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Exam-style questions

1 Nominal GDP is GDP measured in terms of money values, and so it is influenced by the price level or inflation in an economy. If inflation has increased by 10% by the end of the year, nominal GDP will have increased by the same amount but the amount of output produced by the economy may have remained unchanged. To overcome this calculation difficulty, GDP figures are “deflated” by the increase in the price level to remove the effects of inflation. ‘UK nominal GDP rose by 1.3% in 2010 Q2, reflecting a 1.2% increase in real output and a 0.1% rise in inflation’ – here, real GDP has actually risen by 1.2%, but nominal GDP has risen by 1.3% as it includes inflation, which increased by 0.1%.

2 A recession is when there are two consecutive quarters of falling real GDP. GDP is the total value of goods and services produced by the factors of production in an economy in a given time period. In the extract we are told that GDP fell by a total of 6.5% during the recession, suggesting at some point there were at least two consecutive quarters of negative GDP growth.

3 Outline:

Government spending is an injection into the circular flow of income. (2 marks)

Possible mechanisms include:

  • A direct boost to AD that the government brings as it purchases additional goods and services directly, for example by purchasing additional defence equipment such as aircraft and missiles.

  • An indirect boost to AD as the government employs additional workers (e.g. teachers), boosting their incomes and thereby their spending. This additional expenditure 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 in turn will boost their consumption.

Make reference to the multiplier effect as spending moves around the circular flow.

4 Outline:

  • Define real income (nominal income adjusted for inflation).

  • Define real income per head (per person or per capita).

  • Data reference from extract and explain that income per person fell when adjusted for inflation.

5 Outline:

Factors might include: (4 marks each)

  • Real post-tax income growth falling by ‘0.5% in the first quarter of 2008’.

  • Consumer confidence/expectations of financial situation.

  • Low savings ratio in the past suggesting stocks of wealth may be low so there is no positive wealth effect.

6 Circular flow of income diagram: (up to 4 marks)

Knowledge and analysis: (up to 4 + 4 marks)

  • Definition of investment: expenditure by firms on capital goods such as machinery.

  • Description of the effects of a fall in investment combined with suitable annotation on a diagram.

  • Reduction in injections, for example:

  • Reduced purchases of capital equipment.

  • Reduced output by firms that buy and install the new machinery.

  • Reduced incomes for firms producing the capital equipment, leading to reduced employment, leading to reduced income for households, leading to reduced spending.

Evaluation: (1 x 4 marks or 2 x 2 marks). Factors might include:

  • Depends on the level of leakages: savings, tax and imports.

  • 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 spare capacity there is in the economy.

  • Multiplier effects might depend on confidence of households.

Topic 3

Aggregate supply and macroeconomic equilibrium

Short-run aggregate supply


The SRAS is upward sloping because as prices rise firms find it more profitable to increase production and thus will be incentivised to do so. This is because, in the short run, wages and other input prices are assumed to be fixed. With fixed cost inputs and higher-priced outputs, companies can increase profit by increasing production. Thus, as the price level increases in the short run, real wages (and other real costs) fall, giving the SRAS an upward slope.

2 Knowledge and analysis: (8 marks)

AS analysis: initial equilibrium shown (P1, Y1); aggregate supply will decrease with increased costs of production, new equilibrium shown (P2, Y2) and explained.

Further explanation: firms use oil for many purposes and it has few substitutes so demand is likely to be price inelastic. Oil price increases will also add to transport costs, pushing up costs of production for all firms. This means the increase in AS may be substantial. In the long run, households are also likely to see an increase in key costs of living (petrol and other goods prices). This may lead to a wage–price spiral, pushing up SRAS even further.

Evaluation: (4 marks: 1 x 4 or 2 x 2 marks)

  • Magnitude of the shifts and importance of oil to the UK economy.

  • Context: have there been recent price increases or reductions.

  • How rapidly are oil price rises passed through to firms or consumers?

Long-run aggregate supply

3 Knowledge and analysis: (4 + 4 marks)

  • Analysis of the effects of increased training/expertise on the productivity of the UK labour force.

  • AD/AS diagram showing effects of LRAS shift to the right, increase in equilibrium output/ potential output growth.

6 marks for analysis of up to three factors. Factors might include:

  • Beneficial effects on economic growth — e.g. leading to increase in employment; increased income and corporation taxes.

  • Beneficial effects on lower inflation (from LRAS shift to the right).

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

Evaluation: (2 x 2 or 1 x 4 marks). Factors might include:

  • Time lag: training takes time to take full effect. Courses must be designed and implemented then workers must put their skills into practice.

  • Demand-side approaches may be more immediate in their effects.

  • Quality of training can be varied. Poor-quality training may result in a deadweight welfare loss.

The multiplier

4 Knowledge and analysis: (8 marks)

Identification of multiplier. (2 marks) Diagram showing rightward shift in AD and explanation. (4 marks) Analysis of multiplier (4 x 1 marks). Points might include:

  • 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 government spending, e.g. building of new railway lines, or employment of more teachers.


1 – MPC

he extent of the final increase can be shown with the multiplier formula as follows, though this is not required.

straight connector 2

Evaluation: (2 x 2 or 1 x 4 marks). Factors might include:

  • 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 (Keynesian vs Classical).

  • Other things might not be equal, e.g. interest rates or exchange rate might change.

Extension material

5 Outline:

Definition of the multiplier. (2 marks) Analysis of multiplier (2 x 1 marks) with an example.

Points might include:

  • Expenditure by one person becomes other people’s incomes and process continues until all extra income is leaked away.

  • Explanation of the effects of leakages (4 marks). Effects of taxation with example. (2 marks) Effects of imports with example. (2 marks)

Effects can be shown with the multiplier formula, although this is not required.

Macroeconomic equilibrium


The level of AD is shown by AD1 and the economy is in initial equilibrium at P1 Y1. This is where AD1 is equal to AS. However, as shown in the diagram, the level of full employment (or potential) output is denoted by the output level Y2. This is the point at which all resources are fully employed. The gap Y2 – Y1 shows the level of the negative output gap in this economy.


Also allow illustration of output gap on AD/AS diagram (4 marks).

The output gap is a measure of the difference between actual output and potential output.

A negative output gap occurs when actual output (measured by actual real GDP) is less than potential output. This is also called a deflationary gap. In this situation the economy is producing less than potential. A negative output gap will often be associated with low or falling inflation.

A positive output gap occurs when actual output is greater than potential output. It often involves firms asking workers to do overtime and/or capital working above normal utilisation rates. There will usually be inflationary pressures.

8 KAA: (8 marks)

Definition of ‘output gap’ and an explanation of a positive output gap and a negative output gap.

Marks will be gained by giving analysis and evaluation of either a positive output gap or a negative output gap, for example, for a widening negative output gap.

Diagram showing output gap increasing on either AD/AS diagram or diagram with actual and potential GDP.

Consequences in terms of output forgone (opportunity cost); increase in unemployment; fall in government revenue and increase in government spending on JSA etc.

Discussion of the possible benefits of a negative output gap (a fall in inflation, possible fall in current account deficit) will also gain marks.

Multiplier effects which may result in the negative or positive output gap growing beyond the initial effects (1 mark).

Evaluation: (4 marks). Factors might include:

  • Discussion of the size of the output gap – it is useful to illustrate this with an example, e.g. a small negative output gap is unlikely to be a problem since it implies only a small level of unemployment/ excess capacity.

  • It is unlikely that an economy can always be at trend growth rate at full capacity.

  • The difficulty of measuring the size of output gap – especially because potential output is very difficult to measure and potential growth rates are difficult to estimate.

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