Workbook answers

Exam-style questions (multiple choice)

Exam-style questions (data response)

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. (4 marks)

Reasons might include: (up to 2 marks each)

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  unreliable data/revisions to past data which are collected from many sources
  
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  recovery in GDP growth unpredictable or other unexpected development
  
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  miscalculation
  

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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 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.
  
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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 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.
  

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  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.
  
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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 objectives and policies

The main macroeconomic objectives

1 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)

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  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).
  
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  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.
  
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  Identification of groups of beneficiaries from an increase in inflation, e.g. borrowers, mortgage holders (as inflation reduces the real value of the debt).
  
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  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).
  
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  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.
  

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  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.
  
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  Higher-income groups might arguably have larger mortgage interest payments as a proportion of their income.
  
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  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.
  

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)

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)

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 whereas rising import prices will reduce demand for imports. 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.

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)

Demand-side policies

7 A government has a budget deficit when, in a given year, total government expenditure exceeds total revenue (from taxes and other charges). (1 mark)

8 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. (1 mark)

9 The government was running 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 £623 billion; total revenue was £545 billion, leaving a deficit of £78 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. (£157 bn in 2008–9).

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 £83 bn in 2008–9.) (2 marks)

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 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. (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)

Extension material: Ricardian equivalence

Definition of fiscal policy: policies conducted by government concerning government spending and taxation. (2 marks)

Use of fiscal policy: identification (1 mark) and explanation (1 mark) 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. (4 marks)

Marks will also be given for an explanation of the multiplier process. (2 marks)

Any two evaluation points (1 x 4 marks or 2 x 2 marks each): Remember evaluation must be linked closely to the question/extract to score the highest marks:

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  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.
  
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  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.
  
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  Possibility that the economy might already be operating at full capacity — hence the effect will be on the price level and not real output.
  
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  Relax ceteris paribus assumption, e.g. the monetary position; world prices; changes in LRAS.
  
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  The possibility of government failure: spending on wasteful projects that may not boost AD or spending on benefits that might reduce incentives to work.
  

Definition of fiscal policy: government spending and taxation. (2 marks)

Definition of unemployment (2 marks).

Expansionary fiscal policy: identification and explanation of fall in taxes and increase in government spending including transmission mechanisms. (Identification 1 mark + explanation 3 marks)

Provide an AD/AS diagram to illustrate the above point above, showing changes in price and output, and connection to reduced unemployment fully explained (firms employ additional workers to produce the extra output produced). (4 marks)

An explanation of the multiplier process. (2 marks)

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  Discussion of whether government spending (G) or taxation (T) is more effective.
  
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  What is happening on the supply side/how might the policies affect incentives to work?
  
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  Time lags.
  
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  The relative inflexibility of fiscal policy.
  
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  Crowding out issues, especially with an increase in G.
  

Supply-side policies

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.

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 to 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 (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.

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.

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.

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.

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 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. The scope for further privatisation in the UK is limited as most state-owned firms have been sold off.

Conflicts between macroeconomic objectives

16 Definition of employment.

Definition of unemployment plus one measure (labour force survey or claimant count).

Possible reasons might include:

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  increase in participation rate when employment increases
  
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  increase in size of working population (e.g. women entering the labour force)
  
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  increase in immigration in response to growing economy (4 marks)
  

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  Distribution of income improves (if justified): identification of winners and losers affected by cut in interest rates, e.g. borrowers, mortgage holders, pensioners.
  
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  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.
  

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  higher-income groups are not necessarily higher savers
  
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  higher-income groups might have larger mortgage interest payments as a proportion of their income
  
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  time implications for impact of interest rate changes
  
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  effects on income might take longer than wealth effects or other wealth issues
  
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  other time issues
  

Conflicts in the use of macroeconomic policy instruments

Use of fiscal policy: identification and explanation of expansionary fiscal policy through tax cuts.

Identification and explanation of transmission mechanisms, for example:

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  Decrease in taxation (T), leading to 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.
  
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  Use an AD/AS diagram to illustrate the above, showing changes in price and output. (2 marks)
  

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  Increase in employment may result in increased overall tax revenues despite the fall in tax rates.
  
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  Increase in output may result in increase in income from other taxes such as VAT or corporation tax.
  
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  Cuts in income tax may result in increased incentives to work, so an increase in overall tax revenue.
  
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  Time lags.