AS Paper 2: Government and the Economy
Covers Market Failure and Externalities, Government Intervention in Markets, Measuring Economic Performance, Aggregate Demand and Aggregate Supply, Fiscal and Monetary Policy and Supply-Side Policy and Economic Growth.
Questions
Question 1 [2 marks]
Government Intervention in Markets
Define "government failure" and give one example of how a government intervention intended to correct a market failure could make the allocation of resources less efficient.
Question 2 [3 marks]
Aggregate Demand and Aggregate Supply
Define "automatic stabilisers", and explain, using an example, how they help to reduce the size of fluctuations in aggregate demand over the economic cycle without any new government decision being made.
Question 3 [3 marks]
Fiscal and Monetary Policy
The marginal propensity to consume (MPC) in an economy is 0.75, and there are no other withdrawals from the circular flow of income.
Calculate the value of the simple Keynesian multiplier, and the resulting change in national income from an initial increase in government spending of 8 billion pounds.
Question 4 [3 marks]
Supply-Side Policy and Economic Growth
A government spends 6 billion pounds on a national broadband infrastructure project, expected to raise potential output by 4 billion pounds per year once complete. The government collects 35% of any extra output as tax revenue.
Calculate the extra annual tax revenue the project is expected to generate, and calculate approximately how many years it would take for this extra revenue to cover the cost of the project.
Question 5 [3 marks]
Market Failure and Externalities
Define "demerit good", give one example, and explain why a free market is likely to over-consume it relative to the socially efficient level.
Question 6 [5 marks]
Aggregate Demand and Aggregate Supply
Global oil prices fall sharply due to a rise in oil production by major exporting countries.
Explain, using the concept of the short-run aggregate supply (SRAS) curve, the likely effect of this fall in oil prices on an oil-importing country's price level and level of real output in the short run.
Question 7 [4 marks]
Supply-Side Policy and Economic Growth
Explain how increased government spending on apprenticeship schemes could act as a supply-side policy to raise long-run aggregate supply.
Question 8 [5 marks]
Measuring Economic Performance
Explain two limitations of using real GDP growth alone as a measure of a country's economic wellbeing.
Question 9 [4 marks]
Supply-Side Policy and Economic Growth
Explain how privatising a state-owned steel manufacturer could act as a market-based supply-side policy to raise the economy's long-run aggregate supply.
Question 10 [5 marks]
Government Intervention in Markets
Explain, using the concept of price elasticity of supply, why the burden of an indirect tax on a good with highly elastic supply falls mostly on consumers rather than producers.
Question 11 [5 marks]
Fiscal and Monetary Policy
Explain two reasons why there is normally a time lag between a change in interest rates by the Bank of England and its full effect on the rate of inflation.
Question 12 [6 marks]
Government Intervention in Markets
A government wants to increase the proportion of children attending free before-school breakfast clubs, which have positive externalities for child health and educational attainment.
Evaluate whether a subsidy to schools running breakfast clubs or a regulation requiring all schools to provide one is more likely to be effective.
Question 13 [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 14 [6 marks]
Measuring Economic Performance
The table below shows UK data for a given year.
Real GDP growth: 2.1%
CPI inflation: 3.5%
ILO unemployment rate: 4.2%
Current account balance: -2.8% of GDP
Using this data, analyse the overall macroeconomic performance of the economy against the four main policy objectives of economic growth, low and stable inflation, low unemployment and a stable balance of payments.
Model solutions
| Question 1[2 marks] | |
|---|---|
| Answer or working | Marks |
| a correct definition of government failure as a situation where government intervention leads to a net welfare loss, or a less efficient allocation of resources than before the intervention | 1 |
| a valid example, e.g. a subsidy intended to support struggling farmers instead being used to expand production of a crop already in surplus, wasting government resources | 1 |
| Final answer: Government failure occurs when an intervention makes resource allocation less efficient than before, e.g. a farm subsidy intended to help struggling farmers instead expanding output of an already oversupplied crop. | |
| Question 2[3 marks] | |
|---|---|
| Answer or working | Marks |
| a correct definition of automatic stabilisers as changes in government tax revenue and benefit spending that occur automatically as the economy moves through the economic cycle, without any new policy decision | 1 |
| a valid example, e.g. in a recession, tax revenue falls automatically as incomes and spending fall, while spending on unemployment benefits rises automatically as more people lose their jobs | 1 |
| explaining that this automatically raises the government's budget deficit, or reduces its surplus, in a recession, which cushions the fall in aggregate demand and household disposable income, without any new government decision being needed | 1 |
| Final answer: Automatic stabilisers are changes in tax revenue and benefit spending that occur automatically over the economic cycle, e.g. tax revenue falling and unemployment benefit spending rising in a recession, which cushions the fall in aggregate demand without any new government decision. | |
| Question 3[3 marks] | |
|---|---|
| Answer or working | Marks |
| using the multiplier formula, k = 1 / (1 - MPC) | M1 |
| calculating k = 1 / (1 - 0.75) = 4 | M1 |
| the resulting change in national income = 8 x 4 = 32 billion pounds | A1 |
| Final answer: Multiplier = 4; national income rises by 32 billion pounds. | |
| Question 4[3 marks] | |
|---|---|
| Answer or working | Marks |
| calculating the annual extra tax revenue, 4 x 0.35 = 1.4 billion pounds | M1 |
| dividing the project cost by this annual revenue, 6 / 1.4 | M1 |
| approximately 4.3 years for the extra tax revenue to cover the cost of the project | A1 |
| Final answer: Extra tax revenue = 1.4 billion pounds per year; it would take about 4.3 years for this revenue to cover the project's cost. | |
| Question 5[3 marks] | |
|---|---|
| Answer or working | Marks |
| a correct definition of a demerit good as a good that is over-consumed if left to the free market, often because consumers underestimate the harm it does to themselves or to third parties | 1 |
| a valid example, e.g. tobacco or alcohol | 1 |
| explaining that consumers focus on the private benefit they receive, such as enjoyment, while ignoring or underestimating the wider costs, such as harm to their own future health or costs imposed on others, leading to over-consumption | 1 |
| Final answer: A demerit good, such as tobacco, is over-consumed in a free market because consumers focus on their private enjoyment while underestimating harm to themselves or costs imposed on others. | |
| Question 6[5 marks] | |
|---|---|
| Answer or working | Marks |
| identifying that oil is a key input (cost of production) for many firms across the economy, e.g. transport and manufacturing | 1 |
| explaining that a fall in oil prices lowers firms' costs of production across the economy | 1 |
| explaining that this shifts the SRAS curve to the right, since firms are willing and able to supply more output at every price level | 1 |
| concluding that, other things being equal, the price level is likely to fall and real output is likely to rise | 1 |
| a developed point, e.g. this represents a positive supply-side shock, in contrast to a negative shock such as a rise in oil prices, which would instead shift SRAS to the left and worsen both inflation and output | 1 |
| Final answer: Falling oil prices lower firms' costs across the economy, shifting the SRAS curve to the right; other things being equal, this lowers the price level and raises real output, the opposite of a negative supply shock such as a rise in oil prices. | |
| Question 7[4 marks] | |
|---|---|
| Answer or working | Marks |
| identifying that apprenticeships raise the skills and qualifications of the workforce | 1 |
| explaining that this raises labour productivity, since more skilled workers can produce more output per hour | 1 |
| explaining that higher labour productivity increases an economy's productive capacity | 1 |
| concluding this shifts the long-run aggregate supply curve to the right, raising potential output | 1 |
| Final answer: Apprenticeships raise workforce skills and productivity, increasing productive capacity and shifting LRAS to the right. | |
| Question 8[5 marks] | |
|---|---|
| Answer or working | Marks |
| identifying a limitation, e.g. GDP does not directly measure income distribution, so growth could accompany rising inequality with many people no better off | 1 |
| explaining the consequence, e.g. average GDP per capita could rise while median living standards stagnate if gains are concentrated among a few | 1 |
| identifying a second limitation, e.g. GDP excludes non-market activity such as unpaid housework or caring, and does not subtract negative externalities such as pollution | 1 |
| explaining the consequence, e.g. GDP growth could overstate genuine wellbeing if it comes with worse environmental quality or a decline in valuable unmeasured activity | 1 |
| a further valid point, e.g. GDP does not capture leisure time, so growth achieved through very long working hours may not represent a genuine improvement in wellbeing | 1 |
| Final answer: Real GDP growth does not show how gains are distributed, so it can rise alongside worsening inequality, and it excludes non-market activity, environmental damage and leisure time, all of which affect true economic wellbeing. | |
| Question 9[4 marks] | |
|---|---|
| Answer or working | Marks |
| explaining that private owners typically face a profit motive that state-owned firms may lack | 1 |
| explaining that this profit motive gives the new private firm a stronger incentive to cut costs and operate more efficiently, e.g. reducing X-inefficiency | 1 |
| explaining that if the industry is also opened up to competition at the same time, this creates further pressure on the firm to innovate and improve productivity | 1 |
| concluding that these efficiency gains can lower costs and raise output at every price level in the industry, contributing to a rightward shift in the economy's long-run aggregate supply | 1 |
| Final answer: Privatisation gives the firm's new private owners a profit motive to cut costs and reduce inefficiency, especially if the industry is also opened to competition, and the resulting efficiency gains can raise output and shift long-run aggregate supply to the right. | |
| Question 10[5 marks] | |
|---|---|
| Answer or working | Marks |
| identifying that elastic supply means producers can easily reduce the quantity they supply in response to a fall in the price they receive | 1 |
| explaining that if producers reduce quantity supplied in response to the tax, this creates a shortage at the original price, pushing the market price up | 1 |
| explaining that producers therefore pass most of the tax on to consumers via a higher price, being unwilling to absorb it themselves | 1 |
| explaining that if supply were inelastic instead, producers would find it harder to reduce quantity, so a larger share of the burden would fall on them | 1 |
| a concluding point that the more elastic supply is relative to demand, the greater the share of the tax passed on to consumers | 1 |
| Final answer: Elastic supply lets producers easily redirect resources away from a taxed good, so the price rises and most of the tax is passed on to consumers; the more elastic supply is relative to demand, the larger the consumer's share of the burden. | |
| Question 11[5 marks] | |
|---|---|
| Answer or working | Marks |
| identifying that it takes time for households and firms to adjust spending and borrowing decisions once interest rates change | 1 |
| explaining that many households are on fixed-rate mortgages that do not reset immediately, so higher rates only gradually feed through to disposable income as deals expire | 1 |
| identifying a second lag, that it takes time for a resulting change in aggregate demand to feed through to firms' output, employment and pricing decisions | 1 |
| explaining that firms may initially absorb changed demand through inventories or margins before adjusting prices, delaying the effect on measured inflation | 1 |
| a further valid point, e.g. these lags are commonly estimated at 18-24 months in the UK, which is why the Bank of England sets rates based on forecasts of future inflation rather than only current data | 1 |
| Final answer: Lags arise because many borrowers are on fixed-rate deals that only reset gradually, and because it takes time for changed demand to feed through to firms' output, employment and pricing decisions; UK estimates put the full lag at around 18 to 24 months. | |
| Question 12[6 marks] | |
|---|---|
| Answer or working | Marks |
| identifying that breakfast clubs generate positive externalities and so are likely under-provided or under-attended by the free market | 1 |
| explaining that a subsidy lowers the cost to schools of running clubs, encouraging more schools to offer them and more children to attend | 1 |
| explaining that regulation directly mandates provision, guaranteeing availability regardless of a school's financial choice | 1 |
| an evaluative point on the subsidy, e.g. take-up still depends on individual schools and parents choosing to participate, so provision may remain patchy | 1 |
| an evaluative point on regulation, e.g. it guarantees availability but may strain school budgets without financial support, and does not ensure children actually attend | 1 |
| a reasoned overall judgement, e.g. combining a subsidy with a regulatory requirement is likely to be more effective than either alone | 1 |
| Final answer: A subsidy encourages provision by lowering cost but leaves take-up optional, while regulation guarantees availability but may strain school budgets; combining the two, mandating provision and subsidising its cost, is likely to be more effective than using only one instrument. | |
| Question 13[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 14[6 marks] | |
|---|---|
| Answer or working | Marks |
| identifying that real GDP growth of 2.1% suggests positive but modest economic growth | 1 |
| identifying that CPI inflation of 3.5% is above the UK's usual 2% inflation target, suggesting some overheating or cost pressure in the economy | 1 |
| identifying that an ILO unemployment rate of 4.2% is relatively low by historical standards, close to typical estimates of full employment | 1 |
| identifying that a current account deficit of 2.8% of GDP represents a persistent balance of payments imbalance | 1 |
| a developed analytical point linking two objectives, e.g. above-target inflation alongside low unemployment could indicate demand-pull pressures from an economy operating close to full capacity | 1 |
| an overall reasoned judgement on performance, e.g. growth and unemployment are reasonably healthy but the inflation target is being missed and the current account shows a persistent external imbalance, so performance is mixed rather than uniformly strong or weak | 1 |
| Final answer: Performance is mixed: growth and unemployment are reasonably healthy, but inflation is above target and the current account deficit signals a persistent external imbalance. | |