A Level Paper 2: The Global Economy
Covers International Trade and the Balance of Payments, Money, Banking and the Financial Sector, Measuring Economic Performance, Aggregate Demand and Aggregate Supply, Fiscal and Monetary Policy and Supply-Side Policy and Economic Growth.
Questions
Question 1 [3 marks]
Measuring Economic Performance
Define "underemployment", and explain why a country's official unemployment rate might understate the true amount of spare capacity in its labour market.
Question 2 [3 marks]
International Trade and the Balance of Payments
Define "protectionism", give one example of a protectionist policy a government could use, and explain its effect on domestic consumers.
Question 3 [3 marks]
Aggregate Demand and Aggregate Supply
In a given year, a country's consumption is 900 billion pounds, investment is 220 billion pounds, government spending is 400 billion pounds, exports are 300 billion pounds and imports are 340 billion pounds.
Calculate aggregate demand.
Question 4 [3 marks]
Fiscal and Monetary Policy
Define "contractionary monetary policy", give one example of a specific tool a central bank could use to implement it, and explain its intended effect.
Question 5 [4 marks]
Money, Banking and the Financial Sector
The required reserve ratio in a banking system is 5%.
Calculate the value of the simple money (credit) multiplier, and the maximum total increase in bank deposits that could result from an initial new deposit of 20 million pounds into the banking system.
Question 6 [5 marks]
Supply-Side Policy and Economic Growth
A government spends 4.5 billion pounds building a new rail line, which is expected to raise the country's potential output by 0.15% once complete, in an economy with a current potential output of 2600 billion pounds.
Calculate the expected increase in potential output resulting from this project, and comment on whether this appears to represent good value for the government's spending.
Question 7 [5 marks]
Measuring Economic Performance
The claimant count and the Labour Force Survey (LFS) are the two main measures of UK unemployment.
Explain two reasons why these two measures might give different unemployment figures at the same point in time.
Question 8 [5 marks]
Money, Banking and the Financial Sector
A bank holds total assets of 900 million pounds, of which 45 million pounds are held as liquid reserves.
Calculate the bank's liquidity ratio as a percentage of total assets, and explain the trade-off the bank faces in choosing how high to set this ratio.
Question 9 [5 marks]
Supply-Side Policy and Economic Growth
A government introduces generous tax credits for firms that spend money on research and development (R&D), reducing the effective cost of R&D spending for those firms.
Explain how this policy could raise the economy's long-run aggregate supply, and identify one reason its effect might be smaller than the government hopes.
Question 10 [6 marks]
Money, Banking and the Financial Sector
Following the introduction of stricter bank capital requirements after the 2008 financial crisis, some commentators argue banks have become "too safe to lend enough" to support economic growth.
Evaluate this view.
Question 11 [6 marks]
International Trade and the Balance of Payments
The nominal exchange rate between the pound and the US dollar is 1.30 dollars per pound. UK export prices rise by 4% over a year, while equivalent US export prices rise by 1%, with the nominal exchange rate unchanged.
Calculate the resulting change in the UK's relative price competitiveness against the US, and analyse the likely effect on UK export volumes.
Question 12 [6 marks]
Fiscal and Monetary Policy
During a period of very low interest rates, a central bank creates new money electronically to buy large quantities of government bonds from financial institutions, as part of a programme of quantitative easing (QE).
Evaluate the effect of this policy on the government's cost of borrowing, and consider one significant risk associated with using QE on a large scale.
Question 13 [6 marks]
International Trade and the Balance of Payments
A government imposes an import quota of 500000 tonnes of sugar per year, below the 800000 tonnes that would be imported under free trade, when domestic production was 300000 tonnes and total consumption was 1100000 tonnes per year. After the quota raises the domestic price, domestic producers increase output to 380000 tonnes per year, while total consumption falls to 880000 tonnes per year.
Calculate the amount, in tonnes, by which increased domestic production replaces some of the fall in imports, and analyse one key difference between the welfare effects of this import quota and an equivalent tariff that also reduced imports to 500000 tonnes.
Model solutions
| Question 1[3 marks] | |
|---|---|
| Answer or working | Marks |
| a correct definition of underemployment as a situation where a worker is employed but would like to work more hours, or is working in a job that does not fully use their skills or qualifications | 1 |
| explaining that the official unemployment rate only counts people with no job at all who are actively seeking and available for work, so it does not include underemployed workers | 1 |
| explaining that if underemployment is widespread, for example many part-time workers wanting full-time hours, the true amount of spare labour market capacity is greater than the unemployment rate alone suggests | 1 |
| Final answer: Underemployment is when a worker has a job but wants more hours, or is overqualified for their role. Since the unemployment rate only counts people with no job at all, widespread underemployment means the true spare capacity in the labour market is greater than the unemployment rate alone suggests. | |
| Question 2[3 marks] | |
|---|---|
| Answer or working | Marks |
| a correct definition of protectionism as government policies restricting or discouraging imports to protect domestic industries from foreign competition | 1 |
| a valid example, e.g. a tariff, an import quota, or a subsidy to domestic producers | 1 |
| explaining that this raises the price or restricts the quantity of imports, protecting domestic firms but tending to raise prices for domestic consumers | 1 |
| Final answer: Protectionism is government action restricting imports to protect domestic industry, e.g. a tariff, which raises the price of imports and protects domestic firms but tends to raise prices for domestic consumers. | |
| Question 3[3 marks] | |
|---|---|
| Answer or working | Marks |
| using AD = C + I + G + (X - M) | M1 |
| substituting the values, 900 + 220 + 400 + (300 - 340) | M1 |
| AD = 1480 billion pounds | A1 |
| Final answer: Aggregate demand = 1480 billion pounds. | |
| Question 4[3 marks] | |
|---|---|
| Answer or working | Marks |
| a correct definition of contractionary monetary policy as policy aimed at reducing aggregate demand, typically by raising interest rates or reducing the money supply | 1 |
| a valid example, e.g. raising the base or policy interest rate, or selling government bonds | 1 |
| explaining that this raises the cost of borrowing, discouraging consumption and investment and reducing aggregate demand | 1 |
| Final answer: Contractionary monetary policy reduces AD, typically via a central bank raising the base interest rate, which raises borrowing costs and discourages consumption and investment. | |
| Question 5[4 marks] | |
|---|---|
| Answer or working | Marks |
| using the money multiplier formula, 1 / reserve ratio | M1 |
| calculating the multiplier, 1 / 0.05 = 20 | M1 |
| the maximum total increase in deposits, 20 x 20 = 400 million pounds | A1 |
| correctly noting this is a theoretical maximum, assuming all banks are fully loaned up and no cash is withdrawn from the system | 1 |
| Final answer: Money multiplier = 20; maximum total increase in deposits = 400 million pounds (a theoretical maximum). | |
| Question 6[5 marks] | |
|---|---|
| Answer or working | Marks |
| increase in potential output = potential output x 0.15% | M1 |
| substituting 2600 x 0.0015 | M1 |
| increase in potential output = 3.9 billion pounds | A1 |
| comparing this to the 4.5 billion pound cost, noting the single-year output increase (3.9 billion) is smaller than the one-off cost | 1 |
| a developed point that this rise in potential output recurs every year once the line is built, so the project's value should be judged over its full lifetime rather than a single year | 1 |
| Final answer: Expected increase in potential output = 2600 x 0.0015 = 3.9 billion pounds; this is smaller than the 4.5 billion pound cost in a single year, but because this rise in potential output recurs every year once the line is built, the project could still represent good value when judged over its full lifetime rather than one year alone. | |
| Question 7[5 marks] | |
|---|---|
| Answer or working | Marks |
| identifying that the claimant count only measures those actually claiming unemployment-related benefits | 1 |
| explaining this excludes people who are unemployed but not eligible for or not claiming benefits, e.g. some school leavers or those with a working partner, causing the claimant count to understate unemployment | 1 |
| identifying that the LFS is based on a survey using the internationally agreed ILO definition, counting anyone actively seeking and available for work in the reference period | 1 |
| explaining that the LFS can include people not claiming any benefit, so it can differ from the claimant count depending on benefit eligibility rules | 1 |
| a further valid distinction, such as timing or publication differences, since the claimant count is administrative monthly data while the LFS is based on a rolling three-month survey | 1 |
| Final answer: The claimant count only captures benefit claimants while the LFS uses a survey-based ILO definition including non-claimants, so the two rarely give identical figures. | |
| Question 8[5 marks] | |
|---|---|
| Answer or working | Marks |
| liquidity ratio = liquid reserves / total assets x 100 | M1 |
| liquidity ratio = 45 / 900 x 100 = 5% | A1 |
| identifying that a higher liquidity ratio would make the bank more able to meet a sudden surge in customer withdrawals | 1 |
| explaining that holding more liquid, often lower-yielding, reserves means less is available to lend out at higher interest rates, reducing profitability | 1 |
| concluding that banks and regulators must balance the safety benefits of higher liquidity against this profitability cost | 1 |
| Final answer: Liquidity ratio = 45 / 900 x 100 = 5%; a higher liquidity ratio would make the bank better able to meet a surge in withdrawals, but holding more low-yielding liquid assets reduces the amount available to lend at higher interest and so reduces profitability. | |
| Question 9[5 marks] | |
|---|---|
| Answer or working | Marks |
| explaining that reducing the effective cost of R&D encourages firms to spend more on developing new products, processes and technologies | 1 |
| explaining that successful R&D can lead to innovation that raises productivity, e.g. new production methods that allow more output from the same resources | 1 |
| explaining that this would shift the long-run aggregate supply curve to the right, since the economy's productive potential rises | 1 |
| identifying that innovation from R&D often benefits other firms as well as the one carrying it out, e.g. through knowledge spillovers, adding a further benefit beyond the immediate firm | 1 |
| identifying a reason the effect might be smaller than hoped, e.g. some firms might have carried out the R&D anyway and are simply claiming the tax credit for spending they would have undertaken regardless | 1 |
| Final answer: R&D tax credits lower the cost of research, encouraging more innovation that can raise productivity and shift long-run aggregate supply to the right, with the added benefit of spillovers to other firms; the effect may be smaller than hoped if some firms simply claim the credit for R&D they would have carried out anyway. | |
| Question 10[6 marks] | |
|---|---|
| Answer or working | Marks |
| identifying that higher capital requirements mean banks must fund a greater share of lending from their own capital rather than from customer deposits or borrowing | 1 |
| explaining this raises the cost of making loans, which banks may pass on through higher interest rates or by lending less overall, potentially reducing credit available for investment and consumption | 1 |
| identifying the counter-argument that higher capital requirements make banks more resilient to shocks, reducing the risk and severity of a future financial crisis | 1 |
| explaining that a future crisis avoided, or reduced in severity, would itself be far more damaging to lending and growth than a modest, ongoing reduction in credit availability | 1 |
| an evaluative point, e.g. the balance between these effects depends on how far above the safe minimum requirements are set, and whether credit availability is actually the main constraint on investment | 1 |
| a reasoned overall judgement, e.g. some reduction in lending is a reasonable trade-off for a more stable banking system, so the view likely overstates the cost relative to the stability benefit, though requirements set too high could still restrict useful lending | 1 |
| Final answer: Higher capital requirements do raise the cost of bank lending and could modestly reduce credit available for growth, but they also make the banking system more resilient to a future crisis, which would be far more damaging to lending if it occurred; on balance the stability benefit likely outweighs the modest cost to lending, though requirements set too high could still unnecessarily restrict useful credit. | |
| Question 11[6 marks] | |
|---|---|
| Answer or working | Marks |
| identifying relative price change = UK price inflation - US price inflation | M1 |
| relative price change = 4% - 1% = 3 percentage points | A1 |
| stating that UK export prices have risen 3 percentage points faster than US export prices, so with an unchanged exchange rate, UK goods have become about 3% less price competitive | 1 |
| explaining that this is likely to reduce the volume of UK exports demanded, as foreign buyers switch toward relatively cheaper US alternatives | 1 |
| a developed point, e.g. the actual scale of the fall depends on the price elasticity of demand for UK exports, being larger the more elastic demand is | 1 |
| a further valid point, e.g. the unchanged nominal exchange rate means this loss of competitiveness comes entirely from relative price (inflation) differences rather than any currency movement | 1 |
| Final answer: UK export prices rose 3 percentage points faster than US export prices, so with the exchange rate unchanged the UK loses about 3% price competitiveness against the US; this is likely to reduce UK export volumes as buyers switch toward relatively cheaper US goods, with the size of the fall depending on the price elasticity of demand for UK exports. | |
| Question 12[6 marks] | |
|---|---|
| Answer or working | Marks |
| explaining that when the central bank buys large quantities of government bonds, this raises demand for those bonds | 1 |
| explaining that higher demand for government bonds pushes up their price, and because bond yields move inversely to price, this lowers the yield, the effective interest rate, on government debt | 1 |
| explaining that a lower bond yield directly reduces the government's cost of borrowing on both new and refinanced debt | 1 |
| identifying that this could be especially useful when a government wants to borrow heavily, for example to fund a large fiscal stimulus, without pushing up its own borrowing costs sharply | 1 |
| identifying a significant risk, e.g. the large expansion of the money supply from QE could eventually contribute to excessive inflation, or asset prices such as shares and property, which QE also tends to inflate, could become unsustainably high | 1 |
| a reasoned overall judgement, e.g. QE can be an effective way to hold down government borrowing costs during a crisis, but sustained large-scale use carries a real risk of longer-term inflationary pressure or inflated asset prices, particularly if not reversed once the economy recovers | 1 |
| Final answer: By buying large quantities of government bonds, QE raises their price and lowers their yield, directly reducing the government's cost of borrowing; but sustained large-scale QE risks contributing to future inflation or unsustainably inflated asset prices, particularly if the resulting expansion of money and credit is not reversed once the economy recovers. | |
| Question 13[6 marks] | |
|---|---|
| Answer or working | Marks |
| calculating the increase in domestic production, 380000 - 300000 | M1 |
| an increase in domestic production of 80000 tonnes, part of the reason total sugar available has fallen by less than the full cut in imports | A1 |
| explaining that a tariff would instead raise government tax revenue on any imports that continue to enter the country at the higher price | 1 |
| explaining that with a quota, the same gap between the world price and the higher domestic price instead typically becomes extra profit for whoever holds the licence to import the fixed quota amount, rather than government revenue | 1 |
| identifying that this transfer of that gap to quota-holders, rather than to the government, is a key welfare difference between a quota and an equivalent tariff | 1 |
| a developed point, e.g. this makes a tariff generally preferable to a quota from the government's perspective, if raising revenue is one of its objectives, even where both achieve the same reduction in imports | 1 |
| Final answer: Domestic production rises by 80000 tonnes, replacing part of the fall in imports. The key welfare difference is that a tariff would raise tax revenue for the government on continuing imports, whereas with a quota the gap between the world price and the higher domestic price instead becomes extra profit for whoever holds the import licence, rather than government revenue, making a tariff generally preferable to the government if raising revenue is a goal. | |