups of beneficiaries from an increase in inflation, e.g. borrowers, mortgage holders (as inflation reduces the real value of the debt).
• Identification of losers: those on fixed incomes; savers (inflation erodes the real value of savings), especially if nominal interest rates increase by less than inflation; pensioners; benefit recipients (if benefits are not indexed to inflation).
• Further analysis, e.g. savers are likely to be the higher-income groups; monthly mortgage interest payments may rise if interest rates also rise, possibly affecting lower-income groups more as a proportion of their income; link between inflation and house prices.
Evaluation (up to 6 marks):
• Lower-income groups are often least able to protect themselves against increasing inflation by hedging or buying assets that can protect them. They are also worst hit as they are often already close to subsistence.
• Higher-income groups might arguably have larger mortgage interest payments as a proportion of their income.
• Inflation changes may take time to have an effect, especially if workers have just received wage increases or if interest rate changes do not happen right away. Effects on income might take longer than wealth effects or other wealth issues.
3 Summary of causes of cost–push inflation: an increase in AD particularly when the economy is close to full employment might be caused by loose fiscal policy, higher house prices, greater confidence, increased credit availability, depreciation in the exchange rate. (4 marks)
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Summary of causes of demand–pull inflation: a substantial increase in costs of production results in SRAS shifting to the left. Causes might be rising oil prices, higher indirect taxes, rising wages, depreciation in the exchange rate. (4 marks)
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4 a When exports exceed imports the country has a current account surplus.
(1 mark)
b When imports exceed exports the country has a current account deficit.
(1 mark)
5 Example answer:
The balance of payments is a record of the extent of trade between one country and the rest of the world. The current account is the largest part of the balance of payments, the main elements of which are the balances of exports and imports in goods and services.
The exchange rate is the value of one currency expressed in terms of another — for example, £1 = $1.45. A decline in the value of the currency (depreciation) will, ceteris paribus, lead to import prices rising but export prices falling. This should boost demand for UK exports to overseas countries and hence the quantity of exports should rise. On the other hand, rising import prices will reduce demand for imports and the volume of imports should fall. As a result, the trade deficit should narrow.
However, if the price elasticity of demand for imports were relatively inelastic, then a rise in the price of imports would lead to a less than proportionate fall in demand, in which case total expenditure on imports would rise. This would, ceteris paribus, lead to a deterioration in the trade deficit. Equally, if the demand for exports were price inelastic then a fall in the price of exports would result in very little increase in the demand for UK exports. Total sterling export earnings will nevertheless increase in this case, since it is their price in foreign currency terms that has fallen.
We can also relax the ceteris paribus assumption. When global growth is strong there will be a high level of demand — some of which will be demand for goods from abroad. At the same time, exporters may recognise that there is a buoyant demand in the UK and switch sales from export markets to those in the domestic market. The net effect is for exports to fall and imports to rise, thus contributing to the widening of the deficit. (10 marks)
6 B. (1 mark). Explanation: this will cause net trade (X − M) to increase and AD to shift to the right. NB Explanation is not required for mark.
Demand-side policies
7 A government has a budget surplus when, in a given year, total government revenue (from taxes and charges) exceeds total expenditure. (2 marks)
8 A budget deficit is where government spending exceeds taxes. The deficit has to be financed by borrowing. The stock of accumulated borrowing is called the government, or national, debt. (2 marks)
9 The government was projected to run a budget deficit. A budget deficit occurs when, in a given year, total government expenditure exceeds total revenue (from taxes and other charges). Total spending was projected to be £842 billion; total revenue was projected to be £809 billion, leaving a deficit of £33 billion. (3 marks)
10 A direct tax is one paid directly to the government by the person on whom it is imposed. Examples include income taxes (£193 billion in 2019–20).
An indirect tax (such as value added tax (VAT)) is a tax collected by an intermediary (such as a retail store) from the person who bears the ultimate economic burden of the tax (such as the customer). VAT was £156 billion in 2019–20. (2 marks)
11 Quantitative easing is when the central bank purchases government bonds in order to drive down yields and increase the amount of cash circulating in the economy. (1 mark)
12 a Consumption: an increase in Bank of England base rates will result in an increase in the rates set by the commercial banks. (This is because the interest rate charged to the commercial banks by the Bank of England will now be higher.) As a result, the interest rate customers earn on their savings will also increase. This will tend to increase savings and reduce consumption as it means that the return from saving and the opportunity cost of consumption have increased. Equally, the cost of borrowing will have risen so consumers will tend to borrow less money. Those consumers with outstanding loans will have to pay higher interest rates, so their discretionary income will be lower.
Another influence on consumer spending arises from the effects of interest rate change on consumer confidence and expectations of future employment and earnings prospects. (4 marks)
b Investment: an increase in Bank of England base rates will be passed on to customers by commercial banks, which find that the cost of funds increases when they need to borrow from the Bank of England.
An increase in interest rates will have a direct effect on firms that rely on bank loans.
A rise in interest rates increases borrowing costs and therefore reduces the amount that firms might wish to borrow. The rise in interest rates also reduces the profits of such firms and increases the return that firms will require from new investment projects, making it less likely that they will start them. (4 marks)
c Net trade: an increase in UK base rates will, ceteris paribus, lead to an increase in hot money inflows into sterling bank accounts. This is because banks will tend to increase the interest rates they offer on UK accounts, thereby attracting additional money into sterling accounts. This will increase the demand for sterling, thereby increasing the exchange rate.
The increase in the exchange rate will make the price of exports more expensive in foreign markets, while reducing the price of imported goods in the UK. This will tend to result in a fall in export volumes and an increase in import volumes. The effects on net trade (X − M) will depend on the price elasticity of demand, but it is likely to result in a fall in net trade in the long run. (4 marks)
13 QE is where the Bank of England purchases UK government securities from banks and other members of the private sector. By the middle of 2018, the Bank of England had purchased £435 billion of bonds as part of its QE programme. This would have two effects on consumption. First it would increase the amount of cash in circulation (as anyone who sold bonds to the Bank of England would receive cash from the Bank of England in exchange for the bonds they sell to it). This would allow households to consume more goods and services. Second, the increased demand for gilts causes a rise in their price and a consequent fall in their yield. This lowers overall interest rates, which in turn would encourage a fall in savings and an increase in consumption.
However, the extent of any increase in consumption depends upon the overall level of consumer confidence. QE has generally been introduced when consumer confidence has been fragile and if consumers are uncertain about the economic future, they may prefer to hold higher savings for precautionary reasons.
Extension material: Ricardian equivalence
14 Knowledge, application and analysis (up to 6 marks):
• Definition of fiscal policy: policies conducted by government concerning government spending and taxation.
• Use of fiscal policy: identification and explanation of cut in taxes and increase in government spending including transmission mechanisms: increase in government spending; decrease in taxation.
Add an AD/AS diagram to illustrate the above, showing changes in price and output. Marks will also be given for an explanation of the multiplier process.
Evaluation (up to 4 marks):
• Possibility of crowding out: additional government spending financed by borrowing bids up interest rates as the government seeks to attract more funds from lenders to finance its increased borrowing.
• Discussion of Ricardian equivalence: if the government embarks on a debt-financed expansionary fiscal policy, then rational consumers or businesses will react by cutting their current spending. This is because they believe that the government will need to increase taxes in the future to pay the additional interest and debt payments.
• Possibility that the economy might already be operating at full capacity — hence the effect will be on the price level and not on real output.
• Relax ceteris paribus assumption, e.g. the monetary position; world prices; changes in LRAS.
• The possibility of government failure: spending on wasteful projects that may not boost AD or spending on benefits that might reduce incentives to work.
15 Knowledge, application and analysis (up to 9 marks):
• Definition of fiscal policy: government spending and taxation.
• Definition of unemployment.
• Expansionary fiscal policy: identification and explanation of fall in taxes and increase in government spending including transmission mechanisms. Provide an AD/AS diagram to illustrate this point, showing changes in price and output, and the connection to reduced unemployment fully explained (firms employ additional workers to produce the extra output).
• An explanation of the multiplier process.
Evaluation (up to 6 marks):
• Discussion of whether government spending (G) or taxation (T) is more effective.
• What is happening on the supply side/how might the policies affect incentives to work?
• Time lags.
• The relative inflexibility of fiscal policy.
• Crowding out issues, especially with an increase in G.
Supply-side policies
16 a Government expenditure on education and training
Knowledge, application and analysis (up to 6 marks):
Increased government spending on education and training will equip the workforce
with better skills and capabilities. This will increase their productivity, allowing them to produce more goods in a given period of time or improve the quality of the goods they produce. Equally, it might equip workers to work in higher value-added areas where they will produce more highly valued products.
Government spending on education improves human capital, but this also has the knock-on effect of improving physical capital as opportunities for innovation arise with increased educational presence, such as in universities. This spending also reduces structural unemployment, as it provides improved training, such as for those made recently unemployed in a previous industry, and the occupational mobility of workers
is improved.
Foreign investment will also increase in a country with significant spending on education, as expectations of future success will be much higher for the future population. Improved education also increases incentives to work, as future earnings prospects are raised with better education and training. This spending all causes the LRAS curve to shift outwards, resulting in an increased level of output (Y1 to Y2) and ultimately economic growth.
Evaluation (up to 4 marks):
Education and training is a long-term policy which takes a considerable period of time to come into effect. For example, changing the school education system may require legislative changes.
The significance of this shift in the LRAS curve, however, is determined by a number of factors. First, the economic state of the country in question is an important factor — an increased level of spending on education in a poorer country will make a relatively large difference in future economic prosperity compared with the same real amount for a more developed country. This concept is similar to the law of diminishing returns, as the amount of money needed for another significant development rises as the amount of money already spent does. For example, a new secondary school in a European country will have less of an impact on the country as a whole than one in a developing country where the standard of education is low.
b Cuts in income tax rates
Knowledge, application and analysis (up to 6 marks):
A fall in income tax will affect the supply of labour in the market. This may incentivise people to work for longer hours, due to the substitution effect. For a higher real income after tax, people may be willing to work harder as well, as the opportunity cost of not working (taking leisure) is far greater. It could also be argued that a decrease in the tax rate will result in an increased incentive to work legally, as opposed to working in the informal sector. This may result in higher tax revenues for the government, which in turn could be spent on improving economic growth via other means. This can be represented by a ‘Laffer curve’, which shows the optimum level of taxation at which most revenue is gained.
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In both of these situations, the potential quantity of goods and services in the economy is increased, shifting the LRAS curve outwards (LRAS1 to LRAS2). This usually leads to an increased real level of output (Y1 to Y2), measured by increased real GDP, and therefore economic growth ceteris paribus.
Evaluation (up to 4 marks):
A decreased level of income tax could reduce incentives to work; some people would rather continue at the same real income and work for fewer hours than the same number of hours for a higher real income. This could cause a decrease in the supply
of labour.
c Privatisation of publicly owned industries
Knowledge, application and analysis (up to 6 marks):
Privatisation is the sale of state-owned assets to the private sector. This is often achieved through listing the new private company on the stock market. Private companies are often argued to be more efficient than state-owned companies. This is because profit-maximising firms have a profit incentive to cut costs and be more efficient, thereby boosting returns to shareholders. Managers of state-owned firms do not usually share in any profits and may become complacent. As a result, privatisation should result in a decline in costs and possibly an increase in productivity per worker. This should help increase LRAS and improve an economy’s competitiveness. This is particularly important for privatisations of key services such as telecommunications or electricity, which are important costs for many businesses in an economy. It is also argued that privatisation might result in an increase in competition and that this can be an additional drive towards increased efficiency.
Evaluation (up to 4 marks):
Sometimes privately owned companies may be less willing to invest in productivity-enhancing methods than state-owned companies because their shareholders
are focused on short-term gains in profits rather than investing for the long term.
In addition, privatisations are not always followed by an increase in competition and
it is the deregulation of the market rather than the privatisation that usually provides this increased competition. A privately owned monopoly may be less efficient than a state-owned monopoly. The scope for further privatisation in the UK is limited as most state-owned firms have been sold off.
Conflicts between macroeconomic objectives
17 Knowledge:
• Definition of employment.
• Definition of unemployment plus one measure of unemployment (labour force survey
or claimant count).
Analysis: possible reasons might include (4 marks):
• increase in the participation rate when employment increases
• increase in the size of working population (e.g. women entering the labour force)
• increase in immigration in response to a growing economy
18 Knowledge, application and analysis (up to 9 marks):
• Explanation of expansionary monetary policy (cut in interest rates; increase in QE).
• Distribution of income improves (if justified): identification of winners and losers affected by cut in interest rates, e.g. borrowers, mortgage holders, pensioners.
• Further analysis, e.g. savers are likely to be the higher-income groups and their returns will fall, monthly mortgage interest payments will reduce, affecting lower-income groups more as a proportion of their income, link between interest rates and house prices.
Evaluation (up to 6 marks):
• higher-income groups are not necessarily higher savers
• higher-income groups might have larger mortgage interest payments as a proportion of their income
• the time implications for impact of interest rate changes
• the effects on income might take longer than wealth effects or other wealth issues
• other time issues
Conflicts in the use of macroeconomic policy instruments
19 Supply-side policies are policies designed to improve the quality or quantity of factors of production and thus boost sustainable economic growth by shifting LRAS to the right. Successful supply-side policies should help achieve several economic objectives at the same time. For example, a successful reform of higher education creating high-quality graduates will cut unemployment, increase tax revenues and possibly help promote additional exports by increasing the competitiveness of UK exports. (4 marks)
20 Knowledge, application and analysis (up to 9 marks):
• Definition of fiscal policy: government spending and taxation.
• Use of fiscal policy: identification and explanation of expansionary fiscal policy through tax cuts.
• Identification and explanation of transmission mechanisms, for example a decrease
in taxation (T), leading to an increase in disposable income, leading to an increase in consumption (C), leading to increased AD. This causes increased Y, which should promote an increase in employment as firms hire more workers to increase production. Use an AD/AS diagram to illustrate this, showing changes in price and output.
• Provide a written explanation of effects on the budget deficit. Definition of budget deficit: difference between G and T. Cuts in T should lead to a fall in government tax revenue and hence an increase in the deficit or a fall in the surplus.
Evaluation (up to 6 marks):
• Increase in employment may result in increased overall tax revenues despite the fall in tax rates.
• Increase in output may result in increase in income from other taxes such as VAT or corporation tax.
• Cuts in income tax may result in increased incentives to work, so an increase in overall tax revenue.
• Time lags.
Exam-style questions (data response)
1 The output gap is the difference between actual and potential output. (AO1, 1 mark) Output is measured by real GDP, which measures the total output produced by the factors of production in an economy in a year. (AO1, 2 marks) The extract suggests that during 1980 GDP in the UK fell by ‘nearly 2% in each of the second and third quarters of the year, to nearly 4% below the quarterly average of 1979’. (AO2, 2 marks) Given that UK potential output growth was estimated at around 2% a year, this suggests that the gap between potential output and actual output continued to rise. (AO3, 1 mark) This analysis is confirmed by the continued rise in UK unemployment, implying a very large number of unemployed resources, suggesting the UK was operating well within its PPF.
2 Unemployment in the UK had risen to a record of ‘nearly 8.5% of the workforce’. This coincided with a fall in GDP, while potential output growth was estimated to have been rising by 2% a year. This suggests that one possible cause of unemployment might have been demand-deficient, or cyclical, unemployment. Demand-deficient unemployment can be shown by an economy where the level of AD is below that required to maintain the economy at the point of full-employment equilibrium. (5 marks. Reward use of diagram to illustrate this.)
Another point might be, the extract notes ‘the power of trade unions in keeping real wages high’. This could also reflect classical or real wage unemployment if the unemployed young workers were unwilling to work for lower real wages or if UK nominal wages were being kept artificially high by minimum wage legislation or by powerful restrictive practices maintained by trade unions or labour laws. (5 marks. Reward use of a labour market diagram to illustrate this.)
Also reward other explanations which might include: structural unemployment (if properly developed); regional unemployment.
3 Knowledge, application and analysis (up to 6 marks):
Measures that might have been employed include:
• Investment in worker training: spending on training schemes to re-skill the unemployed through investment in vocational education or guaranteed work experience for unemployed ‘outsiders’ in the labour market.
• Expansionary fiscal policy: cutting personal income taxes to increase household consumption or corporation tax to increase investment, thereby shifting AD to the right, thereby increasing equilibrium income, thereby reducing unemployment.
• Regional policy incentives: give grants and subsidies to firms to locate in areas of high unemployment.
Evaluation (up to 4 marks):
• The measures are likely to require an increase in government spending, which would have been difficult for the UK given the size of current deficit and debt — ‘the budget deficit having soared due to the fall in tax receipts and increase in benefits payments, there was little scope to use reflationary fiscal policy’.
• The possibility of government failure.
• The problems of specific initiatives, e.g. regional policy does not solve the problem of occupational immobility. It often needs extra retraining schemes to give workers the relevant skills to allow them to take up new jobs.
4 4 marks for each set of costs identified and explained. Costs might include:
• Opportunity cost. Unemployment represents an opportunity cost because there is
a loss of output that workers could have produced had they been employed. The government may also need to spend more on unemployment benefit. The money going on unemployment benefit could be spent on hospitals or schools. (Reward use of a PPF diagram showing an economy operating within the PPF.)
• Waste of resources. Resources not employed are left idle and this is a waste to an economy — education and training costs are wasted when individuals who have received these benefits do not work.
• Workers’ skills might deteriorate. This might cause a longer-term problem for the economy of hysteresis. This is where the deterioration of workers’ skills leads to those workers becoming less employable by firms. As a result, the NRU might rise. When the economy recovers, unemployment might stay permanently higher.
5 Knowledge, application and analysis (up to 9 marks):
• Definition of productivity and long-term economic growth.
• Definition of productivity: more output from the same inputs; output per person per hour. Credit for reference to increased efficiency, but not for increased production per se.
• Effects of increase might include:
– that this is likely to lead to economic growth or improved living standards (or equivalent answer)
– costs of production fall/efficiency increases, so more profit
– removes inflationary pressure
– encourages inward investment
– effect on the current account
– shift out in the PPF/increase in productive potential
– effect on employment levels
Allow answers based on competitiveness.
Evaluation (up to 6 marks). The extent of the benefits might depend on:
• productivity growth relative to that of competitor countries
• need for increase in AD as well — supported by other measures
6 The bank rate is the interest rate set by the Bank of England when it lends to commercial banks. The bank rate was cut to 0.5%. (2 marks)
Quantitative easing is purchases of government bonds by the central bank with the purpose of reducing long-term interest rates and expanding the money supply. A total of £375 billion of quantitative easing has been injected since 2009. (2 marks)
7 Outline (5 marks):
• Definition of and explanation of inflation target. (2 marks)
• Application from extract, i.e. ‘in the UK, the government has set the Bank of England an inflation target of 2%’ (+/−1%) over the medium term for CPI inflation. (2 marks)
• Use of interest rates to achieve this, e.g.: (1 mark)
– If inflation goes too high then interest rates must rise. (1 mark)
– If inflation goes too low then interest rates must fall. (1 mark)
8 Knowledge, application and analysis (up to 9 marks):
• Concept of inflation target, i.e. 2% (+/−1%) and the role of monetary policy in achieving it.
• Benefits of low inflation in terms of encouraging economic growth:
– It will increase business confidence and hence encourage investment because businesses will be more confident about being able to make a profit in the future and not having it eroded by inflation.
– It will increase consumer confidence since households will have greater confidence in their long-term planning and that their savings won’t be eroded by inflation and hence will encourage more consumption.
– It will promote international competitiveness (because prices won’t increase by more than those of competitor nations).
• Reasons why low inflation might cause a trade-off in the short run: low inflation might be due to a shift in AD to the left and hence a short-run fall in economic growth.
• Analysis of other factors necessary for economic growth: e.g. increase in AS through supply-side policies; increase in productivity.
Evaluation (up to 6 marks). Effects might depend on:
• productivity growth relative to that of competitor countries
• the need for increase in AD as well
9 Explanation (5 marks):
• Definition of quantitative easing: central bank purchases of government bonds in order to drive down bond yields/interest rates and increase the amount of cash circulating in the economy.
• Explanation of current problems with ‘conventional’ monetary policy: e.g. interest rates at historic low and little scope for further falls; banking system not working effectively following the financial crisis, so not supplying firms with enough new loans.
• Explanation of how QE might boost economic growth and keep inflation within the Bank of England target range in the medium term: wealth effect of increased bond prices; increased spending of free cash balances; increased bank lending.
10 Knowledge, application and analysis (up to 6 marks):
Economic data the Bank might consider include:
• state of the banking system or other credit problems
• unemployment/employment levels
• productivity growth
• changes in the exchange rate and the effects on import prices and demand for exports
• exogenous shocks such as the eurozone crisis
• government fiscal policy (government spending and taxation)
• money supply growth
• commodity prices
• house price changes
1 mark for identification/explanation of each point.
1 mark for analysis/explanation of why the MPC considers the data and 1 mark for linking the point to price level/inflation.
1 mark for applying the extract to each point.
Evaluation (up to 4 marks):
• Each type of data would need to be considered in the context of other developments in the economy.
• The significance of each type of data needs to be assessed.
Example answer:
Monetary policy is the manipulation of interest rates and QE to manipulate AD (usually to achieve the government’s inflation objective). One type of economic data the Bank may consider is the level of the exchange rate, which the extract suggests has fallen sharply since the global financial crisis. This will cause upward pressure on import prices and hence inflation. Another type of data is the level of productivity growth. This has also ‘weakened substantially since 2010’. Weak productivity growth will result in a slower growth in LRAS and hence upward pressure on inflation in the long term.
Nevertheless, the Bank of England needs to judge carefully the significance of these types of data. The effect of the fall in the exchange rate is likely to be temporary and if AD remains weak in the short to medium term, it would be unwise to raise interest rates and risk undermining very weak economic growth.
This answer, while brief, receives 6 marks for two identified points, application and brief analysis. There is also one good piece of evaluation which receives 2 marks.
11 Knowledge, application and analysis (up to 16 marks):
• Express a clear understanding of monetary policy.
• Make reference to low and stable prices and to the inflation target in the UK.
• Explain use of interest rates and transmission mechanism with links to the components of AD and hence to price level/inflation.
• A written or diagrammatic application to AD/AS.
• An analysis of one other policy that may be suitable for achieving price stability.
Evaluation (up to 9 marks):
• Problems of operating monetary policy when interest rates are at historic lows.
• Challenges of QE and possibility of long-run effect on inflation.
• Lagged effect of changing interest rates.
• Difficulty in achieving accurate information.
• MPC’s continued record of overshooting its target.
• Banks may not adjust interest rates or respond to QE by increasing lending.
12 Knowledge, application and analysis (up to 16 marks).
Evaluation (up to 9 marks).
Analysis 1:
• QE is where the Bank of England purchases government bonds in order to drive down yields and increase the amount of cash circulating in the economy.
• Government bonds are the benchmark for other long-term rates, so as yields fall, other interest rates fall on sterling-related assets.
• Lower interest rates mean reduced costs of borrowing.
• Therefore, we can expect a rise in consumption as loans to purchase durable goods are cheaper.
• As consumption is a component of AD, an increase in GDP is a likely economic effect.
Evaluation 1:
• Brexit and the lack of business and consumer confidence which come with such a radical departure from decades of precedent may reduce the extent to which consumption and investment actually increase.
• The UK’s total QE programme before August 2016 was £375 billion, so a 16% increase is not hugely significant in this light.
Analysis 2:
• If there are lower interest rates in the UK, there will be greater hot money outflows as investors will look for a greater return elsewhere (this is assuming a ceteris paribus effect with relative interest rates being lower).
• This will lead to a lower demand for sterling on the foreign exchange markets.
• As demand decreases, further depreciation occurs, making export prices more price competitive.
• As this occurs, there will be an increase in the value of exports and a reduction in the value of imports — this leads to an increase in (X − M).
• Since (X − M) is a component of AD, as this increases there is a shift to the right in the AD curve, which leads to an increase in real output from Y1 to Y2, and an increase in the price level from P1 to P2.
• The uncertainty of Brexit could lead to a sharp depreciation in sterling, and QE could further this effect, so there is the potential for an improvement in the trade deficit on the current account of the balance of payments.
Evaluation 2:
• This depreciation may be further increased, depending on the final outcome of the Brexit negotiations.
• Moreover, an improvement in the UK’s the balance of trade would only be observed in the long run under the Marshall–Lerner condition due to the PED of imports and exports being fairly inelastic in the short term with contracts, etc. Therefore, more of a J-curve effect is likely to be observed.
Conclusion: this needs to be a substantiated judgement drawing on the context. For example, the additional QE is small in comparison to the already outstanding stock of QE, but nevertheless, the QE programme is likely to provide a further stimulus to the UK economy, which could be critical at a time of weak consumer and business confidence. Evaluating the extent of the effect is difficult since we don’t know how the economy would have performed in its absence.
13 Example answer:
Fiscal policy is the manipulation of government spending (G) and taxation (T) in order to finance the government’s spending commitments and help the government achieve its macroeconomic objectives.
Tighter fiscal policy involves cutting government spending or increasing taxation. Tighter fiscal policy could have a significant effect on the current account of the balance of payments (the balance between exports from and imports into the UK economy). If the government increased direct taxation (e.g. personal income tax), this would decrease households’ disposable income. With lower income, households would need to reduce their consumption. This would include the consumption of imported goods, which is particularly significant in the UK where households have a very high marginal propensity to import. Hence imports will fall and the current account of the balance of payments will improve.
However, not all forms of tighter fiscal policy will result in an improved current account balance, particularly in the long term. If the government chooses to cut government spending on vital areas of infrastructure (e.g. roads and rail) or education and training, this will damage UK productivity growth. This is likely to result in rising unit labour costs and hence a deterioration in international competitiveness. This will cause exports to fall and imports to rise. Hence the current account of the balance of payments may deteriorate.
Tighter fiscal policy is also likely to have significant effects on economic growth. If the government tightened fiscal policy by increasing corporation tax (taxes on company profits), this would lead to fewer profits being available for investment. If firms responded to lower profits by cutting their level of investment, this would reduce the level of AD (AD =
C + I + G + (X − M)). Thus, the AD curve would shift inwards from AD1 to AD2, reducing the equilibrium level of output from Y1 to Y2 and lowering actual economic growth. If the economy was already in a weak state, such as the UK economy in 2010, this would possibly increase the severity of the recession. In addition, if investment was to fall and this was to be sustained, this would reduce the size of the capital stock. This would have a negative effect on potential economic growth by shifting the LRAS inwards. Furthermore, should the government also choose to cut government spending as part of its contractionary fiscal policy, this would reduce G and further increase the magnitude of the deflationary effects.
Nevertheless, the effects of this policy are likely to depend on the state of the economy and the condition of government finances. If, prior to the policy tightening, the government had a very large fiscal deficit, then cutting government spending and increasing taxes may help restore confidence and encourage businesses to re-invest in the UK economy. Cutting borrowing might also help improve the government’s credit rating and hence lower borrowing costs (and wasteful spending on interest payments). Some economists might argue that high levels of government spending might crowd out private sector spending, so cutting G might actually help to crowd in spending. In addition, should the government choose to target wasteful areas of government spending and remove inefficiencies, the effects on the supply side of the economy may be diminished.
In conclusion, tighter fiscal policy is a very powerful tool of policy. It will certainly have significant effects on an economy, affecting both the current account and the macroeconomy. Ultimately, the significance of these effects depends upon the state of the economy and government finances at the time when the policies were implemented.
This answer is a thorough exploration of the question. It receives L4 for knowledge, application and analysis with two fully developed points which are well applied to the question and given with some context. It also receives L3 for evaluation with two well-developed points and a balanced judgement within the conclusion.
14 Example answer:
Income inequality is the extent to which the distribution of household income between households in a country diverges from perfect equality and it may be measured by an indicator such as the Gini coefficient. One way of reducing income inequality is through
an increase in the minimum wage (the minimum wage is a statutory minimum price for labour, above the equilibrium wage, shown in the figure below as Wmin). Increasing the minimum wage would increase the proportion of available income going to those on lower-income jobs and so income inequality between the highest and lowest earners would be diminished. One positive effect of this might be an increase in productivity and sustained high levels of employment.
[pic]
The minimum wage was introduced in the UK in 1999 at £3.60 per hour. It has increased steadily ever since, reaching £8.21 per hour in 2019. A higher wage might plausibly increase labour productivity, due to, for example, higher morale among the workforce and a greater sense of loyalty to the firm. This is because workers now believe they are being properly rewarded for their labour. Firms may also be incentivised to invest in new capital and training schemes. This will have the effect of boosting labour productivity because workers would be producing goods with more efficient capital. As a result, the marginal physical product of labour will increase, which leads to a greater marginal revenue product of labour (MRPL = MPP ( price of good). Thus, due to higher marginal revenues per unit of labour, the labour demand curve will shift outwards as shown in the diagram from D1 to D2, leading to reduced income inequality via higher equilibrium wages and no adverse effect on employment, which remains at QE.
However, such an effect cannot be taken for granted. If the minimum wage is set too high, and labour is not sufficiently motivated or able to increase productivity, then an adverse effect of raising the minimum wage may also result in decreased employment, which would disproportionately impact those in the low-skill labour force, since the wage rate
is to be set above the equilibrium level at which the market clears and full employment
is reached. Moreover, since the relative cost of labour has increased, firms may choose
to invest in new technology which requires very little labour, replacing workers with machinery and reducing wage costs, thus compounding the problem of unemployment. This unemployment will potentially increase poverty and reliance on welfare, while also causing hysteresis. This may actually lead to increased income inequality in the long run as a result, as it may be the case that lower-skill, lower-income workers are discriminated against by minimum wage legislation in terms of employment possibilities.
Another economic effect of policies to reduce income inequality might be an increase in consumption and hence real GDP. For example, a policy implemented by many countries has been to provide a tax credit, where people earning below a certain amount receive supplemental pay from the government instead of being taxed. For example, in 2014, Italy deployed a system where workers earning up to €26,000 a year receive a monthly payment of €80. This has helped household income in Italy rise by 1.8%. This extra income will get many families out of absolute poverty. Because this tax credit is available only to the lowest earners, this will redistribute income and reduce inequality. Low-income families have a very high MPC, hence the increase in income will generate an increase in consumption. This will feed through to an increase in AD from AD1 to AD2 and hence real output will also increase.
[pic]
In evaluation, this tax credit could help cause a poverty trap. This is a condition when a rise in pre-tax/benefits income leads to a fall in post-tax/benefits income either because of a high marginal rate of taxation or because of the withdrawal of means-tested benefits. As a consequence, the lowest earners have little incentive to increase their income, therefore they are more likely to remain poor. While Italy has tended to have a very generous benefits system by international standards, it still has a high Gini coefficient, which could be due partly to the incentive effects of these elements of the benefits system. The consequence is that income levels will remain low as households remain on benefits and do not work. Hence consumption will not increase as argued above and AD and real income levels will remain low at Y1.
The minimum wage and tax credits are two policies which will appear to reduce inequality, at least initially. Neither is a panacea, however, and each may have substantial effects on the economy. Careful calibration would be needed to reflect the condition of the economy in which they are implemented. On balance, governments will need to decide carefully which policy is best implemented in their own economic circumstances.
Another thorough exploration of the key issues. Two economic effects of policies to reduce income inequality are thoroughly explored. Both paragraphs of analysis draw out the effects of the policies but would be better if they got to the effects more quickly and spent less time on explaining the policies. L3/L4 border for analysis. The evaluation is strong throughout and receives a clear L3, finishing with a solid judgement.
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