Download Theme 2 The UK economy: performance and

WORKBOOK ANSWERS
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.
Topic 1
Measures of economic performance
Economic growth
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)
Inflation
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)
Edexcel Economics A
Theme 2 The UK economy: performance and policies
© Andrew Sykes
Philip Allan for Hodder Education
1
TOPIC 1
Measures of economic performance
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:
–81,875+
49,852+
31,282–
14,765
= –15,506
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%
Edexcel Economics A
Theme 2 The UK economy: performance and policies
© Andrew Sykes
Philip Allan for Hodder Education
2
TOPIC 1
Measures of economic performance
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 welleducated/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.
Edexcel Economics A
Theme 2 The UK economy: performance and policies
© Andrew Sykes
Philip Allan for Hodder Education
3
TOPIC 1
Measures of economic performance
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)
Edexcel Economics A
Theme 2 The UK economy: performance and policies
© Andrew Sykes
Philip Allan for Hodder Education
4
TOPIC 2
Aggregate demand
Topic 2
Aggregate demand
Aggregate demand
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)
Consumption (C)
2 Marginal propensity to consume (MPC) is the increase in personal consumer spending
(consumption) resulting from an increase in income. (1 mark)
OR
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)
Edexcel Economics A
Theme 2 The UK economy: performance and policies
© Andrew Sykes
Philip Allan for Hodder Education
5
TOPIC 2
Aggregate demand
Investment (I)
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.
Exam-style questions (multiple choice and short answer)
1 D. (1 mark) Explanation: it will reflect a fall in X or an increase in M. Both represent a fall in
AD. NB Explanation is not required for mark.
2 A. (1 mark) Explanation: a decrease in imports will reduce withdrawals so boost X – M and
hence the expenditure measure of GDP. NB Explanation is not required for mark.
3 The exchange rate is the price of one currency in terms of another. (1 mark)
4 24%. Calculation: 100 x ((2 – 1.52)/2)) (2 marks)
Edexcel Economics A
Theme 2 The UK economy: performance and policies
© Andrew Sykes
Philip Allan for Hodder Education
6
TOPIC 2
Aggregate demand
5 Outline:

Define exchange rate: the price of one currency in terms of another. Application: the
value of the pound has fallen by 24% between July 2008 and January 2009.

A decrease in the value of the pound means that the price of UK goods falls in foreign
markets; hence demand for them increases, meaning increased volume of falls X and
hence a rise in AD.

A decrease in the value of the pound means that the price of imported goods rises;
hence there is a decrease in demand for imports which may be substituted for UKproduced goods, leading to a decrease in M and a rise in AD.
Evaluation: two separate points needed with relevant use of context:

Long-term contracts between companies mean that a fall in export earnings will not
happen straight away. Export earnings may rise in the short run or stay the same.

Exporting companies may choose to keep prices unchanged and receive higher profit
margins.

PED for exports and imports may be highly price inelastic. So some foreign
countries/firms may take the hit of having to pay a higher price due to a better quality
of goods. So export earnings may remain stable.
6 Possible answers include:

Define economic growth: increase in real GDP.

Define balance of payments: record of transactions between the UK and the rest of
the world. Current account includes exports minus imports of goods and services plus
net income from abroad plus net transfers between residents.

If growth is accompanied by an increase in domestic demand (C + I + G) then the
increase in growth may be accompanied by a rise in imports as households, firms
and government use their rising income to purchase more goods from abroad. In this
case, the balance of payments might deteriorate.

If growth is export led then the balance of payments might improve. (This could count
as evaluation depending on how analysis is developed.)
Evaluation (1 x 4 or 2 x 2 marks): to score 3 or 4 marks the evaluation must be put in the
context of the question/extract. For example:

Impact depends on the changes in the exchange rate over the time period. Since
sterling depreciated sharply between 2008 and 2009, this will offset some of the
effect.

Extent of the change depends on the relative growth rates in UK vs trading partners.
If UK grows by more than trading partners, it is likely that balance of payments will
deteriorate. In 2009 major trading partners were going into recession.
Edexcel Economics A
Theme 2 The UK economy: performance and policies
© Andrew Sykes
Philip Allan for Hodder Education
7
TOPIC 2

Aggregate demand
Effect of increase in domestic demand depends on the marginal propensity to import.
In the UK this has remained very high despite the recession. The MPM means the
effect of an increase in UK growth on the current account deficit will be magnified.
Exam-style questions (data response)
7 Nominal GDP is GDP measured in terms of money values, and so it is influenced by the
price level or inflation in an economy. GDP figures are converted to ‘constant price’
numbers to remove the effects of inflation.
‘UK nominal GDP rose by 1.3% in 2010 Q2, reflecting a 1.2% increase in real output and a
0.1% rise in inflation’. Here, real GDP has actually risen by 1.2%, but nominal GDP has
risen by 1.3% as it includes inflation, which increased by 0.1%. (4 marks)
8 A recession is when there are two consecutive quarters of falling real GDP. GDP is the
total value of goods and services produced by the factors of production in an economy in a
given time period. Real GDP is GDP adjusted for inflation.
In the extract we are told that GDP fell by a total of 6.5% during the recession, suggesting
that at some point there were at least two consecutive quarters of negative GDP growth.
(4 marks)
Edexcel Economics A
Theme 2 The UK economy: performance and policies
© Andrew Sykes
Philip Allan for Hodder Education
8
TOPIC 3
Aggregate supply
Topic 3
Aggregate supply
Short-run aggregate supply
1
The SRAS is upward sloping because as prices rise firms find it more profitable to
increase production and thus will be incentivised to do so. This is because, in the short
run, wages and other input prices are assumed to be fixed. With fixed cost inputs and
higher-priced outputs, companies can increase profit by increasing production. Thus, as
the price level increases in the short run, then real wages (and other real costs) fall, giving
the SRAS an upward slope. (4 marks)
2 The initial SRAS is SRAS1.
a
SRAS3 (2 marks)
b
SRAS3 (2 marks)
c
SRAS2 (2 marks)
Edexcel Economics A
Theme 2 The UK economy: performance and policies
© Andrew Sykes
Philip Allan for Hodder Education
9
TOPIC 3
Aggregate supply
3 AD/AS diagram showing:

initial AD/AS curves and axes correctly labelled (1 mark)

initial equilibrium correctly labelled (1 mark)

contraction (leftwards/inward shift) in SRAS (1 mark)

new equilibrium correctly labelled showing a fall in the equilibrium level of real
national output and an increase in the equilibrium average price level (1 mark)
Further explanation (not needed to score marks in exam): firms use oil for many purposes
and it has few substitutes so demand is likely to be price inelastic. Oil price increases will
also add to transport costs, pushing up costs of production for all firms. This means the
increase in AS may be substantial. In the long run, households are also likely to see an
increase in key costs of living (petrol and other goods prices). This may lead to a wage–
price spiral, pushing up SRAS even further.
Long-run aggregate supply
4 The short run is the period in which at least one factor of production is assumed to be
fixed. Labour is usually assumed to be variable. In the long run, all factors of production
are variable. (4 marks)
The Keynesian and classical LRAS
curves
5 AD/AS diagram showing:

initial AD/AS curves and axes correctly labelled (1 mark)

initial equilibrium correctly labelled (1 mark)

increase (rightward shift) in LRAS (1 mark)
Edexcel Economics A
Theme 2 The UK economy: performance and policies
© Andrew Sykes
Philip Allan for Hodder Education
10
TOPIC 3

Aggregate supply
new equilibrium correctly labelled showing an increase in the equilibrium level of
real national output and a fall in the equilibrium average price level. (1 mark)
6 C. (1 mark)
7 At low levels of output (real GDP) the LRAS curve is horizontal. With a high level of
unemployment and a lot of ‘spare capacity’ in the economy, output can be increased
without a rise in wages as more workers can be employed at the current wage rates and a
rise in the demand for raw materials and capital will not raise their price. Then at higher
levels of output the LRAS starts to slope up as firms begin to experience rises in costs as
they have to compete for increasingly scarce resources (e.g. raw materials and labour).
The price level will rise to compensate for the higher costs. At the full employment level
(maximum potential output), there is no spare capacity and the LRAS curve becomes
perfectly inelastic. (4 marks)
Exam-style questions (multiple choice and short answer)
1 C. (1 mark) Explanation: this would reduce the price of imports hence the costs of
production would fall and SRAS would shift to the right. NB Explanation is not required for
mark.
2 Labour productivity measures the output per worker per period of time. For example,
GDP/total employment. (1 mark)
3 AD/AS diagram showing:

initial AD/AS curves and axes correctly labelled; vertical LRAS (1 mark)
Edexcel Economics A
Theme 2 The UK economy: performance and policies
© Andrew Sykes
Philip Allan for Hodder Education
11
TOPIC 3
Aggregate supply

initial equilibrium correctly labelled (1 mark)

increase (rightwards/outwards shift) in AD (1 mark)

new equilibrium correctly labelled showing an increase in the equilibrium average
price level but no change in output (1 mark)
Also reward further explanation: a classical LRAS is drawn as vertical at the level of full
employment. This is because classical economists believe the market is always selfequilibrating. An increase in AD from AD1 to AD2 will simply raise the price level from P1 to
P2 (draw on diagram), but output will remain at Qfe.
4 Up to 6 marks for analysis of up to three factors which might include:

beneficial effects on economic growth, e.g. leading to increase in employment;
increased income and corporation taxes

beneficial effects on lower inflation

beneficial effects on balance of payments (increased competitiveness of exports
leading to increase in X – M)
Also reward AD/AS diagram showing effects of LRAS shift to the right, increase in
potential/trend output growth rate. (2 marks)
Evaluation (1 x 4 or 2 x 2 marks): possible points might include:

Time lag: training takes time to take full effect. Courses must be designed and
implemented, then workers must put their skills into practice. Reforming the A-level
specification was done extremely rapidly, but still took over 4 years from initial
conception of the idea until the courses were first taught. Rapid policy changes may
not be fully thought through and may have unforeseen effects.

Demand-side approaches may be more immediate in their effects. Monetary policy
may be changed monthly by the MPC though its effects might have ‘long and
variable’ time lags.

Quality of training can be very varied. Poor quality training may result in a deadweight
welfare loss.
NB To score 3 or 4 marks the evaluation must be put in the context of the question/extract
presented.
Edexcel Economics A
Theme 2 The UK economy: performance and policies
© Andrew Sykes
Philip Allan for Hodder Education
12
TOPIC 4
National income and macroeconomic
equilibrium
Topic 4
National income and macroeconomic
equilibrium
National income
1 (4 marks)
Injections and withdrawals
2 (6 marks)
3 Income is a flow of factor incomes such as wages from labour or rent from the ownership
of land. Wealth is a stock of financial or real assets such as property or ownership of land.
Edexcel Economics A
Theme 2 The UK economy: performance and policies
© Andrew Sykes
Philip Allan for Hodder Education
13
TOPIC 4
National income and macroeconomic
equilibrium
Therefore, in the circular flow of income, income might be the wages that a firm pays to
households and wealth might be the property that people own or the cash in their bank
accounts. (2 marks)
The multiplier
4 Definition of the multiplier, e.g. the multiplier formula. (1 mark)
Analysis of the multiplier. (2 marks) Points might include:

spending by one person becomes other people’s incomes

process continues until all extra income is leaked away

relevance to government spending, e.g. on hospitals
Explanation of the effects of leakages, e.g. tax, imports. (Up to 2 marks for each leakage
properly explained.)
(4 marks max.)
5 Definition of multiplier. (1 mark)
The extent of the final increase can be shown with the multiplier formula:
K=
1
1 – MPC
Calculation of the size of the multiplier (i.e. K = 2) using the data provided. (2 marks)
Analysis of multiplier. (Up to 4 marks) Points might include:

spending by one person becomes other people’s incomes

process continues until all extra income is leaked away in savings, taxes or imports

application to examples of investment spending
Evaluation (2 x 2 marks or 1 x 4 marks. To score 3 or 4 marks the evaluation must be put
in the context of the question/extract presented.) Factors might include:

discussion of the size of the multiplier — size and types of leakages, e.g. applied to
the example, which has a high MPS of 0.5, but no other leakages as it has no
taxation or imports. Contrast with UK which has low MPS but high MPM and MPT

time-lag effects

depends on the shape of the AS curve

other things might not be equal, e.g. the pound might change in value
Edexcel Economics A
Theme 2 The UK economy: performance and policies
© Andrew Sykes
Philip Allan for Hodder Education
14
TOPIC 4
National income and macroeconomic
equilibrium
Exam-style questions (multiple choice and short answer)
1 D: accelerator. (1 mark)
2 2 marks:
1
K = 1  MPC = 1/(1 – 0.9) = 10
Exam-style questions (data response)
3 Knowledge:

Define real income (nominal income adjusted for inflation). (1 mark)

Define real income per head (per person or per capita). (1 mark)
Application:

Refer to data from extract and explain that income per person fell when adjusted for
inflation. (1 mark)
4 Knowledge (4 marks): factors might include:

real post-tax income growth falling

consumer confidence/expectations of financial situation

low savings ratio in the past suggesting stocks of wealth may be low so no positive
wealth effect
Two factors must be developed.
Application (2 marks):

real post-tax income growth falling by ‘0.5%’ in first quarter of 2008

surveys suggest that households expect their financial situation to ‘weaken sharply
over the next 12 months’; another indicator of income expectations is household
spending on durable goods, such as cars and televisions
5 Outline:
Government spending is an injection into the circular flow of income. (2 marks)
Possible mechanisms include: (up to 2 marks each)

Increased government spending boosts incomes through higher benefits payments.
These act as an injection to income, and this in return boosts consumption from that
extra income.

This then has a multiplier effect through businesses and investment, and again
through incomes paid to employees.
Edexcel Economics A
Theme 2 The UK economy: performance and policies
© Andrew Sykes
Philip Allan for Hodder Education
15
TOPIC 4
National income and macroeconomic
equilibrium

Direct boost to consumption that the government brings as it purchases a range of
goods and services. This will induce firms to produce more of these goods and
services. This will lead to an increased employment of workers, whose incomes will
rise. This will in turn boost their consumption.

Reference to multiplier effect as spending moves around the circular flow.
Reward appropriate use of circular flow of income diagram, showing an increase in G (up
to 4 marks).
6 Circular flow of income diagram. (Up to 4 marks)
Definition of investment.
Description of effects of fall in investment and annotation on diagram (2 marks). Reduction
in injections, for example: (up to 2 marks each)

reduced purchases of capital equipment

reduced output by firms who buy and install the new machinery

reduced incomes by firms producing the capital equipment

leading to reduced employment

leading to reduced income by households

leading to reduced spending
Evaluation (1 x 4 marks or 2 x 2 marks): points might include:

depends on the level of leakages: S, T or M

short-/long-run effects: fall in investment may reduce the quality of the capital stock
and decrease the productivity of labour and capital

the effects depend on how much capacity there is in the economy

multiplier effects might depend on the confidence of households
Edexcel Economics A
Theme 2 The UK economy: performance and policies
© Andrew Sykes
Philip Allan for Hodder Education
16
TOPIC 4
National income and macroeconomic
equilibrium
7 Definition of imports.
Explanation that imports are a leakage from the circular flow of income.
Explanation that fall in imports leads to increase in (X – M) so a rise in AD.
Diagram showing AD shift to the right (1 mark) and changes in the equilibrium points (1
mark).
Growth:

increase in AD (1 mark)

via increase in (X – M) caused by fall in M (1 mark)

multiplier effects (1 mark)
Effects on national income (Y) and price level (P) must be clearly explained and marked
on diagram.
Further analytical marks for consequences for growth, e.g. through damaging effects of
inflation (2 marks).
Evaluation (6 marks: 3 x 2 marks):

discussion of the size of the multiplier (size and types of leakages, e.g. applied to UK
which has low MPS but high MPM)

time-lag effects

depends on the shape of the AS curve (vertical LRAS vs flatter LRAS)

other things might not be equal, for example the pound might change in value
Edexcel Economics A
Theme 2 The UK economy: performance and policies
© Andrew Sykes
Philip Allan for Hodder Education
17
TOPIC 5
Economic growth
Topic 5
Economic growth
1 Short-term growth is measured by change in national output. National output is measured
by gross domestic product. GDP growth may be measured in money (or current prices) or
real (adjusted for inflation) terms.
Long-term growth is shown by an increase in trend or potential GDP and this is illustrated
by an outward shift in a country’s long-run aggregate supply curve (LRAS). (4 marks)
The business cycle and output gaps
2 A negative output gap occurs when actual output (measured by actual real GDP) is less
than potential output. (1 mark)
3 A positive output gap occurs when actual output is greater than potential output (1
mark). There will usually be inflationary pressures.
4 A decline in unemployment. An economic boom occurs when real GDP shows a
sustained increase at or above the trend real GDP growth rate. This is likely to result in an
increase in employment as firms hire more workers to produce the additional output.
Hence unemployment will fall. (2 marks)
An increase in demand–pull inflation. Since an economic boom reflects a sustained
increase in AD at above trend real GDP growth, it is likely to result in bottlenecks
developing and shortages in several markets. The excess of AD over AS is likely to result
in prices being driven up on a sustained basis. (2 marks)
5 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. (1 mark)
In Q1 2009 GDP fell sharply by around 2.5%. (2 marks)
6 The output gap is the difference between actual GDP and potential GDP. (1 mark)
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 Q3 2011 to around 2.5% of GDP.
(2 marks)
7 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
Edexcel Economics A
Theme 2 The UK economy: performance and policies
© Andrew Sykes
Philip Allan for Hodder Education
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TOPIC 5

Economic growth
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. (6 marks)
8 AD/AS diagram (2 marks):
Explanation (2 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 (2 marks):
Explanation (2 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
Edexcel Economics A
Theme 2 The UK economy: performance and policies
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Philip Allan for Hodder Education
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TOPIC 5
Economic growth
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.
9 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. (8 marks)
The impact of economic growth
10 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 in 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
Edexcel Economics A
Theme 2 The UK economy: performance and policies
© Andrew Sykes
Philip Allan for Hodder Education
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TOPIC 5
Economic growth
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.
11 Economic growth will possibly be accompanied by an increase in negative externalities
such as pollution and congestion. Parts of the UK are also already highly congested.
Economic growth will result in more firms producing increased output with a consequential
increase in pollution, noise (and other externalities) and more goods being transported.
This will add additional negative externalities such as congestion and atmospheric
pollution.
In addition, if economic growth exceeds potential output growth for a prolonged period, it is
likely to lead to an increase in inflation. The most likely type of inflation resulting from
strong growth in AD is demand-pull inflation. This occurs when the economy is close to full
capacity and AD shows a strong increase, pulling up prices in particular in those parts of
the economy where there are capacity constraints. 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. (6 marks)
Exam-style questions (multiple choice)
1 D. (1 mark)
Exam-style questions (data response)
2 Definition of economic growth. Possible factors include:
Low interest rates and a growing economy have already led to substantial house price
inflation in the UK.
It could lead to workers seeking higher wage demands as their own costs of living are also
increasing. This could be a significant problem.
Rapid economic growth might also cause a further deterioration in the UK’s current
account deficit. Not only might rapid economic growth lead to an increase in demand-pull
inflation, which will undermine the UK’s competitiveness and increase the price of exports,
it might also lead to increased demand for imports from consumers benefiting from higher
incomes. (4 marks)
3 Explanation of GDP growth: increase in real output produced by factors of production of an
economy in any given time period. (1 mark)
Reasons might include: (up to 2 marks each)

unreliable data/revisions to past data which are collected from many sources

recovery in GDP growth unpredictable or other unexpected development

miscalculation
4 Outline: (AO1, AO2, AO3 9 marks)
Edexcel Economics A
Theme 2 The UK economy: performance and policies
© Andrew Sykes
Philip Allan for Hodder Education
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TOPIC 5
Economic growth

Definition of economic growth; distinction between actual economic growth and
potential economic growth.

Possible benefits: economic growth can increase employment in an economy as
there is greater demand for goods and services, which leads to increased
consumption of goods due to higher disposable incomes. An increase in C leads to
an increase in AD. If the economy is growing faster than the population then per
capita incomes are rising, resulting in a better quality of life as people can afford more
goods and services than they could before.

There will be increased government revenues via its tax receipts as more people are
making more money, leading to increased spending on health and education. An
increase in productivity leads to an increase in AS.

Increased investment into the economy results in greater confidence due to higher
profits from firms. There will be more capital goods in the economy which will lead to
increased productivity and an increase in AS. Also the multiplier effect will be in
evidence — multiple rounds of repeat spending associated with increased
investment, leading to increased employment, leading to increased consumption.
Evaluation:

Phillips curve: the higher the growth in employment in the economy, the greater the
upward pressure there is on the price level (demand-pull inflation). Therefore there
will be higher inflation. The increase in the cost of living means that the standard of
living does not increase by that much.

GDP measurement issue: standard of living is not just associated with money; it could
include access to clean water or green spaces. Economic growth can lead to
degradation of the environment as more polluting resources are used. A poorer
environment leads to a poorer quality of life.
Edexcel Economics A
Theme 2 The UK economy: performance and policies
© Andrew Sykes
Philip Allan for Hodder Education
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TOPIC 6
Macroeconomic objectives and policies
Topic 6
Macroeconomic objectives and
policies
The main macroeconomic objectives
1 Inflation is an increase in the average price level, as measured by the percentage increase
of the CPI. Inflation can cause uncertainty for businesses and a fall in investment. This is
partly because inflation might reduce consumer confidence and spending and so reduce
aggregate demand. Export demand might also suffer as inflation increases costs and
reduces competitiveness, which can lead to falling demand for exported goods and rising
demand for imports. Falling confidence is likely to force firms to postpone capital
investment.
Inflation can also create ‘shoe leather’ and ‘menu’ costs. Shoe leather costs are where
firms and businesses need to make an additional effort to seek out the best deals. These
costs are also called search costs, reflecting the increased time spent attempting to find
the lowest available prices. Menu costs are costs associated with having to regularly reprice products to bring them in line with general inflation.
In evaluation of this, provided the inflation is anticipated by firms they might be able to plan
ahead for its effects by hedging their costs. They might also not suffer any loss of
competitiveness in the short run if the exchange rate falls to compensate for the increase
in domestic prices.
In addition, the internet has increased the availability of information and considerably
reduced the problem of search costs. Search engines and comparison sites have also
made it much easier to access the cheapest product even at times of rapidly rising prices.
(15 marks)
2 Knowledge, application and analysis (9 marks):

Definition of inflation (sustained increase in the general price level measured by the
annual percentage change in an index such as the CPI or RPI).

Understanding of distribution of income: how the GDP of a country is distributed
among different groups (the highest percentile earners and the lowest percentiles, or
other identified groups) of a country.

Identification of groups of beneficiaries from an increase in inflation, e.g. borrowers,
mortgage holders (as inflation reduces the real value of the debt).
Edexcel Economics A
Theme 2 The UK economy: performance and policies
© Andrew Sykes
Philip Allan for Hodder Education
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TOPIC 6
Macroeconomic objectives and policies

Identification of losers: those on fixed incomes; savers (inflation erodes the real value
of savings), especially if nominal interest rates increase by less than inflation;
pensioners; benefit recipients (if benefits are not indexed to inflation).

Further analysis, e.g. savers are likely to be the higher-income groups; monthly
mortgage interest payments may rise, if interest rates also rise possibly affecting
lower-income groups more as a proportion of their income; link between inflation and
house prices.
Evaluation (3 x 2 marks or 2 x 3 marks): Factors might include:

Lower-income groups are often least able to protect themselves against increasing
inflation by hedging or buying assets that can protect them. They are also worst hit as
they are often already close to subsistence.

Higher-income groups might arguably have larger mortgage interest payments as a
proportion of their income.

Inflation changes may take time to have an effect, especially if workers have just
received wage increases or if interest rate changes do not happen right away. Effects
on income might take longer than wealth effects or other wealth issues.
3
Summary of causes of cost–push inflation: an increase in AD particularly when the
economy is close to full employment might be caused by loose fiscal policy, higher house
prices, greater confidence, increased credit availability, depreciation in the exchange rate.
(4 marks)
Edexcel Economics A
Theme 2 The UK economy: performance and policies
© Andrew Sykes
Philip Allan for Hodder Education
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TOPIC 6
Macroeconomic objectives and policies
Summary of causes of demand–pull inflation: a substantial increase in costs of production
results in SRAS shifting to the left. Causes might be rising oil prices, higher indirect taxes,
rising wages, depreciation in the exchange rate. (4 marks)
4 a
When EXPORTS exceed IMPORTS the country has a current account surplus. (1
mark)
b
When IMPORTS exceed EXPORTS the country has a current account deficit. (1
mark)
5 The balance of payments is a record of the extent of trade between one country and the
rest of the world. The current account is the largest part of the balance of payments,
the main elements of which are the balances of exports and imports in goods and
services.
The exchange rate is the value of one currency expressed in terms of another — for
example, £1 = $1.45. A decline in the value of the currency (depreciation) will, ceteris
paribus, lead to import prices rising but export prices falling. This should boost demand for
UK exports whereas rising import prices will reduce demand for imports. As a result the
trade deficit should narrow.
However, if the price elasticity of demand for imports were relatively inelastic, then a rise in
the price of imports would lead to a less than proportionate fall in demand, in which case
total expenditure on imports would rise. This would, ceteris paribus, lead to a deterioration
in the trade deficit. Equally, if the demand for exports were price inelastic then a fall in the
price of exports would result in very little increase in the demand for UK exports. Total
sterling export earnings will nevertheless increase in this case.
We can also relax the ceteris paribus assumption. When global growth is strong there will
be a high level of demand — some of which will be demand for goods from abroad. At the
same time, exporters may recognise that there is a buoyant demand in the UK and switch
sales from export markets to those in the domestic market. The net effect is for exports to
fall and imports to rise thus contributing to the widening of the deficit. (10 marks)
6 B. Explanation: this will cause net trade (X – M) to increase and AD to shift to the right. (1
mark)
Edexcel Economics A
Theme 2 The UK economy: performance and policies
© Andrew Sykes
Philip Allan for Hodder Education
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TOPIC 6
Macroeconomic objectives and policies
Demand-side policies
7 A government has a budget deficit when, in a given year, total government expenditure
exceeds total revenue (from taxes and other charges). (1 mark)
8 A budget deficit has to be financed by borrowing. Governments usually do this by issuing
bonds. The stock of accumulated borrowing is called the government, or national, debt.
(1 mark)
9 The government was running a budget deficit. A budget deficit occurs when, in a given
year, total government expenditure exceeds total revenue (from taxes and other charges).
Total spending was £623 billion; total revenue was £545 billion, leaving a deficit of £78
billion. (3 marks)
10 A direct tax is one paid directly to the government by the person on whom it is imposed.
Examples include income taxes. (£157 bn in 2008–9).
An indirect tax (such as value added tax (VAT)), is a tax collected by an intermediary
(such as a retail store) from the person who bears the ultimate economic burden of the tax
(such as the customer). (VAT was £83 bn in 2008–9.) (2 marks)
11 Quantitative easing is when the central bank purchases government bonds in order to
drive down yields and increase the amount of cash circulating in the economy. (1 mark)
12 a
Consumption
An increase in Bank of England base rates will result in an increase in the rates set by the
commercial banks. (This is because the interest rate charged to the commercial banks by
the Bank of England will now be higher.) As a result, the interest rate customers earn on
their savings will also increase. This will tend to increase savings and reduce consumption
as it means that the return from saving and the opportunity cost of consumption have
increased. Equally, the cost of borrowing will have risen so consumers will tend to borrow
less money. Those consumers with outstanding loans will have to pay higher interest rates
so their discretionary income will be lower.
Another influence on consumer spending arises from the effects of interest rate change on
consumer confidence and expectations of future employment and earnings prospects. (4
marks)
b
Investment
An increase in Bank of England base rates will be passed on to their customers by
commercial banks, which find that the cost of funds increases when they need to borrow
from the Bank of England.
An increase in interest rates will have a direct effect on firms that rely on bank loans. A rise
in interest rates increases borrowing costs and therefore reduces the amount that firms
might wish to borrow. The rise in interest rates also reduces the profits of such firms and
increases the return that firms will require from new investment projects, making it less
likely that they will start them. (4 marks)
Edexcel Economics A
Theme 2 The UK economy: performance and policies
© Andrew Sykes
Philip Allan for Hodder Education
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TOPIC 6
c
Macroeconomic objectives and policies
Net trade
An increase in UK base rates will, ceteris paribus, lead to an increase in hot money inflows
into sterling bank accounts. This is because banks will tend to increase the interest rates
they offer on UK accounts, thereby attracting additional money into sterling accounts. This
will increase the demand for sterling, thereby increasing the exchange rate.
The increase in the exchange rate will make the price of exports more expensive in foreign
markets, while reducing the price of imported goods in the UK. This will tend to result in a
fall in export volumes and an increase in import volumes. The effects on net trade (X – M)
will depend on the price elasticity of demand, but it is likely to result in a fall in net trade in
the long run. (4 marks)
Extension material: Ricardian
equivalence
13 Knowledge, application and analysis (6 marks max.):
Definition of fiscal policy: policies conducted by government concerning government
spending and taxation. (2 marks)
Use of fiscal policy: identification (1 mark) and explanation (1 mark) of cut in taxes and
increase in government spending including transmission mechanisms: increase in
government spending; decrease in taxation.
Add an AD/AS diagram to illustrate the above, showing changes in price and output. (4
marks)
Marks will also be given for an explanation of the multiplier process. (2 marks)
Any two evaluation points (1 x 4 marks or 2 x 2 marks each): Remember evaluation
must be linked closely to the question/extract to score the highest marks:

Possibility of crowding out: additional government spending financed by borrowing
bids up interest rates as the government seeks to attract more funds from lenders to
finance its increased borrowing.

Discussion of Ricardian equivalence: if the government embarks on a debt-financed
expansionary fiscal policy, then rational consumers or businesses will react by cutting
their current spending. This is because they believe that the government will need to
increase taxes in the future to pay the additional interest and debt payments.

Possibility that the economy might already be operating at full capacity — hence the
effect will be on the price level and not real output.

Relax ceteris paribus assumption, e.g. the monetary position; world prices; changes
in LRAS.

The possibility of government failure: spending on wasteful projects that may not
boost AD or spending on benefits that might reduce incentives to work.
Edexcel Economics A
Theme 2 The UK economy: performance and policies
© Andrew Sykes
Philip Allan for Hodder Education
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TOPIC 6
Macroeconomic objectives and policies
14 Knowledge, application and analysis (9 marks max.):
Definition of fiscal policy: government spending and taxation. (2 marks)
Definition of unemployment (2 marks).
Expansionary fiscal policy: identification and explanation of fall in taxes and increase in
government spending including transmission mechanisms. (Identification 1 mark +
explanation 3 marks)
Provide an AD/AS diagram to illustrate the above point above, showing changes in price
and output, and connection to reduced unemployment fully explained (firms employ
additional workers to produce the extra output produced). (4 marks)
An explanation of the multiplier process. (2 marks)
Evaluation (3 x 2 marks or 2 x 3 marks):

Discussion of whether government spending (G) or taxation (T) is more effective.

What is happening on the supply side/how might the policies affect incentives to
work?

Time lags.

The relative inflexibility of fiscal policy.

Crowding out issues, especially with an increase in G.
To score 5–6 evaluation marks, evaluation must include a developed chain of reasoning
which is linked directly to the core parts of the question/context.
Supply-side policies
15 a
Government expenditure on education and training
Knowledge, application and analysis (6 marks):
Increased government spending on education and training will equip the workforce with
better skills and capabilities. This will increase their productivity, allowing them to produce
more goods in a given period of time or improve the quality of the goods they produce,
Equally it might equip workers to work in higher value-added areas where they will
produce more highly valued products. Government spending on education improves
human capital, but this also has the knock-on effect of improving physical capital as
opportunities for innovation arise with increased educational presence, such as in
universities. This spending also reduces structural unemployment, as it provides improved
training, such as for those made recently unemployed in a previous industry, and the
occupational mobility of workers is improved. Foreign investment will also increase in a
country with significant spending on education, as expectations of future success will be
much higher for the future population. Improved education also increases incentives to
work, as future earnings prospects are raised with better education and training. This
Edexcel Economics A
Theme 2 The UK economy: performance and policies
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Philip Allan for Hodder Education
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TOPIC 6
Macroeconomic objectives and policies
spending all causes the LRAS curve to shift outwards, resulting in an increased level of
output (Y1 to Y2), and ultimately economic growth.
Evaluation (4 marks):
Education and training is a long-term policy which takes a considerable period of time to
come into effect. For example, changing the school education system may require
legislative changes.
The significance of this shift in the LRAS curve, however, is determined by a number of
factors. First, the economic state of the country in question is an important factor — an
increased level of spending on education in a poorer country will make a relatively large
difference in future economic prosperity compared to the same real amount for a more
developed country. This concept is similar to the law of diminishing returns, as the amount
of money needed for another significant development rises as the amount of money
already spent does. For example, a new secondary school in a European country will have
less of an impact on the country as a whole than one in a developing country where the
standard of education is low.
b
Cuts in income tax rates
Knowledge, application and analysis (6 marks):
A fall in income tax will affect the supply of labour in the market. This may incentivise
people to work for longer hours, due to the substitution effect. For a higher real income
after tax, people may be willing to work harder as well, as the opportunity cost of not
working (taking leisure) is far greater. It could also be argued that a decrease in the tax
rate will result in an increased incentive to work legally, as opposed to working in the
informal sector. This may result in higher tax revenues for the government, which in turn
could be spent on improving economic growth via other means. This can be represented
by a ‘Laffer curve’, which shows the optimum level of taxation at which most revenue is
gained.
In both of these situations, the potential quantity of goods and services in the economy is
increased, shifting the LRAS curve outwards (LRAS1 to LRAS2). This usually leads to an
increased real level of output (Y1 to Y2), measured by increased real GDP, and therefore
economic growth ceteris paribus.
Evaluation (4 marks):
A decreased level of income tax could reduce incentives to work; some people would
rather continue at the same real income and work for fewer hours than the same number
of hours for a higher real income. This could cause a decrease in the supply of labour.
Edexcel Economics A
Theme 2 The UK economy: performance and policies
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Philip Allan for Hodder Education
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TOPIC 6
c
Macroeconomic objectives and policies
Privatisation of publicly owned industries
Knowledge, application and analysis (6 marks):
Privatisation is the sale of state-owned assets to the private sector. This is often achieved
through listing the new private company on the stock market. Private companies are often
argued to be more efficient than state-owned companies. This is because profitmaximising firms have a profit incentive to cut costs and be more efficient, thereby
boosting returns to shareholders. Managers of state-owned firms do not usually share in
any profits and may become complacent. As a result, privatisation should result in a
decline in costs and possibly an increase in productivity per worker. This should help
increase LRAS and improve an economy’s competitiveness. This is particularly important
for privatisations of key services such as telecommunications or electricity, which are
important costs for many businesses in an economy. It is also argued that privatisation
might result in an increase in competition and that this can be an additional drive towards
increased efficiency.
Evaluation (4 marks):
Sometimes privately owned companies may be less willing to invest in productivityenhancing methods than state-owned companies because their shareholders are focused
on short-term gains in profits rather than investing for the long term. In addition,
privatisations are not always followed by an increase in competition and it is the deregulation of the market rather than the privatisation that usually provides this increased
competition. A privately owned monopoly may be less efficient than a state-owned
monopoly. The scope for further privatisation in the UK is limited as most state-owned
firms have been sold off.
Conflicts between macroeconomic
objectives
16 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 growing economy (4 marks)
17 Explanation of expansionary monetary policy (cut in interest rates; increase in QE).

Distribution of income improves (if justified): identification of winners and losers
affected by cut in interest rates, e.g. 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-
Edexcel Economics A
Theme 2 The UK economy: performance and policies
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Philip Allan for Hodder Education
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TOPIC 6
Macroeconomic objectives and policies
income groups more as a proportion of their income, link between interest rates and
house prices.
Evaluation (2 x 3 or 3 x 2 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 or other wealth issues

other time issues
To score 5–6 evaluation marks, evaluation must include a developed chain of reasoning
which is linked directly to the core parts of the question/context.
Conflicts in the use of macroeconomic
policy instruments
18 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. (4 marks)
19 Definition of fiscal policy: government spending and taxation. (1 mark)
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.
(2 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 (3 x 2 or 2 x 3 marks):
Edexcel Economics A
Theme 2 The UK economy: performance and policies
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Philip Allan for Hodder Education
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TOPIC 6
Macroeconomic objectives and policies

Increase in employment may result in increased overall tax revenues despite the fall
in tax rates.

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.
To score 5–6 evaluation marks, evaluation must include a developed chain of reasoning
which is linked directly to the core parts of the question/context.
Exam-style questions (data response)
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. (1 mark AO1) The extract suggests that during 1980 GDP in the UK
fell by ‘nearly 2% in each of the second and third quarters, to nearly 4% below the
quarterly average of 1979’. (2 marks AO2) Given that UK potential output growth was
estimated at around 2% a year, this suggests that the gap between potential output and
actual output continued to rise. This analysis is confirmed by the continued rise in UK
unemployment, implying a very large number of unemployed resources, suggesting the
UK was operating well within its PPF. (2+ marks AO3)
2 Unemployment in UK had risen ‘to a record of nearly 8.5% of the workforce’ (1 mark AO2).
This coincided with a fall in GDP, while potential output growth was estimated to have
been rising by 2% a year. This suggests that one possible cause of unemployment might
have been 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. (Reward use of diagram to illustrate
this.)
In addition, the extract notes ‘the power of trade unions in keeping real wages high’. This
could also reflect classical or real wage unemployment if the unemployed young workers
were unwilling to work for lower real wages or if UK nominal wages were being kept
artificially high by minimum wage legislation or by powerful restrictive practices maintained
by trade unions or labour laws. (Reward use of a labour market diagram to illustrate this.)
Also reward other explanations which might include: structural unemployment (if properly
developed); regional unemployment.
3 Measures that might have been employed 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, thereby shifting AD to the
right, thereby increasing equilibrium income, thereby reducing unemployment.
Edexcel Economics A
Theme 2 The UK economy: performance and policies
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Philip Allan for Hodder Education
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TOPIC 6

Macroeconomic objectives and policies
Regional policy incentives: give grants and subsidies to firms to locate in areas of
high unemployment.
Evaluation might include:

Likely to require increase in government spending, which would have been difficult for
the UK given size of current deficit and debt — ‘the budget deficit having soared due
to the fall in tax receipts and increase in benefits payments, there is little scope to use
reflationary fiscal policy’.

Possibility of government failure.

Problems of specific initiatives, e.g. regional policy does not solve the problem of
occupational immobility. Often needs extra retraining schemes to give workers the
relevant skills to allow them to take up new jobs.
4 4 marks for each set of costs identified and explained. 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 be spent on hospitals or schools. (Reward
use of a PPF 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 for the
economy of hysteresis. This is where the deterioration of workers’ skills leads to
those workers becoming less employable by firms. As a result the NRU might rise.
When the economy recovers, unemployment might stay permanently higher.
5 Productivity definition (2 marks) and long-term economic growth definition (2 marks).
Definition of productivity: more output from the same inputs; output per person per hour.
Credit for reference to increased efficiency (1 mark), but not for increased production per
se. (0 marks)
Effects of increase might include:

that this is likely to lead to economic growth or improved living standards (or
equivalent answer)

costs of production fall/efficiency increases so more profit

removes inflationary pressure

encourages inward investment

effect on the current account

shift out in the PPF/increase in productive potential
Edexcel Economics A
Theme 2 The UK economy: performance and policies
© Andrew Sykes
Philip Allan for Hodder Education
33
TOPIC 6

Macroeconomic objectives and policies
effect on employment levels
Allow answers based on competitiveness.
Evaluation (2 x 3 or 3 x 2 marks):
Extent might depend on:

productivity growth relative to that of competitor countries

need for increase in AD as well — supported by other measures
To score 5–6 evaluation marks, evaluation must include a developed chain of reasoning
which is linked directly to the core parts of the question.
6 Knowledge:
Bank rate is the interest rate set by the Bank of England when it lends to commercial
banks.
Quantitative easing is purchases of government bonds by the central bank with the
purpose of reducing long-term interest rates and expanding the money supply.
Application:
Bank rate was cut to 0.5%.
A total of £375 billion QE injected since 2009.
7 Outline:

Concept of target, i.e. 2% over the medium term (+/– 1%). (2 marks)

Explanation of ceiling and floor (must have both). (1 mark)

Use of interest rates to achieve this: (1 mark)
o
If inflation goes too high then interest rates must rise. (1 mark)
o
If inflation goes too low then interest rates must fall. (1 mark)
o
If explanation of transmissions mechanism of AD shift is given then award up
to 2 marks.

Look at a range of indicators. (2 marks)

Emphasis on keeping within target range over medium term.

Sole objective, i.e. independent and apolitical.
Credit will also be given for recognising changes in emphasis of monetary policy after the
financial crisis and need to foster growth.
8 Knowledge, application and analysis (9 marks):
Concept of inflation target, i.e. 2% (+/–1%), and the role of monetary policy in achieving it.
Edexcel Economics A
Theme 2 The UK economy: performance and policies
© Andrew Sykes
Philip Allan for Hodder Education
34
TOPIC 6
Macroeconomic objectives and policies
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 (6 marks):
Effects might depend on:

Productivity growth relative to that of competitor countries.

Need for increase in AD as well.
9 Outline: (5 marks)
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: e.g. 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.
10 Factors the Bank might consider include:

state of banking system or other credit problems

unemployment/employment levels

levels of debt/savings

change in retail sales/consumer spending

exogenous shocks such as Eurozone crisis

government fiscal policy (government spending and taxation)

money supply growth

commodity prices

skills shortages

recent inflation/cost pressures (for explanation mark there must be reference to
expected rates or pattern of inflation)
Edexcel Economics A
Theme 2 The UK economy: performance and policies
© Andrew Sykes
Philip Allan for Hodder Education
35
TOPIC 6

Macroeconomic objectives and policies
house price changes
1 mark each for identification/explanation of each point.
1 mark each for explanation of why MPC considers the data/link of point to price
level/inflation.
1 mark each for application to the extract.
11 Knowledge, application and analysis (14 marks):

Demonstrates precise knowledge and understanding of the concepts, principles and
models.

Ability to link knowledge and understanding in context using appropriate examples.
Analysis is relevant and focused with evidence fully and reliably integrated.

Economic ideas are carefully selected and applied appropriately to economic issues
and problems. The answer demonstrates logical and coherent chains of reasoning.
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.
Evaluation (3 x 2 or 2 x 3 marks):
To score 5–6 evaluation marks, evaluation must include a developed chain of reasoning
which is linked directly to the core parts of the question:

Evaluative comments supported by relevant reasoning and appropriate reference
to context.

Evaluation is balanced and considers the broad elements of the question, leading
to a substantiated judgement.

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.
Edexcel Economics A
Theme 2 The UK economy: performance and policies
© Andrew Sykes
Philip Allan for Hodder Education
36
TOPIC 6

Macroeconomic objectives and policies
Banks may not adjust interest rates or respond to QE by increasing lending.
12 Knowledge, application and analysis (14 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 2 or 2 x 3 marks):
To score 5–6 evaluation marks, evaluation must include a developed chain of reasoning
which is linked directly to the core parts of the question:

Evaluative comments supported by relevant reasoning and appropriate reference
to context.

Evaluation is balanced and considers the broad elements of the question, leading
to a substantiated judgement.

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.
13 Knowledge, application and analysis (14 marks):
Definition of fiscal policy: government spending and taxation. (1 mark)
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 1 mark and explanation 1 mark)

increase in taxation (T)
Edexcel Economics A
Theme 2 The UK economy: performance and policies
© Andrew Sykes
Philip Allan for Hodder Education
37
TOPIC 6

Macroeconomic objectives and policies
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 (3 x 2 or 2 x 3 marks):
To score 5–6 evaluation marks, evaluation must include a developed chain of reasoning
which is linked directly to the core parts of the question:

Evaluative comments supported by relevant reasoning and appropriate reference
to context.

Evaluation is balanced and considers the broad elements of the question, leading
to a substantiated judgement.

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.
Edexcel Economics A
Theme 2 The UK economy: performance and policies
© Andrew Sykes
Philip Allan for Hodder Education
38