J Lee

EASTER HOMEWORK
a)(i) Explain how the Consumer Price Index is calculated (4)
The CPI is calculated from the change in the price level of a basket of average UK goods. The
basket contains items that are most frequently purchased by a sample of UK households, and
each month, the price change relative to the base year is shown by an index (with 100 being
the first/base year which is 1996). A weighting system is used, whereby goods/services that
take up a considerably higher proportion of household income have a higher weighting and so
have a greater effect on the overall price level change. This measure does exclude mortgages
and other costly expenditures that are not classified as "goods or services".
a)(ii) Analyse two possible reasons why the CPI measure of inflation was above its
target range in 2011 (6)
A low interest rate determined by the Bank of England could have stimulated higher inflation.
When interest rates are low, the cost of borrowing/loaning is decreased and the reward for
saving is reduced, thus creating an incentive for consumers to take out loans and increase
their consumption and an incentive for firms to increase investment along with a disincentive
to save. Both consumption and investment are large components of AD, hence if both of these
rise, a drastic rise in AD will be experienced which will push up the price level and inflation will
occur.
Additionally, the monetary policy of Quantitative Easing could have been in practice, where
the Bank of England creates electronic money and then buys back government bonds from
banks. This increases the amount of money banks have, hence they are likely to offer more
loans and reduce the cost of borrowing for consumers as they have more money to lend. The
outcome of this is that consumption and investment increases as consumers/firms have
greater access to credit, and as previously mentioned, this will lead to a rise in AD and
consequently a rise in inflation.
a)(iii) Assess the likely impact of a reduction in households' real income on the
standard of living in the UK (10)
As real income is the amount of income after the effects of inflation have been considered, a
fall in this value will mean that households will have less disposable income, that is income
left over after the necessities and taxes/social security charges have been deducted.
Consequently, consumers will be unable to purchase as many luxury goods and so may feel
more unhappy as sometimes lower consumption can be linked to decreased levels of national
happiness. This weaker consumption due to a fall in real income can lead to the negative
multiplier effect, where firms begin to lay off more/employ less
workers in order to satisfy weaker levels of output, which is
illustrated on the diagram to the left. We can see how the shift to
the left of the AD curve (from AD to AD1) causes a movement
down the LRAS curve to the region of the graph where there is
higher spare capacity, in other words higher unemployment,
which is where the LRAS curve begins to flatten. As a result of
this unemployment, further falls in AD will occur as even less
people have a steady income. This wage price spiral is likely to
lead to a lower standard of living, as less consumption and higher unemployment can be
associated with increase crime and social deprivation.

J Lee
However, it is important to address the means of calculating the level of standard of living
when answering this question. A measure such as the level of households' real income may
simply be misleading, as there are many other determinants of standard of living. Health,
education, job satisfaction, strength of community/friendships/family and many more factors
other than simply income are all attributed to higher standards of living. Additionally, the
magnitude of the fall in real income is important, as a fairly small reduction will likely have
very insignificant effects. Extract 1 states the "UK households are facing pay cuts in real terms
of more than 3.5%", which whilst is sounds large, may not be a considerable amount for the
lower income earners who are influential on the overall standard of living. Also, many may not
fully appreciate the concept of "real" income; whilst the level of income adjusted for inflation
had fell, "the median salary for a full-time worker in the UK rose 1.4% in 2011 to 26244",
meaning that the slightly less well-informed may be unaware that their 'rise' in income does
not match the "Consumer Price Index inflation rate of 5%" in this example. Consequently,
there is a possible connection between workers on low pay or the unemployed being less
happy, but lower real income may not be directly influential on the level of standard of living
due to other factors, the magnitude of the fall in income and knowledge gaps.
b)(i) With reference to Extract 2, outline one possible reason why GDP estimates
are frequently revised (4)
As Extract 2 states "though most think the economy is now growing again" there had been
"deficit reduction policies of cuts in government spending and increases in tax",
demonstrating how it is very hard to predict the economic prospects and how there is much
disagreements between economists. This means that GDP estimates may need constant
revising, as new figures and policies emerging means that growth prospects may have been
affected. The extract says that "The Office for National Statistics estimated that the GDP fell
0.3% in the fourth quarter of 2011, down from its previous estimate of 0.2%" showing the
erratic nature of GDP forecasts.
b)(ii) Explain two likely economic consequences of inflation falling "below the 2%
target" (6)
A possible effect is that real incomes will rise. Real income is the value of income after
inflation has been accounted for, hence if inflation falls, then real incomes will be higher as
less will be deducted from nominal incomes to account for it. The economic significance of
this is that consumption may rise as higher real income means that consumers can enjoy
larger amounts of disposable income, which could have knock on economic effects such as
greater economic growth etc.
But, the Phillips curve is a concept that suggest that there is an
inverse relationship between inflation rates and unemployment.
This dictates that as inflation falls, there is likely to have been a
rise in unemployment, shown on the diagram to the left. This
means that lower inflation could be linked with poor economic
performance, as more people unemployed and without a steady
income stream will stimulate weaker levels of AD and
consequently higher unemployment can be indicated by weaker
inflation. But it is important to consider that this is simply a
concept developed by AW Phillips, and was merely based on
annual wage inflation and unemployment rates in the UK for the period 1860 1957 plotted

J Lee
on a scatter diagram. This means that this may be slightly outdated and unrealistic to use in
modern economies.
b)(iii) With reference to Extract 3 and using an aggregate demand and aggregate
supply diagram, discuss the extent to which "Monetary policy is supporting
economic recovery" (10)
Monetary policy is the use of interest rates and the money supply
in order to manipulate the total level of Aggregate Demand in the
economy. As extract 3 states, "Monetary policy is supporting
economic recovery, with the Bank of England interest rate at
0.5% and quantitative easing being resumed", stating two types
of monetary policy. Low interest rates such as the "0.5%" rate
mentioned creates an incentive to take out loans and increase
consumption for both consumers and firms as the cost of
repaying said loans will be less expensive, simultaneously
creating a disincentive to save as savings accounts will be less
profitable if the rate of interest is lower. This pushes up AD as both consumption (which makes
up 67% of AD) and investment will increase. Secondly, quantitative easing is when the Bank
of England creates electronic money which they use to purchase government bonds back from
other banks, increasing the amount of money banks have to lend. This both increases the
willingness of banks to lend and pushes the cost of borrowing down as banks are able to
afford this with their acquired extra money. Hence, both consumption and investment rise as
loans are more available, resulting in a shift of AD to the right, as shown on the diagram to
the left. The shift from AD to AD1 causes a movement up the LRAS curve, towards the region
where the curve begins to curve upwards, meaning that the economy has moved towards
fuller employment. Therefore both decreasing interest rates and performing quantitative
easing causes employment to rise, hence a rise in output as firms produce more, which
consequently aids economic recovery from a recession because economic growth will reach a
positive value.
The success depends on the level of employment within the economy. If it is at close to full
employment, then the shift of AD to the right will lead primarily to inflation, rather than extra
employment, which may have adverse effects on recovery. However, it is fairly unlikely that
an economy in recession will have a high rate of employment, but still a possibility. Lowering
interest rates may also be an unrealistic policy if the current rate of interest is already low. As
of March 2016, the base rate determined by the Bank of England is 0.5%, so further cuts in
this rate will be very difficult to enact without entering a liquidity trap (where rates near 0%
mean that further monetary policy will be ineffective as low confidence banks will hoard the
extra money they receive from quantitative easing as they fear deflation or insufficient AD).
An effect that hasn't been considered yet is the effect on the Pound. Lowering interest rates
causes savers across the world to be discouraged to save in UK banks as their return from
such a savings account will be low, so less Great British Pounds will be demanded (savers
have to convert their currency to GBP to store in British banks). Consequently the Pound will
weaken, meaning that the purchasing power of UK consumers demanding imports will be
reduced, whilst the competitiveness of UK exports in other countries will increase, which will
have benefits on the current account deficit and may lead to further export-led economic
growth.
(c) To what extent is the policy of reducing the fiscal budget deficit helping the
government to achieve its macroeconomic objectives? (20)

J Lee
A fiscal budget deficit is when the spending of the government on the provision of public
goods and benefits exceeds the income generated from taxes, whilst macroeconomic
objectives are the aims of the government to improve the state of the economy. Reducing the
fiscal budget deficit involves cutting government spending (i.e. cutting benefits and spending
on public goods) whilst increasing the rate of taxation. This is
primarily helping the government achieve its objective of a
reduced budget deficit, but also helps manipulate the level of AD
as cutting government spending is an example of contractionary
fiscal policy. Government spending is one of the constituents of
the AD equation (AD=C+I+G+(X-M)), so cutting this will result in
a decrease in the level of AD in the economy, illustrated on the
diagram to the left. The shift from AD to AD1 causes a movement
down the LRAS curve to a new equilibrium point with a lower P
(from p to p1) and lower real output (from y to y1). AD also falls
due to this policy as increasing both indirect and direct taxes (taxes levied on the producer
who then pass the cost onto consumers in the form of higher prices and taxes levied directly
to an individual based on a component of income respectively) causes a contraction in
consumption due to higher prices and less disposable income. The effects of the fall in AD
that this causes helps achieve not only the policy of reduced budget deficit but can control
high inflation rates to help achieve the objective of low and stable inflation (2%). This is
because controlling the level of AD with contractionary fiscal policy can be used to relieve
inflationary pressures, allowing the price level to return to a lower level.
Whist possibly achieving these two objectives, this contraction in AD can be very damaging to
other objectives. The negative multiplier effect may be set in motion, as lower levels of AD
means that firms need to produce less output and so need less labour to fulfil this.
Consequently unemployment will rise as firms will lay off more workers and employ less new
workers, causing further drops in disposable income and hence even weaker levels of AD, and
the spiral continues. As one of the macroeconomic objectives is full employment, this will
damage the progress towards achieving it. In addition, contractionary monetary policy is far
better at achieving the low and stable inflation objective, which involves increasing rates to
stimulate an incentive to save and a disincentive to spend causing weaker AD and lower
inflation. Monetary policy is more successful and has less damage on other macroeconomic
objectives. But, the greatest criticism of the point about inflation is that UK inflation is already
very low (at 0.3%), so cutting government spending and increasing taxes will only benefit the
budget deficit objective in today's economy as only damage would be inflicted on the
inflation target if the rate is pulled down any further.
Contractionary fiscal policy, that is reducing the budget deficit through the aforementioned
cut to government spending and increase in taxation, can also help achieve the objective of
greater protection and reduced damage of the environment. If real output falls as shown on
the previous LRAS/AD diagram, then firms are producing less, hence there will be less
greenhouse gas emissions and pollution produced from factories, transport and machines that
are involved in the production and transportation of the goods/services they produce. This will
cause less strain on the environment and will help progress towards the government's
objective.
But, this policy may only benefit the environmental objective in the short run. The
contractionary fiscal policy mentioned can only be maintained for so long before taxes have to
be cut and spending increased otherwise there is risk of recession as this damages economic

J Lee
growth. Hence, the benefits to the environment of decreased output and production will only
last as long as the policy will, meaning this may not progress towards the objective in the long
term. Over time, firms naturally tend to innovate and decrease the environmental impact of
their production processes in order to minimise costs, so it is probably more beneficial in the
long run to allow firms to innovate. Expanding on the previous point about economic growth,
extract 2 states that "Gross Domestic Product fell 0.3% in the fourth quarter of 2011, down
from its previous estimate of 0.2%" due to, as an 'opposition spokesman' said, "sticking to
policies that are failing on jobs, growth and the deficit". This is referencing the policy of
reducing the fiscal (budget) deficit, and it caused economic growth to fall as this is measured
by a growth in real output, that is nominal output of a country adjusted for inflation. If
unemployment rises due to weaker AD that is stimulated by higher taxes, then the productive
potential of the economy is going to shrink as labour is not being efficiently used. This
therefore highly damages economic growth, which is a fundamental objective of the
government.