Section 4

Textbook Answers

24- The Role Of Government

a. Define a private good.

A private good is rival and excludable. One person consuming the product will stop someone else
consuming the product. Consumption of the product can be made dependent on payment and so free-
riders can be excluded.

b. Explain two reasons why a government may run hospitals.

A government may run hospitals to ensure that everyone has access to the essential services. It is
likely to provide these services free of cost or at a reduced price, whereas private sector health care
providers may charge a higher price. It may also run hospitals to encourage everyone to make
sufficient use of these services. Healthcare tends to be underconsumed if left to market forces, as it is
a merit good.

c. Analyse how the level of government intervention varies according to the type of economic
system countries operate.

Government intervention is at its highest in countries operating a planned economic system

where most capital and land is owned by the government and most workers are employed
in state-owned enterprises. Government intervention is at its lowest in countries operating a
market economic system. In these countries, market forces allocate most of the resources. The level
of government intervention in countries operating a mixed economic system comes in the middle
between the level in a planned and a market economic system.
d. Discuss whether or not the government of a country with a large industry producing cigarettes
should ban the production of cigarettes.

There are arguments for a government banning the production of cigarettes. A strong one is that
cigarettes are a demerit good. They generate higher private costs on consumers than they may realise.
As well as the cost of purchasing cigarettes, smoking can damage the health of smokers. The
production and consumption of cigarettes can also generate external costs. Non-smokers’ health may
be damaged by inhaling the smoke, their medical treatment may be delayed because smokers are
being treated and they may have to pay higher taxes to finance the medical treatment of smokers. The
factories producing the cigarettes may also cause air pollution.
If a government thinks that other governments may ban or restrict the consumption of cigarettes, it
may decide that the industry will decline in the near future and this might strengthen its view to ban
its production.
Some people may argue about the extent to which cigarettes are a demerit good. They may suggest
that consumers are informed about the risks of smoking and they should be allowed to judge whether
the pleasure they gain from smoking is greater than the risks involved.
A government would also be concerned that a ban that would force the closure of a large industry
would reduce the country’s output and employment. These costs may be experienced without any
benefit, if the closure of the domestic industry does not reduce the consumption of cigarettes in the
country. What might happen is that people may smoke the same number of cigarettes but just buy
them from industries in other countries.
If a government is going to ban the production of cigarettes, it should think about how the resources
used to produce cigarettes can be smoothly transferred to other industries. This may require the
government to provide training to the workers and provide investment subsidies to speed up the
expansion of growing industries.

2
 25. The Macroeconomic Aims Of The Government

a. Identify two macroeconomic aims apart from full employment.

Two macroeconomic aims from: economic growth, price stability (low inflation), balance of
payments stability and redistribution of income.

b. Explain what is meant by full employment.

Full employment is the lowest possible level of unemployment. Those people who are willing and
able to work at the going wage rate can find employment. This does not mean zero unemployment.
Some workers will always be in the process of changing jobs and some industries will be expanding
while others are declining.

c. Analyse why governments want to achieve full employment.

Governments want full employment as it will mean that the maximum output that can be made with
the labour force will be produced. Labour resources will not be wasted and the economy will be
producing on its production possibility curve, if other resources are being fully used.
With full employment, governments also earn high tax revenue as income, spending and profits are
likely to be high. High tax revenue can be used to improve economic performance and increase living
standards.
In addition, full employment reduces the amount governments have to spend to support the
unemployed. The tax revenue that might have been spent on unemployment benefits could be used
instead, for example, to improve education and healthcare.
d. Discuss whether or not all governments will have the same economic aims.

All governments are likely to want to achieve economic growth. This is because a higher output has
the potential to improve living standards. Success tends to breed success. A growing economy is
likely, for instance, to encourage firms to invest, which will further increase economic growth.
All governments are also likely to want to achieve full employment and price stability. Full
employment can reduce poverty, raise tax revenue and reduce spending on unemployment benefits.
Price stability can bring a number of advantages, including making it easier for economic agents to
plan ahead and maintain or increase international price competitiveness.
Governments usually want to equate export revenue and import expenditure. If more is spent on
imports than is earned from the sale of the exports, then the country is consuming more than it can
afford. In contrast, any country that has higher export revenue than import expenditure, is not buying
all that it could afford. Most governments do try to redistribute some income and wealth from the
rich to the poor to reduce income and wealth inequality. Achieving greater equality can be seen as
fair and helps to reduce poverty.
The extent to which governments seek to achieve these objectives and which one they give priority to
will, however, vary between countries and over time. Some countries accept a greater degree of
income and wealth inequality than others. A government whose country is experiencing a high
inflation rate is likely to have price stability as its main priority. In contrast, the government of a
country with falling output is likely to prioritise economic growth.2
 26 – Fiscal Policy

a. Define a progressive tax.

A progressive tax is a tax that takes a higher proportion of the income of the rich than the poor.

b. Explain the difference between a direct tax and an indirect tax, giving an example of each.

A direct tax is a tax on the income or wealth of people and the profits of firms. The burden of the tax
is borne by the person or firm on which the tax is imposed. An example of a direct tax is income tax.
An indirect tax is a tax on spending. The burden, or some of the burden, of the tax can be shifted on
to another person. An example of an indirect tax is GST.

c. Analyse the reasons why governments impose taxes.

Governments impose taxes for a number of reasons. These include to raise revenue to finance
government spending, including on public and merit goods. It is also used to discourage the
consumption of demerit goods by imposing an extra cost on the firms producing them and so raising
their price. External costs can be turned into private costs by putting a tax on those creating them.
Taxes can be used to redistribute income. The rich can be taxed at a greater rate than the poor and
some of the revenue earned can be spent to help the poor. Besides correcting market failure and
promoting equity, taxes may be used to discourage imports. Tariffs placed on imports make them
more expensive, and are designed to encourage people to buy domestic goods rather than foreign
products.
In addition, taxes are used to influence total demand. If a government wants to reduce total
demand (perhaps to reduce inflationary pressure) it will increase tax rates.
d. Discuss whether or not an increase in income tax rates will improve economic performance.

An increase in income tax rates can have a number of effects on an economy. Such a move will
reduce disposable income. This, in turn, will be likely to reduce consumption. Lower consumption
will discourage investment. A fall in consumption and investment will cause a reduction in total
demand. The diagram shows that a fall in total demand can reduce an economy’s output.

Lower output may result in a rise in unemployment. The incentive to work will be reduced, which
will lead to cyclical unemployment. Besides this, there may be some voluntary unemployment also.
The higher rates may discourage foreign direct investment and may encourage some workers to
emigrate to countries with lower income tax rates.
A reduction in total demand may, however, cause a fall in demand-pull inflation. Lower domestic
expenditure may also result in an improvement in the current account position. This is because it is
likely that fewer imports will be bought and so products, originally intended for the international
market, may be diverted to the home market.
In the short term, higher income tax rates will increase government tax revenue. If the government
spends this tax revenue, total demand may not fall. If the fall in consumption and investment is not
offset by a rise in government expenditure, however, real GDP is likely to decrease. A lower GDP
may mean that despite higher income tax rates, income tax revenue will decline as there will be less
income available for taxing.
The effect of an increase in income tax rates will depend on the size of the rise, the reaction of the
people and the initial state of the economy. A small rise will obviously have less of an impact than a
large rise. It is possible that a rise in income tax will reduce the expenditure by smaller than expected
amounts. People may reduce their savings rather than their expenditure if their disposable income
falls. If an economy is operating at full capacity with inflation, a rise in income tax rates would be
more beneficial than if it was operating with considerable spare capacity and high unemployment.
 27 – Monetary Policy

a. Define monetary policy.

Monetary policy is concerned with influencing the supply of money and/or the price of money.
Monetary policy measures are changes in the money supply, the rate of interest and the exchange
rate.

b. Explain one similarity and one difference between monetary policy and fiscal policy.

Both monetary policy and fiscal policy are designed to achieve the government’s macroeconomic
aims by influencing total demand. This is why they are both sometimes referred to as demand
management policies.
The difference between the two is that they use different measures to influence total demand.
Monetary policy uses changes in the rate of interest, money supply and the exchange rate, whereas
fiscal policy uses changes in government spending and taxation.

c. Analyse why trade unions are likely to welcome an increase in the money supply.

Trade unions are likely to welcome an increase in the money supply as it would be expected to help
them achieve the objectives it has for its members. This is because it would increase total demand.
With more money, consumer expenditure will be likely to increase. Higher consumer expenditure
may encourage firms to expand. This would be likely to increase demand for labour. Higher demand
for labour would be expected to create more jobs and raise wages as firms compete for workers. To
attract people to work for them, firms may also improve the working conditions of their workers.
d. Discuss whether or not an increase in the rate of interest will reduce consumer expenditure.

An increase in the rate of interest would be expected to reduce consumer expenditure. This is because
households would have to pay more if they borrow. As a result, spending financed by borrowing
would be reduced. The higher interest rate would also increase the reward for saving, so households
may decide to save a higher proportion of their disposable income and spend a smaller proportion of
their disposable income.
Households that have borrowed at a variable interest rate in the past will have less money to spend,
as more of their income will be going in servicing their debt.
There are, however, a number of reasons why it is possible that an increase in the rate of interest may
not reduce consumer expenditure. If households are very confident about the future, they may
continue to borrow and spend at the same rate. If they expect that they will earn more in the future,
they may think they will have no problems paying a higher interest rate.
A small rise in the rate of interest, especially from a low rate may have little or no effect. For
example, a rise from 1% to 1.25% is unlikely to discourage many people from borrowing or
encourage many people to save more. A rise that is not expected to last may also not affect
households’ borrowing and saving plans. Indeed, some saving and borrowing is at a fixed rate of
interest and so is not affected by short run changes in the rate of interest.
In addition, a higher rate of interest may mean that some households who are saving for a particular
target sum may have to save less to achieve their objective. This would give them income to spend.
 28. Supply Side Policy

a. Define deregulation.

Deregulation is the removal of rules and regulations.

b. Explain whether a cut in income tax is a fiscal policy measure or supply-side policy measure.

A cut in income tax is a fiscal policy measure if it has been made with the intention of increasing
total demand. A reduction in income tax will increase households’ disposable income, which may
encourage them to spend more. It might also be a supply-side policy measure if the intention is to
increase total supply. A lower rate of income increases the reward from working and so may increase
the supply of labour, which would increase productive potential. In some cases, the policy measure
may be used in an attempt to achieve both an increase in total demand and an increase in total supply.

c. Analyse, using a production possibility curve, the intended outcome of a supply-side policy
measure.

A supply-side policy measure has the intention of increasing total supply. A higher total supply will
increase an economy’s productive potential. An ability to make more products will mean that the
economy’s production possibility curve will shift to the right as shown in the diagram below.
d. Discuss whether or not supply-side policy measures always reduce unemployment.

One key supply-side policy measure, education and training, would be expected to reduce
unemployment. If workers are better educated and trained, they will be more skilful and more
productive. This will make them more attractive to employers. It should also mean that they are more
occupationally mobile. Should they lose a job, they should be able to find another one relatively
quickly.
Whether the other supply-side policy measures will always reduce unemployment is more debatable.
The intention behind cutting income tax and lowering unemployment benefit may be to reduce
unemployment by making work more attractive relative to depending on unemployment benefit. If
the gap between pay and unemployment benefit is widened, some of the unemployed may search
more actively for jobs. If, however, there is a lack of demand for labour or if the unemployed do not
have the skills to fill any job vacancies, unemployment will not fall.
One of the aims of labour market reforms is also to reduce unemployment. If, for instance, it is made
easier for firms to hire and fire workers, firms may be encouraged to employ more workers. There is,
nevertheless, the possibility that removing employment protection may increase shortterm
unemployment as workers may be made redundant on a more frequent basis.
It is debatable whether privatisation will increase or decrease unemployment. It may increase
employment if the industry responds to the greater exposure to market forces by becoming more
efficient and increases its sales. Privatisation, on the other hand, may not increase efficiency. The
industry may just change from a state-owned monopoly to a private sector monopoly. If so,
competitive pressures on the industry will not increase and it may not become more efficient. A
private sector industry may also be less concerned about keeping employment high than a
stateowned industry. Indeed, it may be prepared to reduce output in order to push up the price. If it
takes such action, unemployment would rise.
So it cannot be concluded that supply-side policy measures will always reduce unemployment. It
would be hoped that they would, but there is a chance that some may increase unemployment. The
outcome will be influenced by the supply-side policy measures used and how economic agents
respond to them.
 29. Economic Growth

a. Define real GDP.

Real GDP is the value of a country’s total output adjusted for inflation.

b. Explain two consequences of a recession.

One consequence of a recession is very likely to be an increase in unemployment. With less output
being produced, fewer workers will be needed and so firms are likely to dismiss some of their
workers.

Another possible consequence is a fall in the price level. If the recession has been caused by a fall in
total demand, firms may lower their prices in a bid to increase demand.
c. Analyse the relationship between economic growth and the budget balance.

Economic growth would be expected to reduce a budget deficit or increase a budget surplus. This is
because higher output and so higher incomes and more employment would increase income tax
revenue. Higher incomes are usually accompanied by higher expenditure and so a rise in indirect
taxes. Economic growth may also generate higher profits and so increase revenue from corporation
tax.
As well as increasing tax revenue, economic growth may reduce government spending. With lower
unemployment, less will be spent on unemployment benefit and other benefits associated with low
income. With higher incomes, people may also be healthier due to better nutrition and housing
conditions. A healthier population may reduce government spending on healthcare.
d. Discuss whether or not an increase in government spending will lead to economic growth.

An increase in government spending may lead to economic growth. If a government spends more on,
for example, defence, it will directly increase aggregate (total) demand. If it increases benefits, it will
allow the recipients to spend. In the case where an economy is operating below its productive
capacity, an increase in total demand can result in an increase in output. More demand will encourage
firms to produce more and to do so they will use previously unemployed resources. Figure 1 shows
this outcome using both an AD/AS diagram and a PPC diagram. Total demand and the production
point are moving closer to full capacity. As a result, actual economic growth is achieved.

Higher government spending may also increase real GDP by raising both total demand and total
supply. For example, an increase in government spending on training will raise total demand and will
increase total supply if the workers become more productive. Figure 2 shows both actual and
productive economic growth being achieved.
A rise in government spending will not, however, cause economic growth if it just increases total
demand and the economy is initially operating at full capacity. If, for example, a government
increases state benefits, the unemployed, for example, may spend more. There will, however, not be
resources available to produce the extra output they want. In this case, total output does not rise. It is
just the price level that rises as shown in Figure 3.

There is also the possibility that an increase in government spending may be offset by a fall in
another component of total demand. If, for example, the government increases its tax revenue more
than the rise in its spending, consumer expenditure and investment may fall.
 30. Employment and Unemployment

a. Define cyclical unemployment

.
Cyclical unemployment is unemployment that is caused by a lack of total demand.

b. Explain how the unemployment rate may fall while the number of people employed declines.

It is possible for the unemployment rate to fall while the numbers employed also decrease. This could
occur if the size of the labour force fell. For instance, the labour force may initially be 30 m, with 27
m people being in employment and 3 m being unemployed. In this case, the unemployment rate
would be 3 m /30m × 100 = 10%. If then the labour force fell to 25 m, employment could fall to 23
m, while the unemployment rate would fall to 2 m /25 m × 100 = 8%.

c. Analyse how a cut in the rate of interest could reduce unemployment.

A cut in the rate of interest may reduce unemployment as it may increase total demand. A lower
interest rate may encourage households to borrow more and discourage them from saving and so
consumer expenditure may rise. It may also stimulate investment as it will be cheaper for firms to
borrow, less rewarding for them to save and will increase their expected sales. Higher total demand
will encourage firms to expand their output and so they are likely to employ some of those looking
for jobs. Higher total demand will reduce cyclical unemployment.
d. Discuss whether or not unemployment is harmful.

Unemployment does provide some flexibility, making it easier for expanding firms to recruit more
workers. It can also keep inflationary pressure down as rising total demand can be matched by higher
output. Also, the workers may become reluctant to press for wage rises for the fear of easy
replacement by the unemployed labour. It is generally thought, however, that the costs of
unemployment exceed any benefits. Unemployment imposes a number of costs on an economy. A
key one is lost output. If the unemployed had been in work, more goods and services could have been
produced and hence living standards could have been higher. Potential tax revenue is lost, which may
mean that taxes may be imposed at higher rates. The government may have to spend additional
money on unemployment benefits, which could have been used for other purposes. The government
may also have to spend more on healthcare and other benefits. This occurs as people tend to suffer
from poor physical and mental health and lower income when unemployed. Unemployment can also
cause unemployment. The longer people are out of work, the greater the risk there is that they will
lose their skills, their confidence and their motivation to work. They may become discouraged
workers.

The magnitude of the cost of unemployment is influenced by its rate, duration and cause. A 10%
unemployment rate will obviously have more serious consequences than a lower rate of 4%. In fact, a
government may not be too concerned about a 4% rate, as it is likely to be close to full employment.
Longer-term unemployment is particularly serious as those affected may lose skills, miss out on
training and lose the habit of work. Cyclical unemployment and structural unemployment are more
harmful than frictional unemployment, as they are likely to affect more people and last longer.
 31. Inflation and Deflation

a. Define inflation.

A sustained increase in the prices of goods and services.

b. Explain how a consumer boom could cause inflation.

A consumer boom means that households are increasing their spending at a significant rate. Higher
consumer expenditure will increase total demand. If the economy is getting close to full capacity,
there will not be many resources to meet the higher total demand. Prices will be forced up and
demand-pull inflation will occur.

c. Analyse how inflation is measured.

Researchers calculate inflation by constructing a weighted price index. First they select a base year to
ascertain the change in the general price level with respect to prices prevalent in base year. A number
of households are asked to keep records of their expenditure. From the information gathered from
this household survey, researchers decide the items to be measured and the weight attached to them.
The higher the proportion spent on an item, the greater the weight ascribed to it. For example, if 10%
of expenditure goes on food and 20% on transport, food would have a weight of 1/10 while transport
would have a weight of 1/5. Changes in the prices of the items selected are found by visiting a
number of trade outlets and obtaining information from, for instance, gas suppliers. The weights of
the items in the basket of products are multiplied by their price changes to give a weighted price
index. Then, the inflation rate is calculated. If, for instance, a consumer price index rises from 100 to
106, the inflation rate is 6%.
d. Discuss whether or not workers suffer as a result of inflation.

Workers may suffer from inflation in a number of ways. If the inflation is cost-push inflation, the
country’s output will fall. This is likely to result in some workers losing their jobs. An unemployed
worker will be likely to experience a low standard of living.
If workers’ wages do not rise in line with inflation, they will experience a fall in real wages. This will
mean that the amount of goods and services that they will be able to consume will decline.
To try to retain their real wages, workers will have to press for wage rises. This may bring them into
conflict with employers and worsen industrial relations. Unskilled workers are likely to have less
bargaining power than skilled workers as they can be replaced more easily. This is why there is more
risk of the real wages of unskilled workers falling during cost-push inflation than the real wages of
skilled workers falling.
Workers may also suffer during periods of very high demand-pull inflation, especially hyperinflation.
Very rapid rises in the price level will make it difficult for workers to assess what is an appropriate
wage to accept.
A relatively stable rate of demand-pull inflation, however, can benefit workers. Higher total demand
will encourage firms to produce more. They will increase their demand for workers. This higher
demand is, in turn, likely to increase employment opportunities and raise wages. If wages rise by
more than inflation, real wages and the purchasing power of workers will increase. The higher
demand may also improve working conditions and increase the chances of promotion. The impact of
inflation on workers will be influenced by its cause, its rate and the bargaining power that workers
have.