1

Unit 1 Keynesian Theory of income and employment common past paper questions
Q1
Explain the difference between multiplier and accelerator effects and discuss whether
they reinforce or contradict each other {20}
Q2
“If investment increases it will cause an increase in output. If output increases it will cause
an increase in investment.”
Discuss whether both these statements can be true. [20]
7 Investment:
Investment in economics is spending on capital goods and can be categorized in 3
ways;
1 Fixed capital formation:
Spending on capital goods e.g., machinery, roads etc.
2 Residential houses: new construction only is considered investment
3 Stocks (Finished goods by retail company)
Multiplier:
When increase in an injection (withdrawal) causes a greater change in national income
than the original injection.
K = change in Y / change in Injection
For example, a 100 m $ investment causes 500 m $ increase in national income (Y)
500/100 = 5
This is because each spending causes incomes, 100 m investment caused incomes of
100 m $. Now lets’ say marginal propensity of consumption is 0.8. Out of 100 m $, 80 m
$ will be spent. Next time 0.8 of 80 m $ will be spent again i.e., 64 m $. This will keep
happening till initial injection is withdrawn.
Calculating multiplier in advance
K = 1/1-MPC or 1/MPW
K = 1/1-0.8
1/0.2 = 5
 2

1/0.2 = 5
The higher the MPC, the more the multiplier effect.
The lower the MPC, the lower the multiplier effect.
MPC = 0.5

As seen above figures higher MPC (lower figure) causes AE curve to become steeper
and multiplier effect is stronger.
Assumptions/limitations

• There is only autonomous investment and no induced investment

• MPC is constant for the economy
• No time lags
• Price level is constant
• Economy is currently operating below full employment
 3

In the above table each machine can make 10 units and one machine depreciates each
year. As seen in the above table when consumer demand (national income) rose from
80 to 100 units i.e., 25%, investment rose from 1 to 3 i.e., 200%. When consumer
demand rises at a faster rate from 100 to 160 unit i.e., 60%, investment rose from 3 to 7
machines i.e., 125%. Therefore, as per accelerator theory if national income rises at a
faster rate, investment increases by a greater proportion.
When national income / consumer demand rose from 160 to 180 units i.e., only 12.5%,
investment fell from 7 machines to just 3 as per the theory.
Limitations of accelerator theory

• If the firms have spare capacity i.e., unused machinery, they will not invest more
even if national income rises faster than previous year as they can use the spare
capacity available
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• If firms train their workers and become more productive, they may not invest
more in new machinery even if national income rises faster than previous year as
they can produce more with more efficient workers
• If technological advances make machinery more productive, accelerator theory
may not apply as firms may be able to meet the extra demand through fewer
machines
Relationship between Multiplier and Accelerator and vice versa
When an economy moves towards boom, there is a multiplier effect on national income
as discussed earlier. The national income rises at a faster rate and that causes firms to
invest more bringing an accelerator effect. Rise in investment causes an injection in “I”
component of AD and again national income rises manifolds due to multiplier effect. To
sum up multiplier causes accelerator and accelerator causes multiplier.
Q 3 (Mixed from different past paper)
Discuss what is meant by inflationary and deflationary gaps and why are they an
economic problem. [20]
Every economy has a full employment level of national income (potential GDP). Full
employment means maximum possible employment or natural level of unemployment.
This is shown at Yf by a vertical line in Keynesian cross diagram.

Above diagram shows current equilibrium level of national income (Ye) is equal to full
employment level of national income (Yf) and there is no inflationary or deflationary
gap.
However, economies do not often operate at the full employment level of national
income. At any particular time they may be producing where total spending is above or
below that needed for national income to equal potential output and there is either
inflationary or deflationary gap existing in the economy.
 5

An inflationary gap will exist if current level of national income (Ye) is above full
employment level of national output (Yf). Refer to figure below;

Economy is in equilibrium at Ye which is above full employment level Yf. There is YE to

YF inflationary/positive output gap. Govt should reduce spending to eliminate d to EF
inflationary expenditure gap.
Now this is an economic problem as current output exceeds potential output due to
over time working of labour and no breaks given to machines for maintenance. This
cannot be sustained for long and is bringing inflation.

Inflation will bring many International Trade problems especially If inflation rate is
higher in the country compared with its’ trading partner countries, export prices will
become expensive, demand for exports will fall. Import prices will fall and demand for
imports will increase. This can lead to current account deficit if demand was elastic.

Domestic currency will depreciate causing cost-push inflation as this will lead to
expensive imported raw materials.

Businesses: will experience rise in menu costs. This is the cost of reprinting menus and
brochures etc. due to constant rise in price level. Shoe-leather costs will rise as people
keep moving their savings from one bank to another searching for higher interest rate to
protect the real value of their saving. Businesses may start hoarding (store goods to sell
later at higher price)

Individuals on fixed incomes lose the real value/ purchasing power of their money and
become poorer in real terms e.g., pensioners, unemployed receiving benefits etc.
Whereas those owning property, assets, shares, gold etc. will benefit from rise in the
value of their assets during inflation. Hence rich become richer and income gaps widen.
 6

Whether inflation is always harmful will depend on the comparative rate of inflation with
other countries, whether it is demand pull or cost push inflation as cost push inflation is
more harmful as it causes unemployment as well.

Now let’s look at deflationary gap and how it is a problem for the economy.
A deflationary gap will exist if current level of national income (Ye) is below full
employment level of national output (Yf). Refer to figure below;

The problem here is under utilization of resources and unemployment of resources

especially labour. This brings many problems as mentioned below;
Short run problems for individual workers are fall in incomes and living standards. Long
run problems are deskilling i.e., loss of skills and reduced chances of re-employability.
Depression and crime rates may rise. However workers will have leisure time and
possibility to retrain and improve their employability.
There will be a fall in spending hence AD and sales will reduce for firms, reducing their
profitability.
However. there will be easy availability of skilled/unskilled workers and firms will not
face trade union pressure, hence pay lower wages and become more competitive
Govt tax revenue will fall from both direct and indirect taxes and they will have to spend
more on unemployment benefits. This will result in a budget deficit and need for
borrowing may emerge.
Low incomes will lead to low savings and low investment causing a fall in growth and
development
Country will produce inside its PPC, hence inefficiency
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However, reduced production will result in low external costs e.g., pollution etc.
Both demand-pull and cost push inflation will reduce
To conclude both inflationary and deflationary gaps cause problems and economy
either faces inflation or unemployment.
Unit 2 Money, banking and interest rate determination
common past paper questions

Q1
Explain how interest rate is determined according to LPT by Keynes? (20)
Q2
Discuss how interest rate is determined according liquidity preference theory by J. M.
Keynes and if credit cards become popular, how would it affect the different motives of
demand for money {20}

MJ 20 P42 Q7 a

Q3
MJ 19 P42 Q6
Discuss how far
i) An increase in wages and
ii) A loss of business confidence might affect the rate of interest. [20]

According to J.M.Keynes Interest rate is determined by interaction of demand and

supply of money.
According to Keynes money supply is determined by central bank and is inelastic to
changes in interest rate.

Money supply is determined by central bank through open market operations, changes to
Liquidity ratio, by changing Discount rate and use of Special deposits etc.
 8

According to LPT by Keynes, people demand money/cash/liquid assets for three

motives i.e., transaction motive, precaution motive and speculation motive.
1 Transaction motive: People keep cash/liquid assets for day-to-day purchases e.g.,
groceries, fuel, utility bills etc. Firms also keep cash for day-to-day expenses such
as running expenditure e.g., wages, bills, raw materials etc. Govt also keeps liquid
money for their office supplies etc.
This motive of demand for money is perfectly inelastic to changes in interest rates.

This motive of demand for money is influenced by changes in income, Inflation rate and
Intervals of pay etc.
Rise in incomes, inflation and interval of payment will cause an increase in demand for
money and vice versa

2 Precautionary motive:
It is the demand for cash/liquid assets for unforeseen emergencies e.g., surgery,
accident etc. Firms also keep cash for unexpected break downs of machinery etc.

3 Speculation motive:
This is when people invest for short term gains e.g., government bonds. They try to gain
from difference in selling price and purchase price.
 9

Govt bonds are saving certificates which are sold at a discount rate and have a fixed
interest.
For example, a bond with face value of £100 and has fixed interest of 10£.
If price of bond falls in the open market e.g., £50, now the interest rate would be 10/50 *
100 = 20%.
People do not invest in bonds when their price is high and interest rate is low. They keep
holding cash and demand for money rises.
Thus, it shows that demand for money for speculative purposes is interest elastic.

When speculative motive is added to other motives of demand for money, the whole
demand curve / liquidity preference curve become interest elastic.

Interest rate determination: (Important)

According to LPT, interest is determined through demand for and supply of money.

As seen in the figure, interest rate was determined at IR0 through demand and supply of
money. If IR rises to IR1, Money supply is greater than demand for money a to b area.
People will have surplus liquid assets and will invest in bonds as bond price is low and
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interest is high. Demand for bonds will rise and their price will rise, bringing interest rate
down and vice versa.

Limitations of LPT:
1 The view that transaction and precaution motives are interest inelastic is not correct.
They do change when interest rate changes
2 The notion that people only invest in bonds for speculation is incorrect as people
invest in stocks, property etc.
3 Money supply being perfectly inelastic to interest rate changes may be true in short
run only
4 According to Keynes changes in money supply may not affect interest rates if
“liquidity trap” exists. This is a situation when price of bonds is too high and interest
rate is too low. People keep holding their cash and do not invest in bonds.

Q 1’s Answer ends here

For Q 2 add;
(This will be added after limitations of the theory)
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If credit cards become popular and are accepted by widespread retailers and
institutions, the effect on motives of demand for money will be as follows.
People and firms may use more and more of credit card buying option for daily needs
like fuel and groceries etc., hence demand for transaction motive of money will fall.
They will not need to keep that much cash for daily base transactions now.
Demand for liquid money for precautionary motive may also fall as people and firms will
know credit cards can be used to pay for any unforeseen emergencies e.g., an accident
or a surgery required. Since hospitals, mechanics etc. will accept credit card payment.
This will result in more cash and liquid asset now becoming available for speculative
motive.
To conclude popularity of credit cards is likely to reduce demand for money for
transaction and precaution motive and as a result more money will be demanded for
speculative motive.
For Q3 add;
(This will be added after limitations of the theory)
Increase in wages will increase people’s incomes, hence demand for both transaction
and precaution motives of money will shift to the right as becoming rich means adopting
a better lifestyle, hence more spending for transaction and more kept for emergencies
as well.
If increase in wages is taken to be an indicator of firms’ profitability, firms will also
demand more liquid money for transaction and precaution motives.
It is debatable as to what will happen to speculative motive of demand for money. It is
quite possible that rise in incomes and profit may mean people do not want to invest in
bonds and other assets for speculative purposes as they are already using most of the
increased incomes on transactions and precautionary motives. On the other hand, they
may want to invest the increased incomes in bonds to enhance short-term gains.
Irrespective, overall demand for money, the LPC curve will shift to right raising the rate
of interest (make a diagram with shift of LPC to right).
Loss of business confidence will certainly reduce the demand for money for transaction
and precaution motives as firms will be investing less or even reducing the scale of
operations and may pay lower salaries and make some workers redundant again
reducing demand for money by people too.
Speculative motive demand for money may also fall as loss of business confidence in
bond and stock markets will make people vary of investing in them. Hence demand for
money curve will shift to the left reducing the rate of interest (make a graph with LPC
shifting to the left).
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The impact on interest rate will depend on the size and magnitude of both shifts, hence
it remains uncertain.
Unit 3 and 4 PPP questions
Q1
MJ 2022 P42 Q 7 b
Discuss if monetary policy alone is sufficient for a govt to achieve its’ macroeconomic
aims simultaneously [20]

The main macroeconomic aims of a govt are attaining full employment which equates
to the natural rate of unemployment (NRU) and is usually around 3% unemployment
rate. They also aim for price stability which means a low and stable rate of inflation and
BOP equilibrium over time and within its’ different accounts as neither persistent
surpluses nor deficits are good for the country.

They also aim for sustainable economic growth that lasts for future generations, is
inclusive (benefiting all) and leads to economic development i.e., better living standards
via better education, healthcare and environment etc.

Subsidiary aims can be stability of exchange rate, poverty alleviation etc.

In order to achieve these aims, govt can use demand-side policies namely Fiscal and
monetary policies which also includes exchange rate changes alongside a range of
supply-side policies.

Monetary policy refers to changes in interest rates and/or money supply by central bank
to achieve a govt’s macroeconomic objectives. Exchange rate is sometimes also used.

In times of economic downturn, when AD is low, unemployment is high and GDP is low
or on a decline. Govt will use expansionary monetary policy.

Interest rate will be reduced and money supply will be increased. Reduced interest
rates will reduce cost of borrowing and return on saving. People will save less and
borrow more, consumption will rise. Firms will also investment more to meet the
increase in consumption and to benefit from low cost of borrowing as MEC i.e., return
on addition capital employed will be greater than cost of investment i.e., interest rate.
AD will rise due to injections of “C and I”.
 13

Reduced interest rates will result in outflows of hot money from the country and
exchange rate will depreciate. This will make exports cheaper and exports expensive,
causing an injection into net exports component of AD.

This may cause a multiplier effect and national income might increase by a greater
proportion than the initial injections. If MPC is high in the economy, multiplier effect will
be stronger. The figures below show the effect of expansionary monetary policy on the
economy;

As seen in the figure on the left, national income rises and unemployment will fall and
economic growth/GDP will rise. Figure on the right, shows multiplier increase in national
output/income. Injections were only a to b and national income rose by a larger amount
i.e., Y0 to Y1

However, Demand-pull inflation might occur if economy is close to full employment and
aggregate supply cannot be increased. BOP current account might worsen as increased
incomes will be spent on import of luxury consumer goods e.g., cars and electronics,
however this may not be the case if exchange rate was also devalued.

Contractionary monetary policy will be used during high inflation. Interest rate will be
increase and money supply will be reduced. This will reduce AD due to high cost of
borrowing and high return on saving. Consumption and investment will reduce and so
will AD which might lead to a downward multiplier effect.

Here the govt was able to control demand-pull inflation and perhaps current account of
BOP might exhibit a reduced deficit due to lower imports. However, unemployment will
rise and economic growth will fall as shown in figure below;
 14

The shift of AD to the left resulted in reduced demand-pull inflation and price level fell
from P0 to P1, but also reduced real GDP from Y0 to Y1 leading to fall in economic
growth which may lead to rise in unemployment.
As discussed above, there are clear conflicts between achievement of govt aims of
controlling inflation and BOP equilibrium with maintaining a steady economic growth
and reducing unemployment

There are also many limitations of monetary policy, such as time lags as change in
interest rate may affect the economy in 12 to 16 months. GDP and CPI may be an
unreliable data, hence policies designed on basis of such data may be inaccurate

If firms and people are confident about future, an increase in interest rates may not
deter Investment and spending and vice versa. As per Keynesian view, a Liquidity trap
may exist. It is a situation where interest rate is too low and bond prices are too high.
Any change in Money supply will not affect interest rate and economy.

External global shocks for example, Covid-19 and 9/11 attacks may make internal govt
policies ineffective as people and firms will not react as expected.
 15

Considering the above discussion, govt can use alternative policies too. They might use
fiscal policy. Fiscal policy is the use of taxes and govt spending to achieve
macroeconomic objectives

Expansionary Fiscal policy may be used in times of recession and high unemployment.
Govt will reduce taxes (especially direct taxes) and increase their spending. Reduced
taxes will increase disposable incomes, consumption will increase, and firms will
increase investment to meet the increase in demand as they have more retained profit
due to reduction in corporation tax. Govt spending will also inject in AD.

AD will rise This will result in reduced unemployment and GDP/economic growth will
increase. However, increased income maybe spent on imports of luxury goods
worsening the current account of BOP. Rise in AD, not matched by increased
Aggregate supply as the economy was on full employment, will cause demand-pull
inflation.

Contractionary fiscal policy may be used during high inflation and govt will raise taxes
and reduce Govt spending. This will reduce inflationary pressures and improve current
account due to lower spending on domestic as well as imported products, but economic
growth will decline and unemployment may rise.

Fiscal policy has its own limitations such as Crowding out effect i.e., If govt increase
spending by borrowing they compete with everybody else in the economy who wants to
borrow the limited funds available. As a result of this, the real interest rate rises (due to
more demand for loans) and causes a fall in private investment.
This policy is often used for political gains instead of economic benefits. Although taxes
have a very quick impact, there are huge time lags before govt spending affects the
economy. Low future confidence among firms and consumers may also result in
reduced effect of expansionary fiscal measures and many other limitations reduce its
effectiveness and vice versa.
Supply-side policies which are aimed at increasing Aggregate supply of goods/services
through greater efficiency and productivity may also be used.
There is a whole range of supply-side measures including education and training of
labor, subsides to firms, privatization of govt businesses, reducing barriers to entry /
contestable markets development which is done through Deregulation, more
Investment in research and development (RND) and development of development of
infrastructure etc.
 16

All of these will reduce firms’ costs and increase their profitability causing expansion in
the economy’s productive potential while creating job opportunities and economic
growth.

The above figure shows result of supply side policies. It will shift long run AS. Govt can
achieve all its’ aims if it is able to use demand side policies (AD shifts out) along with
supply side policies in the long run.

Limitations of Supply side policies include Long-run effect and opportunity cost of govt
spending. Demand-pull inflation may occur in short run due to Increase in either
government spending or investment by private sector firms. There will be brain drain as
highly trained and skilled workers may leave the country and all the expenditure on their
training may become a wasted effort.
Free-trade may result in closure of some infant and sunset industries as they will not be
able to withstand the competition from cheap and good quality imports, causing
unemployment in short run.
In light of the above discussion, monetary policy may not be enough to achieve all govt
aims simultaneously. Govt can achieve all its’ aims if it is able to use demand side
policies in short run along with supply side policies in the long run.
Q2
MJ 22 P41 Q 6 a
Explain what is meant by a transmission mechanism of monetary policy and consider
why it may not work in practice [20]
Ans)
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A transmission mechanism of monetary policy refers to the way changes in monetary

policy (such as changes in money supply) affect the broader economy. This can occur
through several channels, such as changes in borrowing costs, spending, investment,
and expectations.

Keynes suggested Indirect MTM. According to this view Money supply changes first
affect interest rate and then affects economy. When money supply increase, interest
rates fall. This results in lower cost of borrowing and lower return on saving. People
save less and borrow more. Consumption rises, firms meet the increase demand by
more investment. As a result, AD rises due to injections of C and I.

Fall in interest rates reduce the inflows of hot money in country’s banks and demand for
currency falls, resulting in depreciation of currency. Now exports will cheaper and their
demand will rise. On the other hand, imports will become expensive and their demand
will fall. Current account improves if Marshall Lerner condition is met i.e., the joint PED
for exports and imports is greater than 1. Again, AD rises due to injection of X-M. This
may cause a multiplier effect especially if MPC is high in the economy.

This will cause unemployment to fall and GDP to rise, however demand-pull inflation
may occur if AS cannot rise as much. Refer to figures below;

Above figure of the left shows an increase in money supply from MS0 to MS1 causes
interest rate to fall from IR0 to IR1 which results in shift of AD curve to the right (figure
on the right) reducing unemployment as national output increases from Y to Y1,
However, demand pull inflation occurred causing the price level to rise from P to P1.
However, the transmission mechanism of monetary policy may not work in practice due
to various obstacles, such as:
 18

According to Keynes changes in money supply may not affect interest rates if “liquidity
trap” exists. This is a situation when price of bonds is too high and interest rate is too
low. People keep holding their cash and do not invest in bonds.

Bank lending constraints: If banks are not able or willing to lend, changes in interest
rates may not lead to a corresponding increase in credit and spending.
Inertia in wages and prices: If wages and prices are slow to adjust, changes in interest
rates may not have an immediate impact on inflation and economic activity.
Imperfect information: If economic actors (e.g., consumers, firms) lack complete
information about the state of the economy and future prospects, they may not respond
to changes in monetary policy as expected.
Future confidence may be low among economic agents and even reduced interest rate
don’t generate expansion as demand for loans will be interest inelastic.
Global factors: In an increasingly globalized economy, monetary policy may be less
effective if movements in international interest rates or exchange rates offset its effects.
Therefore, while the transmission mechanism of monetary policy provides a theoretical
framework for understanding how monetary policy affects the economy, it is not a
guarantee that it will work as intended in practice.
Q3
MAR 19 P 42 Q 7
“Keynesian policies to solve the problem of unemployment will not work because they
will conflict with the attainment of other key macroeconomic aims.
Assess the accuracy of this statement. [20]

The main macroeconomic aims of a govt are attaining full employment which equates to
the natural rate of unemployment (NRU) and is usually around 3% unemployment rate.
They also aim for price stability which means a low and stable rate of inflation and BOP
 19

equilibrium over time and within its’ different accounts as neither persistent surpluses
nor deficits are good for the country.

They also aim for sustainable economic growth that lasts for future generations, is
inclusive (benefiting all) and leads to economic development i.e., better living standards
via better education, healthcare and environment etc.

Subsidiary aims can be stability of exchange rate, poverty alleviation etc.

Unemployment is when people are willing and able to work, but can not find a job. It can
be measured by the formula; number unemployed / labor force * 100. Where labor force
includes both employed and unemployed.

Keynesian demand-management policies refer to use of fiscal policy. Fiscal policy is the
use of taxes and govt spending to achieve macroeconomic objectives. Govt may use
expansionary fiscal policy if there is a recession and unemployment is high.

Govt will reduce taxes and increase their spending and use a budget deficit. Reduced
direct taxes will increase disposable incomes, consumption will increase, and firms will
increase investment to meet the increase in demand as they will have more retained
profit due to cut in corporation tax. Govt spending will also inject in AD. The injections
of C + I + G may cause a multiplier effect and national income might increase by a
greater proportion than the initial injections.

If MPC is high in the economy, multiplier effect will be stronger. This is because every
spending generates incomes which are spent again. The national income/output will
keep increasing till the initial injection(s) are fully withdrawn.

The figures below show the effect of expansionary fiscal policy;

 20

AD will rise This will result in reduced unemployment and GDP/economic growth will
increase.

However, increased income maybe spent on imports of luxury goods worsening the
current account of BOP. Rise in AD, not matched by increased Aggregate supply as the
economy was on full employment, will cause demand-pull inflation

Fiscal policy has many limitations too which may reduce its effectiveness. Fiscal policy
especially govt spending is slow to operate. There will be recognition, implementation
and effectivity lags.
Fiscal policy is often used for political purposes rather than sound economic logic. For
example, politicians may increase spending near elections to gain popularity. They may
avoid an unpopular tax especially income tax that was needed for economic
improvement.
GDP and CPI are themselves prone to error, hence policies designed on basis of such
data may be inaccurate. If people and firms feel govt will retract/change the tax rates
back again. They will save the extra disposable income rather than increase spending.
If govt increase spending by borrowing they compete with everybody else in the
economy who wants to borrow the limited funds available. As a result of this, the real
interest rate rises (due to more demand for loans) and causes a fall in private
investment. This is called crowing out.
According to USA president Regan’s adviser (Laffer), if govt reduces the additional rate
of tax at the higher level of incomes, tax revenue will rise. This is because of greater
incentive to firms and workers.
 21

As seen in the figure when tax rate was reduced from 50% to 40%, tax revenue
increased.
The statement in the question has some elements of truth but is also an
oversimplification. Keynesian policies, such as increased government spending and
monetary expansion, can help reduce unemployment in the short-term. However, they
can also lead to inflation if not properly managed, and may conflict with the goal of
maintaining price stability.
Additionally, other macroeconomic objectives, such as fiscal sustainability and balance
of payments, may also be affected by Keynesian policies, particularly if they result in
higher government debt and current account deficits.
In conclusion, the effectiveness of Keynesian policies in reducing unemployment and
the potential conflicts with other macroeconomic objectives depend on the specific
circumstances of each economy and the manner in which the policies are implemented.
Q4
MJ 20 P 42 Q 5
In January 2018 tax reductions were introduced in the US, and the Federal Reserve
Bank, (the US central bank) announced it would raise the interest rates later in the year.
Discuss how these policies may cause conflicts for a govt in trying to achieve its
macroeconomic aims. [20]

Ans) The main macroeconomic aims of a govt are attaining full employment which
equates to the natural rate of unemployment (NRU) and is usually around 3%
unemployment rate. They also aim for price stability which means a low and stable rate
of inflation and BOP equilibrium over time and within its’ different accounts as neither
persistent surpluses nor deficits are good for the country.

They also aim for sustainable economic growth that lasts for future generations, is
inclusive (benefiting all) and leads to economic development i.e., better living standards
via better education, healthcare and environment etc.
 22

Subsidiary aims can be stability of exchange rate, poverty alleviation etc.

Reducing taxes is from Keynesian demand-management policy named fiscal policy.

Fiscal policy is the use of taxes and govt spending to achieve macroeconomic
objectives. Govt may use expansionary fiscal policy if there is a recession and
unemployment is high.

As per American govt’s announcement, reduced direct taxes will increase disposable
incomes, consumption will increase, and firms will increase investment to meet the
increase in demand as they will have more retained profit due to cut in corporation tax.
Govt spending will also inject in AD. The injections of C + I may cause a multiplier effect
and national income might increase by a greater proportion than the initial injections.

If MPC is high in the economy, multiplier effect will be stronger. This is because every
spending generates incomes which are spent again. The national income/output will
keep increasing till the initial injection(s) are fully withdrawn.

The figures below show the effect of expansionary fiscal policy;

AD will rise This will result in reduced unemployment and GDP/economic growth will
increase.

However, increased income maybe spent on imports of luxury goods worsening the
current account of BOP. Rise in AD, not matched by increased Aggregate supply as the
economy was on full employment, will cause demand-pull inflation
 23

Fiscal policy has many limitations too which may reduce its effectiveness. Fiscal policy
especially is slow to operate. There will be recognition, implementation and effectivity
lags.
Fiscal policy is often used for political purposes rather than sound economic logic. For
example, politicians may reduce taxes near elections to gain popularity. They may avoid
an unpopular tax especially income tax that was needed for economic improvement.
GDP and CPI are themselves prone to error, hence policies designed on basis of such
data may be inaccurate. If people and firms feel govt will retract/change the tax rates
back again. They will save the extra disposable income rather than increase spending.
If govt increase spending by borrowing they compete with everybody else in the
economy who wants to borrow the limited funds available. As a result of this, the real
interest rate rises (due to more demand for loans) and causes a fall in private
investment. This is called crowing out.
According to USA president Regan’s adviser (Laffer), if govt reduces the additional rate
of tax at the higher level of incomes, tax revenue will rise. This is because of greater
incentive to firms and workers.

As seen in the figure when tax rate was reduced from 50% to 40%, tax revenue
increased.

The announcement to raise interest rate is contractionary monetary policy. Interest rate
will be increased. This will reduce AD due to high cost of borrowing and high return on
saving. Consumption and investment will reduce and so will AD which might lead to a
downward multiplier effect.

Here the govt will be able to control demand-pull inflation and perhaps current account
of BOP might exhibit a reduced deficit due to lower imports. However, unemployment
will rise and economic growth will fall as shown in figure below;
 24

The shift of AD to the left resulted in reduced demand-pull inflation and price level fell
from P0 to P1, but also reduced real GDP from Y0 to Y1 leading to fall in economic
growth which may lead to rise in unemployment.
As discussed above, there are clear conflicts between achievement of govt aims of
controlling inflation and BOP equilibrium with maintaining a steady economic growth
and reducing unemployment

There are also many limitations of monetary policy, such as time lags as change in
interest rate may affect the economy in 12 to 16 months. GDP and CPI may be an
unreliable data, hence policies designed on basis of such data may be inaccurate

If firms and people are confident about future, an increase in interest rates may not
deter Investment and spending and vice versa. As per Keynesian view, a Liquidity trap
may exist. It is a situation where interest rate is too low and bond prices are too high.
Any change in Money supply will not affect interest rate and economy.

External global shocks for example, Covid-19 and 9/11 attacks may make internal govt
policies ineffective as people and firms will not react as expected.
 25

To sum up, the introduction of tax reductions and the announcement to raise interest
rates by the US central bank can create conflicts for the government in achieving its
macroeconomic goals.
Tax reductions can stimulate aggregate demand and boost economic growth in the
short-term, but if the government is also trying to control inflation, the increase in
demand can push up prices and lead to higher inflation. This can undermine the
government's goal of maintaining price stability.
On the other hand, raising interest rates can help control inflation by reducing aggregate
demand, but it can also slow down economic growth and increase the cost of borrowing.
This can be detrimental to the government's goal of promoting economic growth and
reducing unemployment.
Therefore, the government may need to strike a balance between these two policies to
achieve its macroeconomic objectives of low inflation, economic growth, and low
unemployment. However, this can be challenging, as the effects of these policies may
not be immediate and may take time to materialize, making it difficult to determine the
right course of action.
Past Papers Questions Unit 5
Specimen paper 2023 P4 Q 4
“Devaluation of a country’s currency will reduce a persistent balance of payments
deficit on its current account in goods and services in the short run, but will inevitably
lead to high levels of inflation in the long run.”
Evaluate this statement [20]
CAIE mark scheme for this question was a complete answer, hence sharing that
 26

AO1 Knowledge and understanding and AO2 Analysis 14 marks

Evaluation 6 Marks
 27

Unit 6: Past Paper Questions

Q1
O/N 18 P 43 Q5 b
Some economists argue that govt intervention is the best way to reduce natural rate of
unemployment while others suggest that it would be better to allow market forces to
reduce this type of unemployment.
Compare both approaches and assess which one is likely to be more effective. [20]
Ans) Natural rate of unemployment exists when labor market is in equilibrium i.e., ADL =
ASL Or according to new classical economists it is the rate an economy will get back to
in the long run and there will be a constant rate of inflation. It is also known as NAIRU
i.e., non-accelerating inflation rate of unemployment.
It is calculated by the formula; NRU = No of naturally unemployed / Labour force * 100

Above figure of NRU or equilibrium unemployment shows Y no of workers are employed

and YZ are unemployed. These workers are experiencing voluntary unemployment due to
frictional unemployment e.g., search unemployment. The problem here is due to supply-
side reasons.
The ALF curve moves closer to ALS curve as the real wage rate rises. This is because
more people are willing to work now, who were previously unwilling to work as real
wage rate rises.
Government intervention and market forces are two different approaches to reducing
the natural rate of unemployment. Government intervention refers to policies and
programs implemented by the government to directly address unemployment, such as
job creation initiatives, training programs, and subsidies to firms hiring workers. Market
forces refer to the interactions of supply and demand in the labor market, which
determine the wage rate and the level of employment.
 28

To reduce Natural rate of unemployment (NRU), govt might try to increase the
willingness and ability of workers to join jobs at current wage rate. They can use the
following policies;
They can widen the gap between low pay and unemployment benefits. This can be done
by cutting unemployment benefits or reducing basic rate of income tax. The result will
be more workers take on work as there is a greater earning incentive and “poverty trap”
will reduce.
Govt can improve education and training A more skilled labor force is likely to find it
easier to switch from one job to another and so suffer less from structural
unemployment. Training of the unemployed can be important in overcoming the
problem of “hysteresis”. Workers who experience long periods of unemployment can
lose confidence in gaining another job and their skills may become out of date. Firms
may also be reluctant to employ someone who has been out of work for they may think
the long term unemployed will have lost the work habit and may have to be retrained at
the firm’s expense.
Govt can improve labor mobility, i.e., occupational and geographical because if workers
are more mobile, it is likely that more job vacancies will be matched with their skills and
they can also move to other locations.
Market forces will work better if minimum wage law is removed, firms will hire more
workers as their cost of production falls.
New classical economist favour reducing the power of trade unions and a national
minimum wage. They argue that trade unions and a national minimum wage can push
the wage rate above equilibrium level. They also think that trade unions can restrict the
tasks workers are prepared to do, which may reduce labour productivity.
Greater flexibility by firms may also increase employment. The more flexible firms are in
terms of, for example, the hours worker can work and where they can do work, the more
workers may be prepared to accept the jobs on offer at the current wage rate.
Firms in private sector also organize job-fairs, outreach programs at universities, offer
internship and training opportunities. Workers also join trainings and upgrade their
education etc. All this allows reduction of NRU without govt intervention.
Evaluation:
Proponents of government intervention argue that it can help to reduce the natural rate
of unemployment by increasing the demand for labor, thereby reducing unemployment.
They also argue that market forces can be slow to respond to changes in the labor
market, and that government intervention can help to speed up the adjustment process.
 29

On the other hand, proponents of relying on market forces argue that government
intervention can have unintended consequences, such as distorting the labor market
and creating disincentives for firms to hire workers. They also argue that government
intervention can be slow and bureaucratic, and that relying on market forces can be a
more efficient way of reducing unemployment.
In conclusion, both approaches have their strengths and weaknesses. The effectiveness
of each approach will depend on the specific circumstances of each economy and the
particular policies and programs that are implemented. A balanced approach that
incorporates elements of both government intervention and market forces may be the
most effective in reducing the natural rate of unemployment.
Unit 7 Past paper questions
Q 1 O/N 21 / P41 / Q7 a
Explain what is meant by infrastructure and consider the view that an increase in
investment in infrastructure will promote both an increase in actual and potential
growth [20]
Hard infrastructure refers to the basic physical and organizational structures and
facilities (e.g., buildings, roads, power supplies) needed for the operation of a society or
enterprise. Whereas soft infrastructure refers to investment in human capital i.e.,
education and healthcare to make the human resource more productive. Both forms of
infrastructure provide the foundation for economic activity and is essential for
economic growth.
Economic Growth is when real GDP rises over time. It can be actual or potential growth.
Economic Growth: Real GDP 2 – Real GDP 1 / Real GDP 1 * 100
 30

The above figure on the left shows actual growth by a movement from point U inside
PPC to point B which is closer to the PPC and from B to A on the PPC. This is due
increase in AD as shown in figure on the right.
Potential Growth:
It is when economy’s productive potential increases. This is linked to outward shift of
PPC and outward shift of long run aggregate supply. This occurs in long run due to
increase/improvement in quantity and/or quality of resources.

The above graph shows potential growth through shifts of PPC and LRAS curves and
Actual growth through shift of AD curve and movement from a point “u” inside PPC to
the point “B”.
The view that an increase in investment in infrastructure will promote both actual and
potential growth is based on the idea that improved infrastructure can lead to higher
productivity, lower costs, and increased competitiveness. By providing a more efficient
means of transport and communication, better infrastructure can reduce the time and
costs associated with moving goods and people, which in turn can lead to increased
economic activity. Improved infrastructure can also make it easier to access markets
and increase the ability of firms to take advantage of economies of scale, thereby
boosting productivity.

In addition to these short-term benefits, increased investment in infrastructure can also

have long-term effects on potential growth. By providing the infrastructure necessary
for new technologies and industries to emerge, it can help to create new economic
opportunities and spur technological innovation. This, in turn, can lead to higher
potential growth in the long run.
 31

Overall, the argument is that investment in infrastructure is a crucial component of

economic growth and that increasing investment in this area can lead to both higher
actual and potential growth. However, it's important to note that the benefits of
infrastructure investment can vary depending on the specific infrastructure projects, the
local conditions, and the quality of the investment itself.
Q2
M/J 18 P4 42 / Q 6 a
Consider how the causes of recession may differ from causes of inflation [12]

Recession is part of “business cycle” and refers to a fall in real GDP for at least two
quarters (6 months) in an economy.
Recession may occur due to both demand-side and supply-side reasons as explained
below;
A decrease in consumer spending: Consumer spending drives the economy, and if
people start to cut back on spending, it can lead to a slowdown in economic activity and
eventually a recession as AD falls.
Increased unemployment: When businesses start to lay off workers, it creates a
downward spiral as those workers no longer have the income to spend, which can lead
to more layoffs and less consumer spending.
Decreased business investment: If businesses start to decrease their investment in new
projects, it can lead to a slowdown in economic growth and eventually a recession due
to fall in AS.
Housing market crash: A sharp decrease in housing prices can lead to a decrease in
consumer spending as people feel less wealthy and less confident in their financial
future, hence AD falls.
Tight monetary policy: If a central bank raises interest rates too quickly, it can slow
down borrowing and spending, which can lead to a decrease in economic activity and a
recession. This will reduce both AD and AS.
Inflation is the constant rise in general level of goods and services in an economy over a
period. It can be demand-pull or cost push.
Demand-pull inflation occurs due to an injection in one or more components of AD i.e.,
consumption, investment, govt spending and net exports. A rise in AD which cannot be
matched by an increase in AS because the economy is near or on full employment will
cause a rise in general price level.
 32

Cost-push inflation occurs due to increase in cost of inputs which in turn will cause a
rise in cost of production for firms leading to a fall in aggregate supply. Producers will
pass some of the increased costs to consumers.
Add graphs for cost-push and demand-pull inflation and explain them briefly.
The causes of inflation can be;
Increased consumer demand: If consumer demand for goods and services increases
faster than the economy can produce them, it can lead to higher prices and inflation.
Increased production costs: If the costs of producing goods and services increase,
businesses may need to raise prices in order to maintain their profit margins, leading to
inflation.
Increase in the money supply: If the central bank increases the money supply faster
than the economy is growing, it can lead to more money chasing the same amount of
goods and services, leading to higher prices and inflation.
Devaluation of the currency: If a country's currency loses value relative to other
currencies, it can make imports more expensive, leading to higher prices and inflation.
In conclusion, while inflation and recession can both have significant impacts on an
economy, they are caused by different underlying economic factors when it comes to
demand-side reasons. Recession is caused by a fall in aggregate demand, whereas
inflation is caused by a rise in aggregate demand.
For supply-side reasons a fall in aggregate supply will cause both a rise in inflation and
a recession so causes can be similar.
Q3
M/J 15 P42 Q5 a
What is a recession and is it always caused by a lack of consumer spending? [12]
A recession is a period of economic decline characterized by a decrease in gross
domestic product (GDP) for two or more consecutive quarters. It is generally associated
with a decline in consumer spending, investment, and employment, but it is not always
caused solely by a lack of consumer spending.

A recession can be caused by a variety of factors, including a decline in consumer

spending certainly reduces economic activity as it is probably the biggest engine of
economic growth. Fall in consumer spending will cause AD to fall and may result in a
recession.
 33

However, other factors such also cause it such as:

Business confidence plays a role in changing AD. If businesses are pessimistic about
future, they will reduce investment. This will reduce AD, GDP will fall and there will be a
negative multiplier and accelerator effect causing a recession and even slump. On the
other hand, if they are optimistic about future, multiplier and accelerator will work in the
opposite direction.
Money supply changes may also affect AD. If money supply reduces, there be reduced
consumption and investment causing AD to fall and result in negative multiplier and
accelerator effect causing a recession and vice versa.
Political cycles also affect AD. Before an election govts increase their spending and cut
taxes to gain popularity causing economic growth, but after election spending is cut
causing a downward multiplier effect and may cause a recession.
Stock market crashes: Significant drops in stock prices can lead to decreased
consumer confidence, which can cause consumers to spend less.
Bank failures: If there is a widespread failure of banks, it can lead to a credit crunch
and decreased lending, which can slow economic growth.
Government policies: Government policies, such as changes in tax laws or
regulations, can also affect economic growth.
There may also be supply-side shocks;
Global events, such as natural disasters, war, or trade disputes, Covid-19 and 9/11
attacks can also impact the economy and lead to a recession.
So, while a decline in consumer spending can play a role in causing a recession, it is
not always the sole cause as many other demand-side and supply-side reasons may
bring about recessionary pressures too.
Q4
MAR 16 P 42 Q5 b
Consider whether the main cause of growth is an increase in population, and hence an
increase in labor supply. [12]
Economic Growth: This is when real GDP rises over time. It can be actual or potential
growth.
Economic Growth: Real GDP 2 – Real GDP 1 / Real GDP 1 * 100
Real GDP 2 (Current year) and Real GDP 1 (Previous year)
2020 = 103 B $
 34

2019 = 100 B $
3% Economic Growth
Actual Economic Growth

Potential Growth:
It is when economy’s productive potential increases. This is linked to outward shift of
PPC and outward shift of long run aggregate supply. This occurs in long run due to
increase/improvement in quantity and/or quality of resources.

The above graph shows potential growth through shifts of PPC and LRAS curves and
Actual growth through shift of AD curve and movement from a point “u” inside PPC to
the point “B”.
 35

Rise in population and increase in labour supply will increase the quantity and perhaps
quality of resources in the country if skilled labour had immigrated to that economy.
This will cause long run economic growth and shift long run AS curve and PPC
outwards as shown in above diagram of potential growth.
Economy with large labour supply may attract multi-National companies and result in
employment opportunities, rise in incomes, consumer spending and GDP which might
result in both actual and potential growth. If there were labour shortages in the country
earlier, firms will hire the now available labour and the economy will move closer to its
PPC.
However, there may be an increase in unemployment in short run as firms may not be
able to reach the new production capacity immediately.
It's also worth noting that an increase in population can also have negative impacts on
economic growth. For example, if the increase in population outpaces the growth of the
economy's productive capacity, it can lead to overpopulation, unemployment, and other
economic challenges.
Other important factors include technological advancements, productivity
improvements, investment in physical and human capital, favorable macroeconomic
conditions, and favorable trade and regulatory environments. All of these can lead to
increased productivity, increased output, and thus, economic growth.
Economic growth can be caused by a variety of factors, and an increase in population,
and thus an increase in labor supply, can be one of them. However, it is not the only
factor, and often not the main factor, that contributes to economic growth.
Therefore, while an increase in population can contribute to economic growth, it is only
one of many factors that need to be considered in understanding the drivers of
economic growth.
Unit 8 Past paper questions
O/N 21 / P42 / Q7 /b
Discuss whether fiscal policy alone can promote a more equal distribution of income.
[20]
Ans) Fiscal policy, or the use of government spending and taxation to influence the
economy, can play a role in promoting a more equal distribution of income, but it is not
the only solution and cannot achieve this goal alone.

One way, fiscal policy can contribute to income equality is through progressive taxation,
where higher earners pay a larger share of their income in taxes. This allows for the
 36

government to redistribute wealth through spending on programs that benefit lower-

income individuals and families, such as affordable housing, education, and healthcare.
However, high income earners especially businesses may evade taxes and the rise in
direct taxes may cause a disincentive to work and produce, reducing the overall growth
and incomes in the country.
Additionally, fiscal policy can also encourage income equality by investing in physical
and human capital. For example, investing in infrastructure and education can increase
the productivity and earning potential of lower-skilled workers, leading to higher wages
and a more equal distribution of income.
However, this may take a long time to materialize and govt will face an opportunity cost
of other areas where this money could have been spent.
Means-tested benefits are another way in which fiscal policy can help with reducing
income gaps. These benefits are targeted towards the most vulnerable groups in the
economy e.g., unemployed, retired and extremely poor. Taxes taken from rich and
given to such groups can certainly improve income distribution, but they create a
“poverty trap”.
Poverty trap refers to situation where unemployment benefits are too close to minimum
wage and workers if they join work will still remain poor as govt will withdraw the
benefits being paid. This causes a disincentive to join work and workers tend to stay
home receiving the unemployment benefits from the govt.
Another way is negative income tax scheme where are families declare their income
and govt pays them a subsidy. Those on very low income end up receiving the subsidy
instead of paying tax. This policy again weakens work incentive and reduces efficiency
in the country.

However, fiscal policy alone is not sufficient to address the root causes of income
inequality, such as discrimination, lack of access to educational and job opportunities,
and technological change. To achieve a more equal distribution of income, it may be
necessary to also address these underlying issues through a combination of fiscal,
monetary, and structural policy measures, as well as social and cultural changes.

In conclusion, while fiscal policy can play a role in promoting a more equal distribution of
income, it should be viewed as just one part of a larger effort to address the complex
and multi-faceted issue of income inequality.
Q 2 Discuss how a govt’s policies towards income and wealth distribution can affect a
consumer’s demand. [12]
 37

Policies aimed at redistributing incomes can have a significant impact on consumer

demand. This is because changes in income levels can influence how much consumers
are able to spend on goods and services.
If the government implements policies that increase the incomes of lower-income
households, for example, by providing direct cash transfers, tax credits, or social
welfare programs, these households may have more disposable income to spend on
goods and services. As a result, consumer demand for a wide range of products and
services may increase, stimulating economic growth.
On the other hand, if the government implements policies that decrease the incomes of
higher-income households, for example, by increasing taxes or reducing benefits, these
households may have less disposable income to spend. This could result in a decrease
in consumer demand for luxury goods and services, potentially leading to a slowdown in
economic growth.
It's important to note that the impact of income redistribution policies on consumer
demand can be influenced by a number of factors, including the size of the
redistribution, the specific groups of people targeted by the policies, and the state of the
overall economy.

In general, however, policies aimed at redistributing income can play an important role
in shaping consumer demand and the overall health of an economy.
Unit 9 Past paper questions (MOST IMPORTANT)
O/N 21 / P 42 / Q 5
Q) Discuss the extent to which GDP is a useful measure of living standards [20] Repeat
question
O/N 20 / P42 / Q7 b
Discuss why alternatives to GDP are increasingly used to measure the standard of living
[20]
O/N 19 / P43 / Q7
There have been many attempts to measure changes in living standards both within
and between countries. Although some have been more useful than others, none of
these alternative measures has produced a sufficiently accurate, indicator of change in
living standards. “How far would you agree with this statement”? [20]
All of the above have a similar answer, just change it a bit according to the
statement of question
 38

Ans) Countries use many measures of living standards or economic development to

compare their own performance with the past and with other countries as well.
Economic development/living standards refers to the overall quality of life in the country.
It is a much wider concept than economic growth and includes not just monetary, but
also other many non-monetary factors such as education, healthcare, environmental
conditions, leisure time, law and order, freedom of speech etc.
The most common measure of living standards is GDP which is the money value of all
output produced within the geographical boundaries of a country over a year.
GDP rise indicates economic growth and hence rise in incomes which mean people can
buy more goods and services, afford better education and healthcare, improving their
quality of life. GDP can be converted into real GDP which accounts for the effect of
inflation in the country. It can be converted into real GDP per capita by dividing real
GDP with population to enable comparison of average income per head.
However, GDP has many limitations as a measure of development as discussed below.
 39

Therefore, countries use other measures as well such as HDI, NEW/MEW and MPI etc.
Human Development Index (HDI) is a composite measure of economic development
which includes 1/3rd weightage to GNP at purchasing power parity, 1/3rd Literacy index
i.e., average years of schooling for a 25-year-old in a country and his school attendance
and 1/3rd to life expectancy index i.e., how many years a new born can expect to live.
If a country scores 1 HDI, it means fully developed and if the answer is 0, totally
underdeveloped
The benefit of using HDI over GDP is that It is a more composite measure and shows
better indication of development. However, it is not the most commonly used measure
and HDI Figures not available easily
 40

Net Economic Welfare/Measurable economic welfare (NEW/MEW) can also be used.

This measure adjusts GDP to become a better measure of development
We add the value of hidden economy and leisure time to GDP and subtract the value of
external costs etc. from GDP.
It is an attempt to improve the most common measure of living standards i.e., GDP, but
it is difficult to find figures for comparisons and it involves a lot of guess work to
estimate hidden economy and external costs etc. hence becomes an inaccurate and
normative measure.
Multidimensional Poverty Index (MPI) is a United Nations’ measure that indicates the
level of poverty in a country. It judges living standards on three indicators, namely
“education” which is judged by years of schooling and school attendance for a person,
“healthcare” which is judged by infant mortality and nourishment and “living standards”
which is judged on cooking, fuel, sanitation, floor space, assets and availability of clean
drinking water.
A weightage of 33% is given to each of these indicators. If a family scores poorly on any
of the 33%, it is considered multidimensionally poor. It is said that a family is considered
poor if it has lost one child and the other one is not attending school.
MPI allows to indicate the level of poverty and in turn level of development or living
standards in a country. It allows for future planning by govts and international
organizations like UNICEF.
However, it is more concerned with level of poverty rather than level of development of
people. Cost of colleting figures may be high and inaccuracies in figures might exit
especially in developing countries.
Considering the above discussion NO one measure is satisfactorily describing living
standards, hence a combination of quantitative measures such as GDP, real GNP per
capita and a host of qualitative measures like HDI, NEW/MEW, MPI, GPI etc. may be
needed to indicate a better picture of economic development and living standards.
41