Points

Question 1

Factors of production + rewards

Answer 1

• Land / Rent
• Labour / Wages, salaries and profits
• Capital / Interest
• Entrepreneurship / Profit

Question 2

Advantages of free market (4)

Answer 2

• Customer sovereignty
• Incentive for workers
• Firms to be efficient and innovative
• Lack of bureaucracy

Question 3

Disadvantages of free market (7)

Answer 3

• Inequitable distribution of income
• Risk of unemployment of income
• Underconsumption of merit goods
• Overconsumption of demerit goods
• Lack of provision of public goods
• Information failure
• Abuse of market power

Question 4

Advantages of planned economies (7)

Answer 4

• Full employment of resources
• Avoidance of wasteful duplication
• Equitable distribution of resources
• Consideration of externalities
• Provision of merit goods and public goods
• Discouragement of demerit goods
• Long term planning and support for vulnerable goods

Question 5

Disadvantages of planned economies (4)

Answer 5

• Slow responses to changes in consumer demand
• Too much bureaucracy
• A lack of incentives
• Too much concentration in capital goods

Question 6

Problems of transition when central planning is reduced (5)

Answer 6

• Lack of entrepreneurship and skills
• Rising unemployment
• Rising inflation
• Corruption
• Inequality

Question 7

Factors shifting demand (4)

Answer 7

• Income
• The price of substitutes
• The price of complements
• Tastes, preferences and fashion

Question 8

Factors influencing supply (6)

Answer 8

• Cost of production
• Size and nature of industry
• Government policy
• Joint supply
• Changes in the prices of a substitute in production
• Other (i.e. climate condition)

Question 9

Functions of price mechanism (3)

Answer 9

• Signaling function (signal to producers to expand production)
• Rationing function (ration scarce resources)
• Transmission of preference (allows consumer preference to be made known to producers)

Question 10

Factors affecting price elasticity of demand (PED) (6)

Answer 10

1. Close substitutes
   - Availability of substitutes
2. Relative cost of the item
   - If costs a relatively small portion of income, more price inelastic
3. Complements to an expensive product
   - Increase in price of the cheaper complement among two products has less response, more price inelastic
4. Durability of product
   - Consumers can put off buying durable goods and wait for price to go down
5. Time
   - Short run is more price inelastic
   - Long run is more price elastic
6. Necessity of the product
   - Necessary goods are more price inelastic

Question 11

Business relevance of income elasticity of demand (YED)

Answer 11

Can determine whether to increase production for normal or inferior goods

Question 12

Business relevance of cross elasticity of demand (XED)

Answer 12

• If XED is negative, companies can develop a strategy to increase sales of another product
• If XED is positive, when price increases, consumers are more likely to buy cheaper substitute

Question 13

Factors influencing price elasticity of supply (PES) (4)

Answer 13

1. Availability to hold stocks
   - Durability and perishability
2. Extent of space capacity in the firm
3. Time period / Length of production period
4. Availability of substitutes
   - Products that can be easily substituted has elastic PES

Question 14

Business relevance of price elasticity of supply (PES)

Answer 14

• If supply is elastic, producers can increase output without a rise in cost or a time delay.
• If supply is inelastic, firms find it hard to change production in a given time period.

Question 15

Reasons for government intervention in market (3)

Answer 15

• To correct market failure
• Improve efficiency of allocation of resources
• To achieve equal income and wealth distribution

Question 16

Methods of government intervention in market (3)

Answer 16

1. Regulation
   - Control production and consumption (i.e. control of price, quality and quantity of gns)
2. Financial intervention
   - Taxes and subsidies
3. Government provision / Direct provision
   - Government take over partial or whole production of goods or services
   - Supply goods or services free of charge

Question 17

Canons of taxation (4)

Answer 17

• Canon of equality/equity
• Canon of certainty/transparent
• Canon of economy
• Canon of convenience

Question 18

Impact of maximum price (3)

Answer 18

1. Inefficiency/shortages
2. Existence of black market
3. Queue

Question 19

Impact of minimum price (3)

Answer 19

1. Oversupply - leads to inefficiency
2. Higher prices for consumers
3. Producers have pressure to lower price to Pe to clear excess supply

Question 20

Advantages of minimum price (2)

Answer 20

• Protect producer’s income
• Higher wage rate

Question 21

Disadvantages of minimum price (3)

Answer 21

• Consumers pay more
• Wastage of production resources
• Unemployment

Question 22

Advantages of maximum price (1)

Answer 22

• Consumers purchase products at a lower price

Question 23

Disadvantages of maximum price (3)

Answer 23

• Black market
• Quantity produced decreases
• Receive illegal payment from consumers

Question 24

Advantages of information provision (1)

Answer 24

Help consumers act rationally, allows market to work properly

Question 25

Disadvantages of information provision (3)

Answer 25

• Expensive for government, increase opportunity cost
• Government might not have information, difficult to inform consumers
• Consumers may not listen to information provided due to irrational behaviour

Question 26

Economic reasons for inequality of income and wealth (8)

Answer 26

1. Education, training and skills
2. Trade unions (Stronger trade union, income increase)
3. Benefit system (Benefits increasse, income of B40 increase)
4. Pension payment (Ensure a minimum standard of living for retirees)
5. Wage rates (National minimum wage)
6. Employment legislation (More workers protected by law)
7. Tax structure (Progressive tax system)
8. Asset ownership (Assets generate income)

Question 27

Government policies to redistribute income and wealth (3)

Answer 27

1. Providing benefits
2. Through tax system
3. Other policies (i.e. important services provided free for public, transfer payment, minimum wage)

Question 28

Why is there an inverse relationship between AD and price level? (3)

Answer 28

1. Wealth effect
   - Price level increases, individual wealth decreases, purchasing power decreases, consumer spending on goods and services decreases, AD contracts
2. International effect
   - Price level increases, local product price competitiveness decreases, export decreases, net export decreases, AD contracts
3. Interest rate effect
   - Price level increases, inflation increases, interest rate increases, cost of borriwng increases, spending decreases, AD contracts

Question 29

Why is there a positive relationship between price level and real GDP in an economy? (3)

Answer 29

1. Profit effect
   - Price level increases, cost of production remains unchanged, profit increases
2. Cost effect
   - Other average costs increases as output increases (i.e. labour cost, utilities), cost of production increases, price level increases
3. Misinterpretation effect
   - Producers may think that the irse in price is due to popularity of their product, feel encouraged to produce more.

Question 30

Causes of shifts in SRAS curve (4)

Answer 30

1. Changes in factor of production
2. Changes in government taxation
3. Changes in factor productivity / quality of resources
4. Changes in quantity of resources

Question 31

Why is the LRAS curve assumed to be vertical? (New classical economist)

Answer 31

• In long run, economy will operate at its full capacity.
• When economy operates at full capacity, the AS curve becomes inelastic because even at higher prices, firms cannot produce more.
• Hence, LRAS curve is assumed to be vertical, as it does not change when price level changes.

Question 32

Explain the Keynesian model.

Answer 32

• LRAS curve is represented as perfectly elastic (recession) at low rates of output
• Then the curve becomes upwards sloping (recovery) over a range of output.
• Finally, it becomes perfectly inelastic (boom). (Moves to new classical range)

Question 33

Factors that could shift LRAS curve (5)

Answer 33

1. Net immigration
   - Immigrants are working age, labour force increases, LRAS shifts outwards
2. An increase in retirement age
   - Size of labour force increases, LRAS shifts outward
3. Discovery of new resources
   - Factors of production increases, output increases, LRAS shifts outward.
4. Improved education and training
   - Skilled labour increases, LRAS shifts outward
5. Advances in technology
   - Cost of production decreases, LRAS shifts outward

Question 34

Factors in contributing to economic growth (2)

Answer 34

1. Increase in quantity of resources (factors of production)
2. Increase in quality of resources
   - Technological advancement
   - Training increase, productivity increase, real GDP increase

Question 35

Costs of economic growth (4)

Answer 35

1. Opportunity cost
   - Capital goods increase, consumer goods decreases
   - In the long run, sufficient investment could increase both capital and consumer goods
2. Country undergoes structural changes
   - Move from command economy to mixed economy
   - Working hours increase, production increase, deregulation, competition increases
   - Recession moves to recovery/boom period, GDP increases
3. Depletion of natural/scarce resources
   - Pollution increases, environmental damage increases
   - Demand increases, resources used increases, depletion increases
4. Inflation
   - Cost push inflation
   - Demand pull inflation

Question 36

Benefits of economic growth (5)

Answer 36

1. Increase standard of living
   - Poverty rate decreases
2. Increases tax revenue
   - Income increases, spending increases, tax revenue increases, financial aid to those who need it from government increases
3. Lower unemployment
   - AD increases, number of jobs increases
4. Increase business and consumer confidence
   - Investment rate increases, consumption/savings increases
5. Using and conserving resources
   - Using: Exports increase, better BOP, export revnues increase, improve infrastructure
   - Conserve: Protect environment, encourage tourists to visit rainforest and wildlife

Question 37

Causes of unemployment (3)

Answer 37

1. Frictional unemployment
   - Temporary and arises when people are in-between jobs
   a) Casual unemployment: Workers out of work between periods of unemployment
   b) Seasonal unemployment: Demand for labour fluctuates according to time of the year
2. Structural unemployment
   - Caused by changing structures of economic activity
   a) Regional unemployment: Unemployment concentrated in declining industries concentrated in a particular area
   b) Technological unemployment: Unemployed due to introduction of advanced technology
   c) International: Demand switch from domestic to foreign industries
3. Cyclical unemployment
   - Caused by lack of aggregate demand
   - Business activity decreases, unemployment increases
   - AD decreases, firm’s output decreases, demand for labour decreases
   - AD decreases, consumption decreases, output decreases, demand for labour decreases, unemployment increases

Question 38

Which type of unemployment affects the economy the most?

Answer 38

• Frictional: Temporary (not serious), will still have jobs ultimately
• Structural: Declining industries, firms restructure, people lose jobs
• Cyclical: AD decreases, price level decreases, real GDP decreases

Evaluation: Cyclical more serious because it affects real GDP

Question 39

How to calculate RPI

Answer 39

Percentage change in the price is multiplied by its weight to determine average change in the RPI

Question 40

What’s the differences between consumer price index and retail price index? (2)

Answer 40

• CPI does not take into account costs of your home while RPI takes it into account.
• CPI uses geometric mean while RPI uses arithmetrical mean between the old price and new price.

Question 41

Limitations of cost price index (CPI) (7)

Answer 41

1. Time lags
2. Relevant to metropolitan households, not rural households
3. Changed expenditure patterns update a fixed regimen (only changed five-yearly)
4. Price increases may reflect improved quality
5. Substitution effect - If price of potatoes increases, households may substitute something not in the regiment.
6. It is an average, spending patterns vary from one household to the next
7. Household expenditure survey may be unreliable

Question 42

Disadvantages of inflation (6)

Answer 42

1. Reduction in net export
   - Price competitiveness decreases, demand by other countries decreases, export revenue decreases
2. Menu cost
3. Fiscal drag
   - Income and revenue increases (bonus payouts), push to higher tax brackets, income tax increases
4. Discouragement of investment
   - Unanticipated investment causes uncertainty, firm is unable to plan long term production, hesitate to invest
   - Business confidence decreases, because prices keep changing, cannot make decisions for prices
5. Inflationary noise
   - Confusion over relative prices caused by inflation
   - A rise in the price of a product may not mean that it
   has become more expensive relative to other products; the product
   may have risen in price by less than inflation and so may have
   become cheaper in real terms.
   - Consumers and producers may make wrong decisions
   - e.g. producers increase output because price increases, but price increase is due to inflation, this may cause misallocation of resources (overproduction)
6. Inflation causing inflation
   - Workers demand higher wages, firm rises prices to cover expected higher costs.

Question 43

Advantages of inflation (3)

Answer 43

A low and stable rate of inflation can bring advantages to the economy.\
1. Stimulating output
- Increasing demand may make firms feel optimistic about the future
- Price increase is more than cost increase, profits increase, investment increases

2. Reduce debt burden
   - Real interest rate may fall due to inflation
   - Those who borrowed money to buy a house may experience fall in their mortgage interest payments.
   - Debt decreases, consumption increases, output and employment increases
3. Prevent some unemployment

Question 44

Factors affecting consequences of inflation (5)

Answer 44

1. Cause of inflation
   - Demand-pull inflation: output increases
   - Cost-push inflation: output decreases
2. Rate of inflation
   - High rate causes more damage
3. Accelerating or stable inflation rate
   - Can cause uncertainty, investment decreases
4. Anticipated or unanticipated inflation
   - Unanticipated inflation may cause firms and consumers to delay their investment and consumption
   - If anticipated inflation, can take measures to adapt and avoid harmful effects
5. Inflation rate compared to other countries
   - If inflation rate is below main competitors, goods and services price competitiveness increases

Question 45

Macroeconomic aims (4)

Answer 45

1. Full employment
2. Price stability
3. Economic growth
4. External balance

Question 46

How to use fiscal and monetary policy to lower unemployment and its difficulties

Answer 46

• Increase AD
• Monetary: Decrease interest rate, increase money supply
• Fiscal: Decrease indirect taxes, increase government spending
• Difficulties: Higher inflation in short term, could increase national debt

Question 47

How to use fiscal and monetary policy to lower rate of inflation and its difficulties

Answer 47

• Decrease AD
• Monetary: Increase interest rate, decrease money supply
• Fiscal: Increase direct taxes, decrease government spending
• Difficulties: Unemployment increase, output decreases
• Unpopular with voters (people get angry with GOV if interest rate increases)

Question 48

How to use fiscal and monetary policy to solve current account deficit on BOP and its difficulties

Answer 48

• Decrease AD
• Monetary: Increase interest rate
• Fiscal: Increase taxation
• Difficulties: Effectiveness depends on PED for imports and export

Question 49

Give some examples of supply-side policy. (8)

Answer 49

1. Cutting corporate tax
2. Cutting income tax
3. Reduction in welfare payments
4. Increase spending on education and training
5. Increase spending on infrastructure
6. Privatisation
7. Deregulation
8. Subsidies

Question 50

Benefits of free trade (6)

Answer 50

1. Competition created can lower prices and raise quality for consumers
2. Allows people to access great range of products
3. Firms have wider choice of raw materials and may reduce costs of production
4. Firms have larger market, enable them to take greater advantage of economies of scale
5. Allows efficient allocation of resources with countries being able to concentrate on producing products that they have comparative advantage.
6. Allow countries to specialisem increases output, higher employment and ultimately improve living standards.

Question 51

Causes of changes in terms of trade (4)

Answer 51

1. Demand and supply of imports and exports
   - If price of exports increase, ToT improves
2. Price level
   - Inflation increases, export prices higher than import prices, ToT improves
3. Exchange rate
   - Devaluation reduces export price
   - Increases export price competitiveness
   - ToT worsens
4. Prebisch
   - In the long run, price of primary goods decreases in proportion to manufactured goods.
   - ToT moves against primary producing countries
   - Demand for manufactured goods increases more than demand for primary goods when income increases
   - In recent years, relative price of agricultural products decreases, volatility in commodity prices increases

Question 52

Explain favourable and unfavourable rise in ToT

Answer 52

1. Favourable rise in ToT: If price of exports increases because of demand increase, overall export revenue increases (more domestic products sold)
2. Unfavourable rise in ToT: If price of exports increases because cost of production increases, overall expot revenue decreases (demand for country’s products fall)

However, unfavourable rise in ToT may reduce current account deficit. If Marshall-Lerner condition is met, fall in export prices relative to import prices should increase export revenue relative to import expenditure.

Question 53

Impacts of change in terms of trade (4)

Answer 53

1. Living standards
   - When ToT increases, country can buy more imports for any given quantity of exports.
   - When ToT decreases, means more domestic output has to be exported to pay for imports.
2. Impact on BOP
   - If price of exports increase because demand from trading partners increases, exports earnings increases, current account improves
   - If price of exports increases because cost of production increases, exports’ price competitiveness decreases, exports earnings decreases
   - If price of exports decreases because world demand decreases, can lead to current account deficit (export revenue decreases, amount of foreign currency flowing into the country decreases, country;s net exports decreases, current account balance decreases)
   - Changes in import prices can cause improvement or worsening of the current account
3. Impact on inflation
   - If ToT improves due to falling import prices, this could result in lower inflation because domestic producers may have to lower prices to compete with imports
   - If ToT worsens, this could cause rising inflation as workers may seek pay increases due to increasing import prices, leading to an escalation of the wage price ‘spiral’.
4. Impact on growth and employment
   - If ToT improves because export demand increases, growth and employment levels will be maintained or improved.
   - But if ToT improves due to import prices decreasing or price of exports increase due to costs increase, it is likely that growth and employment decreases

Question 54

Causes of current account deficit (4)

Answer 54

1. Growing domestic economy
   - Imported raw materials increases, output increases
   - Likely to be short-term and self-correcting (output increases, exports increases)
2. Declining economic activity in trading partners
   - Trading partners experience economic recession, imports decreases
   - Also known as cyclical deficit
   - Short-term and self-correcting
3. Structural problem
   - Domestic firms are not internationally competitive becaue of overvalued exchange rate, relatively high inflation rate and low labour or capital productivity.
   - Not self-correcting over time
4. For primary-producing countries:
   - They need to import high prices of oil, raw materials and manufactured goods
   - Export primary products: Agricultural where it has to continue to export in large quantity to get high revenue

Question 55

Consequences of current account deficit (3)

Answer 55

1. Country consumes more products than it produces (spend more on imported goods)
   - Country has to finance the deficit by attracting investment into the country or by borrowing
   - This will involve outflow of money in the future in the form of investment income.
2. Reduce AD
   - Demand for domestic currrency decreases, depreciation happens, price of imports increases, price of exports decreases, demand for domestic goods decreases, demand for foreign goods increases
   - Slow down economic growth
   - Causes unemployment
3. Lenders might think borrowers are unable to repay the loan, stop lending

Question 56

Consequences of current account surplus (2)

Answer 56

1. Living standards decreases
   - Demand increases, money supply increases, inflation increases
2. Cause friction between countries
   - Deficit countries put pressure on surplus countries to change its policies

Question 57

Explain reasons why currency traders buy domestic currency

Answer 57

1. Purchase goods and services from the country
2. Invest in the country
3. Speculate on making profits if the value rises in the future

Question 58

Advantages of floating exchange rate (2)

Answer 58

1. Restore balance on current account in BOP
   - If there is current account deficit:
   - Demand for currency decreases, supply of currencyy increases which leads to depreciation
   - Exports become cheaper, imports expensive
   - In the long run, deficit moves towards surplus
2. Governments are assumed not to intervene in foreign exchange markets through their central banks
   - Since GOV has no exchange rate target, it is free to pursue other policy objectives
   - Independence in economic policy making

Question 59

Disadvantages of floating exchange rate (3)

Answer 59

1. Exchange rates may fluctuate greatly
   - Create uncertainty
2. Remove pressure on GOV to maintain price stability
3. No guarantee that floating exchange rate will eliminate current account surplus or deficit
   - If there is speculation that currency will rise in the future, foreign exchange value may still increase in the future

Question 60

Advantages of fixed exchange rate (2)

Answer 60

1. Promote international trade and investment
   - Reduce uncertainty in currency fluctuation
2. Imposes discipline on government to keep inflation low so that a loss of international price competititveness does not put downward pressure on exchange rate
3. Need to keep high reserves
   - There is opportunity cost in keeping reserves, which could be usedd for other purposes
4. Over time, market pressures may push government to set higher fixed exchange rate.

Question 61

Factors underlying changes in exchange rates

Answer 61

1. Change in demand and supply for a currency will cause a change in the price of the currency under floating exchange rate. / put downward or upward pressure on fixed exchange rate.
2. Demand for the currency will rise if export increases.
   - Include foreigners buying share into local firms, invest into local country due to high interest rate or rise in labour productivity, as well as speculation.
3. Increase in supply of the currency will cause a fall in its value.
   - Could due to higher imports, increase in foreign travelling (demand for foreign currency increase, supply of domestic currency decreases), set up firms abroad.
4. Value of fixed or managed floating exchange r ate may change by pressure of market floats.
   - Government may decide to revalue its currency if they think their currency is undervalued, vice versa.
5. Government may change the value to achieve macroeconomic aim.
   - Devalue its currency to increase price competitiveness, improve current account position. (export increases, reduces deficit)

Question 62

Effects of depreciation/devaluation on domestic and external economy (3)

Answer 62

1. Make exports cheaper in terms of foreign currencies
   - Imports become more expensve in terms of domestic currency.
   - This may enable domestic firms to sell more products both at home and abroad.
2. Rise in exports will increase AD
   - As economy approaches full capacity, resources will become increasingly scarce and prices will bid up.
   - Imported products become more expensive and impact consumer price index. (inflation)
   - Cost of production will be pushed up due to higher import raw materials costs. (cost-push inflation)
3. Lower exchange rate will reduce current account deficit.
   - Outcome depends on price elasticities of demand for both exports and imports. (Satisfy Marshall-Lerner condition)
   - In short term, PED for exports and imports is relatively inelastic, causing current deficit to worsen after devaluation.
   - Over time, people will respond to the price changes. (J-curve effect)

Question 63

Effects of appreciation/revaluation on domestic and external economy

Answer 63

1. Makes export more expensive in terms of foreign currencies and imports cheaper in terms of domestic currency.
   - This result faill in demand for domestic demand; lower AD may result rise in unemployment and slowdown in economic growth.
2. Cause a reduction in inflationary pressure if the economy is operating close to or at its maximum capacity.
   - In the absence of rise in exchange rate, AD may increase causing price level to rise.
   - A rise in exchange rate may reduce growth of AD hence inflation rate is lower than it would be.
3. A higher exchange rate may reduce inflationary pressure by shifting the AS curve outward due to lower cost of imported raw materials.
   - Price of imported finished products will fall as well, tehre would be pressure on domestic produced firms to restrict price increase in order to maintain the competitiveness at home and aboard.
4. It may reduce current account surplus and make it replaced by current account deficit.
   - Marshall-Lerner condition and J-curve would work in reverse.
   - Curent account surplus would only be reduced if PED for exports and imports is less than 1. (inelastic)

Question 64

Impact of expenditure-switching policies (2)

Answer 64

1. Fall in import expenditure - fall in supply of country’s currency on forex market
2. Rise in export earnings - rise in demand for country’s currency in forex market

Question 65

Impact of expenditure-dampening policies (2)

Answer 65

1. A reduction in spending will mean that there will be fewer purchases on imported goods and services.
2. Domestic producers will find that their domestic market is dampened. As a result, they will try to offset the decrease in domestic sales with increase in sales abroad.

Overall impact: Fall in imports, rise in exports

Question 66

How to use fiscal policy to correct current account deficit and its limitations.

Answer 66

• Government could raise tax and reduce government spending.
• Rise in income tax reduces disposable income, resulting less income for household to spend on both imports domestically produced products.
• Lower government spending (reduce subsidies to the people) will directly reduce demand for goods and services.
• Fiscal policy measures may change a country’s current position in the short term but are unlikely a long term solution.

Limitations:
- Raising income tax reduces overall demand, discourages supply (lower AS), increase unemployment and slow economic growth.
- Imposing trade restrictions on other countries may provoke retaliation, limit innovativeness on domestic firms to be more efficient.

Question 67

How to use monetary policy to correct current account deficit and its limitations.

Answer 67

• If economy has a low inflation rate and current account deficit, its central bank may reduce the interest rate to put downward pressure on a floating exchange rate.
• A lower exchange rate may result in the country’s produce becoming more price competitive internationally (reducing current account deficit), but there is a risk in generating inflationary pressure.
• A higher interest rate may act as expenditure dampening policy measures, reducing demand for imported goods and reducing inflationary pressure. (Decrease domestic demand)
• It may raise a floating exchange rate that could reverse the fall in demand for imports.
• Government may change its exchange rate as an expenditure switching policy measure.
• If an economy is experiencing current account surplus and has a fixed exchange rate, the government may decide to revalue its currency.
• In recent decades, monetary policy has become more popular because it is independent from any political influences.

Limitations:
- There is a time lag between changing interest rate and full effect being transmitted to the macro economy.
- A rise in interest rate benefits the savers but harms borrowers.
- High cost of borrowing could lead to unemployment and slow down economic growth.
- High interest rates also discourage foreign direct investments as this raises foreign firm’s costs.
- Also, if a country reduces its interest rates noticeably lower than its rival countries, this could create hot money.

Question 68

How to use supply side policy to correct current account deficit.

Answer 68

• Makes domestic products more competitive and more attractive to invest in.