Edexcel Economics Paper 2, June 2018

Section A

(a) D

You are not required to explain your answer to this question. However:

The trade agreement is designed to create free trade, which implies a lack of tariffs.
It is therefore most likely that tariffs on European exports to Canada will decrease.

(b) Comparative advantage exists when a country can make a product at lower
opportunity cost than other nations. In the example, below, Canada has an absolute
advantage in both products (it can produce both products more efficiently), but has
the lower opportunity cost only in Timber. The UK has its comparative advantage in
financial services. By each country specialising in the products where they have their
comparative advantages, there will be a higher total output of both products and
this output can be shared between the countries through trade, in order to increase
their GDP.

Output per resource Timber Financial Services Opp cost

unit
Canada 20 20 1T = 1FS
UK 5 10 1T = 2FS

There are 4 marks available for this question. Two marks are available for
knowledge, such as the definitions of comparative advantage and absolute
advantage. The use of the numerical example secures a mark for application and the
analysis of the example earns a fourth mark. Please note that this question explicitly
requires the use of comparative advantage, so full marks would not be possible
without including this concept in the answer.

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(a) D

You are not required to explain your answer to this question. However:

All income is either consumed or saved. A fall in the marginal propensity to consume
implies that a greater percentage of each £ of income will be consumed. This will
cause AD to increase because consumption is a component of AD.

(AD = C + I + G + X –M)

(b)

There are 4 marks available for this question. A fully correct and labelled diagram
earns all the marks because the command is simply to “draw an AS/AD diagram to
illustrate…….” This means there is no need for any written analysis. Some marks
could be earned even if there were inaccuracies in the diagram such as missing
labels. I always stress to students that they should draw diagrams in a logical order,
beginning with the “initial set up”. This means labelling the axes correctly, along
with the original AS and AD curves and initial equilibrium. Only having done this
should they shift a curve, and add labels to the new curve and the equilibrium.
Students have a tendency to draw all the curves and then go back and add labels,
but this can result in errors such as labelling AD1 and AD2 the wrong way round.

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(a) 1998: Deficit = £200bn. 2006: Deficit = £800bn

% change = (Change/original value) x 100

% change = (£600bn/£200bn ) x 100

% change = 300% increase

The correct answer will score the full 2 marks even if no working is shown, but it is
highly advisable to show working. A mark may be awarded for an incorrect answer if
some of the calculations and/or method are correct.

(b) The current account of the balance of payments is a record of international income
and expenditure for a country over a period of time. Income is recorded as an inflow
(credit) and expenditure as an outflow (debit). The figures in the current account
relate to trade in goods, trade in services, primary income and secondary income.

There are 2 marks available for this question and these are earned by a fully correct
explanation of the term “current account of the balance of payments”. A partially
correct explanation such as the “current account of the balance of payments is
exports minus imports” would score only 1 mark.

(c) C

You are not required to explain your answer to this question. However:

The current account balance has a negative value throughout the time period shown
in the chart. The current account is therefore always in deficit.

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Edexcel Economics Paper 2, June 2018

(a) A budget surplus exists when taxation revenue is greater than government spending.
One likely reason why the 2019 budget surplus target was abandoned is that the
economy grew more slowly than had been hoped. This would result in lower income
and corporation tax receipts, making a budget surplus more difficult to achieve.

Two marks are available for this question, 1 mark for correctly identifying a likely
reason why the 2019 budget surplus target was abandoned and another for analysis
(‘linked development’) of this reason.

(b) The UK national debt is the accumulation of budget deficits over time less any
surpluses. Abandoning the surplus target means deficits, where government
spending is greater than taxation revenue are more likely. This implies that the
national debt is likely to increase.

Two marks are available for this question, 1 mark for correctly identifying the likely
impact of abandoning the budget surplus target and another for analysis (‘linked
development’) of this impact.

(c) B

You are not required to explain your answer to this question. However:

The budget surplus relates to government spending and taxation revenue. Fiscal
policy is defined as policy in relation to government spending and taxation.

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(a) One reason why the demand for bank loans may have increased is due to higher
consumer confidence. Confident consumers are more likely to believe they can
repay the loans in the future and may therefore be willing to borrow to buy big-
ticket items like cars and holidays.

Two marks are available for this question, 1 mark for correctly identifying a reason
why demand for bank loans may have increased and another for analysis (‘linked
development’) of this reason.

(b) B

You are not required to explain your answer to this question. However:

Borrowing is usually for the purpose of consumption and thus consumption is likely
to increase. An improvement in net trade is unlikely because some of this
consumption will involve spending on imports. An increase in unemployment is
unlikely because more consumption will generate a higher derived demand for
labour. Deflation is an unlikely result because more consumption will add to
aggregate demand.

(c) Bank lending in 2015 is given the value 100 because this is the base year.

In 2016, bank lending has increased by 4% since 2015.

2016 index = 104

The correct answer will score the full 2 marks even if no working is shown, but it is
highly advisable to show working. A mark may be awarded for an incorrect answer if
some of the calculations and/or method are correct.

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Section B
Parts of this resource are colour coded to show the skills that are used.

Knowledge = black Analysis = blue Application = purple Evaluation = Green

Please note that there is some overlap between the skills and, especially in longer questions, worth
12 marks and more, there may be some scope for interpretation as to which skill is being shown at a
particular point. The skill of knowledge can be demonstrated by knowledge of relevant points, by
defining key terms and knowledge of economic facts. Analysis involves detailed explanation using a
‘links in chain’ approach. Application can be shown either by applying the data extracts or by writing
in the context provided by the question, for example a particular market in microeconomics, or
country in macroeconomics. It is important that evaluative comments and judgements are
supported using economic analysis and application to context wherever possible.

(a) Absolute poverty affects those who lack basic necessities such as food, water and
shelter. It therefore threatens human survival. It is measured by the World Bank
using an income threshold of $1.90 per day (using 2011 purchasing power parity
exchange rates) as seen in Figure 1.

In contrast, to be in relative poverty is to be poor relative to other members of

society. It is usually measured using a threshold of 50 or 60% of median income. It
is thus possible to be in relative poverty without being in absolute poverty. For
example, in the UK, rates of absolute poverty are low, but relative poverty rates
significantly higher.

There are 5 marks available for this question. Correct definitions of both absolute
and relative poverty earn 1 mark each. A further two marks are scored for
application such as “threshold of $1.90 per day” and “threshold of 50 or 60% of
median income”. The fifth mark is for analysis (“linked development). Note that the
question required that reference be made to the information provided, such as
Figure 1.

(b) Figure 1 shows that there has been a much more rapid decline in the absolute
poverty rate in East Asia (from more than 60% in 1990 to around 5% in 2012) than in
Sub-Saharan Africa (55% in 1990 to around 45% in 2012).

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Edexcel Economics Paper 2, June 2018

One factor that might explain the more rapid decline in absolute poverty in East Asia
is greater access to education than in Sub-Saharan Africa. Extract B says that there
are “an estimated 780m illiterate adults worldwide”. If lack of education
disproportionately affects Sub-Saharan Africa, this would affect the skills of its
workforce, reducing the productivity of labour (output per hour per worker). This
would limit the capacity of the economy and constrain economic growth. The rapid
economic growth achieved in East Asia in recent decades has been of particular
significance in explaining its poverty reduction.

A second factor is that there may be “lower chances of receiving key healthcare” in
Sub-Saharan Africa than in East Asia. Lack of healthcare may mean that worker have
to take more time of work or the spread of illness and disease could mean that the
labour force is reduced by high death rates. Again, this constrains economic capacity
and growth. Lack of access to healthcare has been a key factor restraining economic
growth in Sub-Saharan Africa with, for example, high infant mortality rates and the
spread of AIDS through lack of knowledge and access to appropriate contraception.

For 8 mark questions such as this one, there are 2 marks available for knowledge, 2
for analysis, 2 marks for application (eg application of the data extracts or
application of theory to particular examples), and 2 marks for evaluation (achieved
as 1 mark for each of 2 evaluative comments).

(c) One macroeconomic policy that might be used to reduce the negative effects of
globalisation is the use of fiscal policy. For example there could be “more activist
demand management” (Extract B). During slowdown or recession, government
spending could be increased or income tax be reduced. Cutting income tax would
increase disposable income, helping to support higher levels of consumption and
aggregate demand. This would result in a higher derived demand for labour and
lower unemployment. Through demand management, the government would
provide a greater net injection into the circular flow of income during periods of
slowdown, helping to reduce the output gap. There are further advantages to the
policy. For example, the injection would generate a bigger impact on national
income. The multiplier might be large in a developing economy because leakages
through savings and imports are often small. Furthermore, demand management
could be beneficial by targeting the measures to help the poor. For example, tax
cuts could be focused on low-income earners or increased spending be allocated to
education and healthcare.

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A second macroeconomic policy that could be used is “structural reform to boost

growth”. Such reforms could include greater openness to foreign direct investment
and measures to encourage entrepreneurship such as lower rates of corporation tax.
These measures should result in supply-side improvements such as boosting the
quantity and quality of capital stock, increasing the productive potential of the
economy and facilitating long-run economic growth. Reforms of this nature may be
hugely beneficial because they allow for sustainable economic growth, in the sense
that the economy can support higher levels of aggregate demand without
experiencing inflation because it has the capacity to produce more goods and
services. Sustainable economic growth of this kind tends to be associated with
significant poverty reduction, as seen in Sub-Saharan Africa. It is true, however, that
supply-side improvements are not quick and easy to achieve and the need to reduce
the negative effects of globalisation in developing countries may be so pressing that
it requires quicker solutions.

For 12 mark questions such as this one, a mark out of 8 is given for the skills of
knowledge, analysis and application (KAA) collectively (using a mark scheme that
features 3 levels of response). A mark out of 4 is given for evaluation (using a mark
scheme that features 2 levels of response). To get top marks for evaluation, it is
important to support evaluative comments with relevant reasoning and appropriate
reference to the context of the question.

Please note that this particular question required the covering of two policies, so
including only one reason would significantly have affected the level and mark for
KAA. Similarly the question was explicit that protectionism could not be one of the
policies. If protectionism had been included as a policy, the examiners would simply
have discounted it.

(d) “Some level of inequality is desirable to maintain an appropriate incentive structure”

because it encourages behaviour that will support growth and development. For
example, if wages are much higher in the IT industry in India than in the textile
industry, workers have greater incentive to train to enhance their IT skills. This
improve their productivity and allows them to command a higher wage. Wage
differentials can reflect “different levels of effort” and thus individuals are
encouraged to work harder. These effects are likely to lead to an improved quantity
and quality of labour supply to the economy, supporting economic growth, which in
turn leads to poverty reduction.

Furthermore, inequality may be associated with lower taxes. A progressive tax

system is often used to redistribute income within an economy and lessen

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inequality. Features of a progressive tax system include higher income tax rates for
high income earners and high rates of corporation tax. If these taxes are reduced,
more skilled workers may be attracted to the economy and, due to the profit motive,
more business start-ups are likely to occur. Foreign direct investment may be
attracted. Again, the capacity of the economy is boosted, this time through the
greater availability of capital and entrepreneurship as factors of production.

It is important to note, however, the emphasis on an “appropriate level” of

inequality to act as an incentive. Very high levels of inequality are associated with
high rates of relative poverty and could be inappropriate because they could actually
be de-incentivising for those with low incomes who may feel that the high standards
of living enjoyed by others are completely out of their reach. In this sense,
inequality may be harmful to economic growth. The benefits of inequality as an
incentive in developing countries may also be limited by lack of access to education
and training. Workers are likely to need to acquire new skills in order to rise up the
income ladder, but may not have the means to teach themselves these skills, nor
access to the education and training they need. This may mean that workers wish to
gain new skills but are unable to regardless of the incentive of higher wages.

For 10 mark questions such as this one, a mark out of 6 is given for the skills of
knowledge, analysis and application (KAA) collectively (using a mark scheme that
features 3 levels of response). A mark out of 4 is given for evaluation (using a mark
scheme that features 2 levels of response). To get top marks for evaluation, it is
important to support evaluative comments with relevant reasoning and appropriate
reference to the context of the question.

(e) A key role of the financial sector in the growth and development of developing
countries is that banks act as financial intermediaries. This means that they accept
deposits from savers, then lend to consumers and firms who wish to borrow.
Lending to firms for investment purposes is particularly important for growth and
development. Investment adds to the capital stock, thus increasing the capacity of
the economy and allowing for sustainable economic growth. Indeed, according to
the Harrod-Domar model, an economy’s growth rate is determined fundamentally
by its savings ratio along with the productivity of its capital. The existence of an
efficient means of channelling funds from savers to borrower is thus a vital
determinant of economic growth. The importance of the financial sector in this
regard may be reduced in developing countries by the fact that some saving occurs
outside of the banking system. For example, those engaged in subsistence farming

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may make small savings of grain each year or those who save currency may do so
without ever depositing it with a bank.

The growth of microfinance has been particularly important in development in

recent years. Microfinance provides for the funding of small scale investment
projects, often tied directly to development objectives. For example, microfinance
may be used to provide funding at reduced interest rates to help a community install
water supply, thus meeting basic needs. This is important as it is less likely to lead to
“development-less growth” than lending on commercial terms to larger
organisations. Such growth occurs when national income rises but is accompanied
by increases in inequality and fails to meet basic needs in order to sustain life.

The financial sector is also important in terms of growth and development because it
allows for the exchange of currencies. Exports, for example of agricultural produce
or tourism, tend to be important in development terms. The exchange of currencies
is important to international trade and can allow developing countries to specialise
in line with their comparative advantage and thus to achieve a higher standard of
living. For instance, in the example below, India has a comparative advantage in
textiles because it can produce a unit of textiles by giving up 0.02 of a mobile phone:
1T = 0.02MP. This means that India can produce textiles at a lower opportunity cost
than China where 1T = 0.04MP and could potentially specialise in textile production
while China specialises in making mobile phones.

Output per resource unit Textiles Mobile phones

India 50 1
China 100 4

If India and China can trade at terms of trade anywhere between these domestic
opportunity cost ratios, trade can be mutually beneficial to both countries. For
example, if the terms of trade are 1T = 0.025MP, then India could swap each 50 units
of textiles it makes for 1.25 mobile phones thereby experiencing increased living
standards compared to self-sufficiency. India’s production possibilities per resource
unit are shown in Figure 1, along with its consumption possibilities following trade,
and the gains from trade it can achieve.

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Edexcel Economics Paper 2, June 2018

Figure 1: The gains from specialisation and trade

The financial sector may not be able to play these roles in growth and development
efficiently for a number of reasons. A key reason in developing countries is
inadequate protection of property rights, often accompanied by corruption. Studies
show that there is a clear statistical correlation between these factors and poor rates
of growth and development. For example, entrepreneurs have little incentive to
invest if they do not believe their ownership of the capital they create will be
protected by the government. This means that they will not necessarily borrow from
the financial sector and that rates of investment and growth may be low. Similarly,
savings may never reach financial intermediaries if there are fears that the deposits
will not be protected. Corruption by government officials may mean, for example,
that development funds are not allocated to where they will have the most impact
but instead for the personal gain of those officials. Further complications in the role
of the financial sector include the possibility that financial markets may themselves
fail. For instance, there may be monopoly providers of finance in a particular
developing country, with price-making power leading to exploitative interest rates
which would discourage borrowing and investment. The global financial crisis of
2008-2009 could be seen as a huge market failure which may have impacted on
access to funding in developing countries.

For 15 mark questions such as this one, a mark out of 9 is given for the skills of
knowledge, analysis and application (KAA) collectively (using a mark scheme that
features 3 levels of response). A mark out of 6 is given for evaluation (using a mark
scheme that features 3 levels of response). To get top marks for evaluation, it is
important to support evaluation with relevant reasoning and appropriate reference
to the context of the question.

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Edexcel Economics Paper 2, June 2018

The answer I have written here is arguably longer than would be possible under
exam conditions and offers multiple examples of all the relevant exam skills. It may
be necessary to shorten the answer because of pressure of time.

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Section C
Parts of this resource are colour coded to show the skills that are used.

Knowledge = black Analysis = blue Application = purple Evaluation = Green

Please note that there is some overlap between the skills and, especially in longer questions, worth
12 marks and more, there may be some scope for interpretation as to which skill is being shown at a
particular point. The skill of knowledge can be demonstrated by knowledge of relevant points, by
defining key terms and knowledge of economic facts. Analysis involves detailed explanation using a
‘links in chain’ approach. Application can be shown either by applying the data extracts or by writing
in the context provided by the question, for example a particular market in microeconomics, or
country in macroeconomics. It is important that evaluative comments and judgements are
supported using economic analysis and application to context wherever possible.

One economic impact of the planned increase in government expenditure of £23bn over
five years is to increase aggregate demand for goods and services produced in the UK
economy. Government spending is a component of aggregate demand (AD = C + I + G + X –
M) and the resulting increase in the derived demand for labour and other factors of
production will help to close the output gap. This will enable short run growth as firms use
the spare capacity in the economy to meet their increased orders. Further, the injection
into the circular flow of income should generate a multiplier effect as the government
spending creates jobs and incomes, leading to further rounds of spending and income
creation. For example, those employed in infrastructure projects may spend their income in
shops and restaurants boosting the local economy. Figure 1 highlights the possibility that an
increase in aggregate demand can help the economy to grow, with real output increasing
from Y1 to YP.
Figure 1: The effect on AD of an increase in government expenditure

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Edexcel Economics Paper 2, June 2018

It should be noted, however, that the increase of £23bn is not huge, especially when spread
over 5 years. In the 2017 election, the Liberal Democrats proposed to increase the rate of
income tax by one penny in each pound and suggested that it would increase taxation
revenue by £6bn a year. Thus, the increase in spending suggested by the government is
quite modest and is unlikely to have a huge impact on the economy. This is especially the
case when we keep in mind that the UK is an open economy with a high marginal propensity
to import, in virtue of the fact that we have a relatively small manufacturing sector. This
means that the multiplier is quite small. Although Cloyne (2013) suggested that the
multiplier for the UK may reach a maximum of 2.5, other economists suggest much smaller
values. Cloyne also indicated that it would take 10 quarters, which is two-and-a-half years,
for the full impact of the multiplier to be felt. This indicates that the long run impact on
aggregate demand will be greater than the short run effect, although it is likely that neither
will be large.

Government expenditure on innovation and infrastructure should also help to boost the
supply-side of the economy. For example, spending on infrastructure may increase the
geographical mobility of labour. It is possible that the spending will boost labour
productivity (output per worker per hour). In this way, the capacity of the economy, which
is a function of the quantity and quality of resources available is boosted. This allows for the
economy to achieve sustainable long run economic growth, able to accommodate a higher
level of aggregate demand without generating inflationary pressure. Indeed, supply-side
improvements hold the advantage that simultaneous improvement with regard to all four of
the government’s main macroeconomic objectives (growth, low inflation, low
unemployment and an acceptable trade position) is possible, in contrast to changes in the
level of aggregate demand which tend to involve trade-offs between the objectives. This
said, in the current context of the UK economy, demand-pull inflation does not appear to be
a significant worry.

The supply-side boost to the UK economy could be particularly valuable. The UK has long
lagged behind key comparator nations such as the USA and Germany in terms of labour
productivity. 2018 figures from the OECD show that productivity in the UK is about 26%
below that in the USA. Over recent years the UK’s “productivity puzzle” has particularly
troubled economists and any measures to boost UK productivity must surely be welcomed,
although there is no guarantee that they will be effective. The UK has invested in, and
reformed, the supply side of its economy for many years without being able to close its
productivity gap.

The emphasis on innovation via the increased government expenditure may help to boost
the UK’s trade position, which has long seen a significant deficit on the current account of
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Edexcel Economics Paper 2, June 2018

the balance of payments. Due to relatively high wages and thus high unit labour costs, the
UK struggles to compete on price against manufactured goods from economies such as
China. However, the UK is more strongly placed to compete on non-price factors.
Innovation would generate UK products with unique features which would create the basis
for customer loyalty and inelastic demand. UK products would then be able to command a
price premium while still finding a significant market. The sale of these UK exports would
generate foreign currency earnings and credits on the current account of the balance of
payments, helping to reduce the deficit.

Such an improvement in the current account would be useful for the UK’s macroeconomic
performance, especially as the UK runs a structural deficit. This means that the deficit is
always there, smaller during recessions when reduced income means less consumer
spending and thus less imports, but larger during recovery and boom. Current account
deficits must be financed by inflows on the capital account such as international borrowing
by UK firms and this implies incurring liabilities that must be repaid in the future. In
essence, running a current account deficit means enjoying a higher standard of living today
at the expense of living standards in the future and it would be a good thing for the UK to
reduce the deficit by becoming more competitive on non-price factors via the increase in
government spending on innovation.

Overall, the additional £23bn spending on innovation and infrastructure is most likely to
have positive impacts on the UK economy, although as indicated, these may be quite small.
The most significant benefits are perhaps those to the supply-side of the economy, where
the boost can help to generate sustainable growth. There are downsides, such as spending
more at a time when the rising national debt is a cause for concern. However, we should
not be too worried about this, bearing in mind that if the increase in government
expenditure does boost national income, this will increase the base of taxable economic
activity and generate higher tax rates in the future.

For 25 mark questions such as this one, a mark out of 16 is given for the skills of knowledge,
analysis and application (KAA) collectively (using a mark scheme that features 4 levels of
response). Knowledge can be shown by definitions of key terms, or simply knowledge of a
relevant point to discuss. Your answer should feature extended chains of analysis (the more
links in a chain of analysis, the stronger the analysis is) and diagrams can be used to support
this analysis. As a general rule, I recommend that you include a diagram in each 25 marker.
Your answer should also feature application to the “real world” context given in the
question. The use of real world facts and examples is an important way of showing
application.

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Edexcel Economics Paper 2, June 2018

A mark out of 9 is given for evaluation (using a mark scheme that features 3 levels of
response). To get top marks for evaluation, it is important to support evaluative comments
with relevant reasoning and appropriate reference to the context of the question.
Evaluation should recognise different viewpoints and be critical of evidence and
assumptions underlying analysis.

Informed judgements are of vital importance in 25 markers. These are most likely to be
seen in the conclusion, but there should ideally be evaluation throughout the essay, helping
to support a final judgement. I recommend a structure where each point is covered in a
paragraph that features knowledge, analysis and application (KAA) and that point is then
immediately evaluated. The evaluation can usefully be conducted in a separate paragraph
to break the work up and avoid paragraphs that are too lengthy.

Your conclusion should pass the conclusion test, which means that the examiner should
know what the question is simply by reading your conclusion and nothing else. If this isn’t
the case, the chances are that you have not really answered the question. The easiest way
to pass the conclusion test is to use the exact wording of the question in stating your final
judgement. Your final judgement should be based on the evaluation earlier in your essay. I
also recommend that you include “something extra” in your conclusion so that you are not
simply summarising what you have written earlier in your essay. For example, you may
choose to bring in a new piece of real world evidence to bring further support to your
judgement.

For this particular question it is important to recognise that increases in government

spending have impacts on both the demand and supply sides of the economy. The majority
of students recognise that government spending contributes to demand and can offer some
analysis and evaluation of its impact, but many do not include coverage of the impact on the
supply side of the economy. The evaluation of the size of the UK multiplier in this answer is
particularly strong and could be transferred to many other questions about injections into
the circular flow (investment, government spending and exports).

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A likely impact of a fall in the British pound by over 10% against the US dollar is to boost
demand for UK exports and hence future economic growth. This is because consumers in
the US will have to give up less of their own currency to buy UK products. For example, if
the pound depreciates from £1 = $1.70 to £1 = $1.53, then consumers in the US would have
to pay $153 for a product priced at £100 instead of $170. The fall in price experienced by
US consumers would lead them to substitute towards UK exports in preference to products
produced in the US. Similarly, UK consumers are more likely to buy UK products rather than
importing. This is because they receive less dollars in exchange for each pound and
therefore have lower purchasing power when buying products from the US. These effects
combine to increase UK net exports (X-M) and therefore to increase UK aggregate demand
(AD = C + I + G + X – M). The resulting increase in the derived demand for labour and other
factors of production will help to close the output gap. This will enable short run growth as
firms use the spare capacity in the economy to meet their increased orders and GDP grows.
Figure 1 highlights the possibility that an increase in aggregate demand can help the
economy to grow, with real output increasing from Y1 to YP.

Figure 1: The effect on output of an increase in net exports due to a depreciation of the pound

Further, the injection into the circular flow of income should generate a multiplier effect as
the boost to exports creates jobs and incomes, leading to further rounds of spending and
income creation. For example, those employed in the export sector may spend their
income in shops and restaurants boosting the local economy. This said, the UK may be
poorly placed to take advantage of the depreciation in its currency. This is because has a
primarily service based economy, while the manufacturing sector is generally regarded as
more “tradable”. US consumers cannot turn towards the UK if it does not have the products
to sell. Moreover, the multiplier effect of the initial injection may be small because of the

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UK’s high marginal propensity to import, meaning that a substantial proportion of the
injection leaks out at each stage of the circular flow of income. Although Cloyne (2013)
suggested that the multiplier for the UK may reach a maximum of 2.5, other economists
suggest much smaller values. Cloyne also indicated that it would take 10 quarters, which is
two-and-a-half years, for the full impact of the multiplier to be felt. This indicates that the
long run impact on the depreciation of the currency on aggregate demand and thus
economic growth will be greater than the short run effect.

Further reason for thinking that long run impact will be greater than the short run impact is
that it will take time for firms and consumers to adjust to the currency change. For
example, firms in the USA may be locked into contracts to buy raw materials and finished
goods from other firms in their domestic economy and may not immediately be able to
substitute towards UK exports. The impact will be felt over time as existing contracts
expire, meaning that the elasticity of demand for UK exports increases the longer the time
that has elapsed since the depreciation. The same is true of elasticity of demand for
imports. The Marshall-Lerner condition suggests that net exports will only increase
following a depreciation if the elasticities of demand for imports and exports sum to greater
than one. In the short run this condition may not be satisfied and net exports may actually
fall, dampening economic growth. In the longer term, perhaps 18-24 months looking at the
evidence from previous large depreciations of the , such as that which occurred during the
financial crisis of 2008, net exports are more likely to rise, this supporting economic growth.

In theory, the currency depreciation might not boost economic growth but instead be a
cause of inflation. This is because the increase in aggregate demand that it may cause could
be a source of demand-pull inflation if there is limited spare capacity in the economy. This
could be the result of “too much spending chasing too few goods” giving UK firms the
confidence to put up prices. For this to happen, however, not only would there have to be
little spare capacity but it would probably be necessary for the depreciation of the pound to
be not just large (10% is a fairly significant depreciation) but sustained. The depreciation
might also be a source of cost-push inflation as imported raw materials from the USA
become more expensive for UK firms. The increased production costs would reduce
profitability and firms may attempt to pass some or all of this cost increase on to consumers
as higher prices in an attempt to restore profit margins. Indeed, the experience of recent
depreciations has been that they have been accompanied by cost-push inflation. For
example, in 2018 in the wake of a 25% depreciation of the pound, inflation reached 5.2%,
although this was caused partly by other factors such as growth in China pushing up
demand for commodities such as wheat and this forcing food prices to rise. If the
depreciation of the pound is accompanied by inflation, there is a danger that the economy
might not grow, because wages may not keep pace with inflation and real wages may fall,
leading to falls in consumption.

Overall, the impact of a fall of over 10% in the pound sterling against the US dollar on the
future economic growth of the UK is likely to be positive due to a rise in net exports.
However, the effect may take time to occur and may not be large due to constraints such as

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the relatively small manufacturing base in the UK. The effect may be very small indeed if
the depreciation of the pound is not sustained and we should note that, in reality, exchange
rates are notoriously volatile. Thus the depreciation may impact on future UK growth to
only a limited extent. Growth that does occur is not likely to occur evenly across the
economy and is most likely to be concentrated in sectors of the economy where exports are
important, such as manufacturing. This may imply that growth will also be concentrated in
geographical region where manufacturing is important to the local economy, such as large
parts of the north and the midlands.

For 25 mark questions such as this one, a mark out of 16 is given for the skills of knowledge,
analysis and application (KAA) collectively (using a mark scheme that features 4 levels of
response). Knowledge can be shown by definitions of key terms, or simply knowledge of a
relevant point to discuss. Your answer should feature extended chains of analysis (the more
links in a chain of analysis, the stronger the analysis is) and diagrams can be used to support
this analysis. As a general rule, I recommend that you include a diagram in each 25 marker.
Your answer should also feature application to the “real world” context given in the
question. The use of real world facts and examples is an important way of showing
application.

A mark out of 9 is given for evaluation (using a mark scheme that features 3 levels of
response). To get top marks for evaluation, it is important to support evaluative comments
with relevant reasoning and appropriate reference to the context of the question.
Evaluation should recognise different viewpoints and be critical of evidence and
assumptions underlying analysis.

Informed judgements are of vital importance in 25 markers. These are most likely to be
seen in the conclusion, but there should ideally be evaluation throughout the essay, helping
to support a final judgement. I recommend a structure where each point is covered in a
paragraph that features knowledge, analysis and application (KAA) and that point is then
immediately evaluated. The evaluation can usefully be conducted in a separate paragraph
to break the work up and avoid paragraphs that are too lengthy.

Your conclusion should pass the conclusion test, which means that the examiner should
know what the question is simply by reading your conclusion and nothing else. If this isn’t
the case, the chances are that you have not really answered the question. The easiest way
to pass the conclusion test is to use the exact wording of the question in stating your final
judgement. Your final judgement should be based on the evaluation earlier in your essay. I
also recommend that you include “something extra” in your conclusion so that you are not
simply summarising what you have written earlier in your essay. For example, you may
choose to bring in a new piece of real world evidence to bring further support to your
judgement.

For questions such as this one which focus on exchange rate fluctuations, the Marshall-
Lerner condition, which tends to be satisfied in the long run but not in the short run, offers a

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Edexcel Economics Paper 2, June 2018

very useful route to evaluation. A particularly strong feature of this answer is the depth of
analysis offered for the impact of the depreciation in increasing aggregate demand and
economic growth. This analysis is transferable to other questions which require discussion
of the impact of increasing aggregate demand.

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