Economics

The Economy
Student Activities
(Higher)

5625

August 1999

HIGHER STILL

Economics
The Economy
Student Activities
Higher

Support Materials

HIGHER ECONOMICS: STUDENT ACTIVITIES: THE ECONOMY

Introduction
This pack contains classroom and homework activities to support the learning and
teaching process for Economics at Higher level. It covers those parts of the course
content listed under the heading of The Economy (H) and the material associated with
the unit specification, The Economy (H). It does not include the student activities
pack for Outcome 5 of the Economy unit Explain the international economic
environment which are to be issued as a separate pack containing core notes and
activities.
This pack is divided into three sections:
Section 1 Student exercises
Section 2 Objective test items
Section 3 Extended response items
This pack complements other materials available to support Economics at a Higher
level such as the course planner, the expanded syllabus, the induction pack and the
student activities for Microeconomics (H).
Using this pack
Teachers and lecturers will have their own preferred ways of using the material in this
pack. Each of three sections, however, has a slightly different purpose.
Section 1 Student exercises
These are intended to complement the delivery of the course concepts. They are
exercises which can be done in class or as homework to introduce relevant
knowledge, to reinforce new knowledge and understanding or to extend existing
knowledge and understanding. While their primary use is likely to be during the
actual delivery of course material, they can be used for revision purposes.
Section 2 Objective test items
These are primarily intended for consolidation and revision purposes. Thus, their
most likely use is towards the end of a particular topic where they can be used as a
classroom exercise or as homework. Students could be asked to attempt them
individually (or in pairs or small groups) and the responses discussed among the
whole class. Because they help students consolidate ideas and reinforce knowledge
and understanding, these questions can also serve as preparation for internal
assessment.
Section 3 Extended response items
These are integrative essay questions which tend to range over the whole content of
this part of the course. Generally, each question covers several parts of the course
content in this area of the course. As a result, they are particularly suited to helping
students prepare for the external assessment. While this is their primary purpose, they
can also be used in a similar way to the multiple choice questions as a way of
reinforcing and consolidating previous learning. They are more likely to be used as
homework exercises than classroom activities, although the answers may well be
discussed in class.
Economics: The Economy Student Activities (Higher)

Teachers and lecturers may find it helpful to refer to the course planner when deciding
exactly how to integrate these various activities into their learning and teaching
programme.
Layout of the activities
In general, the activities have been organised in a way that matches the order of the
course content as set out in the Arrangements document for Economics at Higher
level. This coincides with that used in the course planner, the expanded syllabus and
the induction pack.
However, the nature of the subject matter is such that it is not always possible, nor is
it always desirable, to keep a direct link with the order of the course content. This is
because there are many overlaps between different parts of the course. In addition,
the layout of the activities reflects the fact that integration of subject matter is a
guiding principle behind the development of the course.
The three sections of this pack have been organised in slightly different ways.
The student exercises in Section 1 have been split into a number of separate sections
which broadly follow the order of the course content. A cross-referencing grid which
relates the sections to the course content follows this introduction and should help
teachers and lecturers identify which sections are appropriate for which parts of the
course content. In this way, it should be possible for teachers and lecturers to
integrate the exercises into their preferred order of delivering the material, although it
may be necessary to adapt each section accordingly e.g. by missing some exercises
out; using some exercises from later sections at an earlier stage, etc.
To a degree also the layout of the sections reflects a particular teaching order,
however, there is no implication that this order should be followed. Teachers and
lecturers should feel free to determine their own delivery sequence in line with the
requirements of their students and their own personal preferences.
The multiple choice questions in Section 2 are grouped into clusters also but they are
broader than those used in Section 1. This is to enable students to consolidate or
reinforce significant topic areas.
The integrative extended responses questions in Section 3 are subdivided into 3 broad
areas. Because they are integrative, they cover all aspects of the relevant course
content so classification into sub-sections is not appropriate. Teachers and lecturers
will need to check through the list and decided which ones are most suitable for their
purpose e.g. in which areas do students require essay writing practice prior to the
external assessment.

Economics: The Economy Student Activities (Higher)

Suggested Solutions
Suggested solutions are provided for all the exercise and questions in this pack. For
section 2, the multiple choice questions, a single correct answer is possible. For all
other exercise and questions, this is not always the case and a number of possible
responses can often be made. The solutions given thus represent some of the possible
answers which could be acceptable. When using the exercises and questions, some
discretion should be used when judging responses. Students should be given credit
for responses which are an acceptable answer to the exercise or questions but which
do not appear in the Suggested solutions.
Please note that students only require knowledge of economic events for the 10 years
prior to the date of the external assessment. Therefore, it is important that teachers
and lecturers take account of contemporary economic issues and policies by regularly
updating the answers to this pack which deal with knowledge of actual
macroeconomic events over the last ten years.

Economics: The Economy Student Activities (Higher)

Economics: The Economy Student Activities (Higher)

CONTENTS
Section 1 Student exercises
Exercise
National Income
A1
A2
A3
A4
A5
A6
A7
A8

Details of activity/exercise
Circular flow of income
Circular flow of income
National Income statistics
Economic activity
Economic growth
Uses of National Income statistics
Equilibrium National Income
The Multiplier

International Trade and Payments

B1
International Trade
B2
Absolute and comparative advantage
B3
Exchange rates (1)
B4
Exchange rates (2)
B5
Exchange rates (3)
B6
Exchange rates (4)
B7
The Sterling Index
B8
The Balance of Payments (1)
B9
Components of the Balance of Payments
B10
Managed Exchange Rate systems
B11
The Balance of Payments (2)
B12
The Asian Crisis
B13
The Balance of Payments (3)
Macroeconomics Issues and Policies
C1
The quantity theory
C2
Demand-pull inflation
C3
Problems caused by inflation
C4
Anti-inflationary policies
C5
Inflation and the Euro
C6
Monetary policy and inflation
C7
Unemployment
C8
Employment
C9
Unemployment statistics
C10
Patterns of unemployment
C11
Unemployment policies (1)
C12
Unemployment policies (2)
C13
Economic Growth (1)
C14
Economic Growth (2)
C15
Economic Growth (3)
C16
Inward Investment
C17
Taxation
C18
The Public Sector Borrowing Requirement (1)
C19
The Public Sector Borrowing Requirement (2)
Economics: The Economy Student Activities (Higher)

Section 2 Objective Test Items

A
B
C

National Income
International Trade and Payments
Macroeconomic Issues and Policies

Section 3 Extended Response Items

A
B
C

National Income
International Trade and Payments
Macroeconomic Issues and Policies

Economics: The Economy Student Activities (Higher)

THE ECONOMY
SECTION 1 STUDENT EXERCISES

A
B
C

National Income
International Trade and Payments
Macroeconomic Issues and Policies

Economics: The Economy Student Activities (Higher)

Economics: The Economy Student Activities (Higher)

THE ECONOMY
A1 CIRCULAR FLOW OF INCOME (1)

(a) Explain the difference between microeconomics and macroeconomics.

(b) In the above model, households supply the factors of production to firms.
(i)

Which factors of production do they supply to firms?

(ii)

What do households receive in return for the factors of production they

supply?

(c) (i)
(ii)

Explain the difference between real flows and money flows.

In the above model, which items are real flows and which are money flows?

Economics: The Economy Student Activities (Higher)

THE ECONOMY
A1 CIRCULAR FLOW OF INCOME (1) SUGGESTED SOLUTION

(a)

Microeconomics deals with the economic behaviour of individuals or groups

within society. Macroeconomics deals with the economy as a whole.

(b)

(i) Land, labour, capital and enterprise.

(ii) Rent, wages, interest and profit.

(c)

(i) Real flows are the flows of products and factor services whereas money
flows are the monetary value of the products and factor services.
(ii) Real land, labour, capital, goods and services
Money rent, wages, interest and profit, spending on goods and services

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THE ECONOMY
A2 CIRCULAR FLOW OF INCOME (2)

The circular flow of income shows how income circulates in an economy.

Theoretically, the circular flow of income could go on at the same value indefinitely
because nothing is being added or taken away from the system. However, realistically
this does not happen because all economies will have injections and leakages.

(a) Explain, using a diagram, what is meant by the circular flow of income
(b) (i)

Describe the different injections into, and leakages from, the circular flow.

(ii)

What will happen to the value of income in the circular flow if injections
are greater than leakages.

(iii)

What will happen to the value of income in the circular flow is leakages
are greater than injections.

(c) When will the level of National Income be in equilibrium?

(d) Explain what will happen to the equilibrium level of National Income if there is an
increase in an injection.

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THE ECONOMY
A2 CIRCULAR FLOW OF INCOME (2) SUGGESTED SOLUTIONS

(a) Students should draw diagram, correctly labelled and explained.

(b) (i)

Injections any expenditure on UK goods and services other than

consumer expenditure. Student should describe injections into the circular
flow (i.e. Government spending, investment and exports).
Leakages any income generated in producing national output which is
not passed on within the system. Students should describe leakages from
the circular flow (i.e. savings, taxes and imports).

(ii)

Injections greater than leakages value of income in the circular flow will
rise.

(iii)

Leakages greater than injections value of income in the circular flow will
fall.

(c) This is when the flow of money round the circular flow of income is constant
(there will be no tendency to change within the system). This will occur when
total injections and total leakages are equal.
(d) Any increase in an injection will cause the amount of money entering the circular
flow to increase. The equilibrium level of National Income would therefore rise.
The extent of the rise depends on the value of the multiplier.

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THE ECONOMY
A3 NATIONAL INCOME STATISTICS

The amount of money flowing round the circular flow of income gives a value to the
level of economic activity within a country i.e. the value of national income. This
value can be measured in 3 different ways.

(a) Describe the 3 different methods by which the value of national income can be
measured.
(b) Describe the relationship between 3 different methods of valuing national income.
(c) What difficulties arise when calculating a countrys national income?

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THE ECONOMY
A3 NATIONAL INCOME STATISTICS SUGGESTED SOLUTIONS

(a) Value of:

National expenditure i.e. spending by households, producers and government
(C + I + G) on the good and services produced by firms expenditure method;
National output i.e. the value of the goods and services produced by firms (private
and public sector) output method.
National income i.e. the income earned by all owners of factors of production
income method.
(b) Three ways of measuring the same thing. End value is equal because the different
methods of measurement are defined in such a way as to be identical i.e. output
expenditure income.
(c) The difficulties of measuring national income include:
Statistical inaccuracy, shadow (black) economy, double counting, paid/unpaid
production e.g. DIY, valuation of output of the public sector, etc.

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THE ECONOMY
A4 ECONOMIC ACTIVITY

Investment is considered to be one of the main causes of economic growth. It affects

the level of economic activity from both the demand and supply sides.
On the demand side, an increase in investment will, in the short term, cause an
increase in aggregate monetary demand and cause a multiple rise in national
income. In the long term it will increase the productive potential of the economy.

(a) Explain what is meant by the following:

(i) economic growth;
(ii) economic activity.
(b) (i)
(ii)

Explain what is meant by the term aggregate monetary demand.

What are the components of aggregate demand?

(iii) Explain how an increase in investment will in the short term, cause an
increase in aggregate monetary demand and cause a multiple rise in national
income.
(c) (i)
(ii)

Explain what is meant by the term productive potential.

Explain how an increase in investment will increase the long term
productive potential of the economy.

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THE ECONOMY
A4 ECONOMIC ACTIVITY SUGGESTED SOLUTION

(a) (i)
(ii)
(b) (i)
(ii)

An increase in the productive potential in an economy (usually measured in

terms of a real increase in GDP).
The production of goods and services.
Total level of demand/expenditure in the economy.
Consumption, Investment, Government Spending, (Exports-Imports) i.e.
C+I+G+X-M

(iii) Leads to an increase in income and output, these increases cause an increase
in aggregate demand, however this causes a greater change in income than
the original increase in investment because, when those who receive an
income rise spend it, this spending creates a rise in income for other people.
(c) (i)
(ii)

The maximum amount that an economy can produce with existing resources.
Investment is the addition to the capital stock used to produce goods and
services (physical capital) or investment in human capital (education and
training etc). Both of which are causes of economic growth and therefore
increase the productive potential in an economy. NB: Investment should be
targeted at growth areas for a long term increase in productive potential to
take place.

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THE ECONOMY
A5 ECONOMIC GROWTH

UK Real Gross Domestic Product (GDP) Growth

(Annual percentage change)

(Years)

(a) Explain what is meant by real GDP growth.

(b) What happened to real GDP between 1988 and 1989.
(c) Account for the trend in real GDP growth as shown in the above graph.
(d) What are the main costs and benefits to an economy of a sustained high level of
real GDP growth?
(e) How might a country with a very low level of real GDP growth try to improve its
growth rate in the future?

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THE ECONOMY
A5 ECONOMIC GROWTH SUGGESTED SOLUTION

(a) An increase in the value of output produced after adjustment for changes in the
level of prices.
(b) It has increased, but at a decreasing rate.
(c) 87-88 high growth rates (5.9% in 88), then fell rapidly to 2% in 91. Increased
between 91 to 4.5% in 94. Fell between 94 and 96, then increased in 97.
Reasons:
87/88 high growth consumer boom (tax cutting budgets, depreciating currency,
low interest rates, growth of consumer credit) leading to
excess demand in the economy/economy overheating.
89-91 large increases in interest rates to dampen the economy as well as world
recession and strong pound leading to fall in aggregate demand (both in domestic
and foreign markets), unemployment, lack of investment.
92-94 increase in consumer spending as country comes out of recession
(reduced interest rates) as well as export-led growth, capital investment,
government spending.
95-96 slow down in consumer spending, loss of momentum in export markets.
97 return of consumer confidence increasing consumption, investment spending
picking up, increase in exports.
(d) Costs include:
Overheating of the economy, inflation, excessive wage demands, skills shortages,
can lead to lack of competitiveness in export markets, therefore increased
unemployment.
Benefits include:
Full use of resources, low unemployment, increase in standard of living, reduction
in PSBR (increased tax revenue/lower benefit payments), easier to redistribute
income.
(e) An increase in quality or quantity of any factor of production. For example:
Land discovery of new resources e.g. oil, improving existing resources;
Labour increasing the number of workers, improving the productivity of
workers (education and training) and the flexibility of the labour force;
Capital increasing the capital stock, sustained investment;
Technical Progress/innovation.

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THE ECONOMY
A6 USES OF NATIONAL INCOME STATISTICS

National income statistics are used to measure a countrys economic growth in a

particular year. Any increase in the value of national income is taken to mean that
living standards in a country have risen. The statistics are used by governments when
planning their budgets, to make comparisons with the rate of growth in the past and to
make comparison with other countries growth rates.
Although it is generally accepted that national income accounts do have their uses,
difficulties arise when calculating a countrys national income which mean that the
uses of the accounts have certain limitations.

(a) (i) Explain what is meant by the term national income.

(ii) Explain why national income statistics might be of use to a government when
planning its Budget.
(b) Explain the difficulties which arise in the calculation of a countrys national
income.
(c) What problems arise when using national income accounts to:
(i) compare the standard of living within a country in different years;
(ii) compare the standards of living in different countries.

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THE ECONOMY
A6 USES OF NATIONAL INCOME STATISTICS SUGGESTED
SOLUTIONS

(a) (i)
(ii)

The total money value of the income arising from a countrys economic
activity (production of goods and services) over a period of time.
Governments use national income statistics to forecast changes in the
economy and this information is used to direct the economy. For example
government may use this information from national income statistics to aid
decision making regarding taxes and government spending in the Budget.

(b)

Explanation of:
Double counting (e.g. transfer payments), home produced goods/services,
paid/unpaid production e.g. DIY, valuation of public sector output, statistical
inaccuracies, black (shadow) economy.

(c) (i)

Students should be aware that an increase in national income implies an

increase in standard of living, however the following present problems
when making comparisons over several years.
Inflation, population, unequal distribution of income, negative externalities,
non consumer items, quality of goods and services, decreases in leisure
time, worsening of work conditions, defence and related expenditure.

(ii)

Problems of using national income accounts to compare standards of living

between countries:
Exchange rates, statistical procedures, accuracy and presentation of
statistics, extent of shadow (black) economy, variable distribution of income,
proportion of GNP spent on defence.

Economics: The Economy Student Activities (Higher)

20

THE ECONOMY
A7 EQUILIBRIUM NATIONAL INCOME

(a) What does the 45 line represent?

(b) When National Income is OX what does AB represent?
(c) When National Income is OZ what does LM represent?
(d) Explain why National Income level OY is the equilibrium level of National
Income.

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THE ECONOMY
A7 EQUILIBRIUM NATIONAL INCOME SUGGESTED SOLUTIONS

(a) Line which indicates points where all income is spent.

(b) Consumption is greater than income i.e. dissaving.
(c) Income is greater than consumption i.e. saving.
(d) Expenditure equals income, leakages equal injections = 0.

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THE ECONOMY
A8 THE MULTIPLIER

In the short run Aggregate Monetary Demand (AMD)

is the main determinant of national output

Consumption, a component of AMD accounts for

the major part of expenditure in the UK
(more than 75% of Gross National Product)
Income, is the major determinant of consumption
and the relationship between income and consumption
is know as the propensity to consume

(a)

Other than consumption, what are the components of AMD?

(b)

Explain what is meant by Gross National Product.

(c)

Explain what is meant by:

(i)
(ii)
(iii)
(iv)

Average Propensity to Consume (APC);

Marginal Propensity to Consume (MPC);
Average Propensity to Save (APS);
Marginal Propensity to Save (MPS).

(d)

Using a numerical example, explain the relationship between the MPC and
MPS.

(e)

Explain what is meant by the multiplier.

(f)

Assume that in a simple, two sector closed economy the National Income is
2,000m and the MPC is 0.75. Calculate the effect on National Income of an
increase in investment of:
(i) 50m;
(ii) 200m.

(g)

In a simple, two sector, closed economy an increase in investment of

7m leads to National Income increasing from 1,000m to 1,035m. Calculate
the MPC.

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THE ECONOMY
A8 THE MULTIPLIER SUGGESTED SOLUTIONS

(a) Investment, government expenditure, exports and imports.

(b) GNP value of output produced by all UK factors of production at home and
abroad over a period of time (usually a year).
(c) (i)
(ii)

The proportion of any income which is spent on consumption.

The proportion of any small increase in income which is spent on
consumption.

(iii) The proportion of any income which is saved.

(iv)The proportion of any small increase in income which is saved.
(d) MPC + MPS = 1 (student should use numerical example to explain)
(e) The extent to which income increases due to an increase in investment (or any
other injection). The size of the multiplier depends on how much or how little of
the increase in expenditure leaks from the circular flow. The value of the simple
multiplier can be calculated as follows:
1
1
Multiplier = MPS or
Multiplier = 1-MPC
(f) (i)

Multiplier = 4. Therefore initial increase of 50m would cause an increase in

income of 200m. National income would increase to 2,200m.

(ii)

Multiplier = 4. Therefore initial increase of 200m would cause an increase

in income of 800m. National Income would increase to 2,800m.

(g) Increase in National Income of 35m. Initial investment of 7m has caused

national income to increase 5 times i.e. value of multiplier = 5.
Therefore 5 = 1/1- MPC, so value of MPC = 0.8.

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THE ECONOMY
B1 INTERNATIONAL TRADE

The benefits of international free trade for countries and consumers do not arise
because different countries are absolutely more efficient at producing certain goods,
i.e. they have an absolute advantage, but because they are relatively more efficient i.e.
they have a comparative advantage in the production of certain goods. These benefits
may, however, be short lived if countries try to protect themselves from foreign
competition by using trade restrictions, as these have effects not only on a countrys
volume of trade but also on consumers within that country, exchange rates and gross
national product.
(a)

Explain what is meant by:

(i)
international free trade;
(ii)
exchange rates;
(iii)
gross national product.

(b)

Explain the difference between comparative and absolute advantage.

(c)

(i) Explain how countries may benefit if they specialise and trade.
(ii) What disadvantages may arise if a country only specialises in the
production of one or two goods.

(d)

What advantages are there for consumers within a country if free international
trade takes place?

(e)

Explain how and why countries may wish to restrict trade. (Examples of reallife situations may be used in your answer).

(f)

Explain why a country is limited in its ability to use trade restraints?

(g)

If the UK uses trade restraints, discuss the effects this will have on the:
(i)
UK volume of trade;
(ii)
UK consumers;
(iii)
UK exchange rates;
(iv)
UK Gross National Product.

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THE ECONOMY
B1 INTERNATIONAL TRADE SUGGESTED SOLUTION

(a) (i)

The exchange of goods and services between countries with no government

intervention. Where trade takes place according to the theory of
comparative advantage.

(ii)

The price of one currency in terms of other currencies, for example sterling
in terms of dollars, francs, etc. Exchange rates are regularly quoted
between all major currencies.

(iii)

The measure of the money value of goods and services available to a

country from economic activity over a period of time.

(b) Absolute advantage when one country (A) is absolutely more efficient than
another country (B) in the production of a certain good or service (i.e. when using
the same amount of resources, it can produce more of a good or service than
another country).
Comparative advantage where one country specialises in the production of goods
in which it is relatively more efficient at producing compared with another
country (i.e. specialises in goods which have the lowest opportunity cost
compared to another country). Students could use a numerical example to
explain the above concept.
(c) (i)

(ii)

Benefits of specialisation and division of labour for domestic producers e.g.

economies of scale, strengthening of political relations, increased output
reduction in unemployment and increased economic growth, trade with
other countries may lead to the spread of technology.
If demand for their particular product falls, then there are serious
consequences for the economy in question, for example, increased
unemployment in exporting industries, fall in economic growth, balance of
payments deficits, pressure on government finances, etc.

(d) Greater variety of goods for consumers, opportunity to obtain goods which a
country cannot produce itself, consumers welfare may increase as a result of
lower prices.
(e) How tariff, quota, exchange controls, embargoes, administrative restrictions,
health and safety restrictions, voluntary export agreements, non competitive
purchasing by governments, imposing safety standards.
Why protect infant industry, job protection, prevent dumping, raise revenue,
avoid overspecialisation, correct balance of payments deficit, protect strategic
industries, preserve a particular way of life, protection from unfair foreign
competition, dangerous products, etc.

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THE ECONOMY
B1 INTERNATIONAL TRADE SUGGESTED SOLUTION

(f)

Other countries may retaliate, membership of various bodies e.g. GATT, EU

(g)

No correct answer for (g) (i)-(iv) depends on arguments student puts forward.
Students should be aware that the economy is affected in different ways.
Although some answers are outlined below, students could put forward other
arguments which are equally correct.

(i)

For example trade restrictions should lead to a decrease in the volume of

imports, hence an improvement in the balance of trade. However, if other
countries retaliate exports could also decrease therefore cannot say what may
happen to balance of trade.

(ii)

For example less variety of goods/services, increased price of imports,

possible unemployment in export industries, could boost UK import competing
industries.

(iii)

For example depends on balance of trade, if this improves exchange

rate of Sterling will rise.

(iv) Whether GNP increases or decreases depends on how exporting/domestic

industries are affected by restraints and how consumers react to higher prices of
imports (UK has a high propensity to import). For example if domestic import
competing industries are boosted, then GNP will increase.

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THE ECONOMY
B2 ABSOLUTE AND COMPARATIVE ADVANTAGE

1. Two countries with identical resources divide their factors of production equally to
produce the present output as follows:
Saltland
Pepperland

Walking boots (pairs)

1,500
600

Pot plants (units)

9,000
18,000

(a) Which product is Saltland more efficient at making?

(b) Which product is Pepperland more efficient at making?
(c) If each country specialises in the good it is most efficient at making, what will be
the new total world output of:
(i) Walking boots;
(ii) Pot plants.
(d) What happens to total output after specialisation?
(e) Explain why countries may specialise in the production of particular goods.
2. Output per unit resource:
Holland
Italy

Cheese (kgs)
360
300

Personal CD players (units)

240
200

(a) Which country has an absolute advantage in the production of:

(i) Cheese;
(ii) Personal CD players?
(b) Which country has a comparative advantage in the production of:
(i) Cheese;
(ii) Personal CD players?
(c) Will there be any gain if each country specialises and trades? Explain your
answer.

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THE ECONOMY
B2 ABSOLUTE AND COMPARATIVE ADVANTAGE

3. (a) What goods does the UK specialise in?

(b) Why does the UK specialise in the production of these particular goods?
(c) Think of 2 countries which specialise in the production of particular goods.
Explain why they specialise in these goods.

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THE ECONOMY
B2 ABSOLUTE AND COMPARATIVE ADVANTAGE SUGGESTED
SOLUTION

1. (a) Walking boots

(b) Pot plants
(c) (i) 3,000
(ii) 36,000
(d) It has increased
(e) Climate, natural resources, particular skills, etc. (Students should use examples
in explanation).
2

2. (a)
(i) Holland
(ii) Holland
(b) (i) Neither
(ii) Neither
(c) No no country has any comparative advantage in the production of either
good (opportunity cost is identical), therefore no country is relatively better at
producing either good than the other. This means that there would be no
benefit in either country specialising in the production of one of the goods.

3. (a) Students should give their own examples. Financial services, whisky
(Scotland).
(b) Comparative advantage in financial services, expertise in the City of London.
4
5

(c) Students own examples and explanation of these. For example Japan
specialises in electronic goods expertise, particular skills.

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THE ECONOMY
B3 EXCHANGE RATES (1)

Some countries argue for a floating exchange rate, that is, that the UKs Foreign
Exchange Market (FOREX) should be allowed to operate like any other market in
that the forces of supply and demand should operate to bring about equilibrium. This
equilibrium will, therefore, reflect the strength of Sterling.
Opponents of this approach suggest that leaving the FOREX to the forces of supply
and demand will produce great fluctuations in the value of Sterling. They believe its
value should be fixed, either by government intervention or by the establishment of an
international system of fixed exchange rates.

(a) Explain what is meant by the following terms:

(i) Foreign Exchange Market;
(ii) Fixed exchange rates.
(b) What factors could affect:
(i) the demand for Sterling on the FOREX;
(ii) the supply of Sterling on the FOREX?
(c) Why might great fluctuations in the value of Sterling occur if the FOREX is left
to the forces of supply and demand?
(d) (i) Explain using a diagram, how Sterling can become stronger.
(ii) Explain the advantages and disadvantages for the UK economy of Sterling
becoming stronger.
(e) What are the advantages of a freely floating exchange rate?
(f) (i) What are the advantages of a fixed exchange rate?
(ii) How can government intervene to fix the exchange rate of a currency?

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THE ECONOMY
B3 EXCHANGE RATES (1) SUGGESTED SOLUTION

(a) (i) Market where foreign currencies are bought and sold.
(ii) An exchange rate system where a currencys value if fixed in terms of others
and does not fluctuate. For example, if Sterlings exchange rate with the dollar
is fixed at 1 = $1.80 it will remain at this rate and will not change.
(b) (i) Foreign demand for UK goods and services, foreign tourists, foreign investors,
speculators wishing to take advantage of a future rise in the value of the ,
government wishing to add s to their reserves to increase the value of the ,
foreign governments wanting to lower the value of their currencies.
(ii) UK demand for imported goods and services, UK resident wanting to invest
abroad, speculators, government wanting to replace reserves of s with other
assets or lower the value of the , foreign governments wishing to raise the
value of their currencies.
(c) Demand and supply conditions are affected by many different variables i.e.
demand and supply factors mentioned above. These variables change daily and
the extent to which they change determines by how much Sterling will rise or fall,
therefore there could be great fluctuations in sterlings value.
(d) (i) Any factor which increases demand for Sterling, or decreases supply of
Sterling will cause sterling to become stronger against other currencies. For
example the price of Sterling in terms of dollars.

(ii) Demand could increase to D2, supply could decrease to S2, or there could be a
combination of both factors which could cause an increase in the price of
Sterling.
Advantages cheaper imports (especially raw materials), other importers will
get cheaper supplies e.g. electrical goods and may boost sales in the UK, helps
inflation and increases competitiveness in export markets.

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THE ECONOMY
B3 EXCHANGE RATES (1) SUGGESTED SOLUTION

Disadvantages export problems especially in manufactures where fierce

international competition exists, reduction in foreign tourists, possible
recession, increase in imports and reduction in exports balance of payments
problems.
(e)

Forces of demand/supply determine the value of a currency, therefore this

reflects the true value of the currency. The rate of exchange will vary quickly
to bring demand and supply into equilibrium therefore the system is selfregulating. Also, there is no need for the government to hold large reserves of
gold or foreign currency. Since the balance of payments ceases to be a
problem, government can concentrate its efforts on other problems (for
example, floating exchange rates make monetary policy more effective).

(f) (i) Promotes international trade if currency fluctuations do not exist businesses
know exactly how much they will receive for their products, consumers will
not be affected by fluctuations in the prices of imported commodities.
(ii) Buy/sell currencies, raise or lower interest rates, deflate demand for imports.

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THE ECONOMY
B4 EXCHANGE RATES (2)

The Market for Sterling

(a) If the UK government wanted the exchange rate to be 1 = $2, how could this be
achieved?
(b) Explain the advantages and disadvantages to a country of having a freeely floating
exchange rate.

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THE ECONOMY,
B4 EXCHANGE RATES (2) SUGGESTED SOLUTION

(a) Interest rate manipulation, market intervention, for example, Bank of England
buys sterling and sells foreign currency reserves, various measures which deflates
demand for imports or increases demand of exports.
(b) Advantages forces of demand/supply determine the value of a currency,
therefore this reflects the true value of the currency. The rate of exchange will
vary quickly to bring demand and supply into equilibrium, therefore, the system is
self-regulating. Also, there is no need for the government to hold large reserves of
gold or foreign currency. Since the balance of payments ceases to be a problem,
government can concentrate its efforts on other problems (for example, floating
exchange rates make monetary policy more effective).
Disadvantages currency fluctuations, uncertainty for international business,
possibility of protectionist measures if exchange rates continuously rise or fall.
Effects on employment/economic growth, effects on individual consumers
especially when firms pass unexpected costs on to the customer (e.g. surcharges
which travel firms pass on when changes in the exchange rate put up their
overseas costs). The effects on other countries, for example, if the balance of
payments in one country is brought into equilibrium by reducing the level of
imports from another country, then the other country suffers
unemployment/inflation.

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THE ECONOMY
B5 EXCHANGE RATES (3)

If a currency is allowed to fluctuate freely on the Foreign Exchange Market, then its
exchange value is determined by the forces of supply and demand alone.
1. Explain, using diagrams, how each of the following might affect the value of
sterling:
(a) an increase in the cost of an imported raw material;
(b) an increase in the sales of UK manufactured computers to Germany;
6
7

(c) the quantity of UK goods demanded by Asian countries decrease due to the
financial crisis in Asia;

(d) an increase in the deficit on the UK Balance of Trade in Goods;

(e) the Bank of England have raised their interest rates by 1%;
10 (f) the latest inflation figures show that the UKs rate of inflation at 2.9% is
now lower than the rest of the EU countries, but slightly higher than that in the
USA.

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THE ECONOMY
B5 EXCHANGE RATES (3) SUGGESTED SOLUTION
1.

(a)

Increase in supply of Sterling (supply

shifts downwards) as UK firms sell
Sterling and buy, for example, Canadian
$, therefore the exchange rate of Sterling
falls against the Canadian $.

(b)

Increase in demand for Sterling by

German firms (demand shifts upwards),
therefore exchange rate of Sterling rises
against the Dmark.

(c)

Decrease in demand for Sterling by

Asian countries (demand shifts
downwards), therefore Sterling
exchange rate falls against Asian
currencies.

(d)

If caused by increased imports

increase in supply of Sterling (supply
shifts downwards), therefore exchange
rate of Sterling falls.

If caused by decreased exports, decrease

in demand for Sterling (demand shifts
downwards), therefore exchange rate of
Sterling falls.

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THE ECONOMY
B5 EXCHANGE RATES (3) SUGGESTED SOLUTION

(e)

Increased speculation and foreign

investment causes increased demand for
Sterling (demand curve shifts upwards),
therefore exchange rate rises. (Depends
on relative interest rates).

(f)
If UK rate of inflation is lower than
other countries, prices of goods and
services are rising more slowly than
foreign prices. This makes UK goods
and services more competitive which
should increase demand for sterling
relative to EC countries (D2), therefore
exchange rate rises. However, since UK
prices are higher relative to US prices
there is a decreased demand for Sterling
from the US demand for Sterling
would fall to D3. Therefore exchange
rate falls. Students could mention
elasticity of demand for exports.

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THE ECONOMY
B6 EXCHANGE RATES (4)

(a) A UK electrical manufacturer ordered a component parts from the USA. These
parts cost a total of $16m when the exchange rate was 1 =$1.60. However the
value sterling has fallen to 1 = $1.50.
(i)

Explain what has happened to the cost of the component parts to the UK
manufacturer.

(ii)

How might the UK manufacturer react?

(iii) What effects might this fall in the exchange rate have on UK rates of inflation
11
and unemployment?
(b) A British car manufacturer wanted to sell 1,000 cars to a US company. The total
cost of the cars was 2 million when the exchange rate was 1 = $1.60. However,
by the time the US company was ready to place their order their exchange rate
was 1 = $1.50
(i) What has happened to the cost of the UK cars to the US importer?
(ii) What might the US company do now?
(c) UK firms ordered one million tons of wheat from Canada at a total cost of $30
million. The exchange rate was 1 = $1.50. However, sterling became stronger
and the exchange rate rose to 1 = $1.80.
(i) Explain what has happened to the cost of the wheat to the UK firms.
(ii) What effects will this have on the UK firms who ordered the wheat?
(d) A German company wanted to place an order for 20,000 computers from a
Scottish company. The total cost of the computers was 20 million when the
exchange rate was 1 = 1.5DM. However sterling has risen on the foreign
exchange market and the exchange rate is now 1 = 2DM.
(i)

Explain what has happened to the cost of the computers to the German
company.

(ii) What might the German company do now?

(iii)

What effects might the rise in the exchange rate have on the Scottish
economy?

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THE ECONOMY
B6 - EXCHANGE RATES (4) SUGGESTED SOLUTION

(a) (i) More expensive. Previously UK manufacturer would receive $1.60 for every
, however, now they will only get $1.50 making it more expensive for them
to purchase the component parts.
(ii) Increase price of their product to take account of the increased cost, cut profit
margins or a combination of both.
(iii) As UK has a high propensity to import raw materials and component parts,
the final cost of the product is more expensive causing a rise in inflation (if
prices are increased). If this happens and the goods are less competitive,
demand could fall and unemployment could result. If profit margins are cut,
firm has less money available for investment and expansion (could cause
unemployment).
If value of sterling falls, exports become more competitive, imports cheaper
with the result that level of unemployment would fall.
(b) (i)
(ii)
(c) (i)
(ii)

(d) (i)

Cheaper in the US. US companies now receiving more s for every $,

making it less expensive for them to buy UK cars.
Order more, lower prices in the US, increased profit margins.
Cheaper (student should give an explanation).
Reduce their costs, making it cheaper for them to produce their final product.
Could pass on cost saving in the form of reduced prices to the consumer or
use the increased profits to invest, or pay to shareholders.
German company has to pay more for the computers (price has increased).

(ii) Buy less or none from the Scottish company and look for a more
competitive price elsewhere.
(iii)

Reduce exports, possibly causing unemployment in export industries

with
the resultant effect on other industries. Possible increase in cheaper foreign
imports. Balance of Payments deficit.

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THE ECONOMY
B7 THE STERLING INDEX

(a) Explain what is meant by the term Sterling Index.

(b) Explain what has happened to the foreign exchange value of Sterling as shown in
the above diagram, between January 1996 and January 1998.
(c) What factors might have caused the change in the value of Sterling as shown in
the above diagram?
(d) What are the main advantages and disadvantages to the UK economy of the trend
shown in the above diagram?

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THE ECONOMY
B7 THE STERLING INDEX SUGGESTED SOLUTION

(a) An index which gives the average exchange rate of Sterling against other
currencies. It is trade weighed and influenced mostly by exchange rate
movements against the currencies of the UKs main trading partners.
(a) Foreign exchange value of Sterling has increased between 1996 and 1998.
(b) Increase in interest rates, economic growth (increase in export led growth),
reduction in imports, reduction in government PSBR, speculation.
(c) Advantages:
Reduced Sterling price of imported raw materials helps reduce cost of
production which in turn helps exporters in the form of reduced costs, exports
become more competitive. This could increase the volume of exports. Goods
may also become more competitive in the home market.
Increased standard of living consumers can buy imported goods/holidays
cheaper.
Increased inward investment which helps reduce unemployment.
Disadvantages:
An increase in the volume of imports could cause a slow down in economic
growth.
Balance of Payments problems cheaper imports/increase in export prices in
industries not benefiting from cheaper imported raw materials (loss of
competitiveness).

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THE ECONOMY
B8 THE BALANCE OF PAYMENTS (1)

Shown below is the composition of the UK Balance of Payments 1996

( billion)
Balance of trade in goods and services
Net investment income
Transfers

- 5.7
8.5
- 4.9

Balance on Current Account

- 2.1

Net transactions in assets and liabilities

2.1

(a) Explain, using examples, what is meant by the following terms:

(i)
(ii)
(iii)
(iv)

Balance of trade in goods and services;

Net investment income;
Transfers;
Net transaction in assets and liabilities.

(b) Explain why a country keeps a financial record of its international transactions.
(c) Explain how an increase in the exchange value of Sterling might affect the
Balance of trade in goods and services
(d) The Bank of England increases interest rates. How might this affect:
(i) the demand for UK exports
(ii) the UKs demand for imports
(iii) net transactions in assets and liabilities
(e) If the UK inflation rate falls below those of its main competitors, how might this
affect the UKs balance of trade in goods and services?

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THE ECONOMY
B8 THE BALANCE OF PAYMENTS (1) SUGGESTED SOLUTION

(a) (i)

Exports Imports of goods (plus examples) + Exports Imports of services

(plus examples)

(ii)

Interest, profit and dividends received on UK investments overseas less

interest, profit and dividends to foreigners investing in the UK.

(iii)

Gifts, pensions, paid to UK nationals overseas

(iv)

Direct and portfolio investment, international aid and grants e.g. EU

subsidies to UK industry, speculation, buying and selling foreign currency
reserves, transfers of income e.g. UK national living abroad transferring
money into UK banks.

(b) Used as a measure of the overall health of the economy.

(c) No correct answer for this question it depends on students response. Possible
answers could be as follows:
Increase in the value of sterling would cause the price of imports to fall and the
price of exports to increase. This would probably increase the demand for
imports. If demand is elastic, then the quantity of imports would increase by more
than the fall in price and the UKs import bill would be higher. Demand for our
exports by foreigners would decrease and value of exports may fall (again
dependent on elasticity of demand for our exports). This may result in a
deficit/increased deficit on UK balance of trade in goods and services.
However, if price of imports are cheaper, UK has a high propensity to import
especially raw materials. If the cheaper import prices result in UK manufacturers
charging lower prices to consumers, UK goods would become more competitive
in both domestic and overseas markets. UK consumers may buy home produced
goods in preference to foreign alternatives and UK export markets may increase
due to their increased competitiveness in overseas market. This may result in a
surplus/reduced deficit on UK balance of trade in goods and services.
(d) No correct answer for this question it depends on students response. Possible
answers could be as follows: (answer continued overleaf)

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THE ECONOMY
B8 THE BALANCE OF PAYMENTS SUGGESTED SOLUTION

(i)

Demand for UK exports:

firms costs of production would increase and if this was passed on to the
consumer, it would result in increased prices this may mean that UK
exports would be less competitive in overseas markets and demand would
decrease.
If increase in interest rates results in an increase in the exchange rate then
exports may become less competitive and demand may decrease.

(ii)

UKs demand for imports

interest rate increase would reduce aggregate demand in the economy,
therefore demand for imports should decrease.
firms costs of production would increase and if this was passed on to the
consumer, it would result in increased prices in the domestic economy
(imports may possibly be more competitive).
if increase in interest rate results in an increase in the exchange rate then
imports may become more competitive and demand may increase.

(iii)

Net transactions in assets and liabilities:

Higher UK interest rates may mean inflows of hot money and increased
direct/portfolio investment. (increase in surplus/reduction in deficit in this
item).

(e) If inflation rates lower than main competitors, prices in UK rising more slowly
than in other countries, therefore UK goods become more competitive in foreign
and domestic markets. This could reduce the quantity of imports and increase
the quantity of exports.

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THE ECONOMY
B9 COMPONENTS OF THE BALANCE OF PAYMENTS

It can be argued that the balance of trade in goods and services is the catalyst for the
entire Balance of Payments Account. When the UK exports more goods there will be
knock on effects on other components in the balance of payments.
For example: Sales of British cars to the European Union (EU) increase.

(a) Explain, using examples, what is meant by:

(i) Balance of trade in goods
(ii) Balance of trade in services
(b) How will an increase in the sale of UK cars to the EU affect the UKs balance of
trade in goods?
(c) (i) In the example shown above, which items will affect the UKs balance of trade
in services?
(ii) How will these items affect the UKs balance of trade in services?
(d) (i) In the example shown above, which items will affect the UKs transactions in
assets and liabilities?
(ii) How will these items affect the UKs transactions in assets and liabilities?
(e) How might the exchange rate if sterling be affected by the increase in sales of cars
to the EU? Explain your answer?

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THE ECONOMY
B9 COMPONENTS OF THE BALANCE OF PAYMENTS SUGGESTED
SOLUTION

(a) (i) Exports imports of goods i.e. visibles (for example electrical goods,
manufactures, etc.)
(ii) Exports imports of services i.e. invisibles (for example transport, insurance
etc.)
(b) Increased exports of cars would either increase any trade surplus or help reduce
the deficit.
(c) (i) EU buyers paying UK transport firms, UK firms providing after sales service.
(ii) Improve balance of trade in services i.e. increase in exports of services.
(d) (i) Speculators buying sterling, Government selling sterling, foreigners attracted
to the UK, foreigners buying shares in UK companies.
(ii) Should result in a positive figure for net transactions in assets and liabilities as
UK increases its assets (relative to liabilities).
(e) Increase in the exchange rate of sterling, initially through the sale of cars, then
from speculators buying sterling, EU buyers paying UK transport firms, EU
buyers paying for after sales service, foreigners wishing to invest in new factories
or in shares in UK companies. (All of the above increase the demand for sterling).
However, government selling sterling would increase the supply of sterling in the
foreign exchange market and would cause the exchange rate of sterling to fall.

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THE ECONOMY
B10 MANAGED EXCHANGE RATE SYSTEMS

(a) Explain what is meant by the DM/ exchange rate?

(b) (i) Explain what is meant by the ERM and describe how this type of system
operates.
(ii) What are the advantages and disadvantages of an exchange system similar to
the ERM.
(iii)

Describe the trend in the DM/ exchange rate between 1994 and 1996.
Give possible reasons for this trend

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THE ECONOMY
B10 MANAGED EXCHANGE RATE SYSTEMS SUGGESTED SOLUTION

(a) Exchange value of Sterling against the DM i.e. the quantity of DMs which can be
exchanged for 1 Sterling
(b) (i) Exchange rate mechanism is a managed exchange rate system which is
designed to keep currency exchange rates within agreed limits against each
other. A central rate is set by the central bank and finance ministers. Each
currency has a central rate against each of the others. The currency is then
allowed to fluctuate within a certain band. Currencies are kept within band by
central bank intervention (other central banks may also intervene), or
alternatively domestic monetary policy may be used. If both market
intervention and monetary policies fail, central rate may be reset.
(ii) Advantages:
- Promotes international trade - less risk of exchange rate fluctuations.
- Greater economic certainty for industry encourages investment and long
term planning.
- Firms forced to become more competitive as it is difficult for them to pass
higher production costs on in the form of higher output prices.
Disadvantages:
- Need to match other countries interest rates to keep currency stable.
- Lose reserves if they are sold to keep currency within its band.
- Pressure to keep inflation in line with other countries.
- Pressure to become competitive.
- Cost to the country of keeping exchange rate within its band.
- If the central rate is too high UK goods lose their competitiveness.
(c) Fell from beginning of 1994 to early 1995, recovered slightly by mid 1995, then
fell again. Rose sharply from beginning of 1996 to end of 1996.
Falling UK interest rates.
Export led growth in UK.
Recovery from recession of early 1990s.

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THE ECONOMY
B11 THE BALANCE OF PAYMENTS (2)

The following diagram shows the UK Balance of Trade in Goods and Services and
the UK Current Account balance for the years 1988-1996. Study the diagram,
then answer the questions which follow.

(a) Describe the trend in the UK Balance of Trade in Goods and Services as shown in
the diagram and give reasons for the trend.
(b) Balance in Trade and Goods and Services is a major part of the Current Account
Balance.
(i) What other items are included in the Current Account.
(ii) Explain how these items have affected the UK situation in the years shown
(c) If a country has a persistent deficit on its Current Account Balance:
(i) What measures could it take in order to try to reduce the deficit in the future?
(ii) Explain why it would want to reduce the deficit?

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THE ECONOMY
B11 THE BALANCE OF PAYMENTS (2) SUGGESTED SOLUTION

(a) Deficit throughout the years shown large deficit which increased between 1988
and 1989, then fell until 1991, increased slightly in 1992, then fell until 1995 with
a slight increase in 1996.
Reasons Lawson boom (87-89) large number of foreign imports sucked into
the UK as consumers had more money to spend, also falling interest rates at this
time which had the same effect of increasing aggregate demand. As UK has high
propensity to import, many imported consumer goods were brought into the
country.
Recession 1990-1992 rising interest rates, high unemployment, low economic
growth and fall in aggregate demand, hence demand for imported goods fell.
1993 onwards falling interest rates, recovery led to increased imports. However,
export led growth counterbalanced this causing the balance of trade in goods and
service to improve.
(b) (i) Interest, profits and dividends (investment income) and transfers.
(ii) 1988, 1990 and 1994-1996 surplus on these items helped reduce current
account deficit. 1989, 1991-1993 deficit on these items worsened current
account situation.
(c) (i) Students should be aware that imports need to be reduced and exports
increased.
Reduce imports of foreign goods and services for example, import controls,
domestic fiscal and monetary policies to dampen aggregate demand (however
UK has high propensity to import/relatively inelastic price elasticity of
demand especially in raw materials. Government manipulation of exchange
rate to make imports relatively more expensive (short-term effects).
(ii) To stop downward pressure on the exchange rate, reduce unemployment, stop
decline of regions dependent on manufacturing, stop economy becoming
overheated then falling into recession (if imports greater than exports
unemployment and recession may follow), to encourage foreign investment.

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THE ECONOMY
B12 THE ASIAN CRISIS

The collapse of many Asian Financial Markets during 1997 sent economic shock
waves around the world.
At the beginning of 1997, there were few signs of the trouble which lay ahead and
indeed world confidence in the region was so high that Governments were able to
maintain a currency peg with the US dollar.
However, cracks began to appear in the second half of the year. Trouble began in
Thailand when the failure of a number of property companies caused a run on its
currency. Panic selling spread to other Asian currencies with the South Korean
currency being one of the worst affected. Its currency peg with the US dollar was
swept away by waves of speculative selling and by the end of the year the value of
the South Korean currency was less than half its former level.
The adverse effects on the UK of Asias problems have initially been confined to a
relatively small number of companies which have strong business connections with
that region. However, in the longer term, the economic crisis in Asia could create a
threat to UK exports, inward investment and continued economic expansion.

(a) Explain what is meant by the following terms:

(i) currency peg;
(ii) speculative selling.
(b) Explain why the failure of a number of property companies in Thailand could
cause a run on its currency.
(c) the value of the South Korean currency was less than half its former level.
What effect would the fall in the value of the South Korean currency have on:
(i) South Korean exports to other countries;
(ii) South Korean imports from other countries?
(d) What adverse effects could there be for the UK companies who have strong
business connections with Asia?
(e) In the longer term, how might the economic crisis in Asia affect UK inward
investment?
(f) How might some UK businesses be in a position to benefit from the crisis in Asia?

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THE ECONOMY
B12 THE ASIAN CRISIS - SUGGESTED SOLUTION

(a) (i) Currency peg when a currencys exchange rate us fixed in terms of another
currency. For example, the South Korean currency is fixed in terms of dollars
i.e. exchange rate stays the same and does not change.
(ii) Speculators people who buy/sell currencies to make a profit. Speculative
selling is when speculators sell currencies, thereby increasing supply and
causing the exchange rate to fall.
(b) The failure of property companies gives an indication to investors that there is
instability within the economy. Investors in real estate, property etc would
therefore remove their investments from the country. They would therefore sell
the Thai currency causing a run on the currency.
(c) (i) Become cheaper, therefore increased volume of exports from Korea to other
countries.
(ii) Much more expensive, may cause inflation in South Korea especially if
demand is price elastic.
(d) Share prices could fall, lack of demand from South Korean companies who may
buy goods from them causing unemployment.
(e) Recently, some of the largest inward investment projects announced have been
Korean. The crisis in Asia has meant that these projects have been put on hold and
may possibly be abandoned.
(f) Falling asset prices in Asian countries mean that there is the opportunity for UK
businesses to expand by acquiring land and property cheaply in Asia. Previously,
they may not have been able to afford to do this.

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THE ECONOMY
B13 THE BALANCE OF PAYMENTS (3)

What policies can the government adopt to maintain a stable Balance of Payments?

Suggested Solution

Government could use import controls tariffs, quotas, exchange controls, although
membership of international organisations such as the European Union and General
Agreement of Tariffs and Trade.
It could also devalue its currency to make exports cheaper in foreign markets and also
make imports more expensive in the domestic market.
The government implement deflationary measures to reduce demand in the economy
and therefore imports.
The government could encourage British firms to improve the marketing of their
products abroad e.g. trade fairs.
Government could help to improve the quality of British products by improving
education and training of workers giving financial aid to firms to encourage
investment in research and development.
The Government could also give subsidies to sunrise industries.
All of the above measures should enable the Government to maintain a stable Balance
of Payments situation.

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THE ECONOMY
C1 THE QUANTITY THEORY

Some economists believe that a link exists between the rate of growth of the quantity
of money and the rate of price increases. The theory underlying this monetarist
viewpoint is called the Quantity Theory of Money and is derived from the following
equation.
MV = PT
Where:
M=Money Supply
V=Velocity of Circulation
P=General level of prices
T=Number of Transactions

(a) Explain what is meant by:

(i)
(ii)
(iii)
(iv)

Money supply;
Velocity of circulation;
General level of prices;
Number of transactions.

(b) Assume that the money supply is 300, V is 10 and T is 150.

(i)
(ii)

What is the value of P?

If the money supply now doubles and V and T remain constant, what is the
new value of P?
(iii) At the new money supply level, T now increases to 200 whilst V remains
constant. Explain what will happen to the level of prices.
(c) Explain the monetarist view that if the government controls the money supply, the
result will be to prevent prices rising.

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THE ECONOMY
C1 THE QUANTITY THEORY SUGGESTED SOLUTIONS

(a) (i)
(ii)

The total amount of money in an economy.

The speed at which a given sum of money circulates in the economy (i.e.
the number of times a unit of money changes hands during a specified time
period).

(iii) The average price of each transaction which took place during a specified
period of time.
(iv)

This is the number of transactions which have taken place in the economy
during a specified time period.

(b) (i)

20

(ii)

40

(iii) Average level of prices will fall from 40 to 30.

(c) Monetarists believe that, in the short term, V is fairly constant and there is an
upper limit to the size of T. Therefore, the average level of prices is largely
determined by the money supply. For example, if the money supply increase and
V and T are constant, then this will have the effect of increasing the average level
of prices (i.e. rising prices). So to control rising prices (inflation), then
government must have a firm control of the money supply in the economy.

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THE ECONOMY
C2 DEMAND PULL INFLATION

Outline the policies that the government can adopt to curb demand pull inflation.

Suggested Solution

Government must adopt a deflationary policy.

Fiscal policies:
Reduce government spending reduces aggregate demand in the economy.
Increase in income tax reduces consumer spending this reducing pressure on
prices.
Monetary policies:
Increase interest rates this will reduce bank lending and therefore reduce
Aggregate Monetary Demand (AMD). It will also increase mortgage rates and
reduce consumer spending.
The above action will reduce in particular items bought on credit.
Open market operations government could sell treasury bills thus reducing the
amount of money that commercial banks have available for lending.
Exchange rate policy:
Increase in the value of the pound on the foreign exchange markets this can
reduce inflation in three ways:
It lowers the price of imported goods and imported raw materials.
It also puts pressure on domestic firms to lower costs and prices to remain
competitive against cheaper foreign imports in their home market and to offset the
rise in price of their exports in foreign markets.
Membership of a fixed rate system such as the ERM can also be used as an antiinflationary measure.

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THE ECONOMY
C3 PROBLEMS CAUSED BY INFLATION

What are the main problems associated with inflation?

Suggested Solution
Inflation will have adverse effects on people on fixed incomes pensioners etc. They
will see their purchasing power decreasing as prices rise.
Banks and other lenders will also lose out as money lent out will be worth less by the
time that it is repaid.
Exporters will suffer if the UK inflation rate was greater than our main competitors
UK goods would be more expensive abroad and therefore more difficult to export.
Workers who have weak bargaining powers will also lose out as their wage increases
will fall behind the price increases they will see a drop in their real incomes as a
result.
There are other groups who do benefit however during times of rising prices
borrowers, importers and workers with industrial muscle.
If the UK inflation rate is higher than the rates of our main competitors then this can
lead to large trade deficits and even a recession higher levels of unemployment and
a fall in the level of AMD.
The UK would price itself out of jobs and markets.
Inflation encourages inefficiency producers can hide their inefficiency behind rising
prices.
It also discourages savings and encourages borrowing and creates instability.
Once inflation gets a hold in an economy it is difficult for a government to control
self-perpetuating.

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THE ECONOMY
C4 ANTI-INFLATIONARY POLICIES

What would be the main advantages/costs of the UK government following an antiinflationary policy?

Suggested Solution

This policy if successful will create an atmosphere of stability within the UK

economy - it will make it easier for producers and consumers to plan.
It should encourage trade increased competitiveness of UK goods could lead to
trade surpluses and rising employment in the medium to long term.
It would also lead to an increase in savings and could reduce interests rates and
increase investment this in turn could lead to an increase in employment and AMD
closer to the production possibility frontier.
Growth in the economy would also make it easier for the government to redistribute
income from the wealthier to the poorer sections of society.
Growth would also lead to an increase in Education and Health spending.
The costs of following an anti-inflation policy however could be considerable. To
achieve success in this policy the government might have to adopt very tight monetary
and fiscal policies which would reduce AMD in the economy and force the country
into recession with all of the problems associated with this.
Recession low levels of AMD resulting in a fall in output and a rise in
unemployment spiral downwards.
Government must be aware of the problems associated with trying to achieve one
objective at the expense of others.
If the UK inflation rate fell to a level below that of our main competitors then this
could be deemed a success it could be achieved without plunging the economy into
a recession resulting in mass unemployment.

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THE ECONOMY
C5 INFLATION AND THE EURO

Country X is a member of the Single European Currency but is experiencing a much

higher rate of inflation than other members.

a. If this situation continues, explain how it will affect the economy of country X.
b. What fiscal measures could the government of Country X take to try and reduce
its inflation rate? Explain how these measures would work.
c. Explain why country X will not use monetary measures (e.g. raising interest rates)
to try to reduce its inflation rate.
d. Describe two advantages, for the UK of joining the Single European Currency.

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THE ECONOMY
C5 INFLATION AND THE EURO SUGGESTED SOLUTION

a. The economy of country X will require to become more competitive in the

production of some of its goods and services. If it cant, the industries which cant
compete may be forced to close down and make people unemployed.
b. Fiscal measures to reduce inflation are:
Reduce government expenditure
Increase taxation
These reduce AMD and therefore remove inflationary pressures from the
economy. This is accentuated by the multiplier effect.
c. Country X will not be able to use independent monetary measures as it no longer
has control over its own interest rates. Interest rates will now be set by the
European central bank for all countries participating in the Single European
currency.
d. Advantages of joining the Single European Currency are:
Reduced transactions costs when dealing with countries within the currency
belt
Firms can plan ahead with more certainty (as the Euro might not fluctuate as
much as sterling)
Easier for citizens of counties within the currency belt to compare prices and
buy goods.

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THE ECONOMY
C6 MONETARY POLICY AND INFLATION

The continuous fall in the level of unemployment over the last few months is causing
concern. Some economists see it as an indication that the output gap (i.e. the
difference between potential and actual output) is getting smaller. If this is the case,
then sooner or later, inflationary pressures will build up. If this happens, the
Monetary Policy Committee could well raise interest rates.
a. Explain the difference between potential and actual output.
b. Explain how a reduction in the size of the output gap could lead to inflationary
pressures.
c. Explain why high rates of inflation are undesirable.
d. What is the Monetary Policy Committee and what is its role in the UK
economy?
e. Explain how an increase in interest rates could reduce inflationary pressures.

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THE ECONOMY
C6 MONETARY POLICY AND INFLATION SUGGESTED SOLUTIONS

a. Potential output indicates how many goods and services which could be made in
the economy if all resources are fully employed and working to a maximum
efficiency, during a particular time period. Actual output indicates the actual
amount of goods and services which have been produced during a time period.
b. The closing of an output gap would indicate that the economy is working at or
near its productive potential. This would mean that it would find it difficult to
produce many more goods and services in response to any increase in Aggregate
Monetary Demand. As a result, an increase in demand would be more likely to
lead to an increase in prices, rather than an increase in the volume of goods and
services produced.
c. High rates of inflation are undesirable as they cause the prices of UK goods to
become uncompetitive (both at home and abroad) which could lead to
unemployment in the UK. High rates of inflation also hurt:
Creditors, (as the money paid back is not worth as much as when it was lent)
People on fixed incomes (as their incomes usually rise slower than the rise in
prices e.g. pensioners, unemployed people etc.)
Savers as the money they save, loses its value over time (ignoring the effect
of interest rates).
d. The Monetary Policy Committee is an independent group of financial economists
who have been delegated by the Chancellor of the Exchequer (through the Bank of
England) to set the basic rate of interest (on which all other interest rates are
based).
e. An increase in interest rates could reduce inflationary pressures as if it causes the
mortgage rate to rise, it can cause an effective reduction in the disposable income
of mortgage payers. It can also increase the amount of savings and reduce the
amount of withdrawals effectively reducing aggregate monetary demand. An
increase in the rate of interest will also affect firms, who may defer investment
decisions thus again reducing aggregate monetary demand.

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THE ECONOMY
C7 - UNEMPLOYMENT

Full employment has not been seen in the UK since the mid 1960s, however, the
Chancellors statement to the Labour Party Conference in October 1997 set an
ambitious target for a sustained level of employment in the economy.
But, will it lead to full employment? There is certainly no shortage of ideas and
policies for the improvement of job creation in the economy.
Much rests on how we define the term full employment. One interpretation sees full
employment occurring when only frictional and seasonal unemployment remain
(perhaps 3-5% of the labour force), but we are unlikely to achieve full employment in
the near future. Why? Because of the high level of structural unemployment
present in the economy at this time, as well as the high level of youth unemployment.

(a) Explain what is meant by full employment.

(b) (i) Explain what is meant by structural unemployment.
(ii) How might the UK government attempt to reduce the level of structural
unemployment in the UK economy?
(c) (i) Explain why there is such a high level of youth unemployment.
(ii) How has the UK government attempted to solve the problem of youth
unemployment?
(d) Why can no country ever achieve zero unemployment?

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THE ECONOMY
C7 - UNEMPLOYMENT SUGGESTED SOLUTION

(a) Full employment can be taken to mean full employment of factors of production,
however in this context it refers to full employment of labour.
Various definitions of full employment:
Traditional definition the situation where everyone who wants a job, either has
one or can get one without too much difficulty.
The rate of unemployment occurring when only frictional unemployment remains
in the economy. (Perhaps 3-5% of the labour force).
Natural rate of unemployment: the rate of unemployment implied by the present
structure of the economy (i.e. rate of unemployment determined by structural and
frictional forces in the economy which cannot be reduced by increasing aggregate
demand). Can be as high as 8-9% of the labour force.
(b) (i) Structural unemployment results from long term changes in demand patterns
leading to the decline of certain industries and the expansion of others. There
is a mismatch between job vacancies and the unemployed. That is, those
unemployed havent the proper skills/live in the correct location to fill job
vacancies (arises because of labour force inflexibility/immobility both
geographically and occupationally).
(ii) Any policy or programme which reduces inflexibility of the labour market e.g.
Welfare to Work Programme, investment in re-training etc.
(c) (i) Youth unemployment (not only a problem in the UK) lack of employment
opportunities in general especially for those who leave school with few
qualifications, school leavers may have little vocational training and
employers are looking for people who are already trained (to save the cost of
training them).
(ii) Various schemes, for example: YOPS, YTS, YT and from April 1998
New Deal targeting 18-24 year olds. Changes in educational curriculum
for example investment in technology to ensure school pupils receive training
in the use of IT.
(d)

Existence of frictional unemployment i.e. there will always be some people

who are moving between jobs, some newly redundant workers or workers
entering the labour market (for example, school/college/university leavers)
who are trying to find appropriate jobs.

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THE ECONOMY
C8 - EMPLOYMENT

(a) (i) Explain what is meant by the term self-employed.

(ii) What factors might have caused such a large increase in the number of self
employed in the period shown?
(b) Explain possible reasons for the fall in the number of male full time employees.
(c) Explain why there has been such a large increase in female employment.

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THE ECONOMY
C8 - EMPLOYMENT SUGGESTED SOLUTION

(a) (i) People who work for themselves i.e. have their own business rather than work
for an employer.
(ii) Government/EU incentives to start up a business (to reduce unemployment)
grants, help with start up costs. Many businesses which started up are small
service sector businesses with low start up costs and no barriers to entry.
(b) Demise of male dominated industries, de-industrialisation, equality.
(c) Changing demands for labour. For example, many jobs available in service sector
which has favoured female (and part-time) workers. Changing attitudes to
working mothers and government assistance (nursery voucher scheme/workplace
creches).

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THE ECONOMY
C9 UNEMPLOYMENT STATISTICS

UK Rate of Unemployment (1988-1996)

(a) Explain what is meant by the rate of unemployment.

(b) Explain how unemployment is measured in the UK.
(c) Describe the trend in the UK rate of unemployment shown in the above graph and
give reasons for this trend.
(d) How might a government try to reduce the rate of unemployment in an economy?
(e) Why might a government want to reduce the rate of unemployment in an
economy?

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THE ECONOMY
C9 - UNEMPLOYMENT STATISTICS SUGGESTED SOLUTION

(a) The percentage of the workforce who are willing and able to work but are unable
to find work i.e.
numbers unemployed x 100
working population
1
(b) Two main ways i.e. UK level and UK rate (new measure Labour Force Survey).
Various measures including number of people eligible to claim a job seekers
allowance, survey of claimant count, number of registered unemployed (frequent
changes to the definition of unemployment has made the measurement a
controversial issue).
(c) 88-90 falling unemployment increased aggregate demand in the economy after
87 tax giving budget, falling interest rates, stricter eligibility to claim benefits
(restart programme for long term unemployed), increase in self employment.
90-93 increase in unemployment due to world recession.
93-96 fall in rate of unemployment as US economy starts to grow.
(d) Improve flexibility of labour market, education and training, reduce trade union
power, employment legislation, policies which increase rate of economic growth.
(e) Improve resource utilisation, to increase income taxation revenue and/or reduce
public spending and the PSBR.

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THE ECONOMY
C10 PATTERNS OF UNEMPLOYMENT

One of the benefits of the economic recovery and renewed growth has been a rapid
fall in the level of unemployment. However, whilst falling unemployment is an
indicator of this recovery and the social effects are very beneficial, potential problems
are beginning to emerge for businesses.
Diagram A
UK Level of Unemployment (millions)
(1988-1997)

Diagram B
Selected Rates of Unemployment
(by Region, September 1997)

(a) Explain the difference between the level of unemployment and the rate of
unemployment.
(b) Describe the trend in the UK level of unemployment (Diagram A) and explain
how the economic recovery and renewed growth has led to a fall in the level of
unemployment.
(c) What are the effects of a falling level of unemployment?
(d) (i) Look at Diagram B and state which region had the highest and which region
had the lowest rate of unemployment in September 1997.
(ii) Explain why unemployment rates might be vary between different regions.

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THE ECONOMY
C10 PATTERNS OF UNEMPLOYMENT

(e) What effects will different unemployment rates in different regions have on:
(i)
(ii)

businesses in a region with average unemployment;

businesses in a region with below average unemployment.

(f) How might a government try to reduce unemployment in regions with

above average unemployment?

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THE ECONOMY
C10 PATTERNS OF UNEMPLOYMENT SUGGESTED SOLUTION

(a) Unemployment level is the actual number of people officially unemployed.

Unemployment rate is the unemployment level as a percentage of the working
population i.e.:
Unemployment rate

Unemployment level x 100

Working population
1

(b) 88-90 - decreasing level of unemployment, 91-93 increasing level of

unemployment, 93-97 falling level of unemployment.
Economic recovery/renewed growth indicate expansion of the economy and
increasing aggregate demand. Therefore firms output increases and demand for
workers increases. This causes unemployment to fall.
(c) People have more income, therefore aggregate demand increases. This leads to
business expansion/increased revenue for businesses. Could make businesses
more competitive both in domestic and foreign markets.
Increased revenue for government (taxes) and less paid out in benefits therefore
fall in the PSBR.
Social effects such as reduction in suicides, health problems, etc.
(d) (i) Highest Merseyside, Lowest South East
(ii) Different regions dependent on different industries, therefore if demand for
goods from a particular industry declines unemployment results.
Government targeting of certain areas grants, incentives to locate etc.
Economic growth does not affect all regions equally.
(e) (i)

(ii)

Many applications for work (often applications may be from unsuitable

candidates) whenever vacancies are advertised, therefore no shortage of
labour.
Applications low in volume, candidates may be choosy about which jobs to
apply for and will try to negotiate high salaries. Vacancies in specific skill
areas may go unfilled, business expansion could suffer. Businesses may
have to spend more money advertising nationally and also pay relocation
expenses.

(f) Increase the level of training of workers and the unemployed (Welfare to
Work/New Deal etc), Regional Policy.

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THE ECONOMY
C11 UNEMPLOYMENT POLICIES (1)

What steps can Government take to reduce the rate of unemployment?

Suggested Solution

Increase aggregate demand in the economy until all resources are used.
Fiscal policies:
Increase in Government spending on goods and services (e.g.) health, education,
housing this will lead to a direct increase in employment.
Reduction in taxation reduce both income tax and corporation tax this should
stimulate private spending both consumption and investment.
Government could also increase pensions and social security payments this will
increase demand as people receiving such payments have a high marginal
propensity to consume (MPC).
Government could also give investment grants to private business to encourage
investment.
Government may have to adopt a budget deficit to implement the above policies.
Monetary policies
Government could relax commercial bank lending activities.
Reduction of interest rates (Bank of England acts independently now).
This should encourage people to borrow and therefore increase aggregate demand.
It should also encourage people to take out mortgages and/or move house and
therefore stimulate demand for household products, etc.
It will also encourage businesses to borrow increase investment as it will be
cheaper to do so increase in employment as a result.
Open market operations, Government buy treasury bills gives commercial banks
more money to lend stimulating aggregate demand.
Exchange rate policy:
Government could lower exchange rate exports will become cheaper and
imports more expensive there should be a switch in demand from foreign goods
increase in demand will result in a rise in employment.
Supply side approach:
To prevent inflation government must increase aggregate supply. Tax incentives
to encourage investment and improvement in productivity (e.g. training and
development).
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THE ECONOMY
C12 UNEMPLOYMENT POLICIES (2)

How can government achieve a high and stable level of employment?

Suggested Solution

Unemployment results mainly from a lack of aggregate demand in the economy.

Government can take an active role in correcting this problem. Government can
influence the components of aggregate demand consumption, investment,
government spending and exports.
Taxation reduction in income tax and tax on profits will help to stimulate Aggregate
Monetary Demand (AMD) and investment.
Increase in investment will help British products become more competitive at home
and abroad and will lead to an increase in employment.
Government must also be prepared to run budget deficits.
Governments can also make it easier for commercial banks to lend money open
market operations, special deposits.
Reduction in interest rates will also increase the amount of money consumers have to
spend e.g. lower mortgage rates it should also lead to an increase in borrowing.
If the exchange rate of the in relation to other currencies falls this would also
stimulate demand both at home and overseas and again lead to an increase in
employment.
As more and more people obtain work they in turn will have more money to spend
and this will increase demand even further and create more employment (the
multiplier effect).
The above actions however could cause inflation in the long run it would be better
for the economy if the efficiency of labour was improved to make it more attractive
to employers.

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THE ECONOMY
C13 ECONOMIC GROWTH (1)

During 1996 and 1997 the pace of the economic recovery in the UK quickened and
some business sectors are benefiting from this. However, government and business
would prefer that there was sustained growth, where the economy grew at a nice
steady rate. The reality is, though, that economies typically suffer from a cycle of
growth and recession.

(a) Explain what is meant by the following:

(i) sustained economic growth;
(ii) economic recovery.
(b) Explain, using examples, why some business sectors are benefiting from the
economic recovery.
(c) (i) Explain what is meant by the term recession.
(ii) What factors may cause an economic recession?
(d) (i) Explain why the above % GDP figures have been adjusted to remove the
effects of inflation.
(ii) To what extent does the information in the above graph support the view that
economies typically suffer from a cycle of growth and recession?

(e) Explain why businesses would prefer that the economy grew at a nice steady
rate.
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THE ECONOMY
C13 ECONOMIC GROWTH (1) SUGGESTED SOLUTION

(a) (i) The maximum increase in real GDP that an economy can maintain in the
long term without overheating.
(ii)
(b)

Economy coming out of recession, typified by increased economic growth

increased output, falling unemployment, and increasing consumer confidence.
The businesses which may be benefiting from economic recovery are those
which are in growth areas of the economy for which there is a growing
demand for their product. Other businesses may still be suffering and
therefore threatened with closure. Also depends on reason for the recovery,
for example is the recovery due to increased demand for UK exports. If so,
then businesses in the export sector may thrive whilst other struggle.

(c) (i) Two or more successive quarters of negative growth. Characterised by

rising unemployment, increasing business failure, falling aggregate demand.
(ii) Knock on effects of recession in other parts of the world, falling demand for
goods and services (high interest rates), budget surpluses.
(d) (i) If effects of inflation had not been considered then the change in
GDP would not be at constant prices, so a rise in prices may be responsible for
the increase in GDP and there may in fact be no increase in GDP at all. By
removing the effects of inflation GDP is stated at constant prices so a year by
year comparison can be made.
(ii) Increasing (and positive) changes in GDP between 1987 and 1990 indicate that
the economy is growing, therefore this is seen as a period of growth of the
economy. Between 1990 and 1992, economic growth was negative showing a
contraction in the economy i.e. a recession. From 1992 onwards the economy
comes out of recession and into a period of growth again. Because the
information is only over a period of 10 years there is no conclusive evidence
that economies suffer from a cycle of growth then recession.
(e)

Relative stability, therefore easier for businesses to make long term plans,
less risk, etc.

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THE ECONOMY
C14 ECONOMIC GROWTH (2)

The term economic growth can be defined in 2 ways:

Economic Growth:

Economic Growth:

An increase in economic
capacity

An increase in real Gross

Domestic Product (GDP)

(a) Explain what is meant by real Gross Domestic Product(GDP).

(b) Explain, using a production possibility curve, why an increase in real GDP does
not necessarily mean that there has been economic growth.
(c) Explain why, in practice, economists tend to treat all increases in GDP as
economic growth.
(d) Explain the main cause of an increase in a countrys economic growth rate.
(e) Why is it important for a country to have a sustained level of economic growth?

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THE ECONOMY
C14 - ECONOMIC GROWTH (2) SUGGESTED SOLUTION

(a) The value of the total output of the economy measured after inflation has been
deducted.
(b)

A shift in the production possibility

curve (economic growth) shows an
increase in maximum potential output
i.e. an increase in the quantity and/or
quality of resources, or an increase in
technology. On the diagram a
movement from A to B would show
economic growth an increase in
economic capacity.

However, it may be that there are unemployed resources in the economy. A

movement from X to A (economic recovery/increase in economic activity) would
show as an increase in real GDP, but does not necessarily mean that economic growth
in its true sense has taken place.
(c) In practice, economists do not know the exact position of an economys
production possibility curve, therefore any increase in real GDP is treated as
economic growth.
(d) In the long term National output can be increased if there is an increase in the
quantity or quality of the factors of production. For example, land - exploitation
or discovery of raw materials, labour changes in population, increase in worker
participation rates, improving quality of labour (education, training), improving
flexibility of factor markets, capital increasing capital stocks, investment
targeted at growth industries, technological progress product and process
innovation.
Short term: the level of AMD is the main factor explaining economic growth.
National output rises when aggregate demand for goods and services is increasing
and when domestic producers can satisfy that demand (i.e. aggregate supply
responds to the level of AMD). Therefore, any factor affecting aggregate demand
will affect economic growth, for example, interest rates, taxation levels, exchange
rates etc.
(e) To maintain improving standards of living, eliminate poverty, bad housing and to
make it easier to redistribute wealth.

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THE ECONOMY
C15 ECONOMIC GROWTH (3)

What are the benefits and costs of economic growth?

Suggested Solution

Economic growth will lead to an increase in living standards of the population e.g.
increased ownership of houses, cars, etc.
It will also lead to an increase in the number of places available in fulltime further
education this in turn will lead to a better educated workforce.
People should also be able to retire earlier.
More resources should also be used to provide more social services for those people
who need them pensions, council housing etc.
There are costs associated with economic growth however.
In order to obtain growth current living standards must be sacrificed more money
saved and used for investment in capital.
This increase in capital goods can result in less consumer goods being produced in the
short term.
The increase in living standards can also lead to an increase in pollution noise, air,
traffic congestion, etc.
It will also lead to a more rapid depletion of natural resources.
With the rapid increase in economic growth machines and workers will become
redundant.
There could be a greater gap between rich and poor.

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THE ECONOMY
C16 INWARD INVESTMENT

UK Inward Investment (Number of Projects) 1987-1996

(a) (i) Explain what is meant by the term inward investment.

(ii) Describe the trend in UK inward investment as shown above and suggest
reasons for this trend.
(b) (i) Explain the main benefits of inward investment to an economy.
(ii) What are the main disadvantages to an economy of a high level of inward
investment?
(c) Explain the effects the economic crisis in Asia might have on the level of UK
inward investment in the future.

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THE ECONOMY
C16 INWARD INVESTMENT - SUGGESTED SOLUTION

(a) (i)

Investment (direct and portfolio) into the UK by foreign companies.

(ii) Increasing 87-90, fell between 91 and 92, increased steadily between 93 and
96. Reasons: Access to Euro markets, relatively low labour costs, flexible and
skilled labour force, Government/EU assistance, transport and communication
system. All of the above are reasons for the increases (87-90 and 93-96).
Between 91 and 92, world recession could have been the cause of the falling
number of inward investment projects.
(b) (i) Economic growth (and benefits of), growth of ancillary industry, increased
employment, improved living standards, spread of new production and
managerial techniques.
(ii) Economy becomes too reliant on foreign firms, if these businesses pull out of
the country there are severe effects on the UK economy in the form of
unemployment, government revenue from taxes/benefits payments; economic
growth - knock on effect on other businesses who supply foreign firms.
Domestic competitors may suffer, often the jobs created are low skill, low
paid assembly jobs.
(c) It may fall as Asian businesses are likely to have little money to invest overseas, it
may also mean that projects already started in the UK will be put on hold or
wound up completely. (Student should provide examples).

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THE ECONOMY
C17 TAXATION

Describe and discuss the possible economic effects of a reduction in direct taxation
and an increase in indirect taxation in the UK.

Suggested Solution

Reduction in direct taxation:

Income tax reductions in this tax will increase the disposable income of consumers.
This will cause AMD to increase it could lead to an increase in imports and
therefore a balance of payments deficit. It can also cause inflationary pressures.
Corporation tax businesses would retain more of their profits which would give
them more money for investment and therefore lead them to become more efficient
and competitive leading to an increase in the number of workers employed.
Increases in indirect taxation:
VAT puts pressure on prices and reduces the spending power of consumers. It is a
regressive taxation policy, therefore the poorer members of society pay
proportionately more on taxation than those better off.
Excise duties tobacco, alcohol as these goods are addictive then the government
will obtain an increase in revenue. Again, this harms relatively poorer members of
society as they spend a greater proportion of their income on such products.
More expensive for the government to collect and administer indirect taxes.

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THE ECONOMY
C18 THE PUBLIC SECTOR BORROWING REQUIREMENT (1)

(a) What is meant by the PSBR?

(b) How is it measured?
(c) How do governments attempt to control the size of the PSBR?

Suggested Solution

It is the difference between the income and expenditure of the whole of the public
sector.
The government receives income in taxes, national insurance, etc. and spends it on
schools, defence, hospitals, social security, etc. if the government spends more than
it receives then it will have a budget deficit.
A deficit is financed by the government borrowing this includes central government,
local government and public corporation borrowing.
The amount of money that is borrowed in one year is called the public sector
borrowing requirement.
Measured in billions and it would be useful to think of the PSBR as a percentage of
GDP.
The total amount of accumulated debt is known as the national debt.
If the amount of money received is greater than the amount of money spent then this
is called the PSDR public sector debt repayment.
Government can attempt to control the size of the PSBR by the selling of state assets.
Increase taxation (freeze tax allowances, extend VAT). Reduce the level of
government spending e.g. roads, education, social security payments.
Firm control of public sector pay awards.

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THE ECONOMY
C19 THE PUBLIC SECTOR BORROWING REQUIREMENT (2)

Why do Governments wish to reduce the size of the PSBR?

Suggested Solution

The more money that government borrow then the greater the amount of interest
payments which must be made on the National Debt.
More revenue will need to be raised in future to pay interest on debt.
The more money that government borrow less money available for private sector to
borrow and this can drive up interest rates (crowding out).
Funds more efficiently allocated by the private sector government should therefore
strive to reduce the size of PSBR.
If government borrowing increases then this increases the money supply and can also
lead to a rise in prices inflation.
If any future British Government wants to join the single currency then budget deficits
will need to be kept within a certain ceiling 3% of GDP.
If government increases the PSBR then this can also lead to a weakening of
confidence in the financial markets.

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THE ECONOMY
SECTION 2 OBJECTIVE TEST ITEMS

A
B
C

National Income
International Trade and Payments
Macroeconomic Issues and Policies

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THE ECONOMY
A. NATIONAL INCOME

Multiple choice questions

1. Over a 12 month period a countrys inflation rate was 10%. Over the same period
the growth in nominal Gross National Product (GNP) was 8%. Which of the
following correctly describes what happened over the 12 month period?
A
B
C
D

The real GNP fell

The money supply increased by 18%
The money supply decreased by 2%
There was an increase in the velocity of circulation of money.

2. The value of the multiplier will increase as a result of

A
B
C
D

an increase in the marginal propensity to consume

a decrease in the marginal propensity to consume
an increase in the average propensity to consume
a decrease in the average propensity to consume.

3. In the last three months the economy expanded at an annual rate of 3.9%. The
largest contributing factor to this increase in the Gross National Product was the
narrowing of the trade deficit.
Given the above statement, it must be true that the value of:
A
B
C
D

exports increased but the value of imports increased more

imports increased but the value of exports increased more
capital inflows increased
exports increased and the value of capital inflows decreased.

4. Using estimates of real national income to compare economic welfare

internationally can be misleading, because of disparities between nations in
A
B
C
D

inflation rates
levels of population
depreciation rates
levels of imports and exports.

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5. For which one of the consumption functions shown below are all of three of the
following conditions true?
I The marginal propensity to consume is constant.
II The marginal propensity to consume equals the average propensity to
consume.
III The average propensity to consume is constant.

6. In a period of high unemployment the government of a country decided to borrow

5 billion from its own citizens by offering Saving Certificates at attractive
interest rates. After the money was borrowed and spent by the government, the
reduction in unemployment was less than had been expected. One possible reason
for this could be that
A
B
C
D

exports from the country were higher than expected

imports into the country were higher than expected
income tax receipts were lower than expected
private savings were lower than expected.

7. The bad news is that the economy is experiencing an output gap, i.e. actual
output is less than potential output. The good news is that, at this actual output
level, the
I inflation rate must be decreasing
II trade deficit must be decreasing.
Which of the following is correct:
A I only
B II only
C Both I and II
D Neither I nor II

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8. In 1992 , the National Income of country X increased by 5% in both real and

nominal terms.
The above statement implies that, in 1992, the inflation rate of country X was
A
B
C
D

10%
5%
0%
-5%

9. Real GNP per capita in a nation is affected by

I the quantity and quality of resources under the nations command
II how efficiently the nation uses its resources in producing good and services
III the size of the dependent population
Which of the following is correct?
A
B
C
D

III only
I and II only
I and III only
I, II and III

10. The following table refers to an economy.

YEAR

GROSS NATIONAL
PRODUCT (GNP)

RETAIL PRICE INDEX

1993

100 bn

100

1994

102 bn

103

From the above table it can be concluded that between 1993 and 1994:
A
B
C
D

real GNP increased and nominal (money) GNP increased

real GNP increased and nominal (money) GNP decreased
real GNP decreased and nominal (money) GNP increased
real GNP decreased and nominal (money) GNP decreased.

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11. The following diagram shows consumer spending in an economy in a year when
National Income was equal to OX.

From the above diagram, it can be concluded that, for the above year,
A
B
C
D

consumer spending was greater than National Income

there was net saving
there was a budget deficit
the inflation rate was rising

12. The following table shows the Gross National Product at current prices and
population of a country in two consecutive years
YEAR

GNP (BN)

POPULATION

Year 1

100

500,000

Year 2

120

550,000

From the above information it follows that:

A
B
C
D

real GNP increased between year 1 and year 2

GNP per capita was higher in year 2 than year 1
real GNP decreased between year 1 and year 2
GNP per capita was higher in year 1 than year 2

13. If, in a two sector, closed economy the marginal propensity to consume is 0.8, the
value of the multiplier will be
A
B
C
D

0.2
0.8
1.25
5.0

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14. If the UK economy were operating at full employment, a decrease in aggregate

demand accompanied by an increase in potential output would result in an
increase in
A
B
C
D

the inflation rate

the unemployment rate
real GNP
nominal GNP

15. Which of the following would cause a fall in the value of UK National Income in
the short term?
A
B
C
D

A decrease in the rate of income tax

A decrease in the level of savings
An increase in the value of UK exports
An increase in the value of UK imports

16. During 1995, the real GNP and the nominal GNP in an economy both increased
by 4%. It follows that, in 1995, the economy also experienced which of the
following?
A
B
C
D

zero inflation
an inflation rate of 4%
no change in average living standards
no economic growth

17. The economy of a country has a deflationary gap of 12 bn. The government
increased its expenditure by 4 bn, which decreased the deflationary gap to 4 bn.
In order to have achieved full employment, the government should have
increased its expenditure by
A
B
C
D

6 bn
8 bn
12 bn
16 bn

18. A country has a deflationary gap of 15 billion. In order to eliminate this, the
Government proposes to increase its spending by 5 billion. If the government is
correct in its calculation, the value of the multiplier is
A 1/3
B 3
C 10
D 75

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THE ECONOMY
A. NATIONAL INCOME

Multiple choice solutions

1. A
2. A
3. B
4. B
5. A
6. B
7. D
8. C
9. B
10. C
11. B
12. B
13. C
14. B
15. D
16. A
17. A
18. B

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THE ECONOMY
B. INTERNATIONAL TRADE AND PAYMENTS

Multiple choice questions

1. If the UK demand for French wine is price elastic, a significant decrease in the
exchange value of sterling in terms of the franc will, ceteris paribus,
I
II
III
IV

increase the volume of imports of French wine

increase sales revenue of French wine exporters
reduce the volume of French wine imports
reduce the sales revenue of French wine exporters

Which of the following is correct?

A
B
C
D

I and II only
I and IV only
II and III only
III and IV only

2. Under a floating exchange rate system and assuming no speculative dealings, the
exchange rate of sterling will depreciate if
I
II
III
IV

foreign spending on UK exports increases

foreign spending on UK exports decreases
UK spending on imports increases
UK spending on imports decreases

Which of the following is correct?

A
B
C
D

I and III only

I and IV only
II and III only
II and IV only

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3. A large decrease in the exchange rate of Sterling if reflected in the prices of the
UK imports and exports will result in
I

an increase in UK spending on imports if UK demand for imports is price

inelastic
II an increase in UK spending on imports in UK demand for imports is price
elastic
III an increase in the revenue from UK exports if demand for UK exports is price
inelastic
IV an increase in the revenue from UK exports if demand for UK exports is price
elastic.
Which of the following is correct?
A
B
C
D

I and II only
I and IV only
II and III only
II and IV only

4. The strong Yen in the first half year has reduced our companys profits by around
4%. From this statement it follows that the company in question
A
B
C
D

buys its raw materials from Japan

exports its goods to Japan
produces products which compete with those from Japan
does not produce in Japan.

5. The volume of UK visible exports increased by 3% last month while the volume
of UK visible imports increased by only 2%. There was no improvement in the
UK balance of visible trade.
This result can be explained by the fact that last month
A
B
C
D

the exchange rate of the decreased

there was a net outflow of capital from the UK
the exchange rate of the increased
there was a decrease in UK interest rates.

6. Both the UK demand for imports and foreign demand for UK exports are price
elastic. If this statement is correct, a decrease in the exchange value of the will
lead to:
A
B
C
D

an improvement in the UK Balance of Trade

a deterioration in the UK Balance of Trade
an increase in the value of UK exports and imports
a decrease in the value of UK exports and imports.

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7. The following figures have been extracted from the Balance of Payments of
country X.
Visible balance
Investment and other
Capital flows
Invisible balance
Official financing

+30 million
-10 million
-5 million
-15million

The current account balance is:

A
B
C
D

zero
+15 million
+25 million
+30 million

8. A continuous appreciation of the against other currencies will result in

A
B
C
D

UK export earnings being higher than they otherwise would have been
UK export earnings being lower than they other wise would have been
the price of UK imports being higher than they otherwise would have been
the price of UK imports being lower than they otherwise would have been.

9. The recent increase in interest rates should ease the downward pressure on the .
The above statement is correct because an increase in interest rates will cause
A
B
C
D

an increase in liquidity preference

a reduction in the flow of hot money out of the UK
an immediate reduction in the rate of inflation in the UK
an improvement in the Balance of Trade.

10. Country X and Country Y impose tariffs on goods imported from each other.
Which of the following would be a long term effect of the imposition of such
tariffs?
A
B
C
D

Real Income would be higher in X but lower in Y

Real Income would be lower in Y but higher in X
Real Income would be lower in both X and Y
None. Tariffs affect exports and imports, not real income.

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11. The incentive for two countries to trade with each other would be removed by
I
II
III

people in both countries having similar tastes and preferences

transportation costs between the two countries more than offsetting the
differences in relative production costs
per capita GNP being much higher in one country than the other.

Which of the following is correct?

A
B
C
D

II only
III only
I and II only
None of the above

12. The dollar has risen against other currencies since January, defying the
forecasters who thought Americas widening trade deficit must cause the value of
the dollar to fall.
From the above information, it can be correctly concluded that, since January
A
B
C
D

the strengthening dollar has improved the US Balance of Payments

US exports have become less price competitive
the US inflation rate has increased
US interest rates have increased

13. In the UK last month there was an increase in the quantity of goods exported and
a decrease in the quantity of goods imported. However the UK visible trade
balance did not improve.
The above situation can be explained by which of the following?
A
B
C
D

The exchange rate of the decreased

There was a net outflow of capital from the UK
The exchange rate of the increased
The rate of inflation in the UK increased.

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14. Over the last six months the exchange rate of the has fallen from $1.90 to
$1.70.
Assuming that the above change in the exchange rate of the was reflected in the
price of UK exports and imports, it can be concluded that, over the last six
months,
I
II
III
IV

UK exports to the USA decreased in price

UK exports to the USA increased in price
UK imports from the USA decreased in price
UK imports from the USA increased in price

Which of the following is correct?

A
B
C
D

I and III only

I an IV only
II and III only
II and IV only

15. If the Bank of England wishes to support the , it could

I Use dollars to buy pounds on the foreign exchange market
II Raise interest rates
III sell more government securities to the UK banking system
Which of the following is correct?
A
B
C
D

I and II only
I and III only
II and III only
I, II and III

16. The visible trade deficit in 1991 was accompanied by a downward trend in the
invisible trade surplus.
From the above statement it can be correctly concluded that during 1991
I
II
III
IV

the value of goods exported was greater than the value of goods imported
the value of goods exported was less than the value of goods imported
the value of services exported was greater than the value of services imported
the value of services exported was less than the value of services imported

Which of the following is correct?

A
B
C
D

I and III only

I and IV only
II and III only
II and IV only

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17. Which of the following combinations of government actions is most likely to

cause the value of Sterling to rise against the German Mark?
A
B
C
D

Selling sterling for German Marks and lowering UK interest rates

Buying sterling with German Marks and increasing UK interest rates
Selling sterling for German Marks and increasing UK interest rates
Buying sterling with German Marks and lowering UK interest rates

18. In the short term, a fall in the foreign exchange rate of Sterling will tend to result
in which of the following?
A
B
C
D

An increase in the UK inflation rate and an increase in the competitiveness of

UK exports
An increase in the UK inflation rate and an decrease in the competitiveness of
UK exports
A decrease in the UK inflation rate and an increase in the competitiveness of
UK exports
A decrease in the UK inflation rate and a decrease in the competitiveness of
UK exports

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THE ECONOMY
B. INTERNATIONAL TRADE AND PAYMENTS

Multiple choice solutions

1. D
2. C
3. B
4. A
5. A
6. A
7. C
8. D
9. B
10. C
11. A
12. B
13. A
14. B
15. A
16. C
17. B
18. A

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THE ECONOMY
C. MACROECONOMIC ISSUES AND POLICIES

Multiple choice questions

1. If, in a fully employed, closed economy, the supply of money and the velocity of
circulation of money both increase, then in the short-run.
A
B
C
D

unemployment of factors will result

real national output will expand
the volume of transactions will increase
the average level of prices will rise

2. In volume terms, Aprils retail sales were 2.4% lower than a year earlier. In value,
b they were up to 5%.
The above statements imply that, for the retail trade, over the period concerned:
A
B
C
D

prices increased
profits increase
productivity increased
demand was price elastic

3. Last year in a certain country the Public Sector Borrowing Requirement (PSBR)
was 40 billion. This year the PSBR will be only 10 billion.
From this information it can be correctly concluded that this years National Debt
will
A
B
C
D

decrease by 30 billion
increase by 30 billion
decrease by 10 billion
increase by 10 billion.

4. The following figures relate to a particular economy.

Money supply - 500 million
Number of transactions 250 million
Average price of transactions - 10
From the above information, it can be correctly concluded that each pound was
spent an average of
A
B
C
D

2 times
5 times
25 times
50 times

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5. The following policies have been proposed to help reduce unemployment in an

economy
I Lengthening the repayment period on consumer loans
II Increasing the down payment requirement on the purchase of consumer
durables
III The Central Bank selling securities to the non-banking sector
Which of the following is correct?
A
B
C
D

I only
III only
I and II only
I, II and III

6. Which one of the following is an example of an external cost of a factory

producing cars?
A Transporting the completed cars to the market
B Transport for the workers to and from work
C Repairs to the public road outside the factory when it is damaged by heavy car
transporters
D Training the car workers in the use of new equipment
7. An increase in the UK rate of inflation which is not accompanied by any change
in the volume of consumer goods sold will automatically increase the
A
B
C
D

revenue from Value Added Tax

level of UK company profits
level of UK unemployment
average level of wages in the UK

8. The increase in the Public Sector Borrowing Requirement (PSBR) to almost 50

billion this year will automatically lead to
A
B
C
D

a higher rate of inflation

a fall in the rate of unemployment
an increase in the National Debt
a deterioration in the Balance of Payments

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9. In an economy the unemployment rate and the trade deficit are increasing. In
addition the level of capital investment is low and the rate of inflation is higher
than in other countries.
The government has reacted by increasing interest rates. This suggests that the
governments main objective is to
A
B
C
D

reduce the rate of unemployment

improve the Balance of Trade situation
reduce the rate of inflation
increase the level of capital investment

10. If the retail price index is 10 percentage points higher at the end of the year than it
was at the beginning of the year, it can be correctly concluded that during the year
A
B
C
D

the average UK family suffered a 10 per cent reduction in real living standards
the money supply increased by approximately 10 per cent
the cost of living increased on average by 10 per cent
real GNP rose at a faster rate than nominal GNP

11. At the end of the year it was found that the money supply in an economy had
decreased but the nominal value of its Gross National Product (GNP) and the
price level had both remained unchanged.
Which of the following must also have occurred during the year?
A
B
C
D

A decrease in the interest rate

An increase in the velocity of circulation of money
A decrease in real GNP
An increase in the demand for money

12. In the short term, a fall in the foreign exchange value of Sterling will tend to
result in which of the following?
A An increase in the UK inflation rate and an increase in the competitiveness of
UK exports
B An increase in the UK inflation rate and a decrease in the competitiveness of
UK exports
C A decrease in the UK inflation rate and increase in the competitiveness of UK
exports
D A decrease in the UK inflation rate and a decrease in the competitiveness of
UK exports.

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13. The following table refers to an economy.

DATE

INTEREST RATE

ANNUAL RATE OF
INFLATION

31 December 1992

12%

10%

31 December 199

8%

8%

31 December 1994

4%

5%

From the above table, it can be concluded that:

A the real rate of interest was positive on 31 December 1994
B average prices fell between 31 December 1992 and 31 December 1993
C for the dates shown, borrowing was cheapest, in real terms, on 31 December
1994
D there was no incentive for saving on 31 December 1993.
14. Over a 12 month period a countrys inflation rate was 10%. Over the same period
the growth in nominal Gross National Product (GNP) was 8%. Which of the
following correctly describes what happened over the 12 month period?
A
B
C
D

The real GNP fell

The money supply increased by 18%
The money supply increased by 2%
There was an increase in the velocity of circulation of money.

15. In the course of recent weeks the Government has been urged by many people to
cut interest rates in order to increase growth and reduce unemployment in the UK.
However, the Government has refused to do so, fearing that the effect of a cut in
interest rates would be to cause the value of the pound to fall on the foreign
exchange markets.
It follows that, in the short term, the Government is less concerned about
increasing growth than it is about which of the following?
A
B
C
D

Possible Balance of Payments deficits

The danger of increased inflation
Reducing the public sector borrowing requirement
The danger of making the UKs exports less competitive.

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16. An increase in UK interest rates will make higher than it otherwise would have
been
A
B
C
D

The value of Sterling on the foreign exchange market

The UK money supply
The UK Balance of Payments deficit
The rate of UK economic growth.

17. In a period of high unemployment the government of a country decided to borrow

5 billion from its own citizens by offering Savings Certificates at attractive
interest rates. After the money was borrowed and spent by the government, the
reduction in unemployment was less than had been expected. One possible
reason for this could be that
A
B
C
D

exports from the country were higher than expected

imports into the country were higher than expected
income tax receipts were lower than expected
private savings were lower than expected.

18. A significant decrease in the real GNP of European Union countries led to a
decline in the UK exports to these countries. As a result of this, the UK
government increased interest rates from 8% to 14% but made no other change in
policy.
From the policy adopted, it can be concluded that the UK government is
concerned more about the
A
B
C
D

rising unemployment rate than the rising inflation rate

rising unemployment rate than the deteriorating balance of payments
deteriorating balance of payments than the rising inflation rate
deteriorating balance of payments than the rising unemployment rate.

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THE ECONOMY
C. MACROECONOMIC ISSUES AND POLICIES

Multiple choice solutions

1. D
2. A
3. D
4. B
5. A
6. C
7. A
8. C
9. C
10. C
11. B
12. A
13. C
14. A
15. B
16. A
17. B
18. D

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THE ECONOMY
SECTION 3 EXTENDED RESPONSE ITEMS

A
B
C

National Income
International Trade and Payments
Macroeconomic Issues and Policies

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THE ECONOMY
A. NATIONAL INCOME - EXTENDED RESPONSE ITEMS

(a)

Identify an describe briefly the main factors which affect the

level of potential output in the UK economy

10

(b)

Discuss, using examples, how maximising potential output

can lead to external costs and benefits as well as private costs
and benefits.

(c)

Discuss ways in which those responsible for social costs

might be made to help pay for them.

(a)

What is meant by the circular flow of income in an economy?

10

(b)

Describe the effects of injections and withdrawals on the

circular flow of income.

(c)

Explain how and increase in investment would affect the

equilibrium level of income.

The calculation of National Income statistics is a slow, complex and

expensive process.
(a)

Explain what is meant by National Income and describe

some of the problems involved in calculating it.

12

(b)

Discuss the uses to which National Income statistics can be

put.

(c)

Describe some of the limitations to be considered when using

National Income statistics.

Economic growth can bring costs as well as benefits to an

economy.
(a)

Explain what is meant by economic growth and describe its

benefits to an economy.

(b)

Explain how a country could increase its rate of economic

growth.

12

(c)

Describe some of the costs of a high rate of economic growth. 6

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THE ECONOMY
A. NATIONAL INCOME EXTENDED RESPONSE ITEMS SUGGESTED
SOLUTIONS
1

(a)

Investment in capital goods short term reduction in standard

of living for longer term benefits lowering of costs.
Investment in education, training in skills to raise long term
efficiency of labour.
Discovery of new resources (examples if possible).
Stable political environment.

(b)

(c)

(a)

Using resources efficiently, specialisation, economies of

scale, full employment. Students need not mention all these
factors in order to receive full marks.

10

Explanation of external costs and benefits cost/benefits

which affect the community/country/environment but which
are not borne by the firm. For example: increased pollution
as firms strive to maximise profits and cut costs, traffic
congestion, landscaping etc. The move towards maximising
potential output can increase external costs as firms produce
more goods and services

Enact legislation imposing limits on the pollution from

chimneys, waste ducts etc, forcing firms to buy filters.
Impose penalties for non-compliance with regulations e.g.
fines or no government contracts. Encourage firms who do
comply (tax cuts or exemptions). Impose higher taxes on
goods which emit greater pollution e.g. large cars. Increase
the number of inspectors or ensure legislation is enforced.

Circular flow of income

National product term used to describe total of all wealth
produced, distributed and consumed in an economy over a
period of time.
Two sides to the national product national income and
national expenditure.

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Simple model of the economy, where firms produce goods

and services which hire factor services provided by the people
from households (with money being used as a medium of
exchange).
For these services firms pay wages, rent, interest and
dividends.
Therefore there is a flow of factor services from households
to firms and a flow of income from firms to households.
However, households are also purchasers of national output,
so there is a flow of spending from households to firms and a
flow of good and services from firms to households (income
is spent creating more income for firms and so on).
(b)

10

Effects of injections and withdrawals

Define withdrawals Savings,Taxes and Imports a
withdrawal is any part of income not passed on within the
circular flow.
Define injections Investment, Governments Expenditure and
Exports an injection is an addition to the circular flow
which does not come from the expenditure of domestic
households.
If a value of consumption (C) were equal to income (Y), there
would be no tendency for the level of Y to change i.e. the
economy would be in equilibrium.
An increase in withdrawals reduces National Income in the
circular flow.

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An increase in the injections increase National Income in the

circular flow (size depends on value of the multiplier).
If the total of withdrawals is greater than that of injections
National Income will contract because planned expenditure of
the economy is insufficient to take up all the goods and
services which firms had planned to produce.
8
(c)

Definition of simple multiplier

=

/1- MPC

or

/MPS

Change in National Income = Change in injection/withdrawal

x multiplier
Or rise in National Income = Rise in investment x multiplier
Credit numerical examples.
3

Certain amount of overlap possible between parts (a) and (b)

provided students relate their points to the question.
(a)

(b)

National income (NY) is the total value of the goods and

services produced by a countrys resources over a given
period of time. Explanation of Net National Product
(although not necessary) can gain further credit.
Calculation difficulties include exclusion of transfer
payments, avoidance of double-counting, the calculation of
capital depreciation, certain outputs (e.g. education and
defence) difficult to value, non-monetary transactions, the
black economy, data collection difficulties, real or nominal
income. Credit descriptions of methods of calculating
National Income if it is used to explain the problems.

12

The figures show levels of production, investment, incomes

etc and are used to measure economic growth and standard of
living (SoL), to help the government plan future economic
policy and to compare the SoL of different countries or the
same country in different years.

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(c)

(a)

(b)

(c)

Answers can be very wide ranging, but basically the

limitations stem from the fact that the figures are, at best,
only estimates and can be misleading especially when used
as indicators of economic welfare. Good students will
mention that the figures only measure material well being and
ignore the influence of e.g. pollution, freedom, etc. Other
answers may mention the difficulties of comparing countries
(different currencies, work rates, needs, income distribution
etc) and comparing years inflation, population growth,
changes in work habits, demand patterns, etc).

Economic growth is an increase in the productive capacity of

a country usually measured by increases in real GDP per
capita. Benefits include an increase in living standards,
decrease in unemployment, easier to reduce income
inequalities, budget surpluses or more scope for government
spending etc.

Students should describe how a country can increase the

quantity and quality of its resources (e.g. land reclamation,
irrigation, scientific farming, immigration, education, retraining, specialisation, low interest rates, increased capital
allowances, reduced corporation tax etc).

12

Main costs are resource depletion, pollution and

environmental problems, decreases in quality of life and the
danger of the economy overheating (increased inflation and
imports). Credit relevant examples.

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THE ECONOMY
B. INTERNATIONAL TRADE AND PAYMENTS - EXTENDED RESPONSE
ITEMS

(a)
(b)

10

Describe the methods by which a country could reduce its

imports and explain why it may be restricted in the use of
such methods.

15

In 1990 sterling joined the Exchange Rate Mechanism (ERM) as a

step towards economic and monetary union.
(a)

Explain how the ERM operates.

(b)

Describe what is meant by economic and monetary union.

(c)

What will be the costs and benefits to the UK economy of

economic and monetary union?

The Exchange Rate Mechanism (ERM) is designed to promote

exchange rate stability within the European Community
(a)

Explain how the ERM promotes exchange rate stability.

(b)

Describe some of the benefits to the UK of membership of

the ERM.

10

(c)

Explain how countries may benefit from trading freely with

one another.

Suggest some of the difficulties membership of the ERM

might create for the UK.

In view of the ever present deficits in the UK Balance of Payments

on the Current Account, the UK should implement measures to
reduce imports and increase exports.
(a)
(b)
(c)

Explain why the UK has had persistent deficits on the

Current Account.

10

Describe possible measures which could be used to reduce

UK imports.

Describe possible measures which could be used to increase

UK exports.

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In recent years, the UK has had a trade deficit in manufactured

goods.
(a)

Explain and describe the factors which have led to this

deficit.

10

(b)

What have been the economic consequences of the deficit?

(c)

Suggest some measures, apart from import controls, which

could be taken to reduce the deficit.

The main reason countries trade with each other is because of

comparative advantage.
(a)
(b)
(c)

(a)
(b)
(c)

(a)

(b)(i)

Outline the theories of absolute and comparative advantage

as they relate to international trade.

13

Apart from absolute and comparative advantage, suggest

some other reasons why countries trade with each other.

Briefly explain why countries may impose restrictions on

trade.

Explain the terms Balance of Trade, Balance on Current

Account and Balance of Payments.

Describe and account for the UKs Current Account situation

over the last 10 years.

10

Suggest measures which could be taken to reduce a

persistent Balance of Trade deficit and explain how these
would work.

What is meant by the exchange rate of currency? Explain

why this would be of interest to a Scottish tourist visiting
France.

Explain the factors which determine the demand for a

currency.

(b)(ii) Explain the factors which determine the supply of a

currency.
(c)

Discuss the likely consequences for the UK economy of a

prolonged fall in the exchange rate of Sterling.

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THE ECONOMY
B. INTERNATIONAL TRADE AND PAYMENTS - EXTENDED RESPONSE
ITEMS SUGGESTED SOLUTIONS

(a)

Countries benefit from trading freely with each other:

Free trade free exchange of goods and services

between countries.

Arises because economic resources unevenly distributed

and mobility of resources is limited.

Absolute/comparative advantage comparison of relative

efficiencies (no need for numerical example).

E.g. ABSOLUTE : one country produces cars more

cheaply than the other. The other produces coffee more
cheaply. One has absolute advantage in cars, the other in
coffee. To their mutual advantage to trade.

E.g. COMPARATIVE : one country can produce more

than one commodity more cheaply country specialises
in what it is relatively best at.
Economies of scale.
Increased competition efficiency of production.
Promotion of political/economic links.
Greater variety of goods.
Increased employment.
Increased living standards.
Increased real output.

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(b)

Reduce Imports

Quotas/tariffs/embargo etc subsidies not legal on

exports.

Disguised barriers e.g. health and safety regulations.

Trade diversion e.g. EU has common external tariff on

non EU goods. Restrictions on use of methods.

Retaliation by other countries.

EU rules and treaty agreements.

WTO reduction of trade barriers, consultation amongst

nations on restrictions.

Membership of international organisations IMF, World

Bank, etc.

Reward highly actual examples e.g. USA and import of

steel, threat to French wine etc.
2

(a)

15

How the ERM operates

ERM to promote monetary stability and low inflation

in Europe.

designed to keep currency exchange rates within agreed

limits against each other.

central rate set by central bank and finance ministers.

each currency has a central rate against each of the

others.

currency only allowed to fluctuate within a certain band

(narrow +/- 2.25%, wider +/- 6%) of central value.

currencies kept within bands by central bank intervention

in foreign exchange markets (e.g. buying/selling
currency).

other central banks may also be asked to intervene.

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central banks have access to unlimited short term credit

to finance such intervention.

alternative is to use market intervention/domestic

monetary policy e.g. increase interest rates to raise
currency value.

if both market intervention and monetary policies fail,

government may agree to re-alignment i.e. resetting
central rate. This would happen as a last resort.

(b)

Economic and monetary union

Economic union refers to the process of integration between
the economies of the EU.
Monetary union refers to the culmination of the process of
closer co-operation on monetary policy between member
states. Economic agents can buy, sell invest and work as
easily in one region as another.
Single internal market within EU member states for goods,
services, labour and capital.
Cross border procedures and regulations harmonised EU a
single unit v rest of world.
Single common currency.
Harmonisation of government policies across a wide range
of activities e.g. technical, health and safety standards,
taxation, social security, monetary policy.

(c)

Costs

scope for national economic autonomy reduced

government policies converge, therefore uses of fiscal
and monetary policies to meet individual objectives are
limited e.g. exchange rate and money supply policies
cannot now be used as widely.

EU monetary policy may not suit particular need of each

National economy.

Less control over the value of sterling.

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Labour markets not perfectly competitive

unemployment
May occur in certain regions.

loss of sovereignty.

Benefits
lower transactions costs in trade within the EU leading to
greater efficiency and growth.
Lower costs which allow EU firms to compete with firms
outside the EU.

(a)

Euro is a stronger currency and rival the yen and dollar

as a store of value, thus attracting more capital to Europe.

eliminate the risk of exchange rate fluctuations, thereby

promoting international trade.

countries able to exploit their own comparative

advantages more certain about the future, so can make
investment decisions.

companies become larger and more specialised.

lower inflation/interest rates.

How the ERM promotes exchange rate stability

designed to keep currency exchange rates within agreed
limits against each other so a degree of stability exists.

each currency has a central rate against each of the others

(central rate set by the central bank and finance
ministers).

currency is only allowed to fluctuate within a certain

band (narrow +/- 2.25%, wider +/- 6%) of central value
(now 15%).

currencies kept within bands by central bank

buying/selling currency in foreign exchange markets
(other central banks may also intervene)

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(b)

(c)

central banks have access to unlimited short term credit

to finance such intervention (alternative is to use market
intervention/domestic monetary policy)

if market intervention and monetary policies fail,

government may agree to the resetting of the central rate
(this would happen as a last resort) realignment

above conditions mean that exchange rates may only

fluctuate within certain bands and member countries
exchange rates are relatively stable against each other.

Benefits of membership of the ERM

promotes international trade between member countries

because less risk of exchange rate fluctuations

lower inflation/interest rates through tightening of

monetary policy

greater economic certainty for British industry

encourage investment and long term planning

control higher wage costs - more difficult for British

firms to pass on higher wage costs in higher output prices
10
therefore firms forced to become more competitive.

Difficulties membership may create

country limited in use of monetary policy

need to match other countries (e.g. German) interest rates

to keep sterling stable (if interest rates high
unemployment)

pressure to keep inflation in line with other member

countries pressure on to become competitive.

cost to the country of keeping exchange rate within it

band in ERM (buying currency).

if too high a rate fall in competitiveness of UKs goods.

Credit Credit answers which deal with the reasons for the UKs
withdrawal from the ERM.

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(a)

High UK inflation means that UK goods are uncompetitive

particularly in the manufacturing sector. Reasons for
collapse of shipbuilding, motor cycles, motor cars, electrical
and electronic goods foreign competition particularly from
Japan and the Far East (who have better technology and
investment, and lower wage costs respectively).
High currency value of Sterling in the 80s as it was a petrocurrency which caused exports to be overpriced and imports
to be relatively cheaper.
Higher value of Sterling due to the high interest rate policy
used by the Government to reduce inflation.

(b)

(c)

Lack of investment in the UK by firms and poor industrial

relations record, e.g. in shipbuilding where deadlines were
not often met. Low productivity in UK compared to some
countries e.g. Germany and Japan. Reward any plausible
reasons.

10

Import controls e.g. tariffs, quotas, embargoes, sanctions,

also limit on the use of these due to international treaty
obligations and membership of the EU. Reward answers
which mention the dangers of such policies. Increase the
competitiveness of UK industry.

Reduce price of exports by reducing UK inflation, making

UK exports more competitive. Increase competitiveness in
such areas as design, reliability or availability of the product.
Reduce the value of the Exchange Rate to make UK exports
more competitive there are limits on this due to
membership of ERM. Good answers should mention the
limits to some government aid due to EU restrictions.
Increased investment in the UK to increase efficiency of
capital to provide long term boosts to competitiveness.
Increased skills training and education to boost the
productivity of labour.

(a)

Scope here for a variety of answers, so credit any plausible

reason. However the basic reason is an increase in foreign
competition and the fact that many imports are superior both
in technical performance and value for money. This,
combined with our relatively high inflation, high unit wage
costs and (until recently) low productivity, has resulted in a
shift of comparative advantage in manufacturing from the
UK to e.g. Japan and the tiger economies.

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Also credit general reasons for our poor export record e.g.
the fact that many UK producers lack the aggressive selling
techniques of some foreigners and are inclined to export only
when the domestic market is sluggish they also have a
tendency to sell traditional manufactured goods to countries
where demand is stagnant instead of selling new, high-tech
goods to the Newly Industrialised Countries.

(b)

(c)

(a)

Please note that students only require knowledge of

economic events over the past 10 years. Therefore teachers
and lecturers will require to update their answers each year.

10

Main consequences have been increased import

penetration, leading to overall trade deficits and increased
unemployment (especially in certain manufacturing
industries); continued decline of regions dependent on
manufacturing; de-industrialisation; greater need for retraining and measures to improve occupational mobility;
downward pressure on Exchange Rate, etc.

This is a difficult question and some students might

concentrate on the results of the measures rather than the
measures themselves be lenient should they do this but
credit highly anyone who attempts to explain the actual
measures. Basically the ideal way to reduce the deficit is to
create the conditions for export-led growth therefore credit
any measures which would e.g. help reduce inflation, keep
interest rates low or help keep the Exchange Rate stable.
Also credit any measures aimed at increasing productivity
and efficiency e.g. increased government spending on
education and training, greater tax allowances for research
and development spending and capital investment which
might help divert resources out of the technically stagnant
industries into technically dynamic ones and encourage the
export of high tech capital equipment.

Look for a clear, simple explanation of both theories

showing that international specialisation on the basis of
absolute or comparative advantage can benefit all (both)
countries. Be lenient with numerical examples which do not
work out exactly they are notoriously difficult to
construct accurately during exams. Reward an awareness of
the difference between the two concepts plus any real world
example. An understanding of the assumptions and
limitations of the theories although not necessary for full
marks should also be rewarded.

13

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(b)

(c)

(a)

Climatic differences, haphazard distribution of raw

materials, variety, to augment home supplies, encourage
export industries of LDCs, promote harmony etc. 3
reasons for full marks.

To protect infant industry and essential industries, improve

trade balance, reduce unemployment, retaliation, prevent
dumping etc. 3 reasons for full marks.

Note: There is now a new layout used for Balance of

Payments statistics.
Balance of Trade This is the balance of trade in goods
only, the visible balance. This is now called the trade in
goods and is the difference between the value of imports
and exports.
Balance on Current Account The current account was the
balance of visible and invisible trade i.e. the trade in goods
and services. It excluded the capital account i.e. long term
capital flows across international boundaries.
The new layout for Current Account is:
Total of goods and services + investment income + transfers
Balance of Payments a summary as follows:
Trade in goods
Trade in invisibles
Current Balance
Plus Capital Account
Plus balancing item*

bn
bn
---bn
---bn
bn
----

Balance of Payments

* to take account of
errors in the
estimates

bn
----

The resulting surplus or deficit was the Balance for Official

Financing. A surplus would allow the government to add
to reserves; a deficit would require to be financed either by
borrowing or by drawing from reserves.
Under the new layout, the Capital Account is replaced by
net transactions in UK assets and liabilities.

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(b)

The UKs Current Account situation over the last 10

years.
In 1987-89, this was the Lawson Boom, a time of
considerable overheating of the UK economy. The deficit
was 21.3 bn and growing. Since then the deficit has more
or less continuously declined and last year moved into a
small surplus of 1.4bn.
REASONS
1987-89 Lawson Boom was in full flight, real incomes
were rising and Britain has a high propensity to import
manufactured goods. In boom times too, British people
spend more on foreign travel.
British firms feeding the boom increased production and this
required more imported raw materials. British firms found it
easy to sell in the home market and export growth suffered.
At the same time, Britains traditional surplus in invisibles
declined due to increased foreign competition.
1990-1992 Britain now went into recession. This meant
that real incomes were not so large and less was spent on
imports. At the same time, UK firms found it much harder
to sell in the home market and switched much of their
attention to the foreign market.
1992-1995 According to critics, the pound has been
overvalued (=2.90DM) and the market took actions
against it. On Black Wednesday the pound fell to a much
more competitive level and this helped exporters
enormously. Some degree of recovery in Europe also helped
exporters and our surplus on invisibles improved again (by
almost 2 bn).
1996 - 1997- our surplus in invisibles continued to improve.
Despite a stronger pound, our exports rose in volume by 7%
in 1997, largely due to an increase in productivity in the UK.
Please note that students only require knowledge of
economic events over the past 10 years. Therefore teachers
and lecturers will require to update their answers each year.

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(c)

Measures to reduce a persistent Balance of Trade deficit

International negotiations have been for years proceeding to
try to bring more free trade into international relations. This
means that certain things are not allowed under World Trade
Organisation rules. However, there is no police force to
enforce these regulations and sometimes the agreements are
broken.
Measures
direct import controls not used by the UK in peacetime

tariffs additional tariffs used in the past as an

emergency measure

quotas e.g. for years there was an agreed limit to

Japanese car imports

exchange controls limiting access to foreign currency

to pay for imports (not used by UK in peacetime)

subsidies to domestic industry not allowed under

international agreement (except for infant industry)

non-tariff barriers using very high safety or quality

standards to keep out goods from some countries
(regarded as being unfair)
a more competitive exchange rate can be adopted (being
achieved by lower interest rates). This makes exports
cheaper in foreign markets and imports relatively more
expensive. The final result will depend on the elasticity
of demand for imports and exports.

FISCAL POLICY

MONETARY POLICY

Increase taxes
Reduce government spending

increase interest
increase controls on
credit

supply side measures to increase the performance of

British industry, some taken by firms, some taken by
government
higher investment
better design
improve quality
more spent on education

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higher Research &

Development spending
better after sales service
more staff training

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(a)

usual supply side measures to improve UK industry

deregulation, flexible labour markets, privatisation, more
efficient markets, lower taxes for entrepreneurs the
wealth creators.

The exchange rate of a currency

All western currencies are convertible into each other to
promote international trade. A currency can be converted
into another at the going rate of exchange i.e. the exchange
rate is the price of one currency in terms of another on the
foreign exchange market (e.g. so much Sterling for so many
Deutschmarks). Like all prices, the exchange rate is
determined by the demand and supply for that currency.
It would be of interest to a Scottish tourist visiting France
because the exchange rate will determine how many Francs
he gets for his Sterling. A strong pound would mean more
Francs for the pound. On the other hand, the strong Franc
policy adopted by the French for many years meant that a
Scottish tourist found his holiday in France expensive.

(b)

(i)

Factors which determine the demand for a currency

foreign demand for our exports to pay for British goods,
a foreign country sell their currency and buys sterling on
the forex market.

Foreign tourists coming to Britain will have to buy

Sterling with their currency.

Foreign investment in this country either in terms of actual

factories and offices financed from abroad or the purchase
of British shares with foreign money.
Foreign embassies, trade fairs etc various actions of
foreign governments need financed in Sterling.
Speculation an enormous amount of the demand for
currencies is speculative and these flows are nicknamed
hot money. Foreign investors or banks may buy sterling
because it is financially advantageous e.g. high UK
interest rates.
Much of the above is affected by the level of UK interest
rates, inflation and the general health of the British
economy.

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(b)

(ii)

Factors which determine the supply of a currency

By supply here is meant how much Sterling finds its way
onto the foreign exchange market. This can happen in a
number of ways:

When Britain imports goods, we sell Sterling and buy

foreign currency to pay for the goods. The more we
import, the more Sterling we sell.

When British tourists go abroad, they sell Sterling and

buy foreign currency to finance their holiday. This of
course involves millions of people.

Britain has very large foreign investments either as actual

Factories e.g. ICI factories abroad, or as British
ownership of foreign shares.

Speculation if British investors or banks buy a foreign

currency for a speculative purpose e.g. because interest
rates are higher abroad, then they sell sterling. Again,
this money may not stay long in any one country and is
nicknamed hot money.

The above may be influenced by the relative levels of

Foreign interest rates, inflation rates as well as the states
Of the British and other economies.

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(c)

Consequences for the UK economy of a prolonged fall in

the exchange rate of Sterling
The immediate effect is that our exports are cheaper in
foreign markets and our imports are more expensive. This
simple fact has a number of knock-on effects in the British
economy.
With cheaper exports and dearer imports, our Balance of
Payments would tend to improve though this would
depend on the elasticity of demand for our exports and
imports.
Our improved exports would cause unemployment to fall
and this effect would be further strengthened by consumers
switching out of imports and into domestic goods.

Similarly our rate of economic growth would increase as

we experiences export led growth.

Foreign tourists would find that their currency was

strong
in relation to Britains and there would be an increase in
tourism.

All of the above effects are dependent on a beneficial

competitive pound giving us expanding exports.
However, if the pound was too low, this would have
serious consequences. A prolonged fall in the value of
Sterling would cause import prices to rise so much that we
would begin to experience fairly serious inflation. Also, if
Sterling is too low, the beneficial effects on exports can
disappear, firms finding that their earnings on their exports
are simply too low (total revenue = sales times price).
If the exchange rate was too low for a prolonged period of
time, the government would have to take action:
Support the pound by buying sterling and selling foreign
currency. (If we were still in the ERM, other European
governments would step in and do the same). This policy
can run into difficulty because of the enormous sums of
money traded on the foreign exchange markets. As with
Black Wednesday the government might find that it is
unable to support the pound adequately because it has
insufficient reserves of foreign currency.

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 The government would put up interest rates to make

sterling an attractive currency to hold and also to make it
more difficult to borrow. In a really serious crisis, interest
rates would be increased substantially.
Anti-inflation measures would have to be used in
addition to increasing the rate of interest, government
spending might be cut and a public sector pay policy
hardened. The Chancellor would make speeches about the
dangers of high pay settlements.

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THE ECONOMY
C. MACROECONOMIC ISSUES AND POLICIES - EXTENDED RESPONSE
ITEMS

UK governments have difficulty in achieving all their economic

objectives simultaneously
(a)

Describe briefly the main economic objectives of recent UK

governments.

Give a full account of the main policy measures which can

be used to achieve these objectives.

12

Why is it difficult for governments to achieve these

objectives simultaneously?

(a)

Describe the economic factors which cause inflation.

(b)

How can governments attempt to control the rate of

inflation?

What are the economic costs of a high rate of inflation?

(b)
(c)

(c)
3

Although unemployment is inevitable, high rates of unemployment

are economically undesirable.
(a)

Explain the views expressed in the above statement.

(b)

(i) Describe the major trends in UK unemployment since the

mid 1980s.

(ii) Identify and explain the main causes of these trends.

10

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THE ECONOMY
C. MACROECONOMIC ISSUES AND POLICIES - EXTENDED RESPONSE
ITEMS

During a recession it is almost inevitable for a government to have a

budget deficit.
(a)

(b)

(i) What is meant by a recession?

(ii) Explain why budget deficits are almost inevitable

during a recession.

(iii)

Discuss the view that budget deficits can help an

economy to come out of a recession.

Explain how a Budget can be used to reduce income

inequalities.

(a)

What have been the main trends in the pattern and types of
UK employment in recent years?

12

(b)

Examine the causes of these trends and discuss their

probable consequences for the UK economy.

13

Over the last 10 years there have been significant changes in the
structure of Public (government) Finance the major one being the
shift from direct to indirect taxation.
(a)

Explain, with examples, what is meant by direct and indirect

taxation.

(b)

Discuss the advantages and disadvantages for an economy of

a shift from direct to indirect taxation.

(c)

Describe and account for the major changes in the level and
pattern of government spending over the last ten years.

10

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THE ECONOMY
C. MACROECONOMIC ISSUES AND POLICIES - SUGGESTED
SOLUTIONS

(a)

(b)

Description of low inflation, full employment, economic

growth, balance of payments equilibrium, (possibly
redistribution of income), environmental protection.
Fiscal measures including taxation, government expenditure
policies particularly recent measures.
Monetary measures including interest rates, money supply,
open market operations, etc, particularly recent measures.

(c)

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Difficulty of achieving full employment and inflation

simultaneously by use of fiscal and monetary policy. Also
full employment and Balance of Payment equilibrium, and
low inflation and economic growth.
Reward use of up to date examples particularly recent UK
experience and the slump of the early 90s.
Forecasting problems and time lags.

(a)

Economic factors which cause inflation

Inflation sustained increase in general level of prices,
measured by RPI.
Demand pull Aggregate Demand > value of output at full
employment.
Goods and services in short supply because economy is fully
utilised or economy cannot grow fast enough to meet
increasing demand.
Cost push increased costs passed on to consumer
(economy near full employment).
Wages - wage price spiral i.e. higher wages, increased costs
of production, to maintain profit margin, prices are raised.
Wages price wage spiral monopoly power of large
businesses push up prices. When prices are raised, cost of
living increases, therefore workers demand higher wages.

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Import prices increased raw material/energy costs,

increased costs of production, to maintain profit margins
prices are raised.
Exchange rates depreciation of external value of Sterling
imports more expensive.
Mark up pricing (unit cost plus profit) prices more
sensitive to supply and therefore tend to go up automatically
with increased costs.
Monetary inflation caused by rapid increase in money
stock, if there is no rise in output (MV=PT).
(b)

How governments can control inflation

Fiscal policy Budget surplus reduce government
spending, raise taxes.
To reduce aggregate demand will only be successful
against demand pull inflation.
Monetary policy control money supply.
Open market operations sell securities, people have less
money in their bank accounts, therefore less demand for
goods and services.
Set firm targets on monetary growth to reduce expenditure.
Decrease interest rates (short term) cheaper to borrow,
reduces costs of production, price stability. Mortgage
payments fall, RPI, fall in inflation rate.
Increase interest rates (long term) to reduce aggregate
demand.
Credit control e.g. increase % deposit on goods bought on
HP, reduce repayment period which helps to reduce demand
for consumer durables.
Prices/incomes policy e.g. control public sector pay rises
wages and other incomes do not rise faster than
improvements in productivity.

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(c)

Economic costs of a high rate of inflation

Effect on economic growth increased uncertainty,
discourages saving
Increased nominal interest rates discourages investment
favours borrowers/spenders at the expense of lenders/savers.
Adverse effect on Balance of Payments imports cheaper
and exports more expensive (relative rates of inflation).
Distribution of income reduced purchasing power for those
on low/fixed Incomes.
Increased unemployment.

(a)

Inevitable because some element of seasonal, frictional,

residual (and perhaps even technical) must always exist
look for at least two explanations.
Explanation of NAIRU natural rate of unemployment
credit highly.
Undesirable because it is a waste of a scare resource, costly
to the government (unemployment benefit and lost tax
revenue) and can cause social problems.
Both aspects need to be covered for full marks.

(b)

1986 March 1990: unemployment fell form 3.2 m to 1.6 m.

April 1990 January 1993 : unemployment increased to
almost 3 m. February 1993 March 1995 : unemployment
fell from 3 m to 2.3 m
Also credit changes in structure of unemployment e.g. the
increase in skilled male unemployment (especially in
manufacturing, construction and transport) and the increase
in the long term unemployed.

(b)(ii) The main cause has been cyclical i.e. boom of the late 80s
and the present recovery caused the respective falls in
unemployment while the recession of the early 90s was the
main cause of the rise.
Other points to look for include:

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Late 80s falling exchange rate, slower growth in unit wage

costs (UWC), growth of the tertiary sector, government help
for small firms, lenient 88 Budget, more flexible labour
market, changes in the way unemployment was measured.
Early 90s high interest rates (R), strong (both because of
the ERM), recession was worldwide.
1993 onwards lower R, weak , falling UWC, decrease in
activity rates, more flexible labour market.

(a)(i)

(ii)

(iii)

Good students will attempt to explain how their causes will

influence unemployment.

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The current (American) definition is two consecutive

quarters of negative growth, but also look for some
understanding that it is characterised by falling (or at least
sluggish) demand, decreasing output, investment and profits
and rising unemployment.

Budget deficits occur when the governments expenditure is

greater than its revenue. In a recession, rising
unemployment increases government expenditure on
unemployment benefit and reduces the revenue from income
tax. Falling consumer demand (expenditure) reduces VAT
revenue and falling profits reduce revenue from Corporation
Tax.

Students should also explain how budget deficits increase

the level of demand (AMD) in an economy since the
government is injecting more money (and therefore
spending) into the economy through its expenditure than it is
taking out through taxation. The resultant increase in
consumer spending should stimulate output and investment
and reduce unemployment. However the extra spending
could increase the rate of inflation and much of it could be
spent on imports resulting not in recovery, but in
stagnation.
Also credit students who mention the problems of repeated
budget deficits and large PSBRs i.e. crowding out, high
interest rates, loss of confidence, etc.

(b)

Make taxes more progressive by e.g. increasing the top rate

of income tax, switching from indirect to direct etc. so that
the rich pay proportionally more than the poor. The extra
revenue gained could then be used to increase the real value
of welfare benefits, pensions etc. Credit any sensible
suggestion.
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(a)

Recent years includes last 10 years, therefore credit any

correct reference to employment (not unemployment) trends
within that period.
Main trends (pattern and types overlap): increase (around 1.5
m) in number employed, decrease in male employment more
than offset by the increase in female employment (nearly as
many women in work now as men). Decrease in
manufacturing and increase in service employment, growth
of part-time employment and self-employment, growth of
work-related government training programme, e.g. New
Deal
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(b)

Causes: look for an explanation of de-industrialisation

(decline of manufacturing), rising living standards (growth
of services), growth of services (rise in female employment),
part-time workers cheaper and more flexible, government
encouragement of the enterprise culture, etc.
Consequences: rise in male unemployment, greater need for
retraining, labour mobility and childminding facilities,
decline in family income, decline in exports, increase in
import penetration, more flexible workforce.

(a)

Direct - levied on income and wealth, sent directly to

revenue authorities e.g. income tax, corporation tax, capital
gains tax etc.
Indirect levied on spending, revenue authority collects
them from an intermediary who passes the burden on to the
consumer e.g. VAT.

(b)

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Advantages greater incentive to work and risk-taking

(investment), greater freedom, encourages foreign
investment, increase level of capital available for ploughing
back, etc
Disadvantages regressive, distorts demand patterns,
inflationary (in the short term), discriminates against certain
consumers (e.g. car driving, drunken smokers), does not
automatically stabilise the economy.

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(c)

1986-89 government spending fell as a % of GDP because

of increased economic growth, since then it has increased
due to the recession falling now with the recovery. Major
change in pattern has been the increase in social security
spending because of the pension increase (ageing
population), increase in disability spending and payments to
long-term sick (mirroring the increase in the long-term
unemployed) and increased spending (up to 1994) on
unemployment benefit. Defence spending has decreased
recently due to the peace dividend. Only major changes
need to be mentioned but look for some degree of
explanation for full marks.

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