Cambridge International AS and A Level Economics

Answers to Coursebook activities

Chapter 5: Government macro intervention
Self-assessment task 5.1 (page 117)
1 If the economy was experiencing deflation, i.e., falling or negative inflation rates and interest rates can go no
lower, then the purchase of bonds (e.g., government debt) by the central bank would pump more money into
the financial institutions that sell this bond, such as commercial banks or insurance companies, leading to an
increase in lending. This could lead to more investment or consumption (due to cheap money) and consequently
shifting AD to the right bringing inflation back in line with its target.
2 Given the uncertainty regarding future growth rates, firms might be unwilling to invest and so might purchase
shares instead with the extra finance in order to generate a return, leading to an increase in demand for shares
and an increase in prices.
3 Forward guidance helps creates greater certainty and stability regarding interest rate movements, enabling firms
and households to plan in advance for any potential changes. However, if the Bank of England fails to act when
certain conditions are met, e.g., it does not raise interest rates when unemployment falls below 7% as it said it
would, then markets lose confidence in the reliability of such guidance. It is worth noting that there is no rule
that the Bank of England will not raise interest rates even if unemployment fails to fall below 7%. Moreover, it
is suggesting that there is a link between falling unemployment and rising inflation but the link might not be as
strong as assumed. Unemployment might fall but workers are working fewer hours on average hence there is less
inflationary pressure from rising wages and so less need to raise interest rates. Finally, targets might change due
to political interference.

Self-assessment task 5.2 (page 118)

a an increase in unemployment benefit fiscal
b an increase in government spending on state pensions fiscal
c an increase in the rate of interest monetary
d a reduction in restrictions on bank lending monetary
e a reduction in legal restrictions on firms supply side
f a reduction in the exchange rate monetary

Self-assessment task 5.3 (page 119)

1 It is considered to be a supply side policy as it will improve the quality of labour in the long run as it could raise
productivity through higher literacy and numeracy skills. However, there will be an implication for fiscal policy
in the medium to long term, too, as government spending on education by the Brazilian government is set to
increase from 5.7% to 10% of GDP.
2 If teachers retirement age is extended it will mean that they are in the workforce for a longer period of time than
would otherwise have been the case and therefore the aggregate supply curve should shift to the right, leading to
lower inflation and higher output. However, this depends on the number of teachers who do continue working
and by how many years the retirement age is increased.

Self-assessment task 5.4 (page 121)

1 Concerned about Egypts current account deficit the Egyptian Central Bank sold some of its reserves in 2013,
increasing supply and creating a downward pressure on the Egyptian pound (E) in an effort to reduce demand
for imports and stimulate demand for exports.
2 The depreciation would make imports relatively more expensive, especially for strategic imports such as food,
fuel and medicines for which demand will be relatively price inelastic in the short run. This would increase costs
of living and effectively reduce the purchasing power of a given level of income.

Cambridge University Press 2015 Cambridge International AS and A Level Economics Chapter 5 Coursebook activities 1
 Cambridge International AS and A Level Economics

3 Exchange controls may deter foreign direct investment (FDI) as it reduces a companys ability to convert any
profits made in E into its own domestic currency or being forced to pay a higher exchange rate to do so,
reducing the potential returns to an investment.

Self-assessment task 5.5 (page 122)

1 The Thai government could have: subsidised farmers in order to reduce their costs of production; helped with
the introduction of more capital-intensive production; or funded research into the development of higher
yielding rice strains. Such measures would shift the supply curve of rice to the right, lowering the price.
Consumers might have switched demand from competitor countries such as Bangladesh and Vietnam, and
Thailand could have a gained a greater share of the global rice market.
2 In theory, offering above equilibrium prices for rice (50% higher than market rates) should create an incentive
for farmers to grow more rice, leading to an increase in output, shifting the production possibility curve
outwards and hence a shift right of the countrys LRAS. However, the output was stored at a time when India
removed its export ban and Vietnam lowered the price of its rice, increasing supply onto world markets. The
Thai government is now spending around 8% of its public sector budget on the scheme, diverting resources away
from other sectors, e.g., health, education and infrastructure, which could affect aggregate supply adversely in
the longer run. Any shift right of the LRAS could be offset by declining investment due to the recent political
protests, which have led to a climate of uncertainty and so reduced business investment. Moreover, lower rice
sales will have dented exports shifting AD to the left.

Self-assessment task 5.6 (page 123)

1 A flat sum tax is a flat rate tax, e.g., 1 peso per litre, rather than a percentage.
2 Inflation is measured by comparing the price of a basket of goods and services purchased by the average
Mexican household over time. Since public transport will be one of the items contained in the basket, a tax on
public transport would increase prices of this service and so increase inflation. Its impact would depend on the
relative weight of the item in the basket.
3 A reduction in poverty suggests that average household income is rising and so consumers are likely to purchase
more income elastic goods such as luxuries and devote a relatively smaller proportion of household income
to essentials. Therefore, the relative weight of food would reduce as newer items enter the basket of goods
and services bought by the typical household. This depends on how much poverty is reduced by and whether
increases in income are offset by rises in inflation, thereby reducing purchasing power.
4 A tax on food would shift the supply curve to the left, increasing the price. With more household income being
spent on food since demand for food is relatively price inelastic as it is a necessity it would reduce the
amount of discretionary spending households would have to purchase other items and might need to cut back
on fuel, clothing and rent, leading to a fall in standards of living. However, the 8% tax on highly calorific foods
might encourage households to switch to relatively cheaper and healthier foodstuffs. If the high calorie foods are
imported, e.g., sweets and ready meals, and the healthier foodstuffs are produced domestically it could improve
the current account of the balance of payments and create more jobs within the country, raising GDP and
average income per capita as a result. The tax raised could also be used to improve the health and education of
the poorest households, thus improving productivity and increasing earnings in the long run.

Self-assessment task 5.7 (page 124)

1 With pay increases averaging 1% in the UK but inflation rising at 2%, real incomes were falling by 1% leading to
a reduction in workers purchasing power.
2 Given that the UK economy had experienced sharp falls in economic growth and a prolonged recession, the
economy was not back to its pre-recession levels until mid-2014 so the economy was not operating close to full
capacity, i.e., the output gap had not been closed.

Cambridge University Press 2015 Cambridge International AS and A Level Economics Chapter 5 Coursebook activities 2
 Cambridge International AS and A Level Economics

Self-assessment task 5.8 (page 125)

1 Rising inflation of 7% in Turkey would make its exports relatively more expensive and imports relatively cheaper
leading to a rise in demand for imports, a fall in demand for exports and a deterioration in the countrys current
account.
2 In theory, a rise in the countrys interest rate would increase the demand for the lira from international savers
and speculators. These hot money flows would push up its exchange rate. A stronger currency should make
imports relatively cheaper. Given that Turkey imports 97% of its energy and demand for energy is relatively price
inelastic, importing similar quantities at lower prices should lead to lower expenditure on this item and reduce
the current account deficit. However, an appreciation would also make exports relatively more expensive, which
would lead to a fall in demand for Turkish exports. The overall impact depends on the relative price elasticities
of demand for imports and exports.
3 Firstly, building new energy infrastructure will reduce Turkeys dependence on imports of energy and so reduce
the current account deficit in this respect. However, it will take time for the power station to become fully
functional and it might only account for a small proportion of the countrys total energy requirements. As the
economy grows in the future, more energy will be needed and so it might lead to a further increase in imports.
Secondly, employing more teachers should shift the LRAS to the right, making Turkish workers more productive
and improving the countrys international competitiveness. However, once again, it will take time before the
effects are felt and simply employing more teachers will not necessarily lead to better quality education but it
could lead to smaller class sizes.

Self-assessment task 5.9 (page 126)

1 Expansionary fiscal policy involves higher government spending and lowering tax rates to stimulate growth.
This policy would shift AD to the right as households would have more to spend, leading to an increase in
output, income and employment.
2 Japan has suffered a period of deflation where households have been delaying purchases in the expectation that
prices would continue to fall in the future. If firms and households believe that inflation could rise in the future,
it might encourage them to bring forward their purchases and further increase AD. Depending on how close the
economy is to full capacity, this could put upward pressure on prices. Prices had been falling in 2012 and early
2013 but inflation was back in positive territory by the middle of 2013. Moreover, if Japanese companies increase
wages, there will be an increase in disposable income, further increasing consumption.
3 A lower exchange rate should make imports relatively more expensive and exports relatively cheaper. Japans
economy is export-oriented so a fall in the exchange rate should shift AD to the right, leading to a rise in
inflation, depending on how close the economy is to full capacity. If demand for imports is relatively price
inelastic, more expensive imports, e.g., food and fuel, will lead to higher core inflation. However, the impact
depends how much the exchange rate depreciates by. The currency had depreciated by approximately 20% at the
end of 2012/beginning of 2013. Moreover, there will be time lags between the depreciation and the impact on
domestic inflation.

Exam-style questions
1 The current account of a countrys balance of payments records the credits and debits arising from the inflow
and outflow of goods, services, income such as interest, profits and dividends, and current transfers. Generally,
the trade in goods and services will be larger than income and current transfers and so a current account surplus
will usually arise as a result of the value of exported goods and services being greater than the value of imported
goods and services.
The current account of a countrys balance of payments records the credits and debits arising from the inflow
and outflow of goods, services, income such as interest, profits and dividends, and current transfers. Generally,
the trade in goods and services will be larger than income and current transfers and so a current account surplus
will usually arise as a result of the value of exported goods and services being greater than the value of imported
goods and services.

Cambridge University Press 2015 Cambridge International AS and A Level Economics Chapter 5 Coursebook activities 3
 Cambridge International AS and A Level Economics

The demand for exports might be greater than the demand for imports due to lower exchange rates making
exports relatively cheaper and imports relatively more expensive. The US, which runs a significant trade deficit
with China, has criticised the Chinese government for actively intervening in the currency market to reduce the
external value of its currency in order to give it a competitive advantage.
A second cause might be lower production costs. For example, China has relatively cheap labour with respect to
manufactured goods leading to greater productive efficiency enabling firms to charge lower prices and making
them more internationally competitive.
A third cause might be superior quality and greater allocative efficiency. Germany, Japan and South Korea have
current account surpluses as they produce the goods which consumers want relative to other countries and this
has been achieved through greater investment in research and development.
Fourthly, increased economic growth in a countrys major trading partners could also contribute to a current
account surplus on a countrys balance of payments. For example, Germany has benefitted from the growth in
China and has seen its exports of capital equipment to China increase in recent years.
[For knowledge and understanding of the current account up to 2 marks. For application describing two
causes of an increase in a countrys current account surplus up to 6 marks.]
2 Using monetary policy such as reducing the interest rate will reduce the cost of borrowing and reduce the
reward for saving which, in theory, should lead to an increase in consumption as firms and households borrow
more and save less. Some of this additional spending power should stimulate demand for imports. The extent of
the increased demand will depend upon the countrys marginal propensity to import. If it is low it will have little
impact and increased consumption might stimulate domestic demand shifting AD to the right without reducing
the current account surplus.
Using monetary policy such as reducing the interest rate will reduce the cost of borrowing and reduce the
reward for saving which, in theory, should lead to an increase in consumption as firms and households borrow
more and save less. Some of this additional spending power should stimulate demand for imports. The extent of
the increased demand will depend upon the countrys marginal propensity to import. If it is low it will have little
impact and increased consumption might stimulate domestic demand shifting AD to the right without reducing
the current account surplus.
However, lower interest rates will, other things being equal, reduce the demand for the countrys currency, if
it is freely floating, putting downward pressure on its external value leading to a depreciation. This will make
imports relatively more expensive but exports relatively cheaper which could further increase the surplus
and shift the AD curve to the right, putting upward pressure on inflation and increasing the cost of living for
domestic citizens. The effect of a depreciation depends on the price elasticity of demand for imports and exports:
if demand for a countrys exports and imports are both price inelastic it could lead to a fall in the value of the
current account surplus.
Interest rates are a blunt instrument, and reducing interest rates might not be focused on the cause of the
surplus. Moreover, it might take 12 to 18 months to have an effect. Other policies which might be used to reduce
a current account surplus might be fiscal policies such as increasing tax on exporters which will raise their costs
of production and so increase selling price making goods and services less internationally competitive shifting
the AD curve to the left. This might be a more focused policy but the fall in demand for domestically produced
goods and services could lead to a rise in unemployment. However, output could be diverted into domestic
markets making more available at lower prices and so raising economic welfare. The impact depends on the size
of the tax and price elasticity of demand for the countrys exports.
According to free market economists, a current account surplus might be self-correcting in the long term: as the
demand for a countrys exports increases so does the demand for its currency, therefore causing an appreciation
of the currency making a countrys exports relatively more expensive in the long run.
[For analysis of how an interest rate fall might reduce a current account surplus on a countrys balance of
payments up to 8 marks. For evaluative comment on how an interest rate fall might not reduce a current
account surplus on a countrys balance of payments or on the effectiveness of the policy. Candidates might
consider alternative policies which could prove more effective. Up to 4 marks.]
Cambridge University Press 2015 Cambridge International AS and A Level Economics Chapter 5 Coursebook activities 4
 Cambridge International AS and A Level Economics

3 a i 2005
ii 2008
b Depreciation is a fall in the value of a currency caused by market forces. This will make exports relatively
cheaper but imports relatively more expensive leading to a rise in demand for Turkish exports and possibly
a switch from imported goods to domestic products. Both of these effects will shift the AD curve to the right
leading to demand-pull. Higher import prices could also lead to increased costs shifting the AS curve to the
left, causing cost-push inflation [up to 4 marks].
c Chile had a lower inflation target (3%+/1%) than Brazil (4.5%+/1%). However, Chile breached its upper
limit whereas Brazil remained within its target range. This might be due to Brazil adopting more effective
anti-inflationary policies. Perhaps Chile experienced an unexpected depreciation, which might have increased
demand-pull and/or cost-push inflation. Government spending in Chile might have been higher than
planned, increasing AD and putting upward pressure on prices [up to 4 marks].
d An inflation target creates an anchor for expectations. If households and firms believe that the government
will implement policies to help achieve the target then they will act accordingly. For example, workers might
accept lower wage settlements and producers might choose to limit price rises in order to avoid interest rate/
tax increases [up to 4 marks].
e A consumer price index measures the average change in the prices of a representative basket of products
bought by households and is used to calculate inflation rates. The problems of constructing an accurate CPI
include the decisions regarding which goods and services to include and the weights to attach to each group
of items. The basket will have to be updated regularly to take account of changes in consumers preferences
and buying behaviour. The basket could be manipulated by policy-makers in order to reduce the reported
inflation rates by excluding goods whose price is rising significantly. A further problem might be choosing a
sufficient sample size: a small sample size will be unrepresentative but cheaper to conduct. The choice of base
year might be a problematic: it should be a typical year for comparison purposes. In conclusion, a CPI is an
average and so each individual might actually face a different inflation rate.
[Allocate marks for identification of problems and explanation, and reserve 1 mark for a valid conclusion]

Cambridge University Press 2015 Cambridge International AS and A Level Economics Chapter 5 Coursebook activities 5