Edexcel AS, 2nd edition (Peter Smith) - Hodder Plus Home

2nd edition

Edexcel AS

Economics Peter Smith

Answers

Contents Unit 1 Competitive markets: how they work and why they fail Chapter 1 Introducing economics. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3 Chapter 2 The nature of demand. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5 Chapter 3 The nature of supply . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7 Chapter 4 Market equilibrium and price. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9 Chapter 5 The price mechanism in action . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11 Chapter 6 The market for labour . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13 Chapter 7 Market failure and externalities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15 Chapter 8 Other forms of market failure. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16 Chapter 9 Government intervention and government failure. . . . . . . . . . . 18

Unit 2 Managing the economy Chapter 10 Measuring economic performance. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19 Chapter 11 Developed and developing countries. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20 Chapter 12 Income, wealth and the circular flow. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21 Chapter 13 Aggregate demand. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22 Chapter 14 Aggregate supply and macroeconomic equilibrium . . . . . . . . . 23 Chapter 15 Economic growth. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24 Chapter 16 Macroeconomic policy objectives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25 Chapter 17 Macroeconomic policy instruments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27

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Edexcel AS Economics

Introducing economics

Chapter 1

1 Answer: B Explanation: ● Resources are limited in supply. ● Wants are unlimited so the issue of scarcity arises. ● Therefore, choices must be made which involve opportunity cost (the (1 + 3 marks) sacrifice of the next most desired alternative). 2 Answer: D Explanation: ● Definition of opportunity cost: the sacrifice of the next most desired alternative. ● A movement from B to C means that, to get more capital goods, some consumer goods must be sacrificed. An annotated diagram could be used to show this. ● Answer C is incorrect because no opportunity cost is incurred since unemployed resources are being used. ● Answer B is incorrect because a movement from B to Y could mean that more (1 + 3 marks) of both goods can be produced. 3 Answer: D Explanation: ● Definition of sustainable resource: one which is not depleted when used. ● Explanation that energy generated from wind does not use up finite resources. ● All other methods are incorrect because coal, oil and shale gas are depleted (1 + 3 marks) when used. 4 Answer: D Explanation: ● In a market economy prices are determined by the interaction of supply and demand. ● A change in consumer demand for a particular good would cause a shift in the demand curve and a change in its price. ● A supply and demand diagram could be used to illustrate this. 5 Answer: C Explanation: ● Definition of a positive economic statement. ● Definition of a normative economic statement. ● Application: the first statement can be verified by reference to published data. ● The second statement contains the word ‘should’, which implies a value (1 + 3 marks) judgement. Answers © Peter Smith

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Unit 1 6 Answer: A Explanation: ● Definition of division of labour: subdivision of one task into a series of subtasks. ● Workers are trained to do one specific sub-task. ● Therefore, workers will have a limited skill and if they lose their jobs, they may lack skills for alternative jobs. ● Answer B is incorrect because firms do usually use division of labour as a (1 + 3 marks) means of increasing productivity.

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The nature of demand

Chapter 2

1 Answer: D Explanation: ● Higher real incomes imply that people are better able to afford to buy a new car. ● This would cause demand to increase, so shifting the demand curve to the right. ● Answers A and B are incorrect because these are conditions of supply, and would cause a shift in the supply curve. ● Answer C is incorrect because cars and petrol are complements, so a rise in (1 + 3 marks) petrol prices would cause a decrease in demand for cars. 2 Answer: A Explanation: ● A subsidy is a grant which reduces the cost of production. ● Therefore, a subsidy would cause a rightward shift in the supply curve for bread so causing a movement along the demand curve for wheat. This could be illustrated with a diagram. ● The other answers all impact on the demand curve for bread. (1 + 3 marks) 3 Answer: B Explanation: ● Definition of an inferior good: an increase in real income causes a fall in demand. ● Definition of a normal good: an increase in real income causes a rise in demand. ● Rice has a negative income elasticity of demand (YED) and is therefore an inferior good, but carrots have a positive YED and are a normal good. ● Answer D is incorrect because demand for carrots is price inelastic and (1 + 3 marks) income inelastic. 4 Answer: D (and also B) Explanation: ● Definition of price elasticity of demand (PED): a change in price causes a more than proportionate change in quantity demanded. ● If a new substitute becomes available, then demand for the product will be more sensitive to a price change because the rival product is similar. ● Answer A is incorrect because it affects price elasticity of supply (PES). ● Answer B is correct because if a product becomes more durable, it is easier for consumers to postpone the purchase of a replacement. ● Answer C is incorrect because this would make demand less sensitive to a (1 + 3 marks) price change.

Answers © Peter Smith

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Unit 1 5 Answer: A Explanation: ● Definition of cross-price elasticity of demand (XED): the responsiveness of a change in quantity demanded of product B to a change in the price of product A (or give the formula for XED). ● A complement refers to a product which is used in conjunction with another product. ● Example: an increase in the price of cars would cause a fall in demand for (1 + 3 marks) petrol then the XED would be negative. 6 Answer: B Explanation: ● Definition of price elasticity of demand (PED): a change in price causes a more than proportionate change in quantity demanded. ● Total revenue is price × quantity demanded. ● Therefore, a fall in price from £10 to £9 (10%) causes the quantity demanded to rise from 100 kilos to 150 kilos (50%), and total revenue would rise from £1,000 to £1,350. ● Answer D is incorrect because nothing can be inferred about profits without (1 + 3 marks) knowing the impact on costs.

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The nature of supply

Chapter 3

1 Answer: D Explanation: ● An increase in productivity causes a fall in the costs of production so causing an increase in supply. ● Answer A is incorrect because it would cause a decrease in supply. ● Answers B and C would affect the demand curve. (1 + 3 marks) 2 Answer: A Explanation: ● A health scare would cause the demand for beef to fall, so causing a leftward shift of the demand curve. This could be illustrated by a supply and demand diagram. ● Answers B and D are incorrect because they would cause a rightward shift in the supply curve. ● Answer C is also incorrect because it would cause a leftward shift in the (1 + 3 marks) supply curve (because costs of production would increase). 3 Answer: C Explanation: ● Value added tax (VAT) is an indirect tax which is a percentage of the price of a product. ● It causes an increase in the cost of supplying the product. ● Therefore, the more tax paid, the higher the price, so causing the new supply curve to be steeper than the original supply curve. This can be illustrated by (1 + 3 marks) a diagram. 4 Answer: B Explanation: ● Definition of inelastic supply: when a change in price causes a less than proportionate change in quantity supplied. ● Perishable goods cannot be stored. ● Therefore, supply cannot be changed quickly in response to a change in demand. ● Answers A and C are incorrect because they would affect price elasticity of (1 + 3 marks) demand (PED). 5 Answer: D Explanation: ● Definition of price elasticity of supply (PES): the responsiveness of quantity supplied to a change in price (or give the formula for PES). ● Substitute values into the formula to find that PES = 1 or unity. ● Answer A is incorrect because if supply is perfectly inelastic, the PES would equal 0. Answers © Peter Smith

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Unit 1 Answer B is incorrect because if supply is perfectly inelastic, the PES would equal 0. ● Answer C is incorrect because if supply is perfectly elastic, the PES would (1 + 3 marks) equal infinity. ●

6 Answer: B Explanation: ● A subsidy is a grant from the government which reduces the costs of production so causing the supply curve to shift to the right. ● In turn, this would cause the price of honey to fall. This can be illustrated by a supply and demand diagram. ● Answers C and D are incorrect because a subsidy would shift the supply curve to the right, i.e. more would be supplied at each (1 + 3 marks) given price.

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Market equilibrium and price

Chapter 4

1 Answer: C Explanation: ● Definition/characteristic of a free market economy: e.g. private ownership of resources; profit motive. ● Understanding of the price mechanism: interaction of supply and demand to determine price. ● Therefore, the role of the price mechanism cannot be to keep prices stable since they will change as a result of changes in conditions of demand and/or supply. ● Answers A, B and D are all functions of the price mechanism. (1 + 3 marks) 2 Answer: C Explanation: ● Price would fall to equilibrium level which would cause an extension of demand and a contraction of supply. This can be illustrated with a supply and demand diagram. ● Answer B is incorrect because the price is already above its equilibrium level. ● Answer D is incorrect because there is nothing to suggest that conditions of (1 + 3 marks) demand have changed. 3 Answer: B Explanation: ● An increase in supply would cause the whole supply curve to shift to the right. ● This should be drawn on the diagram. ● The result will be a fall in the price and a movement down the demand curve (1 + 3 marks) (extension of demand). 4 Answer: C Explanation: ● Definition of consumer surplus: difference between how much consumers are willing to pay and the market price. ● Definition of producer surplus: difference between the market price and cost of supply. ● An increase in demand will cause the whole demand curve to shift to the right and so cause an increase in both consumer surplus and producer (1 + 3 marks) surplus — this can be shown on the diagram. 5 Answer: A Explanation: ● Definition of production possibility frontier: combinations of two goods which could be produced assuming all resources are fully employed. Answers © Peter Smith

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Unit 1 ● ●

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Diagram to illustrate a production possibility frontier. Any point inside the production possibility frontier would imply that there unemployed resources, whereas any point to the right of the production (1 + 3 marks) possibility frontier is unattainable.


The price mechanism in action

Chapter 5

1 ● An increase in VAT would cause the supply curve to shift to the left and become steeper. The diagram should be included. ● This would cause a rise in price and fall in quantity. (6 marks) 2 a ● Demand and supply are very price inelastic. ● Supply is subject to significant changes resulting from changes in weather conditions. ● Demand may also change in response to changes in tastes and the prices of substitutes such as tea. ● A supply and demand curve diagram should be included showing either a (8 marks) shift in the supply curve or the demand curve. ● b Explanation of a buffer stock scheme: e.g. a scheme by which price fluctuations are reduced by removing some of the coffee from the market when there are bumper harvests and releasing stocks of coffee when there are poor harvests. ● Diagram to illustrate a buffer stock scheme (see page 114 in the textbook). ● Effect of scheme: coffee price should fluctuate less, therefore the revenues of producers should fluctuate less; consumers will have greater certainty about price. Evaluative comments could include: ● The difficulty of setting the floor and ceiling prices to equate long-run supply and demand. ● A series of good harvests would cause stocks to increase steadily with associated costs. ● Or, a series of shortages would mean that there were insufficient stocks to keep the price below the ceiling price. (14 marks) 3 a ● Demand for rented accommodation has increased because of the difficulty of securing mortgages from banks and building societies as well as the need to provide large deposits. ● Supply and demand diagram showing a rightward shift in the demand curve for rented accommodation with a consequent rise in price and increase in quantity. (6 marks) b Factors include: ● Mortgage interest rates. ● State of the economy and job security. ● Cost of renting accommodation. ● Size and age distribution of population. (8 marks) c ● Definition of elasticity of supply: responsiveness of quantity supplied to a change in price. ● Supply likely to be inelastic, i.e. a change in price would cause a less than


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Unit 1 proportionate change in quantity supplied because of the time taken to gain planning permission and then the time to actually build the houses.(8 marks) d ● Definition of subsidy: grant from the government to producers which have the effect of reducing the cost of supply. ● Supply and demand diagram showing a rightward shift of the supply curve for houses, resulting in a fall in the price of new houses and a rise in quantity. ● Effect on consumers: more people will be able to afford to buy new houses causing less demand for rented accommodation. ● Effects on house building companies: increased demand resulting in higher sales and increased revenues. Also, more demand for household goods as house sales increase. Evaluative comments might include the following: ● The effect on price depends on the amount of the subsidy and the elasticity of demand for new houses. ● The subsidy might have little impact if other costs of building new houses rises or if house builders do not pass the subsidy on to house buyers. ● Demand may be price inelastic if confidence about the future state of the (14 marks) economy is low.

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The market for labour

Chapter 6

1 Answer: C Explanation: ● Demand for workers in the vegetable farming industry is a derived demand, i.e. it is dependent on the demand for the final product. ● If machinery becomes cheaper relative to labour, more machinery will be used. ● In turn, this will cause a reduction in the demand for workers. ● All other answers would imply an increased demand for workers. (1 + 3 marks) 2 Answer: C Explanation: ● Definition of inelastic demand for labour: a change in the wage rate causes a less than proportionate change in the demand for the product. ● If wage costs are a small proportion of the firm’s total costs, then a change in the wage rate will have little impact on the demand for labour. ● Answer B is incorrect because if it is easy to replace workers with machines, (1 + 3 marks) then the demand for labour would be elastic. 3 a ● Explanation of a National Minimum Wage: a legally binding minimum amount which a firm must pay its workers per hour. ● Possible reason: to decrease inequality, i.e. it should mean that the gap (4 marks) between the highest and lowest paid workers would decrease. b ● Number of tourists and business people requiring hotel accommodation. ● Quality of service provided by hotels. (6 marks) ● c Workers in the hotel industry are frequently paid low wages so an increase in the National Minimum Wage would have a significant impact. ● However, it may be difficult to replace workers with machines because it is a labour-intensive service industry. Therefore, the demand for labour is likely to be inelastic. ● Since many of the jobs in the tourist industry are relatively unskilled, supply may be fairly elastic. This should be illustrated with a diagram showing the National Minimum Wage above the free market wage. ● The extent of job losses depends on how much the National Minimum Wage is above the equilibrium wage, the price elasticity of demand (PED) for hotel workers and the price elasticity of supply (PES) (14 marks) of hotel workers. d The supply of labour to the hotel industry will depend on factors such as: ● Size of working population, but this could be supplemented by immigration. ● Wage rate, but the basic wage rate may be less significant in this industry because workers often receive tips.


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Unit 1 Level of skills required: e.g. specialist qualifications required for chefs in contrast to the few qualifications required for cleaners, but some hotels provide in-house training. ● Hours and conditions of work: the anti-social hours may be a significant (14 marks) factor in deterring people from working in this industry. ●

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Market failure and externalities

Chapter 7

1 Answer: D Explanation: ● Characteristics of positive consumption externalities: non-excludability and non-rivalrous. ● Reason why these would not be provided in a market economy: the free-rider problem. ● Consequently, resources would not be allocated efficiently. (1 + 3 marks) 2 Answer: D Explanation: ● OX is the free market level of output (where MPB = MPC). ● OY is the socially efficient level of output (where MSB = MSC). ● Welfare loss at OX would be ABC. Therefore, a reduction in output below OX would reduce the welfare loss. (1 + 3 marks) 3 a ● Private benefits of production of new vaccine: revenue to the company producing the vaccine. ● Private benefits of consumption of new vaccine: consumers enjoy better health, i.e. no coughs and colds. (4 marks) b ● Definition of opportunity cost: sacrifice of the next most desired alternative when a choice is made. ● By providing the vaccine free to consumers, there may have to be cutbacks in other parts of the health service, or cuts in other forms of public expenditure.(6 marks) ● c Definition of external benefits: benefits to third parties who are not part of the transaction; or the difference between social benefits and private benefits. ● Examples of the external benefits of the new vaccine: less absenteeism from jobs, resulting in higher production and revenues for producers; lower costs for the National Health Service as fewer people get complications from coughs and colds and have to visit their doctor or the local hospital. ● Include a diagram to show external benefits of consumption. Evaluative comments could include: ● The difficulty of quantifying the external benefits. ● The long-run effects might be greater than the short run effects. ● The costs of providing the vaccine free of charge must be (14 marks) considered.


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Chapter 8

Other forms of market failure 1 Answer: D Explanation: ● Non-excludability implies that once the good is supplied it is impossible to prevent people from using it. ● Therefore, if someone has provided the product, others may use it without charge — a free-rider. ● This may be illustrated by means of an example. ● Answer B is incorrect because resources are used to produce a public good (1 + 3 marks) which has alternative uses. 2 Answer: D Explanation: ● Definition of non-exludability: that once the good is supplied it is impossible to prevent people from using it. ● Definition of non-rivalrous: consumption by one person does not limit consumption by others. ● Example of a public good contrasted with an example of a private good. ● Answer C is incorrect because private goods would only be under-provided if (1 + 3 marks) there were external benefits. 3 Answer: A Explanation: ● There are information gaps: people do not know how long they will live; they do not know what their needs will be in retirement. ● Therefore, there is a need for government intervention or provision. ● Answer C is incorrect because life expectancy is increasing in most (1 + 3 marks) countries. 4 Answer: C Explanation: ● Definition of occupational mobility of labour: movement of workers between different occupations. ● With fewer training programmes it would be more difficult for the unemployed to get jobs in other occupations. ● Answers A, B and D would increase geographical mobility of labour so are (1 + 3 marks) incorrect. 5 Answer: C Explanation: ● Definition of inelastic demand: a change in price causes a less than proportionate change in quantity demanded. ● Definition of inelastic supply: a change in price causes a less than proportionate change in quantity supplied.

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Other forms of market failure

Chapter 8

Therefore, a shift in either the demand curve or supply curve would cause a sharp change in price. This could be illustrated with a supply and demand diagram. ● Answer D is incorrect because a continuous fall in demand for maize would cause a continuous fall in its price. (1 + 3 marks) ●

6 Answer: B Explanation: ● Definition of a buffer stock scheme: a system in which surpluses are stored and then released in times of shortage. ● A buffer stock scheme usually involves ceiling and floor prices. ● The operation of a buffer stock scheme may be illustrated by means of a diagram. ● Answer C is incorrect because the scheme could cost the government money if it were operated by the government and there were continuous surpluses. (1 + 3 marks)


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Chapter 9

Government intervention and government failure a ● Private costs: those incurred by the consumer in buying the product, e.g. the price of a packet of cigarettes. ● External costs: those incurred by the producer in making the product, e.g. the cost of raw tobacco. (4 marks) b Diagram showing leftward shift in supply curve causing a rise in price and fall in quantity with supporting explanation, i.e. a tax causes an increase in the cost of supply so causing a decrease in supply. (6 marks) c ● Definition of government failure: when intervention by the government in the market leads to a net welfare loss. ● In this case, the tax on tobacco has been increased significantly which has led to an increase in smuggling, the development of black markets and a fall in tax revenues from tobacco. ● However, the higher tax has led to fewer people smoking and becoming ill from smoking-related diseases. ● High taxes on tobacco have also reduced demands on the NHS. (10 marks) d ● A minimum price for alcohol implies that no price can be charged below that set in law. ● If the minimum price is above the equilibrium price, then the quantity demanded will fall and the quantity supplied would increase, resulting in a surplus. This can be illustrated by a diagram. ● The effects on the different economic agents should be considered: — on alcohol producers: they would suffer a fall in demand and revenues (unless demand is very price inelastic) — on consumers: they would face higher prices and fall in consumer surplus (depends on how much the minimum price is above the equilibrium price) — on the government: it may suffer a fall in revenue from taxes on alcohol (14 marks) (depends on the price elasticity of demand) e There are two alternative ways by which the government might discourage alcohol consumption: education or a complete ban on alcohol consumption. Education: ● programmes to inform people about the dangers of drinking alcohol ● these should be aimed at decreasing consumption to the socially efficient output ● but this involves cost to the government ● also these may be ineffective Complete ban: ● eliminates all the disadvantages of alcohol consumption ● but there are implications for alcohol producers and their employees ● and there are problems with the cost of enforcement (and no tax revenue to the government) (14 marks)

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Measuring economic performance

Chapter 10

1 Nominal GDP is the value of goods and services produced by a country in a year in money terms, whereas real GDP measures the change in the volume of goods and services produced in a year, i.e. the effects of inflation have been discounted.(4 marks) 2 a China’s output increased between 2011 and 2012 but at a slower rate than in 2011.(4 marks) b The level of prices in Brazil was higher in 2011 than in 2012. However, prices were increasing less quickly in 2012 than in 2011. (4 marks) c The UK’s balance of trade in goods and services deficit implies that the value of goods and services imported is greater than the value of goods and services exported. This deficit rose by £0.2bn. (4 marks) 3 Economic growth implies that the production possibility frontier would shift to the right. (4 marks) 4 The consumer price index is constructed by: ● Selecting a base year to which a value of 100 is given. ● Surveying 7,000 households (the Living Costs and Food Survey). ● Assigning weights to each product in accordance with their relative importance in consumer expenditure. ● Conducting a price survey of 650 goods and services. ● Multiplying price changes by the weights to give a price index.

(6 marks)

5 ● The claimant count measures those who have claimed Job Seekers’ Allowance (JSA). ● It excludes those ineligible to claim JSA, even if they are technically unemployed. ● The ILO is a survey. ● It measures those who have been out of work for 4 weeks and are available (6 marks) for work in 2 weeks. 6 a A fall in the demand for UK goods and services will cause a fall in demand for sterling on the foreign exchange market, causing a fall in the exchange rate.(4 marks) b A decrease in demand for foreign imports will reduce the supply of sterling on the foreign exchange market, causing a rise in the value of the pound sterling.(4 marks)


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Chapter 11

Developed and developing countries 1 a ‘GDP per capita based on purchasing power parity’ is the total value of all goods and services produced in the country at prices prevailing in the USA in a particular year, divided by the total population. (6 marks) b ● The definition of living standards relates not only to income per head but also to quality of life and welfare. ● GDP by itself takes no account of changes in population or of changes in (12 marks) income distribution. 2 a The Human Development Index (HDI) is a composite measure of development and consists of three elements: ● health: life expectancy ● education: expected years of schooling ● income: gross national income per capita at purchasing power (4 marks) parity b Advantages: ● The HDI takes a broader measure of welfare than income alone. ● The information is usually readily available and so cheap to collect. ● It gives a better indication of future living standards. ● It might be indicative of successful government policies. However: ● The HDI gives no indication of poverty. ● There is no indication of changes in income distribution. ● The GDP measure may quickly become out of date as exchange rates fluctuate. ● There is no indication of changes in quality of life and consumer welfare.(12 marks) c Other measures could include: ● The percentage of the population with access to the internet. ● The percentage of the adult male population employed in agriculture. The benefits and disadvantages of each of these measures should be (12 marks) considered.

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Income, wealth and the circular flow

Chapter 12

a Income is a flow of money around the economy, whereas wealth is a stock of (4 marks) assets. b ‘Real income per head will be lower’ means that total income divided by population (4 marks) and discounting the effect of inflation will have decreased. c ● Leakages (withdrawals) are an outflow from the circular flow of income. Savings, taxes and imports are leakages. ● Injections are inflows into the circular flow of income. Investment, (6 marks) government expenditure and exports are injections. d See the diagram on page 163 of the textbook. (6 marks) e ● Definition of investment: increase in capital goods. ● Definition of economic growth: increase in real GDP. ● Investment would lead to an increase in aggregate demand (since it is a component of aggregate demand) and also an increase in long-run aggregate supply because the country’s productive capacity has increased. Therefore, (12 marks) economic growth will increase.


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Chapter 13

Aggregate demand a The components of aggregate demand are: C + I + G + (X – M). Only G (6 marks) (government expenditure) is not mentioned. b Two factors include: ● Changes in real incomes: this is usually considered to be the most important factor influencing consumption. However, other factors such as consumer confidence may play a greater role, especially in times of great economic uncertainty. ● Changes in interest rates: these affect the cost of borrowing and the opportunity cost of saving. However, the inflation rate must also be considered because this will determine the real interest rate. Further, other factors such as job security might be more significant in determining (12 marks) consumer expenditure. c The UK’s trade deficit increased from £23bn to £37bn. This implies that leakages increased relative to injections. Therefore, aggregate demand would fall. (6 marks) d ● Investment: increase in capital stock. ● Rate of interest: cost of money. (12 marks) e Two factors include: ● Expectations about the future state of the economy — decisions about investment are closely related to the prospects of making profits. ● The profits of companies: many businesses use past profits to finance (8 marks) investment. ● f If the marginal propensity to save (MPS) increases, then the value of the multiplier would fall. ● The multiplier formula (in a two-sector economy) is 1/MPS. ● Therefore, the higher the value of the MPS, the lower will be the value of the (8 marks) multiplier g ● House prices are an asset which is a form of wealth. ● A rise in house prices would, therefore, represent an increase in wealth. ● This would increase consumer confidence and enable homeowners to increase their borrowing on the basis of the increased value of their houses. ● Consequently, consumer spending would increase. ● As consumption is a component of aggregate demand, the AD curve would shift to the right, causing an increase in real output and in the price level. ● Higher real output would result in a decrease in unemployment (12 marks)

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Aggregate supply and macroeconomic equilibrium

Chapter 14

a Aggregate supply: the amount producers in the economy are willing to supply at (4 marks) various price levels. b ● An increase in oil prices represents an increase in costs of production. ● Therefore, the short-run aggregate supply curve will shift to the left causing an increase in the price level and fall in real output. ● The AD/AS diagram should show the original AD and AS curves with a new AS curve to the left of the original one. ● The impact on real output and price level will depend on the gradient of the AD curve: if it is very steep, there will be a small decrease in real output but a large rise in the price level. Other analysis: ● Since the UK is a net importer of oil, the rise in the price of oil will cause a decrease in net exports, which will result in a decrease in aggregate demand. ● This would result in a fall in real output and a fall in the price level. In practice, this effect is likely to be less significant than the impact on (12 marks) aggregate supply. c ● Public expenditure (G) is a component of aggregate demand. ● Therefore, a decrease in public expenditure would cause a decrease in aggregate demand (and to a leftward shift in the AD curve). ● In turn, this would cause a fall in the price level and a fall in real output. ● Since G is an injection to the circular flow, a decrease in G would cause GDP (8 marks) to fall by a large proportion via the multiplier effect. d ● Definition of productivity: usually this relates to labour productivity, i.e. output per worker per hour worked. ● An increase in US productivity would cause a rightward shift in the aggregate supply curve. ● This would cause a decrease in the price level and an increase in real output in the US. ● It implies that US goods and services would become more competitive relative to UK goods and services. ● Consequently, the UK’s trade balance with the USA may deteriorate. (12 marks)


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Chapter 15

Economic growth a The output gap is the difference between actual GDP and the potential GDP. It can be illustrated with an AD/AS diagram, with the equilibrium level of real (4 marks) output at a level lower than the full employment level of real output. b The possible consequences include: ● It implies that actual output is lower than that required to produce full employment. ● It could mean that the economy is in recession, i.e. at least two quarters of negative economic growth. ● This suggests that there would be involuntary unemployment, but this might be small if employers hoard labour in the hope that the situation would be temporary. ● It is likely that there would be a fall in the rate of inflation because demand– pull inflation would be depressed. However, if inflation is being caused by cost factors, then there would be little impact on the rate of inflation. (12 marks) c Export-led growth is when growth in real GDP is caused primarily by a sustained (4 marks) increase in exports. d Possible factors include: ● An increase in foreign direct investment: this would cause an increase in the productive capacity of the country enabling more goods to be produced. ● A sustained increase in exports resulting from increased competitiveness (12 marks) and/or increased demand for the country’s goods and services. ● e Definition of economic growth: increase in real GDP. ● Diagram to illustrate economic growth, e.g. a rightward shift in the production possibility curve or an AD/AS diagram showing a rightward shift in the AS curve. ● The costs of economic growth include: – external costs, e.g. pollution – the opportunity cost of growth: the sacrifice of present consumption so that resources can be reallocated to the production of capital goods – increased inequality: the possibility that benefits of growth will go to entrepreneurs rather than to workers – depletion of non-renewable resources ● Benefits of economic growth include: – an increase in living standards: higher real incomes could be used by consumers to improve their quality of life – increased tax revenues for the government: these could be used to improve public services such as education and health, or to redistribute wealth to the poor – increased revenues and profits for firms who benefit from increased demand for their goods: in turn, shareholders might benefit from increased (30 marks) dividends

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Macroeconomic policy objectives

Chapter 16

1 a The weights used in the CPI are changed each year to reflect the changes in (4 marks) the relative importance of products in consumers’ expenditure. b ● A fall in the rate of inflation could imply an increase in the competitiveness of a country’s goods and services. In turn, this could lead to an improvement in the country’s trade in goods and service balance. ● It could also lead to a cut in the base rate of interest by the Bank of England’s Monetary Policy Committee if the rate of inflation is below (or expected to fall below) the 2% target. In turn, this could lead to an (8 marks) increase in consumption and in investment. 2 a ● The claimant count is calculated on the basis of those who have claimed Job Seekers’ Allowance (JSA) and who are actively seeking work; various exclusions apply, e.g. the savings cap. ● The ILO method measures those who have been out of work for 4 weeks and who are available for work in 2 weeks. It is based on a survey/ interview covering the age range is 16–65 and is internationally (8 marks) comparable. b Two costs include: ● A waste of resources: the economy would be operating inside its production possibility frontier; these goods are lost for ever. ● The cost to taxpayers: the government would have less tax revenue and would have to increase expenditure on transfer payments in the form of (8 marks) benefits to the unemployed, such as JSA, housing benefits. 3 ● Definition of a recession: at least two consecutive quarters of negative economic growth. ● A recession is usually associated with increased unemployment so it might be expected that inequality would increase. ● Some industries are likely to be more affected than others so unemployment will not be spread evenly across industries or geographical areas. ● The increase in inequality may be offset by transfer payments from the government to the unemployed, or by measures to retrain workers and/or to (12 marks) find new jobs for unemployed workers. 4 ● Definition of balance of payments on current account: this primarily relates to the value of goods and services exported minus the value of goods and services imported (together with investment income and current transfers). ● An increase in real income is likely to lead to an increase in consumption. ● Some of this extra consumption will be on imported goods. ● Consequently, there is likely to be a deterioration in the current account of the balance of payments.


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Unit 2 But, much depends on the marginal propensity to import, i.e. that proportion of an increase in imports that is spent on consumer goods. ● Also, the cause of the increase in real income may be significant. For example, if it is caused by an increase in exports then the impact on the current account will be less significant than if it was caused by higher (12 marks) wages. ●

5 ● Definition of economic growth: increase in real GDP. ● Other macroeconomic objectives include full employment, a low rate of inflation and balance of payments equilibrium. ● Economic growth and full employment: increasing economic growth implies an increase in real incomes. Therefore, demand for goods and services should increase which would cause an increase in the demand for labour so helping to ensure there is no conflict between growth and full employment. However, the jobs created may only be part-time or low-skilled. ● Economic growth and a low rate of inflation: economic growth is associated with higher real incomes which may lead to increased consumption. This could cause an increase in the rate of inflation. However, this may not be the case if growth has been caused by increased investment which would increase long-run aggregate supply and so reduce inflationary pressures. ● Economic growth and a clean environment: economic growth is associated with the increased production of goods and services. In turn, this is likely to result in an increase in the external costs associated with increased energy use and an increase in pollution and waste. However, as a country becomes richer, it has more resources to combat such external costs so the conflict may be more evident in developing countries rather than in developed (30 marks) economies.

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Macroeconomic policy instruments

Chapter 17

1 ● Definition of crowding out: this is when increased government expenditure leads to an increased fiscal deficit and a higher national debt. ● In turn, this could cause an increase in the rate of interest at which the government can finance its extra borrowing. ● This would cause financial crowding out because it will be more expensive (6 marks) for firms to borrow money. 2 ● Expansionary fiscal policy implies an increase in public expenditure (G) and/ or a decrease in taxation. ● In this case, increased expenditure on infrastructure implies an increase in aggregate demand. ● Since G is an injection into the circular flow, there will be a multiplier effect on GDP. ● In the long run, more infrastructure will cause an increase in long-run aggregate supply. ● An AD/AS diagram showing a rightward shift of the AD and (8 marks) AS curves. 3 ● Increased public expenditure might increase aggregate demand and also aggregate supply, especially if spent on education, health and infrastructure. ● In turn, this might cause economic growth to increase. ● But higher public expenditure on social benefits might act as a disincentive to work. ● Higher public expenditure as a proportion of GDP might also restrict economic growth because the resources used by the public sector might not be allocated efficiently because of the absence of the profit motive. (12 marks) 4 ● A reduction in interest rates would make saving less attractive and borrowing cheaper. ● This would encourage both consumption and investment. ● Further, lower interest rates are likely to cause a fall in the exchange rate (because it is less attractive for people to hold cash in domestic banks). ● This would cause a rise in net exports. ● Consequently, aggregate demand would increase so causing an increase in GDP. ● In turn, it is likely that unemployment would fall (unless firms have workers who are currently underemployed). ● The increase in aggregate demand would cause a rise in the price level (unless the economy was on the horizontal part of the AS curve). ● An increase in the money supply would have similar effects if it results in an (12 marks) increase in the rate of inflation.


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Unit 2 5 ● Explanation of expansionary monetary policy: lower interest rates and/or quantitative easing (or other relevant schemes such as funding for lending). ● The impact of lower interest rates, e.g. in the UK: hot money outflows from the UK to other countries where interest rates are higher, causing an increase in the supply of sterling on the foreign exchange market. ● In turn, this will cause a fall in the value of the pound against other currencies. ● This will cause a fall in the foreign currency price of UK exports but a rise in the price of imports into the UK. ● This increase in competitiveness of UK goods will cause the UK’s net exports (X – M) to increase. ● In turn, this will cause aggregate demand to rise, leading to a rise in real output and in the price level. ● Cost–push inflation might also increase because the cost of imported raw (30 marks) materials will have increased. 6 a ● Fiscal policy relates to changes in government expenditure and taxation in order to influence the level of economic activity. ● Monetary policy relates to changes in interest rates and money supply in (4 marks) order to influence the level of economic activity. b ● A fiscal deficit implies that government expenditure is higher than tax revenue. ● Therefore, an increase in the fiscal deficit indicates that the gap between (6 marks) government expenditure and tax revenue is increasing. c ● An increase in the budget (fiscal) deficit implies that injections (government expenditure) are rising relative to leakages (tax revenue). ● Therefore, aggregate demand will increase. ● Consequently, the AD curve will shift to the right resulting in a rise in real output and in the price level. This should be illustrated on an AD/AS diagram. ● The multiplier describes how a change in an injection causes a more than proportionate change in GDP. ● In this case, injections are rising relative to leakages. Therefore, GDP will rise by a greater proportion than the change in the budget deficit. However, the overall impact depends on factors such as: ● the size of the change in the budget deficit ● the size of the multiplier ● the gradient of the AS curve Also, if the increased budget deficit is used to finance extra expenditure on infrastructure and education then aggregate supply might increase so (12 marks) limiting any impact on the price level. d ● Monetary policy relates to changes in interest rates and the money supply in order to influence the level of economic activity. ● A negative output gap implies that GDP is growing at a slower rate than

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Government intervention and government failure

Chapter 9

the long-term trend rate of growth. It is usually associated with increasing unemployment. ● To close the negative output gap, the base interest rate could be decreased by the Bank of England’s Monetary Policy Committee. ● This would make it cheaper for consumers and firms to borrow money, leading to an increase in consumption and investment. Since these are components of aggregate demand, the AD curve would shift rightwards to causing real output to increase. ● However, if consumer and business confidence is low then lower interest rates might not result in higher consumption and investment. Also, commercial banks may not reduce their interest rates following a cut in the base interest rate. ● Alternatively, the Bank of England may engage in quantitative easing, e.g. buying bonds from commercial banks. This would have the effect of increasing the money supply and the commercial banks’ ability to lend to consumers and businesses. ● However, if banks are risk averse, then this policy may have little effect (12 marks) because they will be unwilling to lend. e ● The current account of the balance of payments refers to a country’s day-today financial transactions with other countries. It includes the balance of trade in goods and services, investment income and current transfers. ● Depreciation of the pound implies that the foreign price of UK exports would fall, whereas the price of imports into the UK would rise. ● This would lead to a rise in exports and to a fall in imports so it should lead to an improvement in the current account. ● However, this will not be the case if the demand for exports and imports are very price inelastic, e.g. because of contracts. ● Further, UK suppliers may be unable to meet any increased demand if they are currently working at full capacity. ● In the longer term, there is a danger that any competitive advantage will be lost if increased costs of imported raw materials results in higher prices of (12 marks) UK goods. f ● Definition of supply-side policies: polices aimed at increasing aggregate supply by increasing competition and productivity. ● AD/AS diagram to show the impact of supply-side policies with the AS curve shifting to the right. ● Polices could include: – Training schemes, e.g. apprenticeships. But much will depend on the quality of the schemes and their relevance to the jobs available. – A reduction or the abolition of the National Minimum Wage. But if these measures result in lower incomes, then aggregate demand might fall so the impact of unemployment may be limited. – A reduction in employers’ National Insurance Contributions. These are sometimes referred to as a tax on employment so cutting these would


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Unit 2 encourage firms to employ more workers. However, firms might not take on more workers but simply enjoy an increase in profits. – A reduction in the level of benefits to the unemployed. This would provide an incentive for the unemployed to seek employment. However, if no jobs are available then this measure would be ineffective and would (30 marks) cause an increase in inequality. g Living standards is a broader measure than just amount of income; it also refers to the quality of life, which includes factors such as happiness, quality of housing and health, pollution etc. Policies could include: ● Increased government spending, e.g. on health and education. This could increase quality of life but much will depend on how the money is spent in these sectors. ● Cutting income tax rates: this would increase disposable incomes and enable people to increase their expenditure on goods and services so raising their living standards. However, production and consumption of goods and services would lead to increased pollution, waste and other external costs which may reduce the standard of living. ● Redistributive policies to increase living standards, e.g. increase pensions and means-tested benefits to the elderly. But there would be an opportunity cost, e.g. fewer resources available for the National Health Service. (30 marks)

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