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AQA A2 Economics

Unit 4

The National and International Economy

1

Philip Allan, an imprint of Hodd
er Education


© Ray Powell, James Powell

WORKBOOK ANSWERS


AQA A2
Economics

Unit 4


The

N
ational and International Economy

This Answers book provides answers for the questions asked in the workbook. They are intended as a
guide to give teachers and students feedback. The candidate responses suppl
ied here for the longer
essay
-
style questions are intended to give some idea about how the exam questions might be answered.
The examiner commentaries (underlined text) have been added to give you some sense of what is
rewarded in the exam and which areas
can be developed. Again, these are not the only ways to answer
such questions but they can be treated as one way of approaching questions of these types.


Introduction to the national and


international economy

1

Microeconomics is the branch of the subject

that studies individ
ual markets, such as commodity
,
energy, car

and clothes

markets
. Macroeconomics is the branch of the subject that studies the national
economy

in aggregate, and how the national economy

interacts with the wider

global

economy.

Topic 1
Macroeconomic indicators

1

The economic cycle is a period of approximately
6

or
7

years in which the economy
complete
s
a cycl
e
of downturn,

recession
, recovery and boom
.

A peak and a trough are further features of the cycle.

2

Boom
:

The period leading up t
o the peak of the cycle when an overheating economy is experiencing
high GDP growth and inflationary pressures driven by unsustainable demand. Speculative activity,
which tends to gro
w in the boom period, is a

factor
that

makes a boom unsustainable.

Recess
ion:

The part

of the economic cycle when the depressed economy is experiencing negative
economic growth. A collapse of aggregate demand brings about a recession.

Recovery:

The period after a recession when the economy starts to experience steady GDP growth

without significant inflationary pressures.

Double dip recession:

When an economy falls back into recession before it has properly recovered
from the first recessionary ‘dip’. A double

dip recession can lead into a ‘lost decade’

of negative or
stagnant ec
onomic growth.

Economy’s growth rate:

Long
-
term economic growth, or trend growth
,

is the rate of growth the
economy can sustain, ignoring the short
-
term ups and downs of the economic cycle. It can be
illustrated by the outward movement of the economy’s pro
duction possibility frontier.

The percentage
annual increase in real GDP measures economic growth.

3

Economic growth is most commonly measured in terms of the annual percentage rate of change in real
gross domestic product (GDP).

4

First, demand
-
side growt
h is caused by a change in one of the components of aggregate demand. If
any of the components increases (consumption, investment, government spending or exports), the
economy will grow.


TOPIC 1

Macroeconomic indicators


AQA
A2 Economics

Unit 4

The National and International Economy

2

Philip Allan, an imprint of Hodder Education


© Ray Powell, James Powell

Second, supply
-
side growth occurs when the productive capacity of the

economy increases. This takes
place due to an increase in the physical capital infrastructure of the national capital stock or because of
the enhancement of either the depth or the breadth of the economy’s human capital stock.

5

The two main costs of econ
omic growth are resource depletion and environmental damage.



Economic activity requires factor inputs and will often lead to scarce resources such as fossil fuels
being consumed and lost forever because they cannot be replaced.



Environmental damage occurs
when the production process creates harmful toxics, gases and
waste in the course of making consumer and capital goods. This has also been called the paradox
of prosperity, as human living standards improve as a result of greater access to consumer goods
b
ut decline as a result of environmental destruction, poorer air quality and polluted water supplies.

Th
e two main benefits of growth ar
e improved living standards and technological advancement.



As an economy grows, the output of capital and consumer goods
will increase, which should in
turn lead to an increase in the level of employment as firms need more workers to maintain
production. The higher level of employment combined with increased production should result in
the average household being able to att
ain
buy

consumer goods, which will improve their standard
of living.



Technological advancements will often occur as an economy grows because firms will seek to
maximise profits by inventing new products to develop new markets and meet consumer needs.
This
dynamic growth will normally occur when an economy is growing because it will require firms
to undertake investment, which is encouraged by higher business confidence.

6

Gross domestic product is the total value of an economy's domestic output of goods and

services.
Gross national product is the same as GDP except that it adds what a country earns from overseas
investments and subtracts what foreigners earn in a country and send back home.

7

National income statistics underestimate the true level of economi
c activity, and hence people’s living
standards, because the non
-
monetised economy is under
-
represented. In the UK, housework and ‘do
-
it
-
yourself’ home improvement take place without money incomes being generated. The contribution of
these to living standa
rds is
imputed, but the ‘guesses’ are generally too low
.

Economic activity undertaken illegally in the hidden economy is also omitted. Economic transactions
conducted in cash because people are engaging in tax evasion are not recorded in the national incom
e
figures, so their contribution to living standards is also not recorded.

8

Two economic indices learnt at AS are the Retail Prices Index (RPI) and the Consumer Prices Index
(CPI). Both are used to measure the average price level for goods and services th
at people buy. A
main purpose of most economic indices is to remove the distorting effect of inflation from the data
being measured.

9

National income figures fail to measure the extent to which the positive externalities
that

benefit people
add to their e
conomic welfare and standards of living. They also don’t measure the human happiness
people enjoy from mixing with their family and friends.

10

(i)

Cyclical unemployment
: This is unemployment caused by an economic downturn and collapse
of aggregate demand.

It is
sometimes referred to as demand
-
deficient or Keynesian unemployment.
The slowdown in economic activity results in firms laying off workers due to a lack of demand for their
output.

(ii)

Frictional unemployment
: This is ‘between jobs’ unemployment
th
at

occurs when workers leave
one job and start searching for a new job.


TOPIC 1

Macroeconomic indicators


AQA
A2 Economics

Unit 4

The National and International Economy

3

Philip Allan, an imprint of Hodder Education


© Ray Powell, James Powell

(iii)
Structural unemployment
: This is a

destructive form of unemployment
that

occurs when an
industry or sector of the economy enters structural decline and sometimes disappears

compl
etely
.
Workers find themselves redundant or no longer needed
, without the skills to match any new jobs
.

11

(i)

Whereas the money wage rate or nominal wage rate is the hourly wage rate measured in money
that a worker receives for supplying labour, the real
wage rate is measured in terms of the goods and
services the worker can buy with the money at the current price level.

(ii)

Wage ‘stickiness’ or wage inflexibility may prevent the real wage rate falling to the full
-
employment
wage rate. Stickiness or infle
xibility is caused by labour market imperfections and by workers’
unwillingness to accept cuts in the nominal wage rate
,

which are usually necessary for real wage rates
to fall.

1
2

As stated in the answer to question 1
0

(i), cyclical unemployment is caused

by a collapse of aggregate
demand in the downturn of the economic cycle.

1
3

Every month, the Office for National Statistics (ONS) collects information on about 120,000 prices for a
'shopping basket' of about 650 goods and services. The change in the price
s of those items is used for
calculating the rate of inflation, shown by changes in the Consumer Prices Index (CPI). The contents of
the basket are reviewed every year, and changes can be made for a number of reasons. Some items
enter the basket because sp
ending on them has reached a level that demands inclusion, to ensure that
the basket represents typical consumer spending. Some are included to make

data

collection easier or
to improve coverage of particular categories.

Changes to the basket are often mad
e to improve coverage of a sector where spending has increased.
The ONS tracks consumer spending, and uses survey results to ensure that items on which people
spend most have the biggest share of the basket. Each is assigned a proportion, or 'weight', of t
he
index. The 'weight' of each category in both the CPI and the RPI is adjusted every year to take account
of these changes, giving more prominence to areas whose 'weight' is rising.

The Living Costs and Food Survey (LCF
S
), which in 2008 replaced the Expen
diture and Food Survey
(EFS), collects information on spending patterns and the cost of living that reflects household budgets
across the country. A primary use of the survey is to provide information about spending patterns for
the Consumer Prices Index.

1
4

The average price level has risen at a relatively fast rate since 2008, despite the deep recession that
the UK experienced in 2008/09. The rise in the price level has been driven by rising global commodity
prices and the devaluation of sterling followin
g the banking crisis in autumn 2008.

The rising price of global commodities has been
partly caused

by demand from the emerging
economies, especially China and India. These economies have been experiencing strong GDP growth
of between 7 and 11%

per year
, wh
ich has significantly increased demand for raw materials and
sources of energy such as oil and gas. This economic growth has created millions of jobs and lifted
more people out of poverty than in any other period in history. As a result levels of disposabl
e income
have increased and demand for food has surged.

The fall in the value of sterling on the international currency markets followed near collapse of the
British banking system and the lack of international business confidence in the UK economy.
After
July
2008, sterling

lost approximately 25% of its value agai
nst the US dollar,

although there was some
recovery in 2012.
However, some economists argue that the Bank of England and HM Treasury

encouraged

devaluation

through a process of ‘benign neglect’. T
hey have been relaxed about the
devaluation, which has been exacerbated by the Bank's monetary policy setting interest rates at 0.5%
and pursuing the unorthodox quantitative easing programme, in order to make exports price
competitive on the international
markets and imports unattractive to domestic consumers.


TOPIC 1

Macroeconomic indicators


AQA
A2 Economics

Unit 4

The National and International Economy

4

Philip Allan, an imprint of Hodder Education


© Ray Powell, James Powell

Although the price level has generally risen, and at a rate of inflation sometimes touching 5%, for a
very short period in the depth of the recession in 2009 the price level fell, at least when measur
ed by
changes in the RPI, though not the CPI. There was a very short period of deflation (a falling price
level).

1
5


Demand
-
pull inflation


Cost
-
push inflation

1
6

Demand
-
pull inflation occurs when there is an increase in the level of aggregate demand in

the
economy. Aggregate demand consists of five components
,

which are stated in the following
equation
:

AD

= consumption + investment + government spending + (exports


imports)

When there is an increase in one of the components


consumption, investment,
government
spending or exports


the level of economic activity in the economy will increase and real national
output will increase. This will be represented on a diagram as
AD

shifting to the right. However, as
aggregate demand increases there will be gre
ater pressure on resources, and firms supplying goods
and services may face the problem of excess demand, especially if production capacity is limited. This
will result in businesses increasing prices and/or employing more overtime workers less efficiently

to

TOPIC 1

Macroeconomic indicators


AQA
A2 Economics

Unit 4

The National and International Economy

5

Philip Allan, an imprint of Hodder Education


© Ray Powell, James Powell

satisfy demand. The higher prices will feed into the inflation indices CPI and RPI as the price level
increases at the same time as GDP growth occurs (providing there is spare capacity in the economy).

Demand
-
pull inflation has been caused mainly by th
e growth in consumption spending,
caused by

rising levels of disposable income, which in turn stems from a combination of increased employment,
tax cuts, lower interest rates, easy credit and increased household confidence.

17

Cost
-
push inflation occurs wh
en the costs of production increase, causing the short
-
run aggregate
supply curve to shift to the left.

The major causes of cost
-
push inflation are rising prices of raw materials, oil, gas and food, or a
sudden increase in wage rates. Increased business co
sts imposed on firms squeeze profit margins and
force firms to push up their prices, which
then causes cost
-
push inflation
.

The cost
-
push inflation experienced in the UK since 2009 has two main sources. First, the devaluation
of sterling on the currency ma
rkets has made imported goods and services into the UK more
expensive. Second, the
global increases just noted in the prices of food, energy and commodities have
been causing a cost
-
push inflation in the UK
.

1
8

The Fisher equation is:

money supply
(stock o
f money)



velocity of circulation of money =

price level


total transactions in the economy

or

MV

=
PT

In the Fisher equation, for a particular time period, say a year, the
stock of money in the economy

(or
money supply
) shown by the symbol (
M
) multipli
ed by the
velocity of circulation of money
(the
number of times money changes hands
) or

(
V
) equals the
price level

(
P
) multiplied by the
total
number of transactions

(
T
). A transaction occurs when a good or service is bought.
T

measures all
the purchases o
f goods and services in the economy.

To convert the equation of exchange (
MV

=
PT
)


which is true by definition


into a theory of
inflation, it is necessary to make three assumptions. The first two are:



The velocity of circulation
o
r speed at which money

is spent

and total transactions (which are
determined by the level of real national

output in the economy) are

fixed, or at least stable.



In
the quantity theory, money is a
medium of exchange

(or
means of
payment
),
but

not

a
store
of value
. This means

tha
t people quickly spend any money they receive.

Suppose the government allows the money supply to expand faster than the rate at which real national
output increases. As a result, households and firms possess money balances (or stocks of money) that
are gre
ater than those they wish to hold. According to the quantity theory, these excess money
balances will quickly be spent. This brings us to the third assumption in the quantity theory: changes in
the money supply are assumed to bring about changes in the pri
ce level (rather than vice versa).

19

Macroeconomic policy trade
-
offs are possible along the short
-
run Phillips curve but are not sustainable
in the long run. In the short run a government can choose between targeting the level of unemployment
or the rate
of inflation. In the short run, expansionary fiscal policy can spur the economy and create
jobs at the cost of a higher rate of inflation.

However, the capacity of the economy is fixed in the short run. The economy’s long
-
run Phillips curve
is a vertical l
ine, whose position is fixed by the economy’s short
-
run productive capacity. It is
impossible to trade off along this line in the long run between the two policy targets of reducing
unemployment and reducing inflation.


TOPIC 1

Macroeconomic indicators


AQA
A2 Economics

Unit 4

The National and International Economy

6

Philip Allan, an imprint of Hodder Education


© Ray Powell, James Powell

Exam
-
style
answers

(data response)

Gl
obal living standards and the UK macroeconomic performance

01

The

absolute difference in gross national income per capita is 29,828 PPP$, which means that UK
income per capita is approximately 860% higher than India’s.

The data are ranked in terms of desce
nding Human Development Index (HDI) for the selected countries.
However, just because a country ranks above other countries in terms of the HDI, this does not mean that
it ranks above the same countries in terms of all the factors that contribute to the va
lue of the country’s
HDI. For example, the Czech Republic lies above the UK in terms of HDI (0.865 compared to 0.863), but
the country is below the UK in terms of life expectancy at birth (an age of 77.7 years as against

80.2 years).

The first part
(01)
o
f the context data response question

in ECON
4

and in ECON
3

will usually be in two
parts. The first part requires a calculation (often a percentage calculation) and the second part asks for
identification of
one other

significant point of comparison, or for

questions where there is only one data
series in Extract A,
one other significant feature

of the data. Some

exam papers may
,

however
,

ask

for
two
significant points of comparison (or features), without a preliminary calculation.
T
his answer
scores
the 2 m
arks for the calculation and picks up all

3 marks
available
for identifying, and backing up with
statistical data, a significant feature of the data.

02

The concept of comparative advantage states that a nation should specialise in the industries
in
which

it has a comparative advantage. Comparative advantage is measured in terms of opportunity cost.
The country with the least opportunity cost when producing a good possesses a comparative advantage in
that good.

In recent years it has become fashionable to a
rgue that the British economy is in decline and that it needs
to re
-
balance in order to compete with the emerging BRIC economies.
O
n coming to office in 2010, David
Cameron and Nick Clegg said that the UK was too dependent on its service sector economy but

needed
to rebuild its economy to be more like that of Germany, which has a proud tradition of exporting high
-
quality capital and consumer goods across the world. In
recent

years Germany's economy has boomed as
it has enjoyed strong balance of payments sur
pluses by selling its goods and services to the BRIC
economies.

The law of comparative advantage, however, suggests that it would be unwise of the UK economy to try to
replicate the German model. First, German firms have already established a leading posit
ion in producing
high
-
quality capital and consumer goods, and the absolute and comparative advantage is already in its
favour. Second, firms in the BRIC economies are attempting to emulate Germany and other engineering
and manufacturing producers. UK firms

could try to compete but they may struggle because they are
unable to employ workers on significantly lower wages. Third, the UK should focus on the industries where
it already has the comparative advantage, namely high
-
quality design, niche top
-
end manuf
acturing and
engineering, and most importantly services. The southeast of England is home to some of the world’s
leading financial, insurance, marketing, consultancy and legal firms. These industries are extremely
difficult to replicate because they are ba
sed on the value of the human capital they employ and not
physical capital. The UK has already established these industries and should be careful not to lose them.
Free
-
market economists would argue that the government would be wiser to listen to the advic
e of David
Ricardo and focus on what the nation already does best rather than trying to copy another nation in a
superior position.

For ECON 4 a
nd

ECON3, the second part of the question
(02)
divides into two parts. The first part (worth

4 marks) asks cand
idates to
explain

the meaning of an economic term (in this case ‘comparative
advantage’. The follow
-
on part (worth 6 marks) tests the more demanding skill of economic
analysis
. An

TOPIC 1

Macroeconomic indicators


AQA
A2 Economics

Unit 4

The National and International Economy

7

Philip Allan, an imprint of Hodder Education


© Ray Powell, James Powell

answer is constrained to a maximum of either 4 marks or 6 marks if only the
explanation or analysis is
attempted.

T
his answer
earns full marks

for

both parts
,
al
though the explanation is really too long, drifting at times
away from the central issue posed by the question. The candidate
might

well have wasted time that would
be be
tter spent answering the last part of the question.

03

UK macroeconomic performance should
be judged on the economy’s long
-
term ability to generate
growth, create jobs, improve livi
ng standards, control inflation,

and run equilibrium on the current account

of the balance of payments.

This answer considers and then evaluates each of these in turn, before
coming to an overall conclusion on whether the growth of emerging market economies has improved or
deteriorated UK macroeconomic performance.

According to I
nvestopedia,

Antoine W. Van Agtmael of the International Finance Corporation of the World
Bank

first mentioned the term emerging market economy (EME)
.

Since then, an EME has become
defined
as an economy with low to middle per capita income.
About 20
%

of gl
obal economies are EMEs and they
contain

about

80% of the
world’s

population
.

The word ‘emerging’ relates to the fact that EMEs have
started

economic development and reform program
me
s,
which involve opening up
their markets
. EMEs
have generally benefited i
n recent decades from fast rates of economic growth. In some countries their
increased integration into the globalised world economy has produced this result
.

However, the success of
many EMEs has arguably been the result of a considerable amount of interv
ention by their governments
(often in the form of state

capitalism) and protectionism


the latter often hidden.

The so
-
called BRIC
countries (Brazil, Russia, India and China)
,

to which South Africa is sometimes added to become the
BRICS, are the most well
-
known EMEs.

With regard to economic growth, a good starting point for analysis and evaluation is the fact that the rate
of economic growth in the UK has been very low, whereas growth rates in many EMEs have been much
higher.
For the UK

and before the onse
t of recession in 2008, the trend rate of growth wa
s estimated to be
around

2.5% per year
. Many
forecasters have
now
downgraded this to below 2%
per

year.

The
downgrade reflects both cyclical factors (the collapse of aggregate demand in the UK associated w
ith
recession and the possibility of Britain having entered a ‘lost decade’ of near zero growth) and structural
factors, one of which is deindustrialisation. By contrast, among the BRICs,
China’s trend growth rate is
around

8

9% per year
and

India
’s rate

i
s

above 6%
per

year.

Deindustrialisation, or the structural decline of many manufacturing industries, along with activities such as
coal mining, is associated with

UK

manufacturing

firms either relocating

to cheaper labour zones

in EMEs,

or go
ing

out of bu
siness in the face of fierce competition

from the EMEs
.
Obviously, workers previously
employed in
UK

manufacturing who have lost their jobs as a result of the structural decline of the
indu
stries that used to employ them

have suffered a decline in their st
andard of living. By contrast, many
UK

households have benefited from
the shift of manufacturing to EMEs

because they have been able to
buy cheap imports from the emerg
ing markets, especially China. Despite the relatively low trend growth
rate, t
he average

standard of living in the UK increased between 1997 and 2007 as the British economy
experienced the benefits of generally falling import prices.

(Since 2008, the standard of living of most UK
residents has fallen. Recession and loss of international compe
titiveness are to blame.)

But even when standards of living rose, this came

at the cost of structural unemployment
,

which has
particularly affected regions in the north of England, Wales, Scotland and Northern Ireland. The
communities that were dependent o
n heavy industry have suffered from hi
gh levels of unemployment
while

other areas of Britain have benefited from cheaper imports and higher living standards.

For free market economists this has been an acceptable consequence of the development of globalisa
tion
and the rise of
EMEs
. On a global scale it has resulted in a more efficient allocation of scarce resources
,

as countries that can produce manufactured goods and export them around the world have done so and

TOPIC 1

Macroeconomic indicators


AQA
A2 Economics

Unit 4

The National and International Economy

8

Philip Allan, an imprint of Hodder Education


© Ray Powell, James Powell

sell goods at significantly lower prices. Fu
rthermore, tens of millions of people in India and China have
been lifted out of poverty.

Taken on its own, importing cheap manufactured goods from EMEs (and also low
-
priced services such as
those provided by call centre
s which have relocated to EMEs)

may
have contributed to a lower UK
inflation rate than would have been the case in the absence of falling prices of manufactured goods.
However, this deflationary effect has probably been more than offset by the rising import prices of food,
raw materials and
energy. Britain increasingly competes with EMEs for these goods. In particular, China
and India have an insatiable demand for raw materials and energy, which are necessary for maintaining
their fast trend rates of growth. Thus deflation in the prices of ma
nufactured goods imported from EMEs is
overwhelmed by high inflation in the prices of food and inputs into the production process. Also, there is
now evidence that EMEs such as China are putting up the prices of their manufactured goods as they also
suffer

from the rising import costs of foods, raw materials and energy. In the UK this is further exacerbated
by the rising price of imports caused by the fall in the value of the £, itself caused in part by Britain’s loss
of international competitiveness vis
-
à
-
vis the EMEs.

A

problem for the UK is that remarkably few
UK
goods or services are exported to

the BRIC countries.
Most of Britain’s exports go to other EU countries, but many EU countries are also suffering from a
collapse in aggregate demand as a result
of their similar loss of international competitiveness.

This is a major
problem for UK economic performance and helps explain the persistent deficit on the
current account of the balance of payments. The UK has been a net importer of goods
for many decades

and, although the UK has a strong service sector, British households have become dependent on
imported goods. The major problem facing the UK is that large current ac
count deficits that have been
in
curred since 2000 have been financed by borrowing from th
e emerging
-
market nations, particularly
China. This is not a sustainable position.

If China were suddenly to decide to sell its holdings of financial
assets, denominated in sterling, that
it

has accumulated as a result of financing the UK’s imports from
Ch
ina, the £’s exchange rate would go into free
-
fall. Although this would make Britain’s exports more price
competitive, in the short run at least, UK inflation would rise

dramatically
, unemployment would grow and
standards of living would fall.

To conclude,

i
f the UK is to benefit from the growth of emerging
-
market economies in the future
,

it must
start exporting goods and particularly services to these countries in greater volumes.

However, this is
much easier said than done and is dependent on a supply
-
si
de led reform of methods of production in the
UK. Nevertheless, t
he British service sector is the home to some of the best service sector firms in the
world. Furthermore, the UK possesses some very competitive niche manufacturing companies. However,
if the

UK economy is to generate jobs and export

more

to
EMEs

in the future
,

it needs to ensure that it
sets up trade links quickly with the main emerging
-
market economies and
fend off competition from other
EU countries, Japan and the USA
.

This

answer is placed

at the
bottom of l
evel 4 (17

21 marks). The answer’s main weakness is failure to
base the analysis and evaluation on a key concept in the question: UK macroeconomic performance.
Whenever you see these words in a question, you should start your answer by e
xplaining the meaning of
the term. Macroeconomic performance can be measured by the extent to which the economy achieves
sustained success in achieving reasonable or good performance with regard to the standard objectives of
macroeconomic policy: low unemp
loyment, economic growth, control of inflation and the export
competitiveness of the country’s industries, reflected in the current account
of the balance of payments.
The

analysis in this answer is good but narrow, and the final paragraph does not really
come to a justified
conclusion.


TOPIC 1

Macroeconomic indicators


AQA
A2 Economics

Unit 4

The National and International Economy

9

Philip Allan, an imprint of Hodder Education


© Ray Powell, James Powell

The grade descriptor for l
evel 4 is:

A2

Levels mark scheme

AO1 Knowledge
and understanding

of theories, concepts
and terminology

AO2 Application

of
theories, concepts
and terminology

AO3 Analysis

of
economic problems
and i
ssues

AO4 Evaluation

of
economic arguments
and evidence,
making informed
judgements

Level 4

17

21 marks

(mid
-
point 19)


Good analysis
but

limited evaluation


or

Reasonable analysis
and

reasonable
evaluation

Good throughout the
answer with few
errors and
w
eaknesses





Good throughout
much of the answer
with few errors and
weaknesses

Good application to
issues

Where appropriate,
good use of data to
support answer




Some good
application to issues

Where appropriate,
some good use of
data to support
answer

R
elevant and precise
with a clear and
logical chain of
reasoning

There is good
awareness of the
interrelatedness of
economic issues

Largely relevant and
well organised with
reasonable logic and
coherence

There is some
awareness of the
interrelatedness of
ec
onomic issues

Limited but showing
some appreciation of
alternative points of
view





Reasonable,
showing an
appreciation of
alternative points of
view

Exam
-
style
answers

(essay)

Unemployment, inflation and the Phillips curve

0
1

Inflation is the rate at w
hich the average price level of goods and services rises in a given time
pe
riod. In the UK
,

the Office for National Statistics

uses two main indices

to measure inflation: the
Consumer Price
s

Index
(CPI)
and the Retail Price
s

Index

(RPI).

The role of inflat
ion expectations in influencing future inflation was an area of economic analysis
developed by Professor Milton Friedman in the 1970s. Friedman argued that workers and firms pay
careful attention to their past experiences when developing expectations about

future inflation. If they have
experienced inflation in the past, workers will expect prices to go up in the future and will make pre
-
emptive wage demands
on the ground that without an inflation
-
adjusted p
ay rise they will experience a

pay cut in real ter
m
s
. This behavio
u
r will actually create the conditions for inflation. Confronted with
increased wage demands and accepting the inflationary record of the past, firms will give in to higher
wage demands and pass
on
the cost increases to consumers in the for
m of higher prices.

Changes in

costs of production will also affect inflation.
In the summer of 2008 the UK

experienced
increased infl
ation as the price of energy

increased in world markets. In July 2008 the price of oil broke the
$100 a barrel mark for th
e first time, although it did fall sharply after the financial crisis. It has, however,
risen steeply again due to the high levels of demand from the emerging markets which may well see the
price of a barrel of oil break the $200 mark in the next few years
. The British economy is dependent upon
oil as a major source of energy,
so

when oil prices increase, the costs of production of almost all firms
increase either directly or indirectly. This feeds into the inflation indexes.

Cost
-
push inflation is illustra
ted on the aggregate demand and supply diagram below. Initially,
macroeconomic equilibrium is at point
X
, with real output and the price level respectively at
y
1

and
P
1
.
Firms’ money costs of production rise


for example because money wages or the price o
f imported raw
materials increase


which causes the
SRAS

curve to move upward and to the left from
SRAS
1

to
SRAS
2
. The cost
-
push inflationary process increases the price level to
P
2
, but higher production costs

TOPIC 1

Macroeconomic indicators


AQA
A2 Economics

Unit 4

The National and International Economy

10

Philip Allan, an imprint of Hodder Education


© Ray Powell, James Powell

have reduced the equilibrium level of output

that firms are willing to produce to
y
2
. The new
macroeconomic equilibrium is at point
Z
.


It should be noted that
falling

costs of production can also result in benign deflation. The UK experienced
a decade of low inflation
between 1997 and 2007
caused
by falling costs of production as firms benefited
from technological advances

that

revolutionised production methods and significantly lower
ed labour costs
by out
-
sourcing production to southeast Asia.

The mark scheme for the first part
(01)
of an essay qu
estion is ‘issue based’. The mark scheme sets out
all the issues deemed to be relevant to the question and indicates the maximum marks that can be
awarded for each issue.
T
he total
mark is usually higher than 15, which is
the maximum mark for the first
par
t of an essay question.
So w
hen an answer earns

more than 15 marks, the
mark awarded is
constrained to the maximum of 15. This is the case with this answer. Both parts of the question are
addressed accurately, earning well over 15 marks

but t
he mark

awarde
d

is
the maximum 15. By the time
you read this

answer, the reasons for recent and current inflation quoted by the candidate may have
changed. In the early months of 2012, for example, falling world oil prices meant that cost
-
push
inflationary pressures wer
e considerably less than they had been in the earlier years quoted by the
candidate.

02

T
he Keynesian economist A.

W. Phillips
developed s
hor
t
-
run Phillips curve analysis in the 1950s.
Phillips had researched the relationship between inflation and unemploy
ment over a
100
-
y
ear period and
found that there was a relationship between the two variables that could be i
llustrated as in the diagram
below.



TOPIC 1

Macroeconomic indicators


AQA
A2 Economics

Unit 4

The National and International Economy

11

Philip Allan, an imprint of Hodder Education


© Ray Powell, James Powell

The Keynesian economists of the1950s and 1960s
used this curve
to present governmen
t officials with a
‘menu c
hoice’
. They could pick either: low inflation and high unemployment (position
A

on
the
diagram); or
high inflation and low unemployment (position
B

on
the
diagram).

The 1970s saw a prolonged period
of mass unemployment and double
-
digit
inflation which led
to
wide
spread disillusionment with Keynesian economics. The neo
-
liberal economic revolution
associated
with

the
1980s
governments of
Margaret Thatcher in the UK and Ronald Reagan in the USA was inspired
by
the revival of free
-
market economics
.

Milton Fried
man from the Chicago School was particularly critical of the Phillips curve for two main
reasons. First, he argued that like Keynesian economics in general, the Phillips curve ignored the supply
side of the economy. In Friedman’s analysis, government polic
y that merely stimulates aggregate demand
will inevitably create inflation unless there is also a policy to increase the supply side. Hence, free
-
market
economists argue that if a government wishes to tackle unemployment it needs to remove obstacles to
mar
kets functioning properly, such as trade unions and unnecessary regulations, and t
o use low taxes and
the profit mot
ive to create incentives for workers and entrepreneurs.

The theoretical roots of this thinking rested in a fiscal policy that advocates low
taxation and low welfare
benefits. By creating incentives to work, the government can encourage workers to sell their labour at a
competitive rate. Moreover, by allowing businesses to make profits, business leaders will invest in the
economy and increase t
he capacity of the national capital stock. This will create more jobs and reduce
inflation.

Economists now generally recognise that the Phillips curve in
the
diagram

above

is a short
-
run Phillips
curve (
SRPC
), representing the short
-
run relationship betwee
n inflation and unemployment. In the next
diagram, a vertical long
-
run Phillips curve (
LRPC
) has been added to the diagram, intersecting the short
-
run Phillips curve where the rate of inflation is zero. The rate of unemployment at this point is called the
natural rate of unemployment (NRU), depicted by the symbol
U
N
.


Once inflation
ary

expectations have been allowed to develop, it is an extremely painful process to get
workers to accept lower wages in the future. Indeed it may take a prolonged period of ma
ss
unemployment to discipline the labour markets and bleed the inflationary pay demands out of the
economy.

Ultimately, a government can achieve economic growth with low inflation and reduce unemployment but
only by tackling the long
-
term structural and su
pply
-
side problems in the economy. If a government is to
shift the
LRPC

to the left (and the long
-
run aggregate supply curve to the right) it needs to pursue an
investment strategy that enhances both the physical and human capital of an economy and reduces

inflationary pressures. In the coming decades the UK economy is going to face increasing competition

TOPIC 1

Macroeconomic indicators


AQA
A2 Economics

Unit 4

The National and International Economy

12

Philip Allan, an imprint of Hodder Education


© Ray Powell, James Powell

from overseas. British firms and workers will be unable to compete on cost but instead will have to offer
services, production techniques and skills that
cannot be easily replicated in other countries. A highly
skilled workforce with the best capital equipment and technology is the objective that the government
should aspire to if it is to reduce unemployment and maintain low inflation.

A
s is the case wit
h
the final part of a c
ontext data response question, the mark scheme for the second part
(02)
of an essay question is ‘level of skill based’. Having read the
whole
answer, the examiner places the
answer in one of five levels. These are:



Level 1


very weak



Level 2


weak with some understanding



Level 3


reasonable including some correct analysis but very limited evaluation



Level 4


good analysis but limited evaluation
or

reasonable analysis and reasonable evaluation



Level 5


good analysis and good evaluat
ion

This answer
is

awarded
21 out of 25

mark
s and is placed

at the top of l
evel 4 in the

mark scheme.
The

answer displays both good analysis and good evalua
tion, but does not quite reach l
evel 5.
It

drifts a little
to
o

much into
‘write all you know about t
he Phillips curve’

and away from focusing on the issue posed by
the question:
‘can governments reduce both the rate of inflation and the level of unemployment?’
The final
paragraph relating to the supply
-
side of the economy is good, but added
as
a bit of a
n after
-
thought to the
main part of the answer. It should appear, and be developed, much earlier in the answer.


AQA A2 Economics

Unit 4

The National and International Economy

13

Philip Allan, an imprint of Hodd
er Education


© Ray Powell, James Powell

Topic 2 Managing the national economy

1



2

The main fiscal objective of Chancellor George Osborne when coming to office in May 2010 was to
e
liminate the UK’s structural deficit and run a balanced budget by 2015. Due to poor economic data the
Treasury later conceded that this could not be achieved
until 2018. However, until June

2012 at least,
the government’s tight fiscal policy (known various
ly as fiscal austerity, fiscal consolidation or fiscal
realism) remains largely in place.

The government announced in March 2011 that it intended to cut government spending by £81 billion
over a 4
-
year period. The main spending cuts would be achieved by cu
tting most of the government
department budgets by up to 20%, although the NHS has been protected from any real cuts. The
number of civil servants employed by the government has been dramatically reduced and 800,000
redundancies have been announced. Welfar
e benefits have been targeted by the Minister for Work and
Pensions, Iain Duncan Smith, who wants to introduce a cap of £26,000 per year on benefi
t claimants.
Public sector pay was

frozen for 2 years and public sector pensions are
in the process of
being
r
eformed to save money. The age for retirement has been increased to 67 and will rise to 68.

At the same time, levels of taxation have increased. The most significant is the increase in
the
VAT
rate to 20%. The government first

maintained the 50% income tax

rate levied on top earners
, but then
cut the rate to 45%
. Public sector pension contributions have been increased and tax bands have been
lowered so that more workers have to pay the higher 40% band of taxation.

3

In the period between 1997 and 2006 the L
abour Chancellor Gordon Brown was committed to the self
-
imposed Sustainable Investment Rule
,

which stated that the national debt would not rise above 40% of
GDP. However, since 2007 the UK’s national debt has almost doubled and is expected to peak at 80%
o
f GDP in 2014.

The causes of the rapid increase in the national debt are threefold. First, during the banking crisis of
2007/08 the British government nationalised the Northern Rock bank and partially nationalised RBS
and HBOS. These bailouts kept the bank
s solvent but saw the British government accept liability for
their massive debts. Second, the government ran up huge budget deficits after 2008. When the
recession hit, tax revenues fell sharply but government spending increased, in part to prevent the
co
llapse of the economy. Third, it is now clear that the British economy has been running a structural
deficit and for too long the nation has lived beyond its means. Even in the good years, government

TOPIC 2

Managing the national economy


AQA
A2 Economics

Unit 4

The National and International Economy

14

Philip Allan, an imprint of Hodder Education


© Ray Powell, James Powell

spending was greater than tax revenues, which meant that

in every year since 2002 the national debt
increased. As a result, the current Chancellor is committed to a programme of spending cuts, with the
long
-
term objective of bringing the budget deficit under control.

The national debt is significant for two rea
sons. First, it will have to be paid back by future taxpayers.
This can only happen if future governments can get the economy to grow and run budget surpluses.
Moreover, higher rates of taxation and lower levels of government welfare provision will reduce
the
standards of living for future generations. Second, an extremely high national debt will make it more
difficult for the British government to borrow from international markets and will mean that the nation’s
debt interest repayments will increase. Beca
use of these problems (and although it does not admit it),
the government will probably be quite happy to see inflation reduce the real value of the national debt.

4

The principle of equity is that a tax should be fair and that the tax is levied on those w
ith the ability to
pay the tax.

The principle of efficiency is that the tax should be easy to collect and that the government should not
have to spend a disproportionate amount of money enforcing the collection of the tax.

5

Government intervention in the
economy, which treats people
in the same circumstances

equally,
obeys the principle of
horizontal equity
. Horizontal equity occurs when households with the same
income and personal circumstances (for example, number of children) pay the same income tax and

are eligible for the same welfare benefits.
Vertical equity

is much more controversial, since it justifies
taking income from the rich (on the ground that they don’t need it) and redistributing their income to the
poor (on the ground that they do need it)
. The distribution of income
after

taxation and receipt of
transfers is judged more equitable than original income before redistribution.

6

Trade union reform

Deregulation

Privatisation

Tax simplification

7


Successful supply
-
side policies shift the
LRAS

curve to the right, increasing the economy’s natural
level of real output from
y
N1

to
y
N2
. The diagram also shows the price level falling (a benign deflation).
However, it may be necessary for the
AD

curve also to shift to the right, to create the demand t
o
absorb the extra output that successful supply
-
side policies produce. In this case, the price level may
not fall.


TOPIC 2

Managing the national economy


AQA
A2 Economics

Unit 4

The National and International Economy

15

Philip Allan, an imprint of Hodder Education


© Ray Powell, James Powell

8

The belief that control of inflation should be the primary economic objective of government can be
traced back to the neo
-
liberal revoluti
on
,

which started in the mid
-
1970s. Free
-
market economists
argue that price stability is essential for long
-
term economic growth because it creates the necessary
conditions for business confidence and private sector investment. If inflation is seen to be o
ut of
control, confidence is destroyed, businesses become uncertain and economic activity stagnates.

9

Until June 2012 at least,
Bank
R
ate has remained at 0.5%,

which is the lowest it has been since the
Bank of England was

f
ounded in 1694.

10

Since 1997

t
he ‘official’ main target of monetary policy has been to ‘hit’ the inflation ra
te target set by
the government. However,

since the onset of recession in 2008 the Bank of England has set interest
rates to stimulate aggregate demand. Low interest rates try t
o achieve this objective in two ways. First,
households with large mortgages have been able to take advantage of the 0.5% rate and pay off debt.
Second, saving has become unattractive and so, in theory at least, people decide to consume rather
than save.

1
1

Quantitative easing (QE) is an unorthodox monetary policy
,

which since 2009 has been intermittently
pursued by the Bank of England and the US Federal Reserve Bank. QE has been used to stimulate
aggregate demand in order to encourage economic activity and

thus to bring the economy out of deep
recession and to prevent it re
-
entering recession.

A central bank operates QE by electronically creating new money in the central bank’s own curr
ent
account. It uses this newly
created electronic money to buy assets s
uch as government bonds,
equities, houses, corporate bonds or other assets from banks. The aim is to inject liquidity into the
financial markets and

push up asset prices

by increasing demand for the assets.

Higher bond prices
cause bond yields, and hence l
ong
-
run interest rates, to fall.

The hope is that as the banks sell assets to the central bank they have greater liquidity and receive
deposits
,

which they in turn use to lend to businesses.

12

Since 1992, UK

monetary policy has
been ‘pre
-
emptive’. In pre
-
emptive monetary policy the authorities
announce that they are prepared to raise interest rates even when there is no immediate sign of
accelerating inflation,
in order to anticipate and head
-
off a rise in the inflation rate that would otherwise
occur many

months later. The policy
-
makers at the Bank of England estimate what the inflation rate is
likely to be 18 months to 2 years ahead (the medium term), if policy (that is, interest rates) remain
unchanged. If the forecast rate of inflation is different from

the target rate set by the government, the
Bank changes interest rates to prevent the forecast inflation rate becoming a reality in the future.
Interest rates are also raised or lowered to pre
-
empt any likely adverse effect upon the inflation rate of
an a
dverse ‘outside shock’ hitting the economy.

However, following the near meltdown of the UK economy in 2008 and in response to the deep
recession of 2009, it is fair to say that for a time at least, British monetary policy became reactive

rather
than pre
-
em
ptive
. This means that interest rates are set (and further bouts of QE are introduced), not
so much with the medium
-
term future in mind, but in reaction to falling national output (in the recession)
and growing unemployment.

13

An international capital flo
w is defined as the movement of mone
y for the purpose of investment or

speculation between countries. It involves selling one currency and buying the currency of the country
into which the flow of funds is moving.

In recent decades a form of international
capital flow known as a speculative ‘hot money’ has grown in
significance. A ‘hot money’ flow occurs when a very rich person or institution decides to switch funds
between currencies. A factor influencing these flows is interest rate differences in differe
nt countries.
Suppose for example the Bank of England cuts Bank Rate to a rate significantly below dollar or euro

TOPIC 2

Managing the national economy


AQA
A2 Economics

Unit 4

The National and International Economy

16

Philip Allan, an imprint of Hodder Education


© Ray Powell, James Powell

interest rates. In response to Bank Rate falling, owners of ‘hot money’ sell the pound and buy dollars
and euros so as to benefit from the hig
her return on these currencies. The selling of pounds causes the
pound’s exchange rate to fall. Hot money flows are speculative in the sense that owners of hot money
also move funds into currencies whose exchange rates the speculators believe are going to
rise.

14


In the diagram the supply of sterling has increased as speculators have sold their stocks of
sterling
.
They have moved their ‘hot money’ out of sterling and into another currency with the effect of shifting
the supply curve to the right. This ca
uses the pound’s exchange rate to fall, thus devaluing sterling.

15

A fall in the exchange rate should make UK exports price competitive in international markets and
increase the demand for them. This should reduce unemployment. However, the fall in the va
lue of the
currency will increase the price of imports, which will lead to import
-
cost
-
push inflation in the UK.

Exam
-
style
answers (
data response)

The impact of eurozone budget deficits on UK macroeconomic performance

01

In 2009, Greece was the eurozone c
ountry with the largest budget deficit (about 16.0% of GDP),
while Finland was the country with the smallest budget deficit (about 2.5% of GDP).

The difference as a
percentage of GDP was 13.5%.

A significant feature of the data is that no eurozone country
managed to run a budget surplus in 2009 (all
were in deficit), whereas in 2007 (the last year of the long boom that had begun in the 1990s), four
countries enjoyed surpluses. These were Ireland, Germany, Spain and Finland, with Finland’s surplus
being the
largest at around 5.5% of GDP.

2

mark
s

are

awarded for
the calculation and

3 marks are earned for identifying, and backing up with
evidence, one other significant feature of the data
, giving the maximum 5 marks.

02

A budget deficit is the shortfall between

a government’s tax revenue and its spending in a given
year. If a government runs a budget deficit, it will have to borrow money from financial markets and its own
citizens by selling bonds, and any new borrowing that is not paid back during the course of

the year will be
added to the national debt. The budget deficit is an example of an economic flow


the difference

TOPIC 2

Managing the national economy


AQA
A2 Economics

Unit 4

The National and International Economy

17

Philip Allan, an imprint of Hodder Education


© Ray Powell, James Powell

between the flow of spending and the flow of tax revenue


whereas the national debt is the stock of
accumulated past central government bor
rowing.

A budget deficit will act as an economy’s automatic stabiliser in a developed economy as it finances the
welfare and taxation system during a downturn. When an economy falls into recession, economic activity
will slow down and unemployment will ris
e. When firms lay off workers, cut wages and cancel overtime
hours, the government’s taxation receipts will fall because fewer hours are being worked. There will also
be an increase in the number of jobless workers claiming benefits such as the Job Seeker’
s Allowance. In
the UK the number of jobless workers applying for the Claimant Count

increased from 780,000 in 2007 to
1,600,000 in 2011.

This increase is largely explained by the growth of cyclical unemployment in the
recession.

These payments will stabil
ise the economy in two ways. First, the deficit borrowing will finance the benefits
system without the government having to increase taxation. Second, the welfare benefit payments will
ensure that workless households continue to have an income. The economi
st Amartya Sen has argued
that developed countries’ welfare benefit systems prevent famines from taking place in industrial
communities confronted with mass unemployment. Furthermore, when jobless workers receive benefits
they are likely to spend all of th
e money in the economy on consumption of essential goods. This acts as a
stabiliser on aggregate demand because consumption is the most important component of demand.

The mark
schemes for the second part (02) of c
ontext data response questions always allow

1 mark for
providing a definition of the key term or concept the answer must
explain
. The candidate gains this mark
by giving a good de
finition of budget deficit. (A common error is to confuse budget deficit with
balance of
payments deficit.) By contrast,

no marks are available for definitions when answering the
analyse

part of
the question. Neverth
eless, providing a definition (
in this case of an automatic stabiliser) ensures a good
starting point for developing the analysis.
The

candidate does not do thi
s but, having earned 4 marks for
explanation, the analysis is still sufficiently good to earn more than enough ma
rks to ensure
the full

10 marks overall.

03

The UK’s future macroeconomic performance should be judged on how average living standards
improve
, inflation is kept under control, the economy grows and unemployment falls, and the extent to
which in the long run the current account of the balance of payments moves towards equilibrium.

The large budget deficits run up by the eurozone economies in rec
ent years are a major concern for the
UK’s future macroeconomic performance. As Extract A indicates, all the eurozone nations have run
budget deficits since 2007 and those of Portugal, Ireland, Italy, Greece and Spain are especially worrying.
The massive b
udget deficits in 2009 of Portugal, Greece and Italy have added to national debts that now
exceed 100% of GDP. Furthermore, Spain has a yo
uth unemployment rate close to 5
0%, which suggests
poor economic performance in the future, and France had its credit
rating downgraded at the beginning of
2012 because of fears about its ability to repay its debts. The inability of these eurozone nations to service
their debts is what Extract C refers to as the ‘sovereign debt problem.

This crisis will affect the UK in t
hree main ways.

First, the UK will be unable to sell its exports to these economies if they are heavily indebted. The
governments of Greece, Portugal and Ireland have already introduced austerity budgets, which have
dramatically cut government spending, we
lfare benefits and public sector wages, and increased taxation.
This has significantly reduced levels of disposable income for households in these countries. If they have
less income they will be unable to afford UK exports, which will in turn affect the i
ncome of British
businesses and do little to help the British government reduce its large current account deficit.

Second, the northern eurozone countries, especially German
y (Extract C, line
6
), which has a strong
economy

and do
es not suffer from excessiv
e debt
, are likely to be tipped into recession by the problems of
the southern nations (the so
-
called ‘Club
-
Med’ countries). This will be especially bad for the UK’s

TOPIC 2

Managing the national economy


AQA
A2 Economics

Unit 4

The National and International Economy

18

Philip Allan, an imprint of Hodder Education


© Ray Powell, James Powell

macroeconomic performance. At present almost 60% of the UK’s trade is with eurozone countr
ies.
Germany is the second biggest export destination after the USA. If the German economy is pulled into
recession and has to bail out the southern eurozone economies in order to save the euro, it will harm the
UK economy. UK exporters will struggle to se
ll their products in Germany, which will in turn harm British
growth and unemployment as firms seek to cut back on production and lay off workers.

Third, if the excessive budget deficits and the sovereign debt crisis bring down the eurozone, the British
go
vernment will inevitably be dragged into a financial bailout. Despite the fact that the current Chancellor,
George Osborne, has resisted all calls for financial support for the struggling eurozone economies of
Greece and Portugal, British business has stro
ngly integrated trade links with the eurozone. Moreover,
major British banks have underwritten French and German banks that are heavily exposed to the bad
government debt in Greece and Portugal. If the Italian or Spanish banking systems collapse, it will c
reate
a chain reaction that will have major repercussions in Paris, Frankfurt and London.

Ultimately the UK will be affected significantly by the problems in the eurozone. At the beginning of 2012
the southern countries were gripped by deep recession and f
acing a decade of high taxation to pay off
their debts. The northern countries have healthier economies but will have to write
-
off the debts of the
‘Club
-
Med’ countries if the euro is to survive. Alternatively, they will have to accept huge financial losse
s if
the eurozone breaks up.

The UK’s macroeconomic performance will suffer because its major export markets will still be in
recession. This will hamper economic growth and unemployment. If the UK is to export in the future it
needs to establish stronger
trade links with the rapidly emerging markets of China, India, Russia and
Brazil (the BRIC countries). This will not be easy and it will require British firms to compete in a highly
competitive international environment. This will mean that British labour
costs and the corporate taxation
regime will have to be competitive, so UK households may experience lower wages and more limited
welfare benefits in the future.

In contrast to the earlier answer to part
03 of the c
ontext data response question in Topic 1,

this answer
does start with a good explanation of the meaning of macroeconomic performance.

This answer
is

placed at mid
-
l
evel

4 (19 marks in the range 17

21 m
arks) rather than in l
evel 5. The

evaluation is good enough for l
evel 5, though a winding
-
up con
cluding paragraph would have added to the
evaluation. However, the analysis is

on the thin side. To ensure a l
evel 5 mark, the candidate could have
included explicit theory (for example
,

the multiplier impact of a collapse in demand for UK exports)

and
bas
ic AD/AS analysis


including an AD/AS diagram


to analyse the impact of decreasing aggregate
demand on UK output and employment.

Exam
-
style
answers

(essay)

Supply
-
side economic policies

01

Traditionally Keynesian economists advocated the use of fiscal de
mand
-
side policies to stimulate
an economy and get it out of recession. The Keynesian approach first advocated in the 1930s argued that
the government should ‘pump
-
prime’ the economy by cutting taxation, increasing government spending
and running a series
of budget deficits. Keynes argued that when an economy was in a deep recession,
the lack of business and household confidence could see the economy falling into a deep depression from
which it would be difficult to pull out. The government in such circumst
ances would need to inject spending
into the economy through a fiscal stimulus and increase the level of aggregate demand in the economy.

In more recent times demand
-
side policy has been largely conducted as a part of monetary policy (and not
fiscal policy
). This means it has been conducted by central banks in accordance with rules
-
based
monetary policy set out by governments. In the UK since 1997 the Bank of England has set
Bank

R
ate to
influence the level of aggregate demand in the economy so as to try an
d hit the government’s long
-
term

TOPIC 2

Managing the national economy


AQA
A2 Economics

Unit 4

The National and International Economy

19

Philip Allan, an imprint of Hodder Education


© Ray Powell, James Powell

inflation target of 2% measured by the changes in the CPI. If demand is considered to be too strong, thus
creating demand
-
pull inflation,
Bank

R
ate

is

increased; if demand is too low,
Bank

R
ate

is

decreased.

Since 2009 the
Bank of England has pursued the unorthodox monetary policy of quantitative easing. It has
created electronic money with which it has bought financial assets. Commercial banks thus exchange
illiquid assets such as bonds for money. This injects liquidity int
o the banking system. The hope has been
that the commercial banks then lend the extra money they now possess to businesses and households for
them to spend.

In practice, however, the banks have simply ‘sat on’ the new money to improve their
balance sheets.

They have not lent the money to their customers.

Demand
-
side policies, which shift the economy’s
AD

curve to the right (as shown in the diagram below)
are mainly short term and intended to alter the level of aggregate demand in the economy.


In contrast
,

the focus of supply
-
side polices, which shift both the
LRAS

curve and the
SRAS

curve to the
right
, as shown in the diagram below
, is to increase the long
-
term capacity of the economy by improving

and enlarging

the national capital stock. Investment is the

engine of long
-
term growth, and supply
-
side
policies generally seek to enhance both the quantity and quality of physical and human capital in an
economy.


Fiscal policy can be used by setting low rates of taxation in the long term to encourage entreprene
urship
and hard work. This can also be combined with a policy of cutting welfare benefits to make unemployment
less attractive than work

in low
-
paid jobs
.


TOPIC 2

Managing the national economy


AQA
A2 Economics

Unit 4

The National and International Economy

20

Philip Allan, an imprint of Hodder Education


© Ray Powell, James Powell

However, supply
-
side policies also seek to improve the efficiency of micro markets. The policies of t
rade
union reform, deregulation, market liberalisation and privatisation all seek to remove distortions from the
market, increase competition and enable the profit incentive to work properly in the marketplace. For

free
-
market economists, the role of gove
rnment is to enable the market to allocate resources and help the
supply side of the economy to expand naturally, not to try to control it directly.

As is the case with part 02 of c
ontext data response questions,
2

marks can be earned by providing
relevant

definitions in the first part of an answer to an essay question.
Unfortunately, the candidate

fails to
provide definitions, thus missing the opportunity to pick up 2 easy marks,

even

though, as the answer is
developed, she shows clearly that she understan
ds the meaning of demand
-
side and supply
-
side
economic policies.
Defining key concepts at the beginning of the answer acts as a good launching pad for
developing the subsequent analysis.

Nevertheless, the differences between the two types of policies are
s
ufficiently well explained to ensure that the full 15 marks are earned.

02

The view that macroeconomic policy should only focus on the supply
-
side performance of the
economy and should ignore the management of the demand side is an extreme free
-
market appr
oach that
has not been seriously attempted by any government in recent times.

There is a general consensus
among free
-
market economists
that supply
-
side reforms are the key to long
-
term sustainable economic growth and that old
-
fashioned Keynesian demand
-
si
de management can
actually be harmful to the economy.

The commonly accepted view driven by
free
-
market

economists in the 1980s and 1990s and accepted by
modern Keynesian economists is that supply
-
side performance is the key to long
-
term economic growth.
Th
is approach rests on the following assumptions.

First, investment in the national capital stock is the engine of sustainable growth. Only by improving the
depth and breadth of physical and human capital can the capacity of the economy increase to provide
m
ore jobs without inflationary pressures.

Free
-
market economists argue that the government needs to encourage investment and enterprise. The
main way in which they can do this is through government fiscal policy keeping income and corporate
taxation levels
low, so that firms are incentivised to make profits which can t
hen be reinvested back into
business
es
.

Second, government policy should liberalise micro markets by getting rid of obstacles that prevent
competition or distort the market. Free
-
market economi
sts favour active competition policy which protects
consumers from anti
-
competitive behaviour and the abuse of monopoly power. They also distrust trade
unions because they see collective bargaining as a means of creating a monopoly supply of labour and a
m
ethod of inflating wages and business costs.

Third, free
-
market economists philosophically believe that markets ‘know best’ on how to allocate society’s
scarce resources. They believe that the market mechanism responds to price signals and is the best
mean
s of responding to human wants and maximising social welfare. This ideological belief in the market
is extremely distrustful of old
-
fashioned Keynesian demand management and socialist command
economies. Free
-
market economists correctly argue that the socia
list command economies were unable
to respond to the needs of the consumer, allowed inefficient methods of production to continue, and
lacked the invention and innovation created by the profit incentive in a market economy.

The demand management of the Key
nesian economists of the 1950s and 1960s is attacked by free
-
marketeers for ignoring the importance of the supply side and using fiscal policy as a blunt instrument to
manage aggregate demand. Free
-
market economists warn against changing levels of taxation

in a
discretionary way to manage aggregate demand
, especially income and business taxes, because this
sends confusing messages to workers and entrepreneurs, distorting long
-
term labour market incentives.


TOPIC 2

Managing the national economy


AQA
A2 Economics

Unit 4

The National and International Economy

21

Philip Allan, an imprint of Hodder Education


© Ray Powell, James Powell

However, this does not mean that there is no place
for demand
-
side policies in supporting macroeconomic
performance. The globalised market economy is prone to volatility and unpredictable economic crises. In
the last
15

years the UK economy has been significantly affected by stock market crashes including
the
Asian crisis 1997/98, the dot.com bubble and terrorist attacks of 2001, the banking crisis in 2008 and the
deep global recession that followed this crisis.

In such periods there is a definite need for government action to prevent the economy plunging i
nto a
deep recession. The ‘animal spirits’ that Keynes warned of in the 1930s still exist today. Indeed one of the
greatest dangers is when a market becomes paralysed with fear. Had Labour’s Chancellor, Alistair
Darling, not intervened in the British econo
my in October 2008 to bail out RBS and HBOS and inject
billions of pounds into the financial markets to restore confidence, it is possible that the entire British
banking system and economy could have collapsed.

Furthermore, it is important to note that th
e US economy appears to be pulling out of recession faster than
the European economies because it has adopted a more active demand
-
side policy. This has come at the
cost of large budget deficits, but if the economy starts growing then it should in the long

run be able to
repay its debts more easily than if it had suffered a prolonged period of low or stagnant growth. In
contrast, the UK
fell

into a double
-
dip recession

in 2011/2012
, in part caused by Chancellor George
Osborne’s aggressive deficit reduction
programme.

O
ften the second part of an essay q
uestion or the final part of a c
ontext data response question contains a
word such as
must
,
always
,
inevitably
, or in this case
solely
. Good candidates

pick up on these words,
arguing (in this case) that

both

d
emand
-
side and supply
-
side policies should be used together
. This is
good evaluation.

This candidate implicitly adopts this approach and the
answer is good enough to reach l
evel 5. However,
once again, the answer lacks sufficient basic economic analysis. T
he AD/AS diagrams included in the
answer to part
0
1 of the question might better have been used in the answer to part
0
2. And once again,
the answer lacks a concluding paragraph.


AQA A2 Economics

Unit 4

The National and International Economy

22

Philip Allan, an imprint of Hodd
er Education


© Ray Powell, James Powell

Topic 3 The international economy

1

Trade liberalisation is the removal of
barriers to trade. This has mainly taken the form of restrictions
created by national governments, such as tariffs, quotas and bureaucratic regulations designed to
protect domestic producers from lower
-
priced international competition. The GATT trade round
s, and
the World Trade Organization which was created in 1994, have tried to establish international free
trade and liberalise markets in order to increase competition and improve economic efficiency.

2

Two of the other main features of globalisation are g
reater international mobility of capital and, to some
extent, of labour. Globalisation enables the movement of capital from developed economies to poor
economies. Capital is relatively plentiful in developed economies while labour is expensive compared
wit
h its price in developing countries. In response to the differing prices of capital and labour, firms
move labour
-
intensive manufacturing processes to poorer countries. In other words, there is an
outward capital flow from rich to poorer countries.

In theo
ry, globalisation also leads to labour mobility in the opposite direction. However, immigration
controls slow down the movement of labour from poor to rich countries. Nevertheless, in recent years
illegal immigration into developed economies has occurred b
ecause rich countries have informally
encouraged migrants to fill the relatively low
-
paid jobs rejected by their own citizens.

3

‘Beggar my neighbour’ policies are government policies that attempt to gain a competitive advantage at
the expense of other cou
ntries. Three examples are:



i
mposing tariffs and other import controls in the hope that
other countries won’t retaliate



d
evaluing the exchange rate, again in the hope that ot
her countries don’t do the same



d
umping, which means selling exports at prices bel
ow t
heir average cost of production

Of course, if other countries respond by retaliating, protectionist and currency wars may be triggered
,

which can end up harming all the countries involved.

4

Absolute advantage is an intuitive trade model
,

which demonst
rates that nations should specialise in
the production of goods and services that they are absolutely the best at making, and then trade their
surpluses. Comparative advantage is a counter
-
intuitive trade model
,

which demonstrates that if
opportunity costs

differ, a nation should specialise if it has the comparative advantage in production
and not the absolute advantage, because the world economy will still benefit from greater output gains.
This means there is a case for specialising in a good and trading
the surplus produced, even if the
country is not absolutely the best at producing the good.

5

Long
-
term direct investment flows are when investors buy physical assets such as land or capital
equipment in another country. This form of investment will normal
ly be undertaken with a view to a
long
-
term commitment, producing in the country over a number of years.

Long
-
term portfolio capital flows are when investors buy equities and bonds in another country with a
view to holding these assets, again for a period
of years.

In contrast, short
-
term speculative ‘hot money’ flows move extremely quickly. For some traders, holding
shares or bonds for longer than two minutes is considered to be the very long run. Speculative
currency
flows are
ca
used
first by different cu
rrencies earning different interest rates and second by the
speculative belief that exchange rates will rise or fall
.

6

A current account surplus can only occur in one country if there is a current account deficit in another
country. Therefore it makes no
sense to argue that a surplus is virtuous and a deficit is shameful. If a
country is running a persistent current account surplus, it implies that the global economy is
imbalanced and that the country is saving too much and spending too little. Moreover, t
he country’s
excess savings are being lent to countries that are running current account deficits as a result of buying
the exports of the surplus nations. This imbalance will inevitably result in a correction that will often
take the form of an internatio
nal economic crisis.


TOPIC 3

The international economy


AQA
A2 Economics

Unit 4

The National and International Economy

23

Philip Allan, an imprint of Hodder Education


© Ray Powell, James Powell

Because the balance of payments must balance for the world as a whole, it is not possible for all
countries to run surpluses simultaneously. Unless countries with persistently large surpluses agree to
take action to reduce their surplu
ses, deficit countries cannot reduce their deficits. This means that
deficit countries may be forced to impose import controls from which all countries, including surplus
countries, eventually suffer. In an extreme scenario, a world recession may be trigge
red by a resulting
collapse of world trade.

7

Advantages: First, in a freely
-
floating exchange rate, the exchange rate should move up or down to
correct a payments imbalance. Second, monetary policy can be used solely to achieve domestic policy
objectives,

such as the control of inflation. This is called an ‘independent’ monetary policy.

Disadvantages: First, in the short run, exchange rates are extremely vulnerable to speculative capital
or ‘hot money’ movements into or out of currencies. Just like a fixed

exchange rate, a floating
exchange rate can be overvalued or undervalued, which means it fails to reflect correctly the trading
competitiveness of the country’s goods and services. Second, by causing the prices of imported food,
energy, raw materials and
manufactured goods to rise,
a falling floating exchange rate

contribute
s

to
cost
-
push inflation.

8

A large ‘hot money’ inflow shifts the demand curve for the currency to the right, leading to the
exchange rate rising and to an overval ued exchange rate in t
erms of the trading competitiveness of the
country’s exports. The current account of the balance of payments is then likely to deteriorate. If there
is a deficit to start with, the deficit will grow larger. A large ‘hot money’ outflow will lead to the opp
o
site
result
.

9

When a currency is freely floating
,

the central bank does not have to set monetary policy to alter the
external value of the currency unless instructed to by the government. In this situation
,

the market
forces of supply and demand

will

dete
rmine

the
exchange rate
.

If a country adopts a fixed exchange rate, the central bank will primarily use its interest rate (
B
ank
R
ate
in the UK) to keep the exchange rate at or close to the fixed exchange rate. In the UK, the Bank of
England would increase
B
ank
R
ate to attract capital flows into the domestic banking system, thus
increasing the demand for the pound. The Bank of England could also buy the pound on foreign
exchange markets to try to prevent the exchange rate from falling, or sell the pound to t
ry to stop the
exchange rate from rising. It could also increase the money supply to prevent the exchange rate from
rising, or reduce the money supply to engineer the opposite effect.

10

A free trade area is an agreement between countries to trade freely w
ith each other but each national
government retains the right to impose its own controls and taxes on imported goods and ser
vices from
countries outside
the agreement. A customs union is when member countries not only agree to trade
freely with other membe
rs but centrally agree to a common set
of import controls and tariffs o
n goods
and services from outside of the union.

The single European market is an even more integrated arrangement in which member countries trade
freely and agree a common set of import

controls but also seek to standardise the laws and rules
between member countries to reduce business costs and encourage trade. In theory, all 27 members
of the EU are meant to implement the commonly agreed laws passed by the governments of member
countri
es and the European Parliament in Strasbourg and Brussels. Non
-
member countries
,

such as
Norway and Switzerland
,

which have a strong trade relationship with the EU
,

have to obey the rules of
the SEM even though they have no say in the law
-
making process.

1
1

The euro is a
common currency used in

the 17 member countries
that

have joined the eurozone since
its creation in 1999. Countries such as Germany and France are locked into the same currency as
Greece and the Republic of Ireland. All 17 countries have th
eir monetary policy set by the European

TOPIC 3

The international economy


AQA
A2 Economics

Unit 4

The National and International Economy

24

Philip Allan, an imprint of Hodder Education


© Ray Powell, James Powell

Central Bank in Frankfurt, and there is no prospect of a weaker economy being able to devalue without
abandon
ing the currency, a process considered impossible until the autumn of 2011.

For countries outside the euroz
one, such as the UK and USA, the euro is just like any other currency
that floats up and down according to the forces of supply and demand. However, there are four EU
countries


Denmark, Latvia, Lithuania and Bulgaria


which have retained their own curre
ncies but
pegged them against the euro. The purpose of this adjustable peg regime is to reduce currency
fluctuation and to prepare these countries for eventual eurozone membership


an increasingly
unlikely possibility since the onset of the eurozone crisi
s in 2011.

Exam
-
style
answers

(data response)

World trade and the UK economy

01

The UK exported £7,055 million of goods and imported £24,828 million, so its balance of trade in
goods with China was in deficit to the tune of

£17,773 million.

A significant
feature of the data is the ranking of the UK’s exports to China and its imports from China. In
terms of the UK’s exports, China is only in ninth position. The UK’s exports to China, valued at £7,055
million, were significantly below its exports to the USA
(£31,712 million) and even behind the UK’s exports
to Ireland (£14,063 million). By contrast, on the import side, China was in third place (behind
Germany

and
the USA
), with the UK purchasing goods valued at £24,828 million from China.

This answer picks up

3 marks for the calculation (where the main danger for the candidate was missing
out the minus sign) and 3 marks for identifying a significant feature in the data. The candidate backed up
her point of comparison with enough accurate statistical data to ea
rn 3 marks, although overall 5 marks
were awarded because 5 is the maximum available for this question.

02

Productivity is the concept that measures how outputs can be maximised from given inputs. In
factories labour productivity is usually calculated by d
ividing total output by the number of workers.

Productivity has generally increased faster in manufacturing because of the invention of superior capital
equipment and the innovation of working practices that have made firms more efficient and less wasteful
.

New technology in manufacturing industries has generally led to the introduction of automated machines
which can perform complex tasks without getting tired or making mistakes. Whereas a car production
plant in the 1950s would have employed workers to pe
rform the manual tasks on the production line,
modern car makers use robots which are monitored by a technician. Car companies, such as BMW and
Toyota, have also invented more efficient management techniques based on the concept of last
-
minute
delivery. Th
ese working practices have significantly cut down on waste and allowed managers to quickly
identify problems in the production process.

Service industries such as law, banking, design, insurance and consultancy can benefit from technological
development bu
t the value of these industries
stems from

the knowledge and skills of
human capital.
Hence there is less scope here for dramatic productivity gains stemming from the invention of a new
technology or production process.

This answer earns 3 of the available

4 marks for explaining the meaning of the term ‘productivity’. A fourth
mark could be earned by explaining that the productivity of other factors of production can be measured,
e.g. capital productivity and total factor productivity, or by providing an ex
ample of labour productivity.

The answer to the second part of the question is good, but not quite good enough to earn 6 marks. The
answer does not mention service industries
,

such as education and healthcare
,

where the nature of the
service being delivere
d makes it difficult to increase labour productivity.


TOPIC 3

The international economy


AQA
A2 Economics

Unit 4

The National and International Economy

25

Philip Allan, an imprint of Hodder Education


© Ray Powell, James Powell

03

If the UK economy is to grow in the future it must export goods and services to the rapidly growing
emerging markets and in order to do this it will have to invest in its capital infrastructure to en
sure that
British firms are market leaders in a highly competitive global marketplace.

The UK will have to export to the emerging markets of Brazil, Russia, India, China and South Africa in the
future because that is where the economic growth and consumer
demand will be. The developed
economies of western Europe and North America and Japan are in decline. They have ageing populations
and low birth rates which means they will experience limited growth in the coming decades. Consumer
demand in developed econo
mies has peaked. This is a major challenge to the UK because, as Extract A
illustrates, the bulk of British exports are currently being sold to these countries. Nine of the top ten British
export destinations are either in the European Union or the USA.

He
nce firms that want to grow in the future need to sell to those economies with younger populations that
are developing a consumer culture,
especially

China and India. Export
-
led growth needs to take place in
two main ways.

First, the UK government needs to

help British businesses set up trade links in the emerging markets. This
could be difficult given the UK’s relationship with the European Union, but the British government needs to
take a leading role with Germany and encourage the EU member countries to
open their markets up to
global competition and resist the protectionist tendencies often advocated by Italy and France.

Second, the UK needs to specialise in industries in which it has a strong advantage, and ensure that its
firms remain the best in the w
orld. As Extracts B and C make clear, low
-
quality manufacturing production
has relocated to the emerging markets. This has resulted in structural unemployment in parts of the UK.
This has happened across the developed world but it makes no sense for politi
cians to focus on
protectionist policies to revive the ‘rust belts’ because the emerging economies can make these goods
more efficiently at lower cost. In the last 20 years multinational firms have built state
-
of
-
the
-
art factories
across southeast Asia bec
ause labour costs there are a fraction of those in Europe or America.

David Ricardo’s economic theory
concludes

that a nation should specialise in what it does best either
absolutely or comparatively. The UK should focus on the ‘higher
-
value goods’ (Extrac
t C, line
s

3

4
)
because the high
-
quality production of these goods stems from the design and marketing teams that
develop the product and brand. These skills are complex and difficult to replicate. Furthermore, the UK
needs to ensure that its service secto
r remains strong in the face of international competition. It has a
clear advantage in this field at present because over a century British firms have developed corporations
that specialise in insurance, law, financial services, marketing and consultancy.
These industries are
complex and are built upon human capital

that

has been assembled over decades.

However, if the UK is to promote its top
-
end manufacturing industry and service sector it has to invest to
ensure that they remain competitive in the global

economy. Investment is an important component of
aggregate demand and increased investment will help to drive economic growth. For this to happen the
UK economy needs to rebalance so that less expenditure is spent on consumption (which has mainly
been fin
anced by borrowing), and households save more of their income to make funds available for
investment.

The
prospects

for the UK economy
are not necessarily

bleak
,

but if Britain is to experience economic
growth in the future it will have to invest to ensure

that it has top companies that can export high
-
quality
goods and services to the emerging markets.

This answer
is placed at

mid
-
l
evel 4 (19

marks).
As with the answers to earlier questions, the candidate
misses the opportunity to pick up marks for appropr
iate analysis. Like perhaps a majority of exam
candidates, he mentions comparative advantage but does not explain the concept. (At the other extreme,
candidates who do attempt to explain comparative advantage often provide time
-
consuming numerical
examples
, unfortunately often riddled with mistakes.)


TOPIC 3

The international economy


AQA
A2 Economics

Unit 4

The National and International Economy

26

Philip Allan, an imprint of Hodder Education


© Ray Powell, James Powell

Othe
r reasons for failing to reach l
evel 5 are insufficient coverage of investment
-
led growth and the lack of
a concluding paragraph.

Exam
-
style
answers

(essay)

Exchange rates and the balance of payments

01

A c
ountry’s balance of payments position indicates the nation’s trading competitiveness. It
comprises four components: the balance of trade in goods, the balance of trade in services, net income
flows, and governmental transfers.

A free
-
floating exchange rate

system is when the government allows the external value of its currency to
be determined by free
-
market forces and instructs its central bank not to intervene in the currency
markets.

The external value of the currency will always affect the balance of pa
yments position of a country. A high
exchange rate will make imports cheap and exports expensive. This
is likely to

result in a current account
deficit as households and businesses switch to the cheaper overseas
-
produced goods and services.
Domestic living

standards will rise but money will leak out of the domestic economy.

In contrast, a low exchange rate should result in a current account surplus, or a narrowing of the size of
the deficit. This will be because at the lower exchange rate exporters become m
ore price competitive and
imports become more expensive, leading to consumers switching away from imports and towards
domestic goods and services.

The circumstances that lead to the decision to allow an exchange rate to float will have a significant effect

on the balance of payments position. When the UK government left the Exchange Rate Mechanism in
1992 the value of sterling fell significantly. This devaluation resulted in UK firms improving their price
competitiveness and the UK economy experienced an ex
port
-
led economic recovery out of recession. The
balance of payments position went from deficit in 1992 to surplus in 1997.

However,
if China were to adopt a freely
floating exchange rate, the value of its currency would increase.
This would see the price
of its exports increase and should in theory see the Chinese current account
surplus decrease and even fall into deficit. This is not certain, given that China has established itself as
the dominant producer of low
-
priced manufactured goods, and given also

that demand for these goods is
price inelastic.

This
answer scores 8 from a possible 15 marks. It misses at least two opportunities to pick up more
marks. First, there is only one correct definition of a relevant concept (a floating exchange rate). The ot
her
definition (of the balance of payments) is wrong. The answer defines the current account, but not the
overall balance of payments, which includes the capital and financial accounts. Second, and more
importantly, the answer lacks sufficient in
-
depth ana
lysis of exactly how a floating exchange rate can
affect a country’s balance of payments on current account. In theory, it provides an automatic adjustment
mechanism, but this can be distorted by ‘hot money’ capital flows. A simple supply and demand diagra
m
showing the equilibrium exchange rate, appropriately labelled, would earn 2 marks, as would a supply and
demand diagram illustrating the adjustment process. (Remember, the synoptic nature of A2 exam papers
legitimises the inclusion of AS micro theory of
supply and demand.)

The candidate could also have included the effects of price elasticities of demand on the adjustment
mechanism. Some mention of ‘clean’ floating versus ‘dirty’ floating would have added to the explanation.

02

Since the onset of the fina
ncial crisis in the autumn of 2008, British policy makers have pursued a
policy of benign neglect, allowing market forces to determine the exchange rate. Officially, the British
gov
ernment has maintained a freely
floating exchange rate but it has happily a
llowed the value of sterling
to fall, in the hope that this will create an export
-
led economic recovery. In July 2008 £1 was worth $2; in

TOPIC 3

The international economy


AQA
A2 Economics

Unit 4

The National and International Economy

27

Philip Allan, an imprint of Hodder Education


© Ray Powell, James Powell

January 2009 £1 was worth $1.35
. However, since then there has been an appreciation of the £,
particularly against the

euro. This has been a response to the
e
urozone crisis
.

The devaluation

occurred for three main reasons. First, the loss of confidence in the recession
-
hit UK
economy, especially the British banking system, caused billions of pounds of speculative money to

leave
sterling for safer havens such as the Swiss franc, and gold. Second, the record low interest rates of 0.5%
set by the Bank of England
made the UK an unattractive location for investors seeking returns on their
savings. Third, the quantitative easing

policy pursued by the Bank of England since 2009
saw

over £300
billion created and released onto
financial markets. This

increased the supply of sterling and pushed the
value of the currency down.

The Conservative

Li beral Democrat coalition government hop
ed that the devaluation of sterling would
create an export
-
led recovery and help to rebalance the UK economy so that it is less dependent on
financial services. Unfortunately there is limited evidence to suggest that this had many benefits for the
UK.

Alth
ough the devaluation of sterling did make imports more expensive and exports cheaper, the effect on
the UK’s current account position has been limited. Two main reasons can be identified. First, even
though UK exports became cheaper, the UK’s main trading
partners did not significantly increase demand
for British exports because they have also been gripped by recession. The ongoing eurozone crisis
,

which
brought the eurozone to the brink of collapse in 2011
,

has made the situation worse. Over 60% of UK
trad
e is done with EU countries, whose markets continue to be frozen in fear. There is evidence that UK
companies have benefited from the lower exchange rate but their gains have been significantly
outweighed by the effect of the wider economic crisis in the E
uropean economies.

Second, UK demand for imports is generally price
-
inelastic. The devaluation of sterling has not led to a
significant reduction in the volume of goods imported into the UK. This stems largely from the fact that the
long
-
term processes of
deindustrialisation caused large sections of the UK’s manufacturing base to shut
down or relocate to cheaper labour zones in southeast Asia. Hence, if British households are to consume
manufactured goods, the goods must be imported from abroad.

The main di
sadvantage imposed on the UK economy since the devaluation has been cost
-
push inflation.
Since 2009
, until June 2012 at least, the UK
experienced a rate of inflation higher than the 3% upper limit
of the Bank of England’s inflation target. The low exchange

rate has been a major cause of this, because
imported goods, especially energy, have increased in price. A wide range of imported goods are
measured in the CPI and RPI inflation indices. Higher inflation has eroded the purchasing power of the
average hous
ehold and resulted in declining standards of living.

Furthermore, imported raw materials and semi
-
finished capital goods are demanded by a large proportion
of UK firms as factor inputs in the production process. Thus a devaluation of the exchange rate has
actually increased the business costs of a number of UK firms. This has fed into domestic inflation in the
form of higher prices, although the effects on the export markets have been offset by the currency’s
devaluation.

It is important to read this questi
on

carefully. It does
not

ask for a discussion of
why
the
downward float of
the pound may have been ineffective in reducing the current account deficit
. Unfortunately, this

answer
leans

too much in this direction.
Instead the question asks for an evaluatio
n of the costs and benefits of a
falling exchange rate. The answer contains insufficient focus on costs and benefits.

Hence the answer is
placed in l
evel 3.


TOPIC 3

The international economy


AQA
A2 Economics

Unit 4

The National and International Economy

28

Philip Allan, an imprint of Hodder Education


© Ray Powell, James Powell

The grade descriptor for
l
evel 3 is:

A2

Levels mark
scheme

AO1 Knowledge
and understanding

of theo
ries, concepts
and terminology

AO2 Application

of
theories, concepts
and terminology

AO3 Analysis

of
economic problems
and issues

AO4 Evaluation

of
economic arguments
and evidence,
making informed
judgements

Level 3

10

16 marks

(mid
-
point 13)


Reasonable
including some
correct analysis but
very limited
evaluation


Satisfactory but
some weaknesses
shown

Reasonable
application to issues

Where appropriate,
reasonable use of
data to support
answer

Reasonably clear but
may not be fully
developed and is
perhaps
confused in
places with a few
errors present

The answer is quite
well organised with
some logical
development

Superficial, perhaps
with some attempt to
consider both sides
of the issue(s)