Cambridge International AS and A Level Economics

Answers to Coursebook activities

Chapter 4: The macroeconomy
Self-assessment task 4.1 (page 85)
A reduction in the rate of interest would be likely to increase aggregate demand, aggregate supply and national
output. The effect on the price level will depend on the relative shifts of AD and AS.
An increase in government spending on health care will also be likely to increase AD, AS and national output.
The effect on the price level will again depend on the relative shifts of AD and AS.
Advances in information technology will increase AS, result in an expansion in AD and an increase in national
output and put downward pressure on the price level.
Net emigration suggests more people are leaving the country than entering and hence a possible reduction in
the size of the labour force. This will shift the LRAS curve to the left leading to a fall in national output and a
movement along the AD curve and a rise in inflation. This depends on the size of net emigration and the skills
and age of the workforce lost.
A cut in income tax will increase AD. It may also increase AS if it acts as an incentive for existing workers to
work more hours and for more people to enter the labour force. It will increase national output and again the
effects on the price level will depend on the relative size of the two shifts.
An increase in wealth will increase AD. This is likely to cause an extension in AS, an increase in national output
and possibly a rise in the price level. Note: in all cases the outcome will be influenced by the initial level of
economic activity.

Self-assessment task 4.2 (page 85)

1 The AD and LRAS curves had shifted significantly to the left by 2010 but were beginning to shift right. However,
the Irish economy was still operating on the horizontal section of the Keynesian LRAS curve as there was still
plenty of spare capacity, as indicated by the high unemployment rate.
2 With significant pay cuts and rises in income tax, consumer expenditure would have been severely constrained
leading to a shift left of the AD curve.

Self-assessment task 4.3 (page 88)

1 An increase in government spending will shift the AD curve to the right, leading to a rise in inflation.
2 Greater confidence in the currency and lower inflation rates.

Self-assessment task 4.4 (page 91)

1 Inflation can erode the value of savings as it reduces the purchasing power of a given level of savings, ceteris
paribus. Interest rates on savings accounts might be below inflation, thus reducing the real value of savings.
2 It depends on how much each item falls by and its relative weight in the basket of goods and services. A small
fall in the price of a large number of items with relatively low weights can be offset by large price rises in fewer
but more significant or heavily weighted items.
3 A depreciation in the Brazilian real would cause an increase in the price of imported goods such as food, fuel and raw
materials, which will raise costs of production leading to a rise in factory gate prices, hence an increase in inflation.
4 a Brazils inflation rate remained the same, which means that prices rose by the same rate in 2008 and 2009. It
does not mean that prices stayed the same, i.e., they increased at the same rate in 2008 as 2009.
b Brazils inflation rate fell from 5.3% to 5.0% so inflation was rising but at a slower rate.
5 Venezuela and Brazils inflation rate both doubled in the period although Venezuelas inflation rate was almost
six times greater than Brazils. Mexicos inflation rate has remained fairly stable during the period.
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Self-assessment task 4.5 (page 93)

1 The proportion of goods consumed that are bought from overseas.
2 An increase in interest, profits and/or dividends received by domestic economic agents.
3 An improvement in the balance of trade can occur for two reasons: a country can either export more or import
less in value terms. Output and productivity had improved in the US leading to lower average costs enabling US
firms to become more price competitive, thus increasing exports. Secondly, the ageing demographic of the US
population means that the nations propensity to import falls as older people tend to spend more on services that
are domestically produced and relatively less on goods that are imported.

Self-assessment task 4.6 (page 94)

a Credits: $24,696m + $5,035m + $826m + $17,686m = $48,243m
Debits: $40,461m + $8,227m + $4,071m + $142m = $52,901m
Current balance = $48,243m $52,901m = $4,658 deficit
b Net of workers remittances: ($32,325m $13,186m) $52,901m = $33,762m deficit
c $20,576 + $1,312m + $220m = $19,044m

Self-assessment task 4.7 (page 98)

1 Fixed as it only allowed to change by +/1% either side of a rate set by the central bank.
2 If the countrys real exchange rate rose more than its nominal rate it suggests that its domestic price index
was relatively high. The higher a countrys inflation rate in relation to its trading partners, the higher its real
exchange rate will be.
3 Rapid growth will shift AD to the right and a shortage of workers will reduce spare capacity, therefore the economy
will be operating on the vertical section of the LRAS curve, pushing up costs of production and increasing inflation.
Moreover, the central bank may raise interest rates in order to dampen inflation, which will lead to an increase in
demand for the renminbi, ceteris paribus, further increasing the countrys real exchange rate.

Self-assessment task 4.8 (page 101)

1 A rise in a countrys current account deficit suggests that the demand for its imports (in value terms) is greater
than demand for its exports (also in value terms), therefore more of the domestic currency is being supplied,
shifting the supply curve to the right (and/or less being demanded, thereby shifting the demand curve to the
left), which will push down the exchange rate.
2 A rise in the exchange value of sterling means that the currency is appreciating. UK tourists planning to holiday
abroad will get more foreign currency for each unit of sterling exchanged whereas foreign citizens will get less
sterling for each unit of their currency exchanged. As a result, exports become relatively more expensive and
imports become relatively cheaper.
3 Following on from the above, an appreciation of a currency could lead to further current account deficits and
higher unemployment, as demand for the countrys goods and services falls in overseas markets, and domestic
products potentially being replaced by imported ones. However, it could lead to lower import costs, e.g., fuel and
raw materials, and thus reduce firms costs of production, leading to lower inflation. The answer depends on how
reliant the country is on exports, the change in the value of the currency and the price elasticity of demand for
imports and exports.

Self-assessment task 4.9 (page 103)

1 Not only does Peru have an abundance of fish, which are used in producing fishmeal, but the workforce have
developed their skills in the industry over time.
2 Comparative advantage occurs where one country can produce a good with a lower opportunity cost ratio than
another country, whereas a competitive advantage means that a country can sell a product more cheaply than
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another country. A country might not have a comparative advantage in producing the good but it can gain a
competitive advantage by, for example, lowering its countrys exchange rate through devaluation or depreciation
or through government subsidies directed at the industry.

Self-assessment task 4.10 (page 105)

1 Answers might include:
Distribution costs are reduced; greater market knowledge; dealing with fewer currencies so lower exchange
rate risks; a country can gain from specialisation. However, it leads to over-reliance on one market. If there is a
downturn in that market then exports could be severely affected, e.g., recession in the USA would lead to a fall
in demand for Canadian goods and services, thus increasing the current account deficit.
2 In a free trade area trade restrictions such as tariffs and quotas are reduced between member states but each
country is free to set the level of their own trade restrictions against non-members, whereas in an economic union
such as the EU all members apply the same trade restrictions (e.g., the Common External Tariff) on non-members.
Furthermore, an economic union might extend the freedom of movement to labour and capital as well as goods.
3 Canadas current account position deteriorated considerably over the period moving into deficit in 2009,
whereas Denmarks current account position improved with an average surplus of 3.2% of GDP throughout the
period. This could be explained by the fact that Denmark is less reliant on a narrow range of trading partners
compared to Canada.

Self-assessment task 4.11 (page 111)

1 A favourable or soft loan occurs where the rate of interest applied to a loan is below the commercial rate. This
might give an exporter an unfair advantage if its competitors do not have access to the same favourable rate. As
it lowers investment costs and is backed by government it could be considered as a subsidy.
2 Dumping means selling a product on foreign markets below its average costs of production, giving producers
a competitive advantage. This can undercut domestic producers and lead to consumers replacing domestically
produced goods with imported ones. It is viewed as unfair as it distorts comparative advantage, masks relative
inefficiency and can lead to more efficient firms exiting the market.
3 Although a subsidy can reduce costs of production enabling a firm to lower its selling price, it may not increase
exports if:
the good is poor quality
the lower costs of production are offset by rising exchange rates, making exported goods relatively more expensive
the firm decides to keep prices the same but use the additional subsidy to boost profits
there is a downturn in export markets.

Exam-style questions
1 Components of current account defined [2] and balance of trade in goods [1]. Understanding of the differences
between deficits and surpluses [1]. Explanation that a deficit in a countrys balance of trade could be offset
by surpluses on the other components of its current account, i.e., services, income and current transfers with
appropriate examples [up to 4 marks].
2 A strong exchange rate might help to reduce the relative price of imports and increase the relative price of
exports thus reducing aggregate demand. This would reduce cost-push inflation but increase the current account
deficit/reduce surplus. However, the impact depends on the price elasticities of demand for imports and exports
and how close the economy is operating to full capacity.
[For knowledge and understanding of the targets identified up to 2 marks. For analysis of the links between
the targets up to 6 marks. For discussion of the trade-offs between inflation and the balance of payments in the
context of a strong exchange rate up to 4 marks]

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3 a Prices in July 2008 (approximately $800) were 300% higher than in 2002, i.e., four times higher. Therefore
divide 800/4 = $200.
b From November 2007 to April 2008 the price of rice rose due to export restrictions by India and Vietnam [1],
which led to a shift in the supply curve to the left and an increase in the price of rice on the world market [1].
However, after May 2008 the Japanese authorities released quantities of previously held stock [1] leading to a
shift right of the supply curve and hence a fall in price [1].
c To increase supply of rice onto the domestic market [1] in order to make it more affordable, especially for
lowincome households [1]. As rice is a staple food in India [1] it will reduce household expenditure and
improve standards of living [1]. Lower price of rice will put downward pressure on inflation [1] depending on
its weight in the basket of goods and services bought by the typical household [1].
d i To be effective, minimum prices should be set above the prevailing equilibrium price in order to protect
producers. This can be shown on a diagram. Producers could earn more revenue by selling their goods in
domestic markets rather than world markets. It should lead to higher earnings [up to 2 marks].
ii Offering to pay exporters a minimum price has an opportunity cost: it will increase government
expenditure and so increase the budget deficit/lower spending elsewhere. The minimum price might have
been set too low in order for it to be effective so fewer products, e.g., rice, are being diverted to the domestic
market [up to 2 marks].
e Protectionism involves protecting domestic industries from foreign competition. It restricts free trade
and the methods used often seek to increase domestic industries relative price competitiveness. For the
Indian economy export restrictions could lead to lower export earnings and a deterioration in its balance of
payments current account. Its trading partners might switch to alternative suppliers and so the country could
lose market share in the longer run. Furthermore, it could trigger retaliation from its major trading partners.
For other economies it could lead to higher import prices and less choice for consumers, which will impact
on their welfare. Importing nations might switch to higher cost producers (i.e., trade diversion) leading to a
welfare loss.
The impact depends on how much trade is affected, e.g., one good or a wide range of goods and services,
and the length of time of the restrictions. We must also consider reaction of other countries. For example, a
reduction in exports of rice from India could be offset by increased supplies onto global markets from Japan.
[Up to 3 marks for each side of the argument]

Cambridge University Press 2015 Cambridge International AS and A Level Economics Chapter 4 Coursebook activities 4