Edexcel AS/A-level Economics A
Theme 2 The UK economy: performance and policies
This Answers document provides suggestions for some of the possible answers that might be given for the questions asked in the workbook. They are not exhaustive and other answers may be acceptable, but they are intended as a guide to give teachers and students feedback.
Measures of economic performance
1 D. Explanation: A, B and C are already included in per capita GDP; D (the quantity or quality of education provision) tends to increase wellbeing. (1 mark)
2 Nominal GDP is the total output of goods and services produced by an economy in a given time period, not adjusted for inflation. (1 mark) Real GDP is nominal GDP adjusted for inflation. (1 mark)
3 Per capita GDP is the total output of goods and services produced by an economy in a given time period divided by that country’s population. (1 mark)
4 GNP = GDP + net property income from abroad. Net income from abroad includes dividends, interest and profit flows from abroad, i.e. GNP includes the value of all goods and services produced by nationals of a country whether in that country or abroad. (2 marks)
5 Deflation is a situation of a continually falling price level, or negative inflation. (1 mark)
6 Deflation is a situation of a continually falling price level, or negative inflation. Disinflation is a situation where the rate of inflation is falling (e.g. from 5% to 3%). (2 marks)
Employment and unemployment
7 Unemployment is when people are out of work and are actively seeking employment. (1 mark)
8 Unemployment is when people are out of work and are actively seeking employment. The claimant count measures unemployment through the number of people claiming job seeker’s allowance. The ILO is a survey. It seeks to measure unemployment by counting the people who have been out of work and have been looking for work for at least 4 weeks and are ready to start work in the next 2 weeks. (2 marks)
Exam-style questions (multiple choice and short answer)
1 The four components of the current account are: trade in goods (exports minus imports of goods into and out of the UK); trade in services (exports minus imports of services into and out of the UK); net income flows from abroad (income from investments); and transfer payments, e.g. UK contribution to EU and aid. (2 marks)
2 Knowledge (1 mark): definition of current account/current account deficit.
Application (2 marks): –£15,506. Calculation:
3 D. (1 mark) Explanation: a decrease in exports will reduce receipts to the UK hence the current account deficit will deteriorate. NB Explanation is not required for mark.
4 The CPI is an index covering a basket of around 650 goods that are weighted according to a typical household’s total expenditure on each item. It gives a measure of the average price level. Comparing it to the CPI in the previous year gives a measure of inflation. (1 mark)
5 Both the CPI and RPI measure the price level, but have different items in the index, e.g. RPI includes mortgage interest costs whereas the CPI does not. Also, the CPI is a geometric mean whereas the RPI is calculated using an arithmetic mean. (2 marks)
6 Knowledge (2 marks): the RPI and CPI are both indices which measure the price level in a country and are used to calculate inflation. The RPI includes mortgage interest costs whereas the CPI does not.
Application (2 marks): The RPI decreased by 1.1% whereas the CPI increased by 2.3%.
7 Application (2 marks): 2.85%. Calculation: 100 x ((123 – 119.6)/119.6) = 2.85%
8 Inflation is the sustained increase in the average cost of living. Inflation occurs when the price level increases. Inflation is measured by the consumer price index. This is an index covering a basket of around 650 goods that are weighted according to a typical household’s expenditure patterns. The CPI is then compared to the previous year at the same time and any increase in prices will highlight how much the price level and hence the cost of living (inflation) has gone up. (4 marks)
Exam-style questions (data response)
9 GDP per capita is a measure of the total output of goods and services in the economy, divided by the population number. In the UK, GDP per head was still ‘8% lower’ than it was before the recession ‘at around $38,000 (US$ PPP)’.
One advantage of using GDP per capita is that it is easy to calculate from official government figures. The methodology for calculating GDP is well understood and it does not require a separate calculation. Governments across the world have agreed on standardised methodologies for calculating GDP and agreeing what activities to include. This also means it is a good comparison between countries.
Second, it is a good indicator of the state of the economy of a country. Higher GDP equates with higher economic wellbeing since it suggests that, on average, households can purchase more goods and services. Economists usually associate greater consumption with greater economic welfare. People with higher incomes can also contribute more to government revenues through tax payments. This can allow for more merit goods such as education and healthcare. By measuring on a per capita basis it also adjusts increases in GDP for increases in output which reflect increases in the population.
However, GDP does not measure the ‘hidden economy’. This occurs when the output of some goods and services are deliberately not declared in order to avoid tax or because the activities are illegal. Therefore, the total production of goods and services in the economy (and economic welfare) may be higher than measured through the GDP numbers alone.
Second, GDP per capita does not tell us anything about the distribution of income within a country. The bulk of income could be earned by an elite of wealthy individuals. Hence GDP per capita may give a false impression of the economy as really the majority of people may not have such a high income. The extract suggests that ‘a large share of the workforce has had no significant increase in real wages’ while the richest deciles ‘have seen a substantial increase in income’. (10 marks)
10 National ‘wellbeing’ is not a precise term, but aims to provide a more comprehensive measurement of how well an economy is performing in satisfying the needs of its residents by including wider measurements of economic and social progress. Economic measures such as GDP and unemployment are supplemented by measures of healthcare, education, personal finance, transport and housing, as well as surveys of satisfaction and happiness.
In the extract, the IFS suggests that education spending will fall by around 3½% a year in real terms for 5 years. Given the rise in the UK population, this might mean a substantial fall in per capita spending on students. This might mean that the UK will have a less well-educated/qualified workforce, which will have a direct negative impact on UK measures of national wellbeing since literacy and education standards are part of wellbeing measures. In addition, a less well-educated workforce will be less productive or less able to work in highly technical parts of the economy. This will cause the LRAS curve to shift inwards, leading to a negative impact on GDP (students could include diagram to illustrate this). This in turn will cause measured wellbeing to fall.
A cut in spending on welfare such as job seeker’s allowance and housing benefit will mean that the average incomes for those who receive benefits will fall. This will reduce the average incomes received by households in the UK and have a direct negative impact on measures of national wellbeing. It might also reduce mobility of labour, particularly for the frictionally unemployed. This could raise the equilibrium unemployment rate, leading to a further fall in national wellbeing.
However, the likelihood of all of these changes having such a dramatic effect on the UK is unlikely. First, even though the extract suggests there has been a real-terms freeze in education spending, nominal spending has at least kept up with increases in the price level. Key elements of the educational system are likely to be maintained hence measured indices of development (such as the HDI) and other measures of ‘wellbeing’ are likely to be maintained.
Second, a cut in government spending is unlikely to be part of a long-term policy in most countries. The main motivation for these cuts is governments’ austerity programmes, as governments need to cut their budget deficit and reduce the growth of debt. However, in the long term, as the economy recovers, these policies may be moderated.
Further, the extract suggests that in the UK healthcare and education have both been protected from the full effects of government austerity programmes. As a result, the effects on national wellbeing will not be as large as in many other countries. (15 marks)
1 a Total planned household expenditure on goods and services. One of the main components of aggregate demand in the UK. (1 mark)
b Expenditure by firms on capital goods such as machinery or equipment, used to manufacture other goods. (1 mark)
c The value of exports minus the value of imports. OR The value of goods and services sold in exchange for foreign currency minus the value of goods and services bought with foreign currency. (1 mark)
2 Marginal propensity to consume (MPC) is the increase in personal consumer spending (consumption) resulting from an increase in income. (1 mark)
Change in consumption/change in income. (1 mark)
3 Average propensity to consume (APC) is the percentage of income spent (C/Y). (1 mark)
4 The rate of interest is the cost of borrowing money. (1 mark) A change in interest rates will have a direct influence on consumption. For example, a fall in interest rates will encourage people to borrow as it means the interest payments on loans or mortgages will fall. Hence, one would expect that the level of borrowing in the economy will increase. Hence consumption will also increase as a result of more money being available to consumers. In addition, the opportunity cost of saving will fall as consumers get a lower return on any savings held in banks. Therefore savings will fall and consumption will rise. A rise in interest rates will have the opposite effect on consumption. (2+ marks)
Wealth is a stock and measures the value of a household’s assets minus its liabilities. (1 mark) A change in wealth will also affect consumption. If the value of household wealth increases then consumers will tend to feel more confident. In addition their ability to finance consumption through extracting wealth from their house by borrowing (mortgage equity withdrawal) will increase. So an increase in wealth will lead to an increase in consumption. (2 marks)
5 Investment is the purchase by firms of capital goods. (1 mark)
6 17.6%. Calculation: 100 x ((34,000 – 28,000)/34,000)) (2 marks)
7 Lower interest rates make it easier to access finance because of lower monthly/yearly repayments. This leads to more borrowing by firms.
In addition, lower interest rates mean that firms expect that more investment projects (marginal projects with a lower expected return) are now profitable. Following MEC theory, this implies profit maximising firms will undertake more investment leading to ceteris paribus an increase in investment. (6 marks)
Government expenditure (G)
8 When an economy is in a recession, national income/output falls. This suggests that employment will fall. This will lead to a fall in income tax receipts as fewer people will be in employment. In addition, spending will tend to fall. So indirect tax receipts (e.g. VAT) will also fall. So taxes will fall. (2+ marks)
In addition, a fall in employment will probably be followed by a rise in unemployment. Hence government spending on job seeker’s allowance will rise. (2 marks)
These effects are known as automatic stabilisers.