Basic economic problem, Resource Allocating, PPC, Money, citrusperibus, Assignment 1

As

1. The diagram shows an economys production possibility curve.

Why does the curve slope downwards?
A Agriculture and industry are subject to decreasing returns to scale.
B Agriculture and industry are subject to increasing returns to scale.
C Resources are shared equally between industrial and agricultural
production.
D Total resources available to the economy are limited.

2. The diagram shows a countrys production possibility curve.

What could allow the economy to move from M to N?
A an increase in consumer spending
B an increase in demand for exports
C an increase in government spending on pensions
D an increase in investment

3. Given a rate of interest of 10% per year, what is the opportunity cost to an individual of saving an
additional $100 in year 1?
A an increase in consumption of $110 in year 2
B an increase in consumption of $10 in year 2
C consumption of $100 in year 1
D consumption of $110 in year 1
4. . In the diagram LM is the production possibility curve of a country that has a comparative
advantage in the production of good Y.

What might enable the country to consume the quantities of X and Y indicated by point R?
A increased specialisation in the production of good X
B international trade
C a reduction in unemployment
D increased specialisation in the production of good Y

5.

6. A student decides to stay in her room to do some work rather than going to the cinema.
What is the opportunity cost of her decision?
A the enjoyment she would have derived from a visit to the cinema
B the improvement in the mark she obtains for her assignment
C the cost of the extra electricity she uses
D the money she would have spent in the cinema

7. The diagram shows a production possibility curve LM.

What might cause the curve to shift to NP?

A technological progress
B unemployment of resources
C the depletion of natural resources
D a reallocation of resources
8. The diagram shows shifts in an economys production
possibility curve.
Which change could have come about as a result of an
improvement in technology?
A S to Y

B T to S

C W to T

D W to Y

9 What is the most abundant form of money (measured by value) in a developed economy?
A bank deposits
B cash
C cheques
D credit cards
10. The diagram shows a production possibility curve for an economy which produces only two
goods, X and Y. The economy produces 400 of good Y and produces on its production possibility
curve. Which quantity of good X is given up?
A 600
C 1200

B 800
D 1600

11. The diagram shows two production possibility curves (EF and GH), before and after
technological
progress has taken place.
After technological progress has taken place, what is the
opportunity cost in capital goods of producing OX consumer
goods?
A MH

B OH

C OM

D YF

12. The diagram illustrates the production possibility curves for an economy in Year 1 (X 1, Y1)
and
Year 2 (X2, Y2)
What can be deduced from the diagram?
A The cost of production was lower in Year 2 than in Year
B The full employment level of output was lower in Year
Year 1.
C The opportunity cost was lower in Year 2 than in Year
D Unemployment rose between Year 1 and Year 2.

1.
2 than in
1.

1d, 2d, 3c, 4c, 5d, 6a, 7c, 8a, 9a, 10b, 11a,

Basic economic problem, Resource Allocating, Money, citrusperibus,

Assignment 2

As

1 The steel required for the construction of a new car-assembly plant in a fully employed
economy
is obtained by increasing the output of the domestic steel industry. What is the opportunity cost
of producing the steel?
A the alternative benefits forgone by diverting additional resources to steel manufacture
B the alternative benefits forgone by increasing the capacity of the car industry
C the alternative benefits that would have been obtained by putting the steel to other uses
D zero, since there is no reduction in the steel supplied to other steel users
2 What would prevent a firm gaining the maximum benefit from the division of labour?
A a high interest rate
B a small market
C high production costs
D low productivity
3 What is meant by the ceteris paribus assumption?
A an assumption that is not supported by the facts
rationally
C an assumption that two factors are in equilibrium
held constant

B an assumption that consumers act

D an assumption that other factors are

4 What is the outcome for consumers and workers as a result of increased division of labour?

5. What is the opportunity cost to a fully employed economy of increasing capital investment?
A a fall in consumption
C a rise in saving

B a fall in income
D a rise in the rate of interest

6. Which group may be disadvantaged by the introduction of division of labour?

A consumers who prefer standardised goods
B companies where the production process has many sub-divisions
C the government, if the product is taxed
D workers who prefer a variety of tasks
7 What is an advantage of using the market mechanism to allocate resources between
alternative uses?
A It ensures that resources will be allocated efficiently.
B It ensures that resources are allocated in accordance with need.
C It minimises the time required to make decisions.
D It gives all consumers an equal voice in deciding how resources should be allocated.

8. In a market economy, what is the basis for determining the allocation of factors of
production?
A the market share of companies
C the pattern of consumers spending

B the needs of the country

D the wealth of entrepreneurs

9. What is meant by ceteris paribus in economic analysis?

A A normative approach is being adopted.
B The effect of a change of one variable is being considered in isolation.
C One good has to be sacrificed to obtain more of another.
D One factor of production is fixed.
10 Doctors should be paid highly because they have to undertake a long period of training.
What can be concluded about this statement?
A It is a normative statement because high pay does not always result from lengthy training.
B It is a normative statement because it expresses an opinion.
C It is a positive statement because doctors do have to train for a long period.
D It is a positive statement because greater skill results in higher pay. 1a, 2b, 3d, 4c, 5a, 6d, 7c, 8c, 9b,
10b

Basic economic problem, Resource Allocating, Money, citrusperibus,

Assignment 3

As

1. What is the main economic problem facing all societies?

A how to reduce unemployment
B how to reduce poverty
C how to allocate scarce resources
D how to control inflation

2 What is the opportunity cost to an unemployed worker who becomes employed?

A the leisure they would otherwise have had
B the value of the goods and services they produce
C the wages they are paid
D zero
3. Which of the following statements about trade unions is normative?
A Since trade unions exist to safeguard the interests of their members, they deserve the legal protection of
the state.
B In countries where trade unions are strong, income distribution is more equal.
C Uneven trade union membership has resulted in a widening of the wage gap between different industries.
D In industries where trade unions are powerful, technical progress tends to be much slower.
4. Which is a normative economic statement?
A Money is the least liquid form of wealth.
B Some firms are subsidised by the government.
C Some workers earn more than others.
D Taxes are the best way to discourage smoking.
5. What is an essential feature of a pure market economy?
A Buyers and sellers have perfect knowledge.
B External costs are taxed.
C Prices respond to the demands of consumers.
D The government provides public goods.
6. What is an example of the factor of production capital?
A a bank account held by a small firm to be used for future purchases
B a forest of hardwood trees ideal for furniture making
C the market value of a companys shares
D word processing software used by a writer to complete her new book
7 The workers in a factory currently earn $240 for a 40-hour week. The management offers
them a
choice between either a 10 per cent wage increase or an increase in the weekly wage to $260
along with a reduction from 40 to 39 hours.

Disregarding the value of leisure time, what is the opportunity cost to each worker of opting for
the 39-hour week?
A $4
B $6
C $20
D $24
8. The table shows the levels of demand for silver in millions of ounces for different uses
between
1999 and 2001.

1c, 2a, 3a, 4d, 5c, 6d, 7a,

Basic economic problem

with marking scheme As

Discuss the desirability of the worldwide movement towards the market economy and away
from the planned economy.
[12]

Markscheme

The market economy has limited government intervention and relies on the profit motive and
consumer sovereignty. It has proved more successful in raising living standards, economic
growth and economic efficiency. Consumers benefit from more choice and lower prices. Planned
economies were state-run with economic plans and large scale government intervention. The
result was low living standards although
employment was usually available and a basic quality of life resulted. The move to market
economies brought beneficiaries and casualties. Russia illustrates the increase in millionaires
while unemployment and poverty grew. Some East European economies are making fast
progress while some former USSR republics are struggling.
Candidates may consider the case of China.
Understanding of the features of economic systems (4)
Discussion of the benefits of the transition (4)
Discussion of the harm of the transition (4) [12]
(a)Explain the differences in the features of a market economy and a planned economy. [8]

Markscheme

Individual actions and consumer sovereignty dominate in the market economy. Motivation is
self interest. Private ownership, the profit motive and the operation of market forces are central
features. In a planned
economy there are government ownership, planning bodies and the state direction of
resources. Motivation is public interest. Decisions by the government dominate economic
activity.
Explanation of the features of a market economy up to 4 marks
Explanation of features of a planned economy up to 4 marks
2 (a) An economy is faced by the exhaustion of an important natural resource at a
time when it is introducing improved technology.
Explain how these events will affect the economys production possibility curve. [8]

Markscheme

Improved technology gives greater efficiency and rising productivity(output per worker per time
period) so should move the production possibility curve outwards, depending upon where the
improvement impacts. The exhaustion of a resource should reduce an input and the resulting
output and move the ppc inwards. The overall effect will depend on their relative strengths but
results from the change in available inputs and their effect on production possibilities. These
changes can be shown by diagrams.
Understanding of the ppc concept up to 2 marks
Awareness of the outcomes up to 4 marks
Balance of the effects/differentiated impact up to 2 marks
(b) Discuss whether the operation of a market economy always produces a desirable
outcome. [12]

Markscheme

A properly functioning market economy should provide choice, quality and competition. It
should make economic use of resources and avoid waste. It is an efficient system of resource
allocation and has outperformed planned economies. However, it has drawbacks such as the
production of externalities and demerit goods and the failure to provide public and merit goods.
Knowledge of the nature of the market system up to 4 marks
Justification of desirable outcome up to 6 marks
Discussion of the failings of the market economy up to 6 marks, subject to maximum of 8 in
total for this and the previous line

(a) Explain how production possibility curves might be used in assessing a country's
economic performance. [8]

Markscheme

A ppc shows the possible combinations of two goods which can be produced by an economy
when it uses all of its resources fully and efficiently. A ppc slopes down to the right and is
usually drawn concave to the origin. Points within show unemployment and inefficiency, points
without are unattainable. Shifts in the curve show growth or loss of productive potential. The
larger the contained area the greater the level of production potential.
For knowledge of a ppc up to 2 marks
For explanation of static position up to 3 marks
For explanation of move in curve up to 3 marks
(b) Discuss whether a mixed economy is the best way for a country to deal with the basic
economic problem. [12]

Markscheme

The basic economic problem concerns limited resources, unlimited wants and scarcity. A mixed
economy combines features of market and planned systems. Private ownership, profit motive
and markets operate as well as government ownership, service provision and market
intervention. The balance between the two varies between time and place. A mixed system
should benefit from the advantages of the two systems. The market system should provide
incentive and efficiency while equity and market failure should be dealt with by the
government. However a mixed economy may suffer from the disadvantages of both
alternatives producing inequality, inefficiency and low levels of welfare.
For understanding the mixed economy and economic problem up to 5 marks
For discussion of the mixed economy's benefits up to 5 marks ] max
For discussion of the mixed economy's drawbacks up to 5 marks
(a) An economy can produce agricultural and industrial goods. Explain the possible
effects on its production possibility curve if there is an increase in the productivity
of
its agricultural workers. [8]
A ppc shows an economys maximum output of two goods when using all of its resources.
Productivity is the measure of output per worker. Assuming the production of agricultural goods
and industrial goods, the ppc would be expected to pivot outwards, as workers produce more,
indicating greater quantities of agricultural goods. Further possibilities include greater
production of industrial goods as well because better food supplies increase overall productivity
or as restriction on agricultural total output shifts resources to industrial
production, which in turn expands.
For knowledge of ppc and productivity up to 2 marks
For understanding of pivot with more agricultural output up to 4 marks
For explanation of alternative outcomes up to 2 marks
(b) Discuss whether a market economy can solve the problem of scarcity more
effectively
than a command economy. [12]
A market economy involves minimal government intervention and relies on private motives and
ownership. A command economy is directed by the government with public motivation. Scarcity
occurs when there is insufficient output to meet peoples wants at zero price. Scarcity arises
because of limited resources and unlimited wants and is shown by the area outside of a ppc.
The market economy may appear to reduce the extent of scarcity more by operating efficiently
and improving the supply of goods and services, however the wants of consumers expand as
more basic needs are satisfied so scarcity remains. The command economy has achieved lower
living standards but with a more even distribution. Economic systems are unlikely ever to
remove the problem of scarcity, although its nature may differ under different systems.
For understanding of the economic systems and scarcity up to 4 marks
For analysis of the ability of each to reduce scarcity up to 6 marks
For discussion of the meaning and solution of scarcity up to 6 marks

Basic economic problem

TEST

1. What is the central problem for an economy?

A to achieve maximum growth in production
uses
C to ensure all resources are fully exploited
distribution

As
B to allocate resources between alternative
D to overcome inequalities in income

2 What are most likely to be disadvantages found in a market economy?

A economic growth and state-owned companies
B merit goods and free competition
C public goods and economic specialisation
D unemployment and external costs
3 The diagram shows the production possibility curve of an economy.
Which statement explains the shape of this curve?
A More efficient workers are drawn away from the production of
consumer goods.
B Resources cannot be switched between producing capital and
consumer goods.
C The economy is more efficient at producing capital than consumer
goods.
D The opportunity cost of producing capital goods increases the more
capital goods are made.
4. What is a correct statement about money?
A Its functions mean the characteristics that it possesses.
B Its liquidity means its use as
legal tender.
C Its supply means the total value of banknotes in circulation.
D Its value means its purchasing power.
5. The diagrams show the change in a countrys production possibility curve between Year 1
and Year 2.

What can be deduced from the diagrams?

A Future growth prospects have been harmed.
B The level of unemployment has
fallen.
C The opportunity cost of consumer goods has risen.
D The proportionate growth in production is greater in consumer goods.
6. What is likely to be greater in a planned economy than a market economy?
A efficiency
B flexibility
C innovation
D stability
7. The diagram shows the production possibility curves of two economies, X and Y.

Which statement about the two economies is correct?

A Both economies always have the identical opportunity costs.
B Both economies have the same future growth prospects.
C The opportunity costs are constant in both economies.
D The two economies can never produce the same combination of
products.

8. The price of good X rises by 10 %. As a result, the demand for a complementary good Y
changes
by 20 %. What is the cross elasticity of demand for good Y with respect to good X?
A +2
B +0.5
C 0.5
D 2
9. A good has unitary price elasticity of demand and at a price of $25 it sells 100 000 units.
Which price must the firm charge if it wants to sell 125 000 units of the good?
A $22
B $20
C $18
D $15

10. Which of the following statements must be true if the use of resources involves an opportunity cost?
A. Not all wants can be satisfied
B. Firms are below optimum size
C. Opportunity cost ratios are constant
D. The economy is operating below its
production possibility frontier
11. Which statement about income elasticity of demand over the range of
income shown is true?
A For cola it is less than 1.
B For cola it is greater than
1.
C For nuts it is greater than 1.
D For nuts it is zero.

12. In which of the circumstances will consumer surplus be zero?

A. Demand is perfectly inelastic
B. Demand is perfectly elastic
C. Elasticity of demand is 1
D. Supply is perfectly elastic
13. The price elasticity of demand for commodity is 0.5. The price of the commodity is initially $5 and the
initial quantity sold is 100. By how much would the price have to reduce to increase sales by 20 units?
A. $0.5
B. $1.00
C. $2.00
D. $3.00
14. The price elasticity of demand for a good is unity. What will increase as result of reduction in the price?
A. expenditure on the good B. expenditure on the substitute. C. quantity demanded D. marginal revenue.
15. What is most likely to make the demand for Good X inelastic?
A Good X is a luxury good.
B Good X is habit-forming.
C The proportion of income spent on Good X is very high.
D There are a large number of substitutes for Good X.
Economic Aspects of Cigarette Smoking
Smoking cigarettes is a controversial matter that illustrates a number of economic issues. As with
most products, the key influence on the level of consumption is the products price. United States
Fig. 1 US cigarette consumption and cigarette prices 1970
2006

A study of cigarette smoking in Malaysia estimated the short-run and long-run price elasticity of
demand (PED) and the income elasticity of demand (YED) for cigarettes between 1990 and 2004.
The results are shown in Table 1.
Table 1: Demand elasticities for cigarettes in Malaysia

In Europe, taxation of cigarettes is particularly heavy. In 2006 it was 76.4% of the final selling price in
Germany, 77.1% in the UK and 80.4% in France. European countries are increasingly banning smoking in
enclosed public areas and workplaces. Some anti-smoking campaigners are calling for the smoking of
cigarettes anywhere to be made illegal.
(a) How far does the data in Fig. 1 confirm that the normal demand curve relationship exists between the
price and the quantity demanded of cigarettes? [3]
(b) (i) What do the three elasticity values in Table 1 tell us about the elasticity of demand for cigarettes? [3]
(ii) What might explain these different elasticity values? [4]
c) Discuss whether a market economy can solve the problem of scarcity more
effectively
than a command economy. [12]

2 Explain how a countrys production possibility curve depends upon its factors of production. [8]
3 With the help of examples, explain why different economic decision makers face the problem
of scarcity. [8]

Transition occurred in the centrally-planned economies mainly as a result of overwhelming international

economic pressures. However, the process of transition itself was either triggered by internal policy shifts or
public upheavals, or was kept under the tight control of the centrally-planned state (e.g. China). In the former
situation, the speed towards reform was politically motivated, but relied heavily on the frustrated protests of
the collective workers who were demoralized by years of secure, but less stimulating, working environments.
In some countries, the major objective was mainly to demolish the old structure without planning for
alternative measures. This led to disruptions in basic community structures and increased the suffering of the
rural poor. Smallholder families were forced to trade their animals for food and other consumables. With
advances in the barter system, the value of livestock as a means of saving and the accumulation of wealth
increased, and the ownership of productive animals shifted in favour of the emerging community of wealthy
herders.
Although the change under the tight control of the centrally-planned countries such as China was also
triggered by external factors (e.g. international trade, the need for hard currency and improved technologies)
as well as by internal factors (e.g. ecological and climatic factors, social changes), the transition has been
smooth and well organized. The new livestock owners are not left to struggle for survival on their own.
Services are gradually being privatized, starting with a progressive recovery of service costs. Rural financing
has been developed under a well-organized banking and unsubsidized credit system. Transition under this
model has been gradual and more effective and has provided donors such as IFAD with opportunities to
support and improve smallholder livestock systems without measures that require drastic changes in the social
structure of the village communities.
Indeed, and in spite of the abruptness of the transition, each country has had its own identity and features. For
example, in some centrally-planned countries such as Laos, the chain of command was weak to start with
because of the lack of resources and the poor infrastructure and poor communication between the central
committee and rural communities. Under such conditions, the day-to-day management of the rural production
systems (cooperatives or otherwise) was kept at the grass-roots level. Because the influence of the state was
minimal, the problems during transition were primarily those with which the livestock producers were faced
during the command economy period. In the case of Laos, the major constraint continues to be the lack of the
capital needed for restocking the animals lost during the war or because of natural calamities, poor soil
fertility, feed deficit, poor animal health services, poor technical skills and losses due to landmines.
The situation in Kyrgyzstan is an example of a violent transition that has demolished the social and economic
fabric of a whole society in a merciless way. Five years after the collapse of the command economy, over 70%
of the population was classified as poor. The former state-supported social and economic privileges (see Box
1) were not replaced by better alternatives under the command of either the private or the public sector; nor
were there alternative community self-help activities. Typically, the poor lack money to buy food and other
essentials. They are unable to produce what they could once produce or unable to sell what they produce.
On the other hand, the transfer of wealth and power to a small portion of society is moving in different ways,
indicating the magnitude of diversity in the transition in this country and others in Central Asia. According to
the six-month University of Wisconsin Land Tenure Study in Kyrgyzstan in 1995, groups of small farms were
established around a large farm, and there was a symbiotic relationship for certain services. Also, some small
private farms have developed close relationships with the former Solkhozes and Kolkhozes they have recently
left. For example, one private farm has a long-term contract to raise heifers for a former collective farm, while
another private farm mills grain and dips animals at cost for another Kolkhoz. According to the team of
researchers for the USAID Collaborative Research Support Programme who visited Kyrgyzstan early 1997
some of the state and collective farms operate as modern businesses, while others have become subsistence
farms and pay members with produce and barter with nearby enterprises. Some seemingly successful
cooperative farms have been purchased by the 'Kolkhoz manager' and a few foreign partners.
The transition to the market economy did not accomplish most of its objectives, and countries remain in
urgent need of support from the international community. Except under the controlled transition in China, the
physical and institutional infrastructure as well as community institutions collapsed, leaving a vacuum at all
levels. Social workers, researchers and professionals (veterinarians, animal production officers) became - in
practice - jobless, while waiting for the evolution of new alternatives. The physical structure eroded, and

productivity declined as a result of the collapse of irrigation systems, the unavailability of inputs and the
collapse of the service delivery mechanism.

The problems of transition economies include:

Rising unemployment
Many transition economies experienced rising unemployment as newly privatised firms tried to become more
efficient. Under communism, state owned industries tended to employ more people than was strictly needed,
and as private entrepreneurs entered the market, labour costs were cut back in an attempt to improve
efficiency. As the newly established private firms became subject to greater competition some were driven out
of the market, which created job losses. In addition, a reduction in the size of the state bureaucracy also meant
that many employees of the state also lost their jobs.

Rising inflation
Many transition economies also experienced price inflation as a result of the removal of price controls
imposed by governments. When this happened, the newly privatised firms began to charge prices that
reflected the true costs of production. In addition, some entrepreneurs exploited their position and raised
prices in an attempt to profit from the situation.

Lack of entrepreneurship and skills

Many transition economies suffered from a lack of entrepreneurs and entrepreneurship, which make it more
difficult to reform their economies and promote market capitalism. In addition, there was also a skills gap with
few workers having the necessary skills required by employers in the newly privatised firms.

Corruption
It is alleged that corruption was widespread during the early years of transition in many former communist
countries, and this inhibited the effective introduction of market reforms. Many products were poorly made
and sold in unregulated and illegal markets, and many have claimed that criminal gangs and widespread
racketeering filled the vacuum left by the deposed communist regimes.

Inequality
Economic transition also led to rapidly increasing inequality as some exploited their position
as entrepreneurs and traders in commodities, while others suffered from
unemployment and rising inflation.
Lack of infrastructure
The transition economies also suffered from a lack of real capital, such as new technology, which is required
to produce efficiently. This was partly because of the limited development of financial markets, and because
there was little inward investment from foreign investors. Clearly, this has changed as the transition
economies have reformed, and joined the global market, which has encouraged inward investment (Foreign
Direct Investment FDI) from around the world.

Lack of a sophisticated legal system

Under communism, the state owned all the key productive assets, and there was little incentive to develop a
sophisticated legal system that protected the rights of consumers, and regulated the activities of producers.
Market-driven economies will only develop when citizens are granted extensive property rights, and can
protect these rights through the legal process. This was large absent in the former communist transition
economies.

Moral hazard

The problem of moral hazard implies that inferior performance can arise when the risks associated with poor
performance are insured against. For example, if individuals insure the contents of their house against theft,
they are more likely to leave their windows open. In the context of transition economies, under communism
people felt that the state would insure them against the risks associated with global competition, including the
risk of losing their jobs. The consequence is that many workers remained inefficient and unproductive,
knowing that employment prospects would not be reduced.

Fiscal Policy Effects

Fiscal policy decisions have a widespread effect on the everyday decisions and behaviour of individual
households and businesses hence in this note we consider some of the microeconomic effects of fiscal policy
before considering the links between fiscal policy and aggregate demand and key macroeconomic objectives.
The microeconomic effects of fiscal policy
1. Taxation and work incentives
Can changes in income taxes affect the incentive to work? This remains a controversial subject in the
economic literature!
Consider the impact of an increase in the basic rate of income tax or an increase in the rate of national
insurance contributions. The rise in direct tax has the effect of reducing the post-tax income of those in work
because for each hour of work taken the total net income is now lower. This might encourage the individual to
work more hours to maintain his/her target income. Conversely, the effect might be to encourage less work
since the higher tax might act as a disincentive to work. Of course many workers have little flexibility in the
hours that they work. They will be contracted to work a certain number of hours, and changes in direct tax
rates will not alter that.
The government has introduced a lower starting rate of income tax for lower income earners. This is designed
to provide an incentive for people to work extra hours and keep more of what they earn.
Changes to the tax and benefit system also seek to reduce the risk of the poverty trap where households
on low incomes see little net financial benefit from supplying extra hours of their labour. If tax and benefit
reforms can improve incentives and lead to an increase in the labour supply, this will help to reduce the
equilibrium rate of unemployment (the NAIRU) and thereby increase the economys non-inflationary growth
rate.
2. Taxation and the Pattern of Demand
Changes to indirect taxes in particular can have an effect on the pattern of demand for goods and services.
For example, the rising value of duty on cigarettes and alcohol is designed to cause a substitution effect among
consumers and thereby reduce the demand for what are perceived as de-merit goods. In contrast, a
government financial subsidy to producers has the effect of reducing their costs of production, lowering the
market price and encouraging an expansion of demand.
The use of indirect taxation and subsidies is often justified on the grounds of instances of market failure. But
there might also be a justification based on achieving a more equitable allocation of resources e.g.
providing basic state health care free at the point of use.
3. Taxation and labour productivity
Some economists argue that taxes can have a significant effect on the intensity with which people work and
their overall efficiency and productivity. But there is little substantive empirical evidence to support this view.
Many factors contribute to improving productivity tax changes can play a role - but isolating the impact of
tax cuts on productivity is extremely difficult.

4. Taxation and business investment decisions

Lower rates of corporation tax and other business taxes can stimulate an increase in business fixed capital
investment spending. If planned investment increases, the nations capital stock can rise and the capital stock
per worker employed can rise.
The government might also use tax allowances to stimulate increases in research and development and
encourage more business start-ups. A favourable tax regime could also be attractive to inflows of foreign
direct investment a stimulus to the economy that might benefit both aggregate demand and supply. The Irish
economy is often touted as an example of how substantial cuts in the rate of corporation tax can act as a
magnet for large amounts of inward investment. The very low rates of company tax have been influential
although it is not the only factor that has underpinned the sensational rates of economic growth enjoyed by the
Irish economy over the last fifteen years.
Capital investment should not be seen solely in terms of the purchase of new machines. Changes to the tax
system and specific areas of government spending might also be used to stimulate investment in technology,
innovation, the skills of the labour force and social infrastructure. A good example of this might be a
substantial increase in real spending on the transport infrastructure. Improvements in our transport system
would add directly to aggregate demand, but would also provide a boost to productivity and competitiveness.
Similarly increases in capital spending in education would have feedback effects in the long term on the
supply-side of the economy.
Fiscal Policy and Aggregate Demand
Traditionally fiscal policy has been seen as an instrument of demand management. This means that changes
in spending and taxation can be used counter-cyclically to help smooth out some of the volatility of real
national output particularly when the economy has experienced an external shock.
Discretionary changes in fiscal policy and automatic stabilisers
Discretionary fiscal changes are deliberate changes in direct and indirect taxation and govt spending for
example a decision by the government to increase total capital spending on the road building budget or
increase the allocation of resources going direct into the NHS.
Automatic fiscal changes are changes in tax revenues and government spending arising automatically as the
economy moves through different stages of the business cycle. These changes are also known as the
automatic stabilisers of fiscal policy

Tax revenues: When the economy is expanding rapidly the amount of tax revenue increases which
takes money out of the circular flow of income and spending
Welfare spending: A growing economy means that the government does not have to spend as much
on means-tested welfare benefits such as income support and unemployment benefits
Budget balance and the circular flow: A fast-growing economy tends to lead to a net outflow of
money from the circular flow. Conversely during a slowdown or a recession, the government normally
ends up running a larger budget deficit.

Estimates from economists at the OECD have found that the effects of the automatic stabilisers of fiscal policy
can reduce the volatility of the economic cycle by up to 20%. In other words, if the government is prepared to
allow the automatic stabilisers to work through fully, the fiscal policy can help to curb the excessive growth of
demand during a boom, but also provide an important support for income and demand during an economic
downturn.
Measuring the fiscal stance
The fiscal stance is a term that is used to describe whether fiscal policy is being used to actively expand
demand and output in the economy (a reflationary or expansionary fiscal stance) or conversely to take demand
out of the circular flow (a deflationary fiscal stance).

A neutral fiscal stance might be shown if the government runs with a balanced budget where government
spending is equal to tax revenues. Adjusting for where the economy is in the economic cycle, a neutral fiscal
stance means that policy has no impact on the level of economic activity
A reflationary fiscal stance happens when the government is running a large deficit budget (i.e. G>T).
Loosening the fiscal stance means the government borrows money to inject funds into the economy so as to
increase the level of aggregate demand and economic activity.
A deflationary fiscal stance happens when the government runs a budget surplus (i.e. G<T). The government
is injecting fewer funds into the economy than it is withdrawing through taxes. The level of aggregate demand
and economic activity falls.
The table below summarises the main changes in government spending and tax revenues and government
borrowing during recent years.
From 2001-2004 there was a huge fiscal stimulus to the UK economy through substantial increases in
government spending on transport, and in particular heavier spending in the twin areas of health and
education. The real level of government spending grew from 364 billion in 2000 to 488 billion in 2004 a
rise of 34%. The share of GDP taken up by government spending has also increased from 38% in 2000 to
41.4% in 2004. This significant increase in government spending has helped to maintain Britains short-term
economic growth at a time when some components of AD (notably export demand and investment) have been
weak.
The Keynesian school argues that fiscal policy can have powerful effects on aggregate demand, output and
employment when the economy is operating well below full capacity national output, and where there is a
need to provide a demand-stimulus to the economy. Keynesians believe that there is a clear and justified role
for the government to make active use of fiscal policy measures to manage the level of aggregate demand.
Monetarist economists on the other hand believe that government spending and tax changes can only have a
temporary effect on aggregate demand, output and jobs and that monetary policy is a more effective
instrument for controlling demand and inflationary pressure. They are much more sceptical about the wisdom
of relying on fiscal policy as a means of demand management. We will consider below some of the criticisms
of using fiscal policy as a tool of stabilising demand and output in the economy.
The multiplier effects of an expansionary fiscal policy depend on how much spare productive capacity the
economy has; how much of any increase in disposable income is spent rather than saved or spent on imports.
And also the effects of fiscal policy on variables such as interest rates
Problems with Fiscal Policy as an Instrument of Demand Management
In theory a positive or negative output gap can be relatively easily overcome by the fine-tuning of fiscal
policy. However, in reality the situation is complex and many economists argue for ignoring fiscal policy as a
tool for managing aggregate demand focusing instead on the role that monetary policy can play in stabilising
demand and output.
Recognition lags and policy time lags
o
o

Inevitably, it takes time to for government policy-makers to recognise that AD is growing either too
quickly or too slowly and a need for some active discretionary changes in spending or taxation
It then takes time to implement an appropriate policy response government spending plans are
subject to a three year spending review and cannot be changed immediately. Likewise the tax system is
highly complex for example income tax can only normally be changed once a year at the time of
the Budget. Indirect taxes can be changed more quickly but they have less of an effect on the level of
aggregate demand
It then takes time for the change in fiscal policy to work, as the multiplier process on national income,
output and employment is not instantaneous.

The importance of the national income multiplier imperfect information

Suppose a government wanted to eliminate a deflationary gap of 1000m. The increase needed in government
expenditure will depend on the size of the multiplier. The problem lies in knowing the exact size of the
multiplier. If the multiplier is 2, then government expenditure would have to rise by 500m. However, if the
multiplier was 4, a rise of only 250m would be needed. Without knowing the precise value of the national
income multiplier it is difficult to fine-tune the economy accurately.
Fiscal Crowding-Out
The crowding-out hypothesis became popular in the 1970s and 1980s when free market economists argued
against the rising share of national income being taken by the public sector. The essence of the crowding out
view is that a rapid growth of government spending leads to a transfer of scarce productive resources from the
private sector to the public sector. For example, if the government seeks to reflate AD by reducing taxation, or
by increasing government spending, then this may lead to a budget deficit. To finance the deficit the
government will have to sell debt to the private sector. Attracting individuals and institutions to purchase the
debt may require higher interest rates. A rise in interest rates may crowd out private investment and
consumption, offsetting the fiscal stimulus.
This type of crowding out is unlikely to make fiscal policy wholly ineffective but large budget deficits do
require financing and in the long run, this requires a higher burden of taxation. Higher taxes affect both
businesses and households neo-liberal economists believe that higher taxation acts as a drag on business
investment, labour market incentives and productivity growth all of which can have a negative effect on
economic growth potential in the long run.
The Keynesian response to the crowding-out hypothesis is that the probability of 100% crowding-out is
extremely remote, especially if the economy is operating well below its productive capacity and if there is a
plentiful supply of savings available that the government can tap into when it needs to borrow money. There is
no automatic relationship between the level of government borrowing and the level of short term and long
term interest rates. We can see from the previous chart that there has been a downward trend in long term
interest rates over the last tent to twelve years. Indeed in 2003 the yield (rate of interest) on ten year
government bonds dipped below 4 per cent one of the lowest long term interest rates in recent history.
Reaction to Tax Cuts Rational Expectations
According to a school of economic thought that believes in rational expectations, when the government
sells debt to fund a tax cut or an increase in expenditure, then a rational individual will realise that at some
future date he will face higher tax liabilities to pay for the interest repayments. Thus, he should increase his
savings as there has been no increase in his permanent income. The implications are clear. Any change in
fiscal policy will have no impact on the economy if all individuals are rational. Fiscal policy in these
circumstances may become impotent.
Partly because of the limitations of fiscal policy as a tool of demand management, many governments have
switched the focus of fiscal policy towards using it to improve aggregate supply as a means of creating the
conditions for sustainable economic growth. This is certainly the case with the current government.
Government borrowing
The level of government borrowing is an important part of fiscal policy and management of aggregate
demand in any economy. When the government is running a budget deficit, it means that in a given year, total
government expenditure exceeds total tax revenue. As a result, the government has to borrow through the
issue of debt such as Treasury Bills and long-term government Bonds. The issue of debt is done by the central
bank and involves selling debt to the bond and bill markets.
Government finances have moved from surplus in the late 1990s to a deficit of over 2.5 % of GDP in 2003-04.
The emergence of a rising budget deficit has been due to a weaker economy and the effects of substantial
increases in government spending on priority areas such as health, education, transport and defence. Both
current and capital spending are rising sharply in real terms. Critics of Gordon Brown argue that he risks
losing control of the budget deficit if tax revenues continue to come in below forecast whilst public sector
spending remains high. Gordon Browns reputation of fiscal prudence has come under pressure both before
and after the most recent election.

Does a budget deficit matter?

There is a consensus that a persistently large budget deficit can be a problem for the government and the
economy. Three of the reasons for this are as follows:

Financing a deficit: A budget deficit has to be financed and day-today, the issue of new government
debt to domestic or overseas investors can do this. In a world where financial capital flows freely
between countries, it can be relatively easy to finance a deficit. But it may be that if the budget deficit
rises to a high level, in the medium term the government may have to offer higher interest rates to
attract sufficient buyers of government debt. This in turn will have a negative effect on economic
growth
A government debt mountain? In the long run, government borrowing adds to the accumulated
National Debt. This means that the Government has to spend more each year in debt-interest
payments to holders of government bonds and other securities. There is an opportunity cost involved
here because this money might be used in more productive ways, for example an increase in spending
on health services or extra investment in education. It also represents a transfer of income from people
and businesses that pay taxes to those who hold government debt and cause a redistribution of income
and wealth in the economy
Crowding-out - the need for higher interest rates and higher taxes. Eventually the budget deficit
has to be reduced. This can be achieved by either by cutting back on public sector spending or by
raising the burden of taxation. If a larger budget deficit leads to higher interest rates and taxation in the
medium term and thereby has a negative effect on growth in consumption and investment spending,
then a process of fiscal crowding-out is said to be occurring.
Wasteful public spending: Neo-liberal economists are naturally opposed to a high level of
government spending. They believe that a rising share of GDP taken by the state sector has a negative
effect on the growth of the private sector of the economy. They are sceptical about the benefits of
higher spending believing that the scale of waste in the public sector is high money that would be
better off being used by the private sector.

Potential benefits of a budget deficit

What are the main economic and social justifications for a higher level of government spending and
borrowing? Two main arguments stand out
1. Government borrowing can benefit economic growth: A budget deficit can have positive
macroeconomic effects in the long run if it is used to finance extra capital spending that leads to an
increase in the stock of national assets. For example, spending on the transport infrastructure
improves the supply-side capacity of the economy. And increased investment in health and education
can bring positive effects on productivity and employment.
2. The budget deficit as a tool of demand management: Keynesian economists would support the use
of changing the level of government borrowing as a legitimate instrument of managing aggregate
demand. An increase in borrowing can be a useful stimulus to demand when other sectors of the
economy are suffering from weak or falling spending. The fiscal stimulus given to the British economy
during 2002-2004 has been important in stabilizing demand and output at a time of global economic
uncertainty. Perhaps Keynesian fiscal demand management has once more come back into fashion!
The argument is that the government can and should use fiscal policy to keep real national output
closer to potential GDP so that we avoid a large negative output gap.
The current situation

Government borrowing in the UK has shot up to 3.4 percent of GDP in the last fiscal year, in excess of
the 3.0 percent limit set by Europe's Stability and Growth Pact. But as the UK is not participating in
the single currency, the UK is not bound by the terms of the fiscal stability pact and this gives it more
flexibility in terms of how much the UK government can borrow
The government has allowed the automatic stabilisers to work during the current cycle. In other
words, it has allowed an increase in government borrowing brought about by a slowdown in domestic
demand and output.

Gordon Brown has introduced his own fiscal rules including the golden rule that government
spending on currently provided goods and services should be financed by taxation over the course of
the economic cycle. Government capital spending (public sector investment) can be financed by
borrowing because it results in the accumulation of capital which has long term economic benefits for
the country

Although government borrowing is currently high, there is little upward pressure on long-term interest
rates (indeed they are low). Financing the budget deficit is not a major problem for the UK as it seems
able to attract inflows of financial capital from overseas and foreign investors are happy to purchase
new issues of government debt. This reduces the risk of the crowding out effect taking place
Total government debt as a percentage of GDP remains low by historical standards (less than 40% of
GDP). And with interest rates remaining low, the government is not facing up to a huge cost of
servicing this debt
It is difficult to forecast government borrowing with great accuracy. Firstly this is because government
tax revenue and spending is sensitive to changes in the economic cycle. Secondly, we are dealing with
huge numbers! Total government spending in 2003-04 is forecast to be 459 billion and total tax
receipts 422 billion (giving a forecast budget deficit of 37 billion). It only takes government
spending and tax revenues to be 1% or 2% different from current forecasts for the budget deficit to
change significantly

Inter-relationships between Fiscal & Monetary Policy

Fiscal policy should not be seen is isolation from monetary policy.
For most of the last thirty years, the operation of fiscal and monetary policy was in the hands of just one
person the Chancellor of the Exchequer. However the degree of coordination the two policies often left a lot
to be desired. Even though the BoE has independence that allows it to set interest rates, the decisions of the
MPC are taken in full knowledge of the Governments fiscal policy stance. Indeed the Treasury has a nonvoting representative at MPC meetings. The government lets the MPC know of fiscal policy decisions that
will appear in the budget.
Impact of fiscal policy on the composition of output
Monetary policy is often seen as something of a blunt policy instrument affecting all sectors of the
economy although in different ways and with a variable impact. Fiscal policy changes can to a degree be
targeted to affect certain groups (e.g. increases in means-tested benefits for low income households, reductions
in the rate of corporation tax for small-medium sized enterprises and more generous investment allowances
for businesses in certain regions)
Consider the effects of using either monetary or fiscal policy to achieve a given increase in national income
because actual GDP lies below potential GDP (i.e. there is a negative output gap)
o

Monetary policy expansion: Lower interest rates will (ceteris paribus) lead to an increase in both
consumer and business capital spending both of which increases equilibrium national income. Since
investment spending results in a larger capital stock, then incomes in the future will also be higher
through the impact on LRAS.
Fiscal policy expansion: An expansionary fiscal policy (i.e. an increase in government spending or
lower taxes) adds directly to AD but if this is financed by higher borrowing, this may result in higher
interest rates and lower investment. The net result (by adjusting the increase in G) is the same increase
in current income. However, since investment spending is lower, the capital stock is lower than it
would have been, so that future incomes are lower.

Effectiveness of Monetary and Fiscal Policies

When the economy is in a recession, monetary policy may be ineffective in increasing spending and income.
In this case, fiscal policy might be more effective in stimulating demand. Other economists disagree they
argue that changes in monetary policy can impact quite quickly and strongly on consumer and business
behaviour.

However, there may be factors which make fiscal policy ineffective aside from the usual crowding out
phenomena. Future-oriented consumption theories based round the concept of rational expectations hold that
individuals undo government fiscal policy through changes in their own behaviour for example, if
government spending and borrowing rises, people may expect an increase in the tax burden in future years,
and therefore increase their current savings in anticipation of this
Differences in the Lags of Monetary and Fiscal Policies
Monetary and fiscal policies differ in the speed with which each takes effect the time lags are variable
Monetary policy in the UK is flexible since interest rates can be changed by the Bank of England each month
and emergency rate changes can be made in between meetings of the MPC, whereas changes in taxation take
longer to organize and implement.
Because capital investment requires planning for the future, it may take some time before decreases in interest
rates are translated into increased investment spending. Typically it takes six months twelve months or more
before the effects of changes in UK monetary policy are felt. The impact of increased government spending is
felt as soon as the spending takes place and cuts in direct and indirect taxation feed through into the economy
pretty quickly. However, considerable time may pass between the decision to adopt a government spending
programme and its implementation. In recent years, the government has undershot on its planned spending,
partly because of problems in attracting sufficient extra staff into key public services such as transport,
education and health.