AQA ECON4 ANSWERS 25 MARK QUESTIONS JUNE 2010

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1 AQA ECON4 ANSWERS 25 MARK QUESTIONS JUNE 2010 I wish to make clear that these answers are my own suggested approach and are not endorsed by AQA. There are other approaches to the question besides the ones taken here, although the intention is that these are examples of good answers to the questions set. In particular, different evaluative judgements to those which I have made in answer to a question may be equally valid if supported by well-placed economic theory or real world evidence or examples. The guidance below provides some support in approaching questions. Good luck with your studies and the exam. Peter Cramp Symbols The answers here are annotated in much the same way that they would be by the examiner when marking candidate scripts. The symbols are designed to highlight the skills being demonstrated at each point in the answer: D Definitions Kn Knowledge, for example of economic events or data I Issue A relevant issue or point is raised. This is often in the first sentence of a paragraph. Ap Application Applying the information in the extract, or knowledge of economic events or data, to help support the answer to the question. An Analysis The use of relevant economic theory in answering the question, building up logical chains of reasoning. E Evaluation Making judgements about the significance of particular factors, especially in providing a final answer to the question. Evaluation should be supported by relevant economic theory, information from the extract or the candidate s own knowledge

2 GUIDANCE 1. It is common exam practice to define key terms in the question in the introduction to your essay. 2. The first sentence of each main paragraph of your work should clearly specify the point or issue which will be analysed in the paragraph. 3. The issue to be analysed in each paragraph should be clearly related to the question. Suppose the question is Evaluate the effects of economic growth in Brazil on the UK economy. It is appropriate to use paragraphs beginning One way Brazilian economic growth may affect the UK economy is 4. The analysis in each paragraph should be a logical chain of reasoning. The more detailed this analysis is, the better, so include as many links in your chain as possible. 5. Appropriate use of economic diagrams is another way of demonstrating the skill of analysis 6. You must have tight focus on the question set. Good economic analysis, but based on material which is irrelevant or of borderline relevance may result in a lower mark than if the material had not been included. 7. The skill of evaluation is vital to scoring high marks for 25 marks answers. This involves making reasoned judgements in response to the question. 8. The main place that evaluation is expected in your work is in your conclusion. You must reach a final judgement that answers the question set and your judgement must be backed substantially by appropriate economic theory and/or real world evidence 9. You are also likely to include some evaluation in the main body of your essay. This can usefully be undertaken at the end of a paragraph following substantial analysis, or in a separate evaluative paragraph following on immediately. 10. The more specific your judgement can be the better. Suppose for instance the question is to Evaluate the effect of higher oil prices on macroeconomic performance. After analysis of the impact of higher oil prices on the main macro indictors, some students might state by way of evaluation: However, the effect all depends on whether the economy is based on manufacturing or services. The evaluation would be much stronger if specific judgement is made, such as: Some economies, such as the UK, increasingly specialise in services. Because services do not use as much oil as the manufacturing sector, the macro performance of these economies will be less damaged than the performance of industrial economies such as that of China, which needs oil to grow. This may be one of a number of concluding judgements made. Another might be: Although higher oil prices generally damage macro performance by constraining growth and employment and fuelling cost-push inflation, some economies might actually benefit. This might be

3 the case for net exporters of oil, whose trade position and therefore national income may improve. Such a scenario is especially likely for Middle East economies for which oil revenue is a large proportion of national income, such as Saudi Arabia. It is a good idea to study previous questions and to have a stock of examples and real world data that would help to answer them. You can pick up such examples from these suggested answers.

4 AQA ECON4 JUNE 2010 CONTEXT 1 D Globalisation refers to the increasing integration of the world economy. Barriers between national economies have been reduced with the effect that there is more free trade, as well as freedom of movement for factors of production such as labour and capital, and free movement for financial capital too. One of the impacts of globalisation is that goods and services can be produced anywhere around the world, almost regardless of the final market they will be consumed in. D Macroeconomic performance is measured by key indicators such as Gross Domestic Product, inflation (derived from the consumer prices index, for example), unemployment and the current account of the Balance of Payments. I Globalisation has the potential to increase world output and therefore to create economic growth for participants in free trade. An The foundation of the argument in favour of globalisation is provided by Ricardo s law of comparative advantage. The UK can benefit from making goods it can produce at a lower opportunity cost than other nations. This is reflected in the international division of labour highlighted in Extract B: Developing nations have had to seek new comparative advantages in high-technology and service sector activities. Suppose that the production possibilities of the UK and Russia using one unit of resources are as shown: Units of output per resource unit Finance Goods Opp Cost UK F = 0.5G Russia 5 5 1F = 1G In the example shown, the UK only has to give up half a unit of goods for each unit of financial services produced, compared to one unit for Russia. Thus, the UK can produce financial output at a lower opportunity cost than Russia, and should specialise in this area while Russia specialises in goods. If one unit of financial services trades for 0.8 of a unit of goods the consumption possibilities for the UK compared to its original production possibilities are shown in Figure 1

5 An Diagram Specialisation and trade increases consumption possibilities I So specialising in line with its comparative advantages in a globalised economy can help the UK to grow and enjoy higher living standards. Ap This may be further supported by the supply-side benefits of globalisation, such as lower prices for raw materials and, as the extract suggests, advanced nations have benefited from cheap imports of manufactured products. These imports have helped to hold inflation down, aided by the fact that competition from workers around the world has limited wage claims in the UK economy. It can be argued that globalisation has helped to limit expectations of inflation and therefore to make the trade-off between unemployment and inflation more favourable. This can be illustrated via the Phillips Curve, as shown in the diagram An Diagram Globalisation may have lowered inflationary expectations I/Ap/E So, there is a strong argument that the high-growth, low inflation years since the late 1990s which were enjoyed until around were in large part a product of

6 globalisation. performance. Despite this, globalisation may damage some aspects of UK economic I A significant problem of globalisation is its potential to cause structural unemployment in the UK. An The skills of many UK workers have been rendered redundant as firms have relocated to nations with plentiful populations and low wages, and thus low unit labour costs. These workers do not necessarily possess the ability to move easily into thriving areas of the UK economy, so a lack of labour mobility and transferable skills have contributed to unemployment and this has tended to be concentrated in particular regions. I/E More recently, the global financial crisis and recession from 2007 onwards have highlighted that globalisation raises the dangers posed by external shocks. Kn/An It can be argued that the crisis emanated from an imbalance between economies, with China running a large current account surplus, and then lending the foreign currency it earned cheaply to western banks. This encouraged banks to undertake risky lending to customers who were not well placed to keep up repayments, leading eventually to debt defaults and a credit crunch. Even the immediate trigger for the financial crisis was located miles from the UK, in the form of defaults in the American sub-prime mortgage market. The resulting crisis was the main cause of the UK s deepest recession since the 1930s, significantly damaging macroeconomic performance with the result that it may be years before output returns to its pre-crisis levels. Evaluation/final judgement (s) I/An It would be possible to judge that globalisation may increase trend growth (through specialisation, competition and investment) and benefit UK macroeconomic performance in the long term, but cause sharper fluctuations around the trend (through vulnerability to external shocks). It might also be noted that one aspect of macroeconomic performance that definitely does seem to have been damaged is in regard to the current account of the UK s balance of payments. Surpluses in areas such as financial services have not been sufficient to combat large deficits in manufactured goods, as the UK s manufacturing base has been eroded by globalisation. This must be addressed if future crises are to be avoided. I/Kn Recent calls from economic leaders suggest that the UK can now only achieve sustainable growth if it is export led. This suggests that the UK s experience of globalisation to date has produced effects on macroeconomic performance which cannot be considered an unqualified success.

7 AQA ECON3 JUNE 2010 CONTEXT 2 Kn The Euro is the single currency launched in 1999 and used by 17 members of the European Union, with Estonia being the most recent state to join. I/Ap A potential benefit for the UK economy of joining the Euro is that it would help to reinforce the benefits of the single market, which the UK has been a member of for many years. An Trade creation could occur as a result of the fact that the Euro removes the transaction costs associated with switching between currencies to undertake trade. Thus trade becomes cheaper and more likely to occur. Ap Still further, there are no exchange rate fluctuations between the member states of the single currency, so it could be seen as a safe haven from the volatility of the pound. Such fluctuations pose risks to traders and can render a profitable contract unprofitable, so there removal would encourage more trade. I Trade creation allows for greater specialisation, such that the UK can benefit from making goods it can produce at a lower opportunity cost than other nations. Suppose that the production possibilities of the UK and Estonia using one unit of resources are as shown: Units of output per resource unit Finance Goods Opp Cost UK F = 0.5G Estonia 5 5 1F = 1G In the example shown, the UK only has to give up half a unit of goods for each unit of financial services produced, compared to one unit for Estonia. Thus, the UK can produce financial output at a lower opportunity cost than Estonia, and should specialise in this area while Estonia specialises in goods. If one unit of financial services trades for 0.8 of a unit of goods the consumption possibilities for the UK compared to its original production possibilities are shown in the diagram.

8 An Diagram Joining the Euro could offer benefits through specialisation and trade I There are also potential secondary benefits for the UK economy of trade creation, such as a stimulus to investment. An It is argued that the Euro increases competition between member states, this supported by the ease with which prices can be compared when they are stated in terms of the same currency, and that this helps to lower inflation. In turn, lower inflation permits lower long term interest rates, making it cheaper for firms to borrow in order to finance investment. This helps to support the long term growth of economies by contributing to their capacity. Firms are likely to want to take advantage of investment opportunities due to their access to the large European single market and the potential for economies of scale which are offered by producing large amounts of output. Evaluation/final judgement (s) I/Ap Key amongst the arguments against UK membership of the Euro is that we would be foolish to lose the power to set our own interest rates. An By necessity, a single currency requires one base rate, which is set by the European central bank. This works well as long as there is a significant degree of convergence of economic conditions in member states. If, however, member states have differing economic conditions, it is likely that the common interest rate will be inappropriate for some economies. Kn/Ap In response to the financial crisis of 2008, the Bank of England moved swiftly to support the economy by slashing its base rate to a record low of 0.5%. It would not have had this power if we had been part of the single currency, and this creates an argument that we should remain outside of the Eurozone. I This argument gains greater weight when it is considered that UK exporters were significantly supported by a fall in the value of the pound against the Euro in This should be considered a reason for remaining outside of the Euro not one for joining it. Without this depreciation, our deep recession may well have been even more serious. The experience of countries such as Italy and Spain within the Eurozone gives this argument compelling force. Kn/Ap Since joining the Euro these countries have lost 40% and 30% on labour cost competitiveness against Germany respectively, and unsurprisingly have

9 experienced weak macroeconomic performance. If they were outside the Euro, their exchange rates would have floated downwards to give their competitiveness a boost. Inside it, such an option is not available. I/Kn/An The Eurozone crisis has completed the case against the UK joining the Euro. It has become clear that the Eurozone is not an optimal currency area. There is not sufficient convergence between economies to tolerate a single interest rate, nor is there sufficient labour market flexibility. Were the UK to have been a member at this time it would not have been able to enjoy the stimulus to its economy that it has gained through a depreciation of the pound and the Bank of England s expansionary monetary policy. Still more, already stretched government finances would have been forced to provide more bailout funding for nations such as Greece than has been the case from outside of the Eurozone. The prospect of the UK government losing its credit-worthiness would then have been strong. The UK can still participate in the single market while using the pound, and any benefits that the Euro might bring through trade creation, are very much outweighed by the damage that its flaws could do to our economy.

10 AQA ECON4 JUNE 2010 ESSAY 1 D Deflation refers to a persistent fall in the general price level, as measured by a weighted basket of goods and services, used to derive a price index such as the consumer prices index or the retail price index. Deflation raises the internal purchasing power of money, such that more goods and services can be purchased with each unit of the currency. The UK s macroeconomic performance is measured via four key indicators: The consumer price index, Gross Domestic Product, the rate of unemployment and the current account of the Balance of Payments. I Deflation usually damages economic growth and is associated with falling GDP. An This is for a number of reasons. First and foremost, falling prices create an incentive to defer spending, in anticipation of prices falling further. Thus consumption is lowered by deflation, and aggregated demand is too. It is also the case that debt default is more likely during times of deflation. Falling prices (including wages paid to labour) make it more difficult to earn the money to repay debts. This causes knock-on effects for creditors, who may in turn default on money they owe to others. Debt default may constrain the growth of the firms who suffer from it or lead to business closures and permanent losses of economic capacity. Still further, supplies of credit are likely to dry up for both consumers and firms as lenders are averse to the increased risk of default. In general, the circumstances surrounding deflation damage the confidence of both consumers and firms and this further depresses spending. With deflation hitting both the demand and supply-sides of the economy, growth is likely to be subdued. Reduced demand, for example, may lead to firms ceasing to produce output and relying on stocks of products already made to meet those orders that do come in. The effects of a fall in AD are shown in the diagram. The output gap in the economy rises and there is significant spare capacity.

11 An Diagram Expectations of future price falls lead to falling aggregate demand I As economic growth falls due to deflation, so unemployment rises. An As firms cut back on output, the derived demand for factors of production falls and demand-deficient unemployment is likely. During lasting periods of deflation, mass unemployment tends to occur. Kn This was the experience in the Great Depression of the 1930s, for example. I One benefit of deflation is that it may lead to an improvement in the current account of the Balance of Payments. An This is due to the fact that falls in prices make the country s products more competitive on international markets. Exports may rise as a result, while import penetration falls, as domestic consumers too are likely to turn to home-produced output due to the fall in its relative price. Kn During Japan s lost decade of growth, for example, its exports of electronic goods and cars were strong, and this helped to alleviate some of the effects of its economic problems. I/E Were the UK to enter a period of deflation at the present time, however, it may not experience such great benefits to its current account. This is because of the UK s relatively small manufacturing base and the fact that we tend to specialise in high value goods with inelastic demand, seeking to sell at a premium rather than competing on price. It is also the case that the economic problems at present are global problems and it is possible that a number of other nations besides the UK would also enter a period of deflation, thus helping to offset any benefits to UK competitiveness that our own deflation might deliver. Evaluation/final judgement (s) Periods of deflation are not to be welcomed. They tend to cause economic stagnation and high levels of demand-deficient unemployment as outlined. I They also tend to make policy ineffective. Kn/An Interest rate cuts do not stimulate spending if consumers are holding back waiting for further price falls, for example. In the UK, the base rate had already been cut to 0.5% by March The Bank of England was praised for its swift action, one of the lessons of Japan s crisis being that early action is crucial in avoiding deflation. However, this

12 meant that there was little or no room for further cuts should prices start to fall, and the only remaining monetary policy option was quantitative easing to boost the money supply. This is a relatively untried policy and there is considerable debate about its effectiveness. Still further, the UK s already large budget deficit and national debt would mean that the government would be poorly placed to use fiscal policy to stimulate the economy in the event of deflation. The difficult in offering any effective policy response from March 2009 onwards meant that the UK has particular reason to fear a period of deflation. Kn The experience of Japan further points to the devastating effects of deflation. Were the UK to experience a lost decade with output no higher than a decade previously, then an awful lot of potential increases in living standards would have been lost. The UK is often thought to have a trend growth rate of around 2.5%, so a lost decade for the UK would leave output a long way below where it would have been expected to be. I It is sometimes suggested that deflation is not to be feared if it comes from supply-side advances rather than collapsing demand. An This is a doubtful proposition as, whatever the source of falling prices, once they begin to fall the dangers of deferred spending are still relevant. Furthermore, this was not the context of the threat of deflation that the UK faced from 2008 onwards: Deflation is damaging to an economy s macroeconomic performance and this helps to understand why policy makers are so keen to avoid it.

13 AQA ECON4 JUNE 2010 ESSAY 2 D The UK Balance of Payments is a record of financial transactions between economic agents in the UK and elsewhere in the world over a given period of time. The current account records international flows of income and expenditure relating to trade in goods, trade in services, transfers and investment income (interest, profit and dividends). The capital account records transactions in assets and liabilities, and broadly shows how a current account deficit is financed or how a surplus is used. D Protectionist policies are designed to shelter domestic producers from international competition. They include tariffs and quotas placed on imports and subsidies given to domestic producers. I A greater use of protectionist policies around the world would impact on UK exports. An Suppose, for example, that there is a greater use of tariff in other countries. A tariff is a tax which raises the cost of imports into a market, thus making them more expensive relative to domestic output. This is an expenditure switching policy, as consumers are encouraged to buy from domestic producers due to an artificial increase in the price of imports. If consumers in other countries buy from their own domestic producers, sales of UK exports to these markets will fall. Exports of goods and services are credits to the current account of the UK Balance of Payments, so a fall in the value of exports would see a deterioration of the current account balance. In the current circumstances of the UK, this would imply that our current account deficit would grow larger than it is at present, requiring us to run a larger capital account surplus by incurring liabilities through international borrowing or inward investment. The effect of the imposition of a tariff in reducing imports to a market is shown in the diagram.

14 An Diagram Tariffs in other countries could reduce UK exports Evaluation/final judgement (s) I The effect on the UK Balance of Payments would be felt primarily on the visible section of the current account, namely trade in goods. An This is because manufactured output is the most tradable sector of the economy. However, the effect may be relatively small. Kn This is because UK firms tend not to compete on price in international markets, largely due to the fact that the UK is a relatively high wage economy compared to emerging nations with plentiful populations and low wages. While UK workers may be productive, this is often not enough to offset the cost of relatively high wages, meaning that unit labour costs in the UK are high, which affects the price of the final product. Instead, UK firms often compete on non-price factors such as quality and innovation. These products are not so price sensitive, so while protectionist policies such as tariffs would undoubtedly damage UK exports, the effect may not be so big. I The impact on the UK Balance of Payments may be smaller than it would be for a nation that specialises in exporting manufactured output such as Germany. Kn/AnThese manufactured goods are perhaps more likely to become the subject of protectionism than areas that the UK specialises in, such as the financial services industry. I It could be argued that quotas would have a greater impact on the UK balance of payments than tariffs. An This is because while tariffs raise the price of UK exports, quotas place a physical limit on access to particular markets. It may be that a tariff would force UK firms to look again at their production processes in a bid to achieve further productivity improvements and partially offset the effect of the tariff, but there are few ways to avoid or offset the effects of a quota. I The effect of protectionist policies around the world on the UK Balance of Payments would be limited by the fact that the UK is a member of the European Union s Single Market. An We do much of our trade within the European Union, although the percentage is shrinking

15 over time. Free movement of goods and services within the EU means that our exports within the EU could not be subjected to protectionism. Indeed, protectionism elsewhere around the world might result in an increase in trade within the EU which would partially offset any loss of UK export markets. It is safe to judge that protectionist policies around the world would impact negatively on the UK s balance of payments, which is already substantially in deficit, but there are good reasons to think that this impact may be fairly small. The arguments made to this effect in the previous paragraphs may be further backed by the fact that it is unlikely that protectionist policies would occur on a blanket basis across the world. It is therefore possible that, given time, UK firms may be able to find new export markets which would not be affected by protectionism, either within the EU s single market or elsewhere. Kn Worryingly, however, the UK currently runs a large trade deficit in relation to the EU ( 46.6bn in 2010). We actually run a surplus in relation to the rest of the world ( 10.3bn in 2010) which offers much needed support to our current account. Protectionist policies around the world would serve to reduce this support, making the negative impact of such policies more of a concern than they might first appear.

16 AQA ECON4 JUNE 2010 ESSAY 3 D The UK government undertakes new borrowing if it runs a budget deficit, in other words if government spending exceeds taxation revenue. Any new borrowing adds to the existing stock of national debt. I Government borrowing sometimes has positive effects. Such borrowing can help to lessen the effects of a downturn or recession in the economy, for example. An Borrowing to finance government spending can help to support aggregate demand for UK products and services which in turn generates employment, as the demand for labour is a derived demand. The stimulation that this offers to the economy may be reinforced by multiplier effects, as government spending, by creating incomes, leads in turn to further rounds of spending. This helps to close the output gap in the economy, reducing spare capacity. Indeed, government borrowing often occurs automatically during a recession, as tax revenues (a leakage from the circular flow) fall and government spending (for example, on benefit payments) increases, providing an injection. Thus, government borrowing is a natural part of its role as an automatic stabiliser to the economy. Successful use of government borrowing to smooth the business cycle would have effects as shown in the diagram An Diagram Government borrowing can be used to smooth the business cycle

17 I/E It is important, however, that borrowing used to smooth the path of the business cycle is offset by running a budget surplus at other stages of the cycle. Borrowing is a much greater concern if it occurs through a structural budget deficit, which remains even when the effects of the business cycle are accounted for. A structural deficit may be larger during a recession and smaller during a recovery, but always present, with the effect that the national debt rises year-on-year. This incurs commitments for future generations of taxpayers and cannot be regarded as being sustainable. The diagram highlights the difference between a structural and cyclical budget deficit. An Diagram Structural deficits are more of a cause for concern than cyclical ones I Government borrowing can also be useful to finance investment, for example in new schools and hospitals. An Such investments are important to the capacity of the economy and in creating sustainable economic growth. These effects are shown in the diagram below. Indeed, these investments may yield a return greater than the interest incurred, and this helps to justify the borrowing used to finance them. Thus, government borrowing is generally not a great cause for concern if it is used to finance productive investments. An Diagram Borrowing can finance investment, creating capacity growth

18 Evaluation/final judgement (s) In the current situation, UK government borrowing must be considered a concern. Kn This is because over the past years the UK has run a structural budget deficit, some of which has been used to finance government spending. The golden rules of fiscal policy that the government would not borrow over the length of the economic cycle except to finance investment, and that national debt would not exceed GDP, were torn up in response to the financial crisis 0f While this may have been necessary at the time in order to provide the funding to bail out banks that are central to the working of the economy and to provide some stimulation to reduce the extent of the recession, governments cannot go on adding to the national debt for ever. According to figures from the Office for Budget Responsibility in March 2012, the UK will continue to run a structural budget deficit up to and including These figures are in spite of major cuts to government spending, themselves a sign of the extent to which the government acknowledges that borrowing is a cause for concern, although there is debate about the related issue of how fast government spending should be cut, given that it helps to support growth and therefore generate tax revenue. I Excessive levels of government borrowing run the risk of crowding out the private sector. An There is a limited supply of loanable funds that the private and public sectors are in competition to borrow, and any increase in the demand for those loanable funds by the government is likely to force interest rates up, making it more expensive for the private sector to borrow. This is of concern because private sector borrowing is used to fund the investment which is crucial to long term growth. Still further, the private sector is generally considered to be more innovative and dynamic than the government sector of the economy, in addition to which it may allocate resources more efficiently due to its responsiveness to price signals. Still more, it is often argued that the private sector may be more efficient due to its incentive to cut waste in order to make profit, this enforced by shareholder discipline on management. Kn The case that UK government borrowing should be considered a cause for concern is made conclusively by the experience of nations whose debts have reached excessive levels. The national debts of Italy and Greece had reached over 100% of GDP in 2010, for example, producing a fear that their governments would default on debt payments. By mid-2011, the Greek government was forced to pay interest rates of up to 20% for new borrowing, as well as requiring bailout funding from its partners in the Eurozone and eventually agreeing writeoffs of existing debt at 50%. Meanwhile, because the UK government had taken measures to reduce its budget deficit it was seen as less risky to lend to, and was able to borrow at rates as low as 2%. Thus, UK government borrowing clearly should be considered a cause for concern at present. Even with measures to reduce the deficit, the Office for Budget Besponsibility expects the national debt to reach 76% by Were either discretionary policy changes or an economic slowdown to cause this figure to rise further,

19 the UK government may well lose credit worthiness, leading to rising interest rate costs and excessive burdens on current and future taxpayers, if not default on the national debt.