2.1 Government and the Economy

Question 1

Benefits of economic growth

Answer 1

• Reduces unemployment
• Increases standards of living
• Reduces absolute poverty
• Increases productive potential

Question 2

Drawbacks of economic growth

Answer 2

• Increases inflation (overheating of the economy)
• Damages the environment
• Higher level of inequality

Question 3

Advantages of GDP as a measure of growth

Answer 3

• Widely used, so can make meaningful comparisons
• Good indicator of a nation’s overall standard of living
• Covers all goods and services, so is reliable
• Can be used to tell the different stages of the economic cycle in real time

Question 4

Limitations of GDP as a measure of economic growth

Answer 4

• Inflation (must use real GDP)
• Population changes
• Statistical errors
• Value of home-produced goods
• Hidden economy
• External costs
• Growth may not be evenly distributed
• Not the only factor that affects living standards (also amount of leisure time, level of pollution, quality of goods and services etc.)

Question 5

Causes of demand-pull inflation

Answer 5

• Rising consumer spending
• Rising demand for resources by firms
• Rising demand for exports
• Sharp increases in government spending

Question 6

Causes of cost-push inflation

Answer 6

• Rising costs of imports
• Increases in wages (and other costs of production)
• Increases in taxation
• Increases in prices by entrepreneurs to increase profits

Question 7

Benefits of inflation to consumers

Answer 7

• Wages may increase, and if increases in wages outpaces the rate of inflation, purchasing power increases and standards of living increase
• Benefits debt payers as the real value of debt decreases

Question 8

Drawbacks of inflation to consumers

Answer 8

• Higher prices/lower purchasing power, lower standards of living
• Shoe leather costs

Question 9

Benefits of inflation to firms

Answer 9

• Higher profits (demand-pull only) because they can sell more/at higher prices, especially if the rate of inflation is low and stable because consumption increases

Question 10

Drawbacks of inflation to firms

Answer 10

• Lower profits/higher costs (workers need higher wages)
• Menu costs
• Shoe leather costs

Question 11

Benefits of inflation to the economy

Answer 11

• Lower unemployment (demand-pull only — AD rises, first need to increase supply)
• Stimulates consumption (if low, stale inflation) because consumers expect prices to rise in the future

Question 12

Drawbacks of inflation to the economy

Answer 12

• Lower business confidence and lower investment
• Lower consumer confidence and lower consumption
• Current account tends towards a deficit (rising prices of exports)

Question 13

Types of unemployment

Answer 13

• Cyclical unemployment
• Structural unemployment
• Seasonal unemployment
• Frictional unemployment
• Voluntary unemployment

Question 14

Benefits of unemployment to workers

Answer 14

• More leisure time, so higher standards of living
• Opportunity to develop skills to increase productivity

Question 15

Drawbacks of unemployment to workers

Answer 15

• Loss of income, so lower purchasing power and lower standards of living
• Pressure on the unemployed person, e.g. social problems like stress and health problems

Question 16

Benefits of unemployment to firms

Answer 16

• Easier to recruit workers (larger pool of available workers)
• Reduction in labour costs (fewer wage demands)

Question 17

Drawbacks of unemployment to firms

Answer 17

• Lower business confidence
• Lower profits as consumption decreases

Question 18

Drawbacks of unemployment to the government

Answer 18

• Less tax revenue (from income taxes)
• Less tax revenue (from indirect taxes, due to falling consumption)
• More benefit payments, increase national debt, spending tends towards fiscal deficit

Question 19

Drawbacks of unemployment to the economy

Answer 19

• Lower standards of living
• Increase poverty (in the long run)
• Opportunity cost on government’s benefit payments
• Average income decreases, consumption decreases, economic activity slows down
• Wastes scarce resources

Question 20

Reasons for changes to the current account

Answer 20

• Quality of domestic goods
• Quality of foreign goods
• Price of domestic goods
• Price of foreign goods
• Exchange rates

Question 21

Benefits of a current account surplus

Answer 21

• Less national debt (more money for the government to spend on education, for example)
• Lower unemployment (higher export sales)
• Economic growth and higher standard of living
• Surplus foreign exchange to invest in other countries

Question 22

Drawbacks of a current account surplus

Answer 22

• Overvalued currency (exports more expensive and imports cheaper as exchange rate increases and the domestic currency gets stronger, leading to a current account deficit)
• Trade imbalances with other countries (causing friction and protectionist measures)

Question 23

Benefits of a current account deficit

Answer 23

• Higher standards of living (more consumption of good quality/cheaper imports)
• Depreciation in the exchange rate, exports are more internationally competitive

Question 24

Drawbacks of a current account deficit

Answer 24

• Leakages from the economy (higher demand for imported goods)
• Inflation (imports will make up a large part of their economy and will cause inflation if prices of imports rise)
• Decline in economic growth and rise in unemployment (low demand for exports)
• Problems finding foreign reserves to fund the deficit as spending on imports is not being fully financed by export revenue, so may have to borrow (increasing national debt)
• Increasing national debt burdens the next generation and creates opportunity costs

Question 25

Benefits of taxes

Answer 25

- Source of revenue for the government (can be used to further protect the environment) - Financial incentive for firms and consumers to protect the environment

Question 26

Drawbacks of taxes

Answer 26

- Reduces choice for consumers - Inflation (firms may pass it on to consumers) - Firms may close down (increased costs of production)

Question 27

Benefits of subsidies

Answer 27

- Financial incentive for firms and consumers to protect the environment - Extra money for the firm can be dedicated to development of more sustainable solutions

Question 28

Drawbacks of subsidies

Answer 28

- Opportunity cost of government spending - Can cause fiscal deficit which leads to national debt

Question 29

Benefits of regulation/fines

Answer 29

- Can protect the environment (e.g. decrease emissions) - Source of revenue for the government (can be used to further protect the environment) - Other firms are disincentivised from polluting if some firms are fined - Harms public image of the fined firm, creating an incentive to follow the regulations

Question 30

Drawbacks of regulation/fines

Answer 30

- Costs of monitoring and enforcing regulation are high - Fines are too small in comparison to profits, so it creates an incentive for the firm to continue polluting - Can take many years for firms to be fined, and the environment had already been harmed - Firms may close down due to higher operating costs

Question 31

Benefits of pollution permits

Answer 31

- Incentive for businesses to invest in cleaner technologies - Incentive to reduce emissions at the lowest cost

Question 32

Drawbacks of pollution permits

Answer 32

- Firms may simply buy more permits and continue to pollute - Incentive for firms to cheat and hide the amount of pollution it creates - Governments may struggle to determine how many pollution permits to give out, if they give out too many the level of emissions don’t change drastically

Question 33

Benefits of park provision

Answer 33

- Reduces government expenditure on healthcare (creates an incentive to lead a healthier lifestyle) - May increase profit for local businesses due to tourism - Protects large areas of land, wildlife and ecosystems

Question 34

Drawbacks of park provision

Answer 34

- Opportunity cost of using land for other purposes - High costs for creation and maintenance for the government, opportunity cost of government spending

Question 35

Benefits of progressive taxation

Answer 35

- Reduces income inequality, reduces relative poverty, higher living standards - Increases government revenue

Question 36

Drawbacks of progressive taxation

Answer 36

- Creates a disincentive to work and earn more money - Tax evasion (incentive for high-income individuals to exploit loopholes/move wealth to lower-tax jurisdictions)

Question 37

Benefits of benefit payments

Answer 37

- Reduces income inequality, reduces relative poverty, higher living standards - Child benefit payments can empower mothers to re-enter the workforce, thus increasing labour productivity and productive potential of the economy

Question 38

Drawbacks of benefit payments

Answer 38

- Creates a disincentive to work because some families are stuck in the poverty trap and may be better off on benefits than working - Opportunity cost of spending on benefit payments, may cause fiscal deficit or growth of national debt for government - Resentment as not everyone receives some benefits (e.g. child benefits)

Question 39

Benefits of investment in education and healthcare

Answer 39

- Increases productivity, leads to higher output and higher income, higher standards of living, lower relative poverty - Empowers individuals to break the poverty cycle and escape the poverty trap

Question 40

Drawbacks of investment in education and healthcare

Answer 40

- Opportunity cost for the government - Slow to take effect

Question 41

Benefits of a fiscal deficit

Answer 41

- Increase standard of living (because government spending is high) - Economic growth (increased government spending on projects that boost profitability)

Question 42

Drawbacks of a fiscal deficit

Answer 42

- Increased national debt (that burdens the next generation) - High opportunity cost of interest payments for national debt

Question 43

Benefits of a fiscal surplus

Answer 43

- Long-term economic growth - Lower national debt - Lower inflation - Government could use it to lower taxes for the people, stimulating increased consumption - Government could use it to fund new education and training programmes - Government could use it to improve existing public services

Question 44

Drawbacks of a fiscal surplus

Answer 44

- Lower short-term economic growth (GDP falls because government spending is a component of GDP. Government withdraws more in taxes than it injects in government spending into the circular flow of income. Governments are not investing as much, leading to a drop in revenue) - Deflation (lower government spending reduces the amount of money circulating in the economy) - Inflation (governments set high taxes that are passed on to consumers) - Lower standard of living (less spending on public services)

Question 45

Benefits of expansionary fiscal policy

Answer 45

- Lower corporate taxes -> higher investment -> more innovation -> higher AD - Lower income taxes -> higher discretionary income -> more consumption -> higher AD - Lower income taxes -> more incentive to work -> lower unemployment - Higher government spending -> more spending on transport/infrastructure projects -> lower unemployment (more public sector workers employed) -> higher AD -> higher output for firms -> lower unemployment - Overall: higher AD -> economic growth -> lower unemployment

Question 46

Drawbacks of expansionary fiscal policy

Answer 46

- Lower government tax revenue -> less government investment -> less government spending -> contractionary fiscal policy -> lower AD - Less revenue for the government - Can lead to fiscal deficit - There is no guarantee that consumers will buy mostly domestic goods, meaning it can have a negative impact on the current account. - There is no guarantee that firms will reinvest the extra profit

Question 47

Benefits of contractionary fiscal policy

Answer 47

- Higher income taxes -> lower discretionary income -> lower consumption -> lower AD -> less pressure on prices -> lower inflation - Higher corporate taxes -> lower investment -> lower AD -> lower inflation - Lower government spending -> lower AD -> lower inflation - More tax revenue for the government, can be spent on improving public services - Leads to fiscal surplus

Question 48

Drawbacks of contractionary fiscal policy

Answer 48

Higher indirect taxes -> higher prices -> higher (cost-push) inflation

Question 49

Benefits of expansionary monetary policy

Answer 49

- Lower interest rates -> loans are cheaper to take out/pay back -> more consumption, more investment -> higher AD -> higher economic growth -> lower unemployment

Question 50

Drawbacks of expansionary monetary policy

Answer 50

- Time lag - Inflation (if supply is not able to keep up with demand)

Question 51

Benefits of contractionary monetary policy

Answer 51

- Higher interest rates -> loans are more expensive to take out -> less consumption, investment lower AD -> lower (demand-pull) inflation - Higher interest rates -> higher reward for saving -> encourages consumers to save instead of spend -> lower AD -> lower (demand-pull) inflation - Higher interest rates -> increase exchange rate (currency appreciates) -> imports get cheaper -> lower (cost-push) inflation

Question 52

Drawbacks of contractionary monetary policy

Answer 52

- Higher interest rates -> loans are more expensive to take out -> less consumption, investment -> lower AD -> lower economic growth -> higher unemployment - Higher interest rates -> loans are more expensive to take out -> higher costs of production for firms -> higher inflation - Time lag

Question 53

Types of supply-side policies

Answer 53

- Privatisation - Deregulation - Education and training - Regional policies - Lower direct taxes - Infrastructure spending - Improving incentives to work and invest

Question 54

Impacts of supply-side policies on macroeconomic objectives

Answer 54

- Higher rate of economic growth (privatisation/deregulation, new firms enter the market) - Lower inflation (lower tax/privatisation/deregulation reduces cost of production to firms) - Lower unemployment (higher quality workforce through education and training, or: projects need workers in the short term, but also in the long term it increases the potential supply capacity of the economy) - Current account tends towards a surplus (prices of domestic goods decrease) - External costs imposed on the environment (large infrastructure/transport projects) - Worse income inequality (deregulation offers less protection against low wage employment, lower taxes result in less government revenue to redistribute income)

Question 55

Disadvantages of supply-side policies

Answer 55

- Opportunity cost (applies for any investment or project, e.g. education and training/healthcare/infrastructure) - High financial cost to the government, may force it to borrow and this has a negative impact on the fiscal balance (applies to investments and projects) - Time lag (applies for investments, e.g. education and training/healthcare/infrastructure) - No guarantee that firms will employ extra workers and won’t just save it as extra profit (applies to lower direct taxes, deregulation)