(2014) 8823 H1 Econs Paper CSQ 2 Suggested Answers by Mr Eugene Toh (A Level Economics Tutor)

(2014) A Level H1 Econs Paper 1 CSQ Q2

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ai U.K. saw negative economic growth in both 2008 and 2009, and a low growth rate of 1.8% in 2010, 0.8% in 2011. This is not dissimilar to other major economies which saw the same trends.

In particular, Japan did worse in 2009 and 2011 compared to the U.K., as she recorded a negative growth of -5.5% in 2009 and 0.6% in 2011.

France too, saw a growth rate of only 1.7% in 2010, which was lower than U.K.’s 1.8%.

aii. Singapore and Japan both saw the lowest economic growth rate in 2009, with Singapore 

recording a negative growth rate of -0.8% while Japan recorded a negative growth rate of -5.5%.

Singapore’s growth performance was better than Japan's as Singapore saw positive GDP growth throughout 2008 - 2011 with the exception of 2009, while Japan saw negative GDP growth throughout 2008-2011 with the exception of 2010.

b. Opportunity cost is the next best alternative forgone. Countries with high levels of investments usually have very high savings rates. A high savings rate will give rise to a large supply of loanable funds, keeping interest rates low,  encouraging a high level of investment. Given that consumers can either save or spend their income, a high saving rate will imply a low level of consumption spending.

This low level of consumption spending can result in a lower than possible level of material standard of living.

Thus, the opportunity cost of a high level of investment might be a lower level of consumption spending, resulting in a material standard of living that is lower than possible.

ci. The four elements that ‘contribute to growth in demand’ are consumption spending, 

investment expenditure, government spending and net exports.

cii. The ‘Keynesian option’ otherwise refers to an expansionary fiscal policy stance where 

the government can take two possible approaches. The government can increase spending on public works projects, e.g., building roads, schools, and hospitals, or increase direct government hiring, e.g., hiring civil servants.

The government can also opt to cut personal or corporate income taxes. Lower personal income taxes will result in higher disposable after-tax incomes, encouraging an increase in Consumption spending. Lower corporate income taxes will result in higher after-tax profits, encouraging an increase in Investment expenditure.

This will increase AD since AD = C+I+G+(X-M).

An increase in AD from AD0 to AD1 will result in a multiplied increase in real national income via the multiplier effect, allowing for higher economic growth.

d. The use of lowered interest rates to increase the level of private investments is known as
expansionary monetary policy.

The central bank will increase the purchase of government bonds in the open market,  

increasing the amount of loanable funds available, resulting in a decrease in interest rates. As interest rates fall, according to the MEI curve, the rate of returns on investments increases and more volume of investments become profitable, resulting in an increase in the volume of investments.

Lowering interest rates to increase the level of private investments may not always be useful in certain situations.

If the economy is facing a downturn, like the UK as mentioned in Extract 8, there may be a sense of pessimism amongst business owners, resulting in investments being relatively more interest rate inelastic. This means that in spite of lowered interest rates, business owners may choose not to increase investments as they might be more risk averse.

Additionally, if interest rates are already at zero or close to zero, an economy can be said to be facing a liquidity trap. In such a case, interest rates cannot be lowered any further to zero or less than zero even if the central bank were to intervene to increase asset purchases in the open market.

e. Explain problems described in Extract 8

There are two key problems outlined in Extract 8. The first is the struggling economic 

growth, the second being the high public sector debt.

Why should opt for drastic cuts

A high public sector debt is caused by years of persistent budget deficits. A budget 

deficit occurs when government expenditure exceeds government revenues.

A high public sector debt is detrimental because of interest payments that must be 

made, which can divert spending resources away from other more productive sectors such as healthcare or education. It is, therefore in the government’s interest to reduce public sector debt.

Opting for drastic cuts to public spending refers to reducing government spending, say in infrastructure, transfer payments or direct hiring.

This should therefore improve the budget position and over time, reduce the accumulation of public sector debt or even improve it.

Why should not opt for drastic cuts

Cutting government expenditure, however, can behave in practice like contractionary fiscal policy.

Since AD = C+I+G+(X-M), a decrease in G, will decrease AD from AD0 to AD1, causing real national income to fall via the reverse multiplier effect by a multiplied extent from Y0 to Y1.

This will reduce economic growth in an already struggling economic growth environment, which is less than ideal.

Evaluative conclusion

In the long run, a government can opt to focus on boosting economic growth instead of cutting public spending. The logic here is that higher economic growth can potentially improve the budget deficit. With higher incomes of both households and firms, the government will be able to collect more tax revenues, potentially improving the budget position.

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