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6353/01Edexcel GCEEconomicsAdvanced SubsidiaryUnit 3 – Managing the EconomyThursday 17 January 2008 – MorningTime: 1 hour
Materials required for examination Items included with question papersNil Nil
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Answer EITHER Question 1 OR Question 2.
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Question 1 Investment, productivity and trade
Extract 1 UK Investment
The investment boom of the 1990s left many sectors in the UK with spare capacity, a situation made more significant to the UK economy by the rapid build-up of productive capacity in China. Despite high and rising profits between 2001 and 2004 investment was sluggish. However, the good news is that business investment grew by 4.6% between 2005 and 2006, three times as strong as consumer spending.
Figure 1 Business investment, % change on a year earlier (2003 prices)
Source of Extract 1 and Figure 1: David Smith, The Sunday Times, 9 July 2006
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Extract 2 UK Productivity
Gordon Brown has described productivity as the ‘fundamental measure of economic performance’. Productivity has risen by only 1.7% a year over the past four years, its slowest level of growth for 15 years. Nevertheless, the productivity gap with France is closing. Despite tax incentives to stimulate more research and development by firms and measures designed to increase competition, productivity growth is still held back by increased regulation and tax burdens. Problems in education, innovation and transport are holding back productivity growth. This is reflected in the negative trade balance over the past decade. Although this is partly explained by the strong pound, it also reflects a structural problem, that of failed supply side policies.
Source: adapted from ‘Gordon Brown and the Economy – Lustre Lost’ The Economist 23 March 2006, and The Financial Times, 23 March 2006
Figure 2 The UK current account of the Balance of Payments
Source: HM Treasury
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(a) With reference to Extract 1 and Figure 1,
(i) Define investment.
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(ii) Contrast the rate of growth in investment in 1998 with that of 2001.
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(iii) Using an aggregate demand and supply diagram, illustrate the likely impact on real output and the price level of the change of business investment between 2005 and 2006 (Extract 1, lines 4–5).
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(b) (i) Explain one reason why productivity growth is a ‘fundamental measure of economic performance’ (Extract 2, lines 1–2).
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(ii) With reference to Extract 2 and Figure 2, assess the likely impact on the current account of the Balance of Payments of the changes in UK productivity.
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(iii) Apart from productivity changes, outline two reasons which might explain the deficit in the current account of the Balance of Payments.
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(c) With reference to the information provided and your own knowledge, evaluate the use of supply side policies as a means to reduce a Balance of Payments deficit on the current account.
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(15) Q1
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N29272A_AS_GCE_Economics_Unit_3_11 11 29/08/2007 09:42:01
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If you answer Question 2 put a cross in this box . .
Question 2 Monetary Policy in the UK
Extract 1 Bank raises interest rates
Householders were left anxious today after the Bank of England’s Monetary Policy Committee (MPC) raised interest rates to 4.75 per cent, which will cost homeowners with an average £80,000 mortgage over £12 a month more. House price rises have not returned to the growth seen in recent years, and major high street banks reported increasing problems with bad debt levels, mainly on personal loans.
It is the first time that interest rates have moved after a year of inactivity and the MPC decision was a surprise for many. In a statement, the Bank of England said that the rise was necessary to bring inflation back to target (see Figure 1). The UK economy grew by more than expected, and retail sales were robust. Gas and electricity bills have contributed to the jump to 2.5 per cent in the rate of inflation (as measured by the Consumer Prices Index, CPI) up from 2.2 per cent in May. Wage pressure is likely to increase in line with fuel price rises. The MPC governor Mervyn King said that there was a ‘50-50 chance’ that the inflation rate would move above 3% over the next six months.
However, there are signs that the interest rate rise was unnecessary. Unemployment is at its highest for six years, and taken together with slow wage growth this suggests there is significant spare capacity. The American-led world economic slowdown may worsen. David Kern, economic adviser at the British Chamber of Commerce, said he thought the rise in the rate of interest was unnecessary. ‘We appreciate that it must make difficult choices but the correct decision by the MPC would have been to keep interest rates on hold.’
Source: adapted from www.independent.co.uk/business 3 August 2006 andThe Sunday Times, 13 August 2006
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Figure 1 Current CPI inflation projection based on market interest rate expectations
The fan chart shows the likelihood of various outcomes for CPI information in the future. The darkest central band represents the most likely outcome.
Source: Bank of England inflation report, August 2006, www.bankofengland.co.uk
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(a) (i) Explain how inflation is measured in the UK. Refer to the concept of weights in your answer.
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(ii) Explain one reason why a rise in the rate of inflation above 3% might be a cause for concern.
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(b) (i) Analyse the likely impact on house prices of an increase in interest ratesi) Analyse the likely impact on house prices of an increase in interest rates (Extract 1, line 2).
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(ii) Using an aggregate demand and supply diagram, analyse the likely impact on the price level and the equilibrium real level of output which may result from the rise in interest rates, as outlined in Extract 1.
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(c) (i) Explain what is meant by spare capacity (Extract 1, line 16).
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(ii) Examine why ‘significant spare capacity’ (Extract 1, line 16) in the economy is a factor that the MPC considers when making its interest rate decision.
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(4)
N29272A_AS_GCE_Economics_Unit_3_18 18 29/08/2007 09:42:02
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(d) With reference to the information provided and your own knowledge, assess the view that ‘the correct decision by the MPC would have been to keep interest rates on hold’. (Extract 1, lines 19–20).
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(15)
TOTAL FOR PAPER: 40 MARKS
END
Q2
(Total 40 marks)
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