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AS Economics Answers
inflation, or too little, so there will still be unemployment. A, B
and C would all help the government achieve its objective.
4 Answer B
The instruments of monetary policy are changes in the money
supply, interest rates and the exchange rate. A, C and D are
examples of fiscal policy instruments.
5 Answer B
If households save most of the rise in disposable income,
consumption will not rise by much and so AD will not increase
significantly. A, C and D will all increase AD.
6 Answer A
If people expect their wages to rise and interest rates to remain
high for only a short time, they may not change their level of
consumption despite a rise in interest rates. This is because
people will feel optimistic that they will be able to afford high
interest payments and they will not have to pay them for long.
8 Managing the economy
1 The nature of government policy
Activity 1, page 291
a An increase in investment and increased international price
competitiveness. Low inflation, especially if it is stable, makes
it easier for firms to plan ahead. Greater certainty over future
costs and profits is likely to encourage firms to expand their
output. The country may become more price competitive if its
inflation rate is below that of its main competitors.
b By encouraging firms to invest and by increasing international
competitiveness. Higher investment and increased demand for
the country’s products from at home and abroad should raise
aggregate demand and increase output. The rise in output will
increase the country’s economic growth and should reduce
unemployment.
Data response questions, page 294
Activity 2, page 292
a Advances in technology and changes in the rate of interest.
Advances in technology make new capital equipment more
productive and so encourage firms to replace at least some of
their capital equipment with new equipment. Changes in the
rate of interest affect consumption, the cost of borrowing and
the opportunity cost of using retained profits for investment.
A lower rate of interest is likely to increase consumption and
thus demand for firms’ products, which should encourage firms
to expand. It will also make it cheaper for firms to borrow to
finance investment, and less interest will be forgone if firms use
profits to buy capital goods instead of placing them in bank
accounts.
b The existence of the hidden economy. Certain economic activity
is not declared either because the activity itself is illegal or
because people want to evade paying tax on the earnings they
receive. If the size of the hidden economy increases, even if
official GDP does not change, the country will be enjoying a
higher output.
c Adding up all the output produced in the country and
calculating the total expenditure on the country’s output.
d An increase in AD will shift the AD curve to the right. If the
economy is initially operating below the full employment level
as shown in Figure 2, the increase in AD will raise output.
a Activity in the housing market and changes in employment.
Increased activity in the housing market would suggest that the
rate of inflation might rise in the future for two reasons:
increased demand for houses will probably push up their price;
when people move homes they spend more on furniture,
carpets and decoration. Higher house prices also make
homeowners feel better off and encourage people to spend
more. Falling unemployment may push up the price level for
three main reasons: an increasing shortage of workers;
increased power of trade unions which will push up wage rates;
increased confidence in the future which will raise spending.
b By encouraging an increase in consumption and investment. If
the interest rate had been lower, households would have had
less incentive to save, borrowing would have been cheaper and
the lower mortgage interest payments would have left them
with more discretionary income to spend. This would probably
have increased consumption, which would have increased
output. The higher consumption and reduced cost of borrowing
would probably have increased investment. An increase in the
quantity and quality of capital goods (if the new capital goods
embody advanced technology) would have increased aggregate
demand further and shifted the LRAS curve to the right.
Multiple choice questions, page 294
Figure 2
1 Answer B
Changes in the rate of interest are an instrument of monetary
policy. Fiscal policy covers changes in taxes and government
spending. Regional policy seeks to influence the distribution of
people and firms and includes measures such as tax incentives for
firms and government spending to regenerate depressed areas.
Supply-side policies seek to increase the productive potential of
the economy.
2 Answer B
Economic growth and full employment are most likely to benefit
from increases in domestic spending, because higher domestic
spending is likely to increase output, which will create extra jobs.
Higher domestic spending may, however, cause demand-pull
inflation. The higher domestic spending may also result in more
imports being purchased and exports being diverted to the home
market and so a deterioration in the current account of the
balance of payments.
3 Answer D
If the government miscalculates the size of the multiplier effect it
is likely to increase its spending by too much, which will lead to
AD3
LRAS
AD2
P3
AD1
price level
AD
AD3
P2
P1
P
AD2
AD1
AD
0
53
Y
Y1
real GDP (output)
Yfe
Activity 5, page 298
Higher output usually leads to a fall in unemployment,
although there may be a time delay because firms often want to
see that the rise in demand will last. If AD shifts to AD2, full
employment will be achieved.
There is a risk, however, that the increase in AD may lead to
inflation. An increase in AD to AD3 will cause a significant rise
in the price level. New classical economists argue that an
increase in AD will push up the price level but have no impact
on output in the long run. Figure 3 shows that if an economy
operates at full employment, an increase in AD will be purely
inflationary.
a
b
c
d
expenditure reducing
expenditure switching
expenditure switching
expenditure reducing
Activity 6, page 299
a A budget surplus occurs when government revenue exceeds
government expenditure.
b It may not have much impact on the economy if much of the
extra spending is not passed on in the economy either because
it is saved or because it is spent on imports.
Figure 3
Multiple choice questions, page 301
price level
AD1
AD
LRAS
1 Answer C
Fiscal policy measures involve changes in government spending
and taxation. An increase in jobseeker’s allowance will involve
higher government spending. B and D are monetary policy
measures.
2 Answer B
An expansionary fiscal policy measure is a change in government
spending or taxation which increases AD. A cut in excise duties is
likely to raise consumption. A and C are expansionary monetary
policy measures. D is a deflationary fiscal policy measure.
3 Answer C
To tackle high demand-pull inflation a government is likely to try
to reduce AD. A rise in income tax would reduce disposable
income, which would probably reduce consumption. A and B may
increase inflation and D is not a fiscal policy measure.
4 Answer A
If there are time lags, there is a risk that by the time policy
measures take effect economic conditions may have changed,
making the measures ineffective or counterproductive. B, C and D
would make fiscal policy more effective.
5 Answer B
Figure 5 shows both an increase in AD and an increase in LRAS. An
increase in government spending on training would have raised
AD and, if it increased labour productivity, it would also have
increased LRAS. A and D may have reduced AD and C may have
reduced both AD and LRAS.
6 Answer D
An automatic stabiliser is a form of government spending or
taxation that changes to offset changes in economic activity
without any deliberate alteration in government policy. When the
economy is booming, corporation tax will rise to dampen down
the high level of economic activity. A, B and C usually change as
the result of a deliberate government decision.
P1
P
AD1
AD
0
Y
real GDP (output)
2 Fiscal policy
Activity 1, page 295
a 29%
b 27.51%
c Government spending was expected to exceed government
revenue, resulting in a budget deficit of £11 billion.
Activity 2, page 296
a Direct taxes are taxes on income, such as income tax and
corporation tax; indirect taxes are taxes on spending, such
as VAT and excise duties.
b It was a reflationary budget because increasing government
spending and reducing taxes would have increased aggregate
demand.
c The budget changes, by increasing aggregate demand, would
probably have raised output, which should have raised
employment and reduced unemployment.
Activity 3, page 297
a By stimulating economic growth. If tax cuts result in a rise in
output, incomes and spending will increase. The lower rates will
be more than offset by people paying taxes on higher incomes
and spending more, and firms paying taxes on higher profits.
b By increasing AD. They can also increase the economic growth
rate in the long term by stimulating a rise in resources. For
instance, cutting corporation tax may encourage firms to invest
more.
Data response questions, page 301
a A cut in income tax and a rise in state pensions would increase
aggregate demand. A cut in income tax would raise disposable
income, and the increased purchasing power would be likely
increase consumption. Higher state pensions would raise the
spending power of pensioners and would be likely to increase
consumption.
b Reflationary fiscal policy involves changes in government
spending and/or changes in taxation designed to increase
aggregate demand. Deflationary fiscal policy also involves
changes in government spending and taxation but is designed
to reduce aggregate demand.
c i It will increase AD. By increasing the country’s infrastructure
it will also raise the productive capacity of the economy.
Figure 6 shows both AD and LRAS curves shifting to the right,
causing output to rise.
Activity 4, page 298
a The cuts would reduce aggregate demand. There would be an
initial fall as the government spends less, and there is a knockon effect as, for instance, firms supplying hospitals spend less
on capital goods and equipment, food and medicines from
other firms.
b i By reducing aggregate demand, such cuts may reduce
demand-pull inflation.
ii They may increase inflationary pressure because cuts in
these areas may reduce the quality of the workforce and so
reduce LRAS. Shifting the LRAS curve to the left will push up
the price level if the economy was previously operating at or
close to full capacity.
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of the components of AD, and this may increase investment,
another component of AD.
b Because it is difficult to decide which items will give the best
indication of future changes in AD.
Figure 6
LRAS LRAS1
AD1
price level
AD
Activity 4, page 304
a Because it would increase AD and may result in labour shortages,
which would push up wage rates and costs of production.
b Low interest rates may encourage consumers and firms to
borrow more money than they can afford to repay.
c Because the economy had come close to experiencing a
recession. The MPC was concerned that at a time when UK
output was rising by only a small percentage, a rise in interest
rates could cause output to fall.
P
AD
0
Y
AD1
Y1
real GDP
ii It will reduce disposable income, which is likely to reduce AD.
Its effect on the economy will depend on the initial position
of the AD curve on the LRAS curve and the size of the
increase in taxation. Figure 7 shows the AD curve moving
from a position near to full capacity to one where there is
significant spare capacity, which lowers output and the price
level. The LRAS curve may shift to the left if the rise in
income tax causes some people to leave the workforce, for
example through earlier retirement.
Activity 5, page 305
a Poland was experiencing mainly cost-push inflation. Polish
firms’ costs were rising as a result of higher transport costs
caused by rising oil prices. Polish food processing firms were
also experiencing higher costs because of a poor harvest and the
imposition of tariffs on a number of farm products.
b A rise in interest rates above 20% would be likely to reduce
consumption and investment by a large amount. Such a high
rise would significantly increase the cost of borrowing, reduce
the discretionary income of people who have borrowed in the
past and encourage saving. It would also discourage investment
by making borrowing more expensive, increasing the
opportunity cost of investing and reducing the expected returns
from investing.
Figure 7
LRAS
AD
price level
AD1
Activity 6, page 305
P
3 Monetary policy
a By encouraging consumption and investment. Lower interest
rates would reduce the return from saving, make borrowing
cheaper and increase the spending power of mortgage holders.
They would reduce the direct and opportunity cost of investing
and increase the expected return from buying capital goods.
They may also stimulate domestic economic activity if there is a
fall in the exchange rate. This is because exports will become
cheaper and imports more expensive, which will encourage a
switch in demand from foreign to domestic products.
b If firms and households are pessimistic about the future. If
households think that unemployment is likely to rise in the
future, they may be reluctant to spend more now. Similarly, if
firms think that demand will not rise in the next year or two or
may even decline, they will not want to expand their capacity.
Activity 1, page 302
Activity 7, page 306
a
b
c
d
e
a Because they improve the current account position by reducing
demand for both foreign and domestically produced products.
b A government could lower its exchange rate, as an expenditure
switching measure, or raise income tax, as an expenditure
reducing measure.
P1
AD
AD1
0
Y1
real GDP
Y
d Deflationary fiscal policy designed to reduce inflation may also
cause unemployment. If the government miscalculates the size
of the multiplier, a cut in its spending may lower AD by more
than intended, causing output and employment to fall.
fiscal policy
monetary policy
fiscal policy
fiscal policy
monetary policy
Activity 2, page 303
Activity 8, page 306
a It will make export prices high and import prices low.
b Because it will make imports more price competitive. Some
consumers may switch their purchases from domestically
produced to foreign products.
c Because it will raise the price of imports. Costs of production
will increase because imported raw materials will be more
expensive. The price of imported finished products will increase
and there will be less pressure on domestic firms to keep down
their price rises.
a If the resulting rise in import prices leads to inflation.
b Because it may reduce demand for their products and will make
it more expensive for them to borrow.
Multiple choice questions, page 308
1 Answer D
Monetary policy measures include changes in the money supply,
the exchange rate and the rate of interest. A is a supply-side
measure and B and C are fiscal policy measures.
2 Answer D
A rise in the external value of the pound will lower the price of
imports. This is likely to reduce inflationary pressure. By making
exports more expensive and imports cheaper, it may also reduce
aggregate demand.
Activity 3, page 303
a A direct relationship would be expected between changes in
the money supply and aggregate demand. An increase in the
money supply is likely to increase consumption, which is one
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3 Answer C
A reduction in consumer spending will reduce demand-pull
inflation. A and D may raise inflation. So may B in the short run.
4 Answer B
To reduce inflation occurring when the economy is operating at
full capacity, the government is likely to seek to reduce AD. It
could do this by increasing interest rates, as this would probably
reduce consumption, investment and possibly net exports. A, C
and D would all be likely to increase AD.
5 Answer C
A fall in interest rates will reduce the cost of borrowing to finance
investment and the opportunity cost of investing. As well as making
it cheaper to invest, the lower rate of interest will stimulate
investment as consumption would be expected to increase.
6 Answer C
If accurate information is not available, there is the risk that the
direction and rate of change in a monetary policy measure may be
inappropriate.
4 Supply-side policies
Activity 1, page 309
a It is interventionist. The government spends money on training
and teaching adults because it thinks that, if left to free market
forces, there would be underconsumption of training and adult
education.
b It will increase labour productivity if the training makes workers
more skilful, meaning that they can follow more complicated
instructions, work with more advanced technology, tackle more
tasks and be more innovative and adaptable. However, if the
training is of a poor quality or is in inappropriate areas, the
productivity of the workforce may not rise.
Activity 2, page 310
With lower corporation tax, firms will have more funds to invest,
and they will pay less tax on any future profits they earn. As a
result they are likely to buy more capital goods, which will
increase AD. The extra capital goods and the advanced technology
they are likely to include will increase the quantity of goods and
services the country is capable of producing. This will shift the
LRAS curve to the right.
Data response questions, page 308
a If households, workers and firms do not expect high inflation
they will not act in a way which causes inflation. Households
will not increase their spending now, workers will not press for
large wage rises and firms will not raise their prices by a large
amount.
b A cut in interest rates would be expected to increase
consumption, investment and net exports (via a fall in the
exchange rate). The resulting increase in AD is illustrated in
Figure 3 by a shift in the AD curve to the right. An increase in
investment will also shift the LRAS curve to the right. If both AD
and LRAS increase, real GDP will increase. The effect on the
price level will depend on the initial position and the size of the
relative changes. In Figure 3 it remains unchanged at P.
Figure 3
LRAS LRAS1
AD1
price level
AD
AD1
AD
0
Figure 3
LRAS
LRAS1
a Illiterate workers will find it difficult to read instructions,
communicate with other workers, fill in forms, work with capital
equipment, benefit from training and keep up-to-date with
developments.
b If the government underestimates the socially optimum level
or lacks the necessary funds. It can be difficult to estimate the
private and external benefits of education. To spend more on
education, a government may have to reduce its spending on
other areas or raise taxation, and it may be reluctant to do this.
price level
AD
P
AD1
AD
Y
real GDP
Y1
Activity 3, page 311
AD1
0
Y
real GDP
Y1
Activity 4, page 311
a A greater quantity and quality of training should reduce
unemployment and cut firms’ costs. Better trained staff will be
more skilful. This should make it easier for them to find a new
job if they lose their current job and so should reduce frictional
unemployment. It should also increase their productivity. This
will lower firms’ costs and make them more internationally
competitive.
b Because of the cost involved and concern that they will not
benefit from the expenditure. As the extract mentions, training
staff can involve costs such as course fees, time off work and the
need to have temporary replacements. Firms that pay for the
training may fail to benefit if the trained staff leave.
c A rise in the rate of interest would increase home buyers’
mortgage interest repayments. This would reduce their
discretionary income and purchasing power. A higher rate of
interest may also cause problems for exporters because it is
likely to encourage an inflow of hot money into the country,
which would push up the exchange rate. A higher exchange rate
will push up the price of exports. This will make it more difficult
for exporters to sell their products on foreign markets.
d The passage mentions the problem of time lags and the
difficulty of influencing AD when households and firms have
firm views about future economic prospects. Interest rate
changes, for example, can take up to 18 months to have an
impact. By then, economic conditions may have changed and
instead of, for example, offsetting inflationary pressures, a rise
in interest rates may contribute to deflationary pressures. A cut
in interest rates or an increase in the money supply will not be
effective in increasing AD if households and firms are
pessimistic about future economic prospects.
Multiple choice questions, page 313
1 Answer D
The aim of supply-side policies is to increase the productive
potential of the economy. The productive potential of the
economy is shown by the vertical part of the LRAS curve. A shift
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to the right of the LRAS curve means that the economy is capable
of producing more goods and services.
2 Answer D
Government grants for retraining are designed to improve the
skills of the workforce and so increase the economy’s productive
capacity. A and C are monetary policy instruments. An increase in
income tax is likely to reduce AD (contractionary fiscal policy). A
cut in income tax may be a supply-side policy if its main aim is to
increase incentives for workers and potential workers rather than
to increase AD.
3 Answer A
A cut in corporation tax may encourage firms to expand and take
on more staff. B is a monetary policy measure which is likely to
reduce AD and employment. A rise in the minimum wage may
increase unemployment if it is set too high and an increase in
jobseeker’s allowance may reduce the incentive for unemployed
people to find work.
4 Answer B
Free market supply-side policies seek to increase the productive
potential of the economy by reducing government intervention.
This should increase economic incentives for workers and firms
and raise efficiency.
5 Answer A
Supporters of free market supply-side policies believe that the
ability of a country to produce goods and services will be
increased by a reduction in government intervention, which
hinders the operation of free market forces. Removing laws, rules
and regulations should enable firms to perform more efficiently.
6 Answer C
If the economy is operating well below full employment and there
is no increase in AD, a shift to the right of the LRAS curve will have
no effect on output (see Figure 4). In the other three cases output
will rise (see Figure 5).
Figure 5
A
LRAS
LRAS1
price level
AD
AD
0
Y Y1
real GDP
LRAS
B
LRAS1
AD1
price level
AD
AD1
AD
0
Y
real GDP
D
AD1
LRAS
LRAS1
price level
AD
Y1
Figure 4
AD1
AD
LRAS LRAS1
0
price level
AD
Y1
d i Lone parents may find it difficult to work because of the
costs of childcare. The jobs they may have the skills for may
be low paid, and once they have paid childcare costs they
may be worse off working than receiving state benefits. Some
lone parents may be concerned that they will not be able to
spend sufficient time with their children.
ii More lone parents entering the workforce will increase the
supply of labour to the economy. This will raise the
productive potential of the economy, shifting the LRAS curve
to the right. The effect may be particularly significant if the
economy is approaching full employment and experiencing
labour shortages.
AD
0
Y
real GDP
Y
real GDP
Data response questions, page 314
a i Productivity is output per unit of factor input. Labour
productivity is usually defined as output per worker hour.
ii Economic growth is often taken to refer to increases in real
GDP. It can also be defined as increases in an economy’s
productive potential since for output to continue to increase
the quantity and quality of resources have to rise.
b Trend growth is the expected increase in potential output over
time. A rise in productivity would enable an economy to
produce more with existing resources and so would increase the
output it is capable of producing.
c It should reduce unemployment because it will increase
geographical mobility. If unemployed people find it easier to
travel to where the work is, this should reduce frictional
unemployment.
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