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Tor Hirst 27.01.2012 Multiple Choice Week Two 1. 2. 3. 4. 5. C D B C C 6. B 7. D 8. B 9. B 10. C 11. B 12. C 13. A 14. C 15. A Budget Boost for the economy (a) (i) Fiscal policy involves using the government’s budget to change the level of aggregate demand within the economy. the government’s budget details the government’s tax and spending plans for the year ahead. On the other hand, monetary policy is administered by an independent Bank of England and involves changing the rate of interest and/or money supply in order to change the level of aggregate demand in the economy. (ii) When incomes rise, consumers are likely to have more disposable income to spend on goods and services, therefore more goods and services will be consumed. The consumption of goods and services creates tax revenue from value added tax (VAT), added to each good and services. This means that if people are consuming more goods, more VAT is being paid to the government. (b) (i) Economic growth occurs when the productive capacity of the economy increases over time. Economic growth rate, expressed as a percentage, is measured by economists by calculating the annual percentage change in real Gross Domestic Product (GDP). GDP measures the total value of all goods and services produced inside a country in a one year period. Real GDP is equal to nominal GDP adjusted to take into account the effects of inflation. (ii) Inflation is the annual percentage increase in the average price level. Inflation is a cost because it reduces the internal value of money by increasing the cost of living, thus decreasing the standard of living. Inflation occurs when aggregate demand exceeds aggregate supply, therefore firms raise their prices and consumers are forced to pay more for goods and services. Keynesians believe that economic growth causes an increase in aggregate demand, which is the cause for inflation. (c) (i) The components of aggregate demand are private sector consumption (C), private sector investment (I), government expenditure (G) and net expenditure on exports (X-M). AD = C + I + G + (X-M) (ii) If the rate of interest increases, private sector investment will decrease. The rate of interest is the price of money. The interest rate influences investment because many firms have to borrow the money needed to pay for expensive new machines by borrowing from the bank. If interest rates rise, it will cost the firm more to borrow the money needed to buy the machine. If Tor Hirst 27.01.2012 borrowing costs rise, the profitability of investing will fall. If the profitability of investing falls, investment levels will fall too. Private sector consumption occurs when households buy goods and services that yield utility immediately, and is determined by income. According to Keynesians, income can either be spent or saved. The average propensity to consume (APC) is equal to the proportion of income that is consumed, whilst the average propensity to save (APS) is the proportion of income that is saved. An increase in interest rates will cause a rise in the APS, as people earn a larger return on their money as it is being saved. If more people are saving, the APC decreases, and private sector consumption falls. Furthermore, the price of borrowing money increases with a rise in interest rates, therefore private sector consumption falls. (d) Government spending is a component of aggregate demand. Increased government spending causes an increase in aggregate demand as people will have more disposable income to spend on goods and services, for example more people will receive Job Seekers Allowance. This increase in AD would be shown on the demand and supply diagram as a shift of the AD curve to the right from AD1 to AD2. Keynesians believe that if firms have spare capacity, they will respond to an increase in demand by producing more rather than by raising prices. Therefore, a shift of the demand curve from AD1 to AD2 will cause an increase in real GDP, showing a rise in output, but average price level will remain the same at AP1. However, average price level will only remain constant up to a certain point. If government spending continues and aggregate demand rises further, there will be a greater shift of the demand curve to AD3. At this point on the diagram, firms are operating at maximum capacity, and have no spare factors of production. An increase from here would move the AD curve to AD4, as Keynesians believe firms with no spare factors of production will respond to the increase in demand by raising the average price level from AP1 to AP2. Once the economy has reached full capacity, output levels will cease to rise and the average price level will continue to rise in response to increasing aggregate demand. Tor Hirst 27.01.2012 (e) The budget information provided shows between 1999 and 2001 it was predicted that there would be changes in the budget, which had the potential to either improve or worsen the UK economy’s economic performance. Consumer spending, government spending, investment and current account are all components of aggregate demand. Whilst the current account deficit is forecast to increase, the rates of the other components are predicted to slow. This means that aggregate demand will increase at a slower rate in 2001 than in 1999. A slow in the rate of rise in aggregate demand could cause poor economic performance in 2001, with less demand leading to less need for factors of production such as labour. If less labour is needed, there are less employment opportunities; therefore the unemployment rate could increase. Unemployment is a sign of poor economic performance. This suggests that the performance of the UK’s economy was not forecast to improve between 1999 and 2001. Balance of payments is a good indicator of an economy’s performance, as it shows its competitiveness with other economies. Table 1 indicates that the UK’s performance was set to worsen between the given years, as the current account deficit was set to increase. A negative balance of payments is bad for the economy as it means less is being produced in the UK, therefore the UK has less potential economic growth, which is why the rate of economic growth forecast for 2001 is relatively low. Economic growth occurs when the productive capacity of the economy increases over time. A high rate of economic growth is generally a signal of good economic performance; however the rate must be sustainable in order to prevent a large rise in the rate of inflation. Table 1 shows that overall; Gross Domestic Product was forecast to increase, thus creating a 2.25-2.75 increase in economic growth. This suggests that 2001 was predicted to have a slightly higher economic performance than 1999. This may not be a dramatic improvement; however, a low rate of economic growth helps to control inflation, meaning the rate of inflation is increasing by just 0.25%, leading to a predicted inflation rate of 2.5% for 2001. Inflation is the annual percentage increase in the average price level. It decreases economic performance as it reduces the internal value of money by increasing the cost of living. Overall, the 2001 economy was predicted to be stronger than that of 1999, with an increase in economic growth rate and increasing levels of aggregate demand, although slower than previous. However, inflation was estimated to rise at a faster rate, and the current account deficit expected to increase from 12.5 to 21. (f) (i) Economic growth occurs when the productive capacity of the economy increases over time. It measures the annual % increase in Real GDP. To increase the rate of economic growth, the government can increase either aggregate demand or aggregate supply. Tor Hirst 27.01.2012 If the economy is operating below full capacity, it has the potential to increase its level of production. In order for firms to increase their output, the government needs to create more aggregate demand within the economy. An increase in aggregate demand would cause a shift of the demand curve to the right from AD1 to AD2, causing an increase in real GDP from NY1 to NY2. The four components of aggregate demand are private sector consumption (C), private sector investment (I), government expenditure (G) and net expenditure on exports (X-M). The government could use fiscal policy increase the rate of aggregate demand, by cutting taxes and increasing the level of government spending. Lower taxes will increase disposable income, therefore people are more likely to spend and private sector consumption will rise. This, along with increased government spending will increase AD. However, by increasing government spending and decreasing tax revenue, the government is forced to run a fiscal deficit. This means they must borrow money from the private sector by asking the Bank of England to sell bonds to the private sector. Selling bonds will have a negative impact on the economy as it will increase the national debt, which will require future generations to pay higher taxes, thus having an adverse effect on economic growth in the future. Another demand side policy which could be adopted by a government to increase aggregate demand, thus raise the rate of inflation, would be cutting interest rates. This is called running a slack monetary policy, and would increase private sector investment and private sector consumption. This is because it would decrease the cost of money, and firms could afford to borrow more from banks in order to invest in capital, whilst consumers would have a higher propensity to consume and a lower propensity to save, as they would make less return on the money they are saving. A main cost of running demand side policies is the time lag between, for example cutting taxes or interest rates and having an effect on aggregate demand. Furthermore, it will not always have an effect on AD. If consumer confidence is low, a cut in interest rates may not necessarily increase consumption. Tor Hirst 27.01.2012 Lastly, Keynesians believe that increasing aggregate demand will cause an increase in the rate of inflation, which increases the cost of living therefore decreasing economic growth in the long run as people cannot afford the same number of goods and services as they previously could. On the other hand, the government could run supply side policies in order to increase aggregate supply, shifting Long Run Aggregate Supply (LRAS) to the right thus increasing the rate of economic growth in the long run. To increase aggregate supply, the government can increase the incentive to work. This could be done by cutting government expenditure on unemployment benefits, and cutting income taxes, to encourage people to work. However, this may not guarantee work incentive and may increase inequality of the distribution of wealth. In order to increase productivity, the government could increase efficiency of the labour market by investing in education and training. This will increase output and therefore cause a rise in economic growth. Nonetheless, the economic growth will be in the long term as there could be a large time lag. In addition, the government may not be well enough informed to subsidise the training of the right professions, and large sums of money could go to waste. Finally, another type of supply side policy would be privatisation. This is when the government sell off government owned industries to the private sector, for example the privatisation of British Rail. The profit maximising private sector has more incentive to increase efficiency, yet it could have a negative effect on the economy as there are dangers that a private monopoly could exploit consumers. This would have an adverse effect on economic growth in the long term, as consumers would not be able to afford all the goods and services produced if some are too expensive. In conclusion, although supply side policies are better for creating long term economic growth, there is a limit to how much the government can increase productivity through these policies, as they have limited control over the development of technology and working ethics. The supply side policies often rely on all other factors remaining equal, something that the government has little hold over. Therefore, it is easier for the government to try and control aggregate demand, using policies that have shorter time lags yet a shorterlived effect.