Price stability means that the general price level in an economy increases at a low, stable and expected rate. [1]

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1 Suggested Answers for CSQ1 (a)(i) Explain what is meant by price stability. [1] Price stability means that the general price level in an economy increases at a low, stable and expected rate. [1] Some students did not explain the general price level in an economy and/or just state price level instead of general price level. Students answer Price stability refers to the prices rising at a low, stable and predictable rate What s wrong Price stability measures general price level rising at a low, stable and predictable rate (a)(ii) With reference to Tables 1 and 2, compare the trend of the general price level in the US and Japan from 2009 to [1] The general price level in the US has increased generally from 2009 to However, the general price level in Japan has declined generally from 2009 to Note: 0m if candidate did not use comparative word. Some students provided the wrong trend. They may have misinterpreted the data on inflation rate or they might have referred to the wrong data. Wrong answers General price level in Japan is generally lower than US from 2009 to 2012 Both US and Japan experienced increase in general price level. Comments You can t tell the absolute general price level from inflation rate trend. You can only tell the CHANGE in general price level over a period. Data given is on inflation rate, that is, CHANGE in general price level. Positive inflation rate should indicate the general price level is increasing, while negative rate indicates that general price level is decreasing. (a)(iii) With reference to Table 2 and Extract 3, explain the change in the general price level in Japan from 2013 to 2014 with the use of an AD/AS diagram. [5] Overall approach: 1. State the change in general price level General price level has increased from 2013 to [1] 2. Explain the reason for the change in GPL using AD/AS analysis with reference to case study material (Table 2 and Extract 3) Japan increased sales tax from 5% to 8%. Hence, firms in Japan will incur higher unit cost of production Leftward shift of SRAS Higher costs passed to consumers through higher prices Statutory-cost push inflation in Japan s economy [2] Diagram [2] 1

2 You are required to state the change in the general price level from 2013 to 2014 but some students did not. Some students merely stated the change in inflation rate but did not further explain the change in general price level. Some students wrongly explained that the increase in sales tax led to a fall in AD. The effect should be a fall in SRAS. The SRAS curve shifts to the leftward and moved along the AD curve. Some students did not give proper labelling. Wrong answers As Japan experiences a fall in retail sales volume due to sales tax hike, there is a fall in consumption expenditure There was an increase in general price level from 2013 to 2014 as shown by rise in inflation rate from 0.35% to 2.76% The implementation of a sales tax would cause an increase in the prices of goods and services available for consumption. With the increase in prices of goods and services, the purchasing power of the Japanese citizens are lowered hence consumption expenditure decreases. Comments Sales tax hike affects unit cost of production in the economy. This reduces SRAS (shifts to the left along AD). It should not be a change in AD Shows wrong interpretation of data. By looking at 2.76% inflation rate in 2014 alone, it would have implied that general price level has increased by 2.76% from 2013 to ) The sales tax should be reflected as a leftward shift of SRAS as it increases the unit cost of production. 2) This leads to an increase in GPL based on AD/AS model and this does not shift the AD but is reflected by a movement along the AD. (b) Japanese retail sales volume fell in April at their fastest pace in three years as sales of cars and electronics declined. (Extract 3) With the aid of a diagram, explain how the increased in sales tax from 5% to 8% would affect the sales volume of cars, and comment on whether the producers or consumers bear a higher burden of the tax. [7] Increase in unit cost of production (1) for car retailers Pivoted leftward shift of SS Fall in Q [1] Diagram [1] State and justify the PED value. [1] Using the PED value stated (PED<PES or PED>PES), explain the burden of the tax on producers and consumers and who bear a higher burden of the tax. [3] 1 mark for showing understanding on relative PED vs PES, 1 mark for explaining the burden in text. 1 mark for referring to tax burden in diagram. 2

3 Some students did not plan before writing the answer and the marker has to read a few times to sieve out the relevant points. The markers for A Level Examination may not be so patient as to read your answer several times. The approach to answer this question is to explain how the increase in sales tax affects market equilibrium quantity, then comment on whether producers or consumers bear a higher burden of the tax by analysing the relative values of IPEDI vs PES. There must be reference made to the diagram drawn when explaining the change in quantity and analysing the burden of the tax. Some students wrote a lengthy answer on whether the demand for cars is price elastic or price inelastic, and explain whether the equilibrium quantity fall more than or less than proportionately. This is not necessary, as long as the supply curve shift leftwards, equilibrium quantity surely fall. The value of the PED should be used to analyse the tax burden, by comparing with the value of PES. Some students did not explain that increased in sales tax increase the unit cost of production for the car retailers or producers. On the other hand, some students did not understand that sales tax is an ad valerom tax hence they did not draw a leftward pivoted shift of the supply curve. Many students were not able to make use of the diagram to analyse the burden of the tax. Some students even thought that burden of the tax refers to the change in total revenue of the producers, which is incorrect! There is some confusion between the concept tax impact vs tax incidence i.e. tax burden. The impact of the tax is that which falls on the person when the tax is first levied (usually the producer). Tax incidence is the division of a tax between the consumers and producers. Tax incidence (burden) can be shifted to the consumers through an increase in selling price. In short, tax impact shows who is to pay the tax initially whereas tax incidence shows who ends up paying the tax ultimately. Some students were able to analyse the burden of the tax but there was no explicit link to the diagram drawn. A few students either drawn a market failure diagram or AD/AS diagram, which is incorrect. This question requires you to draw DD/SS diagram. Students answer Parallel shift of Supply Curve Sales tax will increase cost of production Cars are luxury goods hence PED>1. What s wrong Given that it is an ad valorem tax, the supply curve should shift in a pivotal manner Sales tax will increase unit cost of production. (not penalized but will do so in future) One of the determinants of PED is the degree of necessities ; not the classification of the good (whether it is a luxury good or a necessity). Students need to explain instead that cars have a low degree of necessities because the consumption of cars is non-essential to sustain a basic quality of life (or better still, there are substitutes for cars such as public transport and/or consumers spend a large proportion of their income on cars), hence PED>1. 3

4 (c)(i) Explain a possible reason why deflation is harmful for an economy. [2] Consumers may hold back spending in anticipation of further fall in prices, causing a vicious cycle of falling prices and falling expenditures to become entrenched. [1] Deflation is harmful for an economy when AD falls, leading to falling output and rising unemployment, which is usually accompanied by a recession. [1] Alternative answer Explanation on how labour market rigidity can cause unemployment. Deflation increases wage rigidity in the labour market. Deflation will bring about falling revenues for firms but workers will resist cuts in their nominal wages. As such, unless workers productivity improves to lower unit cost of production, employers will have no choice but to retrench workers since the revenues generated will be insufficient to cover costs and profits will fall. Hence, unemployment increases. Some students wrote a lengthy answer, trying to beat around the bush, but without any explicit link to the harmful effect to an economy Some students did explain possible harmful effects but failed to explain the most important point that AD would fall, leading to falling output and rising unemployment. Students answer Deflation results in lower economic growth as consumers hold off their purchases expecting lower prices later, thus decreasing aggregate demand Deflation occurs when there is excessive decrease in aggregate demand. If AD falls too much, producers would cut back on production and hire less workers this leading to demand-deficient unemployment What s wrong Focus on the anticipation of further fall in prices and complete the analysis on the effect on the economy and not leave it at AD. Deflation does not only occur when there is decrease in demand. It can also occur when there is a rise in SRAS. Also, mild deflation is not harmful. It is only harmful is it leads to a deflationary spiral. (c)(ii) Announcing an end to deflation may help boost private consumption by brightening public sentiment. (Extract 2) Explain how a boost in private consumption can affect the internal macroeconomic goals of the Japan economy, and comment on whether success is guaranteed. [9] Explain how internal macro goals are achieved (5m) Households will be motivated by the positive economic outlook (or the higher confidence level of households) [1m for reason] by increasing spending on goods and services Increase in autonomous C Increase in AD (1) Increase in real national income via multiplier effect Actual growth [1] Explain how this lead to a fall in demand deficient unemployment [1] Explain how this lead to a rise in general price level[1] inflation target of 2% 4

5 Comment whether success is guaranteed (4m) Announcing an end to deflation may help boost private consumption by brightening public sentiment. It would also justify the plan to proceed with a scheduled sales tax hike to 10 percent from 8 percent in 2019, the officials said. The end to deflation would also provide justification for the government to proceed with the scheduled sales tax hike from 8% to 10%. This would raise the prices of goods in Japan leading to higher cost of living. Households would foresee this and choose to save for the future. That is, the current autonomous consumption may not rise thus AD may not increase. The internal goals would not be achieved. [2] On the other hand, households may decide to bring forward their purchase of goods, especially the big ticket items, in view of higher prices in the future. Thus current consumption would rise, leading to increase in AD and the internal goals would be achieved. [2] Max 2m if comment has no reference to case material. Make a stand. Several students did not explain how the announcement can boost private consumption hence increase the AD. They only quoted from the case material that a boost in private consumption increase the AD. The expected reason is the positive outlook/increase in confidence of households. There is also a need to emphasis that the increase in autonomous consumption caused the AD to increase. The explanation on the effect on internal macroeconomic goals ought to be clearer among most students answers. When explaining actual economic growth, there should be explicit elaboration that the increase in AD leads to an increase in real national income via the multiplier effect. When explaining a fall in cyclicial unemployment, there should be explicit elaboration that the firms in the economy employ more factors of production, including labour. When explaining price stability, there should be explicit elaboration that the increase in AD leads to an increase in general price level, achieving a low inflation rate of 2% (as mentioned in case material). Majority of the students did not use the case material to comment whether success is guaranteed. Extract 2 has relevant information that announcing an end to deflation would justify the plan to proceed with a scheduled sales tax hike. Therefore the analysis on how this scheduled sales tax hike might affect AD, hence the internal macroeconomic goals, should be provided when commenting whether success is guaranteed. (d) Using Tables 1 and 2, discuss whether the trends of unemployment rate and size of the labour force would lead you to conclude that the economies of US and Japan have performed better over the period from 2009 to [8] Approach to answer the question: 1. Describe the trends unemployment rate and size of labour force for Japan and US. 2. Use the trends to analyse the economic performance of Japan and US. 3. Use more information from Tables 1 & 2 to conclude whether Japan and US have really performed better. 5

6 1. Describe the trends of unemployment rate and size of labour force for Japan and US The unemployment rates fell from 2009 to 2016 for both US and Japan. During the same period, the size of the labour force increased for US while the size of the labour force decreased for Japan. 2. Use the trends to analyse the economic performance of Japan and US Japan; The size of the labour force has decreased slightly in Japan (0.15%). This suggests that the number of people who retired and left the labour force is more than the number of new people joining the labour force. No. of people who left the labour force > no. of people who enter the labour force Unemployment rate (%) =. x 100 The unemployment rate (%) could have fallen due to the decrease in the no. of unemployed (replace those who left the labour force), and not the increase in the number of jobs created. US The size of the labour force has increased. This suggests that the number of new people joining the labour force is greater than the number of people who retired and left the labour force. No. of people who left the labour force < no. of people who enter the labour force Unemployment rate (%) =. x 100 The rise in the size of the labour force (3.4%) has contributed to the decline in the unemployment rate (5% points). The fact that unemployment rate decreased more significantly than the size of labour force, this suggest that no. of unemployment also declined, suggested that more jobs have been created. Creation of jobs could be due to higher national output compared to the previous years, i.e. economic growth has taken place. The above analysis suggests that the economy of United States of America could have performed better from 2009 to 2016 while the economy of Japan has not. Alternative explanation for Japan Size of labour force in Japan remained roughly the same while unemployment rate has fallen this suggests that there is fuller utilisation of labour more jobs created in Japan Alternative explanation with reference to trends of unemployment rate and size of labour force For US: Fall in unemployment rate in US and Japan Fuller utilization of resources (labour) in the economy Implies that AD is rising over the period from 2009 to 2016 Increase in size of labour force in US Implies that AS is rising over the period from 2009 to 2016, ceteris paribus Therefore, if AD increase in tandem with AS Achieve sustained economic growth Economy performed better 6

7 For Japan: Fall in unemployment rate in Japan Fuller utilization of resources (labour) in the economy Implies that AD is rising over the period from 2009 to 2016 Fall (or remained unchanged) in size of labour force in Japan Implies that AS is falling (or remained unchanged) over the period from 2009 to 2016, ceteris paribus Therefore, if AD increase with no corresponding rise in AS Unable to achieve sustained economic growth Economy performed worse This approach may not be appropriate as it is obvious from the data that Japan has experienced deflation or very low inflation rates over this period. Moreover, there is no explanation whether more jobs are created over the period, which would usually signify whether an economy has performed better. For this approach, cap at L1 max 3m. Use more information from Tables 1 & 2 to conclude whether Japan and US have really performed better (i.e. to widen the scope of analysis to gauge the performance of an economy) However more information is required to conclude if the analysis is valid. The real GDP growth rate for the US shows positive growth rate from 2010 to This further affirms that the economy of United States of America has performed better from 2009 to (can also use real GDP per capita) The real GDP growth rate for Japan shows positive growth rate from 2010 to 2016 except for 2011, where the growth rate was a marginal -0.12%. This suggests that the economy of Japan has performed better from 2009 to 2016.(can also use real GDP per capita) However deflation was observed from and 2016, indicating poor economic performance. Therefore, one cannot definitely conclude that the economy of Japan has performed worse or better by solely based on the trends of the unemployment rate and size of labour force. Level Marking Level 2 (4-6): An answer that uses the trends of unemployment rate and size of the labour force to explain the economic performance of United States of America and Japan appropriately. Level 1 (1-3): An answer that describe the trends of unemployment rate and size of the labour force correctly but unable to provide an appropriate explanation of the economic performance of United States of America and Japan. Evaluation (2): Provides an overall good conclusion on whether the economies of United States of America and Japan have performed better from 2009 to 2016 using relevant data from Tables 1 and 2. Evaluation (1): Attempt to provide a vague or general comment. Issues of underemployment, disguised unemployment or sustainable growth can be discussed (although it is not evident in case study) Max 2m max for EV Majority of the students did not analyse how the trends of unemployment rate and size of labour force might imply whether more jobs are created over the period from 2009 to Instead, many students tend to focus on how falling unemployment rate might suggest more people are employed hence having higher standard of living. Such analysis lacks depth. On 7

8 the other hand, it is encouraging to note that some students were able to link the analysis to jobs creation. Many students did not make use of other relevant data from Tables 1 and 2 to evaluate whether US and Japan have indeed performed better. Some students did mention that information on real GDP or real GDP growth rate is required to have a better assessment of the performance of the two economies but they were not aware that such information is already given in the tables. Some students did not explain the trends of unemployment rate and size of labour force, which is part of the question requirement. Some students tried to compare the performance of US with Japan but this is not required. The answer only requires a discussion on whether economies of US and Japan have performed better. Students answer Lower unemployment rate means that more people will have income. With higher income, these people can consume more goods and services hence output increases. Hence, we can conclude that the economy is better What s wrong This way to explaining is not right. We have gone through this before in TA3. What it needed is to explain that producers only employ more factors of production only when they have output to produce or they are anticipating higher demand for their goods and services. Lower unemployment itself reflects a better economy as more factors of production are utilized to produce goods and services. (e) With reference to Extracts 1 and 2, US has raised interest rates gradually while Japan had a massive cut in interest rates recently. Using evidence from the case study and/or your own knowledge, discuss why the interest rates approach is different for US and Japan. [12] Approach to answer the question: 1. Analyse the current situation of each country using relevant information from the case material. 2. Explain the likely concern faced by each country and what interest rate approach to use. 3. Explain how the interest rate approach works to address the concern for each country. 4. Evaluate on the interest rate approach of each country. Analysis for US: Unemployment Rate has fallen, Inflation rate is positive, Real GDP growth rate positive, Real GDP per capita rising, Size of labour force rising (more people joining the labour force to look for jobs), Positive outlook (even Federal Reserve Chair is optimistic about the economic outlook) These statistics indicate that the economy is expanding Increase in AD PLUS govt has plans to cut tax Further increase C & I and hence AD The concern is that the economy would be overheated Lack of excess capacity in the economy AD increase very near to or along the vertical part of the AS High inflation rate. Although size of labour force is rising, it is likely that the increase in AD is greater than the increase in AS. Moreover interest rate in US has been low since the financial crisis (that occurred in 2008/09, the year need not be included in the answer) (Extract 1). This further explains that the increase in AD is likely to exceed AS. 8

9 Thus the approach is to raise interest rates Raise the cost of borrowing Fall in autonomous C and I Fall in AD Moderate the rise in general price level hence inflation rate However the rise in interest rates would be gradual as the inflation rate is still below the target of 2%. Analysis for Japan: Unemployment Rate has fallen, Real GDP growth rate mainly positive, Real GDP per capita rising BUT deflation is still a concern as shown in 2016 (-0.12%) and Size of labour force is falling. Without an increase in size of labour force, firms are expected to face labour shortage problem and rising wages AND firms would expect a smaller size of the consumer market since many unemployed households would have no purchasing power to buy goods and services Expected profits will be reduced Fall in I Less people joining the labour force Indicating negative outlook in general as the prospects of finding a well-paid job could be very low Households are expected to save than to spend Fall in autonomous C Sales tax expected to rise Households are likely to decrease the consumption of consumer durables, as happened in 2014 when sales tax increased from 5% to 8% (Extract 3) Firms expect a fall in total revenue, hence profits assuming c.p. Firms cut investment Above analysis mean that AD would fall by a large extent Fall in real national output and general price level Deflation would further lead to a fall in AD Thus the approach is to cut interest rates Lower the cost of borrowing To increase autonomous C and I Increase in AD Rise in general price level to achieve inflation Indicating a rise in expected profits for firms and encourages households to increase current consumption AD further increase to achieve economic growth (For info only: Japan has actually implemented negative interest rate policy.) However the cut in interest rates would be a lot, instead of gradual cut, (massive cut, Extract 2) to ensure that the inflation rate reaches the target of 2%. Conclusion: Interest rate approach depends on government s objective, taking into consideration of the economic outlook. In US case, there is positive outlook with encouraging statistics, but it has yet to hit 2% inflation rate gradual rise in interest rate In Japan case, economic outlook is still rather bleak and far from 2% target inflation rate (inflation rate mostly negative or near to 0% from ) massive cut in interest rate. Moreover Japan, being an Asian economy, has a culture that inclines towards saving hence the households are generally thrifty and in times of poor economic outlook, the households would save even more. Therefore a massive cut in interest rates is required to achieve to boost spending. The discussion above hence explains why the interest rates approach is different in US and Japan US raise interest rates while Japan lowers interest rates. 9

10 Level Marking Level 3 (6-9): An answer that explains the rationale of a cut in interest rate for the United States of America and the rationale of a rise in interest rate for Japan with reference to case material. Level 2 (3-5): An answer that explains EITHER the rationale of a cut in interest rate for the United States of America OR the rationale of a rise in interest rate for Japan with reference to case material. OR An answer that explains the rationale of a cut in interest rate for the United States of America and the rationale of a rise in interest rate for Japan BUT the explanation is not well explained or there is lack of reference to case material. Level 1 (1-2): A vague, descriptive answer OR an answer that shows a lot of conceptual errors. Evaluation (2-3): Provided comment that there might be overheating in USA but inflation rate may still be below 2% hence rise in interest rates would be gradual. Provided comment that deflation is likely a problem in Japan hence cut in interest rates would be a lot. (i.e. justify the extent of change in interest rate) Evaluation (1): Attempt to provide a vague or general comment. Majority of the students did not provide a good structure to answer this question. They tend to explain how increase or fall in interest rates affect consumption and investment, hence AD for US and Japan. This is followed by an explanation of why the interest rate approach is different for the two countries, usually as a conclusion. There is no attempt or very little analysis of the current economic situation of both countries and the likely concern faced by US and Japan. Most students are stuck in the Level 2 mark range due to a lack of depth and scope in the discussion. Insufficient case material was used to support their explanation. Although the question allows you to use your own knowledge, you should use case material as evidence to provide the discussion first before you add in your own knowledge. If there is really no relevant case material that you can find, then you can use your entire own knowledge to provide the discussion. For this question, information from the extracts or tables can be used in the discussion hence you are expected to use them in the discussion. Failing to do so will lower the quality of your discussion. Many students explained that the US is concerned with demand-pull inflation hence the Fed raised the interest rates. This shows a lack of understanding of the case material. When the US economy is expanding, there will be a rise in general price level i.e. demand-pull inflation. The concern is whether this inflation is likely to be high or not i.e. overheating. Many students found it difficult to explain why the US was raising interest rates while its inflation rate target was not met. One wrong approach was to explain that the earlier ultra-low interest rate policy led to overheating. This is not substantiated by the evidence from the case. Many students did not provide the detailed elaboration of how interest rates affect consumption and investment, hence AD. The same observation is seen when students explained how tax affect AD. Some students drew diagram but it is not used in the analysis. This is a reminder that diagram when drawn, should be used explicitly in your analysis. [Total = 45 marks] 10