Workbook answers

Exam-style questions (data response)

In addition, the extract notes ‘the power of trade unions in keeping real wages high’. This could also reflect classical or real wage unemployment if the unemployed young workers were unwilling to work for lower real wages or if UK nominal wages were being kept artificially high by minimum wage legislation or by powerful restrictive practices maintained by trade unions or labour laws. (Reward use of a labour market diagram to illustrate this.)

Also reward other explanations which might include: structural unemployment (if properly developed); regional unemployment.

3 Measures that might have been employed include:

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  Investment in worker training: spending on training schemes to re-skill the unemployed through investment in vocational education or guaranteed work experience for unemployed ‘outsiders’ in the labour market.
  
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  Expansionary fiscal policy: cutting personal income taxes to increase household consumption or corporation tax to increase investment, thereby shifting AD to the right, thereby increasing equilibrium income, thereby reducing unemployment.
  
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  Regional policy incentives: give grants and subsidies to firms to locate in areas of high unemployment.
  

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  Likely to require increase in government spending, which would have been difficult for the UK given size of current deficit and debt — ‘the budget deficit having soared due to the fall in tax receipts and increase in benefits payments, there is little scope to use reflationary fiscal policy’.
  
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  Possibility of government failure.
  
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  Problems of specific initiatives, e.g. regional policy does not solve the problem of occupational immobility. Often needs extra retraining schemes to give workers the relevant skills to allow them to take up new jobs.
  

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  Opportunity cost. Unemployment represents an opportunity cost because there is a loss of output that workers could have produced had they been employed. The government may also need to spend more on unemployment benefit. The money going on unemployment benefit could be spent on hospitals or schools. (Reward use of a PPF showing an economy operating within the PPF.)
  
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  Waste of resources. Resources not employed are left idle, and this is a waste to an economy — education and training costs are wasted when individuals who have received these benefits do not work.
  
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  Workers’ skills might deteriorate. This might cause a longer-term problem for the economy of hysteresis. This is where the deterioration of workers’ skills leads to those workers becoming less employable by firms. As a result the NRU might rise. When the economy recovers, unemployment might stay permanently higher.
  

Definition of productivity: more output from the same inputs; output per person per hour. Credit for reference to increased efficiency (1 mark), but not for increased production per se. (0 marks)

Effects of increase might include:

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  that this is likely to lead to economic growth or improved living standards (or equivalent answer)
  
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  costs of production fall/efficiency increases so more profit
  
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  removes inflationary pressure
  
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  encourages inward investment
  
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  effect on the current account
  
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  shift out in the PPF/increase in productive potential
  
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  effect on employment levels
  

Extent might depend on:

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  productivity growth relative to that of competitor countries
  
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  need for increase in AD as well — supported by other measures
  

Bank rate is the interest rate set by the Bank of England when it lends to commercial banks.

Quantitative easing is purchases of government bonds by the central bank with the purpose of reducing long-term interest rates and expanding the money supply.

Application:

Bank rate was cut to 0.5%.

A total of £375 billion QE injected since 2009.

7 Outline:

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  Concept of target, i.e. 2% over the medium term (+/– 1%). (2 marks)
  
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  Explanation of ceiling and floor (must have both). (1 mark)
  
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  Use of interest rates to achieve this: (1 mark)
  
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    If inflation goes too high then interest rates must rise. (1 mark)
    
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    If inflation goes too low then interest rates must fall. (1 mark)
    
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    If explanation of transmissions mechanism of AD shift is given then award up to 2 marks.
    
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  Look at a range of indicators. (2 marks)
  
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  Emphasis on keeping within target range over medium term.
  
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  Sole objective, i.e. independent and apolitical.
  

Concept of inflation target, i.e. 2% (+/–1%), and the role of monetary policy in achieving it.

Reasons why low inflation might promote economic growth: it will increase business confidence and encourage investment; increase consumer confidence and household spending; promote international competitiveness.

Reasons why low inflation might cause a trade-off in the short run: low inflation might be due to a shift in AD to the left and hence a short-run fall in economic growth.

Analysis of other factors necessary for economic growth: e.g. increase in AS through supply-side policies; increase in productivity.

Evaluation (6 marks):

Effects might depend on:

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  Productivity growth relative to that of competitor countries.
  
• 
  Need for increase in AD as well.
  

Definition of quantitative easing: central bank purchases of government bonds in order to drive down bond yields/interest rates and increase the amount of cash circulating in the economy.

Explanation of current problems with ‘conventional’ monetary policy: e.g. interest rates at historic low and little scope for further falls in interest rates; banking system not working effectively following the financial crisis, so not supplying firms with enough new loans.

Explanation of how QE might boost economic growth and keep inflation within the Bank of England target range in the medium term: wealth effect of increased bond prices; increased spending of free cash balances; increased bank lending.

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  state of 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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  exogenous shocks such as Eurozone crisis
  
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  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 (for explanation mark there must be reference to expected rates or pattern of inflation)
  
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  house price changes
  

1 mark each for explanation of why MPC considers the data/link of point to price level/inflation.

1 mark each for application to the extract.

11 Knowledge, application and analysis (14 marks):

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  Demonstrates precise knowledge and understanding of the concepts, principles and models.
  
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  Ability to link knowledge and understanding in context using appropriate examples. Analysis is relevant and focused with evidence fully and reliably integrated.
  
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  Economic ideas are carefully selected and applied appropriately to economic issues and problems. The answer demonstrates logical and coherent chains of reasoning.
  

Reference to low and stable prices and reference to inflation target in the UK. (2 marks) Use of interest rates: 2 explanations and transmission mechanism (2 x 4 marks) on links to components of AD and hence to price level/inflation.

A written or diagrammatic application to AD/AS will be awarded 2 marks.

An analysis of one other policy that may be suitable for achieving price stability.

Credit will be given for fiscal or supply-side policy but this must be linked to price stability.

Evaluation (3 x 2 or 2 x 3 marks):

To score 5–6 evaluation marks, evaluation must include a developed chain of reasoning which is linked directly to the core parts of the question:

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  Evaluative comments supported by relevant reasoning and appropriate reference to context.
  
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  Evaluation is balanced and considers the broad elements of the question, leading to a substantiated judgement.
  

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  Problems of operating monetary policy when interest rates are at historic lows.
  
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  Challenges of QE and possibility of long-run effect on inflation.
  
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  Lagged effect of changing interest rates.
  
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  Difficulty in achieving accurate information.
  
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  MPC’s continued record of overshooting its target.
  
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  Importance of achieving economic growth as well as price stability.
  
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  Banks may not adjust interest rates or respond to QE by increasing lending.
  

Definition of four macroeconomic objectives (low inflation plus three other objectives).

Analysis of possible conflicts, for example:

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  High inflation and economic growth: high inflation leads to a loss of consumer confidence and increased search costs, therefore a decline in consumption. Equally, high inflation leads to a deterioration in business confidence and increased menu costs, therefore a decline in investment. This may lead to a decrease in AD and possibly also LRAS.
  
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  High inflation and current account stability: high inflation leads to an increase in export prices and a loss of international competitiveness and therefore a deterioration in the current account balance.
  
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  High inflation may create unemployment. Developed analysis on the loss of competitiveness and decline in economic growth.
  

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  Evaluative comments supported by relevant reasoning and appropriate reference to context.
  
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  Evaluation is balanced and considers the broad elements of the question, leading to a substantiated judgement.
  

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  Certain objectives may be complementary, e.g. high growth and a positive balance of payments if that growth is export led (e.g. China).
  
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  High growth and low inflation is possible, if led by productivity improvements and the supply side.
  
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  Phillips curve analysis suggests that high inflation may (at least in the short run) lead to lower unemployment. Support this by AD/AS analysis or a Phillips curve.
  

Definition of fiscal policy: government spending and taxation. (1 mark)

Use of fiscal policy: identification and explanation of tighter or contractionary fiscal policy: increase in taxes and/or cuts in government spending.

Transmission mechanisms (identification 1 mark and explanation 1 mark)

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  increase in taxation (T)
  
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  decrease in government spending (G)
  

Give a written explanation of the effects on the balance of payments, see below.

Income falls so M is likely to fall too. Also, the price level falls so competitiveness improves and as a result X may increase. Therefore the balance of payments current account improves.

Evaluation (3 x 2 or 2 x 3 marks):

To score 5–6 evaluation marks, evaluation must include a developed chain of reasoning which is linked directly to the core parts of the question:

• 
  Evaluative comments supported by relevant reasoning and appropriate reference to context.
  
• 
  Evaluation is balanced and considers the broad elements of the question, leading to a substantiated judgement.
  

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  Understanding that other things are not equal, e.g. the monetary position; world prices.
  
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  What is happening on the supply side?
  
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  Reference back to uncertainties in the data.
  
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  Time lags.
  
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  The relative inflexibility of fiscal policy.
  
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  Impact on government revenue and spending.
  
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  Monetary policy or supply-side policies.
  
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  Whether government spending (G) or taxation (T) is more effective.