Guide to give teachers and students feedback

Exam-style questions

High energy prices are likely to feed through into an increase in inflation in Turkey. Firms’ costs of production are likely to increase and this may see either a fall in profit margins or increases in consumer prices. It could lead to workers making higher wage demands as their own costs of living are also increasing. Given the ‘signs of overheating starting to emerge’, this could be a significant problem.

Rapid economic growth might also cause a further increase in the current account of Turkey’s balance of payments. Not only might rapid economic growth lead to an increase in demand-pull inflation, which will undermine Turkey’s competitiveness and increase the price of exports, it might also lead to increased demand for imports from consumers benefiting from higher incomes. This is a significant problem for Turkey and possibly one of the most important issues Turkey might face. At 10% of GDP, Turkey’s current account deficit is large by international standards.

3 Knowledge and analysis: (4 marks each)

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  Definition of economic growth; distinction between actual economic growth and potential economic growth.
  
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  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 consumption 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.
  
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  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.
  
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  Increased investment into the economy results in greater confidence due to higher profits from firms. There will be more capital or an improvement in the quality of the capital stock, leading to 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.
  

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  Phillips curve: the higher the employment in the economy, the greater the upward pressure there is on the price level (cost-push or demand-pull explanations acceptable). The increase in the cost of living means that the standard of living does not increase by that much.
  
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  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.
  

Macroeconomic policy instruments

Demand management policies

1 A government has a budget deficit when, in a given year, total government expenditure exceeds total revenue (from taxes and other charges). A budget deficit has to be financed by borrowing. Governments usually do this by issuing bonds. The stock of accumulated borrowing is called the government, or national, debt.

Definition of a negative output gap: the difference between the actual output and potential output.

Meaning of expansionary fiscal policy and that it represents an addition to the circular flow. (2 marks)

Transmission mechanisms and analysis of effects: (2 x 3 or 3 x 2 marks):

For example, effects of direct tax cut on consumption:

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  Cut in direct tax (personal income tax) leads to increase in disposable income.
  
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  Increase in disposable income should result in increase in consumption and, therefore, in AD.
  
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  Higher AD leads to an increase in real output and an increase in employment. This will help close the negative output gap. Make the link to the diagram.
  

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  Injection might be too large or not large enough.
  
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  Impact may be small if the value of the multiplier is small due to high leakages.
  
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  Short/long-run effects.
  
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  Given the state of economy (falling house prices etc.), the impact may be insignificant.
  
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  Tax cuts may be saved not spent – increase in government spending might be necessary rather than any form of expansionary fiscal policy.
  

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. This will also reduce consumption.

Another influence on consumer spending arises from the effects of interest rate change on consumer confidence and expectations of future employment and earnings prospects.

b Investment

An increase in Bank of England base rates will be passed on to their 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.

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 Factors might include:

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  State of the banking system or other credit problems.
  
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  Unemployment/employment levels.
  
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  Levels of debt/savings.
  
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  Change in retail sales/consumer spending.
  
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  Shocks such as the euro zone crisis.
  
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  The government fiscal policy (government spending and taxation).
  
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  Money supply growth.
  
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  Commodity prices.
  
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  Skills shortages.
  
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  Recent inflation/cost pressures.
  
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  House price changes.
  

Extension material: Ricardian equivalence

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. In the short run, increased government spending will shift the AD curve to the right, raising both the price level and equilibrium output. In the long run, the increase in productivity causes the LRAS curve to shift outwards, resulting in an increased level of output (Y₁ to Y₂) and ultimately economic growth. As a result the price level may also ultimately decline.

Credit will be given for a diagram illustrating these effects.

Evaluation: (4 marks)

Education and training is a long-term policy. The positive effects on productivity in particular will take a considerable period of time to come into effect. For example, changing the school education system may require legislative changes, new teacher training and a new cohort to pass through it before any changes are seen. By contrast the effects of the increase in government spending on AD may be much more immediate. This suggests that in the short run the effects on the price level and real output may both be positive.

Lower income tax rates will mean that workers are able to keep more of their income post-tax. The opportunity cost of taking leisure will also increase as a result. This may incentivise more people to enter the labour market and those in work already to work for longer hours, due to the substitution effect. 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. As result, the supply of labour will shift to the right and the labour market will move towards a new equilibrium with a higher level of output and lower wages. This will shift the LRAS curve outwards (LRAS₁ to LRAS₂). This will lead to an increased real level of output (Y₁ to Y₂), measured by increased real GDP, and therefore economic growth ceteris paribus. As a result the price level may also ultimately decline.

Credit will be given for a diagram illustrating these effects.

Evaluation: (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 work the same number of hours for a higher real income. This could cause a decrease in the supply of labour, causing LRAS to shift inward or reducing the positive impact through the positive substitution effect.

Privatisation is the sale of state-owned assets to the private sector. This is often achieved through listing the 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 is particularly important for privatisations of key services such as telecommunications and 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. This will shift the LRAS curve outwards (LRAS₁ to LRAS₂). This will lead to an increased real level of output (Y₁ to Y₂), measured by increased real GDP, and therefore economic growth ceteris paribus. As a result the price level may also ultimately decline.

Credit will be given for a diagram illustrating these effects.

Evaluation: (4 marks)

Sometimes privately owned companies may be less willing to invest in productivity-enhancing investment than state-owned companies because their shareholders may be 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 de-regulation 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.

Definition of productivity: output per person per hour and definition of productivity growth. (2 marks)

Credit (1 mark) will be given for reference to increased efficiency but no marks will be given for simply referring to increased production.

Economic growth definition. (2 marks)

Effects of increase in productivity might include: that this is likely to lead to economic growth through a rightward shift in LRAS (illustrated with diagram or equivalent analysis, e.g. shift out in the PPF/increase in productive potential); costs of production fall/efficiency increases, resulting in greater profit; removes inflationary pressure; encourages inward investment.

Answers based on competitiveness will be given credit.

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  Need for increase in AD as well as productivity growth.
  
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  Extent might depend upon productivity growth relative to that of competitor countries.