Short answer questions (10 marks each)

Transcription

1 Page 1/12 Section 2.6 Preparing for exams Short answer questions (10 marks each) 1. Basic answer: Define and outline equilibrium income; AS = AD in diagram. A very straightforward method would then be to add a LRAS curve to the left of this equilibrium, showing that the economy is at less than full employment. Another version shows general equilibrium (AS=AD=LRAS) but comments on the fact that full employment in fact entails a degree of unemployment. definition of equilibrium income in AS-AD diagram definition of unemployment; percentage of labour force willing and able to work not holding jobs use of natural rate of unemployment, i.e. that full employment entails o structural, o seasonal, and o frictional unemployment use of labour market diagram to show the above that equilibrium might well mean that output is below potential output at LRAS and that this will mean additional unemployment good reference to real wage and/or cyclical unemployment Diagram(-s): AS-AD including LRAS to show equilibrium national income. Labour market diagram which can be linked to AS-AD diagram to show that equilibrium national income can mean natural unemployment (at LRAS) and cyclical/real wage unemployment at AS =AD below LRAS. Note: Many students hurry past a sound definition of equilibrium and cannot get highest marks. 2. Basic answer: Define both; inflation is a consistent general increase in the price level, while deflation is a consistent fall in the general price level, i.e. negative inflation. A good answer will outline the basic damage to an economy of both, ultimately showing perhaps that deflation, while rarer, can be held by many economists to be the greater of two evils. definition of inflation, consistent etc definition of deflation costs of inflation o shoe leather, menu costs o redistribution effects fixed income earners lose, borrowers gain o behavioural distortions in the economy o effects on output o possible break-down of monetary economy (hyperinflation) use of LR Phillips curve (HL) to show effects of inflation on economy effects of deflation o distinction between benign and malignant deflation o use of AS-AD model to illustrate the above o possibility of negative expectations and o malignant inflation and possibility of self-reinforcing feedback loop

2 Page 2/12 inflation is more damaging; far more common, destroys trust in money and financial system, can take years to correct, see 1922/23 in Germany, Brazil in 1980 s deflation is more damaging; uncommon but when this is the case it is very difficult to get out of a negative feedback loop of falling prices falling demand falling prices see Japan in 1990 s use of AS-AD model to illustrate demand-pull, cost-push inflation illustration of cost-push, demand-pull spirals Diagram(-s): AS-AD to show inflation and spirals, LR Philips curve (HL). 3. Basic answer: It is essential here to include a solid definition based on economic concepts. The natural rate of unemployment is the rate of unemployment which exists when the labour market has cleared leaving voluntary employment comprised of seasonal, frictional and structural unemployment. It seems obvious that a basic definition of employment and labour force is necessary here. concept of full employment, i.e. where all labourers in the labour force who want a job at the going wage rate are employed that this in turn is the labour market in equilibrium, i.e. equilibrium unemployment those who do not accept the going wage rate are voluntarily unemployed there is always an element of voluntary unemployment and this is the natural rate difficulties in assessing the natural rate of unemployment; different definitions of the labour force are possible, part time workers may not be counted, accounting problems such as not registering at employment agencies and discouraged workers that the natural rate of unemployment is not cut in stone but varies over time Diagram(-s): The basic labour diagram (AS L/AD L) could be used clearly showing equilibrium and the natural rate of unemployment between market equilibrium and the TLF. Note: While it is not absolutely necessary, it is common that stronger students include and refer to the labour market diagram. 4. Basic answer: This is something of a classic, dealing with supply-side shocks and the effects on AS and AD. Start off by determining oil as a major factor of production and then use a AS-AD diagram to illustrate the effects on the economy AS decreases and the possibility of cost-push inflation. Reference to the oil crisis of the 1970 s is highly relevant. oil as a factor explanation of the effect on AS of factor prices, i.e. shift to the left supply-side shock o falling output o increase in price level o stagflation (or slumpflation) cost-push inflation as AS decreases further due to bidding up of factor prices and wages possible reflationary policies undertaken to stimulate AD possible cost-push spiral

3 Page 3/12 use of Phillips curve (HL: LR Phillips curve) exemplifying with the stagflationary period of the 1970 s noting that oil producing countries would in all likelihood benefit from oil price increase Diagram(-s): AS-AD including LRAS. Phillips curve and LR Phillips curve (HL). Note: Reward students who clearly differentiate between a supply-side shock and cost-push inflation. 5. Basic answer: High inflation will have serious redistribution costs; create distortions to the economy; reduce international competitiveness; affect the balance of payments and exchange rate; and have negative effects on growth. definition of inflation as a sustained general increase in the price level economic cost include o higher interest rates and reduced investment o insecurity and lack of predictability; firms will be wary of increasing investment and consumers might hold of on spending o shoe leather and menu costs o inflation might cause exports to fall o and depreciate the currency social costs o people on fixed incomes will suffer more than those strong enough to bid up wages in line with inflation o the poor will suffer more than the financially strong redistribution effects for example, borrowers will gain at the expense of lenders (as the real value of debt falls over time when inflation is high) extreme inflation (hyperinflation) might lead to a breakdown in the monetary economy, resulting in time-wasteful bartering Diagram(-s): AS-AD diagram may be used to show inflation, investment schedule may be used to show how investment falls when interest rises. Note: Students often produce a list of ills without bothering to explain or elucidate. Clearly higher marks should be reserved for answers which give some depth as to why a certain effect constitutes an economic and/or social cost. 6. Basic answer: Define supply-side policies as aimed at increasing LR (potential) growth by stimulating labour mobility, capital formation and increased competition. Note that supply side policies are LR policies. outline of supply-side policies o labour policies reducing union power; cutting back on welfare benefits; abolishing minimum wages; easier hire-and-fire policies etc o capital tax breaks for investment and education in firms; lower taxes on profits/dividends etc o competition privatisation and deregulation; subsidies for R&D; trade and general market liberalisation etc

4 Page 4/12 using AS-AD model incorporating the LRAS curve showing the aim of supply-side policies clearly showing how AS and LRAS are affected by these policies use of labour market diagram to show either labour market clearing and/or a decrease in the natural rate of unemployment definitions of natural rate of unemployment and real wage unemployment merits of such policies o have had a degree of success in the UK and US o have been adopted to some extent in many OECD countries o can have severe drawbacks in the SR, i.e. increased unemployment, possible budget deficits as taxes are cut, social costs of decreasing social benefits, rise in income inequality, limitations also include Keynesian criticism; market are imperfect and could take considerable time to clear, highly politicised issues of whether tax incentives actually work, the long run might be very long and painful indeed Diagram(-s): AS-AD including LRAS, LR Phillips curve (HL), labour market diagram. Note: For full marks, some form of assessment must be included hence the command term merits in the question. 7. Basic answer: An examination of the two schools of thought concerning unemployment is the key here. Start off with a definition of the labour force and then a level of full employment or natural rate of unemployment. Monetarist/new classical theory looks at any unemployment in excess of the natural rate of unemployment as real wage real wages are too high to clear the market and labour market impediments/impurities such as minimum wage and strict hire-and-fire policies are disallowing labour market clearing. Keynesians, on the other hand, view addition to the full employment level of unemployment as the result of a decline in economic activity e.g. cyclical or demand deficient. definition of labour force, e.g. proportion of population between 16 and 65 considered economically active real wage unemployment is the monetarist/classical view that any unemployment above the natural rate of unemployment: o the labour market has not cleared o the real wage level is too high o labourers voluntarily decline jobs since at the going real wage rate, there is far higher demand for jobs than there is supply the cause of real wage unemployment is o strong unions keeping wages high o high social and unemployment benefits allowing workers to remain unemployed as they are getting benefits that allow them to remain unemployed o strict hire-and-fire legislation that discourages firms from hiring o minimum wages that keep real wages above market clearing level cyclical unemployment means that unemployment has increased due to a decrease in overall economic activity, AD, and thus a decrease in (the derived) demand for labour o demand-deficient means that AD L has fallen and wages are sticky and/or labour markets are generally immobile o labour markets, like any other market, are inherently unstable/imperfect unions, minimum wage and unemployment benefits do exist and help create downward stickiness and additional unemployment in economic downturns use of labour market diagram to illustrate full employment/nru and

5 Page 5/12 o decreased ADL together with downward stickiness of wages resulting in demanddeficient unemployment o real wages above market clearing level and the resulting real wage unemployment reference to full employment and/or natural rate of unemployment use of AS-AD and LRAS model to illustrate natural rate of unemployment, i.e. full employment level of output Diagram(-s): Labour market diagram, AS-AD including LRAS in order to show full employment level of output. Note: One often sees answers that confuse AD and ADL often occurring in the same diagrams! 8. Basic answer: The answer is centred around redistribution issues governments can influence net disposable income and wealth in a number of ways. Taxes on income, wealth, expenditure and imports can be adjusted to decrease the burden on the poor. Transfer payments and benefits in kind are ways of redistributing incomes. wealth equality; redistribution via land re-distribution schemes, nationalisation and taxes on wealth income redistribution can possibly be aided by shifting the weight of tax bases from basic necessities to income elastic and luxury goods, by increasing income tax progression, minimum wage policies, increased goods and services in kind, increased transfer payments (benefits), increased spending on merit goods etc. relevant discussion on the limits to such governments schemes such as tax evasion, capital flight, increased use of parallel markets, lack of government funds to implement increased transfers etc use of Lorenz curve/gini coefficient (a bit peripheral but illustrative) Diagram(-s): Inward-shifting Lorenz curve to illustrate improved distribution of income. Note: Students often spin off into an answer dealing with why income and wealth inequality should be reduced rather than how. HL only 9. Basic answer: The Phillips curve illustrates the possible trade-off between inflation and unemployment while the LR Phillips curve (expectations augmented in monetarist terminology) shows that the trade-off is at best temporary. This has some profound implications for economic policy in terms of focus on demand-management or supply-side policies. use of Phillips curve to show trade-off underlining the above by using an AS-AD model as support (see page 441) demand-side o the Phillips curve shows a trade-off

6 Page 6/12 o presents a menu of possibilities for government o clear correlation between demand stimulation and unemployment monetarist/supply-side o people/firms do not suffer from money-illusion o thus the fall in real income will be noticed o and firms will increase factor prices and households will bid up wages o in time, AS will shift left, back to equilibrium and the economy will adapt to higher inflation expectations any viable points in the monetarist-keynesian debate, e.g. causes of inflation, market interventionism or not, market clearing issues, SR vs LR etc making clear that knowledge of whether the Phillips curve is a SR version or if indeed a LR version exists will have direct implications for fiscal and monetary policy Diagram(-s): AS-AD, SR and LR Phillips curve. Note: Full marks should not be given to answers which are limited to an itemisation of demand-side and supply-side views of the Phillips curve a clear reference must be made to the effects on policy making. Extended response questions 1. a) Basic answer: Two main paths are available; demand-deficient unemployment and real wage unemployment. After defining unemployment (percentage of the workforce not holding a job), relative depth should be given to these two main rubrics. demand-deficient unemployment o reference to business cycle (cyclical unemployment) o derived demand for labour o illustrating increase in unemployment in labour market diagram, shift left of AD L o possibility of downward stickiness of labour o primary cause is low AD in the economy real wage unemployment o market for labour does not clear due to market imperfections o unwillingness/inability of labourers to accept going real wage rate results in voluntary unemployment o causes include trade union power, minimum wages, high social and welfare benefits natural rate of unemployment, i.e. frictional, seasonal, sectoral unemployment other possible issues o restructuring of the economy, for example in transitional economies o dependency on a narrow range of goods for which demand has fallen for example in many developing countries Diagram(-s): Labour market diagrams illustrating natural rate of unemployment, demand-deficient unemployment and real wage unemployment. AS-AD model to illustrate derived demand for labour, natural rate of unemployment. Note: It should be fully possible to get full marks be exploring either of the main theoretical standpoints in depth.

7 Page 7/12 b) Basic answer: An easy way to organise the answer is to divide possible solutions into two broad groups; interventionist and market (supply-side) solutions. Interventionism should not be limited to simple demand-management but include interventionist supply-side suggestions. Market solutions are firmly centred around monetarist/classical thinking, i.e. supply-side policies. clear definition of the natural rate of unemployment as the unemployment which exists when the labour market has cleared interventionist solutions o demand management; increase the demand for labour by stimulating the economy via interest rates and/or fiscal policies o interventionist supply-side possibilities include labour market programs for retraining and education; grants and subsidies to firms to hire; tax incentives to firms investing in retraining/education of labour etc market based solutions o lowering social/unemployment benefits o decreasing income taxes o relaxing hire and fire legislation to increase labour mobility illustration of natural rate of unemployment in diagram o showing shift in AS L to the right o possible shift of AD L to the right any reasonable suggestion which clearly addresses the issue of getting more members of the labour force to offer their services on the labour market Diagram(-s): Labour market diagram. Note: Answers frequently address the issue of how to remove labour market imperfections, i.e. how to help the labour market to clear. The question, however, deals with decreasing the natural rate of unemployment. 2. a) Basic answer: Define full employment as the rate which exists when labour markets have cleared leaving structural, seasonal and frictional unemployment. The question can be addressed from both a Keynesian side and a monetarist/classical side. Keynesians would claim that sufficient demand in the economy would create full employment, while monetarist/classical theory claims this would lead to inflation instead, supply-side measure should be implemented. definition of full employment use of labour market diagram to illustrate possibly the Phillips curve (HL) Keynesian arguments o increasing AD will increase the demand for labour o as AD L shifts right, unemployment falls monetarist/classical arguments o unemployment level is above the natural rate of unemployment due to market imperfections o reduce market imperfections e.g. union power, minimum wage etc and the market will clear

8 Page 8/12 possible convergence and agreement; most economists would agree that supply-side policies do indeed reduce unemployment in the long term Diagram(-s): AS-AD model, labour market diagram, Phillips curve (HL). Note: In referring to the Keynesian side of the argument, the inverted L shaped AS curve may be used. b) Basic answer: In terms of Keynesian demand-side policies, there might be inflation, government deficit spending, loss of international competitiveness and depreciation of the exchange rate. On the monetarist/classical side, one might see increased unemployment (in the medium term), social costs due to lower social benefits, de-skilling of the workforce, and increased inequality in society as the poorest groups take the brunt of the costs of structural change. possible consequences of Keynesian demand-management policies o inflation (and decreased AS in LR according to monetarist/classical side) o loss of international competitiveness o depreciation of currency o deficit spending, government debt ditto for monetarist/classical supply-side policies o increased unemployment o social cost of unemployment o social costs of lower social benefits o income inequality other possibilities; trade barriers might be used to save jobs, which would render welfare losses to society; resources might be misallocated in saving jobs in sunset industries Diagram(-s): AS-AD model. Note: Good answers will refer to real world examples, such as the massive government deficits during the Reagan period in the US, and the stop-go cycles in the UK during the 1960 s and 70 s. 3. a) Basic answer: Define inflation as a steady increase in the general price level. Then, there are, well, two and a half basic reasons: 1) demand-pull inflation; 2) cost-push inflation and; 2.5) demandpull inflation caused by excess money supply. definition of inflation cost-push inflation o factor costs increase and o fuel bidding up of wages o illustration of cost-push inflation in AS-AD model demand-pull inflation o a demand-side shock increases AD o and households/firms act in anticipation of higher prices, which causes further increase in AD o illustration of demand-pull inflation in AS-AD model excess money supply

9 Page 9/12 o an increase in the supply of money above and beyond the LR potential of output will be inflationary o illustration of excess monetary growth using transmission mechanism (page 436) other reasons; imported inflation when a main trading partner has inflation it is possible for the imports from them to raise the price level (depending on rigidity of exchange rate system and the PED for imports) Diagram(-s): AS-AD model, transmission mechanism (not part of syllabus, page 436) Note: Any two reasons, well illustrated/commented, should be able to get full marks. b) Basic answer: Define monetary and fiscal policies and show how these policies might decrease inflation rates caused by demand-pull, cost-push and excess money supply. Problems such as decreased AD during cost-push inflation should be brought up, and the SR and LR issues of these policies implementation and effect should be given some consideration. definition of monetary policy definition of fiscal policy applied to demand-pull inflation o raising interest rates affect on AD; increased S, lower C and I possibly a higher exchange rate which in turn would lower X and increase M o increased taxes and/or lower G takes some time to implement and take effect applied to cost-push inflation o both increased interest rates and lower G/higher T would affect cost-push inflation, yet o while both monetary and fiscal policies might lower inflation during cost-push times, the effects would be an even greater level of unemployment as AD shifts left applied to excess monetary growth illustrating effects using AS-AD model use of investment schedule to illustrate effects of interest rate increase other possibilities o imported inflation might be combated by devaluing the currency (or possibly by lowering tariffs which is in reality a bit far-fetched) o supply-side policies might be enacted to deal with cost push inflation yet these are of such long term nature that in fact the problem would not be addressed Diagram(-s): AS-AD model, investment schedule. Note: A rather tricky question, as the student must show insight into the basic problem of dealing with cost-push inflation.

10 Page 10/12 4. a) Basic answer: The core issue here is to tweak the tax bases primarily income, expenditure, profits and perhaps tariffs in favour of poorer groups. Income taxes can be made more progressive; expenditure taxes can be shifted from basic necessities to more income elastic goods; profit taxes can be increased; and tariffs can be shifted away from imports purchased by low-income households to more luxury oriented items. outline of key taxable bases; income tax, expenditure tax (e.g. VAT), corporate (profit) tax and tariffs on imports (tariffs) income tax o can be made more progressive o the minimum required level of taxable income can be increased expenditure tax o goods with high yed can be taxed more o lower tax on basic necessities o low yed goods inferior goods taxed less o various forms of luxury taxes can be implemented corporate tax o lower corporate tax on smaller businesses o and shift tax base to larger businesses capital gains tax o increased capital gains tax (tax on, for example, selling shares or property at a profit) will hit primarily the well-off property taxes o an increase in property taxes land, housing and even cruise ships will affect the well off far more than the poor tariffs o shift tariffs from basic necessities to luxury imports Diagram(-s): Progressive tax curve. Note: There is wider scope than illustrated above award marks for reasonable and logical suggestions. b) Basic answer: The answer is primarily that an evening-out of incomes in society has shown to have both growth and developmental effects. More equitable distribution of income lowers a number of social ills, such as crime, alcoholism, corruption etc. Simultaneously, better income distribution enables better and more borrowers (and thus more businesses) and a wider spread of social goods such as education and health care both of which are pro-growth and pro-development. reasons for redesigning of tax bases o better distribution of income o spread of social goods o increasing participation and contribution to society effects of better income distribution and spread of social goods o wider spread of wealth enables more borrowers and thus entrepreneurs o lower crime rates o lower social costs such as drug addiction, prostitution, alcoholism o fairness in society lessens civil tensions between upper and lower income groups fairer income distribution has been shown to be pro-growth and pro-developmental

11 Page 11/12 other effects: lower levels of corruption and nepotism; less favouritism amongst a small elite; wider recruitment of ability in those who have been able to gain education Diagram(-s): Note: Shifting tax bases to target certain societal aspects here, evening-out of income is often a tricky issue for students. HL only 5. a) Basic answer: This is another classic question, and is designed to elicit a discussion on the basic Keynesian-monetarist debate. The Keynesian side posits that policies can indeed be used to stimulate demand demand-side policies and that markets are imperfect and thus need priming. The opposing view, from the monetarist/classical side, argues that any intervention by government aimed at stimulating demand beyond the full employment level of output (i.e. LRAS) will be purely inflationary the trade-off is a SR issue. outline of inflation and unemployment and why they are related o use the AS-AD diagram to illustrate how an increase in AD o would decrease unemployment o but increase the price level (see figure , page 443) yes, there is a trade-off o reference to the Keynesian premise that disequilibrium unemployment is primarily demand-deficient o solution is to stimulate demand (fiscally for the most part), i.e. AD o use the SR Phillips curve to illustrate how an increase in AD will cause a movement along the Phillips curve (page 443 again) maybe, but only in the SR, according to the monetarist/classical side o people/firms do not suffer from money-illusion o thus the increase in AD will result in a fall in real income o and firms will increase factor prices and households will bid up wages o in time, AS will shift left, back to equilibrium and the economy will adapt to higher inflation expectations o thus, there is no trade-off in the LR o this is shown in the LR Phillips curve (page 444) empirical evidence o evidence suggests that a trade-off existed during the 1960 s o additional evidence shows a break-down of the Phillips curve relationship during the 1970 s Diagram(-s): AS-AD model, SR and LR Phillips curve. Note: This is a most important question, as it is at the heart of the Keynesian-monetarist debate. Most students should be able to get reasonable marks here.

12 Page 12/12 b) Basic answer: The implications are as simple as they are hotly debated; Keynesian policies have been adopted by the political left while monetarist/classical policy prescriptions have been supported by the political right. The existence of an inflation-unemployment trade-off suggests that demand-side policies should have a degree of success in lowering unemployment at the cost of higher inflation levels. The implication of a LR Phillips curve is that demand-fuelled growth is temporary at best, leading only to higher inflation in the LR. implications of there being a trade-off o demand-management can be used to regulate the economy o fiscal stimulation has an effect on unemployment o to a certain degree, the economy is able to choose a maximum level of inflation in combating unemployment implications of no trade-off o demand-management does not solve the problem of unemployment o inflation becomes a problem when economy is stimulated via demand-side policies o there is a natural rate of unemployment which cannot be dealt with using demandside policies o the solution lies in supply-side policies; increase LRAS and inflation is kept in check while the natural rate of unemployment falls natural rate of unemployment; illustrating that unemployment will hover around a given rate regardless of demand stimulation any increase in AD which is not upheld by the LR potential (LRAS) of the economy will ultimate result in the natural rate of unemployment but at a higher price level possible convergence; increasingly, the debate has had a degree of convergence, in that economists of demand-side persuasion agree that it is indeed sound policy to also increase output potential in the economy AS yet disagree that this necessarily means a market based solution Diagram(-s): SR and LR Phillips curve, AD-AS model. Note: Students often fall into the trap or repeating themselves here, and accounting for whether there is a trade-off or not. The task, however, is to clarify how the two sides use their theoretical bases to prescribe economic policies.