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Exam-style questions

1 The output gap is the difference between actual and potential output. Output is measured by real GDP, which measures the total output produced by the factors of production in an economy in a year. The extract suggests that GDP in Spain fell in 2012 and is likely to continue to fall (‘by a further 1–1.5%’) in 2013. Given that Spanish potential output growth was estimated at 3% a year, this suggests that the gap between potential output and actual output has continued to rise, and that the Spanish output gap is negative and has continued to widen. The analysis is further confirmed by the continued rise in Spanish unemployment, implying a very large number of unemployed resources and indicating that Spain is operating well within its PPF.

Marks will be awarded for a diagram showing a widening in the output gap.

2 Unemployment in Spain has risen to ‘a record of nearly 25%’. (2 marks application) This has coincided with a fall in GDP, while potential output growth is estimated to have been rising by 3% a year. This suggests that one possible cause of unemployment might be demand deficient, or cyclical unemployment. Demand deficient unemployment can be shown by an economy where the level of AD is below that required to maintain the economy at the point of full-employment equilibrium.

Marks will be awarded for a diagram that illustrates this.

In addition, unemployment amongst 16–24-year-olds in Spain has risen to ‘over 55%’. (2 marks application). This could also reflect classical or real wage unemployment if the unemployed young workers are unwilling to work for lower real wages or if Spanish nominal wages are being kept artificially high by minimum wage legislation or by powerful restrictive practices maintained by trade unions or labour laws.

Marks will be awarded for the use of a labour market diagram to illustrate this.

Other explanations could attract marks, for instance structural unemployment (if properly developed) and regional unemployment.

3 Knowledge and analysis: (8 marks). Measures that might be analysed include:

  • 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.

  • Expansionary fiscal policy: cutting personal income taxes to increase household consumption or corporation tax to increase investment, shifting AD to the right, thereby increasing equilibrium income and reducing unemployment.

  • Regional policy incentives: giving grants and subsidies to firms to locate themselves in areas of high unemployment.

Evaluation: (4 marks). Factors might include:

  • Likely to require an increase in government spending, which is difficult for Spain given the size of its current deficit and debt.

  • Possibility of government failure.

  • The problems of specific initiatives, e.g. a regional policy does not solve the problem of occupational immobility. Extra retraining schemes are often needed to give workers the relevant skills to allow them to take up new jobs.

4 Costs might include:

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 have been spent on hospitals or schools.

Marks will be given for the use of a diagram showing an economy operating within the PPF.

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.

Workers’ skills might deteriorate. This might cause a longer-term problem of hysteresis for the economy. This is where the deterioration of workers’ skills leads to those workers becoming less employable by firms. As a result the non-accelerating level of unemployment might rise. When the economy recovers, unemployment could remain permanently high. (4 marks for each set of costs explained)

Topic 5

Economic growth

Potential economic growth and output gaps

1 KAA: (8 marks)

Definition of potential output growth: increase in the productive potential of an economy. (2 marks)

Diagram showing effects of LRAS shifting to the right or outward movement in PPF, increase in potential/trend output growth rate. (2 marks)

Analysis of the effects of three factors: 6 marks (3 x 2 marks). Factors might include:

  • Increase in productivity of the labour force (e.g. due to increased investment in human capital through worker training).

  • Increase in productivity of capital (e.g. due to investment in new technology).

  • Increase in labour force growth rate (e.g. due to increase in birth rate or migration flows).

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

  • Time lag involved in factors affecting potential output growth (e.g. increase in training spending will not immediately feed through to productivity).

  • Increase in investment spending will not always boost productivity, especially if spent on wasteful projects.

  • Side effects of policies (e.g. social tensions or increased demands on government spending as a result of increased migration).

  • Difficulty in measuring potential output (only actual GDP is measured. Potential output must be estimated and this is full of difficulties).

2 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.

In Q1 2009 GDP fell sharply by just over 2%. Growth continued to fall in Q2 and Q3 2009 but at a slower rate. In Q4 2009 the economy grew by around 0.5%.

3 The output gap is the difference between actual GDP and potential GDP. (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 Q1 2012 to around 2.5% of GDP. However, it did widen again slightly in the middle of the time period. (2 marks)

4 Definition of the output gap as the difference between actual and potential GDP. Actual output remained well below potential output in the period, though the gap narrowed. Possible reasons:

  • 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.

  • We cannot tell which from the data as we are only given the figures for the size of the output gap.

5 Explanation of GDP growth (increase in real output produced by factors of production of an economy in any given time period). (2 marks)

Reasons might include (2 marks each): unreliable data; miscalculation; unexpected or exogenous events (shocks), e.g. the financial crisis; slowdown; unpredictable or other unexpected development; deliberately over-optimistic forecasts (for political reasons in some countries).

Causes of, and constraints on, economic growth

6 AD/AS diagram: (4 marks)

Explanation: (4 marks)

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: (4 marks)

Explanation: (4 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.

7 The financial system consists of a country’s banks, equity markets (markets for stocks and shares) and debt markets (markets in bonds). A more developed financial system should enhance economic growth in a number of respects:

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.

Benefits and costs of economic growth

8 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 activities.

Firms (4 marks)

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.

Government (4 marks)

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.

9 Economic growth will result in more firms in existence and more goods being transported around the country. This is likely to be accompanied by an increase in negative externalities such as noise and air pollution and congestion. Parts of the UK are already highly congested and this will magnify the problems.

In addition, if economic growth exceeds potential output growth for a prolonged period, it is likely to lead to an increase in inflation. 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. (knowledge 4 marks, analysis 4 marks)

Marks will be awarded for analysis of other negative effects of increased inflation.

Policies to create economic growth

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