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Fiscal Policy
MACRO ECONOMICS
“in this world nothing can be said to be certain,
except death and taxes.”
Benjamin Franklin (1789)
"The art of taxation consists in so plucking
the goose as to obtain the largest possible
amount of feathers with the smallest possible
amount of hissing." (Colbert, 1665)
Jean-Baptiste Colbert was the controller general of finance (from 1665) and secretary
of state for the navy (from 1668) under King Louis XIV of France. He carried out the
program of economic reconstruction that helped make France the dominant power in
Europe.
FISCAL
POLICY
Fiscal policy involves changes in government spending and taxation.
The government makes policy decisions (discretionary fiscal policy) to
influence markets, and the wider economy, through using changes in
government spending levels and/or changes in the level of taxation.
Fiscal policy affects predominantly the demand side of the economy,
but can also have significant supply side effects. It is often referred
to as demand side policy (Monetary policy is also demand side).
The government announces its public spending and taxation decisions in
the annual budget.
If the government spends more, in the year, than it raises
in taxation revenue, there would be a
If the government spends less than it raises in taxation
revenue, there would be a
If the government spends roughly the same as it raises
in taxation revenue, there would be a
Euro Government deficits
• http://www.bbc.co.uk/news/business13366011
Does a budget deficit matter?
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Potential Problems of a budget deficit
Financing a deficit: A budget deficit has to be financed. Day- to- day the issue of new
government debt to domestic or overseas investors can do this. But it may be that if the
budget deficit rises to a high level, the government may have to offer higher interest
rates to attract buyers of government debt. In the long run, higher government borrowing
today may mean that taxes will have to rise in the future
The National Debt: In the long run, a high level of government borrowing adds to the
accumulated National Debt. This means that the Government has to spend more each year
in debt-interest payments to holders of government bonds and other securities. There is
an opportunity cost involved here because interest payments might be used in more
productive ways, for example an increase in spending on health services. It also represents
a transfer of income from people and businesses that pay taxes to those who hold
government debt and cause a redistribution of income and wealth in the economy
Wasteful public spending: Neo-liberal economists are naturally opposed to a high level of
government spending. They believe that a rising share of GDP taken by the state sector
has a negative effect on the growth of the private sector of the economy. They are
sceptical about the benefits of higher spending believing that the scale of waste in the
public sector is high – money that would be better off being used by the private sector.
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What is a government bond?
Governments borrow money by selling bonds to investors. A bond is an IOU. In return for the
investor's cash, the government promises to pay a fixed rate of interest over a specific period - say 4%
every year for 10 years. At the end of the period, the investor is repaid the cash they originally paid,
cancelling that particular bit of government debt.
Government bonds have traditionally been seen as ultra-safe long-term investments and are held by
pension funds, insurance companies and banks, as well as private investors. They are a vital way for
countries to raise funds.
What is a bond market?
Once a bond has been issued - and the government has the cash - the investor can hold the bond and
collect the interest every year until it is repaid. But investors can also buy and sell bonds that have
already been issued on the financial markets - just like buying and selling shares on the stock market.
The price of the bond will fluctuate as the outlook for interest rates changes. So, for example, if the
markets think that interest rates are going to rise sharply, then the value of a bond paying a fixed rate
of 4% for the next 10 years will fall. Bond prices will also fall if investors think that there is a risk of
the government that issued the bond not being able to make the annual interest payment or repay it in
full on maturity - and these are the fears which have been pushing down Spanish bond prices
Why do bond markets matter?
Because they determine what it costs a government to borrow. When a government wants to raise new
money, it issues new bonds, and has to pay an interest rate on those bonds that is acceptable to the
market. The yield at which the market is buying and selling a government's existing bonds gives a good
indication of how much interest the government would have to pay if it wanted to issue new bonds. So,
for example, Spanish 10-year bond yields have risen above 6% in recent years. That means that if the
Spanish government wants to borrow new money from the bond market for 10 years, it would have to
pay an interest rate on the new bond of more than 6%
Potential benefits of a
budget deficit
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Government borrowing can benefit economic growth: extra capital spending that leads
to an increase in the stock of national assets. Eg. higher spending on the transport
infrastructure improves the supply-side capacity of the economy promoting long-run
growth. Also increased spending on health and education can boost labour productivity
and employment.
The budget deficit as a tool of demand management: Keynesian economists would
support the use of fiscal policy to manage the level of AD. An increase in borrowing can be
a stimulus to demand when other sectors of the economy are suffering from weak
spending. The argument is that the government can and should use fiscal policy to keep
real national output closer to potential GDP so that we avoid a large negative output gap.
Maintaining a high level of demand helps to sustain growth and keep unemployment low
Types of Taxation
Direct taxation –
are taxes imposed on income of individuals and firms, they include
income tax and corporation tax.
Indirect taxation –
are taxes imposed on expenditure of individuals and firms on goods
and services, they include excise duty and V.A.T. (value added tax).
Taxes, and tax systems, can also be classed as progressive, proportional
or regressive.
A progressive tax is…
one which takes a higher percentage of income from those who can afford
to pay Eg?
A proportional tax…
takes the same percentage of income from all income groups Eg?
A regressive tax…
takes a greater percentage of income from those who are least able to
pay. Eg?
More on the impact of different taxes later…
Reasons for Taxation?
To raise revenue for expenditure.
To influence economic activity to meet its major economic
objectives.
To discourage consumption of demerit goods.
To redistribute income within the economy.
To discourage the purchase of imports.
To tackle the problem of external costs from, for example,
pollution.
What makes a ‘good tax’?
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Adam Smith’s ‘4 Canons of taxation‘
equitable Taxes should be levied according to ability to pay
economical The cost of collection must be low relative to the
yield
certain The timing and amount to be paid must be certain to the
payer
convenient The means and timing of payment must be convenient
to the payer
In addition:
A tax must not hinder efficiency or should involve the least loss
of efficiency
A tax should be compatible with foreign tax systems (in the
UK's case, with Europe's)
Tax should automatically adjust to changes in the rate of
inflation (particularly important in high inflation economies.
i.e. flexible and efficient
Why does the Government Spend?
To provide essential services
To influence economic activity to meet its major
economic objectives.
To encourage consumption of merit goods
To redistribute income within the economy
To fund provision of the welfare state and social
security.
To encourage exports
It can also try to encourage domestic production of
goods that have positive externalities
Government spending, also referred to a public expenditure,
includes spending by central gov, local gov and public corporations.
Classifying Government Spending
Capital Expenditure – building a new school is an
example, also improving capital by spending on roads and
hospitals.
Exhaustive
expenditure
Nonexhaustive
expenditure
Current Expenditure – the spending required to run
services and use the capital employed. Salaries of public
employees (NHS, Education, Police, Local gov’t, Armed
forces….) and materials used (books, medicines,
stationary….) are forms of current expenditure.
Transfer Payments – money transferred, by government, to
individuals in the form of benefits. Transfers to the
unemployed and the elderly are examples, JSA and pensions.
Debt interest payments – these are made to the
government’s creditors (holders of the government debt),
interest paid on government bonds is one type of payment.
Automatic Stabilisers
The revenues from some taxes and some forms of
government expenditure can change automatically
to stabilise fluctuations in real GDP. These are
referred to as automatic stabilisers.
Example:
Government revenue from income tax and VAT increases when
real GDP rises. Government spending on unemployment benefit
will fall as output and employment increases.
These changes in revenue and expenditure, that automatically
occur, will act to stabilise real GDP. These stabilisers also
work when there is a fall in real GDP, spending increases and
tax revenue falls.
The effect of changes in economic activity, and/or
government policy on tax revenue and government spending
Taxation
Revenue and
Government
Expenditure
(as % of GDP)
T-Taxation Revenue
Deficit
Surplus
G-Government Spending
0
Yd Yb Ys
Real GDP
If the government increases G , AD will increase.
As G is a component of aggregate demand, AD=C+I+G+(X-M).
AD should also increase when taxation falls. As taxation falls C
and I is expected to increase, AD=C+I+G+(X-M).
Policies which seek to increase AD, are examples of Reflationary
(or expansionary) fiscal policy.
Policies which seek to reduce AD are examples of deflationary (or
contractionary) fiscal policy.
Illustrate and explain how the government could boost AD by using
fiscal policy
1 page of A4
Include detail of how and why it could work to boost AD.
No evaluation yet!
AS/AD analysis- expansionary fiscal policy
LRAS
Price
Level
AD
AD1
An expansionary fiscal policy (reduced
taxation/increased government spending) would
lead to an increase in AD, shown by a shift to
the right of theLRAS
AD curve from AD to AD1.
Attempting to reflate the economy (increase
output, income and employment)
This policy would be particularly effective when
the economy is operating under capacity/ less
than full 0
employment. If there is cyclical
unemployment this policy could be considered.
AD
AD1
Real GDP
AS/AD analysis- deflationary fiscal policy
Price
AD
Level
LRAS
AD1
A deflationary fiscal policy (increased
taxation/reduced government spending) would lead
to a decrease in AD, shown by a shift to the
left of the AD curve from AD to AD1.Attempting
to deflate the economy (reduce inflation and to
improve competitiveness)
This policy is particularly effective when the
economy is operating
LRAS at full capacity/full
employment.
If there is high inflation, and/or a current
account (BOP) problem, this policy could be
considered.
0
AD
AD1
Real GDP
EFFECTIVENESS
OF FISCAL
POLICY
=Evaluation
Effectiveness of fiscal policy
Can target particular products (demerit and merit goods),
areas of the country and groups within society.
 Can influence every component of AD and also affect the
quantity and quality of resources available (LRAS)
 Can be used to redistribute income and wealth within
society
 Automatic stabilisers are evident (non- discretionary)
Can have a significant impact on the economy, especially
when there is a large multiplier effect An initial change in AD
can have a much greater final impact on the level of equilibrium
NI- “one person’s spending is another’s income” (more to
follow…)
Limitations of fiscal policy
It is difficult to estimate how much AD will alter as a result of
fiscal policy measures.
 Can be inflexible. Changes in taxes are generally announced
annually and budget decisions may take some time to
implement.
 Fiscal policy measures often experience time lags. Not only
in terms of their effect on AD but also the impact on LRAS.
In addition- there is not necessarily a guarantee that
increased health and education spending leads to an
improvement in quality of the service.
 Decisions may be based on inaccurate or insufficient
information.
Limitations of fiscal policy
A measure or a range of measures designed to achieve one
objective may have unintended adverse effects on other objectives.
I.e., A reflationary fiscal policy designed to increase employment
may also increase inflation and worsen our current account balance.
 There may be disincentive effects both for firms and individuals
(eg. Laffer curve… to follow…)
Crowding Out (G ‘crowds out’ I because increased G leads to
increased interest rates which leads to a fall in I) more to follow…
Limitations of fiscal policy
• The effectiveness of Fiscal policy will be
significantly influenced by the underlying
economic conditions. The position of the
AD and LRAS curves can be useful to
consider when indicating how effective
fiscal policy measures may be
• Using a Keynesian LRAS show when a rise
in AD may not be effective at boosting
real GDP and employment
• Now show a position when it will be most
effective
LRAS
Price
Level
PL4
PL3
AD4
PL2
PL1
AD3
AD2
AD1
Y1
Y2 YFE
Real GDP
LRAS
Price
Level
PL4
PL3
AD4
PL2
PL1
AD3
AD2
AD1
Y1
Y2 YFE
Real GDP
Fiscal Policy
MACRO ECONOMICS
More detail…
• Crowding out…
Crowding Out
• When governments run budget deficits in order to boost AD and
reduce unemployment there is a potential problem known as
‘crowding out’
• The “crowding-out hypothesis” became popular in the 1970s and
1980s when free market economists argued against the rising
share of national income being taken by the public sector.
• The view is that a rapid growth of G leads to a transfer of scarce
productive resources from the private sector to the public sector
• Eg. The gov. run a budget deficit to boost AD. To finance the
deficit the government will have to sell debt to the private sector
• Attracting individuals and institutions to purchase the debt may
require higher interest rates. A rise in interest rates may crowd
out private investment and consumption, offsetting the fiscal
stimulus. (Financial Crowding Out)
Investment Theory
• Planned investment is determined by the expected posttax real rate of return on capital projects
• Interest rates may play an influential role – because they
represent the opportunity cost of funds used to finance
investment
• Firms estimate the expected real rate of return on
capital employed using expected revenue streams and cost
projections
• This expected rate of return can then be compared to
the prevailing real rate of interest (a measure of the
opportunity cost of funding an investment project)
• A fall in interest rates decreases the cost of investment
relative to the potential yield – planned investment
projects on the margin may become financially worthwhile
• The rate of return on an investment is known as the MEC
By issuing gov bonds, the gov are
essentially increasing the demand for
savings or ‘loanable funds’.
Real
Interest
Rate
This results in a rise in the real
interest rate and a fall in
investment as the cost of
investment relative to the
potential yield has risen
Real
Interest
Rate
S
R2
R2
R1
R1
D1
D2
Q of loanable
funds
I
I1 I1
Planned
Capital
Investment
(Id)
AD= C+I+G+(X-M)
• The increase in G has resulted in a decrease in I and therefore could
end up reducing AD overall
• Public sector investment has ‘crowded out’ private sector investment
• The Keynesian response to the crowding-out hypothesis is that the
probability of 100% crowding-out is extremely remote, especially if
the economy is operating well below its productive capacity and if
there is a plentiful supply of savings available that the government can
tap into when it needs to borrow money. There is no automatic
relationship between the level of government borrowing and the level
of short term and long term interest rates.
• Neoclassical economists (opposed to use of demand management
policies) argue that crowding out is a significant problem of increased
G
The Multiplier
• An initial change in AD can have a much greater final impact
on the level of equilibrium NI
• This is because injections into the circular flow of income
stimulate further rounds of spending – in other words
• “one person’s spending is another’s income”
• this can lead to a much bigger effect on equilibrium output
and employment.
• The multiplier provides a measure of the magnitude of
changes in GDP caused by changes in AD
• eg. if the multiplier is 3, an increased injection of $100m
will increase Y by $300m
Very Simple Circular Flow of Income Model
S+T+M
•Assume initial injection
of G of $100m
•This goes to firms, then
consumers, then firms,
then consumers and so
on….
•Each time the money is
circulated some ‘leaks’
out of the flow, but still
some of the additional
money will be spent over
and over, increasing GDP
by more than $100m
C
Wages, rent, interest and profit
I+G+X
Example
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A large firm spends an $100m extra on a new factory.
Initially NI rises by $100m
This will set off a chain reaction of increases in expenditures.
Firms who produce the capital goods that are purchased will
experience an increase in their incomes and profits
If they in turn, collectively spend about 3/5 of that additional
income, then £60m will be added to the incomes of others.
At this point, NI has grown by $160m
The sum will continue to increase as the producers of the
additional goods and services realise an increase in their incomes,
of which they in turn spend 60% on even more goods and services.
The increase in NI will then be $196
The process can continue indefinitely. But each time, the
additional rise in spending and income is a fraction of the previous
addition to the circular flow (there are withdrawals at every
stage)
Hence the initial injection of $100m results in NI rising by more
than $100m
• The multiplier process requires that there
is sufficient spare capacity in the
economy for extra output to be produced.
• If aggregate supply is inelastic, the full
multiplier effect is unlikely to occur,
because increases in AD will lead to higher
prices rather than a full increase in real
national output.
• In contrast, when AS is perfectly elastic a
rise in aggregate demand causes a large
increase in national output.
AD= C+I+G+(X-M)
• Autonomous Spending= components of AD which do
not depend on current domestic incomes (exogenous)
• Induced Spending= Components of AD which change
in response to changes in income (endogenous)
• In the previous example the rise in G of $100m
would be classified as autonomous, this further
impacts on AD via increases spending by firms and
consumers, the further impacts would be classified
as induced
Showing the multiplier on a Keynesian AD/ AS diagram
Price
Level
The initial rise in
AD is due to the
autonomous
spending of the
government of
$100m
Due to the multiplier
effect the rise in G
causes induced
spending of $300m
AD1
Y1
Y2
AD3
AD2
Y3
Real National Output
• The multiplier process also requires that
there is sufficient spare capacity in the
economy for extra output to be produced.
• If aggregate supply is inelastic, the full
multiplier effect is unlikely to occur,
because increases in AD will lead to higher
prices rather than a full increase in real
national output.
• In contrast, when AS is perfectly elastic a
rise in aggregate demand causes a large
increase in national output.
Showing the multiplier on a Keynesian AD/ AS diagram
Price
Level
The full effect of the
multiplier can only be
experienced when the
price level is constant,
the greater the price
level increase, the smaller
is the size of the
multiplier effect
AD1
Y1
Y2
AD2
AD3
Real National Output
What are the two things to keep in mind when
government plans to intervene to fill a deflationary gap?
• It must estimate the gap between
the equilibrium output and full
employment output.
• It must estimate the value of the
multiplier so it can judge the suitable
increase in AD that is necessary to
inject into the economy in order to
fill the gap.
The government needs to
consider…
• The higher the withdrawals (taxes, imports
and savings), the lower the multiplicative
effect of any given increase in government
spending.
• Lower interest rates lower withdrawals
• Lower income taxes will lower withdrawals
• Barriers to trade will lower the withdrawals
• The concept of the multiplier process became
important in the 1930s when John Maynard
Keynes suggested it as a tool to help governments
to achieve full employment.
• This macroeconomic “demand-management
approach”, designed to help overcome a shortage
of business capital investment, measured the
amount of government spending needed to reach a
level of national income that would prevent
unemployment.
• More on the multiplier for HL next …
Calculating the size of the
multiplier
• The size of the multiplier depends on what
proportion of additional disposable income
is spent on domestic goods and services
this is known as the marginal propensity to
consume (mpc)
• mpc= ΔC/ ΔYd
The multiplier= 1/ 1-mpc
Eg. If the mpc was 0.6 and there was an
injection of $100m then the change to
national income would be
$100 x (1/ 1-0.6)
= $100 x 1/0.4
= $100 x 2.5
=$250m
Another way…
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The multiplier= 1/ mps + mpt + mpm
mps= marginal propensity to save
mpt= marginal propensity to tax
mpm= marginal propensity to import
• Note: mpc + mps + mpt + mpm = 1
• The mps + mpt + mpm = mpw
• The smaller the value of the withdrawals the larger
the value of the multiplier
• So changes to withdrawals (eg. change in tax rates)
change the value of the multiplier
Activity
£6bn is due to be spent by the UK government in order to
prepare London for the 2012 Olympics. This will bring a
significant multiplier effect upon the UK Economy.
Example 1
Assume that the mpc = 0.7
Therefore change to national income following £6bn injection£6bn * 1/(1 – 0.7) = £19.9bn
Example 2
Assume that the mpc = 0.3
Therefore change to national income following £6bn injection£6bn * 1/(1 – 0.3) = £8.6bn
The government needs to
consider…
• The higher the withdrawals (taxes,
imports and savings), the lower the
multiplicative effect of any given
increase in government spending.
• Lower interest rates will lower the MPS,
• Lower income taxes will lower the MRT
• Barriers to trade will lower the MPM.
• All will lower the MPW and thus increase
the value of the multiplier.
More on Taxation…
• Recall…
• Taxes can be regressive, progressive
or proportional…
Regressive Taxation
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UK VAT is currently 20%
Almost all goods and services have this tax added to the selling price…
VAT is a regressive tax (as are almost all indirect taxes, eg, Malaysian Sales
tax)
A regressive tax means that as a persons income rises their average tax rate
falls.
Scenario 2 people both drive to work every day and purchase £100 of petrol per
week. £20 of this is VAT.
Person 1 earns £300 per week
Person 2 earns £600 per week
Person 1 has an average tax rate of (20/300) x 100 = 6.67%
i.e. this takes takes up 6.67% of their income
Person 2 has an average tax rate of (20/ 600) x 100 = 3.33%
i.e. this tax only takes up 3.33% of their income
Both are consuming the same amount of the good, but one is paying more in tax
(as a percentage of their income) than the other, is this fair?
Therefore we can see that as income rises the average amount paid in tax falls.
If this tax were to increase it would hit the person with the lower income the
hardest, increasing income inequality (generally seen as socially undesirable)
Progressive Taxation
• Income tax in the vast majority of
countries is progressive
• As income rises a higher percentage of
income is paid in tax
• Some exceptions:
• Saudi Arabia, 0% natives, 20% foreigners
• Qatar and UAE 0%
• Kazakhstan 10% (proportional)
• Czech Republic 15% (proportional)
UK Income tax
Rate
2012-13
Personal Allowance
£8,105
Basic rate: 20%
£0-£34,370
Higher rate: 40%
£34,371-£150,000
Additional rate: 50%
Over £150,000
So someone earning £8,000 per year ( for example a student) will pay no tax.
Someone earning £10, 000 per year will pay no tax on the first £8,105, then
20% tax on the remaining £1895. Therefore they will pay £379 tax.
Their highest marginal tax rate is 20%.
Their average tax rate is £379/ £10, 000 x 100 = 3.79%
UK Income tax
Rate
2012-13
Personal Allowance
£8,105
Basic rate: 20%
£0-£34,370
Higher rate: 40%
£34,371-£150,000
Additional rate: 50%
Over £150,000
So someone earning £8,000 per year ( for example a student) will pay no tax.
Someone earning £10, 000 per year will pay no tax on the first £8,105, then
20% tax on the remaining £1895. Therefore they will pay £379 tax.
Their highest marginal tax rate is 20%.
Their average tax rate is £379/ £10, 000 x 100 = 3.79%
Calculate the following
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The total tax per year
The highest marginal tax rate
The average tax rate
For someone earning…
£25, 000 a year
£35, 000 a year
£100, 000 a year
£150, 000 a year
£151, 000 a year
Chargeable Income
Tax(RM)
Calculations (RM)
Rate %
0-2500
On the First 2,500
0
0
2,501-5,000
Next 2,500
1
25
5,001-10,000
On the First 5,000
Next 5,000
3
25
150
10,001-20,000
On the First 10,000
Next 10,000
3
175
300
20,001-35,000
On the First 20,000
Next 15,000
7
475
1,050
35,001-50,000
On the First 35,000
Next 15,000
12
1,525
1,800
50,001-70,000
On the First 50,000
Next 20,000
19
3,325
3,800
70,001-100,000
On the First 70,000
Next 30,000
24
7,125
7,200
Exceeding 100,000
On the First 100,000
Next RM
26
14,325
..........
How much tax would someone earning RM120, 000 per year
pay in tax?
What is their highest marginal rate of tax?
What is their average rate of tax?
Activity
Income Bracket
Tax Rate
$0 - $10, 000
0%
$10, 0001- $20, 000
15%
$20, 001- $35, 000
25%
$35, 001 +
40%
Annual income level
Annual spending on goods and services
Sara
$14, 500
$13, 000
Kathryn
$29, 000
$24, 000
Natalie
$43, 000
$35, 000
Calculate the income tax bill for each person
Calculate the average tax rate for each person. Is it more or less than
their marginal tax rate?
Assume the spending on goods and services does not include taxes.
If they pay 20% in indirect taxation on their spending, calculate how much
indirect tax each person will pay.
What percentage of their income do they pay in indirect taxes?
Is each tax progressive, regressive or proportional, explain why.
Activity
Income Bracket
Tax Rate
$0 - $10, 000
0%
$10, 0001- $20, 000
15%
$20, 001- $35, 000
25%
$35, 001 +
40%
Annual income level
Annual spending on goods and services
Sara
$14, 500
$13, 000
Kathryn
$29, 000
$24, 000
Natalie
$43, 000
$35, 000
Calculate the income tax bill for each person
Calculate the average tax rate for each person. Is it more or less than
their marginal tax rate?
Assume the spending on goods and services does not include taxes.
If they pay 20% in indirect taxation on their spending, calculate how much
indirect tax each person will pay.
What percentage of their income do they pay in indirect taxes?
Is each tax progressive, regressive or proportional, explain why.
Next Topic…
• Supply side policy
HL ‘Paper 3’ Topic references for year 12 exam
Read p83- 84 and p96 &97
• Paper 3 is the paper with the calculations
• Go through your syllabus. Anything we have
covered could be in the exam.
• See the HL topics in your book, plus the
exercises we did in class and the HL
assessment for more detail on the structure
of the paper.
• You will have 1 hour and answer 2 questions
(no choice of questions) similar to the HL
assessment we did