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TOPIC 1 Economic policy objectives and indicators of macroeconomic performance WORKBOOK ANSWERS OCR A-level Economics Macroeconomics 2 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. The student responses for the longer essay-style questions (green text) are intended to give some idea about how the exam questions might be answered. The examiner comments (blue text) have been added to give you some sense of what is rewarded in the exam and which areas can be developed. Again, these are not the only ways to answer such questions, but they can be treated as one way of approaching questions of these types. Topic 1 Economic policy objectives and indicators of macroeconomic performance Economic growth and development 1 The structure of an economy can be explained in terms of the three different sectors of primary, secondary and tertiary production. The primary sector refers to that part of the economy which extracts raw materials from nature. This sector can include industries such as agriculture, forestry, fishing, mining and quarrying. The secondary sector refers to that part of the economy which uses the output of the primary sector to manufacture a variety of different goods. This can include the manufacture or production of cars, clothes and computers. This sector also includes construction, such as the building of a motorway, a tunnel or an airport runway. The tertiary sector refers to that part of the economy which includes services, such as banking, insurance, tourism, education and distribution. 2 The human development index focuses on the measurement of three aspects of development: life expectancy, average income in the form of gross national income per capita, measured through purchasing power parity expressed in US dollars, and years of schooling. The multidimensional poverty index replaced the human poverty index in 2010 and focuses on three dimensions, health, education and living standards, and on ten indicators: child mortality, nutrition, years of schooling, child school attendance, electricity, sanitation, drinking water, type of floor, type of cooking fuel and ownership of assets. OCR A-level Economics © Terry Cook 2016 Macroeconomics 2 Hodder Education 1 TOPIC 1 Economic policy objectives and indicators of macroeconomic performance 3 Economic development differs from economic growth, and economic growth is just one aspect of the process of economic development. Whereas economic growth specifically refers to an increase in output in an economy and is usually measured through changes in gross domestic product (GDP) and, in particular, through changes in real GDP, i.e. after taking the effects of inflation into account (which is not the case with nominal GDP), economic development is concerned with bringing about an improvement in the economic and social well-being of a people. Although growth and development are not the same, growth will lead to the greater possibility of development taking place, particularly in a material sense. 4 Economic development is the sustained promotion of the standard of living in a particular area. It can also be referred to as the quantitative and qualitative changes in a particular society and economy. Development is a broad concept and so is often regarded as being multidimensional. Development goes beyond material progress and, according to Michael Todaro, extends to include such concepts as sustenance, self-esteem and freedom. Development also usually includes the idea of sustainable development, i.e. taking into account the needs of future generations. There may be economic growth in a country, but at the same time poverty could be increasing and there could be increasing inequality in the distribution of income and wealth. Development includes these wider aspects. This is why economic growth might be seen as a necessary condition for economic development, but it is not a sufficient condition. 5 The idea of sustainability stresses the fact that in meeting the needs of the present generation, the needs of the future generation should not be compromised. Sustainable development refers to the process of meeting human development goals while maintaining the ability of the systems to continue to provide the resources on which an economy and society depends. Sustainable development is based on the idea that finite resources should be used in a way that provides not only for the needs of the present generation, but also for the needs of future generations. Sustainable economic development refers to the fact that many resources are finite and that, in the process of development, there can be a depletion of these resources. The term, therefore, refers to the idea that the development process needs to take the environment fully into account. Sustainable development stresses that there should not be a reliance on the exploitation of resources that cannot be replaced. For example, in terms of the use of forests, attention needs to be given to the importance of replanting. According to the World Bank, meeting the needs of future generations means the balancing of a variety of social, economic and environmental objectives when making decisions today. Many of these objectives may conflict with each other in the short term, but in the long term the responsible use of resources now will help to ensure that there are resources available in the future. 6 Economic growth and development can be promoted through aid in the form of different kinds of grants and loans, but sometimes this aid can be ‘tied’, i.e. there are conditions attached to the aid which restrict the freedom of the receiving country to spend that money as it wishes. Economic growth and development can also be promoted through trade, OCR A-level Economics © Terry Cook 2016 Macroeconomics 2 Hodder Education 2 TOPIC 1 Economic policy objectives and indicators of macroeconomic performance especially where free trade is encouraged, but sometimes developing economies specialise in primary products and the price of these has declined relative to the price of secondary products. There is also likely to be greater volatility in the supply conditions of primary products, meaning that prices of such products are more unstable. 7 Economic growth and development can be promoted through aid and trade. Overseas or official development assistance (ODA) is a term used by the Development Assistance Committee (DAC) of the Organisation for Economic Co-operation and Development (OECD) to measure aid given to various countries to promote economic development. Aid can come in several forms, including grants and loans. Sometimes the aid is bilateral, involving just two countries, and sometimes it is multilateral, involving a number of countries and/or aid agencies. The aid can be used to finance investment projects, such as the building of a dam to improve the irrigation system of a region. Economic development can also be promoted through trade. If a country is able to export its products to more countries, this should encourage economic and social development, such as through the employment of a greater number of workers. Some countries have aimed for an export-led strategy to assist economic growth and development. If free trade is encouraged, such as through the reduction or abolition of tariffs, it will be easier to export a country’s products to foreign markets, and this will promote development, although the extent of this will depend on how much can be exported and the price that is paid for these exports. 8 There are a number of possible indicators that can be used to measure economic growth and economic development. Gross domestic product is one of the usual ways to measure economic growth, especially when it is measured in real terms to take into account the effects of inflation. When divided by the population of a country to give a per head or per capita figure, it is a useful way to measure living standards. The human development index (HDI) is an attempt, first established in 1990, to look at economic development from more criteria, going beyond real GDP per capita. The HDI examines the progress of countries in terms of three criteria: the standard of living, life expectancy and education. Although it is an improvement on real GDP per capita, it is still limited to just three criteria. The multidimensional poverty index (MPI) goes further than HDI and takes into account ten criteria: child mortality, nutrition, years of schooling, child school attendance, supply of electricity, sanitation, quality of drinking water, type of kitchen floor, type of cooking fuel and ownership of assets. This indicator has the advantage of including many more criteria than HDI, such as the quality of drinking water. The genuine progress indicator (GPI) supplements GDP by taking into account a number of environmental and social factors that are not measured by GDP. Examples of such factors include resource depletion, pollution and long-term environmental damage. Some indicators also attempt to explore the relationship between economic growth and happiness. The Easterlin paradox, named after the economist Richard Easterlin, points out that in many countries, the average level of happiness did not vary greatly with national income per person. For example, although income per person rose steadily in the USA OCR A-level Economics © Terry Cook 2016 Macroeconomics 2 Hodder Education 3 TOPIC 1 Economic policy objectives and indicators of macroeconomic performance between1946 and 1970, average happiness showed no long-term trend and it even declined between 1960 and 1970. The Office for National Statistics (ONS) has produced data under the heading Measuring National Well-being. Its aim is to develop new measures of national well-being to provide a fuller picture of how society is doing by supplementing existing economic, social and environmental measures. 9 The main purpose of the International Monetary Fund is to coordinate the international monetary system. Its objective is to ensure the stability of the world monetary system and to provide financial support, if required. 10 The International Monetary Fund, set up in 1944, has as its aim the supervision and coordination of the international monetary system. It aims to ensure that there is stability in the international system and it can pursue this aim by providing financial support to countries which are experiencing economic difficulties. This financial support can be useful in the promotion of economic growth and development. This support is sometimes linked with a requirement that a country carries out certain policies. 11 The main purpose of the World Bank is to provide finance to those countries that need it, especially developing economies. Loans are sometimes conditional on a country’s government adopting certain economic policies. 12 The World Bank, or the International Bank for Reconstruction and Development, as it is officially known, was also set up in 1944. It can provide financial support to countries that are facing economic difficulties, and this support can help countries to achieve economic growth and development. However, like the IMF, it can attach conditions to this financial support. 13 The main purpose of the World Trade Organization is to monitor and regulate international trade. Its objective is to reduce trade barriers as much as possible so as to encourage free trade, and free trade is likely to help in the promotion of economic growth and development. 14 The World Trade Organization, set up in 1995, aims to promote free trade between as many countries in the world as possible. It is opposed to trade barriers and aims to reduce as many of these as possible. It encourages discussions among member countries and these discussions are usually given a name. The most recent discussions have been known as the Doha Round. The promotion of free trade is also likely to promote economic growth and development. Unemployment/employment 15 NAIRU refers to the non-accelerating inflation rate of unemployment. 16 The non-accelerating inflation rate of unemployment (NAIRU) can also be referred to as the natural rate of unemployment. It means the level of unemployment at which the rate of inflation is constant. It is the level of unemployment in an economy that cannot be reduced in the long term by increasing aggregate demand. It is often associated with Monetarist, rather than Keynesian, economists, such as Milton Friedman. OCR A-level Economics © Terry Cook 2016 Macroeconomics 2 Hodder Education 4 TOPIC 1 Economic policy objectives and indicators of macroeconomic performance Once unemployment falls below a certain level, the rate of inflation is likely to accelerate. On the other hand, once unemployment rises above a certain level, the rate of inflation is likely to fall. It is even possible that the rate of inflation becomes negative and there is deflation, i.e. the general level of prices in an economy falls. There is thus a trade-off between the level of inflation and the level of unemployment in an economy. The natural rate of unemployment therefore occurs when an economy is at full employment, i.e. when the labour market is in equilibrium. 17 Patterns of employment and unemployment can have a number of consequences for an economy. These can include technological unemployment and cyclical unemployment. A number of people have lost their jobs as a result of technological progress over the last half century, which has required money to be spent on retraining and re-skilling schemes. The financial crisis of 2007–08 led to a credit crunch and a severe recession in 2008–09, which led to the Monetary Policy Committee reducing the bank rate to 0.5% in March 2009 in an attempt to stimulate the level of aggregate demand in the economy. In terms of employment, there has been a steady increase in the UK and there are more workers employed than ever before. However, many of these are part-time workers and indeed a number of these are on zero hours contracts, which means that they are not guaranteed employment, but are simply asked to work when the need arises. Inflation 18 A real value is one which shows a change over a period of time with the effects of inflation removed. This means that the value will be expressed in constant prices. 19 Both indices can be used to measure the rate of inflation in an economy, but there are differences between them. The consumer prices index (CPI) is the standard measure for international comparisons, but does not include housing costs. The retail prices index (RPI) does include housing costs, such as council tax and mortgage interest repayments. The RPI usually shows a higher rate of inflation than the CPI. Income distribution and welfare 20 A Lorenz curve can be used to explain how income and wealth are distributed in an economy. It is a visual representation showing inequality in the distribution of income and wealth in an economy. An example of one is shown in the diagram. OCR A-level Economics © Terry Cook 2016 Macroeconomics 2 Hodder Education 5 TOPIC 1 Economic policy objectives and indicators of macroeconomic performance Figure 1 The 45-degree line shows the line of equality which would exist if a certain percentage of the population received the same percentage of income. The Lorenz curve shows the extent to which the equality of income deviates from this 45-degree line of equality. The more unequal the distribution of income, the more the Lorenz curve will deviate from the 45-degree line. Conversely, the more equal the distribution of income, the closer the Lorenz curve will be to the 45-degree line. The Lorenz curve is therefore a useful way of showing the distribution of income and wealth in an economy. 21 The Gini coefficient refers to the ratio of the area between the 45-degree line of equality (where income is evenly distributed) and the Lorenz curve, and the total area under the line of equality. 22 A Gini coefficient of 0 would show the situation where there was absolute equality in the distribution of income and wealth in an economy. A Gini coefficient of 1 would show the situation where there was absolute inequality in this distribution. In the table, it is clear that the distribution of income and wealth is more equal in Sweden because this country has the lowest Gini coefficient of 0.259. It can also be seen that the distribution of income and wealth is less equal in Mexico because this country has the highest Gini coefficient of 0.476. The UK is in the middle with a Gini coefficient of 0.345. 23 It is possible to distinguish between two different types of poverty — absolute and relative poverty. Absolute poverty is where people are unable to afford the basic necessities of life. For example, this is where certain people are malnourished and homeless. In an attempt to put a figure on absolute poverty, the World Bank stated in 1990 that absolute poverty existed in a country when people were trying to survive on less than US$1.00 a day. This figure was increased to US$1.25 in 2005. Whereas absolute poverty is measured by the same monetary figure in all countries, relative poverty is where some people have less income than others in a society. Relative poverty is defined in terms of the context of a particular society and occurs when people are unable to buy what others are able to afford. This does not necessarily mean that they are poor in absolute terms. OCR A-level Economics © Terry Cook 2016 Macroeconomics 2 Hodder Education 6 TOPIC 1 Economic policy objectives and indicators of macroeconomic performance Trends in macroeconomic indicators 24 Economic growth in the UK has been averaging about 2.2%, but since the credit crunch of 2007–08 there have been two recessions and very nearly a third. In 2015, growth was between 2.4% and 2.6% p.a. The inflation rate has generally been over the target figure of 2% in recent years, reaching as high as 5.1%. In 2015, however, inflation (as measured by the consumer prices index) was below the target figure at 0.1% and in some months actually went into negative figures, indicating a situation of deflation. The unemployment rate has generally been higher than in the recent past since the credit crunch of 2007–08, although there has been an increase in the labour force to over 29 million. In 2015, the unemployment rate was 5.4% as measured by the Labour Force Survey. Finally, the balance of payments on current account has been in deficit, although the invisible balance has generally been in surplus. In 2015, the current account balance for the year was in deficit by about US$150 billion. Exam-style questions 25 Student answer: Economic growth and economic development are likely to involve a process of reallocation of resources so that there is a movement away from the primary sector and a movement towards the secondary and tertiary sectors. In this way, economic development can be seen as when a country moves away from being a developing country and towards being a developed country. The candidate has clearly demonstrated that they understand the relationship between economic growth and development and the likely changes in the structure of an economy. Economic growth and economic development are related and growth will lead to the greater possibility of development taking place, particularly in a material sense. However, they are not the same and economic growth is just one aspect of the process of economic development. Whereas economic growth specifically refers to an increase in output in an economy, economic development is concerned with bringing about an improvement in the economic and social well-being of a people. There may be economic growth in a country, but at the same time poverty could be increasing and there could be increasing inequality in the distribution of income and wealth. Development includes these wider aspects. This is why economic growth might be seen as a necessary condition for economic development, but it is not a sufficient condition. Development is a broader concept and so is often regarded as being multidimensional. Development goes beyond material progress and, according to Michael Todaro, extends to include such concepts as sustenance, OCR A-level Economics © Terry Cook 2016 Macroeconomics 2 Hodder Education 7 TOPIC 1 Economic policy objectives and indicators of macroeconomic performance self-esteem and freedom. Development also usually includes the idea of sustainable development, i.e. taking into account the needs of future generations. The candidate has made clear the relationship between, and the difference between, economic growth and development. Sustainable development is based on the idea that finite resources should be used in a way that provides not only for the needs of the present generation, but also for the needs of future generations. Sustainable economic development refers to the fact that many resources are finite and that, in the process of development, there can be a depletion of these resources. The term, therefore, refers to the idea that the development process needs to take the environment fully into account. According to the World Bank, meeting the needs of future generations means the balancing of a variety of social, economic and environmental objectives when making decisions today. Many of these objectives may conflict with each other in the short term, but in the long term the responsible use of resources now will help to ensure that there are resources available in the future. The candidate has demonstrated a sound understanding of the link between sustainable development, economic development and economic growth. There is thus a close relationship between economic growth, changes in the structure of an economy, economic development and sustainable development. The conclusion is rather limited and could have been developed more fully. MARK: 18/25 26 Student answer: The traditional approach to measuring development has been through GDP per capita, i.e. take the GDP of a country and divide it by the population of the country to give a per head or per capita figure. An even better approach has been to take into account the effects of inflation by using real GDP per capita. A useful start by bringing in both GDP per capita and real GDP per capita. However, given that development is a wider concept than growth, other approaches to measuring development have been introduced. One of these is the human development index. This is a wider concept than GDP per capita. It has included GDP per capita within it, although since 2010 GDP per capita has been replaced by gross national income (GNI) per capita in $US at purchasing power parity. The contrast between growth and development could have been developed more fully. It is good, however, to demonstrate knowledge of recent changes in the construction of the HDI. In addition to GNI per capita, the HDI also includes two other elements. One is life expectancy at birth. The other is years of education; this is actually made up of two elements, mean years of schooling and expected years of schooling. OCR A-level Economics © Terry Cook 2016 Macroeconomics 2 Hodder Education 8 TOPIC 1 Economic policy objectives and indicators of macroeconomic performance There could have been a more detailed consideration of these two aspects. The HDI is, therefore, considered to be a better indicator of development than GDP per capita because it also includes life expectancy and years of schooling. The conclusion could have been developed more fully, discussing in greater depth the advantage of HDI over GDP. MARK: 7/12 27 (a) Student answer: The increase in the person’s real income is 5.2% − 2.9% = 2.3%. The answer is correct and gains both marks. (b) Student answer: Economists are interested in changes in real income because a real value takes into account the impact of inflation. If a person’s income rises by less than the rate of inflation in an economy, then the person’s purchasing power will actually fall, i.e. they will be worse off because the rise in income has not been enough to offset the rise in the general level of prices in the economy. Changes in nominal income simply show a change in a person’s income, without taking into effect the impact of the rate of inflation. The candidate understands the difference between nominal and real income and is able to explain why economists are particularly interested in changes in real income. MARK: 3/4 28 C 29 C 30 D 31 A 32 B 33 B 34 B 35 A 36 C OCR A-level Economics © Terry Cook 2016 Macroeconomics 2 Hodder Education 9 TOPIC 2 Aggregate demand and aggregate supply Topic 2 Aggregate demand and aggregate supply Aggregate demand 1 The term ‘accelerator’ shows the relationship between investment and the rate of change of output. 2 The theory of the accelerator is a way of explaining the relationship between investment and the rate of change of output. The most important feature of the accelerator idea is that it is not the level of output that determines investment but the rate of change of that output. Investment can therefore be said to be a function of a change in national income. If the level of output grows faster than was previously the case, the rate at which new productive capacity is created will need to increase. However, if the level of output stabilises, it will not be necessary to have any additional investment, other than what is needed to take account of depreciation. In this situation, investment will actually fall. The accelerator theory therefore explains why investment changes more than output. It relates to the induced effect on investment of a change in national income, in contrast to the multiplier which explains the effect of an autonomous change in investment on national income, and it assumes a fixed capital–output ratio. Aggregate supply 3 It is possible to distinguish between two different approaches to aggregate supply. Figure 2 The Keynesian approach emphasises that the AS curve is a horizontal, perfectly elastic, line up to the full employment level of real output. An increase in aggregate demand, such as from AD to AD1, will increase the level of real output but not the level of prices. When the full employment level of real output is reached, however, the level of prices will OCR A-level Economics © Terry Cook 2016 Macroeconomics 2 Hodder Education 10 TOPIC 2 Aggregate demand and aggregate supply increase so that the AS curve now becomes a vertical, perfectly inelastic, line. This is shown in Figure 2. Figure 3 The neo-classical approach to aggregate supply adopts a different approach from the Keynesian one. This is shown in Figure 3. In this situation, the AS curve is a vertical line. Any increase in aggregate demand, such as from AD to AD1, will increase the price level, but not output and employment. In order to increase output and employment, supply-side policies are needed to shift the AS curve to the right. These could include measures to cut taxes so as to increase the incentive to work, reduce the power of trade unions, cut benefits to make working appear more attractive, deregulation to increase the level of competition in certain industries and the creation of a more entrepreneurial business climate. Macroeconomic equilibrium 4 There are important differences between these three schools of thought on how the macroeconomy operates. The Keynesian approach emphasises that governments will need to play a key role in helping an economy to achieve full employment. If aggregate demand is too low, a high level of unemployment will arise which is unlikely to be solved by market forces alone. This is in contrast to the neo-classical school of thought, which puts the emphasis on market forces achieving macroeconomic equilibrium without a need for a great deal of government intervention. The Austrian school of thought, such as the ideas of Friedrich Hayek, also focuses on the idea of macroeconomic equilibrium coming about largely as a result of market forces rather than through government intervention. The Phillips curve 5 In the short run, the Phillips curve moves upwards, i.e. it shifts to the right, and so the trade-off between inflation and unemployment remains, but now at a higher rate of inflation OCR A-level Economics © Terry Cook 2016 Macroeconomics 2 Hodder Education 11 TOPIC 2 Aggregate demand and aggregate supply than was previously the case. The Phillips curve may therefore become vertical in the long run. 6 The Phillips curve shows the relationship between the rate of inflation and the rate of unemployment in an economy, emphasising the trade-off between them. This means that increases in the inflation rate would be associated with decreases in the unemployment rate, while decreases in the inflation rate would be associated with increases in the unemployment rate. Thus, the Phillips curve is downward sloping, at least in the short run. This is shown in Figure 4. Figure 4 However, it is also necessary to consider the expectations-augmented Phillips curve. If people have strong expectations of inflation, they are likely to want to negotiate large wage increases to ensure that there is not a loss in the purchasing power of the money they earn. The effect of this is that at any given level of unemployment, the rate of inflation will increase. It therefore becomes necessary to distinguish between the short-run and the long-run Phillips curve. In the short run, the Phillips curve moves upwards, i.e. it shifts to the right, and so the trade-off between inflation and unemployment remains, but now at a higher rate of inflation than was previously the case. However, in the long run the Phillips curve may become vertical. Workers continue to have strong expectations of inflation and this is known as the adaptive-expectations hypotheses, i.e. they base their view of future inflation rates on what has happened in the past. The short-run trade-off comes about because of ‘money illusion’, i.e. workers focus on money wages and not real wages. In the long run, there is no trade-off between the rate of inflation and the rate of unemployment and the economy returns to its long-run equilibrium. The real wage is restored to long-run equilibrium and the economy is at full employment. This is shown in Figure 5. OCR A-level Economics © Terry Cook 2016 Macroeconomics 2 Hodder Education 12 TOPIC 2 Aggregate demand and aggregate supply Figure 5 The economic cycle 7 The four stages of the economic cycle are referred to as boom, recession, slump and recovery. 8 The economic, trade or business cycle refers to the fluctuations in output and employment in an economy over a period of time. During this time, economies will go through four stages of the cycle: periods of boom, recession, slump and recovery. The long-run trend, however, will tend to increase. A boom is the phase of the economic, trade or business cycle in which economic growth is at its most rapid. As the recovery in the economy improves, economic growth becomes faster until it is growing at a rate which is unsustainable in the long run. A recession is the downswing in the economic, trade or business cycle and it is during this phase of the cycle when aggregate demand may begin to decline. Business confidence will be low, so investment is likely to be falling. The technical definition of a recession is two successive quarters of negative growth. The most severe recent depression in the world was in 2008–09. A slump is the low point of the economic cycle. At this phase in the cycle, aggregate demand is well below the level of full-capacity output in an economy. A recovery is the upswing phase of the cycle, when aggregate demand and output begin to rise, although this is likely to be at a slow pace to begin with. 9 It is important to distinguish between short-run causes of economic growth and long-run causes of economic growth. Short-run causes of growth can include changes in aggregate demand, short-run changes in aggregate supply, the interaction of the multiplier and the accelerator and the economic cycle. Long-run causes of growth can include changes in long-run aggregate supply, the quantity and quality of the labour force and changes in capital stock. OCR A-level Economics © Terry Cook 2016 Macroeconomics 2 Hodder Education 13 TOPIC 2 Aggregate demand and aggregate supply Changes in long-run aggregate supply will be relatively elastic to begin with, as output grows, but eventually, as the availability of resources becomes increasingly limited, longrun aggregate supply becomes increasingly inelastic until it eventually becomes a vertical line. However, it is possible in the long run to change the quantity and/or quality of resources. This would allow the long-run supply curve to shift. For example, over time, the labour force can increase, especially as a result of net migration into a country. The quality of a labour force could also be increased as a result of a government’s supply-side measures in proving training and retraining courses, leading to an enhancement of the skills of workers, making them more employable. The capital stock can also be changed in terms of quantity and/or quality in the long run. For example, replacement capital will be able to take advantage of technical progress and innovation, making the equipment more effective and cost-efficient. 10 The multiplier refers to the amount by which an increase in injections into the circular flow of income will be able to increase the level of total income in an economy. These injections can be in the form of investment, government spending and exports. The size of the multiplier will depend on the extent to which these injections into the circular flow of income leak away into withdrawals from the circular flow of income, in the form of savings, taxation or imports. The size of the multiplier in an economy can be calculated in the following way: 1 ________________ MPS + MPT + MPM MPS refers to the marginal propensity to save, MPT refers to the marginal propensity to tax and MPM is the marginal propensity to import. The accelerator refers to the relationship between investment and the rate of change of output in an economy. It is important to understand that it is not simply the change in output that is important, but the rate of change. The effect of this relationship is that investment is likely to fluctuate more than output. The size of the accelerator in an economy can be calculated in the following way: I = f (change in Y) This means that investment is a function of the rate of change in national income. The interaction between the multiplier and the accelerator is very important in explaining the cyclical changes that can occur in an economy. For example, an increase in investment during the upswing of the economic cycle will have a multiplier effect in an economy, leading to a larger increase in income. As an economy approaches full capacity, the accelerator theory stresses that investment will fall, creating a downward or negative multiplier effect. Eventually there will be a need for investment to grow. There is thus an economic cycle which is continually repeating itself. OCR A-level Economics © Terry Cook 2016 Macroeconomics 2 Hodder Education 14 TOPIC 2 Aggregate demand and aggregate supply 11 An output gap shows the difference between the actual output of an economy and the potential output of that economy when it is working at full capacity. It is possible to look at changes in real GDP over a period of time and compare this with the long-run trend rate of growth to see if there is a deviation or divergence. This output gap can be either positive or negative. 12 If the output gap is negative, this means that aggregate demand is below what an economy is able to produce. In this situation, there will be a deflationary gap and there will be a relatively high rate of unemployment in the economy. If the output gap is positive, this means that aggregate demand is more than what an economy is able to produce. In this situation, there will be an inflationary gap. Exam-style questions 13 (a) Student answer: The multiplier is calculated by 1 divided by MPS + MPT + MPM. The answer is therefore 1 divided by 0.1 + 0.3 + 0.4 = 1/0.8 = 1.25. The candidate has produced the correct answer. MARK: 2/2 (b) Student answer: The circular flow model stresses that there are three injections into an economy (government spending, investment and exports) and three leakages or withdrawals from an economy (taxation, savings and imports). The size of the national income multiplier is determined by the strength of the marginal propensity to save, the marginal propensity to tax and the marginal propensity to import. To calculate the size of the national income multiplier, the formula is 1 divided by MPS + MPT + MPM. The candidate clearly has an understanding of the circular flow of income in an economy and is able to identify the three injections into, and the three leakages or withdrawals from, the circular flow of income. However, although the three factors are referred to, and the calculation is given, there is no clear explanation of what is meant by these three factors. MARK: 3/6 14 C 15 B 16 A 17 A OCR A-level Economics © Terry Cook 2016 Macroeconomics 2 Hodder Education 15 TOPIC 3 The application of policy instruments Topic 3 The application of policy instruments Fiscal policy 1 Average and marginal rates of tax can be distinguished. The average tax rate is the average percentage of total income which is paid in taxes. The marginal tax rate is the percentage of additional income which is paid in taxes. The distinction is an important one because if a tax system is progressive, it will mean that the marginal rate of tax will be higher than the average rate of tax. 2 The Laffer curve shows the relationship between the rate of tax and the revenue that is obtained from the tax. The curve shows that higher tax rates will eventually lead to a fall in the revenue received from a tax, i.e. the higher rate acts as a disincentive. This can apply to firms, in relation to corporation tax, and to employees, in relation to income tax. Although the rate of tax is higher, fewer people are working and so the revenue obtained from the tax will be lower. In such a situation, a tax cut could lead to an increase in revenue for a government because more people will want to work and firms will want to expand. The Laffer curve shows that at a low level of taxation, the revenue from tax will increase if the tax rate is raised. On the other hand, at a high rate of taxation, the revenue from tax will decrease if the tax rate is raised, demonstrating the disincentive effect of a tax increase. 3 An automatic stabiliser is a fiscal policy which works to reduce fluctuations in income over the course of the trade cycle without a government needing to further intervene, especially in relation to the different stages of the trade cycle. 4 Income tax can be regarded as an example of an automatic stabiliser. As incomes rise in the boom phase of the trade cycle, the revenue gained from income tax rises more than proportionately because income tax is a progressive tax. As incomes fall in the recession phase of the trade cycle, the revenue gained from income tax falls more than proportionately. Also, government spending on unemployment benefits will automatically rise if the level of unemployment increases and so the extra spending will have the effect of compensating for the reduction in the earned income of workers. The effect of income tax and unemployment benefits working as automatic stabilisers in this way is that income tax takes more spending power out of an economy during a boom than it does in a recession. This helps to counteract the fluctuations in aggregate demand and so reduce the impact of these cyclical events. 5 Fiscal policy could lead to a situation of ‘crowding out’ or ‘crowding in’ when it is expansionary, such as in a time of recession or depression. If there is an increase in government spending and/or a decrease in tax revenue, increased borrowing may be necessary to finance this deficit. If a government needs to borrow more money to finance its increased expenditure, this could reduce investment OCR A-level Economics © Terry Cook 2016 Macroeconomics 2 Hodder Education 16 TOPIC 3 The application of policy instruments spending by the private sector, i.e. the increased borrowing ‘crowds out’ private investing. Crowding out can therefore be seen as a situation where increased public expenditure diverts money or resources away from the private sector. On the other hand, such a situation could give rise to ‘crowding in’. If a government decides to increase its spending, it can possibly lead to higher private investment. Deficit spending by a government is likely to stimulate economic activity and, as an economy grows, private firms may be encouraged to expand and so investment will be encouraged, not discouraged as the ‘crowding out’ hypothesis would suggest. Monetary policy 6 The liquidity trap refers to a situation in the liquidity preference theory where an increase in the money supply, beyond a certain point, does not affect the interest rate. Normally, an increase in the money supply will lead to a fall in the interest rate, but when the demand curve for money becomes horizontal, such a shift to the right will have no effect on the interest rate. The interest rate will fall to a point beyond which it cannot go any lower. Figure 6 The diagram shows that when there is a shift to the right of the money supply curve, from MS to MS1, increasing the quantity of money from 0Q to 0Q1, the interest rate remains constant at 0r. 7 A government may decide to target inflation. This means that a figure will be established, e.g. 2% in the UK, which a government will aim to achieve over a period of time. There is usually a certain range of inflation that will apply in relation to the target, e.g. in the UK it is 1% above or below the target figure. Exam-style questions 8 Student answer: It is important to understand the relationship between a tax rate and the amount of revenue obtained by a government from imposing that tax. It might be assumed that as the rate of a tax increases, the amount of revenue that it produces also continues to increase, but this need not necessarily be the case. OCR A-level Economics © Terry Cook 2016 Macroeconomics 2 Hodder Education 17 TOPIC 3 The application of policy instruments The candidate has provided a useful introduction in terms of what might be expected to be the case. The Laffer curve shows the relationship between the rate of tax and the revenue that is obtained from the tax. It shows that higher tax rates will eventually lead to a decline in the revenue received from a tax. This is because the higher rates can act as a disincentive for firms and employees. A high rate of direct tax, such as income tax, may have a disincentive effect on employees and a high rate of direct tax, such as corporation tax, may have a disincentive effect on firms. Although the rate of tax is higher, fewer people will now be working and so the revenue obtained from the tax will be lower. Figure 7 The candidate has brought in the Laffer curve to show that the relationship is not as straightforward as might be supposed and has included a diagram to illustrate the relationship. In such a situation, a cut in both income tax and corporation tax could lead to an increase in revenue for a government because more people will want to work and firms will want to expand. The Laffer curve is therefore extremely useful in showing this relationship between the tax rate and tax revenue. The conclusion is rather limited and could have been developed more fully. MARK: 8/12 9 Student answer: Many countries set an inflation target and this can be of two types. Symmetric inflation targeting is where a central bank is required to respond to a situation where the rate of inflation in an economy is either too high or too low. This is the case in the UK where the inflation target is 2%. An inflation rate below the 2% target is regarded as a problem just as much as an inflation rate above the target. The inflation target is therefore symmetrical. OCR A-level Economics © Terry Cook 2016 Macroeconomics 2 Hodder Education 18 TOPIC 3 The application of policy instruments The candidate has explained what is meant by symmetric inflation targeting and has given data from the UK to support the point. If the target is missed by more than 1% on either side, i.e. if the inflation rate is more than 3% or less than 1%, the governor of the Bank of England is required to write an open letter to the chancellor of the exchequer explaining the reasons why the rate of inflation has increased or fallen to such an extent and outlining what the Bank proposes to do to ensure that the rate of inflation comes back to the target figure. The candidate has given a clear explanation of what happens in the UK whenever the inflation target is missed. Non-symmetric, or asymmetric, inflation targeting is when a central bank is only required to take action when the rate of inflation is either too high or too low but not in both instances. Usually this will be when the rate of inflation is too high. In such a situation, the central bank is not required to take any action when the rate of inflation falls below the inflation target. The candidate has contrasted asymmetric with symmetric inflation targeting, pointing out the distinction between the two approaches. MARK: 4/4 10 D 11 B 12 C 13 B OCR A-level Economics © Terry Cook 2016 Macroeconomics 2 Hodder Education 19 TOPIC 4 The global context Topic 4 The global context Globalisation 1 Globalisation refers to a number of different characteristics. First, there is increasingly a world market, both in terms of goods and services and in terms of capital. Second, there is more coordination between governments in terms of the macroeconomic policies that are followed. Third, there has been a growth in world trade, improving the standard of living of many people. Fourth, there has been increasing scope for multinational companies to extend their operations all over the world. Fifth, the development of technology has contributed significantly to the growth of the idea of a world market, especially in terms of the use of the internet. 2 Globalisation is caused by a number of factors. The development of an increasingly world market is due to the need of companies to cut costs and to produce more. Multinational firms have grown greatly in recent years, partly to take advantage of different factor endowments in various countries, such as the different costs of labour, and partly to produce more, the larger market leading to larger profits. It is not only in terms of an increasingly world market that globalisation is taking place — it is also the result of movements in capital. The financial system has become more integrated and capital has become increasingly mobile. For example, many companies now have their shares quoted on a number of stock exchanges around the world. Advances in transportation and communication have also contributed towards the greater interdependence of countries in terms of their economic activities. The International Monetary Fund has identified four essential aspects of globalisation. These are trade and transactions, capital and investment movements, the migration of people and the dissemination of knowledge. 3 A multinational firm is one which operates in more than one country. This has to involve some form of actual economic activity in another country and so, therefore, means more than just selling in different countries. Car companies, for example, often have factories in different countries. A multinational firm that builds a factory in another country is involved in what is termed ‘foreign direct investment’. International trade 4 This theory helps to explain why countries trade goods and services with each other. One condition for trade between two countries is that the countries differ in terms of the availability of factors of production, e.g. one country may have a great deal of capital but relatively few workers, while another country may have many workers but relatively few machines. According to the Heckscher–Ohlin theory, a country will specialise in the production of goods and services that is it most suited to produce, i.e. a country will export those goods that are intensive in the use of their more plentiful factor of production, and import those OCR A-level Economics © Terry Cook 2016 Macroeconomics 2 Hodder Education 20 TOPIC 4 The global context goods that are intensive in the use of their scarce factor. The effect of this is that relative prices, and relative factor prices, in different countries tend to be equated. Exchange rates 5 An exchange rate refers to the rate at which one currency can be exchanged for another, i.e. it is the price or value of one currency in terms of other currencies. 6 Exchange rates can be measured in different ways. A bilateral exchange rate involves a pair of currencies, i.e. it is the rate at which one currency can be exchanged for another. An effective exchange rate refers to a weighted average of a basket of currencies. The weightings are in relation to the amount of trade involving the different countries. A nominal exchange rate refers to the value of a currency compared with other currencies without taking into account the inflation rates in the different countries, i.e. it does not show the purchasing power of one currency compared with another. In contrast, a real exchange rate refers to the value of a currency compared with other currencies after taking into account the inflation rate in different countries, i.e. it does show the purchasing power of one currency compared to another. 7 This theory takes into account the different price levels in various countries when their exchange rates are being compared. It enables exchange rates to be compared after they have been adjusted to give comparisons of purchasing power in the different countries. Once this adjustment has been made, the two amounts of money being compared will be able to buy identical baskets of products in both countries. This is an advantage over actual or nominal exchange rates. Trade policies and negotiations 8 There are a number of different methods of protectionism that can be used to reduce the number of imports coming into a country. A tariff is a tax or duty that is imposed on an imported good. It will be included in the price of the product and, as long as demand is elastic, the higher price should discourage consumption of the product. A quota is a limitation on the amount of imports that come into a country. It can be in the form of a limit on the number of products allowed in, the value of the products or the market share that they represent. A subsidy is a financial payment that is paid to a producer to lower the costs of production and, therefore, the price to be charged. If domestic producers are supported by subsidies, this will make these goods more competitive and this is likely to reduce the demand for imported goods. Exchange controls refer to restrictions on the currency that is made available to pay for trade. Imports could be reduced if it is made more difficult to obtain the money to pay for them. OCR A-level Economics © Terry Cook 2016 Macroeconomics 2 Hodder Education 21 TOPIC 4 The global context An embargo is an actual ban on the importation of products. This will usually apply to imports from one country or a specific group of countries. Administrative procedures and restrictions can be used to make the process of importation more difficult because of all the ‘red tape’ that is involved. Voluntary export restraints refer to a situation where a country tries to persuade another country to voluntarily limit its exports. This can be successful because if it is not agreed, there can be a threat of bringing in protectionist methods. 9 Some countries decide to protect their domestic producers for a variety of reasons. One particularly important reason could be to support an infant industry in an economy, i.e. one that has only recently been established and which is therefore not yet ready to compete in international trade with more established firms from other countries. These industries can also be referred to as sunrise industries. Another argument might be to protect declining industries, i.e. those industries which are in the process of decline, but which a government might want to support for at least a limited period of time to enable workers to find new jobs in other industries. If this was not the case, there could be a very dramatic increase in the rate of unemployment in the country. These industries can also be known as sunset industries. One argument that is regarded as relatively strong is that of opposition to dumping. Dumping refers to the fact that imported goods are not only being sold cheaply, but are being sold at a price that is below the cost of production in the home country. A government could decide to impose a tariff as a means of raising revenue, especially on those imported goods for which the price elasticity of demand is relatively inelastic. Even though the advantages of free trade are well known, it is therefore the case that some countries may prefer to use protectionist methods to protect at least some of their domestic producers for a period of time. 10 The World Trade Organization was set up in 1995 and now has 163 members. Its main purpose is to encourage free trade through its supervision of international trade. It deals with the regulation of trade between the member countries and provides a framework for negotiating trade agreements. There are a number of WTO agreements which the member countries are required to adhere to. It also can be involved in the resolution of trade disputes between member countries. The Doha Round of negotiations has not been as successful as had been hoped. One of the difficulties has been over the provision of subsidies to farmers in a number of countries. 11 A free-trade area refers to a form of integration where a group of countries promote free trade among themselves, but keep a separate set of trade barriers against other countries. A customs union, like a free-trade area, encourages free trade among the member countries but, unlike a free-trade area, it imposes a common external tariff against products from countries outside the union. OCR A-level Economics © Terry Cook 2016 Macroeconomics 2 Hodder Education 22 TOPIC 4 The global context A single market refers to a form of integration where there is an attempt to establish a unified market, providing for the free movement of goods, services and people. An economic union refers to a form of integration where the member countries agree to use the same economic policies and regulations. A monetary union is a form of integration where countries agree to use a common currency. The countries in the European Union which are part of the Eurozone would be an example of this form of integration. 12 Membership of the European Union has a number of advantages and disadvantages to member countries. The main advantage of membership of the EU is that the 28 countries constitute a relatively large market of over 500 million people. It is therefore possible for firms to benefit from this market, giving rise to potential advantages of economies of scale in terms of lower costs of production. The labour market has been made more flexible because people have the right to work in any of these countries. A number of jobs have been created as a result of the existence of the EU. Funds have been provided to those areas in the 28 countries that are economically disadvantaged. Many EU directives and regulations have improved the working conditions of employees, such as the European Working Time Directive. There are, however, a number of disadvantages of the European Union. Not all forms have been able to survive the competition from firms in the different EU countries, leading to some workers becoming unemployed. Membership involves payments to be made to the EU, with estimates of the cost per head per year varying between about £300 and £800, although countries can also receive rebates back from the EU. Not all of its policies have been equally successful and one of the least successful has been the Common Agricultural Policy where farmers have been paid to not produce anything to bring down the oversupply of certain produce. Not all countries have joined the single currency, the euro, which was established in 1999 as an accounting currency and as a physical currency with notes and coins in 2002, while those countries that have joined it have found that many major economic decisions are taken by the European Central Bank in Frankfurt rather than by their own central banks, such as decisions on interest rates. In June 2016, the UK held a referendum to decide whether it should remain in, or leave, the EU. It voted to leave. This process is likely to take up to 2 years. This will then leave the EU with 27 member countries and reduce the size of the EU from over 500 million to about 440 million people. In conclusion, it is clear that there are both advantages and disadvantages of a country being a member of the European Union. Exam-style questions 13 Student answer: The effective exchange rate means that the value of the pound is being compared against other currencies in terms of its value against a trade-weighted basket of currencies. The nominal effective rate means that the exchange rate figure of 82.2 has not taken inflation into account. The real effective rate means that the OCR A-level Economics © Terry Cook 2016 Macroeconomics 2 Hodder Education 23 TOPIC 4 The global context exchange rate figure of 90.1 has taken inflation into account, i.e. it is at purchasing power parity. Both figures are being compared with the values in 2005. To enable a comparison to be made with the earlier year, the value is given a figure of 100, known as a base year index. Both the nominal and the real effective rate figures for the pound show that there has been a decline in its value since 2005. The differences between the figures shown in the table are clearly explained. MARK: 4/4 14 Student answer: Multinational firms have had a significant impact on the world economy, both positive and negative. It would have been useful if a definition of a multinational firm had been included in the answer. On the positive side, they can be a significant source of employment, reducing a country’s unemployment rate. This will increase incomes in an economy, contributing to a positive multiplier effect. The government will receive receipts from taxation, both from the taxes on the profits of the company and from the taxes paid by the employees, both direct taxes (such as income tax) and indirect taxes (such as VAT). The workers employed by the multinational firm will learn new skills, making them more productive and, in the long run, more occupationally mobile. The reference to a positive multiplier effect is useful, but the candidate does not actually explain what this means. The candidate might also have questioned the extent to which a great deal of employment would be created, because if the firm mainly used capital-intensive methods of production, not many workers may have been needed. On the negative side, however, many of the top management of the firm will come from the original country and there may not be any opportunities in senior positions for local people. The jobs that the factory workers have may be relatively low-skilled, and so are sometimes called ‘screwdriver jobs’. Sometimes, a government may have offered favourable tax concessions to attract a multinational firm to locate in a country and so it may be the case that little of the profit is taxed. Much of what is not taxed will be repatriated back to the original country. The multinational firm may not be inclined to stay for a large number of years, possibly deciding to close a factory and relocate to another country. The response could also have considered the degree to which a multinational firm will agree to pay wages that are equal to the country’s national minimum wage, if it has one. There are, therefore, both positive and external impacts of a multinational firm locating in a country. The conclusion could have been developed more fully by referring to a few of the main arguments on both sides, before coming to a judgement as to whether the overall impact was likely to be positive or negative. MARK: 15/25 OCR A-level Economics © Terry Cook 2016 Macroeconomics 2 Hodder Education 24 TOPIC 4 The global context 15 B 16 A 17 A OCR A-level Economics © Terry Cook 2016 Macroeconomics 2 Hodder Education 25 TOPIC 5 The financial sector Topic 5 The financial sector The role of the financial sector in the real economy 1 Money performs four functions in an economy. First, it acts as a means of exchange. This means that it is generally acceptable as a means of payment for goods and services. Second, it acts as a unit of account or as a measure of value. This means that it enables different products to be compared. Third, it acts as a store of value or wealth. This means that wealth can be stored in the form of money. Finally, money acts as a standard for deferred payments. This means that people are able to borrow money and pay it back at a later date. 2 Money has a number of characteristics. Money needs to be acceptable if it is going to be used as an effective means of buying and selling goods and services. It also has to be portable and relatively easy and convenient to be carried around. It needs to be relatively scarce, otherwise it could become worthless. It needs to be easily recognised so that people will have confidence in it. Money also needs to be relatively stable in value, although this will be influenced by the rate of inflation in an economy. Money needs to be able to be divided into smaller denominations if it is to be used effectively. It also needs to be durable over time. There needs to be a stability of supply to maintain confidence in it and each piece of money needs to be uniform so that notes or coins of a particular denomination are all equal. 3 It is possible to distinguish between two types of money supply in terms of liquidity: narrow money and broad money. Narrow money refers to cash in the form of notes and coins or to financial assets that can be turned into cash relatively easily and quickly. Broad money refers to financial assets that are less liquid and which would take longer to be turned into cash. It includes a variety of deposits that are held in financial institutions. 4 In the liquidity preference theory, the demand for money is made up three different motives for money: the transactions demand for money, the precautionary demand for money and the speculative demand for money. The first two motives are interest inelastic and are known as active balances. The speculative motive is interest elastic and is known as an idle balance. The three motives together create the overall demand for money. The interest rate is determined by the demand for money and the money supply, as shown in the diagram. OCR A-level Economics © Terry Cook 2016 Macroeconomics 2 Hodder Education 26 TOPIC 5 The financial sector Figure 8 5 The loanable funds theory states that the rate of interest is determined by the demand for, and the supply of, loanable funds in financial markets. The rate of interest is therefore a price and is determined, just like any other price in a market, by the interaction of demand and supply. The demand for loanable funds comes from firms wanting to invest, households wanting to buy consumer products and a government aiming to fund a budget deficit. The supply of loanable funds comes from savings. The diagram shows that the rate of interest will be determined by the intersection of the demand for, and the supply of, loanable funds, i.e. at 0r. Figure 9 The financial sector in developing and emerging economies 6 The Harrod–Domar model is a theory of economic growth which stresses the importance of the generation of savings which can be used to finance investment. This will increase the productive capacity of an economy and so promote economic development. The theory assumes a constant capital–output ratio. OCR A-level Economics © Terry Cook 2016 Macroeconomics 2 Hodder Education 27 TOPIC 5 The financial sector The model therefore shows how much capital investment would be required to bring about a certain level of economic growth, assuming a constant capital–output ratio, and the level of saving that would be required to finance this investment. The model was originally used in relation to developed countries, but it has also been used in relation to developing and emerging economies. 7 Microfinance is a broad term which refers to a number of different financial services. Essentially it refers to a source of financial services for borrowers who lack access to mainstream banking and financial services, such as deposits, loans, payment services, money transfers and insurance. It is therefore seen as a way of helping poor people and low-income households escape from poverty and is an example of financial inclusion. It can also be used by entrepreneurs and small businesses to fund economic activities. Microenterprises may find it difficult to access financial services through traditional financial routes and so microfinance provides an opportunity to gain access to financial services. It can therefore be seen as a way of promoting economic development, employment and economic growth, especially in developing and emerging economies. The role of the central bank 8 A central bank can perform a number of functions in an economy. As the main bank in a country’s financial system, it can support other financial institutions, such as by acting as a lender of last resort to an institution in need of funds. It manages the national debt, which is the total of all debt accumulated since the establishment of the Bank of England in 1694. The central bank acts as banker to the government, handling its accounts, and it also controls the country’s currency through the issuing of notes and coins. It operates monetary policy, in particular through the setting of the interest rate on a monthly basis. Finally, the central bank oversees the financial system as a whole through a system of regulation. 9 The ‘independence’ of a central bank refers to the degree of operational freedom it has in a country’s financial system. The Bank of England was granted operational independence by the government in May 1997. In particular, it is allowed to set the interest rate. This decision is taken each month by the Monetary Policy Committee of the Bank of England. The government, however, retains the power to set the inflation target within which the Bank must operate when carrying out monetary policy. The inflation target is 2% and the governor of the Bank of England must write an open letter to the chancellor of the exchequer if the inflation rate is more than 1% outside of this inflation target. Financial regulation 10 The FPC is responsible for the survival and stability of the UK financial system. Its main objective is ‘identifying, monitoring and taking action to remove or reduce systemic risks with a view to protecting and enhancing the resilience of the UK financial system’. OCR A-level Economics © Terry Cook 2016 Macroeconomics 2 Hodder Education 28 TOPIC 5 The financial sector 11 The PRA is part of the Bank of England. It is responsible for the regulation and supervision of over 1,000 financial services providers in the UK, including banks, building societies, credit unions, friendly societies, insurers and investment firms. Its main objective is ‘to promote the safety and soundness of financial services providers by requiring them to behave prudently, to minimise the impact on financial stability should a provider fail, and to ensure that financial services continue to be supplied to customers’. 12 Unlike the other two institutions, the FPC and the PRA, the FCA is entirely separate from the Bank of England. Its main objective is to ensure that the financial markets work well, so that consumers get a fair deal. It has three statutory objectives: to secure an appropriate degree of protection for consumers, to protect and enhance the integrity of the UK financial system and to promote effective competition in the interests of consumers. Exam-style questions 13 Student answer: The process of credit creation refers to the process of financial institutions increasing their lending by a multiple of new deposits received. When people deposit money in a financial institution, some of this money is kept in reserve and the rest is lent out. This has the effect of increasing the money supply. This multiple is known as the credit creation multiplier. The candidate has a reasonably clear understanding of the credit creation process. A financial institution can keep a relatively small percentage of assets in a relatively liquid form and use the remainder to make loans. This is known as fractional reserve banking, i.e. a financial institution will accept deposits, but only hold a fraction of these as liquid reserves, leaving the remainder available for withdrawal. The candidate has quite a good understanding of fractional reserve banking, but the answer would have been helped by the inclusion of an example of the bank credit multiplier in operation. MARK: 3/4 14 Student answer: The Fisher equation can be used to indicate the quantity theory of money. This shows the relationship between the money supply and the price level in an economy. The Fisher equation is MV = PT, where M refers to the quantity or stock of money or money supply, V refers to the velocity of circulation of money, P refers to the general level of prices in an economy and T refers to the number of transactions financed by this money in a given time period. The candidate has demonstrated a reasonably sound understanding of what is meant by the Fisher equation. V and T are assumed to be constant, so the theory shows that there is a direct relationship between changes in M and changes in P. The theory plays an OCR A-level Economics © Terry Cook 2016 Macroeconomics 2 Hodder Education 29 TOPIC 5 The financial sector important part in Monetarism where inflation is regarded as being largely caused by changes in the money supply, i.e. a change in M can have a direct effect on P. The candidate has developed the explanation to show how it can be used in Monetarist explanations of inflation. MARK: 3/4 15 Student answer: There are three financial regulatory bodies in the UK. These bodies became fully operational in April 2013 when the Financial Services Act 2012 came into effect. The candidate has provided a brief historical background to put the system of financial regulation into context. The Financial Policy Committee of the Bank of England (FPC) is responsible for the survival and stability of the UK financial system. Its main aim is identifying, monitoring and taking action to remove or reduce systemic risks. As a result of carrying out this role, it protects and enhances the strength of the UK financial system. The candidate has explained the role of the FPC, especially in terms of removing or reducing systemic risk. The Prudential Regulation Authority (PRA), like the FPC, is also part of the Bank of England. It is responsible for the regulation and supervision of over 1,000 financial services providers in the UK, including banks, building societies, credit unions, friendly societies, insurers and investment firms. Its main aim is to promote the safety and soundness of financial services providers by requiring them to behave prudently. The candidate has explained the role of the PRA, especially in terms of the regulation and supervision of the variety of financial institutions that operate in the UK. Unlike the other two institutions, the Financial Conduct Authority (FCA) is separate from the Bank of England. Its main objective is to ensure that the financial markets work well, so that consumers get a fair deal. It has three main aims and these are to secure an appropriate degree of consumer protection, to protect and enhance the integrity of the UK financial system and to promote effective competition. The candidate has explained the role of the FCA, especially in terms of securing consumer protection, promoting competition and protecting the integrity of the UK financial system. MARK: 4/4 16 B 17 D 18 C OCR A-level Economics © Terry Cook 2016 Macroeconomics 2 Hodder Education 30 TOPIC 5 The financial sector 19 D OCR A-level Economics © Terry Cook 2016 Macroeconomics 2 Hodder Education 31