Workbook answers

Exam-style questions (multiple choice and short answer)

• 
  initial AD/AS curves and axes correctly labelled; vertical LRAS (1 mark)
  
• 
  initial equilibrium correctly labelled (1 mark)
  
• 
  increase (rightwards/outwards shift) in AD (1 mark)
  
• 
  new equilibrium correctly labelled showing an increase in the equilibrium average price level but no change in output (1 mark)
  

Also reward 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. 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 Q_fe.

• 
  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 balance of payments (increased competitiveness of exports leading to increase in X – M)
  

• 
  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 still took over 4 years from initial 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 MPC 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

Injections and withdrawals

The multiplier

• 
  spending by one person becomes other people’s incomes
  
• 
  process continues until all extra income is leaked away
  
• 
  relevance to government spending, e.g. on hospitals
  

(4 marks max.)

T
1

1 – MPC
he extent of the final increase can be shown with the multiplier formula:

K =

Calculation of the size of the multiplier (i.e. K = 2) using the data provided. (2 marks)

• 
  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
  

• 
  discussion of the size of the multiplier — size and types of leakages, e.g. applied to the example, which has a high MPS of 0.5, but no other leakages as it has no taxation or imports. Contrast with UK which has low MPS but high MPM and MPT
  
• 
  time-lag effects
  
• 
  depends on the shape of the AS curve
  
• 
  other things might not be equal, e.g. the pound might change in value
  

Exam-style questions (multiple choice and short answer)

Exam-style questions (data response)

• 
  Define real income (nominal income adjusted for inflation). (1 mark)
  
• 
  Define real income per head (per person or per capita). (1 mark)
  

• 
  Refer to data from extract and explain that income per person fell when adjusted for inflation. (1 mark)
  

• 
  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
  

• 
  real post-tax income growth 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
  

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 return 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 an 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.
  

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 who 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
  

• 
  depends on the level of leakages: S, T or M
  
• 
  short-/long-run effects: 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
  

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).

Growth:

• 
  increase in AD (1 mark)
  
• 
  via increase in (X – M) caused by fall in M (1 mark)
  
• 
  multiplier effects (1 mark)
  

Further analytical marks for consequences for growth, e.g. through damaging effects of inflation (2 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)
  
• 
  time-lag effects
  
• 
  depends 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
  

Economic growth

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. (1 mark)

3 A positive output gap occurs when actual output is greater than potential output (1 mark). There will usually be inflationary pressures.

4 A decline in unemployment. 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. (2 marks)

An increase in demand–pull inflation. 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. (2 marks)

5 GDP is the value of goods and services produced by the factors of production of an economy within a given time period. Real GDP is the value of nominal GDP adjusted for the effects of inflation. (1 mark)

In Q1 2009 GDP fell sharply by around 2.5%. (2 marks)

The figure suggests that in 2010 the output gap was around 3.5% of GDP. The output gap appeared to narrow on a trend basis between 2010 and Q3 2011 to around 2.5% of GDP. (2 marks)

• 
  increase in actual GDP growth over the period due to a recovery in the components of GDP
  
• 
  fall in potential GDP growth as estimates for the productive potential of the economy were revised down
  

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):



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 outward. This is shown by a movement from PPC₁ to PPC₂.

It should enable businesses to be able to have better access to loans if they need them. This should facilitate additional investment, thus increasing AD. In addition, investment will improve the productive capacity of the economy and therefore might boost LRAS.

Equally it will allow 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 economic growth.

Problems in financial systems not only disrupt this process of channelling savings to investors; they can also undermine the effectiveness of monetary policy, increase the size of economic downturns, and trigger ‘hot’ money leaving the country through capital flight and exchange rate pressures.

Marks will be awarded for other possible benefits (provided they are linked clearly to economic growth) such as:

Produce information about possible investments and allocate capital; monitor investments after providing finance; facilitate the trading, diversification and management of risk; ease the exchange of goods and services. (8 marks)

The impact of economic growth

10 Households (4 marks):

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.

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.

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.

In addition, 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 southeast. (6 marks)