Cambridge International AS and A Level Economics Answers to Coursebook activities Chapter 9: The macroeconomy Self-assessment task 9.1 (page 221) 1 The region’s growth rate fell from 4.5% between 2004 and 2012 to 2.6% in 2013. This means that the region’s economies are still growing but at a slower rate. 2 It is likely that Brazil’s growth rate was closer to its long-run potential as its unemployment rate was lower than Peru’s. 3 Productivity improvements mean that an economy can produce more with the same or fewer workers and it leads to a shift outwards of an economy’s LRAS curve. This leads to higher growth and lower inflation depending on how close the economy is to full capacity. 4 The article states that poor education was a major problem as this will lead to a less skilled workforce that is less able to adapt to modern working practices and make use of new technology. Secondly, a lack of innovation means that firms will lag behind in terms of technological advances. Poor transport infrastructure will make it more difficult for workers to get to work and could lead to delays further affecting productivity. Finally, a lack of competition reduces the incentive for firms to become more efficient and innovative since they may simply pass increased costs on to consumers. Self-assessment task 9.2 (page 224) 1 Economic growth leads to higher national income and more employment. With increased income households will demand more normal goods, such as cars, which have a positive income elasticity of demand. 2 As an economy grows it tends to lead to higher levels of production. Delhi, Beijing, Shanghai and Mexico City have grown rapidly and have experienced high levels of pollution. However, beyond a certain level of growth, governments, firms and households might be able to afford lower polluting technologies. China’s Premier, Li Keqiang, recently announced war on pollution (5 March 2014) describing China’s current growth model as unsustainable. He argued that resources must be devoted to developing cleaner energy sources. There is some fear, however, that this will lead to lower growth rates in the short run suggesting a trade-off between the two. Self-assessment task 9.3 (page 225) The pay of civil servants, the pay of nurses and supernormal profits should be included in measuring GDP by the income method. These are all payments received in return for providing a good or service. Government subsidies to farmers and state pensions are transfer payments. Self-assessment task 9.4 (page 226) a Real GDP is calculated by subtracting the effects of inflation from nominal GDP. In this case nominal GDP has increased by 9.2% but inflation is running at 4%. b Therefore real GDP has increased by 5.2%, i.e. 9.2% − 4% = 5.2%. Self-assessment task 9.5 (page 227) 1 A fall in the country’s growth rate means that the economy is growing positively but at a slower rate. For example, in China the growth rate fell from 7.8% to 7.5%. 2 Investment is the addition to an economy’s capital stock and as a component of aggregate demand it will shift the AD curve to the right creating more employment and income. In the long run, the LRAS will also shift to the right as it comes on stream and will, in theory, improve productivity. 3 A high exchange rate will make imports relatively cheaper and exports relatively more expensive. If an economy, such as China or Germany, is export-orientated then an appreciation of the currency might lead to a fall in demand for its goods, shifting the AD curve to the left. This could be exacerbated by a rise in demand for imported goods and © Cambridge University Press 2015 Cambridge International AS and A Level Economics Chapter 9 Coursebook activities 1 Cambridge International AS and A Level Economics services shifting the AD curve further to the left. The overall impact, however, depends on the size of the appreciation, whether the appreciation has been offset by falling input costs and rising productivity, relative inflation rates and the price elasticity of demand for imports and exports. Moreover, if the country is a net importer then cheaper input costs could help shift the short-run aggregate supply curve to the right, leading to higher growth. Self-assessment task 9.6 (page 228) 1 The rich might benefit most if the tax regime is not particularly progressive and there is limited redistribution of income and small welfare state. In the case of the data, China, India and Indonesia devote less than 4% of GDP to education compared to 5.2% in developed countries, which will reduce the equality of opportunity. Moreover, inequality might exist between rich urban areas and poor rural areas as resources and skilled/productive labour are attracted into cities where they can gain higher rewards. Property rights might be another issue. Consider the case of entrepreneurs who lead successful start-ups, such as Wang Zhongjun who started a company in 1994 and which is now one of the China’s largest media conglomerates with a turnover of $168 million in 2010. Such entrepreneurs can amass property and shares thus adding further to their wealth. 2 A ‘fair and stable tax base’ should lead to more firms and households paying tax, therefore leading to regular tax revenue for the government. If it is fair, fewer individuals will seek to avoid it and, depending on the costs of collection, as income and wealth grow this should lead to higher revenue, which can then be redistributed into education, health and infrastructure, for example, thus benefitting poorer members of society. Self-assessment task 9.7 (page 229) 1 A low tax rate might attract the super-rich. For example, a non-domiciled resident (i.e., a non-UK national) who spends a proportion of their time in the UK only has to pay tax on earnings generated inside the UK. So Roman Abramovich and Lakshmi Mittal can retain more of their earnings rather than relinquish it to the tax authorities. A strong financial infrastructure and rule of law might also be an attraction, e.g., London and New York have lots of wellqualified lawyers, accountants and financial advisers and property rights are strongly enforced. Good schools for their children and access to a plethora of activities on which they can spend some of their income might also be significant. 2 One advantage might be the knock-on effects it has on consumption and employment, known as the ‘trickle down effect’. The super-rich will buy properties, creating work for estate agents, builders, architects, gardeners, nannies, drivers and bodyguards, for example. This can also have a positive multiplier effect. One criticism of the super-rich in London is that the additional spending in the city can inflate prices and create property bubbles as they put upward pressure on house prices, which filters through the regional housing market. Homeowners might benefit from this, leading to a wealth effect but it might create social unrest as income inequality rises. Self-assessment task 9.8 (page 230) 1 Purchasing power parity involves adjusting exchange rates to reflect price levels in different countries. A PPP adjusted exchange would calculate the implied exchange rate by comparing the price of an identical basket of goods in two countries. For example, if the price of Coca-Cola in the US is $0.50 and in China is 2 yuan (CNY) then the implied exchange rate is $1 = 4 CNY. But if the market exchange rate is $1 = 6.23 CNY then the currency is 56% overvalued. 2 Converting GDP into market exchange rates at a low exchange rate would underestimate the size of the economy relative to the USA. Conversely, a higher exchange rate would overestimate the size of the economy. Self-assessment task 9.9 (page 233) 1 In general, it would appear the countries with higher levels of GNI per capita PPP($) have higher levels of education as measured by mean years of schooling. For example, Europe and Central Asia have GNI of $12,243 and 10.4 years of schooling on average whereas South Asia has a GNI of $3,343 and an average of 4.7 years of schooling. So South Asia has approximately one-third of the average income of Europe and Central Asia and less than half the mean years of schooling. However, East Africa and the Pacific has a lower GNI than the Arab states but higher mean years of schooling, and Sub-Saharan Africa has a lower GNI than South Asia but the same level of mean years of schooling. © Cambridge University Press 2015 Cambridge International AS and A Level Economics Chapter 9 Coursebook activities 2 Cambridge International AS and A Level Economics 2 Sub-Saharan Africa has the lowest life expectancy and GNI per capita, which would suggest that it is the least developed region. This, along with the joint lowest mean years of schooling, contributes towards its HDI of 0.475. However, within the region there are countries that have relatively high HDI, e.g., Botswana’s HDI is 0.634 and South Africa’s was 0.629, which is above the South Asian HDI, ranking them 119th and 121st respectively. But it depends how we define ‘least developed’. Self-assessment task 9.10 (page 233) 1 Health poverty is measured through child mortality statistics (i.e., proportion of children dying before their first birthday) as well as nutrition levels (in terms of malnourishment). 2 Floor space and ownership of assets are not mentioned. 3 A lack of education means that children will leave school with lower levels of human capital than those who have higher levels of education and will be less productive as a result. This will lead to lower income levels, which is an important contributor to low standards of living. Although access to education does not necessarily raise productivity, as it depends on the quality of the education, there is generally a correlation between educational attainment and income. Self-assessment task 9.11 (page 237) 1 An ‘ageing’ population means that the average age of the population is rising as more individuals are in the upper age brackets (over 60) relative to lower age brackets. With lower death rates and lower birth rates this will increase the dependency ratio. 2 India’s population has grown more rapidly than China’s due to China’s introduction of the one-child policy, which was introduced in the late 1970s. This ‘prevented’ 400 million births and has slowed down population growth in China. A second reason might be cultural in that women will have more children in the hope of having a boy since families prefer male heirs and female children are more expensive since a potential husband’s family will demand a dowry (in terms of money and assets) before they are able to be married. 3 As incomes rise the opportunity cost of having children increases. This means that as incomes rise families are foregoing or sacrificing larger amounts of additional income by having children. Therefore, in low income households, the opportunity cost of having children is lower. This might help to explain why birth rates are lower in richer countries. 4 According to Malthus, population grows geometrically while food supplies grow arithmetically. Over time, he argued, population growth will outstrip food supply growth causing food shortages. This assumption was based on technical knowledge at the time but the development of high yielding crops, intensive farming methods and mechanisation has improved the productivity of land significantly. However, food production is vulnerable to external supply side shocks, such as drought or floods, which could reduce the amount of food available at a given point in time thus leading to shortages in relation to demand. Self-assessment task 9.12 (pages 238–239) 1 Lower economic growth in Spain has led to fewer foreign citizens wishing to emigrate to Spain and immigrants, as well as native Spaniards, are leaving the country in search of better employment opportunities in other countries. Therefore, more people are leaving Spain than entering, leading to net emigration. 2 Spain has been experiencing negative growth rates as the economy has contracted. 3 A high level of debt divided by a smaller population increases the debt burden on economic agents. This limits the ability of governments to raise additional revenue in order to repay it, without raising tax rates to very high levels, which can be counterproductive as demonstrated by the Laffer curve. 4 One reason might be lower incomes, which reduces the opportunity cost of having children. Therefore, as income falls, households are sacrificing less income by choosing to have a child. Allied to this might be female participation rates in the workforce. If this is low then a woman’s earning potential is lower thus the opportunity cost of having a child is lower. Another factor that could raise fertility rates might be religious attitudes that disapprove of contraception. © Cambridge University Press 2015 Cambridge International AS and A Level Economics Chapter 9 Coursebook activities 3 Cambridge International AS and A Level Economics 5 One advantage is that it will increase the size of the working population in the long run, increasing the tax base leading to higher output and economic growth. However, this might take 15 to 20 years and in the interim it increases the dependency ratio. In sub-Saharan Africa, for example, the number of children aged below 14 is forecasted to more than double by 2050. This will put more pressure on scarce resources such as water, medicines and education. 6 Rapid urbanisation can lead to overcrowding and congestion as infrastructure is unable to cope with the rising demand. There will be more pressure on scarce resources such as land, water and housing, which puts upward pressure on prices leading to inflation. However, it can lead to innovation and a greater pool of workers for firms to choose from. Self-assessment task 9.13 (page 241) 1 Increases in output per hour means that it takes fewer hours to produce the same amount of goods and reduces the costs of production, whereas growth in output per worker can be achieved by increasing the length of the working day. It therefore indicates how efficiently time is being used as a resource. 2 One reason might be the lack of investment in education and training by both the public and private sector. This reduces human capital and will reduce the skills of the population. A second reason could be a lack of investment in new technology and research and development (R&D), which will reduce the quantity and quality of physical capital in the long run. Self-assessment task 9.14 (page 243) 1 Construction workers might have lost jobs due to seasonal factors and so it could be classified as frictional unemployment. As the winter was severe, this would have reduced the number of building projects undertaken and, since labour is a derived demand, reduced the demand for construction workers. 2 Technology replacing workers causes technological unemployment while globalisation has led to firms outsourcing or relocating in low cost economies, which causes international unemployment. Both are examples of structural unemployment. Self-assessment task 9.15 (page 243) 1 Employment can rise as participation rates in the workforce rise, e.g., more women engaging in paid employment and staying in the workforce longer due to higher retirement age. However, if the rise in employment is offset by a greater rise in job losses then there will be an increase in unemployment, e.g., 10,000 jobs created but 11,000 jobs lost, would lead to a net increase in unemployment of 1,000. 2 The rise in the female retirement age would now mean that more women are in the workforce as they would not have been included in the measurement of the country’s workforce prior to the change. Self-assessment task 9.16 (page 247) a The multiplier is: 1 + 0.1 + 0.2 = 1 = 2.5 0.1 0.4 b GDP will increase by $6 billion × 2.5 = $15 billion. c The injection is not sufficient. It is too low, by $5 billion, to close the deflationary gap. Self-assessment task 9.17 (page 255) a Credit multiplier: 100 = 25 4 b $50,000 × 25 = 1,250,000 c $1,250,000 − $50,000 = $1,200,000 Self-assessment task 9.18 (page 260) 1 An excess of inward FDI over outward FDI might lead to a net increase in the country’s capital account, i.e., credits greater than debits. As the investment comes on stream it might lead to greater debits on the current © Cambridge University Press 2015 Cambridge International AS and A Level Economics Chapter 9 Coursebook activities 4 Cambridge International AS and A Level Economics account than credits as investment income is repatriated by foreign firms. However, this depends on the size of the investments and the profitability of both the inward and outward investment. Moreover, if the foreign firms are using their host country as a base from which to export (e.g., as China plans with the Caribbean) this will increase the credits on the current account. 2 China might not wish to invest more in the Caribbean as it has limited resources and relatively expensive labour, which will push up costs of production, reducing the competitiveness of Caribbean produced exported goods. However, this could be offset by the proximity of the Caribbean to the USA, which will reduce costs of transport. Their decision might also be affected by the country’s tax policy and the productivity of its workers. Self-assessment task 9.19 (page 261) 1 ■ ■ Rapid economic growth implies significant increase in output and a rise in GDP. With more jobs being created it will raise average incomes and so lift more people out of absolute poverty. However, it could lead to a rise in relative poverty as the gap between the rich and the poor increases. As national income rises government tax revenue, both direct and indirect, should rise and government spending on welfare spending, for example, might fall. Rapid growth might enable governments to increase tax receipts at a faster rate than the growth in public sector spending. Then the budget will move from a deficit towards a balance. 2 A sound fiscal policy means that a government has a stable tax base and any borrowing is at a sustainable level. It might not necessarily be the same as a balanced budget where government spending equals its tax revenue. Exam-style questions 1 a Unemployment can occur for a variety of reasons. The reasons can be broadly categorised under three headings: frictional, structural and cyclical. Frictional unemployment consists of search and seasonal unemployment. Search unemployment occurs where individuals are between jobs and there is a time lag between leaving one employer and finding a new one or an individual does not accept a paid job and prefers, instead, to spend time looking for a higher paid job. A second type of frictional unemployment is seasonal unemployment where individuals are employed during a particular part of the year, which is quite common in the tourism and construction industries. Structural unemployment occurs when patterns of demand and supply change over time. For example, as an economy shifts from primary to secondary or tertiary production, many in the primary sector will lose their jobs due to geographical or occupational immobility, i.e., they are unable or unwilling to move due to family commitments or do not possess the skills required in the newer industries. Moreover, workers might be replaced by machines and so suffer from technological unemployment, e.g., factory workers. A third form of structural unemployment occurs when consumers switch to relatively cheaper imports, leading to international unemployment as was the case in the UK car and textile industries in the 1960s and 1970s. A downturn in the business cycle can lead to a recession and so a fall in aggregate demand, i.e., a shift left on an AD/AS diagram from AD1 to AD2. Since labour is a derived demand, a fall in output will lead to lower GDP growth from Y1 to Y2 and fewer workers being demanded hence a rise in unemployment. Inflation (%) LRAS P1 P2 AD2 0 Y2 AD1 Y1 Real GDP © Cambridge University Press 2015 Cambridge International AS and A Level Economics Chapter 9 Coursebook activities 5 Cambridge International AS and A Level Economics b A rise in unemployment will lead to less disposable income for households and so a fall in their standards of living as they are able to consume fewer goods and services. If the rise in unemployment is concentrated in a particular region, this can have significant knock-on effects as less is spent in the local community and local businesses experience lower profits, losses or are forced to close down. There will be will less investment in the region adding further to a negative multiplier effect in which indirect jobs are also lost, leading to further loss of output. From the government’s point of view there is an opportunity cost not only in terms of lost output that can never be recovered but also in terms of lower revenue from income tax and corporation tax, as well as higher benefit payments, assuming these are available. Unemployment has social costs, too, such as greater mental health problems, increased divorce rates and higher crime rates, which increase health and policing costs. These factors combined will increase the budget deficit. However, unemployment could lead to lower wages, reducing the costs for firms. This might be beneficial if the firm is a net exporter and there has not been a downturn in demand from its major markets. Moreover, a fall in AD will lead to lower prices and hence lower inflation rates (P1–P2 see diagram above) making domestic goods relatively cheaper, ceteris paribus, in foreign markets. Those who remain in employment might experience a rise in purchasing power if real wage growth remains. In order to reduce unemployment governments might use expansionary monetary policy and so lower interest rates, which will lower the cost of borrowing for firms and households, or use expansionary fiscal policy such as lowering tax rates, e.g., on company profits. Overall, unemployment is harmful on an individual basis as it will affect one’s mental well-being and family relationships. The longer an individual is unemployed the more difficult he or she will find it to obtain paid employment, in a process is known as ‘deskilling’. However, this could lead to a greater incentive for individuals to start their own businesses and, from a macroeconomic point of view, it could have some beneficial effects but it depends on the extent of unemployment and its duration. Unemployment in Greece, for example was around 27% between 2012 and 2014 and this has been a major cause of fiscal, health and social problems for the country during its prolonged depression. 2 GDP is a measure of the total output produced within a country in a year and is used as a basic indicator of standards of living, since total output will also be equal to total income and total expenditure so a higher GDP will mean higher income for the country. However, to make this a more meaningful indicator we firstly have to ensure that any price increases are stripped out of the nominal figures as an increase in GDP that is purely as a result of higher prices will not raise real income of the country. This is done by means of the GDP deflator, which is calculated as follows: Money GDP × price index in base year Price index in current year Secondly, we must then divide this figure by the population in order to arrive at GDP per capita. This, then, gives us the income received by the average citizen. If real GDP is rising faster than the population then we can say that the average standard of living is rising. However, if population growth is greater than the growth in real GDP then the standard of living of the average citizen is falling. A further difficulty with the assumption that rising GDP will increase standards of living is that we do not know how the rising income has been distributed. If the gains have been made by a small group of citizens they might be getting better off but the rest of the population might experience no improvement in their standard of living whatsoever. In order to discover whether this is the case or not we can study the Gini coefficient of a country. The closer the value is to 1, the more income will be unequally distributed. South Africa and Brazil, for example, have a more unequal distribution of income than Sweden. Whether a rise in output will increase living standards also depends on the nature of the increased output. More capital goods produced today might not raise living standards in the short term as current consumption is foregone but it might enable more capital and consumer goods in the future. Higher output might also be the result of increased military production or expenditure. Myanmar has been experiencing official growth rates of 10% in recent years but many still live below the poverty line. This might suggest that GDP data may also be inaccurate. However, standards of living might be higher than implied by GDP per capita data as it does not take nonmarketed output into account. Farmers, for instance, might have low incomes but survive by growing their © Cambridge University Press 2015 Cambridge International AS and A Level Economics Chapter 9 Coursebook activities 6 Cambridge International AS and A Level Economics own food and some groups might have higher incomes due to non-declared incomes received from engaging in illegal activities. For some developing countries we might also need to look at remittances from workers overseas, which supplement the country’s income. In Nepal, for example, this accounted for 25% of its GDP in 2012, according to the World Bank. (Source: http://data.worldbank.org/indicator/BX.TRF.PWKR.DT.GD.ZS) Despite some of its shortcomings, an increase in real GDP per capita is generally associated with higher standards of living, and rising income is a major objective of households and governments. However, other measures have been developed in order to more accurately capture standards of living than simply an increase in GDP, such as the United Nations’ Human Development Index (HDI), which includes life expectancy and educational attainment as well as gross national income (GNI) data. This is because health and education are considered to be essential in the well-being of citizens. The Multidimensional Poverty Index (MPI) includes: six measures of standards of living, such as access to cooking fuel, sanitation, safe drinking water, floor space and assets; education in terms of years of schooling and school attendance; and health indicators, such as child mortality and nourishment. Therefore, such measures might be more useful in assessing standards of living in developing countries. Level Description Marks 4 For a detailed explanation of the usefulness and limitations of using GDP to measure standards of living over time. Answers at this level will contain a reasoned conclusion. 18–25 3 For a good explanation of the usefulness and limitations of using GDP to measure standards of living over time. There will be some attempt at discussing alternative viewpoints but the evaluation may be limited. Answers at this level must contain a valid conclusion. 14–17 2 For a reasonable explanation of the usefulness and/or limitations of using GDP to measure standards of living over time, although answers will be undeveloped. There will be some attempt at analysis but only limited evaluation. 10–13 1 For some understanding of the usefulness and/or limitations of using GDP to measure standards of living over time. There will be some correct facts but may include significant irrelevancies. Errors of theory or omissions of analysis will be significant. 1–9 0 No creditworthy response. 0 3 a A downturn in economic activity or the business cycle or negative economic growth as measured by a fall in GDP for two successive quarters; a rise in unemployment; a fall in AD [up to 3 marks]. b i Higher tax rates create a disincentive to work [1] and increase costs of production [1]. Higher marginal tax rates can, according to the Laffer curve, actually lead to a fall in total tax revenue for the government [1]. [Up to 3 marks] ii Under Ronald Reagan top rates of tax fell from 70% to 28% between 1981 and 1989, which led to an increase in the contribution to total tax revenue of the top 1% from 17.6% to 27.5% over the same period. However, the proportionate fall in top tax rates (i.e., 60%) fall was greater than the rise in total tax take (56%). Moreover, it is stated that there is some evidence that lower tax rates increased economic growth in Russia, Latvia and Estonia but this is not substantiated by any hard evidence. [Up to 6 marks for one side of the argument only] c Central banks used monetary policy, in this case lowering interest rates and quantitative easing (or increasing the money supply). In theory, lower interest rates would make it cheaper to borrow for firms and households. However, the transmission mechanism had failed to work as banks were trying to restore their balance sheets and consumers and investors lacked confidence. Increasing the money supply through the purchase of government bonds would have made money cheaper and given the financial institutions more funds. The danger is that pumping too much money into the economy could be inflationary. However, if an economy is in recession it will be operating below full capacity and so an increase in AD would not be likely to impact on inflation in the short to medium term. In addition, some of the money could leak from the circular flow of income as institutions choose to lend to overseas investors rather than domestic ones and so would limit its impact on growth. The impact also depends on how much money has been pumped into the financial system. [Up to 4 marks for each side of the argument, to a total of 8 marks] 4 Students should distinguish between developed and developing countries and explain how protectionism can lead to higher growth rates and lower unemployment but that this can create inefficiency, large public sector © Cambridge University Press 2015 Cambridge International AS and A Level Economics Chapter 9 Coursebook activities 7 Cambridge International AS and A Level Economics deficits, lower consumer surplus and the possibility of retaliation, for example. This should be followed by an analysis of the benefits of investment in infrastructure, e.g., roads, railways, ports, airports and sanitation, and how these can have positive multiplier effects and increase aggregate supply. However, the effectiveness of this policy depends on the ability to finance it, the types of investment undertaken and time lags. In both cases there is a risk of government failure. In conclusion, students might offer alternative policies to help achieve the objective, e.g., investment in human capital and attracting FDI but recognising their drawbacks. Level Description Marks 4 For a detailed discussion of the benefits and problems of protectionism and investment in infrastructure in helping a country develop. In evaluation, alternative policies might be considered. Answers at this level will contain a reasoned conclusion. 18–25 3 For a good discussion of the benefits and problems of protectionism and investment in infrastructure in helping a country develop, but answers are not fully developed. The evaluation may be limited. Answers at this level must contain a valid conclusion. 14–17 2 For a reasonable discussion of the benefits and problems of protectionism and investment in infrastructure in helping a country develop, though answers will be undeveloped. There will be some attempt at analysis but only limited evaluation. 10–13 1 For some understanding of the benefits and problems of protectionism and investment in infrastructure in helping a country develop, but answers are not focused on the question set. There will be some correct facts but may include significant irrelevancies. Errors of theory or omissions of analysis will be significant. 0 No creditworthy response. © Cambridge University Press 2015 Cambridge International AS and A Level Economics 1–9 0 Chapter 9 Coursebook activities 8