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Exam-style questions

1 Outline:

  • UK target, i.e. 2% CPI inflation over the medium term. (2 marks) Explanation of ceiling and floor (+/– 1%) (1 mark)

  • Use of interest rates to achieve this. (1 mark)

  • If inflation goes too high then interest rates must rise. (1 mark)

  • If inflation goes too low then interest rates must fall. (1 mark)

Explanation of transmissions mechanism of AD shift. (up to 4 marks) Sole objective – i.e. independent and apolitical; use of a range of indicators, with examples. (2 marks each) Emphasis on keeping within target range over medium term.

Credit will also given for recognising the changes in emphasis of monetary policy after the financial crisis.

2 Knowledge (2 marks) and analysis: (6 marks)

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: (4 marks)

Effects might depend upon:

  • Productivity growth relative to that of competitor countries.

  • Need for increase in AD as well.

3 Outline:

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: 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.

4 KAA: (18 marks)

Expressing a clear understanding of monetary policy will gain 2 marks:

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 (4 marks).

Evaluation: (3 x 4 marks or 2 x 6 marks)

  • Problems of operating monetary policy when interest rates are at historic lows.

  • Challenges of QE and possibility of long-run effect on inflation.

  • Lagged effect of changing interest rates.

  • Difficulty in achieving accurate information.

  • MPC’s continued record of overshooting its target.

  • Importance of achieving economic growth as well as price stability.

  • Banks may not adjust interest rates or respond to QE by increasing lending.

Topic 7

Conflicts between macroeconomic objectives and instruments

Conflicts between macroeconomic objectives

1 Outline:

Definition of employment.

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

Possible reasons might include:

  • Increase in participation rate when employment increases.

  • Increase in size of working population (e.g. women entering the labour force).

  • Increase in immigration in response to a growing economy.

2 KAA: (18 marks)

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

AD/AS diagram (4 marks) or other relevant diagrams.

Analysis of possible conflicts, for example:

  • 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.

  • 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.

  • High inflation may create unemployment. Developed analysis on the loss of competitiveness and decline in economic growth.

Evaluation: (3 x 4 marks)

  • Certain objectives may be complementary, e.g. high growth and a positive balance of payments if that growth is export led (e.g. China).

  • High growth and low inflation is possible, if led by productivity improvements and the supply side.

  • 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.

3 KAA: (8 marks)

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

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 2 marks and explanation 2 marks)

  • Increase in taxation (T).

  • Decrease in government spending (G).

Give an AD/AS diagram to illustrate the above, showing changes in price and output. (2 marks)

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: (1 x 4 or 2 x 2 marks)

  • Understanding that other things are not equal, e.g. the monetary position; world prices.

  • What is happening on the supply side?

  • Reference back to uncertainties in the data.

  • Time lags.

  • The relative inflexibility of fiscal policy.

  • Impact on government revenue and spending.

  • Monetary policy or supply-side policies.

  • Whether government spending (G) or taxation (T) is more effective.

4 Knowledge (2 marks) and analysis: (6 marks)

Explanation of expansionary monetary policy (cut in interest rates; increase in QE). Distribution of income improves (with justification): identification of winners and losers from cut in interest rates, e.g. savers, borrowers, mortgage holders, pensioners.

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.

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

Points might include:

  • Higher-income groups are not necessarily higher savers.

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

  • Time implications for impact of interest rate changes.

  • Effects on income might take longer than wealth effects (stock markets or house prices might respond faster than incomes, especially for those on state benefits).

Conflicts in the use of macroeconomic policy instruments

5 Outline:

Supply-side policies are policies designed to improve the quality or quantity of factors of production and thus boost sustainable economic growth by shifting LRAS to the right. Successful supply-side policies should help achieve several economic objectives at the same time. For example, a successful reform of higher education creating high-quality graduates will cut unemployment, increase tax revenues and possibly help promote additional exports by increasing the competitiveness of UK exports.

6 Knowledge (2 marks) and analysis: (6 marks)

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

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

Identification and explanation of transmission mechanisms, for example:

  • 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.

  • Use an AD/AS diagram to illustrate the above, showing changes in price and output. (4 marks)

Provide a written explanation of effects on the budget deficit:

Definition of budget deficit: difference between G and T. Cuts in T should lead to a fall in government tax revenue and hence an increase in the deficit or a fall in the surplus.

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

  • Increase in employment may result in increased overall tax revenues despite the fall in tax rates.

  • Laffer curve analysis.

  • Increase in output may result in increase in income from other taxes such as VAT or corporation tax.

  • Cuts in income tax may result in increased incentives to work, so an increase in overall tax revenue.

  • Time lags.

Exam-style questions

1 Outline:

  • Definition of economic growth.

  • The distinction between actual economic growth and potential economic growth.

  • Explanation of how an increase in actual economic growth is driven by an increase in AD.

  • An AD/AS diagram, illustrating an increase in AD when the economy is operating close to full employment level, causing demand-pull inflation.

2 Outline:

Definition of balance of payments current account. Explanation of deficit (M > X).

Explanation of two possible causes, for example:

  • Real wage costs rising/productivity falling in Brazil; relatively high value of the Brazilian real/low relative value of other currencies. Maybe caused by high interest rates in Brazil attracting hot money flows.

  • High relative inflation rates in Brazil versus competitor countries.

  • Strong domestic demand: ‘…a consumption boom which has seen a rise in the demand for luxury goods and specialist products which are not made by local manufacturers’.

  • A slowdown in other countries reducing demand for Brazilian exports.

3 Knowledge (2 marks) and analysis: (6 marks)

Definition of balance of payments current account: an account recording all the international transactions related to goods and services. It is composed of four parts: trade in goods, trade in services, net investment income (IPD) and current transfers.

Explanation that Brazil has a current account deficit (M > X).

Analysis of possible causes for concern, for example:

  • Brazil may be losing international competitiveness. High inflation and declining competitiveness may suggest that Brazilian companies can no longer compete in international markets.

  • Large or increasing current account deficits may not be sustainable. In particular, current account deficit must be financed by flows from other countries.

  • The extract suggests that FDI and other inflows may become more difficult to attract in future, e.g. due to economic weakness in Brazil or slower global economic growth.

Evaluation: (4 marks)

  • Magnitude of current account deficit is still relatively small as a percentage of GDP and Brazil has continued to finance it.

  • Foreign investors seem happy to finance the deficit through capital inflows (FDI inflows remain high).

  • Current account may reflect Brazilian firms importing products which are not made in Brazil.

  • Current account deficit means living standards for Brazilians are higher than they would have been otherwise.

Edexcel AS Economics Unit 2 Managing the Economy

© Andrew Sykes Philip Allan, an imprint of Hodder Education

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