A-Level Economics A: THEME 4 GENERAL KNOWLEDGE

Question 1

4.1.1 Globalisation

What is globalisation?

Answer 1

Refers to the growing interdependence between countries and the changes it brings about.

Question 2

4.1.1 Globalisation

What are the variables to consider when measuring globalisation?

Answer 2

• Difference between GNP and GDP of a country.
• Remittances as a % of GDP.
• Number of TNCs in foreign countries.
• Membership of free trade agreements and level of protectionism.
• Migration/immigration flows.

Question 3

4.1.1 Globalisation

What are the main factors contributing to globalisation?

Answer 3

• Improvements in transport infrastructure and operations.
• Improvements in ICT.
• Trade liberalisation.
• International financial markets.
• TNCs.

Question 4

4.1.1 Globalisation

How does improvement in transport cause globalisation?

Answer 4

Improvements in transport infrastructure and operations have meant there are quick, reliable and cheap methods to allow production to be separated around the world.

Question 5

4.1.1 Globalisation

How does improvement in ICT cause globalisation?

Answer 5

Improvements in ICT and communication allow companies to operate across the globe.

Question 6

4.1.1 Globalisation

How does trade liberalisation cause globalisation?

Answer 6

Trade liberalisation and reduced protectionism has made it cheaper and more feasible to trade; this has been occurring since 1945. The breakdown of the soviet bloc and the opening of China has shown a whole area of the world for business to expand into.

Question 7

4.1.1 Globalisation

How do international financial markets cause globalisation?

Answer 7

International financial markets have provided the ability to raise money and move money around the world, necessary for international trade.

Question 8

4.1.1 Globalisation

How do TNCs cause globalisation?

Answer 8

TNCs (large companies operating around the world) have led to globalisation by acting to increase their own profit as they want to take advantage of low labour costs. They sell and produce their goods all around the world and have the power to lobby governments.

Question 9

4.1.1 Globalisation

What are the main consumer impacts of globalisation?

Answer 9

• More consumer choice, not just domestic goods.
• Lower prices as firms abuse comparative advantage and produce in countries with lower costs.
• Rise in prices since incomes rise from the growing middle-class. Leads to higher demand for goods and services.
• Some consumers worry over loss of culture or sovereignty.

Question 10

4.1.1 Globalisation

What are the main worker impacts of globalisation?

Answer 10

• Some have gained employment whilst other have lost employment.
• Increased migration lower wages. However migrants can fill labour shortages.
• International competitions has lead to a fall in wages.
• TNCs help provide training and job opportunities.
• Those working in sweatshops see poor conditions and low wages.

Question 11

4.1.1 Globalisation

What are the main producer impacts of globalisation?

Answer 11

• Firms are able to source products from more countries and sell them in more countries. This reduces risk since a collapse of the market in one company will have a smaller impact on the business.
• They are able to employ low skilled workers much cheaper in developing countries and can exploit comparative advantage and have larger markets, both of which can increase profits.
• Firms who are unable to compete internationally will lose out.

Question 12

4.1.1 Globalisation

What are the government impacts of globalisation?

Answer 12

The government may be able to receive higher taxes, since TNCs pay tax and so do the people they employ. However, they could lose out through tax avoidance.

• TNCs also have the power to bride and lobby governments, which could lead to corruption.
• If the government uses the correct policies, they can maximise the gains and minimise the losses.

Question 13

4.1.1 Globalisation

What are the environmental impacts of globalisation?

Answer 13

• Increased demand for raw materials which leads to environmental deterioration.
• Increased trade and production has led to more emissions.
• However, globalisation means the world connections enable shared goals to tackle environmental issues.

Question 14

4.1.1 Globalisation

What are the economic impacts of globalisation?

Answer 14

• Increases investment within countries; the investment of TNCs represents an injection into the economy, and which have a larger impact due to the multiplier.
• TNCs brings about the trickle-down effect through their world class management techniques and technology.
• Comparative cost advantages will change over time and so companies may leave when it a country no longer offers any advantage.

Question 15

4.1.1 Globalisation

How have IGOS like the World Trade Organisation help increase rates of globalisation?

Answer 15

• The WTO helps liberalise free trade, provide a forum to resolve trade disputes, and lower tariffs and barriers.
• The GATT (General Agreement for Tariffs and Trade) was formed in 1948.
• The MFN (Most Favoured Nation Principle) says that any tariff reduction offered to one country must be offered to all (against trade discrimination).

Question 16

4.1.1 Globalisation

How has containerisation helped improve globalisation?

Answer 16

• Containerisation has seen firms exploit volume economies of scale.
• This has promoted international trade by making shipping cheaper.
• Because containers were quicker to load, it encouraged the building of bigger ‘container ships’ Larger loads could be offloaded in a shorter time, this reduced the cost of ship transport and enabled transport economies of scale.

Question 17

4.1.1 Globalisation

What are the benefits of globalisation?

Answer 17

• Free trade
• Free movement of labour
• Increased economies of scale
• Greater competition
• Increased investment

Question 18

4.1.1 Globalisation

What are the benefits of increased free trade?

Answer 18

• Increased specialisation in producing goods where there is a comparative advantage.
• This leads to lower prices and greater choice of goods.
• There are bigger export markets for domestic manufacturers.
• Economies of scale through specialisation.
• International competition.

Question 19

4.1.1 Globalisation

What are the benefits of free movement of labour?

Answer 19

• Helps fill in labour shortages.

- Reduces geographical inequality (e.g the EU).

Question 20

4.1.1 Globalisation

What are the benefits of increased economies of scale?

Answer 20

Production is increasingly specialised. Globalisation enables goods to be produced in different parts of the world. This greater specialisation enables lower average costs and lower prices for consumers.

Question 21

4.1.1 Globalisation

What are the benefits of greater competition?

Answer 21

Domestic monopolies used to be protected by a lack of competition. However, globalisation means that firms face greater competition from foreign firms.

Question 22

4.1.1 Globalisation

What are the benefits of increased investment?

Answer 22

Globalisation has also enabled increased levels of investment. It has made it easier for countries to attract short-term and long-term investment. Investment by multinational companies can play a big role in improving the economies of developing countries.

Question 23

4.1.1 Globalisation

What are the costs of globalisation?

Answer 23

• Free trade harming developing economies
• Environmental costs
• Labour/brain drain
• Tax competition and tax avoidance

Question 24

4.1.1 Globalisation

What are the costs of free trade?

Answer 24

Developing countries often struggle to compete with developed countries, therefore it is argued free trade benefits developed countries more. There is an infant industry argument that says industries in developing countries need protection from free trade to be able to develop. However, developing countries are often harmed by tariff protection, that western economies have on agriculture.

Question 25

4.1.1 Globalisation

What are the costs to the environment?

Answer 25

One problem of globalisation is that it has increased the use of non-renewable resources. It has also contributed to increased pollution and global warming. Firms can also outsource production to where environmental standards are less strict. However, arguably the problem is not so much globalisation as a failure to set satisfactory environmental standards.

Question 26

4.1.1 Globalisation

What are the costs of the labour/brain drain?

Answer 26

Globalisation enables workers to move more freely. Therefore, some countries find it difficult to hold onto their best-skilled workers, who are attracted by higher wages elsewhere.

Question 27

4.1.1 Globalisation

What are the costs with regard to tax competition and tax avoidance?

Answer 27

• Multinational companies like Amazon and Google, can set up offices in countries like Bermuda and Luxembourg with very low rates of corporation tax and then funnel their profits through these subsidiaries. This means they pay very little tax in the countries where they do most of their business. This means governments have to increase taxes on VAT and income tax. It is also seen as unfair competition for domestic firms that don’t use the same tax avoidance measures.
• The greater mobility of capital means that countries have sought to encourage inward investment by offering the lowest corporation tax. (e.g. Ireland offers a very low tax rate). This has encouraged lower corporation tax, which leads to higher forms of other taxes.

Question 28

4.1.2 Specialisation and trade

What does specialisation mean?

Answer 28

• Specialisation means countries often stop making products they need, to focus on producing the products they are better at.
• As a result, trade must happen with other countries, and an efficient exchange system is needed.

Question 29

4.1.2 Specialisation and trade

What is the difference between absolute and comparative advantage?

Answer 29

• The theory of comparative advantage states that countries find specialisation mutually advantageous if the opportunity costs of production are different. If they are the same, there will be no gain from trade.
• Absolute advantage exists when a country can produce a good more cheaply in absolute terms than another country.
• Comparative advantage exists when a country is able to produce a good more cheaply relative to other goods produced.

Question 30

4.1.2 Specialisation and trade

What are the main assumption and limitations of the theory?

Answer 30

• Comparative advantage assumes there are no transport costs , and these could lower or prevent any comparative advantage.
• It also assumes costs are constants and that there are no economies of scales. Economies of scale help to increase the gains from specialisation.
• In the model, goods are assumed to be homogenous, which is unlikely to hold in real life. The fact products aren’t homogenous makes it difficult to conclude that a country has a comparative advantage as their products can’t be perfectly compared.
• It also assumes that factors of production are perfectly mobile , there are no tariffs or other trade barriers and there is perfect knowledge.

Question 31

4.1.2 Specialisation and trade

What are the advantages of specialisation and trade?

Answer 31

• Comparative advantage
• Economies of scale
• Greater choice
• Greater competition

Question 32

4.1.2 Specialisation and trade

How is utilising comparative advantage beneficial?

Answer 32

Comparative advantage shows how world output can be increased if countries specialise in what they are best at producing, this will increase global economic growth.

Question 33

4.1.2 Specialisation and trade

How are economies of scale beneficial?

Answer 33

Trading and specialising allows countries to benefit from economies of scale , which reduces costs and therefore decrease prices globally.

Question 34

4.1.2 Specialisation and trade

How is greater choice beneficial?

Answer 34

Trade enables consumers to have greater choice about the types of goods they buy, and so there is greater consumer welfare.

Question 35

4.1.2 Specialisation and trade

How is competition beneficial?

Answer 35

Trade also means there is greater competition, which provides an incentive to innovate. This creates new goods and services and new production methods, increasing consumer welfare and lowering costs respectively.

Question 36

4.1.2 Specialisation and trade

What are the disadvantages of specialisation and trade?

Answer 36

• Over-dependence
• Structural unemployment
• Environmental deterioration
• Loss of sovereignty

Question 37

4.1.2 Specialisation and trade

How is over-dependence disadvantages?

Answer 37

Trade can lead to over-dependence, where some countries become dependent on particular exports whilst others become dependent on particular imports. This can cause problems if there are large price falls in the exports of if imports are cut for political reasons.

Question 38

4.1.2 Specialisation and trade

How is structural unemployment a disadvantage?

Answer 38

It can cause structural unemployment, as jobs are lost to foreign firms who are more efficient and competitive. The less mobile the workforce, the higher the chance that changes in demand due to trade will reduce output and employment over long periods of time.

Question 39

4.1.2 Specialisation and trade

How is environmental deterioration a disadvantage?

Answer 39

The environment will suffer due to the problems of transport as well as the increased demand for resources e.g. deforestation.

Question 40

4.1.2 Specialisation and trade

How is loss of sovereignty a disadvantage?

Answer 40

Countries may suffer from a loss of sovereignty due to signing international treaties and joining trading blocs, for example in the EU. They may see a loss of culture as trade brings foreign ideas and products to the country.

Question 41

4.1.6 Restriction on free trade

What are the main reasons for restrictions on free trade?

Answer 41

• Infant industries
• Job protection
• Protection from potential dumping
• Protection from unfair competition
• Terms of trade
• Danger of over specialisation

Question 42

4.1.6 Restriction on free trade

What is the infant industry argument?

Answer 42

An infant industry is one that is just being established within a country. They need to be able to build up a reputation and customer base and will have to cover a lot of sunk costs, meaning their AC will be higher. Therefore, the industry would be unable to compete in the international market and so the government protect them until they are able to compete on an equal level.

Question 43

4.1.6 Restriction on free trade

What is the job protection argument?

Answer 43

Governments may be concerned that allowing imports will mean domestic producers will lose out to international firms, and so there will be job losses within the country. Not only would this have negative economic consequences, it would be politically unpopular.

Question 44

4.1.6 Restriction on free trade

What is the protection from dumping argument?

Answer 44

Dumping is when a country or company with surplus goods sells these goods off to other areas of the world at very low prices, harming domestic producers in those countries. The government may need to intervene to protect domestic producers who are unable to compete with firms that are willing to make a loss.

Question 45

4.1.6 Restriction on free trade

What is the protection from unfair competition argument?

Answer 45

Domestic producers may be unable to compete with a firm that has very low labour costs or very low health and safety costs due to regulation or with a firm that is heavily subsidised by the government. Some will argue the government should intervene to protect domestic producers from this.

Question 46

4.1.6 Restriction on free trade

What is the terms of trade argument?

Answer 46

if a country buys a large amount of imports for a certain good, this will increase demand for that good and hence increase the price. This will worsen the terms of trade and so therefore they can buy less imports with the amount of exports. Restrictions will reduce supply of the good and lead to a fall in the price received by the importer, so improve the terms of trade.

Question 47

4.1.6 Restriction on free trade

What is the danger of over specialisation argument?

Answer 47

Some people believe that no country should become totally reliant on another for important products or materials and so it is important to introduce protectionism on these goods to prevent firms and consumers becoming reliant on them.

Question 48

4.1.6 Restriction on free trade

What are the main types of restrictions?

Answer 48

• Tariffs
• Quotas
• Subsidies to domestic products

Question 49

4.1.6 Restriction on free trade

How do quotas restrict trade?

Answer 49

These are limits placed on the level of imports allowed into a country , meaning people are forced to buy domestic goods if they want that good and the quota is already used. There will be a welfare loss and shift of consumer subsidy to producer subsidy but instead of tax revenue, there will be extra revenue for the exporting, foreign firms.

Question 50

4.1.6 Restriction on free trade

How do subsidies to domestic products restrict trade?

Answer 50

These are payments to domestic producers which lower their costs and help them to be more competitive by enabling cheaper prices. Sometimes subsidies are purely given to goods that are exported whilst other times they are given to firms that have a large proportion of their sales as exports. Subsidies can also be given to domestic firms that compete with imports, usually in the form of indirect subsidies like tax breaks or cheap loans.

Question 51

4.1.6 Restriction on free trade

How do subsidies to domestic products restrict trade?

Answer 51

These are payments to domestic producers which lower their costs and help them to be more competitive by enabling cheaper prices. Sometimes subsidies are purely given to goods that are exported whilst other times they are given to firms that have a large proportion of their sales as exports. Subsidies can also be given to domestic firms that compete with imports, usually in the form of indirect subsidies like tax breaks or cheap loans.

Question 52

4.1.6 Restriction on free trade

What is the main impact of protectionist policies on consumers?

Answer 52

• Higher prices for consumers as they are unable to buy imports at the cheaper price, the higher prices is because competition for domestic producers is reduced so they have less incentive to be efficient and keep prices low/competitive.
• They suffer from less choice.

Question 53

4.1.6 Restriction on free trade

What is the main impact of protectionist policies on producers?

Answer 53

• Less competition so can sell more goods at a higher price than before.
• May suffer from higher costs if there are controls on the imports they need for production.
• Foreign producers will lose out as they are limited in where they can sell their goods.

Question 54

4.1.6 Restriction on free trade

What is the main impact of protectionist policies on governments?

Answer 54

• In the short run, governments benefit as they can gain tariff revenues and they are politically popular.
• In the long run, protectionist policies can lead to an inefficient economy dues to less competition which stifles growth.

Question 55

4.1.6 Restriction on free trade

What is the main impact of protectionist policies on living standards?

Answer 55

• As the tariff diagram shows, the imposition of import controls results in deadweight welfare loss.
• It also causes trade wars since the introduction of restrictions often leads to retaliation by other countries.
• Example: US-China trade war, where each country continued to impose more tariffs on the other’s goods. This causes a reduction in trade and a reduction in growth.

Question 56

4.1.6 Restriction on free trade

Why is there a recent rise in economic protectionism?

Answer 56

There has been a rise of economic nationalism in a number of countries, leading to policies which emphasise the domestic control of the economy, labour and capital formation, one of these is restrictions to free trade. The financial crisis and recession led to distrust of globalisation and pressure to put self-interest above anything else. Countries have found it difficult to lower protectionism since they always expect reciprocity, for example the UK would not lower barriers on US goods if they US were not willing to do the same.

Question 57

4.2.2 Inequality

What is wealth inequality?

Answer 57

Inequality in accumulated wealth. The bigger issue and more extreme than another kind.

Question 58

4.2.2 Inequality

What is income inequality?

Answer 58

Income inequality is how unevenly income is distributed throughout a population.

Question 59

4.2.2 Inequality

What is the Lorenz curve?

Answer 59

The Lorenz curve represents the income equality of the economy. Therefore the further the Lorenz curve lies below the line of perfect equality the more inequality.

Question 60

4.2.2 Inequality

What is the Gini Coefficient?

Answer 60

The Gini coefficient is one of the most frequently used measures of economic inequality. The coefficient can take any values between 0 to 1 (or 0% to 100%). A coefficient of zero indicates a perfectly equal distribution of income or wealth within a population.

Question 61

4.2.2 Inequality

What is the distinction between wealth and income inequality?

Answer 61

Income is a flow of earnings, whilst wealth is a stock of assets. Income inequality refers to the extent to which income is distributed in an uneven manner.

Question 62

4.2.2 Inequality

What are the causes of wealth and income inequality?

Answer 62

• Wages
• Wealth levels
• Chance
• Age

Question 63

4.2.2 Inequality

How do wages cause wealth and income inequality?

Answer 63

Some workers simply earn more than others. This can be because of higher educational achievements, because they work longer hours or because their skills are more in demand. Those who aren’t at work will have a lower income than others e.g. pensioners or those on benefits. Moreover, the higher the level of income, the more someone can save and thus the more wealth they can build up. Those on high incomes will be able to build up a stock of assets whilst those on lower incomes may have to spend most of their money on everyday items like food.

Question 64

4.2.2 Inequality

How do wealth levels cause wealth and income inequality?

Answer 64

Someone who already has a high level of wealth, whether through inheritance or saving, is able to build up larger wealth than those on lower levels of wealth. For example, they may undertake more risky investments which will give a higher rate of return. They could buy property in London which they hope will rise in price and make a huge return. Those with lower levels of wealth are unable to do so. Inheritance often allows high levels of wealth. Moreover, high levels of wealth mean people can earn rent and interest on their assets and so, therefore, see increased income.

Question 65

4.2.2 Inequality

How does chance cause wealth and income inequality?

Answer 65

Those who bought houses in the right area or bought the right assets will see a huge increase in the price of their assets and hence an increase in their wealth. They may have been lucky to inherit wealth. Those who chose the right sort of job will have seen their income rise higher than in other areas.

Question 66

4.2.2 Inequality

How does age cause wealth and income inequality?

Answer 66

Working adults at the peak of their career will earn a higher income than those who have just started. Those who are older will have had a chance to build up more assets, although some of this stock may have been used up to pay for retirement.

Question 67

4.2.2 Inequality

What are the two types of poverty?

Answer 67

• Relative poverty

- Absolute poverty

Question 68

4.2.2 Inequality

What is relative poverty?

Answer 68

This is when income is a certain percentage less than the average income. For example, in the UK relative poverty is defined as income 50% less than average income. Therefore a rise in economic growth and average incomes will cause a change in what constitutes relative poverty.

Question 69

4.2.2 Inequality

What is absolute poverty?

Answer 69

This is an income below a certain level necessary to maintain a minimum standard of living. (e.g. enough money to buy the basic necessities of food, shelter and heat.

Question 70

4.2.2 Inequality

What are the advantages of inequality?

Answer 70

• The incentive effect
• Entrepreneurship
• Trickle-down effect
• Fairness

Question 71

4.2.2 Inequality

What are the problems of inequality?

Answer 71

• Inequality arising from monopoly power
• Inequality arising from Monopsony power
• Diminishing marginal utility of income
• Social Problems
• Unemployment
• Inherited Wealth

Question 72

4.2.2 Inequality

How does inequality create the incentive effect?

Answer 72

If someone works harder and as a consequence receives a higher wage then this is not market failure. The promise of a higher wage is essential to encourage extra effort. By rewarding hard work, there will be a boost to productivity leading to higher national output – so everyone can benefit.

Question 73

4.2.2 Inequality

How does inequality create entrepreneurship?

Answer 73

Inequality is necessary to encourage entrepreneurs to take risks and set up new businesses. Without the prospect of substantial rewards, there would be little incentive to take risks and invest in new business opportunities.

Question 74

4.2.2 Inequality

How does inequality create the trickle-down effect?

Answer 74

If some people gain extra income, then this can ‘trickle down’ to other people, e.g. if an entrepreneur sets up a business he may become a millionaire, but also will create jobs and provide income for other workers. There may be a gap between the highest and lowest earners. But, the lowest earners are still better off than without the entrepreneur.

Question 75

4.2.2 Inequality

What is inequality arguably?

Answer 75

Arguably, inequality is a type of market failure. Market failure occurs when there is an inefficient allocation of resources in a free market. It can occur due to.

Question 76

4.2.2 Inequality

What are the main causes of inequality?

Answer 76

• Geographical immobility
• Structural unemployment
• Occupational immobility
• Education levels
• Monopolies
• Government policy

Question 77

4.2.2 Inequality

What is the geographical and occupational immobility of labour?

Answer 77

• Geographical immobility - When it is difficult to move from one geographical area to another.
• Occupational immobility - When it is difficult to move from one type of work to another.

Question 78

4.2.2 Inequality

What is the relation between education and income inequality?

Answer 78

• Education increases a person’s human capital and thus their productivity.
• In 2016, FTSE 100 CEO’s average remuneration was £4.5m, this would take the average worker, 160 years to earn (avg salary = £28,000). In 2016 45% of FTSE 100 CEOs were privately educated, compared to 7% of society.
• 24% went to Oxbridge, of which 63% were privately educated. (53% attended a Russell Group university).

Question 79

4.2.2 Inequality

What is the relation between globalisation/technology to income inequality?

Answer 79

• Increased demand for highly skilled workers in finance and technology (high income).
• Globalisation and offshoring have reduced the bargaining power of low/semi-skilled labour (low income).
• However, technology also helps pull people out of poverty and reduces the price of consumption goods. Globalisation also create more open markets hence increasing demand.

Question 80

4.2.2 Inequality

What is the relation between age and income inequality?

Answer 80

• An ageing population can increase inequality as the elderly tend to have a larger income than expenditure, therefore increasing wealth and often earning more due to more experience.
• Due to rising house prices, those that bought their houses many years ago now have far greater wealth than those struggling to get on the property ladder.

Question 81

4.2.2 Inequality

What is the relation between wealth and income inequality?

Answer 81

• Ownership of financial assets yields income flows, such as interest, profit & dividends.
• Pension rights may be improved through private schemes.
• Inheritance of wealth allows accumulation of assets over generations, particularly in housing where it is a significant share of wealth.
• Thomas Piketty says wealth grows faster than income, hence (as the rich hold more wealth) the rich become richer, found in his book ‘Capital in the 21st Century.’

Question 82

4.2.2 Inequality

What is the significance of capitalism for inequality?

Answer 82

• In a capitalist society, entrepreneurs take risks and are driven by the profit motive. Profits are a reward to take risks. Therefore, inequality is essential to encourage entrepreneurs to take risks.
• Inequality motivates workers, which encourages them to learn new skills and work hard. A higher wage reflects higher productivity in a capitalist society, which results in wage inequality.
• Capitalism leads to monopoly power. Monopolies can exploit consumers with higher prices, and exploit their consumers with lower wages. This allows them to earn even higher profits.

Question 83

4.2.2 Inequality

What are the further implications of capitalism on inequality?

Answer 83

Inheritance is passed down generations, which means wealth is often concentrated in the hands of a few families. Those who inherit lots have more wealth. They can also access the best education and therefore the best jobs, which is not accessible to those with less wealth. It results in an inequality of opportunity and income. Wealth can generate more income for the rich, which widens inequality.

Question 84

4.2.2 Inequality

How can income redistribution and wage equality occur through government intervention?

Answer 84

For example, inheritance tax means rich families cannot keep their entire wealth. Moreover, state education means everyone can access education, and there is regulation for firms with monopoly power. It can be argued that this stops the economic system from being capitalist.

Question 85

4.4.1 Role of financial markets

What are financial markets?

Answer 85

Financial markets are where buyers and sellers can buy and trade a range of services or assets that are fundamentally monetary in nature.

Question 86

4.4.1 Role of financial markets

Why do financial markets exist?

Answer 86

They exist for two main reasons: to meet the demand for services , such as saving and borrowing, from individuals, businesses and the government and to allow speculation and financial gains.

Question 87

4.4.1 Role of financial markets

Why are financial markets very important?

Answer 87

Financial markets are extremely important to the general health of an economy. With effective markets for credit and capital, borrowing and investment will be limited and the whole macroeconomy can suffer. Financial markets often fail to form in command economies and in less developed economies, causing low levels of investment and low growth rates.

Question 88

4.4.1 Role of financial markets

What are the main roles of the financial market?

Answer 88

• Facilitate savings
• Lend to businesses and individuals
• Facilitate the exchange of goods and services
• Forward markets
• Market for equities

Question 89

4.4.1 Role of financial markets

How do the financial markets help facilitate savings?

Answer 89

Allows people to transfer their spending power from the present to the future. It can be done through a range of assets, such as storing money in savings accounts and holding stocks and shares.

Question 90

4.4.1 Role of financial markets

How important is the financial sector to the UK?

Answer 90

• It contributed £119 billion to the UK economy, 6.5% of GDP.
• The sector is largest in London, (where 50% of the sector’s output is generated).
• Accounts for 1.1 million financial services jobs (3.2% of all jobs).
• Financial services industry ran a trade surplus of £51 billion and the sector contributed £27.3 billion in tax in the UK in 2016/17.

Question 91

4.4.1 Role of financial markets

How do the financial markets increase consumption and investment?

Answer 91

They lend to businesses and individuals which allows consumption and investment. They are sometimes referred to as a financial intermediary, the step between taking money from one person to giving to another since money from savings is used for investment.

Question 92

4.4.1 Role of financial markets

How do the financial markets facilitate the exchange of goods and services?

Answer 92

They facilitate the exchange of goods and services by creating a payment system. Central banks print paper money, institutions process cheque transactions, companies offer credit card services and banks and bureau de changes buy and sell foreign currencies.

Question 93

4.4.1 Role of financial markets

How do the financial markets provide forward markets?

Answer 93

They provide forward markets. This is where firms are able to buy and sell in the future at a set price, for example, if a farmer wants to sell the crop they are growing at a guaranteed price in a month’s time. The forward market exists for commodities and in foreign exchange and helps to provide stability.

Question 94

4.4.1 Role of financial markets

What may you use forward markets for?

Answer 94

Trade in currencies and commodities. This is seen in food commodities (wheat), commodities (copper/nickel), and foreign exchange (USD and EURO).

Question 95

4.4.1 Role of financial markets

How do the financial markets provide a market for equities?

Answer 95

They provide a market for equities, company shares. Issuing shares is an important way for companies to finance expansion but people would be unlikely to buy shares if they were unable to sell them in the future. Financial markets provide the ability for shares to be sold in the future, making the asset more appealing.

Question 96

4.4.1 Role of financial markets

What’s the difference between equity and capital?

Answer 96

Equity represents the total amount of money a business owner or shareholder would receive if they liquidated all their assets and paid off the company’s debt (linking back to the idea of liabilities). Capital refers only to a company’s financial assets that are available to spend.

Question 97

4.4.1 Role of financial markets

What are the three main financial markets?

Answer 97

• Money Market
• Capital Market
• Foreign Exchange Market

Question 98

4.4.1 Role of financial markets

What are the money markets?

Answer 98

This is the market for short term loan finance for businesses and households. Money is borrowed and lent normally for up to 12 months. Includes inter-bank lending i.e. the commercial banks providing liquidity for each other. The money market also includes short term government borrowing e.g. 3-12 month Treasury Bills – to help fund the government’s budget (fiscal) deficit.

Question 99

4.4.1 Role of financial markets

What are the capital markets?

Answer 99

Capital markets are the markets where securities such as shares and bonds are issued to raise medium to long-term financing. Includes raising of finance by the government through the issue/sale of medium-term and long-term government bonds for example 10 year and 20-year bonds (loans).

Question 100

4.4.1 Role of financial markets

What are the foreign exchange markets?

Answer 100

A market where currencies (foreign exchange) are traded. There is no single currency market – it is made up of thousands of trading floors. Gains or losses are made from the movement of exchange rates – speculative activity in the currency market is often high.

Question 101

4.4.1 Role of financial markets

What is a commodity market?

Answer 101

A commodity market is a marketplace for buying, selling, and trading raw materials or primary products.

Question 102

4.4.1 Role of financial markets

What is a spot market?

Answer 102

The spot market is where financial instruments, such as commodities, currencies, and securities, are traded for immediate delivery. Delivery is the exchange of cash for a financial instrument. A futures contract, on the other hand, is based on the delivery of the underlying asset at a future date.

Question 103

4.4.1 Role of financial markets

What is a forward market?

Answer 103

A forward market is a marketplace that sets the price of a financial instrument or asset for future delivery. Forward markets are used for trading a range of instruments, but the term is primarily used with reference to the foreign exchange market. It allows a guaranteed price to sell or buy.

Question 104

4.4.1 Role of financial markets

What is a bond?

Answer 104

A bond is a specific type of security that is sold by firms or governments. It is a way for the firm or government to borrow money at a certain interest rate. In return for buying the bond and investor gets a certain interest rate for the duration of the bond.

Question 105

4.4.1 Role of financial markets

How do bonds provide security?

Answer 105

The volatility of bonds (especially short and medium dated bonds) is lower than that of equities (stocks). Thus bonds are generally viewed as safer investments than stocks.

Question 106

4.4.1 Role of financial markets

How are bonds liquid?

Answer 106

It is often fairly easy for an institution to sell a large number of bonds without affecting the price much, which may be more difficult for equities. In effect, bonds are attractive because of the comparative certainty of a fixed interest payment twice a year and a fixed lump sum at maturity.

Question 107

4.4.1 Role of financial markets

How do bonds provide a reinvestment risk?

Answer 107

The reinvestment risk is the possibility that the investor might be forced to find a new place for his money. As a consequence, the investor might not be able to find as good a deal, especially because this usually happens when interest rates are falling.

Question 108

4.4.1 Role of financial markets

How do bonds provide an exchange rate risk?

Answer 108

The exchange rate risk is a financial risk posed by an exposure to unanticipated changes in the exchange rate between two currencies.

Question 109

4.4.2 Market failure in the financial sector

What is asymmetric information?

Answer 109

This is a situation where there is imperfect knowledge. In particular, it occurs when one party has different information from another.

Question 110

4.4.2 Market failure in the financial sector

How is asymmetric information an issue in the financial sector?

Answer 110

One problem with the financial sector is that financial institutions often have more knowledge compared to their customers, both consumers and other institutions. This means they can sell them products that they do not need, are cheaper elsewhere or are riskier than the buyer realises.

Question 111

4.4.2 Market failure in the financial sector

What is an example of asymmetric information in the financial sector?

Answer 111

The Global Financial Crisis was partially caused by banks selling packages of prime and subprime mortgages, but advertising them as all prime mortgages.

Question 112

4.4.2 Market failure in the financial sector

What is an example of externalities in the financial sector?

Answer 112

Significant externalities are created by financial markets, for instance, the cost to the taxpayer of bailing out banks in situations like the 2008 GFC, where the overall cost to the UK taxpayer was £1.162 trillion.

Question 113

4.4.2 Market failure in the financial sector

What is market rigging?

Answer 113

Market rigging occurs when individuals or institutions collude to fix prices or share information to maintain a position in a market.

Question 114

4.4.2 Market failure in the financial sector

What is an example of market rigging in the financial sector?

Answer 114

In the Libor scandal of 2008, financial institutions were accused of fixing the London Interbank Lending Rate (LIBOR), one of the most important rates in the world.

Question 115

4.4.2 Market failure in the financial sector

What is a moral hazard?

Answer 115

Where individuals make decisions in their own best interests knowing there are potential risks.

Question 116

4.4.2 Market failure in the financial sector

What are two forms of moral hazards that arise in the financial sector?

Answer 116

• Individual workers take adverse risks to increase salaries.
• Companies take risks knowing the central bank will lend them out.

Question 117

4.4.2 Market failure in the financial sector

What’s an example of a moral hazard taking place?

Answer 117

The Global Financial Crisis was caused by moral hazard when employees sold mortgages to those who would not be unable to pay them back. By selling more mortgages, they would see higher salaries and bonuses but would not see the negative effects if the loan was not repaid. On top of this, financial institutions may take the excessive risk because they know the central bank is the lender of last resort and so will not allow them to fail because of the impact it would have on the economy.

Question 118

4.4.2 Market failure in the financial sector

What is a market bubble?

Answer 118

Where the price of an asset rises massively and then falls.

Question 119

4.4.2 Market failure in the financial sector

How can the market failure of speculation and market bubbles arise in the financial sector?

Answer 119

They tend to occur because investors see the price of an asset is rising and so decide to purchase this asset as they believe the price will continue to rise and will profit them in the future. This leads to prices becoming excessively high and eventually enough investors decide that the price will fall, so they sell their assets and panic sets in, causing mass selling. This is known as herding behaviour.

Question 120

4.4.2 Market failure in the financial sector

How has the financial market created market bubbles in other markets?

Answer 120

Moreover, the financial market has also caused market bubbles in the housing market by lending too much in mortgages and increasing demand for houses. When this bubble bursts, for example, due to a rise in real interest rates, there is a fall in demand for houses and a negative wealth effect, reducing AD, and banks are left with loans that will not be repaid in full.

Question 121

4.5.2 Taxation

What are proportional taxes?

Answer 121

A proportional tax has a fixed rate for all taxpayers, regardless of income. It is also known as a flat tax. For example, all taxpayers might have to pay a 20% income tax rate.

Question 122

4.5.2 Taxation

What are progressive taxes?

Answer 122

A progressive tax has an increase the average rate of tax as income increases. As income increases, the proportion of income tax increases. For example, income tax is progressive.

Question 123

4.5.2 Taxation

What are regressive taxes?

Answer 123

A regressive tax doesn’t relate to income but means those on the lowest incomes have a higher average rate of tax. The proportion of income paid as tax is higher for those on lower incomes than those on higher incomes. For example, as a percentage of income, the London Congestion Charge and Council Taxes are higher for those on lower incomes.

Question 124

4.5.2 Taxation

What does the Laffer Curve show?

Answer 124

The Laffer Curve shows how much tax revenue the government receives at each level of tax. Up until point T, as tax rates increase, government tax revenue increases. After point T, people do not think it is worthwhile working and the lack of incentive to work leads to falling tax revenue.

Question 125

4.5.2 Taxation

What are the economic effects of changes in direct and indirect taxes on income redistribution?

Answer 125

• There can be income redistribution and wage equality through government intervention. For example, inheritance tax means rich families cannot keep their entire wealth.
• Over the last 20-30 years, the UK has switched towards indirect taxes, which tend to be more regressive than direct taxes.

Question 126

4.5.2 Taxation

What are the economic effects of changes in direct and indirect taxes on real output and employment?

Answer 126

• Expansionary fiscal policy aims to increase AD. Governments increase spending or reduce taxes to do this. It leads to a worsening of the government budget deficit, and it may mean governments have to borrow more to finance this.
• Deflationary fiscal policy aims to decrease AD. Governments cut spending or raise taxes, which reduces consumer spending. It leads to an improvement in the government budget deficit.

Question 127

4.5.2 Taxation

What are the economic effects of changes in direct and indirect taxes on price levels?

Answer 127

Indirect taxes could cause cost push inflation. Indirect taxes could increase the cost of goods such as cigarettes or fuel, if producers choose to pass the costs onto the consumer. Since the demand for cigarettes and fuel is relatively price inelastic, producers are likely to pass the cost of the tax onto consumers.

Question 128

4.5.2 Taxation

What are the economic effects of changes in direct and indirect taxes on the trade balance?

Answer 128

Taxes could be imposed on imports into a country. These are tariffs and they make it more expensive to import goods, which should, in theory, improve the trade balance. However, other countries may retaliate, so exports might decrease as well.

Question 129

4.5.2 Taxation

What are the economic effects of changes in direct and indirect taxes on FDI flows?

Answer 129

Governments can provide a competitive tax environment to encourage FDI so that the market is profitable, fair and has macroeconomic stability. Taxes should also be consistent and predictable, so they are business-friendly. This would encourage FDI flows. High, fickle taxes are likely to discourage FDI flows, since investors will choose to invest elsewhere.

Question 130

4.5.3 Public sector finances

What is capital expenditure?

Answer 130

• Capital expenditure is the spending on goods which create or help market other goods.
• When the governments spend on capital it is usually infrastructure like transport networks which make it easier and cheaper for firms to produce goods and services.

Question 131

4.5.3 Public sector finances

What are transfer payments?

Answer 131

• Transfer payments are payments made by the government without receiving a good or service in exchange.
• Government transfer payments include the spending on benefits and aid expenditure.

Question 132

4.5.3 Public sector finances

What is current expenditure?

Answer 132

• Current expenditure is the spending on consumables and other non-capital goods, services and labour.
• Governments’ current expenditure includes payment of public sector workers.

Question 133

4.5.3 Public sector finances

What is crowding out?

Answer 133

When government spending fails to increase overall aggregate demand because higher government spending causes an equivalent fall in private sector spending and investment.

Question 134

4.5.3 Public sector finances

What is the most common form of crowding out?

Answer 134

One of the most common forms of crowding out takes place when a large government, such as that of the US, increases its borrowing and sets in motion a chain of events that results in the curtailing of private sector spending. The sheer scale of this type of borrowing can lead to substantial rises in the real interest rate, which has the effect of absorbing the economy’s lending capacity and of discouraging businesses from making capital investments.

Question 135

4.5.3 Public sector finances

What are automatic stabilisers?

Answer 135

Policies which offset fluctuations in the economy. These include transfer payments and taxes. They are triggered without government intervention.

Question 136

4.5.3 Public sector finances

How do automatic stabilisers act during a recession and boom?

Answer 136

• In a recession, benefits increase as more people are unemployed and so the benefits are a stabiliser as it means that the overall fall in AD is reduced, preventing too much change in the economy.
• On the other hand, during a boom, tax increases as people have more jobs and higher incomes, and this tax reduces disposable income so decreases consumption and AD, meaning that demand doesn’t grow too high.

Question 137

4.5.3 Public sector finances

What is discretionary fiscal policy?

Answer 137

A policy which is implemented through one off policy changes. Discretionary fiscal policy involves deliberate changes in government expenditure and taxes with the intention of influencing AD.

Question 138

4.5.3 Public sector finances

What is the fiscal deficit?

Answer 138

A government has a fiscal (budget) deficit when expenditure exceeds tax receipts in a financial year.

Question 139

4.5.3 Public sector finances

What is national debt?

Answer 139

The national debt is the sum of all government debts built up over many years.

Question 140

4.5.3 Public sector finances

What are the ways national debt can be measured as?

Answer 140

• Money

- Percentage of GDP

Question 141

4.5.3 Public sector finances

What was the UK’s national debt as of 2018?

Answer 141

National debt in 2018 is around £1.8 trillion, or as a percentage of GDP, the UK’s national debt is 87.7% of total GDP.

Question 142

4.5.3 Public sector finances

What was the UK’s fiscal deficit as of 2018?

Answer 142

In 2018, the fiscal deficit is £48bn, 2.3% of GDP.

Question 143

4.5.3 Public sector finances

What is a cyclical deficit?

Answer 143

A cyclical deficit is the part of the deficit that occurs because government spending and tax fluctuates around the trade cycle. When the economy is in recession, tax revenues are low and spending is high creating a larger deficit.

Question 144

4.5.3 Public sector finances

What is a structural deficit?

Answer 144

This is a deficit which is due to an imbalance in the revenue and expenditure of the government, so it exists at every point in the business cycle.

Question 145

4.5.3 Public sector finances

What is the actual deficit?

Answer 145

The actual deficit is the structural deficit plus the fiscal deficit.

Question 146

4.5.3 Public sector finances

What is likely to continue happening if the government has a structural deficit?

Answer 146

It is likely that national debt will grow over time as the government has to consistently borrow money to finance spending. For this reason, it is argued that structural deficits need to be eliminated but this is difficult since it is impossible to know what part of the deficit is structural and what part of it is cyclical, just as it is impossible to know the size of the output gap.

Question 147

4.5.3 Public sector finances

What are the factors influencing the size of fiscal deficits?

Answer 147

The trade cycle, unforeseen events, debt interest, privatisations, government aims, number of dependants.

Question 148

4.5.3 Public sector finances

How does trade cycle influence the size of fiscal deficits?

Answer 148

Explained by concept of cyclical and structural deficits e.g. during a downturn there is a negative wealth affect on housing, so less taxes on property transactions (stamp duty), causing a fall in revenue and a deficit. In the UK, the fiscal deficit peaked in 2010 at 10.1% of GDP.

Question 149

4.5.3 Public sector finances

How does unforeseen events influence the size of fiscal deficits?

Answer 149

Things like natural disasters or recessions lead to huge increases in spending so increases the deficit.

Question 150

4.5.3 Public sector finances

How does debt interest influence the size of fiscal deficits?

Answer 150

If interest rates on government debt increase, the amount the government pays in interest repayments increases and this is likely to increase the deficit. The impact of this will depend on how significant interest repayments are in the size of the deficit. Interest rates depend on market rates and the credit ratings of the government. 7% of all UK government spending is on interest repayments of loans.

Question 151

4.5.3 Public sector finances

How does privatisation affect the size of fiscal deficits?

Answer 151

Provide one off payments to government to decrease the deficit in SR, depending on the value of the company sold.

Question 152

4.5.3 Public sector finances

How do government aims influence the size of fiscal deficits?

Answer 152

They are important for the size of deficit, as it influences their fiscal policy e.g. austerity policy managed to reduce the fiscal deficit by 75% since 2010. Factors such as the number of dependants in a country affect both spending and tax revenues so influence the deficit.

Question 153

4.5.3 Public sector finances

What affects the size of national debt in terms of running a deficit?

Answer 153

If the government is continuously running a deficit, then the national debt will increase overtime. There is a consensus view that fiscal deficit over 3% will lead to growing national debt as proportion of GDP. It is only when government runs a budget surplus that the size of the national debt decreases.

Question 154

4.5.3 Public sector finances

What affects the size of national debt in terms of an ageing population?

Answer 154

Ageing populations tend to contribute to a high national debt since the government runs a structural deficit in order to fund their pensions and care and this leads to a high national debt.

Question 155

4.5.3 Public sector finances

What is the significance of size of fiscal deficits and national debt on interest rates?

Answer 155

High levels of borrowing may raise interest rates in the economy since an increase in the demand for money will increase the price of money, i.e. interest rates. This could cause crowding out of the economy. However, this may not always be the case as the government may borrow from overseas and during a recession, private sector investment falls which means interest rates may remain unchanged.

Question 156

4.5.3 Public sector finances

What is the significance of size of fiscal deficits and national debt on national debt services?

Answer 156

Countries spend large amount on national debt through interest repayments with high opportunity costs. The impact will depend on the level of interest rates and the size of the primary deficit compared to interest repayments. In a liquidity trap (low interest), the government often borrows at very low rates for long periods of time.

Question 157

4.5.3 Public sector finances

What is a primary budget deficit?

Answer 157

The actual budget deficit but without interest repayments on national debt.

Question 158

4.5.3 Public sector finances

What is the significance of size of fiscal deficits and national debt on intergenerational equality?

Answer 158

High fiscal deficits and national debt benefit citizens today at the expense of future. However, it depends on whether it was caused by current or capital expenditure. Government show run current budget surplus to invest in future, except in recession when they can run a deficit to increase AD.

Question 159

4.5.3 Public sector finances

What is a current budget deficit?

Answer 159

Where government revenues less than current expenditure.

Question 160

4.5.3 Public sector finances

Why is a current budget deficit problematic?

Answer 160

As future generations are forced to pay bills for todays expenditure, but if deficit is for capital expenditure, future generations benefit from increased spending so extra tax bill to pay for todays borrowing can be justified. Value of debt tends to fall overtime as inflation erodes its value and because a country’s GDP grows meaning the debt is easier to pay off, so limits impact on future generation.

Question 161

4.5.3 Public sector finances

What is the significance of size of fiscal deficits and national debt on inflation?

Answer 161

If the government increases their spending and there is no similar fall in private sector spending, AD will rise and this can be inflationary. More dangerously, if a government is unable to borrow money, they will print more money and this can cause hyperinflation as in Germany in 1923 or Zimbabwe in 2008 .

Question 162

4.5.3 Public sector finances

What is the significance of size of fiscal deficits and national debt on credit rating?

Answer 162

High debt can reduce credit rating for government. Private sector companies estimates the likelihood that a government will default on his debt and give it a rating from AAA to D. Lower credit ratings mean that lending to government is riskier so higher interest are demanded from lending. However it is really not size of debt which influences level of risk involved with lending the money, it is whether the country has even defaulted on their loans before and their current economic or political climate.

Question 163

4.5.3 Public sector finances

What is the significance of size of fiscal deficits and national debt on foreign currency?

Answer 163

If government has borrowed from abroad, it may have difficulties getting enough foreign currency to make repayments on its debt. This also causes problems for consumers as if there is not enough foreign currency, they will be unable to import goods.

Question 164

4.5.3 Public sector finances

Why can government borrowing benefit growth?

Answer 164

Government borrowing can benefit growth if it used for capital spending since this will improve the supply side of the economy and thus reduce the deficit in the long term. On top of this, budget deficit can be used as a tool for short term demand management: Keynesians argue a deficit is acceptable to use as a stimulus in demand during recession.

Question 165

4.5.4 Macroeconomics policies in a global context

How do governments reduce deficits and national debts?

Answer 165

• Austerity measures
• Demand stimulus
• Rely on automatic stabilisers
• Default on loans

Question 166

4.5.4 Macroeconomics policies in a global context

How can austerity measure decrease national debt?

Answer 166

To decrease the national debt, the UK government has been using a policy of austerity since 2010, where they attempt to decrease spending. It would also be possible to increase taxes. Both of these are unpopular, could limit growth, and reduce living standards and income equality.

Question 167

4.5.4 Macroeconomics policies in a global context

How can demand stimulus decrease national debt?

Answer 167

Creating demand stimulus by high spending, this will cause economic growth and therefore bring about higher tax revenues. This will allow for budget surpluses and eventually a reduction of national debt.

Question 168

4.5.4 Macroeconomics policies in a global context

How can automatic stabilisers decrease national debt?

Answer 168

Another approach is to simply rely on automatic stabilisers to allow the economy to grow so national debt/fiscal deficit will reduce as a percentage of GDP. This is mainly the approach that the US took after the Global Financial Crisis and their economy recovered fairly quickly. By 2015, the fiscal deficit as a percentage of GDP was similar in the US and UK.

Question 169

4.5.4 Macroeconomics policies in a global context

How can defaults decrease national debt?

Answer 169

One way to reduce national debt would be for the government to default on their loans but the economic cost of this is so large that governments only default if it is the only option. Russia and Argentina have defaulted on their debts in the past.

Question 170

4.5.4 Macroeconomics policies in a global context

What happens when a government defaults?

Answer 170

When a state defaults on a debt, the state disposes of (or ignores, depending on the viewpoint) its financial obligations/debts towards certain creditors. The immediate effect for the state is a reduction in its total debt and a reduction in payments on the interest of that debt.

Question 171

4.5.4 Macroeconomics policies in a global context

What are the objective conflicts of economic growth and the balance of payments?

Answer 171

As an economy grows, import spending is stimulated relative to export revenue. Policy makers have to be aware that a ‘dash for growth’ could lead to balance of payments problems.

Question 172

4.5.4 Macroeconomics policies in a global context

What are the objective conflicts of economic growth and inflation?

Answer 172

Conflict may occur if through a fiscal or monetary stimulus of aggregate demand, the economy may grow too quickly, aggregate supply may not respond quickly. This would drive up prices.

Question 173

4.5.4 Macroeconomics policies in a global context

What are the objective conflicts of economic growth and budget deficit?

Answer 173

A government may feel it needs to reduce the budget deficit. This will require higher taxes and lower spending. However, this tightening of fiscal policy will lead to a fall in AD and lead to lower economic growth.

Question 174

4.5.4 Macroeconomics policies in a global context

What are the objective conflicts of economic growth and the environment?

Answer 174

There can be a strong conflict between economic growth and environmental objectives. Higher GDP leads to higher levels of pollution and consumption of non-renewable resources.

Question 175

4.5.4 Macroeconomics policies in a global context

What are the objective conflicts of unemployment and inflation?

Answer 175

There is often a trade off (at least in the short run) between unemployment and inflation. In a period of high growth – jobs are created, causing unemployment to fall. But, as unemployment falls, it can put upward pressure on wages, leading to inflation.

Question 176

4.5.4 Macroeconomics policies in a global context

What are the issues for policymakers?

Answer 176

• Inability to control external shocks
• Risk and uncertainty
• Inaccurate information