Economics AQA A2 Un 4 Workbook Answers

WORKBOOK ANSWERS AQA A2 Economics Unit 4 The National and International EconomyThis Answers book provides answers for the questions asked in the workbook. They are intended as a guide to give teachers and students feedback. The candidate responses supplied here for the longer essay-style questions are intended to give some idea about how the exam questions might be answered. The examiner commentaries (underlined 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.

Introduction to the national and international economy1 Microeconomics is the branch of the subject that studies individual markets, such as commodity,

energy, car and clothes markets. Macroeconomics is the branch of the subject that studies the national economy in aggregate, and how the national economy interacts with the wider global economy.

Topic 1 Macroeconomic indicators1 The economic cycle is a period of approximately 6 or 7 years in which the economy completes a cycle

of downturn, recession, recovery and boom. A peak and a trough are further features of the cycle.

2 Boom: The period leading up to the peak of the cycle when an overheating economy is experiencing high GDP growth and inflationary pressures driven by unsustainable demand. Speculative activity, which tends to grow in the boom period, is a factor that makes a boom unsustainable.

Recession: The part of the economic cycle when the depressed economy is experiencing negative economic growth. A collapse of aggregate demand brings about a recession.

Recovery: The period after a recession when the economy starts to experience steady GDP growth without significant inflationary pressures.

Double dip recession: When an economy falls back into recession before it has properly recovered from the first recessionary ‘dip’. A double dip recession can lead into a ‘lost decade’ of negative or stagnant economic growth.

Economy’s growth rate: Long-term economic growth, or trend growth, is the rate of growth the economy can sustain, ignoring the short-term ups and downs of the economic cycle. It can be illustrated by the outward movement of the economy’s production possibility frontier. The percentage annual increase in real GDP measures economic growth.

3 Economic growth is most commonly measured in terms of the annual percentage rate of change in real gross domestic product (GDP).

4 First, demand-side growth is caused by a change in one of the components of aggregate demand. If any of the components increases (consumption, investment, government spending or exports), the economy will grow.

AQA A2 Economics Unit 4 The National and International Economy 1

Philip Allan, an imprint of Hodder Education© Ray Powell, James Powell

TOPIC 1 Macroeconomic indicators

Second, supply-side growth occurs when the productive capacity of the economy increases. This takes place due to an increase in the physical capital infrastructure of the national capital stock or because of the enhancement of either the depth or the breadth of the economy’s human capital stock.

5 The two main costs of economic growth are resource depletion and environmental damage. Economic activity requires factor inputs and will often lead to scarce resources such as fossil fuels

being consumed and lost forever because they cannot be replaced. Environmental damage occurs when the production process creates harmful toxics, gases and

waste in the course of making consumer and capital goods. This has also been called the paradox of prosperity, as human living standards improve as a result of greater access to consumer goods but decline as a result of environmental destruction, poorer air quality and polluted water supplies.

The two main benefits of growth are improved living standards and technological advancement. As an economy grows, the output of capital and consumer goods will increase, which should in

turn lead to an increase in the level of employment as firms need more workers to maintain production. The higher level of employment combined with increased production should result in the average household being able to attain buy consumer goods, which will improve their standard of living.

Technological advancements will often occur as an economy grows because firms will seek to maximise profits by inventing new products to develop new markets and meet consumer needs. This dynamic growth will normally occur when an economy is growing because it will require firms to undertake investment, which is encouraged by higher business confidence.

6 Gross domestic product is the total value of an economy's domestic output of goods and services. Gross national product is the same as GDP except that it adds what a country earns from overseas investments and subtracts what foreigners earn in a country and send back home.

7 National income statistics underestimate the true level of economic activity, and hence people’s living standards, because the non-monetised economy is under-represented. In the UK, housework and ‘do-it-yourself’ home improvement take place without money incomes being generated. The contribution of these to living standards is imputed, but the ‘guesses’ are generally too low.

Economic activity undertaken illegally in the hidden economy is also omitted. Economic transactions conducted in cash because people are engaging in tax evasion are not recorded in the national income figures, so their contribution to living standards is also not recorded.

8 Two economic indices learnt at AS are the Retail Prices Index (RPI) and the Consumer Prices Index (CPI). Both are used to measure the average price level for goods and services that people buy. A main purpose of most economic indices is to remove the distorting effect of inflation from the data being measured.

9 National income figures fail to measure the extent to which the positive externalities that benefit people add to their economic welfare and standards of living. They also don’t measure the human happiness people enjoy from mixing with their family and friends.

10 (i) Cyclical unemployment: This is unemployment caused by an economic downturn and collapse of aggregate demand. It is sometimes referred to as demand-deficient or Keynesian unemployment. The slowdown in economic activity results in firms laying off workers due to a lack of demand for their output.

(ii) Frictional unemployment: This is ‘between jobs’ unemployment that occurs when workers leave one job and start searching for a new job.




(iii) Structural unemployment: This is a destructive form of unemployment that occurs when an industry or sector of the economy enters structural decline and sometimes disappears completely. Workers find themselves redundant or no longer needed, without the skills to match any new jobs.

11 (i) Whereas the money wage rate or nominal wage rate is the hourly wage rate measured in money that a worker receives for supplying labour, the real wage rate is measured in terms of the goods and services the worker can buy with the money at the current price level.

(ii) Wage ‘stickiness’ or wage inflexibility may prevent the real wage rate falling to the full-employment wage rate. Stickiness or inflexibility is caused by labour market imperfections and by workers’ unwillingness to accept cuts in the nominal wage rate, which are usually necessary for real wage rates to fall.

12 As stated in the answer to question 10 (i), cyclical unemployment is caused by a collapse of aggregate demand in the downturn of the economic cycle.

13 Every month, the Office for National Statistics (ONS) collects information on about 120,000 prices for a 'shopping basket' of about 650 goods and services. The change in the prices of those items is used for calculating the rate of inflation, shown by changes in the Consumer Prices Index (CPI). The contents of the basket are reviewed every year, and changes can be made for a number of reasons. Some items enter the basket because spending on them has reached a level that demands inclusion, to ensure that the basket represents typical consumer spending. Some are included to make data collection easier or to improve coverage of particular categories.

Changes to the basket are often made to improve coverage of a sector where spending has increased. The ONS tracks consumer spending, and uses survey results to ensure that items on which people spend most have the biggest share of the basket. Each is assigned a proportion, or 'weight', of the index. The 'weight' of each category in both the CPI and the RPI is adjusted every year to take account of these changes, giving more prominence to areas whose 'weight' is rising.

The Living Costs and Food Survey (LCFS), which in 2008 replaced the Expenditure and Food Survey (EFS), collects information on spending patterns and the cost of living that reflects household budgets across the country. A primary use of the survey is to provide information about spending patterns for the Consumer Prices Index.

14 The average price level has risen at a relatively fast rate since 2008, despite the deep recession that the UK experienced in 2008/09. The rise in the price level has been driven by rising global commodity prices and the devaluation of sterling following the banking crisis in autumn 2008.

The rising price of global commodities has been partly caused by demand from the emerging economies, especially China and India. These economies have been experiencing strong GDP growth of between 7 and 11% per year, which has significantly increased demand for raw materials and sources of energy such as oil and gas. This economic growth has created millions of jobs and lifted more people out of poverty than in any other period in history. As a result levels of disposable income have increased and demand for food has surged.

The fall in the value of sterling on the international currency markets followed near collapse of the British banking system and the lack of international business confidence in the UK economy. After July 2008, sterling lost approximately 25% of its value against the US dollar, although there was some recovery in 2012. However, some economists argue that the Bank of England and HM Treasury encouraged devaluation through a process of ‘benign neglect’. They have been relaxed about the devaluation, which has been exacerbated by the Bank's monetary policy setting interest rates at 0.5% and pursuing the unorthodox quantitative easing programme, in order to make exports price competitive on the international markets and imports unattractive to domestic consumers.




Although the price level has generally risen, and at a rate of inflation sometimes touching 5%, for a very short period in the depth of the recession in 2009 the price level fell, at least when measured by changes in the RPI, though not the CPI. There was a very short period of deflation (a falling price level).

15

Demand-pull inflation

Cost-push inflation

16 Demand-pull inflation occurs when there is an increase in the level of aggregate demand in the economy. Aggregate demand consists of five components, which are stated in the following equation:

AD = consumption + investment + government spending + (exports – imports)

When there is an increase in one of the components — consumption, investment, government spending or exports — the level of economic activity in the economy will increase and real national output will increase. This will be represented on a diagram as AD shifting to the right. However, as aggregate demand increases there will be greater pressure on resources, and firms supplying goods and services may face the problem of excess demand, especially if production capacity is limited. This will result in businesses increasing prices and/or employing more overtime workers less efficiently to




satisfy demand. The higher prices will feed into the inflation indices CPI and RPI as the price level increases at the same time as GDP growth occurs (providing there is spare capacity in the economy).

Demand-pull inflation has been caused mainly by the growth in consumption spending, caused by rising levels of disposable income, which in turn stems from a combination of increased employment, tax cuts, lower interest rates, easy credit and increased household confidence.

17 Cost-push inflation occurs when the costs of production increase, causing the short-run aggregate supply curve to shift to the left.

The major causes of cost-push inflation are rising prices of raw materials, oil, gas and food, or a sudden increase in wage rates. Increased business costs imposed on firms squeeze profit margins and force firms to push up their prices, which then causes cost-push inflation.

The cost-push inflation experienced in the UK since 2009 has two main sources. First, the devaluation of sterling on the currency markets has made imported goods and services into the UK more expensive. Second, the global increases just noted in the prices of food, energy and commodities have been causing a cost-push inflation in the UK.

18 The Fisher equation is:

money supply (stock of money) velocity of circulation of money = price level total transactions in the economy

or MV = PT

In the Fisher equation, for a particular time period, say a year, the stock of money in the economy (or money supply) shown by the symbol (M) multiplied by the velocity of circulation of money (the number of times money changes hands) or (V) equals the price level (P) multiplied by the total number of transactions (T). A transaction occurs when a good or service is bought. T measures all the purchases of goods and services in the economy.

To convert the equation of exchange (MV = PT) — which is true by definition — into a theory of inflation, it is necessary to make three assumptions. The first two are: The velocity of circulation or speed at which money is spent and total transactions (which are

determined by the level of real national output in the economy) are fixed, or at least stable. In the quantity theory, money is a medium of exchange (or means of payment), but not a store

of value. This means that people quickly spend any money they receive.

Suppose the government allows the money supply to expand faster than the rate at which real national output increases. As a result, households and firms possess money balances (or stocks of money) that are greater than those they wish to hold. According to the quantity theory, these excess money balances will quickly be spent. This brings us to the third assumption in the quantity theory: changes in the money supply are assumed to bring about changes in the price level (rather than vice versa).

19 Macroeconomic policy trade-offs are possible along the short-run Phillips curve but are not sustainable in the long run. In the short run a government can choose between targeting the level of unemployment or the rate of inflation. In the short run, expansionary fiscal policy can spur the economy and create jobs at the cost of a higher rate of inflation.

However, the capacity of the economy is fixed in the short run. The economy’s long-run Phillips curve is a vertical line, whose position is fixed by the economy’s short-run productive capacity. It is impossible to trade off along this line in the long run between the two policy targets of reducing unemployment and reducing inflation.




Exam-style answers (data response)Global living standards and the UK macroeconomic performance

01 The absolute difference in gross national income per capita is 29,828 PPP$, which means that UK income per capita is approximately 860% higher than India’s.

The data are ranked in terms of descending Human Development Index (HDI) for the selected countries. However, just because a country ranks above other countries in terms of the HDI, this does not mean that it ranks above the same countries in terms of all the factors that contribute to the value of the country’s HDI. For example, the Czech Republic lies above the UK in terms of HDI (0.865 compared to 0.863), but the country is below the UK in terms of life expectancy at birth (an age of 77.7 years as against 80.2 years).

The first part (01) of the context data response question in ECON4 and in ECON3 will usually be in two parts. The first part requires a calculation (often a percentage calculation) and the second part asks for identification of one other significant point of comparison, or for questions where there is only one data series in Extract A, one other significant feature of the data. Some exam papers may, however, ask for two significant points of comparison (or features), without a preliminary calculation. This answer scores the 2 marks for the calculation and picks up all 3 marks available for identifying, and backing up with statistical data, a significant feature of the data.

02 The concept of comparative advantage states that a nation should specialise in the industries in which it has a comparative advantage. Comparative advantage is measured in terms of opportunity cost. The country with the least opportunity cost when producing a good possesses a comparative advantage in that good.

In recent years it has become fashionable to argue that the British economy is in decline and that it needs to re-balance in order to compete with the emerging BRIC economies. On coming to office in 2010, David Cameron and Nick Clegg said that the UK was too dependent on its service sector economy but needed to rebuild its economy to be more like that of Germany, which has a proud tradition of exporting high-quality capital and consumer goods across the world. In recent years Germany's economy has boomed as it has enjoyed strong balance of payments surpluses by selling its goods and services to the BRIC economies.

The law of comparative advantage, however, suggests that it would be unwise of the UK economy to try to replicate the German model. First, German firms have already established a leading position in producing high-quality capital and consumer goods, and the absolute and comparative advantage is already in its favour. Second, firms in the BRIC economies are attempting to emulate Germany and other engineering and manufacturing producers. UK firms could try to compete but they may struggle because they are unable to employ workers on significantly lower wages. Third, the UK should focus on the industries where it already has the comparative advantage, namely high-quality design, niche top-end manufacturing and engineering, and most importantly services. The southeast of England is home to some of the world’s leading financial, insurance, marketing, consultancy and legal firms. These industries are extremely difficult to replicate because they are based on the value of the human capital they employ and not physical capital. The UK has already established these industries and should be careful not to lose them. Free-market economists would argue that the government would be wiser to listen to the advice of David Ricardo and focus on what the nation already does best rather than trying to copy another nation in a superior position.

For ECON 4 and ECON3, the second part of the question (02) divides into two parts. The first part (worth 4 marks) asks candidates to explain the meaning of an economic term (in this case ‘comparative advantage’. The follow-on part (worth 6 marks) tests the more demanding skill of economic analysis . An




answer is constrained to a maximum of either 4 marks or 6 marks if only the explanation or analysis is attempted.

This answer earns full marks for both parts, although the explanation is really too long, drifting at times away from the central issue posed by the question. The candidate might well have wasted time that would be better spent answering the last part of the question.

03 UK macroeconomic performance should be judged on the economy’s long-term ability to generate growth, create jobs, improve living standards, control inflation, and run equilibrium on the current account of the balance of payments. This answer considers and then evaluates each of these in turn, before coming to an overall conclusion on whether the growth of emerging market economies has improved or deteriorated UK macroeconomic performance.

According to Investopedia, Antoine W. Van Agtmael of the International Finance Corporation of the World Bank first mentioned the term emerging market economy (EME). Since then, an EME has become defined as an economy with low to middle per capita income. About 20% of global economies are EMEs and they contain about 80% of the world’s population. The word ‘emerging’ relates to the fact that EMEs have started economic development and reform programmes, which involve opening up their markets. EMEs have generally benefited in recent decades from fast rates of economic growth. In some countries their increased integration into the globalised world economy has produced this result. However, the success of many EMEs has arguably been the result of a considerable amount of intervention by their governments (often in the form of state capitalism) and protectionism — the latter often hidden. The so-called BRIC countries (Brazil, Russia, India and China), to which South Africa is sometimes added to become the BRICS, are the most well-known EMEs.

With regard to economic growth, a good starting point for analysis and evaluation is the fact that the rate of economic growth in the UK has been very low, whereas growth rates in many EMEs have been much higher. For the UK and before the onset of recession in 2008, the trend rate of growth was estimated to be around 2.5% per year. Many forecasters have now downgraded this to below 2% per year. The downgrade reflects both cyclical factors (the collapse of aggregate demand in the UK associated with recession and the possibility of Britain having entered a ‘lost decade’ of near zero growth) and structural factors, one of which is deindustrialisation. By contrast, among the BRICs, China’s trend growth rate is around 8–9% per year and India’s rate is above 6% per year.

Deindustrialisation, or the structural decline of many manufacturing industries, along with activities such as coal mining, is associated with UK manufacturing firms either relocating to cheaper labour zones in EMEs, or going out of business in the face of fierce competition from the EMEs. Obviously, workers previously employed in UK manufacturing who have lost their jobs as a result of the structural decline of the industries that used to employ them have suffered a decline in their standard of living. By contrast, many UK households have benefited from the shift of manufacturing to EMEs because they have been able to buy cheap imports from the emerging markets, especially China. Despite the relatively low trend growth rate, the average standard of living in the UK increased between 1997 and 2007 as the British economy experienced the benefits of generally falling import prices. (Since 2008, the standard of living of most UK residents has fallen. Recession and loss of international competitiveness are to blame.)

But even when standards of living rose, this came at the cost of structural unemployment, which has particularly affected regions in the north of England, Wales, Scotland and Northern Ireland. The communities that were dependent on heavy industry have suffered from high levels of unemployment while other areas of Britain have benefited from cheaper imports and higher living standards.

For free market economists this has been an acceptable consequence of the development of globalisation and the rise of EMEs. On a global scale it has resulted in a more efficient allocation of scarce resources, as countries that can produce manufactured goods and export them around the world have done so and




sell goods at significantly lower prices. Furthermore, tens of millions of people in India and China have been lifted out of poverty.

Taken on its own, importing cheap manufactured goods from EMEs (and also low-priced services such as those provided by call centres which have relocated to EMEs) may have contributed to a lower UK inflation rate than would have been the case in the absence of falling prices of manufactured goods. However, this deflationary effect has probably been more than offset by the rising import prices of food, raw materials and energy. Britain increasingly competes with EMEs for these goods. In particular, China and India have an insatiable demand for raw materials and energy, which are necessary for maintaining their fast trend rates of growth. Thus deflation in the prices of manufactured goods imported from EMEs is overwhelmed by high inflation in the prices of food and inputs into the production process. Also, there is now evidence that EMEs such as China are putting up the prices of their manufactured goods as they also suffer from the rising import costs of foods, raw materials and energy. In the UK this is further exacerbated by the rising price of imports caused by the fall in the value of the £, itself caused in part by Britain’s loss of international competitiveness vis-à-vis the EMEs.

A problem for the UK is that remarkably few UK goods or services are exported to the BRIC countries. Most of Britain’s exports go to other EU countries, but many EU countries are also suffering from a collapse in aggregate demand as a result of their similar loss of international competitiveness.

This is a major problem for UK economic performance and helps explain the persistent deficit on the current account of the balance of payments. The UK has been a net importer of goods for many decades and, although the UK has a strong service sector, British households have become dependent on imported goods. The major problem facing the UK is that large current account deficits that have been incurred since 2000 have been financed by borrowing from the emerging-market nations, particularly China. This is not a sustainable position. If China were suddenly to decide to sell its holdings of financial assets, denominated in sterling, that it has accumulated as a result of financing the UK’s imports from China, the £’s exchange rate would go into free-fall. Although this would make Britain’s exports more price competitive, in the short run at least, UK inflation would rise dramatically, unemployment would grow and standards of living would fall.

To conclude, if the UK is to benefit from the growth of emerging-market economies in the future, it must start exporting goods and particularly services to these countries in greater volumes. However, this is much easier said than done and is dependent on a supply-side led reform of methods of production in the UK. Nevertheless, the British service sector is the home to some of the best service sector firms in the world. Furthermore, the UK possesses some very competitive niche manufacturing companies. However, if the UK economy is to generate jobs and export more to EMEs in the future, it needs to ensure that it sets up trade links quickly with the main emerging-market economies and fend off competition from other EU countries, Japan and the USA.

This answer is placed at the bottom of level 4 (17–21 marks). The answer’s main weakness is failure to base the analysis and evaluation on a key concept in the question: UK macroeconomic performance. Whenever you see these words in a question, you should start your answer by explaining the meaning of the term. Macroeconomic performance can be measured by the extent to which the economy achieves sustained success in achieving reasonable or good performance with regard to the standard objectives of macroeconomic policy: low unemployment, economic growth, control of inflation and the export competitiveness of the country’s industries, reflected in the current account of the balance of payments. The analysis in this answer is good but narrow, and the final paragraph does not really come to a justified conclusion.




The grade descriptor for level 4 is:

A2Levels mark scheme

AO1 Knowledge and understanding of theories, concepts and terminology

AO2 Application of theories, concepts and terminology

AO3 Analysis of economic problems and issues

AO4 Evaluation of economic arguments and evidence, making informed judgements

Level 417–21 marks(mid-point 19)

Good analysis but limited evaluation

or

Reasonable analysis and reasonable evaluation

Good throughout the answer with few errors and weaknesses

Good throughout much of the answer with few errors and weaknesses

Good application to issuesWhere appropriate, good use of data to support answer

Some good application to issuesWhere appropriate, some good use of data to support answer

Relevant and precise with a clear and logical chain of reasoningThere is good awareness of the interrelatedness of economic issues

Largely relevant and well organised with reasonable logic and coherenceThere is some awareness of the interrelatedness of economic issues

Limited but showing some appreciation of alternative points of view

Reasonable, showing an appreciation of alternative points of view

Exam-style answers (essay)Unemployment, inflation and the Phillips curve

01 Inflation is the rate at which the average price level of goods and services rises in a given time period. In the UK, the Office for National Statistics uses two main indices to measure inflation: the Consumer Prices Index (CPI) and the Retail Prices Index (RPI).

The role of inflation expectations in influencing future inflation was an area of economic analysis developed by Professor Milton Friedman in the 1970s. Friedman argued that workers and firms pay careful attention to their past experiences when developing expectations about future inflation. If they have experienced inflation in the past, workers will expect prices to go up in the future and will make pre-emptive wage demands on the ground that without an inflation-adjusted pay rise they will experience a pay cut in real terms. This behaviour will actually create the conditions for inflation. Confronted with increased wage demands and accepting the inflationary record of the past, firms will give in to higher wage demands and pass on the cost increases to consumers in the form of higher prices.

Changes in costs of production will also affect inflation. In the summer of 2008 the UK experienced increased inflation as the price of energy increased in world markets. In July 2008 the price of oil broke the $100 a barrel mark for the first time, although it did fall sharply after the financial crisis. It has, however, risen steeply again due to the high levels of demand from the emerging markets which may well see the price of a barrel of oil break the $200 mark in the next few years. The British economy is dependent upon oil as a major source of energy, so when oil prices increase, the costs of production of almost all firms increase either directly or indirectly. This feeds into the inflation indexes.

Cost-push inflation is illustrated on the aggregate demand and supply diagram below. Initially, macroeconomic equilibrium is at point X, with real output and the price level respectively at y1 and P1. Firms’ money costs of production rise — for example because money wages or the price of imported raw materials increase — which causes the SRAS curve to move upward and to the left from SRAS1 to SRAS2. The cost-push inflationary process increases the price level to P2, but higher production costs




have reduced the equilibrium level of output that firms are willing to produce to y2. The new macroeconomic equilibrium is at point Z.

It should be noted that falling costs of production can also result in benign deflation. The UK experienced a decade of low inflation between 1997 and 2007 caused by falling costs of production as firms benefited from technological advances that revolutionised production methods and significantly lowered labour costs by out-sourcing production to southeast Asia.

The mark scheme for the first part (01) of an essay question is ‘issue based’. The mark scheme sets out all the issues deemed to be relevant to the question and indicates the maximum marks that can be awarded for each issue. The total mark is usually higher than 15, which is the maximum mark for the first part of an essay question. So when an answer earns more than 15 marks, the mark awarded is constrained to the maximum of 15. This is the case with this answer. Both parts of the question are addressed accurately, earning well over 15 marks but the mark awarded is the maximum 15. By the time you read this answer, the reasons for recent and current inflation quoted by the candidate may have changed. In the early months of 2012, for example, falling world oil prices meant that cost-push inflationary pressures were considerably less than they had been in the earlier years quoted by the candidate.

02 The Keynesian economist A. W. Phillips developed short-run Phillips curve analysis in the 1950s. Phillips had researched the relationship between inflation and unemployment over a 100-year period and found that there was a relationship between the two variables that could be illustrated as in the diagram below.




The Keynesian economists of the1950s and 1960s used this curve to present government officials with a ‘menu choice’. They could pick either: low inflation and high unemployment (position A on the diagram); or high inflation and low unemployment (position B on the diagram).

The 1970s saw a prolonged period of mass unemployment and double-digit inflation which led to widespread disillusionment with Keynesian economics. The neo-liberal economic revolution associated with the 1980s governments of Margaret Thatcher in the UK and Ronald Reagan in the USA was inspired by the revival of free-market economics.

Milton Friedman from the Chicago School was particularly critical of the Phillips curve for two main reasons. First, he argued that like Keynesian economics in general, the Phillips curve ignored the supply side of the economy. In Friedman’s analysis, government policy that merely stimulates aggregate demand will inevitably create inflation unless there is also a policy to increase the supply side. Hence, free-market economists argue that if a government wishes to tackle unemployment it needs to remove obstacles to markets functioning properly, such as trade unions and unnecessary regulations, and to use low taxes and the profit motive to create incentives for workers and entrepreneurs.

The theoretical roots of this thinking rested in a fiscal policy that advocates low taxation and low welfare benefits. By creating incentives to work, the government can encourage workers to sell their labour at a competitive rate. Moreover, by allowing businesses to make profits, business leaders will invest in the economy and increase the capacity of the national capital stock. This will create more jobs and reduce inflation.

Economists now generally recognise that the Phillips curve in the diagram above is a short-run Phillips curve (SRPC), representing the short-run relationship between inflation and unemployment. In the next diagram, a vertical long-run Phillips curve (LRPC) has been added to the diagram, intersecting the short-run Phillips curve where the rate of inflation is zero. The rate of unemployment at this point is called the natural rate of unemployment (NRU), depicted by the symbol UN.

Once inflationary expectations have been allowed to develop, it is an extremely painful process to get workers to accept lower wages in the future. Indeed it may take a prolonged period of mass unemployment to discipline the labour markets and bleed the inflationary pay demands out of the economy.

Ultimately, a government can achieve economic growth with low inflation and reduce unemployment but only by tackling the long-term structural and supply-side problems in the economy. If a government is to shift the LRPC to the left (and the long-run aggregate supply curve to the right) it needs to pursue an investment strategy that enhances both the physical and human capital of an economy and reduces inflationary pressures. In the coming decades the UK economy is going to face increasing competition




from overseas. British firms and workers will be unable to compete on cost but instead will have to offer services, production techniques and skills that cannot be easily replicated in other countries. A highly skilled workforce with the best capital equipment and technology is the objective that the government should aspire to if it is to reduce unemployment and maintain low inflation.

As is the case with the final part of a context data response question, the mark scheme for the second part (02) of an essay question is ‘level of skill based’. Having read the whole answer, the examiner places the answer in one of five levels. These are:

Level 1 — very weak Level 2 — weak with some understanding Level 3 — reasonable including some correct analysis but very limited evaluation Level 4 — good analysis but limited evaluation or reasonable analysis and reasonable evaluation Level 5 — good analysis and good evaluation

This answer is awarded 21 out of 25 marks and is placed at the top of level 4 in the mark scheme. The answer displays both good analysis and good evaluation, but does not quite reach level 5. It drifts a little too much into ‘write all you know about the Phillips curve’ and away from focusing on the issue posed by the question: ‘can governments reduce both the rate of inflation and the level of unemployment?’ The final paragraph relating to the supply-side of the economy is good, but added as a bit of an after-thought to the main part of the answer. It should appear, and be developed, much earlier in the answer.



Topic 2 Managing the national economy1

2 The main fiscal objective of Chancellor George Osborne when coming to office in May 2010 was to eliminate the UK’s structural deficit and run a balanced budget by 2015. Due to poor economic data the Treasury later conceded that this could not be achieved until 2018. However, until June 2012 at least, the government’s tight fiscal policy (known variously as fiscal austerity, fiscal consolidation or fiscal realism) remains largely in place.

The government announced in March 2011 that it intended to cut government spending by £81 billion over a 4-year period. The main spending cuts would be achieved by cutting most of the government department budgets by up to 20%, although the NHS has been protected from any real cuts. The number of civil servants employed by the government has been dramatically reduced and 800,000 redundancies have been announced. Welfare benefits have been targeted by the Minister for Work and Pensions, Iain Duncan Smith, who wants to introduce a cap of £26,000 per year on benefit claimants. Public sector pay was frozen for 2 years and public sector pensions are in the process of being reformed to save money. The age for retirement has been increased to 67 and will rise to 68.

At the same time, levels of taxation have increased. The most significant is the increase in the VAT rate to 20%. The government first maintained the 50% income tax rate levied on top earners, but then cut the rate to 45%. Public sector pension contributions have been increased and tax bands have been lowered so that more workers have to pay the higher 40% band of taxation.

3 In the period between 1997 and 2006 the Labour Chancellor Gordon Brown was committed to the self-imposed Sustainable Investment Rule, which stated that the national debt would not rise above 40% of GDP. However, since 2007 the UK’s national debt has almost doubled and is expected to peak at 80% of GDP in 2014.

The causes of the rapid increase in the national debt are threefold. First, during the banking crisis of 2007/08 the British government nationalised the Northern Rock bank and partially nationalised RBS and HBOS. These bailouts kept the banks solvent but saw the British government accept liability for their massive debts. Second, the government ran up huge budget deficits after 2008. When the recession hit, tax revenues fell sharply but government spending increased, in part to prevent the collapse of the economy. Third, it is now clear that the British economy has been running a structural



TOPIC 2 Managing the national economy

deficit and for too long the nation has lived beyond its means. Even in the good years, government spending was greater than tax revenues, which meant that in every year since 2002 the national debt increased. As a result, the current Chancellor is committed to a programme of spending cuts, with the long-term objective of bringing the budget deficit under control.

The national debt is significant for two reasons. First, it will have to be paid back by future taxpayers. This can only happen if future governments can get the economy to grow and run budget surpluses. Moreover, higher rates of taxation and lower levels of government welfare provision will reduce the standards of living for future generations. Second, an extremely high national debt will make it more difficult for the British government to borrow from international markets and will mean that the nation’s debt interest repayments will increase. Because of these problems (and although it does not admit it), the government will probably be quite happy to see inflation reduce the real value of the national debt.

4 The principle of equity is that a tax should be fair and that the tax is levied on those with the ability to pay the tax.

The principle of efficiency is that the tax should be easy to collect and that the government should not have to spend a disproportionate amount of money enforcing the collection of the tax.

5 Government intervention in the economy, which treats people in the same circumstances equally, obeys the principle of horizontal equity. Horizontal equity occurs when households with the same income and personal circumstances (for example, number of children) pay the same income tax and are eligible for the same welfare benefits. Vertical equity is much more controversial, since it justifies taking income from the rich (on the ground that they don’t need it) and redistributing their income to the poor (on the ground that they do need it). The distribution of income after taxation and receipt of transfers is judged more equitable than original income before redistribution.

6 Trade union reformDeregulationPrivatisationTax simplification

7

Successful supply-side policies shift the LRAS curve to the right, increasing the economy’s natural level of real output from yN1 to yN2. The diagram also shows the price level falling (a benign deflation). However, it may be necessary for the AD curve also to shift to the right, to create the demand to absorb the extra output that successful supply-side policies produce. In this case, the price level may not fall.




8 The belief that control of inflation should be the primary economic objective of government can be traced back to the neo-liberal revolution, which started in the mid-1970s. Free-market economists argue that price stability is essential for long-term economic growth because it creates the necessary conditions for business confidence and private sector investment. If inflation is seen to be out of control, confidence is destroyed, businesses become uncertain and economic activity stagnates.

9 Until June 2012 at least, Bank Rate has remained at 0.5%, which is the lowest it has been since the Bank of England was founded in 1694.

10 Since 1997 the ‘official’ main target of monetary policy has been to ‘hit’ the inflation rate target set by the government. However, since the onset of recession in 2008 the Bank of England has set interest rates to stimulate aggregate demand. Low interest rates try to achieve this objective in two ways. First, households with large mortgages have been able to take advantage of the 0.5% rate and pay off debt. Second, saving has become unattractive and so, in theory at least, people decide to consume rather than save.

11 Quantitative easing (QE) is an unorthodox monetary policy, which since 2009 has been intermittently pursued by the Bank of England and the US Federal Reserve Bank. QE has been used to stimulate aggregate demand in order to encourage economic activity and thus to bring the economy out of deep recession and to prevent it re-entering recession.

A central bank operates QE by electronically creating new money in the central bank’s own current account. It uses this newly created electronic money to buy assets such as government bonds, equities, houses, corporate bonds or other assets from banks. The aim is to inject liquidity into the financial markets and push up asset prices by increasing demand for the assets. Higher bond prices cause bond yields, and hence long-run interest rates, to fall.

The hope is that as the banks sell assets to the central bank they have greater liquidity and receive deposits, which they in turn use to lend to businesses.

12 Since 1992, UK monetary policy has been ‘pre-emptive’. In pre-emptive monetary policy the authorities announce that they are prepared to raise interest rates even when there is no immediate sign of accelerating inflation, in order to anticipate and head-off a rise in the inflation rate that would otherwise occur many months later. The policy-makers at the Bank of England estimate what the inflation rate is likely to be 18 months to 2 years ahead (the medium term), if policy (that is, interest rates) remain unchanged. If the forecast rate of inflation is different from the target rate set by the government, the Bank changes interest rates to prevent the forecast inflation rate becoming a reality in the future. Interest rates are also raised or lowered to pre-empt any likely adverse effect upon the inflation rate of an adverse ‘outside shock’ hitting the economy.

However, following the near meltdown of the UK economy in 2008 and in response to the deep recession of 2009, it is fair to say that for a time at least, British monetary policy became reactive rather than pre-emptive. This means that interest rates are set (and further bouts of QE are introduced), not so much with the medium-term future in mind, but in reaction to falling national output (in the recession) and growing unemployment.

13 An international capital flow is defined as the movement of money for the purpose of investment or speculation between countries. It involves selling one currency and buying the currency of the country into which the flow of funds is moving.

In recent decades a form of international capital flow known as a speculative ‘hot money’ has grown in significance. A ‘hot money’ flow occurs when a very rich person or institution decides to switch funds between currencies. A factor influencing these flows is interest rate differences in different countries. Suppose for example the Bank of England cuts Bank Rate to a rate significantly below dollar or euro




interest rates. In response to Bank Rate falling, owners of ‘hot money’ sell the pound and buy dollars and euros so as to benefit from the higher return on these currencies. The selling of pounds causes the pound’s exchange rate to fall. Hot money flows are speculative in the sense that owners of hot money also move funds into currencies whose exchange rates the speculators believe are going to rise.

14

In the diagram the supply of sterling has increased as speculators have sold their stocks of sterling. They have moved their ‘hot money’ out of sterling and into another currency with the effect of shifting the supply curve to the right. This causes the pound’s exchange rate to fall, thus devaluing sterling.

15 A fall in the exchange rate should make UK exports price competitive in international markets and increase the demand for them. This should reduce unemployment. However, the fall in the value of the currency will increase the price of imports, which will lead to import-cost-push inflation in the UK.

Exam-style answers (data response)The impact of eurozone budget deficits on UK macroeconomic performance

01 In 2009, Greece was the eurozone country with the largest budget deficit (about 16.0% of GDP), while Finland was the country with the smallest budget deficit (about 2.5% of GDP). The difference as a percentage of GDP was 13.5%.

A significant feature of the data is that no eurozone country managed to run a budget surplus in 2009 (all were in deficit), whereas in 2007 (the last year of the long boom that had begun in the 1990s), four countries enjoyed surpluses. These were Ireland, Germany, Spain and Finland, with Finland’s surplus being the largest at around 5.5% of GDP.

2 marks are awarded for the calculation and 3 marks are earned for identifying, and backing up with evidence, one other significant feature of the data, giving the maximum 5 marks.

02 A budget deficit is the shortfall between a government’s tax revenue and its spending in a given year. If a government runs a budget deficit, it will have to borrow money from financial markets and its own citizens by selling bonds, and any new borrowing that is not paid back during the course of the year will be added to the national debt. The budget deficit is an example of an economic flow — the difference




between the flow of spending and the flow of tax revenue — whereas the national debt is the stock of accumulated past central government borrowing.

A budget deficit will act as an economy’s automatic stabiliser in a developed economy as it finances the welfare and taxation system during a downturn. When an economy falls into recession, economic activity will slow down and unemployment will rise. When firms lay off workers, cut wages and cancel overtime hours, the government’s taxation receipts will fall because fewer hours are being worked. There will also be an increase in the number of jobless workers claiming benefits such as the Job Seeker’s Allowance. In the UK the number of jobless workers applying for the Claimant Count increased from 780,000 in 2007 to 1,600,000 in 2011. This increase is largely explained by the growth of cyclical unemployment in the recession.

These payments will stabilise the economy in two ways. First, the deficit borrowing will finance the benefits system without the government having to increase taxation. Second, the welfare benefit payments will ensure that workless households continue to have an income. The economist Amartya Sen has argued that developed countries’ welfare benefit systems prevent famines from taking place in industrial communities confronted with mass unemployment. Furthermore, when jobless workers receive benefits they are likely to spend all of the money in the economy on consumption of essential goods. This acts as a stabiliser on aggregate demand because consumption is the most important component of demand.

The mark schemes for the second part (02) of context data response questions always allow 1 mark for providing a definition of the key term or concept the answer must explain . The candidate gains this mark by giving a good definition of budget deficit. (A common error is to confuse budget deficit with balance of payments deficit.) By contrast, no marks are available for definitions when answering the analyse part of the question. Nevertheless, providing a definition (in this case of an automatic stabiliser) ensures a good starting point for developing the analysis. The candidate does not do this but, having earned 4 marks for explanation, the analysis is still sufficiently good to earn more than enough marks to ensure the full 10 marks overall.

03 The UK’s future macroeconomic performance should be judged on how average living standards improve, inflation is kept under control, the economy grows and unemployment falls, and the extent to which in the long run the current account of the balance of payments moves towards equilibrium.

The large budget deficits run up by the eurozone economies in recent years are a major concern for the UK’s future macroeconomic performance. As Extract A indicates, all the eurozone nations have run budget deficits since 2007 and those of Portugal, Ireland, Italy, Greece and Spain are especially worrying. The massive budget deficits in 2009 of Portugal, Greece and Italy have added to national debts that now exceed 100% of GDP. Furthermore, Spain has a youth unemployment rate close to 50%, which suggests poor economic performance in the future, and France had its credit rating downgraded at the beginning of 2012 because of fears about its ability to repay its debts. The inability of these eurozone nations to service their debts is what Extract C refers to as the ‘sovereign debt problem.

This crisis will affect the UK in three main ways.

First, the UK will be unable to sell its exports to these economies if they are heavily indebted. The governments of Greece, Portugal and Ireland have already introduced austerity budgets, which have dramatically cut government spending, welfare benefits and public sector wages, and increased taxation. This has significantly reduced levels of disposable income for households in these countries. If they have less income they will be unable to afford UK exports, which will in turn affect the income of British businesses and do little to help the British government reduce its large current account deficit.

Second, the northern eurozone countries, especially Germany (Extract C, line 6), which has a strong economy and does not suffer from excessive debt, are likely to be tipped into recession by the problems of the southern nations (the so-called ‘Club-Med’ countries). This will be especially bad for the UK’s




macroeconomic performance. At present almost 60% of the UK’s trade is with eurozone countries. Germany is the second biggest export destination after the USA. If the German economy is pulled into recession and has to bail out the southern eurozone economies in order to save the euro, it will harm the UK economy. UK exporters will struggle to sell their products in Germany, which will in turn harm British growth and unemployment as firms seek to cut back on production and lay off workers.

Third, if the excessive budget deficits and the sovereign debt crisis bring down the eurozone, the British government will inevitably be dragged into a financial bailout. Despite the fact that the current Chancellor, George Osborne, has resisted all calls for financial support for the struggling eurozone economies of Greece and Portugal, British business has strongly integrated trade links with the eurozone. Moreover, major British banks have underwritten French and German banks that are heavily exposed to the bad government debt in Greece and Portugal. If the Italian or Spanish banking systems collapse, it will create a chain reaction that will have major repercussions in Paris, Frankfurt and London.

Ultimately the UK will be affected significantly by the problems in the eurozone. At the beginning of 2012 the southern countries were gripped by deep recession and facing a decade of high taxation to pay off their debts. The northern countries have healthier economies but will have to write-off the debts of the ‘Club-Med’ countries if the euro is to survive. Alternatively, they will have to accept huge financial losses if the eurozone breaks up.

The UK’s macroeconomic performance will suffer because its major export markets will still be in recession. This will hamper economic growth and unemployment. If the UK is to export in the future it needs to establish stronger trade links with the rapidly emerging markets of China, India, Russia and Brazil (the BRIC countries). This will not be easy and it will require British firms to compete in a highly competitive international environment. This will mean that British labour costs and the corporate taxation regime will have to be competitive, so UK households may experience lower wages and more limited welfare benefits in the future.

In contrast to the earlier answer to part 03 of the context data response question in Topic 1, this answer does start with a good explanation of the meaning of macroeconomic performance.

This answer is placed at mid-level 4 (19 marks in the range 17–21 marks) rather than in level 5. The evaluation is good enough for level 5, though a winding-up concluding paragraph would have added to the evaluation. However, the analysis is on the thin side. To ensure a level 5 mark, the candidate could have included explicit theory (for example, the multiplier impact of a collapse in demand for UK exports) and basic AD/AS analysis — including an AD/AS diagram — to analyse the impact of decreasing aggregate demand on UK output and employment.

Exam-style answers (essay)Supply-side economic policies

01 Traditionally Keynesian economists advocated the use of fiscal demand-side policies to stimulate an economy and get it out of recession. The Keynesian approach first advocated in the 1930s argued that the government should ‘pump-prime’ the economy by cutting taxation, increasing government spending and running a series of budget deficits. Keynes argued that when an economy was in a deep recession, the lack of business and household confidence could see the economy falling into a deep depression from which it would be difficult to pull out. The government in such circumstances would need to inject spending into the economy through a fiscal stimulus and increase the level of aggregate demand in the economy.

In more recent times demand-side policy has been largely conducted as a part of monetary policy (and not fiscal policy). This means it has been conducted by central banks in accordance with rules-based monetary policy set out by governments. In the UK since 1997 the Bank of England has set Bank Rate to influence the level of aggregate demand in the economy so as to try and hit the government’s long-term




inflation target of 2% measured by the changes in the CPI. If demand is considered to be too strong, thus creating demand-pull inflation, Bank Rate is increased; if demand is too low, Bank Rate is decreased.

Since 2009 the Bank of England has pursued the unorthodox monetary policy of quantitative easing. It has created electronic money with which it has bought financial assets. Commercial banks thus exchange illiquid assets such as bonds for money. This injects liquidity into the banking system. The hope has been that the commercial banks then lend the extra money they now possess to businesses and households for them to spend. In practice, however, the banks have simply ‘sat on’ the new money to improve their balance sheets. They have not lent the money to their customers.

Demand-side policies, which shift the economy’s AD curve to the right (as shown in the diagram below) are mainly short term and intended to alter the level of aggregate demand in the economy.

In contrast, the focus of supply-side polices, which shift both the LRAS curve and the SRAS curve to the right, as shown in the diagram below, is to increase the long-term capacity of the economy by improving and enlarging the national capital stock. Investment is the engine of long-term growth, and supply-side policies generally seek to enhance both the quantity and quality of physical and human capital in an economy.

Fiscal policy can be used by setting low rates of taxation in the long term to encourage entrepreneurship and hard work. This can also be combined with a policy of cutting welfare benefits to make unemployment less attractive than work in low-paid jobs.




However, supply-side policies also seek to improve the efficiency of micro markets. The policies of trade union reform, deregulation, market liberalisation and privatisation all seek to remove distortions from the market, increase competition and enable the profit incentive to work properly in the marketplace. For free-market economists, the role of government is to enable the market to allocate resources and help the supply side of the economy to expand naturally, not to try to control it directly.

As is the case with part 02 of context data response questions, 2 marks can be earned by providing relevant definitions in the first part of an answer to an essay question. Unfortunately, the candidate fails to provide definitions, thus missing the opportunity to pick up 2 easy marks, even though, as the answer is developed, she shows clearly that she understands the meaning of demand-side and supply-side economic policies. Defining key concepts at the beginning of the answer acts as a good launching pad for developing the subsequent analysis. Nevertheless, the differences between the two types of policies are sufficiently well explained to ensure that the full 15 marks are earned.

02 The view that macroeconomic policy should only focus on the supply-side performance of the economy and should ignore the management of the demand side is an extreme free-market approach that has not been seriously attempted by any government in recent times.

There is a general consensus among free-market economists that supply-side reforms are the key to long-term sustainable economic growth and that old-fashioned Keynesian demand-side management can actually be harmful to the economy.

The commonly accepted view driven by free-market economists in the 1980s and 1990s and accepted by modern Keynesian economists is that supply-side performance is the key to long-term economic growth. This approach rests on the following assumptions.

First, investment in the national capital stock is the engine of sustainable growth. Only by improving the depth and breadth of physical and human capital can the capacity of the economy increase to provide more jobs without inflationary pressures.

Free-market economists argue that the government needs to encourage investment and enterprise. The main way in which they can do this is through government fiscal policy keeping income and corporate taxation levels low, so that firms are incentivised to make profits which can then be reinvested back into businesses.

Second, government policy should liberalise micro markets by getting rid of obstacles that prevent competition or distort the market. Free-market economists favour active competition policy which protects consumers from anti-competitive behaviour and the abuse of monopoly power. They also distrust trade unions because they see collective bargaining as a means of creating a monopoly supply of labour and a method of inflating wages and business costs.

Third, free-market economists philosophically believe that markets ‘know best’ on how to allocate society’s scarce resources. They believe that the market mechanism responds to price signals and is the best means of responding to human wants and maximising social welfare. This ideological belief in the market is extremely distrustful of old-fashioned Keynesian demand management and socialist command economies. Free-market economists correctly argue that the socialist command economies were unable to respond to the needs of the consumer, allowed inefficient methods of production to continue, and lacked the invention and innovation created by the profit incentive in a market economy.

The demand management of the Keynesian economists of the 1950s and 1960s is attacked by free-marketeers for ignoring the importance of the supply side and using fiscal policy as a blunt instrument to manage aggregate demand. Free-market economists warn against changing levels of taxation in a discretionary way to manage aggregate demand, especially income and business taxes, because this sends confusing messages to workers and entrepreneurs, distorting long-term labour market incentives.




However, this does not mean that there is no place for demand-side policies in supporting macroeconomic performance. The globalised market economy is prone to volatility and unpredictable economic crises. In the last 15 years the UK economy has been significantly affected by stock market crashes including the Asian crisis 1997/98, the dot.com bubble and terrorist attacks of 2001, the banking crisis in 2008 and the deep global recession that followed this crisis.

In such periods there is a definite need for government action to prevent the economy plunging into a deep recession. The ‘animal spirits’ that Keynes warned of in the 1930s still exist today. Indeed one of the greatest dangers is when a market becomes paralysed with fear. Had Labour’s Chancellor, Alistair Darling, not intervened in the British economy in October 2008 to bail out RBS and HBOS and inject billions of pounds into the financial markets to restore confidence, it is possible that the entire British banking system and economy could have collapsed.

Furthermore, it is important to note that the US economy appears to be pulling out of recession faster than the European economies because it has adopted a more active demand-side policy. This has come at the cost of large budget deficits, but if the economy starts growing then it should in the long run be able to repay its debts more easily than if it had suffered a prolonged period of low or stagnant growth. In contrast, the UK fell into a double-dip recession in 2011/2012, in part caused by Chancellor George Osborne’s aggressive deficit reduction programme.

Often the second part of an essay question or the final part of a context data response question contains a word such as must , always , inevitably , or in this case solely . Good candidates pick up on these words, arguing (in this case) that both demand-side and supply-side policies should be used together. This is good evaluation.

This candidate implicitly adopts this approach and the answer is good enough to reach level 5. However, once again, the answer lacks sufficient basic economic analysis. The AD/AS diagrams included in the answer to part 01 of the question might better have been used in the answer to part 02. And once again, the answer lacks a concluding paragraph.



Topic 3 The international economy1 Trade liberalisation is the removal of barriers to trade. This has mainly taken the form of restrictions

created by national governments, such as tariffs, quotas and bureaucratic regulations designed to protect domestic producers from lower-priced international competition. The GATT trade rounds, and the World Trade Organization which was created in 1994, have tried to establish international free trade and liberalise markets in order to increase competition and improve economic efficiency.

2 Two of the other main features of globalisation are greater international mobility of capital and, to some extent, of labour. Globalisation enables the movement of capital from developed economies to poor economies. Capital is relatively plentiful in developed economies while labour is expensive compared with its price in developing countries. In response to the differing prices of capital and labour, firms move labour-intensive manufacturing processes to poorer countries. In other words, there is an outward capital flow from rich to poorer countries.

In theory, globalisation also leads to labour mobility in the opposite direction. However, immigration controls slow down the movement of labour from poor to rich countries. Nevertheless, in recent years illegal immigration into developed economies has occurred because rich countries have informally encouraged migrants to fill the relatively low-paid jobs rejected by their own citizens.

3 ‘Beggar my neighbour’ policies are government policies that attempt to gain a competitive advantage at the expense of other countries. Three examples are: imposing tariffs and other import controls in the hope that other countries won’t retaliate devaluing the exchange rate, again in the hope that other countries don’t do the same dumping, which means selling exports at prices below their average cost of production

Of course, if other countries respond by retaliating, protectionist and currency wars may be triggered, which can end up harming all the countries involved.

4 Absolute advantage is an intuitive trade model, which demonstrates that nations should specialise in the production of goods and services that they are absolutely the best at making, and then trade their surpluses. Comparative advantage is a counter-intuitive trade model, which demonstrates that if opportunity costs differ, a nation should specialise if it has the comparative advantage in production and not the absolute advantage, because the world economy will still benefit from greater output gains. This means there is a case for specialising in a good and trading the surplus produced, even if the country is not absolutely the best at producing the good.

5 Long-term direct investment flows are when investors buy physical assets such as land or capital equipment in another country. This form of investment will normally be undertaken with a view to a long-term commitment, producing in the country over a number of years.

Long-term portfolio capital flows are when investors buy equities and bonds in another country with a view to holding these assets, again for a period of years.

In contrast, short-term speculative ‘hot money’ flows move extremely quickly. For some traders, holding shares or bonds for longer than two minutes is considered to be the very long run. Speculative currency flows are caused first by different currencies earning different interest rates and second by the speculative belief that exchange rates will rise or fall.

6 A current account surplus can only occur in one country if there is a current account deficit in another country. Therefore it makes no sense to argue that a surplus is virtuous and a deficit is shameful. If a country is running a persistent current account surplus, it implies that the global economy is imbalanced and that the country is saving too much and spending too little. Moreover, the country’s excess savings are being lent to countries that are running current account deficits as a result of buying the exports of the surplus nations. This imbalance will inevitably result in a correction that will often take the form of an international economic crisis.



TOPIC 3 The international economy

Because the balance of payments must balance for the world as a whole, it is not possible for all countries to run surpluses simultaneously. Unless countries with persistently large surpluses agree to take action to reduce their surpluses, deficit countries cannot reduce their deficits. This means that deficit countries may be forced to impose import controls from which all countries, including surplus countries, eventually suffer. In an extreme scenario, a world recession may be triggered by a resulting collapse of world trade.

7 Advantages: First, in a freely-floating exchange rate, the exchange rate should move up or down to correct a payments imbalance. Second, monetary policy can be used solely to achieve domestic policy objectives, such as the control of inflation. This is called an ‘independent’ monetary policy.

Disadvantages: First, in the short run, exchange rates are extremely vulnerable to speculative capital or ‘hot money’ movements into or out of currencies. Just like a fixed exchange rate, a floating exchange rate can be overvalued or undervalued, which means it fails to reflect correctly the trading competitiveness of the country’s goods and services. Second, by causing the prices of imported food, energy, raw materials and manufactured goods to rise, a falling floating exchange rate contributes to cost-push inflation.

8 A large ‘hot money’ inflow shifts the demand curve for the currency to the right, leading to the exchange rate rising and to an overvalued exchange rate in terms of the trading competitiveness of the country’s exports. The current account of the balance of payments is then likely to deteriorate. If there is a deficit to start with, the deficit will grow larger. A large ‘hot money’ outflow will lead to the opposite result.

9 When a currency is freely floating, the central bank does not have to set monetary policy to alter the external value of the currency unless instructed to by the government. In this situation, the market forces of supply and demand will determine the exchange rate.

If a country adopts a fixed exchange rate, the central bank will primarily use its interest rate (Bank Rate in the UK) to keep the exchange rate at or close to the fixed exchange rate. In the UK, the Bank of England would increase Bank Rate to attract capital flows into the domestic banking system, thus increasing the demand for the pound. The Bank of England could also buy the pound on foreign exchange markets to try to prevent the exchange rate from falling, or sell the pound to try to stop the exchange rate from rising. It could also increase the money supply to prevent the exchange rate from rising, or reduce the money supply to engineer the opposite effect.

10 A free trade area is an agreement between countries to trade freely with each other but each national government retains the right to impose its own controls and taxes on imported goods and services from countries outside the agreement. A customs union is when member countries not only agree to trade freely with other members but centrally agree to a common set of import controls and tariffs on goods and services from outside of the union.

The single European market is an even more integrated arrangement in which member countries trade freely and agree a common set of import controls but also seek to standardise the laws and rules between member countries to reduce business costs and encourage trade. In theory, all 27 members of the EU are meant to implement the commonly agreed laws passed by the governments of member countries and the European Parliament in Strasbourg and Brussels. Non-member countries, such as Norway and Switzerland, which have a strong trade relationship with the EU, have to obey the rules of the SEM even though they have no say in the law-making process.

11 The euro is a common currency used in the 17 member countries that have joined the eurozone since its creation in 1999. Countries such as Germany and France are locked into the same currency as Greece and the Republic of Ireland. All 17 countries have their monetary policy set by the European




Central Bank in Frankfurt, and there is no prospect of a weaker economy being able to devalue without abandoning the currency, a process considered impossible until the autumn of 2011.

For countries outside the eurozone, such as the UK and USA, the euro is just like any other currency that floats up and down according to the forces of supply and demand. However, there are four EU countries — Denmark, Latvia, Lithuania and Bulgaria — which have retained their own currencies but pegged them against the euro. The purpose of this adjustable peg regime is to reduce currency fluctuation and to prepare these countries for eventual eurozone membership — an increasingly unlikely possibility since the onset of the eurozone crisis in 2011.

Exam-style answers (data response)World trade and the UK economy

01 The UK exported £7,055 million of goods and imported £24,828 million, so its balance of trade in goods with China was in deficit to the tune of –£17,773 million.

A significant feature of the data is the ranking of the UK’s exports to China and its imports from China. In terms of the UK’s exports, China is only in ninth position. The UK’s exports to China, valued at £7,055 million, were significantly below its exports to the USA (£31,712 million) and even behind the UK’s exports to Ireland (£14,063 million). By contrast, on the import side, China was in third place (behind Germany and the USA), with the UK purchasing goods valued at £24,828 million from China.

This answer picks up 3 marks for the calculation (where the main danger for the candidate was missing out the minus sign) and 3 marks for identifying a significant feature in the data. The candidate backed up her point of comparison with enough accurate statistical data to earn 3 marks, although overall 5 marks were awarded because 5 is the maximum available for this question.

02 Productivity is the concept that measures how outputs can be maximised from given inputs. In factories labour productivity is usually calculated by dividing total output by the number of workers.

Productivity has generally increased faster in manufacturing because of the invention of superior capital equipment and the innovation of working practices that have made firms more efficient and less wasteful.

New technology in manufacturing industries has generally led to the introduction of automated machines which can perform complex tasks without getting tired or making mistakes. Whereas a car production plant in the 1950s would have employed workers to perform the manual tasks on the production line, modern car makers use robots which are monitored by a technician. Car companies, such as BMW and Toyota, have also invented more efficient management techniques based on the concept of last-minute delivery. These working practices have significantly cut down on waste and allowed managers to quickly identify problems in the production process.

Service industries such as law, banking, design, insurance and consultancy can benefit from technological development but the value of these industries stems from the knowledge and skills of human capital. Hence there is less scope here for dramatic productivity gains stemming from the invention of a new technology or production process.

This answer earns 3 of the available 4 marks for explaining the meaning of the term ‘productivity’. A fourth mark could be earned by explaining that the productivity of other factors of production can be measured, e.g. capital productivity and total factor productivity, or by providing an example of labour productivity.

The answer to the second part of the question is good, but not quite good enough to earn 6 marks. The answer does not mention service industries, such as education and healthcare, where the nature of the service being delivered makes it difficult to increase labour productivity.




03 If the UK economy is to grow in the future it must export goods and services to the rapidly growing emerging markets and in order to do this it will have to invest in its capital infrastructure to ensure that British firms are market leaders in a highly competitive global marketplace.

The UK will have to export to the emerging markets of Brazil, Russia, India, China and South Africa in the future because that is where the economic growth and consumer demand will be. The developed economies of western Europe and North America and Japan are in decline. They have ageing populations and low birth rates which means they will experience limited growth in the coming decades. Consumer demand in developed economies has peaked. This is a major challenge to the UK because, as Extract A illustrates, the bulk of British exports are currently being sold to these countries. Nine of the top ten British export destinations are either in the European Union or the USA.

Hence firms that want to grow in the future need to sell to those economies with younger populations that are developing a consumer culture, especially China and India. Export-led growth needs to take place in two main ways.

First, the UK government needs to help British businesses set up trade links in the emerging markets. This could be difficult given the UK’s relationship with the European Union, but the British government needs to take a leading role with Germany and encourage the EU member countries to open their markets up to global competition and resist the protectionist tendencies often advocated by Italy and France.

Second, the UK needs to specialise in industries in which it has a strong advantage, and ensure that its firms remain the best in the world. As Extracts B and C make clear, low-quality manufacturing production has relocated to the emerging markets. This has resulted in structural unemployment in parts of the UK. This has happened across the developed world but it makes no sense for politicians to focus on protectionist policies to revive the ‘rust belts’ because the emerging economies can make these goods more efficiently at lower cost. In the last 20 years multinational firms have built state-of-the-art factories across southeast Asia because labour costs there are a fraction of those in Europe or America.

David Ricardo’s economic theory concludes that a nation should specialise in what it does best either absolutely or comparatively. The UK should focus on the ‘higher-value goods’ (Extract C, lines 3–4) because the high-quality production of these goods stems from the design and marketing teams that develop the product and brand. These skills are complex and difficult to replicate. Furthermore, the UK needs to ensure that its service sector remains strong in the face of international competition. It has a clear advantage in this field at present because over a century British firms have developed corporations that specialise in insurance, law, financial services, marketing and consultancy. These industries are complex and are built upon human capital that has been assembled over decades.

However, if the UK is to promote its top-end manufacturing industry and service sector it has to invest to ensure that they remain competitive in the global economy. Investment is an important component of aggregate demand and increased investment will help to drive economic growth. For this to happen the UK economy needs to rebalance so that less expenditure is spent on consumption (which has mainly been financed by borrowing), and households save more of their income to make funds available for investment.

The prospects for the UK economy are not necessarily bleak, but if Britain is to experience economic growth in the future it will have to invest to ensure that it has top companies that can export high-quality goods and services to the emerging markets.

This answer is placed at mid-level 4 (19 marks). As with the answers to earlier questions, the candidate misses the opportunity to pick up marks for appropriate analysis. Like perhaps a majority of exam candidates, he mentions comparative advantage but does not explain the concept. (At the other extreme, candidates who do attempt to explain comparative advantage often provide time-consuming numerical examples, unfortunately often riddled with mistakes.)




Other reasons for failing to reach level 5 are insufficient coverage of investment-led growth and the lack of a concluding paragraph.

Exam-style answers (essay)Exchange rates and the balance of payments

01 A country’s balance of payments position indicates the nation’s trading competitiveness. It comprises four components: the balance of trade in goods, the balance of trade in services, net income flows, and governmental transfers.

A free-floating exchange rate system is when the government allows the external value of its currency to be determined by free-market forces and instructs its central bank not to intervene in the currency markets.

The external value of the currency will always affect the balance of payments position of a country. A high exchange rate will make imports cheap and exports expensive. This is likely to result in a current account deficit as households and businesses switch to the cheaper overseas-produced goods and services. Domestic living standards will rise but money will leak out of the domestic economy.

In contrast, a low exchange rate should result in a current account surplus, or a narrowing of the size of the deficit. This will be because at the lower exchange rate exporters become more price competitive and imports become more expensive, leading to consumers switching away from imports and towards domestic goods and services.

The circumstances that lead to the decision to allow an exchange rate to float will have a significant effect on the balance of payments position. When the UK government left the Exchange Rate Mechanism in 1992 the value of sterling fell significantly. This devaluation resulted in UK firms improving their price competitiveness and the UK economy experienced an export-led economic recovery out of recession. The balance of payments position went from deficit in 1992 to surplus in 1997.

However, if China were to adopt a freely floating exchange rate, the value of its currency would increase. This would see the price of its exports increase and should in theory see the Chinese current account surplus decrease and even fall into deficit. This is not certain, given that China has established itself as the dominant producer of low-priced manufactured goods, and given also that demand for these goods is price inelastic.

This answer scores 8 from a possible 15 marks. It misses at least two opportunities to pick up more marks. First, there is only one correct definition of a relevant concept (a floating exchange rate). The other definition (of the balance of payments) is wrong. The answer defines the current account, but not the overall balance of payments, which includes the capital and financial accounts. Second, and more importantly, the answer lacks sufficient in-depth analysis of exactly how a floating exchange rate can affect a country’s balance of payments on current account. In theory, it provides an automatic adjustment mechanism, but this can be distorted by ‘hot money’ capital flows. A simple supply and demand diagram showing the equilibrium exchange rate, appropriately labelled, would earn 2 marks, as would a supply and demand diagram illustrating the adjustment process. (Remember, the synoptic nature of A2 exam papers legitimises the inclusion of AS micro theory of supply and demand.)

The candidate could also have included the effects of price elasticities of demand on the adjustment mechanism. Some mention of ‘clean’ floating versus ‘dirty’ floating would have added to the explanation.

02 Since the onset of the financial crisis in the autumn of 2008, British policy makers have pursued a policy of benign neglect, allowing market forces to determine the exchange rate. Officially, the British government has maintained a freely floating exchange rate but it has happily allowed the value of sterling to fall, in the hope that this will create an export-led economic recovery. In July 2008 £1 was worth $2; in




January 2009 £1 was worth $1.35. However, since then there has been an appreciation of the £, particularly against the euro. This has been a response to the eurozone crisis.

The devaluation occurred for three main reasons. First, the loss of confidence in the recession-hit UK economy, especially the British banking system, caused billions of pounds of speculative money to leave sterling for safer havens such as the Swiss franc, and gold. Second, the record low interest rates of 0.5% set by the Bank of England made the UK an unattractive location for investors seeking returns on their savings. Third, the quantitative easing policy pursued by the Bank of England since 2009 saw over £300 billion created and released onto financial markets. This increased the supply of sterling and pushed the value of the currency down.

The Conservative–Liberal Democrat coalition government hoped that the devaluation of sterling would create an export-led recovery and help to rebalance the UK economy so that it is less dependent on financial services. Unfortunately there is limited evidence to suggest that this had many benefits for the UK.

Although the devaluation of sterling did make imports more expensive and exports cheaper, the effect on the UK’s current account position has been limited. Two main reasons can be identified. First, even though UK exports became cheaper, the UK’s main trading partners did not significantly increase demand for British exports because they have also been gripped by recession. The ongoing eurozone crisis, which brought the eurozone to the brink of collapse in 2011, has made the situation worse. Over 60% of UK trade is done with EU countries, whose markets continue to be frozen in fear. There is evidence that UK companies have benefited from the lower exchange rate but their gains have been significantly outweighed by the effect of the wider economic crisis in the European economies.

Second, UK demand for imports is generally price-inelastic. The devaluation of sterling has not led to a significant reduction in the volume of goods imported into the UK. This stems largely from the fact that the long-term processes of deindustrialisation caused large sections of the UK’s manufacturing base to shut down or relocate to cheaper labour zones in southeast Asia. Hence, if British households are to consume manufactured goods, the goods must be imported from abroad.

The main disadvantage imposed on the UK economy since the devaluation has been cost-push inflation. Since 2009, until June 2012 at least, the UK experienced a rate of inflation higher than the 3% upper limit of the Bank of England’s inflation target. The low exchange rate has been a major cause of this, because imported goods, especially energy, have increased in price. A wide range of imported goods are measured in the CPI and RPI inflation indices. Higher inflation has eroded the purchasing power of the average household and resulted in declining standards of living.

Furthermore, imported raw materials and semi-finished capital goods are demanded by a large proportion of UK firms as factor inputs in the production process. Thus a devaluation of the exchange rate has actually increased the business costs of a number of UK firms. This has fed into domestic inflation in the form of higher prices, although the effects on the export markets have been offset by the currency’s devaluation.

It is important to read this question carefully. It does not ask for a discussion of why the downward float of the pound may have been ineffective in reducing the current account deficit. Unfortunately, this answer leans too much in this direction. Instead the question asks for an evaluation of the costs and benefits of a falling exchange rate. The answer contains insufficient focus on costs and benefits. Hence the answer is placed in level 3.




The grade descriptor for level 3 is:

A2Levels mark scheme

AO1 Knowledge and understanding of theories, concepts and terminology

AO2 Application of theories, concepts and terminology

AO3 Analysis of economic problems and issues

AO4 Evaluation of economic arguments and evidence, making informed judgements

Level 310–16 marks(mid-point 13)

Reasonable including some correct analysis but very limited evaluation

Satisfactory but some weaknesses shown

Reasonable application to issuesWhere appropriate, reasonable use of data to support answer

Reasonably clear but may not be fully developed and is perhaps confused in places with a few errors presentThe answer is quite well organised with some logical development

Superficial, perhaps with some attempt to consider both sides of the issue(s)



Documents

Economics AQA A2 Un 4 Workbook Answers