2nd edition

Edexcel AS
Economics
Peter Smith

Answers
 Contents
Unit 1 Competitive markets: how they work and why
they fail
Chapter 1 Introducing economics. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3
Chapter 2 The nature of demand. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5
Chapter 3 The nature of supply . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7
Chapter 4 Market equilibrium and price. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9
Chapter 5 The price mechanism in action . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11
Chapter 6 The market for labour . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13
Chapter 7 Market failure and externalities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15
Chapter 8 Other forms of market failure. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16
Chapter 9 Government intervention and government failure. . . . . . . . . . . 18

Unit 2 Managing the economy

Chapter 10 Measuring economic performance. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19
Chapter 11 Developed and developing countries. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20
Chapter 12 Income, wealth and the circular flow. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21
Chapter 13 Aggregate demand. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22
Chapter 14 Aggregate supply and macroeconomic equilibrium . . . . . . . . . 23
Chapter 15 Economic growth. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24
Chapter 16 Macroeconomic policy objectives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25
Chapter 17 Macroeconomic policy instruments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27

2 Edexcel AS Economics
Introducing economics Chapter 1

1 Answer: B
Explanation:
● Resources are limited in supply.

● Wants are unlimited so the issue of scarcity arises.

● Therefore, choices must be made which involve opportunity cost (the

sacrifice of the next most desired alternative). (1 + 3 marks)

2 Answer: D
Explanation:
● Definition of opportunity cost: the sacrifice of the next most desired

alternative.
● A movement from B to C means that, to get more capital goods, some

consumer goods must be sacrificed. An annotated diagram could be used to

show this.
● Answer C is incorrect because no opportunity cost is incurred since

unemployed resources are being used.

● Answer B is incorrect because a movement from B to Y could mean that more

of both goods can be produced. (1 + 3 marks)

3 Answer: D
Explanation:
● Definition of sustainable resource: one which is not depleted when used.

● Explanation that energy generated from wind does not use up finite

resources.
● All other methods are incorrect because coal, oil and shale gas are depleted

when used. (1 + 3 marks)

4 Answer: D
Explanation:
● In a market economy prices are determined by the interaction of supply and

demand.
● A change in consumer demand for a particular good would cause a shift in

the demand curve and a change in its price.

● A supply and demand diagram could be used to illustrate this.

5 Answer: C
Explanation:
● Definition of a positive economic statement.

● Definition of a normative economic statement.

● Application: the first statement can be verified by reference to published

data.
● The second statement contains the word ‘should’, which implies a value

judgement. (1 + 3 marks)

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Unit 1

6 Answer: A
Explanation:
● Definition of division of labour: subdivision of one task into a series of sub-

tasks.
● Workers are trained to do one specific sub-task.

● Therefore, workers will have a limited skill and if they lose their jobs, they

may lack skills for alternative jobs.

● Answer B is incorrect because firms do usually use division of labour as a

means of increasing productivity. (1 + 3 marks)

4 Edexcel AS Economics
The nature of demand Chapter 2

1 Answer: D
Explanation:
● Higher real incomes imply that people are better able to afford to buy a new

car.
● This would cause demand to increase, so shifting the demand curve to the

right.
● Answers A and B are incorrect because these are conditions of supply, and

would cause a shift in the supply curve.

● Answer C is incorrect because cars and petrol are complements, so a rise in

petrol prices would cause a decrease in demand for cars. (1 + 3 marks)

2 Answer: A
Explanation:
● A subsidy is a grant which reduces the cost of production.

● Therefore, a subsidy would cause a rightward shift in the supply curve for

bread so causing a movement along the demand curve for wheat. This could
be illustrated with a diagram.
● The other answers all impact on the demand curve for bread. (1 + 3 marks)

3 Answer: B
Explanation:
● Definition of an inferior good: an increase in real income causes a fall in

demand.
● Definition of a normal good: an increase in real income causes a rise in

demand.
● Rice has a negative income elasticity of demand (YED) and is therefore an

inferior good, but carrots have a positive YED and are a normal good.
● Answer D is incorrect because demand for carrots is price inelastic and

income inelastic. (1 + 3 marks)

4 Answer: D (and also B)

Explanation:
● Definition of price elasticity of demand (PED): a change in price causes a

more than proportionate change in quantity demanded.

● If a new substitute becomes available, then demand for the product will be

more sensitive to a price change because the rival product is similar.

● Answer A is incorrect because it affects price elasticity of supply (PES).

● Answer B is correct because if a product becomes more durable, it is easier

for consumers to postpone the purchase of a replacement.

● Answer C is incorrect because this would make demand less sensitive to a

price change. (1 + 3 marks)

Answers © Peter Smith 5

Unit 1

5 Answer: A
Explanation:
● Definition of cross-price elasticity of demand (XED): the responsiveness

of a change in quantity demanded of product B to a change in the price of

product A (or give the formula for XED).
● A complement refers to a product which is used in conjunction with another

product.
● Example: an increase in the price of cars would cause a fall in demand for

petrol then the XED would be negative. (1 + 3 marks)

6 Answer: B
Explanation:
● Definition of price elasticity of demand (PED): a change in price causes a

more than proportionate change in quantity demanded.

● Total revenue is price × quantity demanded.

● Therefore, a fall in price from £10 to £9 (10%) causes the quantity demanded

to rise from 100 kilos to 150 kilos (50%), and total revenue would rise from
£1,000 to £1,350.
● Answer D is incorrect because nothing can be inferred about profits without

knowing the impact on costs. (1 + 3 marks)

6 Edexcel AS Economics
The nature of supply Chapter 3

1 Answer: D
Explanation:
● An increase in productivity causes a fall in the costs of production so causing

an increase in supply.
● Answer A is incorrect because it would cause a decrease in supply.

● Answers B and C would affect the demand curve. (1 + 3 marks)

2 Answer: A
Explanation:
● A health scare would cause the demand for beef to fall, so causing a leftward

shift of the demand curve. This could be illustrated by a supply and demand
diagram.
● Answers B and D are incorrect because they would cause a rightward shift in

the supply curve.

● Answer C is also incorrect because it would cause a leftward shift in the

supply curve (because costs of production would increase). (1 + 3 marks)

3 Answer: C
Explanation:
● Value added tax (VAT) is an indirect tax which is a percentage of the price of

a product.
● It causes an increase in the cost of supplying the product.

● Therefore, the more tax paid, the higher the price, so causing the new supply

curve to be steeper than the original supply curve. This can be illustrated by
a diagram. (1 + 3 marks)

4 Answer: B
Explanation:
● Definition of inelastic supply: when a change in price causes a less than

proportionate change in quantity supplied.

● Perishable goods cannot be stored.

● Therefore, supply cannot be changed quickly in response to a change in

demand.
● Answers A and C are incorrect because they would affect price elasticity of

demand (PED). (1 + 3 marks)

5 Answer: D
Explanation:
● Definition of price elasticity of supply (PES): the responsiveness of quantity

supplied to a change in price (or give the formula for PES).

● Substitute values into the formula to find that PES = 1 or unity.

● Answer A is incorrect because if supply is perfectly inelastic, the PES would

equal 0.

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Unit 1

● Answer B is incorrect because if supply is perfectly inelastic, the PES would

equal 0.
● Answer C is incorrect because if supply is perfectly elastic, the PES would

equal infinity. (1 + 3 marks)

6 Answer: B
Explanation:
● A subsidy is a grant from the government which reduces the costs of

production so causing the supply curve to shift to the right.

● In turn, this would cause the price of honey to fall. This can be illustrated by

a supply and demand diagram.

● Answers C and D are incorrect because a subsidy would shift the

supply curve to the right, i.e. more would be supplied at each

given price. (1 + 3 marks)

8 Edexcel AS Economics
Market equilibrium
and price Chapter 4

1 Answer: C
Explanation:
● Definition/characteristic of a free market economy: e.g. private ownership of

resources; profit motive.

● Understanding of the price mechanism: interaction of supply and demand to

determine price.
● Therefore, the role of the price mechanism cannot be to keep prices stable

since they will change as a result of changes in conditions of demand and/or

supply.
● Answers A, B and D are all functions of the price mechanism. (1 + 3 marks)
2 Answer: C
Explanation:
● Price would fall to equilibrium level which would cause an extension of

demand and a contraction of supply. This can be illustrated with a supply

and demand diagram.
● Answer B is incorrect because the price is already above its equilibrium

level.
● Answer D is incorrect because there is nothing to suggest that conditions of

demand have changed. (1 + 3 marks)

3 Answer: B
Explanation:
● An increase in supply would cause the whole supply curve to shift to the

right.
● This should be drawn on the diagram.

● The result will be a fall in the price and a movement down the demand curve

(extension of demand). (1 + 3 marks)

4 Answer: C
Explanation:
● Definition of consumer surplus: difference between how much consumers

are willing to pay and the market price.

● Definition of producer surplus: difference between the market price and cost

of supply.
● An increase in demand will cause the whole demand curve to shift to the

right and so cause an increase in both consumer surplus and producer

surplus — this can be shown on the diagram. (1 + 3 marks)

5 Answer: A
Explanation:
● Definition of production possibility frontier: combinations of two goods

which could be produced assuming all resources are fully employed.

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Unit 1

● Diagram to illustrate a production possibility frontier.

● Any point inside the production possibility frontier would imply that there
unemployed resources, whereas any point to the right of the production
possibility frontier is unattainable. (1 + 3 marks)

10 Edexcel AS Economics
The price mechanism
in action Chapter 5

1 ● An increase in VAT would cause the supply curve to shift to the left and
become steeper. The diagram should be included.
● This would cause a rise in price and fall in quantity. (6 marks)

2 a ● Demand and supply are very price inelastic.

● Supply is subject to significant changes resulting from changes in weather

conditions.
● Demand may also change in response to changes in tastes and the prices of

substitutes such as tea.

● A supply and demand curve diagram should be included showing either a

shift in the supply curve or the demand curve. (8 marks)

b Explanation of a buffer stock scheme: e.g. a scheme by which price
●

fluctuations are reduced by removing some of the coffee from the market
when there are bumper harvests and releasing stocks of coffee when there
are poor harvests.
● Diagram to illustrate a buffer stock scheme (see page 114 in the textbook).

● Effect of scheme: coffee price should fluctuate less, therefore the revenues

of producers should fluctuate less; consumers will have greater certainty

about price.
Evaluative comments could include:

● The difficulty of setting the floor and ceiling prices to equate long-run

supply and demand.

● A series of good harvests would cause stocks to increase steadily with

associated costs.
● Or, a series of shortages would mean that there were insufficient stocks to

keep the price below the ceiling price. (14 marks)

3 a ● Demand for rented accommodation has increased because of the difficulty of
securing mortgages from banks and building societies as well as the need to
provide large deposits.
● Supply and demand diagram showing a rightward shift in the demand

curve for rented accommodation with a consequent rise in price and

increase in quantity. (6 marks)
b Factors include:
● Mortgage interest rates.

● State of the economy and job security.

● Cost of renting accommodation.

● Size and age distribution of population. (8 marks)

c ● Definition of elasticity of supply: responsiveness of quantity supplied to a
change in price.
● Supply likely to be inelastic, i.e. a change in price would cause a less than

Answers © Peter Smith 11

Unit 1

proportionate change in quantity supplied because of the time taken to

gain planning permission and then the time to actually build the
houses.(8 marks)
d ● Definition of subsidy: grant from the government to producers which have
the effect of reducing the cost of supply.
● Supply and demand diagram showing a rightward shift of the supply

curve for houses, resulting in a fall in the price of new houses and a rise in
quantity.
● Effect on consumers: more people will be able to afford to buy new houses

causing less demand for rented accommodation.

● Effects on house building companies: increased demand resulting in higher

sales and increased revenues. Also, more demand for household goods as
house sales increase.
Evaluative comments might include the following:

● The effect on price depends on the amount of the subsidy and the elasticity

of demand for new houses.

● The subsidy might have little impact if other costs of building new houses

rises or if house builders do not pass the subsidy on to house buyers.

● Demand may be price inelastic if confidence about the future state of the

economy is low. (14 marks)

12 Edexcel AS Economics
The market for labour Chapter 6

1 Answer: C
Explanation:
● Demand for workers in the vegetable farming industry is a derived demand,

i.e. it is dependent on the demand for the final product.

● If machinery becomes cheaper relative to labour, more machinery will be

used.
● In turn, this will cause a reduction in the demand for workers.

● All other answers would imply an increased demand for workers. (1 + 3 marks)

2 Answer: C
Explanation:
● Definition of inelastic demand for labour: a change in the wage rate causes a

less than proportionate change in the demand for the product.

● If wage costs are a small proportion of the firm’s total costs, then a change in

the wage rate will have little impact on the demand for labour.
● Answer B is incorrect because if it is easy to replace workers with machines,

then the demand for labour would be elastic. (1 + 3 marks)

3 a ● Explanation of a National Minimum Wage: a legally binding minimum

amount which a firm must pay its workers per hour.
● Possible reason: to decrease inequality, i.e. it should mean that the gap

between the highest and lowest paid workers would decrease. (4 marks)
b ● Number of tourists and business people requiring hotel accommodation.
● Quality of service provided by hotels. (6 marks)
c Workers in the hotel industry are frequently paid low wages so an increase
●

in the National Minimum Wage would have a significant impact.

● However, it may be difficult to replace workers with machines because it

is a labour-intensive service industry. Therefore, the demand for labour is

likely to be inelastic.
● Since many of the jobs in the tourist industry are relatively unskilled,

supply may be fairly elastic. This should be illustrated with a diagram

showing the National Minimum Wage above the free market wage.
● The extent of job losses depends on how much the National Minimum

Wage is above the equilibrium wage, the price elasticity of demand

(PED) for hotel workers and the price elasticity of supply (PES)
of hotel workers. (14 marks)
d The supply of labour to the hotel industry will depend on factors such as:
● Size of working population, but this could be supplemented by

immigration.
● Wage rate, but the basic wage rate may be less significant in this industry

because workers often receive tips.

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Unit 1

● Level of skills required: e.g. specialist qualifications required for chefs in

contrast to the few qualifications required for cleaners, but some hotels
provide in-house training.
● Hours and conditions of work: the anti-social hours may be a significant

factor in deterring people from working in this industry. (14 marks)

14 Edexcel AS Economics
Market failure and
externalities Chapter 7

1 Answer: D
Explanation:
● Characteristics of positive consumption externalities: non-excludability and

non-rivalrous.
● Reason why these would not be provided in a market economy: the free-rider

problem.
● Consequently, resources would not be allocated efficiently. (1 + 3 marks)
2 Answer: D
Explanation:
● OX is the free market level of output (where MPB = MPC).

● OY is the socially efficient level of output (where MSB = MSC).

● Welfare loss at OX would be ABC. Therefore, a reduction in output below OX

would reduce the welfare loss. (1 + 3 marks)

3 a ● Private benefits of production of new vaccine: revenue to the company
producing the vaccine.
● Private benefits of consumption of new vaccine: consumers enjoy better

health, i.e. no coughs and colds. (4 marks)

b ● Definition of opportunity cost: sacrifice of the next most desired alternative
when a choice is made.
● By providing the vaccine free to consumers, there may have to be cutbacks

in other parts of the health service, or cuts in other forms of public

expenditure.(6 marks)
c Definition of external benefits: benefits to third parties who are not part
●

of the transaction; or the difference between social benefits and private

benefits.
● Examples of the external benefits of the new vaccine: less absenteeism

from jobs, resulting in higher production and revenues for producers; lower
costs for the National Health Service as fewer people get complications
from coughs and colds and have to visit their doctor or the local hospital.
● Include a diagram to show external benefits of consumption.

Evaluative comments could include:

● The difficulty of quantifying the external benefits.

● The long-run effects might be greater than the short run effects.

● The costs of providing the vaccine free of charge must be

considered. (14 marks)

Answers © Peter Smith 15

 Other forms of market
Chapter 8 failure
1 Answer: D
Explanation:
● Non-excludability implies that once the good is supplied it is impossible to

prevent people from using it.

● Therefore, if someone has provided the product, others may use it without

charge — a free-rider.
● This may be illustrated by means of an example.

● Answer B is incorrect because resources are used to produce a public good

which has alternative uses. (1 + 3 marks)

2 Answer: D
Explanation:
● Definition of non-exludability: that once the good is supplied it is impossible

to prevent people from using it.

● Definition of non-rivalrous: consumption by one person does not limit

consumption by others.
● Example of a public good contrasted with an example of a private good.

● Answer C is incorrect because private goods would only be under-provided if

there were external benefits. (1 + 3 marks)

3 Answer: A
Explanation:
● There are information gaps: people do not know how long they will live; they

do not know what their needs will be in retirement.

● Therefore, there is a need for government intervention or provision.

● Answer C is incorrect because life expectancy is increasing in most

countries. (1 + 3 marks)

4 Answer: C
Explanation:
● Definition of occupational mobility of labour: movement of workers between

different occupations.
● With fewer training programmes it would be more difficult for the

unemployed to get jobs in other occupations.

● Answers A, B and D would increase geographical mobility of labour so are

incorrect. (1 + 3 marks)

5 Answer: C
Explanation:
● Definition of inelastic demand: a change in price causes a less than

proportionate change in quantity demanded.

● Definition of inelastic supply: a change in price causes a less than

proportionate change in quantity supplied.

16 Edexcel AS Economics
 Other forms of market failure Chapter 8

● Therefore, a shift in either the demand curve or supply curve would cause a
sharp change in price. This could be illustrated with a supply and demand
diagram.
● Answer D is incorrect because a continuous fall in demand for maize would

cause a continuous fall in its price. (1 + 3 marks)

6 Answer: B
Explanation:
● Definition of a buffer stock scheme: a system in which surpluses are stored

and then released in times of shortage.

● A buffer stock scheme usually involves ceiling and floor prices.

● The operation of a buffer stock scheme may be illustrated by means of a

diagram.
● Answer C is incorrect because the scheme could cost the government

money if it were operated by the government and there were

continuous surpluses. (1 + 3 marks)

Answers © Peter Smith 17

 Government intervention
Chapter 9 and government failure
a ● Private costs: those incurred by the consumer in buying the product, e.g. the
price of a packet of cigarettes.
● External costs: those incurred by the producer in making the product, e.g.

the cost of raw tobacco. (4 marks)

b Diagram showing leftward shift in supply curve causing a rise in price and fall
in quantity with supporting explanation, i.e. a tax causes an increase in the cost
of supply so causing a decrease in supply. (6 marks)
c ● Definition of government failure: when intervention by the government in
the market leads to a net welfare loss.
● In this case, the tax on tobacco has been increased significantly which has

led to an increase in smuggling, the development of black markets and a fall

in tax revenues from tobacco.
● However, the higher tax has led to fewer people smoking and becoming ill

from smoking-related diseases.

● High taxes on tobacco have also reduced demands on the NHS. (10 marks)
d ● A minimum price for alcohol implies that no price can be charged below that
set in law.
● If the minimum price is above the equilibrium price, then the quantity

demanded will fall and the quantity supplied would increase, resulting in a
surplus. This can be illustrated by a diagram.
● The effects on the different economic agents should be considered:

— on alcohol producers: they would suffer a fall in demand and revenues

(unless demand is very price inelastic)
— on consumers: they would face higher prices and fall in consumer surplus
(depends on how much the minimum price is above the equilibrium
price)
— on the government: it may suffer a fall in revenue from taxes on alcohol
(depends on the price elasticity of demand) (14 marks)
e There are two alternative ways by which the government might discourage
alcohol consumption: education or a complete ban on alcohol consumption.
Education:
● programmes to inform people about the dangers of drinking alcohol

● these should be aimed at decreasing consumption to the socially efficient

output
● but this involves cost to the government

● also these may be ineffective

Complete ban:
● eliminates all the disadvantages of alcohol consumption

● but there are implications for alcohol producers and their employees

● and there are problems with the cost of enforcement (and no tax revenue to

the government) (14 marks)

18 Edexcel AS Economics
Measuring economic
performance Chapter 10

1 Nominal GDP is the value of goods and services produced by a country in a

year in money terms, whereas real GDP measures the change in the volume of
goods and services produced in a year, i.e. the effects of inflation have been
discounted.(4 marks)
2 a China’s output increased between 2011 and 2012 but at a slower rate than in
2011.(4 marks)
b The level of prices in Brazil was higher in 2011 than in 2012. However, prices
were increasing less quickly in 2012 than in 2011. (4 marks)
c The UK’s balance of trade in goods and services deficit implies that the value
of goods and services imported is greater than the value of goods and ser-
vices exported. This deficit rose by £0.2bn. (4 marks)
3 Economic growth implies that the production possibility frontier would shift to
the right. (4 marks)
4 The consumer price index is constructed by:
● Selecting a base year to which a value of 100 is given.

● Surveying 7,000 households (the Living Costs and Food Survey).

● Assigning weights to each product in accordance with their relative

importance in consumer expenditure.

● Conducting a price survey of 650 goods and services.

● Multiplying price changes by the weights to give a price index. (6 marks)

5 ● The claimant count measures those who have claimed Job Seekers’
Allowance (JSA).
● It excludes those ineligible to claim JSA, even if they are technically

unemployed.
● The ILO is a survey.

● It measures those who have been out of work for 4 weeks and are available

for work in 2 weeks. (6 marks)

6 a A fall in the demand for UK goods and services will cause a fall in demand
for sterling on the foreign exchange market, causing a fall in the exchange
rate.(4 marks)
b A decrease in demand for foreign imports will reduce the supply of sterling
on the foreign exchange market, causing a rise in the value of the pound
sterling.(4 marks)

Answers © Peter Smith 19

 Developed and developing
Chapter 11 countries
1 a ‘GDP per capita based on purchasing power parity’ is the total value of all
goods and services produced in the country at prices prevailing in the
USA in a particular year, divided by the total population. (6 marks)
b ● The definition of living standards relates not only to income per head but also
to quality of life and welfare.
● GDP by itself takes no account of changes in population or of changes in

income distribution.  (12 marks)

2 a The Human Development Index (HDI) is a composite measure of develop-

ment and consists of three elements:
● health: life expectancy

● education: expected years of schooling

● income: gross national income per capita at purchasing power

parity (4 marks)
b Advantages:
● The HDI takes a broader measure of welfare than income alone.

● The information is usually readily available and so cheap to collect.

● It gives a better indication of future living standards.

● It might be indicative of successful government policies.

However:

● The HDI gives no indication of poverty.

● There is no indication of changes in income distribution.

● The GDP measure may quickly become out of date as exchange rates

fluctuate.
● There is no indication of changes in quality of life and consumer

welfare.(12 marks)
c Other measures could include:
● The percentage of the population with access to the internet.

● The percentage of the adult male population employed in agriculture.

The benefits and disadvantages of each of these measures should be

considered. (12 marks)

20 Edexcel AS Economics
Income, wealth and the
circular flow Chapter 12

a Income is a flow of money around the economy, whereas wealth is a stock of

assets. (4 marks)
b ‘Real income per head will be lower’ means that total income divided by population
and discounting the effect of inflation will have decreased. (4 marks)
c ● Leakages (withdrawals) are an outflow from the circular flow of income.
Savings, taxes and imports are leakages.
● Injections are inflows into the circular flow of income. Investment,

government expenditure and exports are injections. (6 marks)

d See the diagram on page 163 of the textbook. (6 marks)
e ● Definition of investment: increase in capital goods.
● Definition of economic growth: increase in real GDP.

● Investment would lead to an increase in aggregate demand (since it is a

component of aggregate demand) and also an increase in long-run aggregate

supply because the country’s productive capacity has increased. Therefore,
economic growth will increase. (12 marks)

Answers © Peter Smith 21

Chapter 13 Aggregate demand
a The components of aggregate demand are: C + I + G + (X – M). Only G
(government expenditure) is not mentioned. (6 marks)
b Two factors include:
● Changes in real incomes: this is usually considered to be the most important

factor influencing consumption. However, other factors such as consumer

confidence may play a greater role, especially in times of great economic
uncertainty.
● Changes in interest rates: these affect the cost of borrowing and the

opportunity cost of saving. However, the inflation rate must also be

considered because this will determine the real interest rate. Further,
other factors such as job security might be more significant in determining
consumer expenditure. (12 marks)
c The UK’s trade deficit increased from £23bn to £37bn. This implies that leakages
increased relative to injections. Therefore, aggregate demand would fall. (6 marks)
d ● Investment: increase in capital stock.
● Rate of interest: cost of money. (12 marks)
e Two factors include:
● Expectations about the future state of the economy — decisions about

investment are closely related to the prospects of making profits.

● The profits of companies: many businesses use past profits to finance

investment.  (8 marks)
f If the marginal propensity to save (MPS) increases, then the value of the
●

multiplier would fall.

● The multiplier formula (in a two-sector economy) is 1/MPS.

● Therefore, the higher the value of the MPS, the lower will be the value of the

multiplier (8 marks)
g ● House prices are an asset which is a form of wealth.
● A rise in house prices would, therefore, represent an increase in wealth.

● This would increase consumer confidence and enable homeowners to

increase their borrowing on the basis of the increased value of their houses.
● Consequently, consumer spending would increase.

● As consumption is a component of aggregate demand, the AD curve would

shift to the right, causing an increase in real output and in the price level.
● Higher real output would result in a decrease in unemployment (12 marks)

22 Edexcel AS Economics
Aggregate supply and
macroeconomic equilibrium Chapter 14

a Aggregate supply: the amount producers in the economy are willing to supply at
various price levels. (4 marks)
b ● An increase in oil prices represents an increase in costs of production.
● Therefore, the short-run aggregate supply curve will shift to the left causing

an increase in the price level and fall in real output.

● The AD/AS diagram should show the original AD and AS curves with a new

AS curve to the left of the original one.

● The impact on real output and price level will depend on the gradient of the

AD curve: if it is very steep, there will be a small decrease in real output but
a large rise in the price level.
Other analysis:
● Since the UK is a net importer of oil, the rise in the price of oil will cause a

decrease in net exports, which will result in a decrease in aggregate demand.

● This would result in a fall in real output and a fall in the price level. In

practice, this effect is likely to be less significant than the impact on

aggregate supply. (12 marks)
c ● Public expenditure (G) is a component of aggregate demand.
● Therefore, a decrease in public expenditure would cause a decrease in

aggregate demand (and to a leftward shift in the AD curve).

● In turn, this would cause a fall in the price level and a fall in real output.

● Since G is an injection to the circular flow, a decrease in G would cause GDP

to fall by a large proportion via the multiplier effect. (8 marks)

d ● Definition of productivity: usually this relates to labour productivity, i.e.
output per worker per hour worked.
● An increase in US productivity would cause a rightward shift in the

aggregate supply curve.

● This would cause a decrease in the price level and an increase in real output

in the US.
● It implies that US goods and services would become more competitive

relative to UK goods and services.

● Consequently, the UK’s trade balance with the USA may deteriorate. (12 marks)

Answers © Peter Smith 23

Chapter 15 Economic growth
a The output gap is the difference between actual GDP and the potential GDP. It
can be illustrated with an AD/AS diagram, with the equilibrium level of real
output at a level lower than the full employment level of real output. (4 marks)
b The possible consequences include:
● It implies that actual output is lower than that required to produce full

employment.
● It could mean that the economy is in recession, i.e. at least two quarters of

negative economic growth.

● This suggests that there would be involuntary unemployment, but this might

be small if employers hoard labour in the hope that the situation would be
temporary.
● It is likely that there would be a fall in the rate of inflation because demand–

pull inflation would be depressed. However, if inflation is being caused by

cost factors, then there would be little impact on the rate of inflation. (12 marks)
c Export-led growth is when growth in real GDP is caused primarily by a sustained
increase in exports. (4 marks)
d Possible factors include:
● An increase in foreign direct investment: this would cause an increase in the

productive capacity of the country enabling more goods to be produced.

● A sustained increase in exports resulting from increased competitiveness

and/or increased demand for the country’s goods and services. (12 marks)
e Definition of economic growth: increase in real GDP.
●

● Diagram to illustrate economic growth, e.g. a rightward shift in the

production possibility curve or an AD/AS diagram showing a rightward shift

in the AS curve.
● The costs of economic growth include:

– external costs, e.g. pollution

– the opportunity cost of growth: the sacrifice of present consumption so
that resources can be reallocated to the production of capital goods
– increased inequality: the possibility that benefits of growth will go to
entrepreneurs rather than to workers
– depletion of non-renewable resources
● Benefits of economic growth include:

– an increase in living standards: higher real incomes could be used by

consumers to improve their quality of life
– increased tax revenues for the government: these could be used to improve
public services such as education and health, or to redistribute wealth to
the poor
– increased revenues and profits for firms who benefit from increased
demand for their goods: in turn, shareholders might benefit from increased
dividends (30 marks)

24 Edexcel AS Economics
Macroeconomic policy
objectives Chapter 16

1 a The weights used in the CPI are changed each year to reflect the changes in
the relative importance of products in consumers’ expenditure. (4 marks)
b ● A fall in the rate of inflation could imply an increase in the competitiveness of
a country’s goods and services. In turn, this could lead to an improvement in
the country’s trade in goods and service balance.
● It could also lead to a cut in the base rate of interest by the Bank of

England’s Monetary Policy Committee if the rate of inflation is below

(or expected to fall below) the 2% target. In turn, this could lead to an
increase in consumption and in investment. (8 marks)

2 a ● The claimant count is calculated on the basis of those who have claimed
Job Seekers’ Allowance (JSA) and who are actively seeking work; various
exclusions apply, e.g. the savings cap.
● The ILO method measures those who have been out of work for 4 weeks

and who are available for work in 2 weeks. It is based on a survey/

interview covering the age range is 16–65 and is internationally
comparable. (8 marks)
b Two costs include:
● A waste of resources: the economy would be operating inside its production

possibility frontier; these goods are lost for ever.

● The cost to taxpayers: the government would have less tax revenue and

would have to increase expenditure on transfer payments in the form of

benefits to the unemployed, such as JSA, housing benefits. (8 marks)

3 ● Definition of a recession: at least two consecutive quarters of negative

economic growth.
● A recession is usually associated with increased unemployment so it might

be expected that inequality would increase.

● Some industries are likely to be more affected than others so unemployment

will not be spread evenly across industries or geographical areas.

● The increase in inequality may be offset by transfer payments from the

government to the unemployed, or by measures to retrain workers and/or to

find new jobs for unemployed workers. (12 marks)

4 ● Definition of balance of payments on current account: this primarily relates

to the value of goods and services exported minus the value of goods and
services imported (together with investment income and current transfers).
● An increase in real income is likely to lead to an increase in consumption.

● Some of this extra consumption will be on imported goods.

● Consequently, there is likely to be a deterioration in the current account of

the balance of payments.

Answers © Peter Smith 25

Unit 2

● But, much depends on the marginal propensity to import, i.e. that proportion
of an increase in imports that is spent on consumer goods.
● Also, the cause of the increase in real income may be significant. For

example, if it is caused by an increase in exports then the impact on the

current account will be less significant than if it was caused by higher
wages. (12 marks)

5 ● Definition of economic growth: increase in real GDP.

● Other macroeconomic objectives include full employment, a low rate of

inflation and balance of payments equilibrium.

● Economic growth and full employment: increasing economic growth implies

an increase in real incomes. Therefore, demand for goods and services

should increase which would cause an increase in the demand for labour so
helping to ensure there is no conflict between growth and full employment.
However, the jobs created may only be part-time or low-skilled.
● Economic growth and a low rate of inflation: economic growth is associated

with higher real incomes which may lead to increased consumption. This
could cause an increase in the rate of inflation. However, this may not be
the case if growth has been caused by increased investment which would
increase long-run aggregate supply and so reduce inflationary pressures.
● Economic growth and a clean environment: economic growth is associated

with the increased production of goods and services. In turn, this is likely to
result in an increase in the external costs associated with increased energy
use and an increase in pollution and waste. However, as a country becomes
richer, it has more resources to combat such external costs so the conflict
may be more evident in developing countries rather than in developed
economies. (30 marks)

26 Edexcel AS Economics
Macroeconomic policy
instruments Chapter 17

1 ● Definition of crowding out: this is when increased government expenditure

leads to an increased fiscal deficit and a higher national debt.
● In turn, this could cause an increase in the rate of interest at which the

government can finance its extra borrowing.

● This would cause financial crowding out because it will be more expensive

for firms to borrow money. (6 marks)

2 ● Expansionary fiscal policy implies an increase in public expenditure (G) and/

or a decrease in taxation.
● In this case, increased expenditure on infrastructure implies an increase in

aggregate demand.
● Since G is an injection into the circular flow, there will be a multiplier effect

on GDP.
● In the long run, more infrastructure will cause an increase in long-run

aggregate supply.
● An AD/AS diagram showing a rightward shift of the AD and

AS curves. (8 marks)

3 ● Increased public expenditure might increase aggregate demand and also

aggregate supply, especially if spent on education, health and infrastructure.
● In turn, this might cause economic growth to increase.

● But higher public expenditure on social benefits might act as a disincentive

to work.
● Higher public expenditure as a proportion of GDP might also restrict

economic growth because the resources used by the public sector might not
be allocated efficiently because of the absence of the profit motive. (12 marks)
4 ● A reduction in interest rates would make saving less attractive and
borrowing cheaper.
● This would encourage both consumption and investment.

● Further, lower interest rates are likely to cause a fall in the exchange rate

(because it is less attractive for people to hold cash in domestic banks).

● This would cause a rise in net exports.

● Consequently, aggregate demand would increase so causing an increase in

GDP.
● In turn, it is likely that unemployment would fall (unless firms have workers

who are currently underemployed).

● The increase in aggregate demand would cause a rise in the price level

(unless the economy was on the horizontal part of the AS curve).

● An increase in the money supply would have similar effects if it results in an

increase in the rate of inflation. (12 marks)

Answers © Peter Smith 27

Unit 2

5 ● Explanation of expansionary monetary policy: lower interest rates and/or

quantitative easing (or other relevant schemes such as funding for lending).
● The impact of lower interest rates, e.g. in the UK: hot money outflows from

the UK to other countries where interest rates are higher, causing an increase
in the supply of sterling on the foreign exchange market.
● In turn, this will cause a fall in the value of the pound against other

currencies.
● This will cause a fall in the foreign currency price of UK exports but a rise in

the price of imports into the UK.

● This increase in competitiveness of UK goods will cause the UK’s net exports

(X – M) to increase.
● In turn, this will cause aggregate demand to rise, leading to a rise in real

output and in the price level.

● Cost–push inflation might also increase because the cost of imported raw

materials will have increased. (30 marks)

6 a ● Fiscal policy relates to changes in government expenditure and taxation in

order to influence the level of economic activity.
● Monetary policy relates to changes in interest rates and money supply in

order to influence the level of economic activity. (4 marks)

b ● A fiscal deficit implies that government expenditure is higher than tax

revenue.
● Therefore, an increase in the fiscal deficit indicates that the gap between

government expenditure and tax revenue is increasing. (6 marks)

c ● An increase in the budget (fiscal) deficit implies that injections (government

expenditure) are rising relative to leakages (tax revenue).
● Therefore, aggregate demand will increase.

● Consequently, the AD curve will shift to the right resulting in a rise in

real output and in the price level. This should be illustrated on an AD/AS
diagram.
● The multiplier describes how a change in an injection causes a more than

proportionate change in GDP.

● In this case, injections are rising relative to leakages. Therefore, GDP will

rise by a greater proportion than the change in the budget deficit.

However, the overall impact depends on factors such as:

● the size of the change in the budget deficit

● the size of the multiplier

● the gradient of the AS curve

Also, if the increased budget deficit is used to finance extra expenditure

on infrastructure and education then aggregate supply might increase so

limiting any impact on the price level.  (12 marks)

d ● Monetary policy relates to changes in interest rates and the money supply in
order to influence the level of economic activity.
● A negative output gap implies that GDP is growing at a slower rate than

28 Edexcel AS Economics
 Government intervention and government failure Chapter 9

the long-term trend rate of growth. It is usually associated with increasing

unemployment.
● To close the negative output gap, the base interest rate could be decreased

by the Bank of England’s Monetary Policy Committee.

● This would make it cheaper for consumers and firms to borrow money,

leading to an increase in consumption and investment. Since these are

components of aggregate demand, the AD curve would shift rightwards to
causing real output to increase.
● However, if consumer and business confidence is low then lower interest

rates might not result in higher consumption and investment. Also,

commercial banks may not reduce their interest rates following a cut in the
base interest rate.
● Alternatively, the Bank of England may engage in quantitative easing,

e.g. buying bonds from commercial banks. This would have the effect of
increasing the money supply and the commercial banks’ ability to lend to
consumers and businesses.
● However, if banks are risk averse, then this policy may have little effect

because they will be unwilling to lend. (12 marks)

e ● The current account of the balance of payments refers to a country’s day-to-

day financial transactions with other countries. It includes the balance of
trade in goods and services, investment income and current transfers.
● Depreciation of the pound implies that the foreign price of UK exports

would fall, whereas the price of imports into the UK would rise.
● This would lead to a rise in exports and to a fall in imports so it should

lead to an improvement in the current account.

● However, this will not be the case if the demand for exports and imports

are very price inelastic, e.g. because of contracts.

● Further, UK suppliers may be unable to meet any increased demand if they

are currently working at full capacity.

● In the longer term, there is a danger that any competitive advantage will be

lost if increased costs of imported raw materials results in higher prices of

UK goods. (12 marks)

f ● Definition of supply-side policies: polices aimed at increasing aggregate

supply by increasing competition and productivity.
● AD/AS diagram to show the impact of supply-side policies with the AS

curve shifting to the right.

● Polices could include:

– Training schemes, e.g. apprenticeships. But much will depend on the

quality of the schemes and their relevance to the jobs available.
– A reduction or the abolition of the National Minimum Wage. But if these
measures result in lower incomes, then aggregate demand might fall so
the impact of unemployment may be limited.
– A reduction in employers’ National Insurance Contributions. These are
sometimes referred to as a tax on employment so cutting these would

Answers © Peter Smith 29

Unit 2

encourage firms to employ more workers. However, firms might not take
on more workers but simply enjoy an increase in profits.
– A reduction in the level of benefits to the unemployed. This would
provide an incentive for the unemployed to seek employment. However,
if no jobs are available then this measure would be ineffective and would
cause an increase in inequality. (30 marks)
g Living standards is a broader measure than just amount of income; it also
refers to the quality of life, which includes factors such as happiness, quality
of housing and health, pollution etc.
Policies could include:

● Increased government spending, e.g. on health and education. This could

increase quality of life but much will depend on how the money is spent in
these sectors.
● Cutting income tax rates: this would increase disposable incomes and

enable people to increase their expenditure on goods and services so

raising their living standards. However, production and consumption of
goods and services would lead to increased pollution, waste and other
external costs which may reduce the standard of living.
● Redistributive policies to increase living standards, e.g. increase pensions

and means-tested benefits to the elderly. But there would be an opportunity

cost, e.g. fewer resources available for the National Health Service. (30 marks)

30 Edexcel AS Economics