Cambridge International AS and A Level Economics
Answers to Coursebook activities
Chapter 10: Government macro intervention
Self-assessment task 10.1 (page 266)
1 The AD curve shifts to the left leading to a fall in output, income and employment. This will reduce pressure
on wages and prices and so lead to lower levels of inflation. However, in the article a falling growth rate was
associated with rising inflation. This could be due to the LRAS curve shifting to the left simultaneously.
2 Inflation – an increase in interest rates will lead to a fall in consumption and investment, putting downward
pressure on prices.
3 Increased government spending on infrastructure will lead to an increase in the budget deficit, ceteris paribus,
particularly in the short run. But the finance could be diverted from other areas, e.g., health, education, defence,
pensions, therefore the budget deficit might not increase. Once the improved infrastructure comes on stream
(e.g., better roads, railways, underground) then it could raise productivity and shift the LRAS curve to the right,
leading to a rise in income and employment, raising taxes and contributing to a lower deficit in the long run.
Self-assessment task 10.2 (page 268)
1 In order to reduce inflation, the central bank might raise interest rates, leading to a fall in consumption and
investment, hence shifting AD to the left, leading to a fall in output, employment and income. In addition,
a rise in domestic inflation will make goods and services relatively more expensive, reducing international
competitiveness and so the demand for the country’s exports falls, shifting its AD curve to the left, and reduce
the demand for the country’s currency, thereby reducing its external value.
2 A fall in inflation in 2009 from 2.8% to −0.03% (this is actually deflation) saw an increase in unemployment
from 6.1% to 9% suggesting an inverse relationship. In 2010, inflation rose to 1.4% but unemployment also
increased to 9.8%. From 2011 unemployment was stable in Sweden at 7.8–7.9% but inflation was falling. This
does not suggest an inverse relationship as outlined by the Phillips curve. Unemployment is a lagged indicator in
that firms do not respond immediately to a rise in inflation by laying workers off, nor do workers automatically
ask for higher wages when faced with increasing inflation, especially if the economy is experiencing a recession.
Self-assessment task 10.3 (page 268)
1 A rise in unemployment will shift the demand curve for labour to the left, leading to lower wages. Those in work
might fear losing their jobs and, given the excess supply of labour, firms will be able to offer lower wage rates,
hence reducing costs of production and prices.
2 The Phillips curve might become more horizontal showing that while inflation is stable, unemployment might
fluctuate, illustrating that there is no particular level of unemployment associated with a level of inflation.
3 Yes, as there will no longer be a trade-off between the two variables. Rising inflation often leads to governments
applying the brakes to reduce inflationary pressure, e.g., lowering government spending, increasing taxation or
raising interest rates and removing them when unemployment rose significantly. These ‘stop-go’ policies created
uncertainty and reduced investment. Hence a breakdown of the link could lead to greater stability in the long
run. However, it does mean that it might be difficult to reduce unemployment below a certain level and an
economy might have to accept a stubborn rate of unemployment in the long run.
Self-assessment task 10.4 (page 270)
1 A lower budget deficit will mean that the government might have to reduce government spending and/or
increase taxation. This will shift the AD curve to the left, resulting in lower growth rates.
2 The value of the yen fell leading to a depreciation. This makes imports relatively more expensive and exports
relatively cheaper. However, according to the article, Japanese firms could have kept their yen prices the same,
allowing them to maintain their profit margins and perhaps benefitting from rising sales due to a lower dollar
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Cambridge International AS and A Level Economics
Chapter 10 Coursebook activities
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Cambridge International AS and A Level Economics
price, but they kept their US dollar price the same and earned more when they converted their earnings back
into yen thus effectively selling the same quantity at higher prices, generating higher profits.
3 A lower deficit will lead to a fall in AD, therefore it could lead to lower inflation as the AD curve shifts to the left.
4 a The J-curve effect describes the impact on the current account deficit when a currency depreciates or is
devalued. In the short run there will be a deterioration in the current account as demand for imports and
exports is likely to be price inelastic. Many firms, e.g., retailers, supermarkets and manufacturers, are often
tied into contracts and so cannot respond quickly to a change in price. However, over time they will be
able to search out cheaper suppliers, demand for the country’s relatively cheaper imports will become more
price elastic and exporters’ revenues will increase. Similarly, importers will switch to the relatively cheaper
domestically produced goods and expenditure on imported goods will fall. If this improvement fails to occur
then it could be argued that the J-curve effect is missing. The improvement in the current account depends,
then, on the Marshall-Lerner condition being met, i.e., that the sum of elasticities for all imported and all
exported goods is greater than 1.
b If energy accounts for a significant proportion of Japanese imports then demand will remain relatively
price inelastic, even in the long run. Therefore a depreciation can increase the country’s current account
deficit. Moreover, Japanese exports such as consumer electronic goods may have lost their international
competitiveness due to less innovation and relatively poorer quality, or manufacturers simply do not have the
domestic production facilities to meet rising demand as facilities have been moved offshore.
5 The government could offer subsidies to exporters in order to lower production costs and boost profit margins
but this may increase the budget deficit and might not work in the short run because the decision to reshore
production facilities or invest in new ones takes time. Japan does have a restrictive policy towards foreign direct
investment (FDI) and an alternative to bringing Japanese firms back might be to encourage new investment
from overseas manufacturers. This might have positive spillover effects in terms of technology transfers and a
positive multiplier effect but the impacts could be limited if foreign firms import significant amounts of capital
or raw material and repatriate large amounts of their profits.
Self-assessment task 10.5 (page 271)
1 A minimum wage of €8.50 would reduce labour market efficiency because it could lead to an excess supply of
labour, depending how far above the free market this is. However, if demand for labour increases this would shift
the demand curve for labour to the right due to greater domestic consumption and so could eliminate any surplus.
2 A current account surplus implies that the country is exporting more than it is importing in value terms and
might be relying too much on export markets to achieve higher growth rates. If Germany’s major trading
partners experience severe recessions in the future this would adversely affect the country’s output and national
income as AD would shift to the left. By diverting output from exports to domestic consumption it reduces
Germany’s vulnerability to such external shocks.
3 a Germany has the largest current account surplus in the world and increasing domestic consumption, it is
believed, will reduce the size of this surplus. If firms divert output from export markets to domestic markets
then this could happen or if German consumers switch to purchasing more imported goods. However,
German manufacturers might not experience falls in demand because they are still producing relatively low
priced and high quality goods and they might benefit from an upturn in demand as growth returns to the
global economy.
b One policy to consider is an increase in interest rates in order to increase the value of the country’s exchange rate,
making imports relatively cheaper and exports relatively more expensive. Even assuming the Marshall-Lerner
conditions are met this policy might reduce investment and consumption, therefore failing to switch demand
from external to internal sources. A depreciation, then, might need to be accompanied by other policies, which
will help boost domestic consumption and private as well as public sector investment. However, in Germany this
policy is not an option because interest rates are set by the European Central Bank (ECB).
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Cambridge International AS and A Level Economics
Chapter 10 Coursebook activities
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Cambridge International AS and A Level Economics
Exam-style questions
1 a The multiplier effect in a two-sector closed economy is expressed as 1 and, for a given an injection
MPS
(investment) into the circular flow of income, will lead to a more than proportionate increase in national income,
thus amplifying the shift in AD. However, due to leakages (savings) this further shift might be dampened. In a
four sector economy with government and foreign trade, the multiplier will now be expressed as
1
. Overall, the impact of the change will depend on the marginal propensity to withdraw.
MPS+ MPM + MRT
Level
Description
Marks
4
For a detailed understanding of the multiplier effect and a good conclusion regarding the overall impact of
the changes.
9–12
3
For a good understanding of the multiplier effect and a reasonable conclusion regarding the overall impact of
the changes.
7–8
2
For a limited explanation of the multiplier effect and a conclusion regarding the overall impact of the changes.
Some errors might be evident or arguments lack structure. No conclusion may be provided.
5–6
1
For an answer that has some basic correct facts but includes significant irrelevancies and omissions of theory.
1–4
0
No creditworthy response.
0
b Students should discuss the consequences of a change in injections on equilibrium national income using the
AD/AS model, illustrating the impact of an increase and a decrease in government spending, investment and
exports on inflation and unemployment. Students should explain that the overall impact depends on the size
of the withdrawals and how close the economy is operating to full capacity. Moreover, there will be time lags,
e.g., there will be a delay between an increase in investment and it becoming fully functional, therefore an
increase in investment could shift AD to the right leading to higher output and higher inflation but it could
lead to lower inflation as the investment comes on stream in the long run.
Level
Description
Marks
4
For a good discussion of the impact of a change in injections on equilibrium national income, unemployment
and inflation using the AD/AS model. Answers are clearly structured and reach a valid and reasoned
conclusion.
9–13
3
For a reasonable discussion of the impact of a change in injections on equilibrium national income,
unemployment and inflation using the AD/AS model but points are undeveloped and not well-structured.
Some attempt at reaching a conclusion.
7–8
2
For a limited discussion of the impact of a change in injections on equilibrium national income,
unemployment and inflation. Answers in this category might be quite descriptive with little development and
no conclusion.
5–6
1
For an answer that has some basic correct facts but includes irrelevancies. Errors of theory or omissions of
analysis will be substantial.
1–4
0
No creditworthy response.
0
2 a Economic growth is an increase in productive capacity of an economy and is illustrated by a shift outwards of
the long run aggregate supply (LRAS) curve and can also be illustrated by a shift outwards of the production
possibility frontier. In the short run it is measured by an increase in real output/national income or GDP.
Using a Keynesian AD/AS diagram we can see that taking the short-term measure of economic growth, an increase
in one of the components of aggregate demand (such as increased consumption, investment, government spending
or net exports) will shift the curve to the right from AD1 to AD2 leading to a rise in real output from Y1 to Y2.
However, depending on how close the economy is to full capacity this could increase the risk of inflation, ceteris
paribus. For example, if the economy is operating at Y2 and AD shifts to the right from AD2 to AD3 it would lead
to an increase in real national income from Y2 to Y3 but an increase in the price level from P1 to P2 as shortages of
factors of production (i.e., land, labour, capital and enterprise) and bottlenecks occur.
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Cambridge International AS and A Level Economics
Chapter 10 Coursebook activities
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Cambridge International AS and A Level Economics
Price level
LRAS
P2
AD3
P1
AD2
AD1
0
Y1
Y2
Y3
Real national income
Figure 1
However, an increase in the productive potential of the economy will shift the LRAS outwards. This can occur
through an increase in the quantity or quality of factors of production. For example, assume the economy is
operating at Y2 and there is an increase in net investment. This will lead to a shift in AD from AD2 to AD3,
which will put upward pressure on the price level but in the longer run, as the investment comes on stream, it
will lead to a shift outwards of the LRAS to LRAS2, as can be seen in Figure 2. This will lead to higher output
Y4 but lower inflation.
Price level
LRAS1 LRAS2
P2
AD3
P1
AD2
AD1
0
Y1
Y2
Y3
Real national income
Figure 2
If the economy was operating between 0 and Y2, any shift outwards of the LRAS would not produce economic
growth. However, if the LRAS curve shifts out at the same rate or greater than the AD curve then this will
produce growth without inflation and is known as sustained growth.
Level
Description
Marks
4
For detailed understanding of economic growth and a very good explanation of sustained growth with a
reasoned conclusion.
9–12
3
For a good understanding of economic growth and a reasonable explanation of sustained growth, although
answers might not be fully developed. A conclusion must be presented.
7–8
2
For a limited explanation of economic growth and sustained growth. Some errors might be evident or
arguments lack structure. No conclusion may be provided.
5–6
1
For an answer that has some basic correct facts but includes significant irrelevancies and omissions of theory.
1–4
0
No creditworthy response.
0
b Government can use demand side policies such as fiscal and monetary policy or supply side policies to help
achieve higher economic growth.
Fiscal policy is the use of government spending and taxation in order to manage the macroeconomy. In order to
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Cambridge International AS and A Level Economics
Chapter 10 Coursebook activities
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Cambridge International AS and A Level Economics
achieve economic growth a government might increase spending on infrastructure projects, such as building dams
or railways. Government spending is a component of AD and so this will shift the AD curve to the right, increase
national income and reduce unemployment since every level of output is associated with a level of unemployment.
This will create direct jobs and income for the workers and suppliers involved in the project as well as benefitting
other economic agents indirectly, thereby amplifying the shift in AD further. The size of this multiplier effect will
depend on the marginal propensity to withdraw. The drawback of this policy depends on how close the economy
is operating to full capacity. If the economy is operating at Y2 in Figure 1 then a shift right of the AD curve will
lead to growth, but at the cost of higher inflation. Moreover, increased government spending might require higher
borrowing, which could increase the budget deficit, leading to higher tax rates in the future as well as crowding out,
i.e., the more the state borrows the less there is available for the private sector to borrow, reducing the quantity of
investment. The benefit of such spending, however, is that it could raise productivity in the longer run and so shift
the LRAS curve to the right from LRAS1 to LRAS2 in Figure 2 and is useful to raise growth in particular regions.
The government might choose to lower interest rates as part of its expansionary monetary policy, which
should make borrowing relatively cheaper. This will, in theory, encourage firms and households to borrow.
This will increase consumption expenditure and investment, which, in turn, will shift the AD curve to the
right, leading to higher output and lower unemployment. As well as the inflation risks, one of the problems
with using such a policy is that there will be a time lag between lowering interest rates and the effects being
felt across the economy. It has been estimated that it could take 12–18 months for economic agents to adjust
their behaviour in response to alterations in monetary policy. Interest rates are usually raised or lowered by
small amounts (¼ to ½%) and so it might take several reductions before much impact is generated. Moreover,
lower interest rates could lead to a depreciation as currency traders sell the domestic currency in pursuit of
higher returns elsewhere. This could make imports relatively more expensive but exports relatively cheaper
and so could shift the AD to the right due to an increase in net exports. The impact on the country’s balance of
payments current account will depend on the sum of the price elasticities of demand for imports and exports:
according to the Marshall-Lerner condition if it is greater than 1 then it should lead to an improvement. In
a prolonged recession such reductions in interest rates might not be effective as firms and households lack
confidence to spend and invest, and governments, through their central banks, have implemented quantitative
easing in order to pump more liquidity into the financial system.
Supply side economists favour product and labour market policies, such as education and welfare reforms,
lower marginal tax rates, trade union reforms, privatisation, deregulation and attracting foreign direct
investment, as a means of achieving higher long-term growth rates. The aim of these policies is to shift the
LRAS to the right, as in Figure 2, and will generate sustained economic growth. However, in the short run
it could lead to higher unemployment as, for instance, privatised firms shed excess labour and so lead to
negative multiplier effects and social unrest.
The choice of policy or policies depends on the economic viewpoint of the government, whether free market
or interventionist, as well as the current state of the economy, i.e., how close the economy is operating to full
capacity. Free market economists argue that supply side policies have contributed significantly to the relative
success of the UK economy in recent years. However, others argue that lower interest rates and cheaper
imports from developing countries such as China have also contributed to such sustained growth. Keynesians
argue that in a prolonged recession where there is plenty of spare capacity, demand side policies will be
required and can achieve growth without the risk of inflation.
Level
Description
Marks
4
For a good discussion and evaluation of the policies that governments might use to promote economic
growth. Answers are clearly structured and reach a valid and reasoned conclusion.
9–13
3
For a reasonable discussion of the policies that governments might use to promote economic growth but
points are undeveloped and not well-structured. Some attempt at reaching a conclusion must be evident.
7–8
2
For a limited discussion of the policies that governments might use to promote economic growth. Answers
might be quite descriptive with very little development and no conclusion.
5–6
1
For an answer that has some basic correct facts but includes irrelevancies. Errors of theory or omissions of
analysis will be substantial.
1–4
0
No creditworthy response.
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Cambridge International AS and A Level Economics
0
Chapter 10 Coursebook activities
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