Download Multiple Choice Week Two

Tor Hirst
27.01.2012
Multiple Choice Week Two
1.
2.
3.
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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.