Edexcel AS Economics Unit 2
Managing the Economy
This Answers document provides answers for the questions asked in the Workbook. They are intended as a guide to give teachers and students feedback.
The abbreviation KAA stands for Knowledge, Analysis and Application.
Measuring economic performance and macroeconomic objectives
1 Unemployment is a situation where 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 measurement is a survey and seeks to measure unemployment as 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 Inflation is a sustained increase in the general price level. This can come about via cost-push inflation (shown by a decrease in AS) or demand-pull inflation (shown by an increase in AD). In the UK, inflation is measured by the consumer price index. This is an index covering a basket of around 650 goods that are weighted according to a household’s total expenditure on a certain item. 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.
3 The four components of the current account are: trade in goods — exports and imports of goods into and out of the UK; trade in services — exports and imports of services into and out of the UK; net income flows from abroad — including income from investments; and international transfers (e.g. UK contribution to the EU).
A current account deficit occurs when the value of a country’s imports exceeds that of its exports and hence its export earnings are less than its import expenditure. This represents an outflow of money from the economy. This deficit can be caused by an overvalued exchange rate leading to a loss in international competitiveness, causing a fall in exports and a rise in imports, or by high unit labour costs leading to higher prices for consumers internationally.
1 GDP is a measure of the total output of goods and services in the economy. It is then divided by the country’s population to give a figure for per capita GDP. The first advantage of using GDP per capita is that it is easy to calculate from official government figures (as it is only a single figure it is not over complicated), hence it acts as a good comparison between countries. Second, it is a good indicator of the state of a country’s economy and the ability of households to consume goods and services, and hence gives an indicator of their quality of life. The data may be measured in real (inflation-adjusted) or nominal terms. If the data are real, rather than nominal, then they are less likely to be distorted by inflation and therefore can give a good measurement of changes in living standards over time.
However, GDP does not measure the ‘hidden economy’ — this occurs when the output of some goods and services are deliberately not declared in order to avoid tax or because the activities are illegal. Therefore, the total production of goods and services in the economy may be higher than indicated by GDP per capita. Second, GDP per capita does not tell us anything about the distribution of income within a country; the bulk of the resources could be being enjoyed by an elite of high-income individuals and hence when GDP per capita is measured, it gives a false impression of the economy. The majority of people do not have such a high income, but those with high incomes are forcing up the average.
2 An index is an economic indicator reflecting a collection of data and allowing it to be compared to a base value. The base is set equal to 100 and the index number is expressed as 100 times the ratio to the base value. The HDI measures life expectancy at birth, education (average actual years of schooling and expected years of schooling) and finally the standard of living measured by gross national income per capita in US$ (at purchasing power parity).
3 The HDI is an index which measures national socio-economic development. As a result of cuts to healthcare we would expect to find a more unhealthy population who are less able to be treated for their illnesses by their health service. Therefore, the immediate impact of this would be for the population to take more days off work and hence become less productive, therefore shifting the AS curve inwards. As a result, the amount of goods and services produced in the economy will fall in the long run and hence so will GDP. On top of that, we would expect the life expectancy at birth to begin to reduce due to people receiving a poorer quality of healthcare through their lives. As life expectancy at birth is a component of HDI, we would expect this part of the HDI measure to fall.
A cut in government spending on education could mean that the country will have a smaller educated/ qualified workforce, once again having a negative impact on the LRAS curve and thereby shifting it inwards, leading to the same effect on GDP. On top of that, a less educated workforce could lead to a high illiteracy rate and as this is one of the components of HDI (literacy rates), we would once again expect this part of the measure to fall and therefore HDI overall to fall.
Finally, a cut in spending on welfare such as benefits will mean that the average incomes for those who receive benefits will fall, thereby reducing the average incomes received by households. On top of that, the effects of the cuts in education and healthcare on AS could also cause overall GDP to fall in the long run, as the country will be producing fewer goods and services. As a result, GDP per capita will fall too. We would therefore expect the HDI to fall overall.
However, the likelihood of all of these changes having such a dramatic effect in the UK is very low. First, the government has ring-fenced health and education from most of the austerity programme. Hence these two components of the HDI are unlikely to be substantially affected in the UK.
Second, a cut in government spending in the UK may not be implemented as a long-run policy. The main force behind these cuts in the UK is austerity, as the UK needs to cut its government budget deficit and debt levels. However, due to pressures such as public opinion and the likelihood that economic growth will finally resume soon, these policies will not last into the long run.
The circular flow of income and the measurement of gross domestic product
Gross domestic product and the circular flow
Injections and withdrawals
3 Income is a flow of factor incomes such as wages or dividends from the ownership of shares. Wealth is a stock of financial and 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 and wealth might be the property that people own or the cash in their bank accounts.
4 a Consumption
Total planned household expenditure on goods and services. One of the main components of aggregate demand in the UK.
Expenditure by firms on capital goods such as machinery or equipment, used to manufacture other goods.
c Net trade
Exports minus imports. (1 mark)
The value of goods and services sold in exchange for foreign currency MINUS the value of goods and services bought with foreign currency. (2 marks)
A positive net trade balance is an injection into the economy. (1 mark)
Determinants of consumption
5 Marginal propensity to consume (MPC) is the increase in consumer spending (consumption) that occurs with an increase in income. (2 marks) Average propensity to consume (APC) is the percentage of income spent (C/Y). (2 marks)
Definition of direct taxes and of disposable income. (2 marks)
Definition of marginal propensity to consume/average propensity to consume. (2 marks)
Explanation of how low-income groups have a high MPC because they need to spend all of their income on necessities and basic goods. Any additional income will probably need to be spent.
Explanation of how high-income groups may have a low MPC because they have satisfied their basic needs and so can save any additional income they receive. (2 marks)
7 A change in interest rates will have a direct influence on consumption. For example, an expansionary monetary policy will mean a fall in interest rates. This will encourage people to borrow as it means that interest payments on the sum borrowed will fall. Hence, one would expect that the level of borrowing in the economy will increase and 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 households will reduce savings balances and choose to spend their cash instead. A contractionary monetary policy will have the opposite effect on consumption. (4 marks)
A change in wealth will also affect consumption. If the value of household wealth increases – for example, as a result of an increase in the price of the house that they own – 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. (4 marks)
Determinants of investment
8 Knowledge and analysis: (4 + 4 marks)
Lower interest rates mean easier access to finance, leading to lower monthly/yearly repayments and more borrowing by firms. In addition, lower interest rates means that firms expect to find that more investment projects (marginal projects with a lower expected return) are now profitable. Following MEC theory, this implies that profit-maximising firms will undertake more investment, leading to (ceteris paribus) an increase in investment.
Determinants of government spending
Explain contraction in economic activity.
When an economy contracts, national income/output falls. This suggests that employment will fall. This will lead to a fall in income tax receipts. In addition, spending will tend to fall due to lower income and lower confidence. So indirect tax receipts (e.g. VAT) will also fall.
In addition, a fall in employment will probably be followed by a rise in unemployment. Hence government spending on unemployment benefits will rise.
These effects are known as automatic stabilisers.
Determinants of expenditure on exports and imports
Define exchange rate: the price of one currency in terms of another.
An increase in the value of the pound means that the price of UK goods increases in foreign markets; hence demand for them falls, meaning reduced X and hence a fall in AD.
An increase in the value of the pound means that the price of imported goods falls; hence there is an increase in demand for imports which may be substituted for UK-produced goods, leading to an increase in M and a fall in AD.
Use of an example to illustrate the effects.
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.
PED for exports and imports may be highly price inelastic, e.g. exports may have few close substitutes especially in the short run. So some foreign households/firms may continue to buy the goods despite the rise in the price. So export earnings might rise. (4 marks)
11 Knowledge and analysis: (4 + 4 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 (could count as evaluation depending on how analysis is developed).
Evaluation: (1 x 4 or 2 x 2 marks)
Impact depends upon the changes in the exchange rate over the time period. If sterling appreciates then the current account may deteriorate even more.
Extent of the change depends upon the relative growth rates in UK vs major trading partners. If UK grows by more than its trading partners, it is likely that the balance of payments will deteriorate.
Effect of increase in domestic demand depends upon the marginal propensity to import.