Download Tor Hirst 02.02.2012 Multiple Choice Week Three Tor Hirst 02.02

Tor Hirst
02.02.2012
Multiple Choice Week Three
1.
2.
3.
4.
5.
C
B
C
C
A
6. D
7. C
8. B
9. A
10. C
11. B
12. D
13. D
14. C
15. C
A Changing employment problem
(a) (i) Aggregate demand is the total amount of expenditure within the
economy at a given average price level over a given period of time. Aggregate
demand is made up of: private sector consumption, private sector investment,
government expenditure and net expenditure on exports.
(ii) Unemployment occurs when someone of working age who is available to
work and is actively seeking employment is not employed.
(iii) The balance of payments is an annual record of a country’s currency
inflows and outflows. The balance of payments is split into two accounts: the
current account, which records currency inflows and outflows linked to foreign
income and expenditure, and the financial account which records currency
inflows and outflows linked to changes to the country’s assets and liabilities.
(b) (i) Labour is a factor of production. In order for real Gross Domestic
Product to rise, and create economic growth, the economy needs spare
factors of production to shift the AD curve from AD1 to AD2. This will cause
economic growth with an increase of GDP from NY1 to NY2. If the economy
lacks labour, it is operating close to, or at, full capacity, at AD3. Keynesians
believe that an increase in aggregate demand will lead to economic growth
provided that firms have spare capacity. However, firms operating at full
capacity will respond to an increase in aggregate demand by raising prices,
moving the AD curve from AD3 to AD4. This does not increase Gross
Domestic Product by a large amount, from NY3 to Y/Fe, but it causes an
increase in the average price level from AP1 to AP2. This is called inflation.
LRAS
Average
Price
Level
AP2
AP1
AD4
AD1
NY1
NY2
AD2
AD3
NY3 Y/Fe
Real GDP
Tor Hirst
02.02.2012
(ii) Unemployment occurs when someone of working age who is available to
work and is actively seeking employment is not employed. These people
claim benefits from the government in the form of Job Seekers’ Allowance
(JSA). Therefore, as the number of unemployed decreases, the number of
people claiming money from the government decreases and government
expenditure falls, or government money can be spent on other services that
will improve living standards, such as education and healthcare.
Unemployment causes crime, as people turn to theft or other forms of illegal
behaviour when they cannot afford to pay for the goods and services they
need or want. This means the government has to spend a lot on the police
force and prisons. Therefore, a fall in unemployment would cause a fall in
crime. Society would be safer, and the government could reduce its
expenditure on combating crime, and again increase spending on services
that would benefit society.
(c) (i) In order to increase aggregate supply, an economy needs spare
capacity in the form of factors of production. Labour is a factor of production,
and immigrants provide labour. This means that foreign workers increase the
labour force, and assuming productivity remains the same, firms are able to
produce more.
(ii)Long run aggregate supply can be increased by improving the productivity
of the labour force, for example through better education and training, or by
purchasing more capital such as investment in new factories.
(iii)
LRAS1
LRAS2
The components of aggregate demand (AD) are private sector consumption
(C), private sector investment (I), government expenditure (G) and net
expenditure on exports (X-M).
AD = C + I + G + (X-M)
Therefore, a rise in consumption will cause a rise in AD. According to
Keynesians, firms will react in two different ways to a rise in AD, depending on
whether they have spare capacity.
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02.02.2012
Firms operating below spare capacity will use their spare factors of
production, such as land, labour and raw materials, to increase output,
therefore shifting the AD curve from AD1 to AD2 and increasing real Gross
Domestic Product (GDP) from NY1 to NY2. This means there will be
economic growth.
However, if firms are already operating at full capacity, AD3, they cannot
increase their production levels. Therefore, they will respond to a rise from
AD3 to AD4 by increasing their average price level from AP1 to AP2. This
increase in average price level is known as inflation. Inflation reduces the
internal value of money because it increases the cost of living. The only way
they could avoid this would be by increasing aggregate supply by, for
example, increasing the productivity of the firm through education and
training. This would shift the LRAS curve from LRAS1 to LRAS2. There would
then be potential for increased GDP, and thus further economic growth.
The rise in consumption will not affect the economy immediately, as there will
be a time lag before companies respond to a change in aggregate demand.
Furthermore, an increase in GDP will only be true up until a certain extent, as
inefficient firms operating below full capacity may respond to the increase in
AD by raising their prices, despite their ability to produce more.
(d) (i) Disposable income is that part of total income that is available for
discretionary spending. Disposable income is equal to net income minus fixed
outgoings, such as mortgage repayments, school fees and credit card
repayments. A change in disposable income may come about for various
reasons, for example a wage increase or a decrease in taxation. It is likely to
cause an equal increase in consumption as it means people have more
money to spend on goods and services. However, this relies on ceteris
paribus. If interest rates were to increase more than disposable income,
consumption may decrease as people are more inclined to save their
disposable income. Furthermore, consumer confidence has an effect on
consumption, and this cannot be changed by disposable income.
(ii) Table 1 shows that the general trend of household disposable income in
relation to household consumption is what would be expected, as whilst
household disposable income rises each year from 1994 to 1999, household
consumption rises.
1994-1995
Percentage increase in household disposable income
= (actual increase ÷ initial value) x 100
= (£13bn ÷ £482bn) x 100
= 2.7%
Percentage increase in household consumption
= (actual increase ÷ initial value) x 100
= (£7bn÷ £431bn) x 100
Tor Hirst
02.02.2012
= 1.6%
These calculations show, however, that the percentage increase in household
disposable income is not equal to the percentage increase in household
consumption. This suggests that people do not spend all of their extra
disposable income.
1998-1999
Percentage increase in household disposable income
= (actual increase ÷ initial value) x 100
= (£18bn ÷ £526bn) x 100
= 3.4%
Percentage increase in household consumption
= (actual increase ÷ initial value) x 100
= (£22bn÷ £513bn) x 100
= 4.2%
These calculations show that a 1% increase in disposable income can lead to
a higher than 1% increase in household consumption, therefore showing that
an increase in disposable income is not the only contributor to increase
household consumption, and that the percentage increase in disposable
income will not necessarily be equal to the percentage increase in
consumption.
(e) Interest rates are controlled by a central bank. In the UK, this bank is the
Bank of England. When the Bank of England increases interest rates, it is to
run a tight monetary policy, often to combat inflation. Interest rates affect
aggregate demand by affecting private sector consumption and investment
which are both components of AD.
Keynesians believe the higher the interest rates, the higher the propensity to
save, as people will make more money on their savings. Furthermore, less
people are likely to borrow money if they have to pay large sums of interest in
return. Therefore, peoples’ propensity to consume decreases and there is a
fall in aggregate demand.
The UK runs a current account deficit. This means that their net import
expenditure is greater than their net export expenditure. Therefore, America is
very likely to export goods and services to the UK. A fall in aggregate demand
in the UK means there are fewer people demanding fewer goods and
services, therefore there is less need to import goods from America.
In order to prevent an excess of stock, America will have to reduce production
as their market is smaller. Therefore, their gross domestic product will fall and
economic growth for America will decelerate.
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02.02.2012
(f) Aggregate demand is the total amount of expenditure within the economy
at a given average price level over a given period of time. Aggregate demand
(AD) is made up of private sector consumption, private sector investment,
government expenditure and net expenditure on exports. Governments use
fiscal policy to change the level of aggregate demand within an economy.
Fiscal policy involves using the government’s budget to change the level of
aggregate demand within the economy. The government’s budget details the
government’s tax and spending plans for the year ahead. The government
runs an expansionary fiscal policy when it runs a fiscal deficit, when planned
government spending exceeds planned tax income. It is used to increase
aggregate demand to help push the economy out of recession. Contractionary
fiscal policy involves the government planning to run a fiscal surplus in order
to decrease the level of aggregate demand in the economy. Governments
tend to use contractionary fiscal policy to reduce demand-pull inflationary
pressure within the economy.
The government can increase aggregate demand by running an expansionary
fiscal policy. This can be done in two ways: by decreasing taxes and/or by
increasing government spending. Lowering taxes will increase aggregate
demand as a decrease in taxation will cause a rise in people’s disposable
income, which will allow consumers to purchase more goods and services.
This is a rise in private sector consumption, a component of AD, thus an
increase in aggregate demand. Furthermore, private sector investment,
another component of aggregate demand, is likely to rise as firms have a
larger incentive to produce more when they have to pay less tax from their
profits. This means that a decrease in taxation will increase Gross Domestic
Product (GDP). When GDP rises, Keynesians believe aggregate demand
does, too, with higher employment levels. Therefore, reductions in taxation
are likely to be effective in increasing both consumption and investment, and
hence aggregate demand will increase.
In addition, the government can increase spending in all sectors of its
economy in order to boost AD. A rise in the number of benefits such as Job
Seekers’ Allowance will mean a rise in the money consumers have to spend
in the economy. This will lead to a rise in the money spent in the economy,
and consequently in AD. Money spent on education and training could
enhance a worker’s employability and productivity, causing a rise in GDP and
a subsequent rise in AD.
On the other hand, fiscal policy can be used to reduce aggregate demand
within the economy to lower the inflation rate. This policy will increase taxation
thus decreasing the person’s disposable income. Therefore their propensity to
consume will fall, and consequently there will be a drop in AD. Furthermore,
AD would be decreased ff the government were to decrease public spending,
as less people would receive benefits such as JSA, meaning there is less
disposable income to be spent within the economy. Keynesians believe a
decrease in AD will be effective to decrease the rate of inflation.
The main cost of the use of fiscal policy to control aggregate demand is the
use of expansionary fiscal policy which causes a budget deficit. This has to be
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02.02.2012
funded by borrowing, therefore increasing the national debt. This has a
negative effect on future generations who will have to repay the debt and
interest. This means that in the long term, government spending will have to
decrease and taxation increase, therefore long term AD will fall.
The effectiveness of fiscal policy is partly based on the extent to which a
change in taxation has on consumption. If there is a high marginal propensity
to consume, consumers will not be affected by the raise in taxes, and will
continue to consume goods and services as before. Similarly, if there is low
marginal propensity to consume, no matter how low the government drops the
tax, domestic consumption will not increase and AD will remain unaffected.
Furthermore, fiscal policy relies heavily on the government being well
informed. If the government believes the economy is about to enter a
recession, they will use expansionary fiscal policy to increase the level of
aggregate demand. If they have been misinformed, they will cause high
inflation rates, thus causing their fiscal policy to be ineffective and
problematic. This is called government failure.
In addition, the government has to be able to predict the future state of the
economy correctly in order to factor in time lags, which will occur between the
change in taxes or government expenditure and the reaction of consumers. If
the government responds to a change in economic growth or inflation too late,
the problem may have grown.
Lastly, the effectiveness of fiscal policy relies on all other factors, such as
interest rates and immigration levels remaining equal, ceteris paribus. This is
because interest rates can affect aggregate demand by changing people’s
propensity to consume, and inflation can increase GDP with a larger
workforce, or increase the reliance of public services, thus contribute to the
impact of a change in government spending.
In conclusion, fiscal policy can be effective in changing aggregate demand in
the short term, running expansionary or contractionary to decide the level of
AD. However, in the long term it will add to the national debt the majority of
the time, as fiscal deficits is often run more frequently than fiscal surpluses by
most economies, such as the UK. Moreover, there are a number of factors the
government must rely on in order for fiscal policy to be effective, and it is not
generally certain that these will remain equal. Therefore, although fiscal
policies can be run to help change AD, there are potentially and more
effective solutions.