2023 Y4 Economics EOY Revision Notes

1 hour 50 minutes, 45 marks, 0830-1020.

Structured Questions (20m) + Essays (25m) Q1 a) 10m, b) 15m OR Q2 a) 10m, b) 15m

1a. Distinguish between the causes of cyclical (demand-deficient) and structural UE. [10]
Introduction
v Define: Unemployment refers to people who are currently without a job but is willing & able to work and is
actively looking for one. Cyclical UE refers to UE caused by a lack of AD. Structural UE refers to UE arising from
changes in the structure of an economy.
v Background info (zoom out)
n Unemployment is always present in the economy, even at full employment.
n There are 4 types/causes of unemployment: Structural, frictional, cyclical & seasonal unemployment.
v Overview – Cyclical unemployment is a demand-side issue whereas structural unemployment is a supply-side issue.
v Some indication of conclusion – both types of unemployment stem from different issues, has a different nature, &
would impact economic agents in different ways.

Point P1: Cyclical (demand-deficient) unemployment is caused by a fall in AD in an economy.

Explain When? It occurs during a recession or an economic downturn.
v How (reason)
v When C & I fall leading to falling AD.
v When
v Hence, firms cut back on production, resulting in a fall in demand for labour. Workers
v Nature/impact
become redundant and unemployment is not voluntary.
v Cyclical unemployment is temporary (short-term). Stemming from a recession or an
economic downturn, it causes a temporary fall in demand for labour in the economy. It is
expected that once AD picks up, ADL should also increase.
Diagram(s) to AD-AS diagram to show demand-deficiency:
support & In times of a recession, C&I fall, hence AD
substantiate decreases, shifting leftward from AD1 to
AD2. Firms cut back on production, thus
output falls from Y1 to Y2.

Labour market diagram to show fall in DD

for labour: Firms cutting back on production
reduces demand for labour from ADL to
ADL1. Real wage should fall from We to W1,
but wages are sticky downwards and hence
unlikely to fall. At We, ADL is smaller than
ASL, creating unemployment of a-b.
Link back to the Q Cyclical UE is caused by a fall in AD, which usually occurs when an economy experiences a
recession, resulting in a fall in DD for labour by firms.
P2: Structural UE – Caused by long-term changes in the structure of an economy
Cause 1: Permanent fall in DD for a particular type of labour
Explain For example, technological advancement makes some types of workers unnecessary and redundant, such
as automation which reduces the need of labour.
Labour market diagram Due to lower labour costs in developing countries than in
developed countries, demand for labour in Country X falls
from D1 to D2. Fewer workers are employed (Q1 to Q2)
and wage falls from $X/hour to $Y/hour. There is an
increase in UE of Q1-Q2, unless these workers can find
other jobs.

Link Permanent fall in DD for a particular type of labour results in workers equipped with skills that are no
longer needed by existing jobs being retrenched.
Cause 2: Labour market rigidities à refers to factors that prevent forces of supply and demand from operating freely
in the labour market.
Employment protection laws make it costly for firms to fire workers as compensation must be made. As a result,
firms are more cautious about hiring workers, leading to reduce DD for labour, causing unemployment.
Link back to the Q Labour market rigidities result in lower Qdd for labour by firms due to increased labour costs.

Structural UE is harmful & more serious as it tends to result in long-term (more permanent) UE. Retrenched workers can
remain structurally unemployed if they are occupationally immobile (lacking necessary skills to move into new or
expanding industries) and/or geographically immobile (unwilling or unable to relocate to take up jobs where available).

Link: Structural UE is caused by changes in the structure of industries, which results in a mismatch between skills of the
unemployed and skills required by jobs available.

Conclusion
v Summarize key points in content: Cyclical UE is caused by low AD resulting in lower demand for labour, whereas
structural UE is caused by changes in the structure of industries in an economy resulting in a mismatch between
skills of the unemployed and jobs available.
v Reaffirm stand/main point: Both types of UE differ in its root cause & the nature/extent of its impact.
v Suggest some possible trends/implications: High UE is costly & can have adverse impact on different economic
agents namely the individual themselves, firms, society, the gov/economy.
v Provide additional insight: UE may bring about negative consequences but gov can reduce UE by using demand-
side policy (expansionary FP and/or MP) to tackle cyclical UE & supply-side policy to tackle structural UE.
Explain the cause of cyclical (demand-deficient) unemployment. [10]
Introduction
v Define – Unemployment refers to people who are currently without a job, but is willing & able to work and is actively
looking for one. They are part of the labour force.
Cyclical unemployment refers to unemployment caused by a lack of AD.

Content
Point P1: Cyclical (demand-deficient) unemployment is caused by a lack of AD in an economy.
Explain When? It occurs during a recession or an economic downturn.
v How (reason) v When the economy contracts or when there is slow or negative growth, C & I fall leading to
v When falling AD.
v Nature/impact v Hence, firms cut back on production, resulting in a fall in demand for labour. Workers
become redundant and unemployment is not voluntary.
v Cyclical unemployment is temporary (short-term). Stemming from a recession or an
economic downturn, it causes a temporary fall in demand for labour in the economy. It is
expected that once AD picks up, ADL should also increase.
v However, cyclical UE arising from lengthy period of down times could eventually result in
structural UE. As the economy picks up later on, the economic climate may have changed.
New form of labour is likely to be needed, while workers made redundant during the
recession may not have the necessary skills. This creates a mismatch between skills of the
unemployed and jobs available, leading to structural UE.
Diagram(s) to AD-AS diagram to show demand-deficiency:
support & In times of a recession, C&I fall, hence AD decreases,
substantiate shifting leftward from AD1 to AD2. Firms cut back on
production, thus output falls from Y1 to Y2.

Labour market diagram to show fall in DD for labour:

Firms cutting back on production reduces demand for
labour from ADL to ADL1. Real wage should fall from We
to W1, but wages are sticky downwards and hence
unlikely to fall. At We, ADL is smaller than ASL, creating
unemployment of a-b.

Link back to the Q Cyclical UE is caused by a fall in AD, which usually occurs when an economy experiences a
recession, resulting in a fall in DD for labour by firms.

Conclusion
v Summarize key points in content: Cyclical UE is caused by low AD resulting in lower demand for labour
v Reaffirm stand/main point
v Suggest some possible trends/implications: High cyclical UE is costly & can have adverse impact on different
economic agents namely the individual themselves, firms, society, the gov/economy.
v Provide additional insight: Cyclical UE may bring about negative consequences but gov can reduce it using
demand-side policy (expansionary FP and/or MP).
Explain why structural unemployment might occur in an economy. [10]
Introduction
v Define – Unemployment refers to people who are currently without a job, but is willing & able to work and is actively
looking for one. They are part of the labour force.
Structural unemployment refers to unemployment arising from changes in the structure of an economy.
v Overview: In the long run, patterns of demand & supply change, causing the economy to undergo structural changes,
with some sectors expanding & some contracting.
v Indication of C: This leads to a mismatch between the skills of the unemployed & the skills required for existing jobs.

Cause 1: Permanent fall in DD for a particular type of labour

Explain v Technological advancement makes some types of workers unnecessary and redundant, such as
automation which reduces the need of labour.
v Change in consumer taste may cause certain industries to decline and others to grow. Workers who
lose their jobs in declining industries may not have the necessary skills in other growing industries.
v Globalization refers to increased interdependence of countries around the globe due to free trade.
n It enables firms to set up operations in countries with lower labour costs, leading to a fall in DD
for labour in more developed economies where labour cost is higher.
n It also enables increased trade. Firms in countries with lower COP have cheaper goods, resulting
in a fall in demand for labour in countries with higher COP.
Labour market diagram Due to lower labour costs in developing countries than
in developed countries, demand for labour in Country X
falls from D1 to D2.
Fewer workers are employed (Q1 to Q2) and wage falls
from $X/hour to $Y/hour.
There is an increase in UE of Q1-Q2, unless these
workers can find other jobs.

Link Permanent fall in DD for a particular type of labour results in workers equipped with skills that are no
longer needed by existing jobs being retrenched.
Cause 2: Labour market rigidities à refers to factors that prevent forces of supply and demand from operating freely
in the labour market.
Explain Minimum wage legislation: Govt may impose a minimum wage (above equilibrium wage) to protect
workers. This may however lead to unemployment, as higher wage (W):
v Raises SSL: more people are willing and able to work BUT
v Reduces DDL: firms are less keen on taking on workers as cost is higher
Greater SSL & lower DDL results in unemployment.
Minimum wage diagram As the govt imposes a minimum wage of Wm which is
higher than equilibrium wage We, Qdd for labour falls
from Qe to Qd due to higher cost for firms. Due to
increased income, workers have greater incentive to
work, resulting in a rise in Qss of labour from Qe to Qs.
This results in labour UE of Q1-Q2.
 Labour union activities & wage bargaining: Workers may ask for higher wages by negotiating peacefully or by going
on strikes. Firms giving in to workers’ demand results in higher than equilibrium wages, and hence unemployment.
Employment protection laws make it costly for firms to fire workers as compensation must be made. As a result,
firms are more cautious about hiring workers, leading to reduce DD for labour, causing unemployment.
Link back to the Q Labour market rigidities result in lower Qdd for labour by firms due to increased labour costs.

Structural UE is harmful & more serious as it tends to result in long-term (more permanent) UE. Retrenched workers
can remain structurally unemployed if they are occupationally immobile (lacking necessary skills to move into new or
expanding industries) and/or geographically immobile (unwilling or unable to relocate to take up jobs where available).

Conclusion
v Summarize key points in content & Reaffirm stand/main point: Structural UE is caused by changes in the
structure of industries, which results in a mismatch between skills of the unemployed and skills required by the
available jobs.
v Suggest some possible trends/implications: High structural UE is costly and more permanent. It can have adverse
impact on different economic agents namely the individual themselves, firms, society, the gov/economy.
v Provide additional insight: Structural UE may bring about negative consequences but gov can reduce it using
supply-side policy that improves workers’ geographical and occupational mobility.
2a. Explain the factors that cause / the differences between demand-pull and cost-push
inflation. [10]
Introduction
v Inflation is the sustained increase in average price level of goods and services in an economy over a period.
v There are 2 types of inflation: demand-pull and cost-push inflation.
v Demand-pull inflation is the inflation caused by an increase in AD in the economy, brought about by changes in
any of the AD determinants (consumption, investment, gov spending, exports & imports) and illustrated as a
rightward shift in AD on the ADAS model.
v Cost-push inflation is the inflation arising from an increase in costs of production or supply-side shocks, which
results in a fall in SRAS. It is illustrated as a leftward shift in SRAS on the ADAS model.
v Some indication of conclusion – both types of inflation indicate that overall price level is rising, but they are
caused by different factors & hence represented differently on the ADAS model.

Point 1: Demand-pull inflation

l Explain:
n What is demand-pull inflation? A rise in APL due to increase in AD in the economy. There’s excess AD over AS.
AD rises faster than SRAS, resulting in APL increasing.
n What causes such demand-pull inflation? Explain the relevant factors that can raise AD.
u Increase in C & I – higher level of consumer & firm confidence/lower interest rates → increase C & I
spending → raise AD
u Increase in G – increase in spending on transfer payments → raise AD
u Increase in X – specialization due to abundant resources domestically → lower prices of X – X more
competitive → raise X revenue → raise AD
u Fall in M – recession in domestic economy → rise in unemployment & fall in income → lower purchasing
power → lower M expenditure → raise AD
l Diagram: AD/AS model – increase in AD; AD shifts right, real output & average price level increases

l Link: changes in any components of AD may lead to a rise in AD, resulting in demand-pull inflation.
Point 2: Cost-push inflation
l Explain:
n Cost-push inflation refers to increases in COP or supply-side shocks, which results in a fall in SRAS.
n Cost-push inflation can be caused by 1) increase in wage rate, 2) increase in prices of domestic or imported
raw materials, 3) depleting resources and increase in taxes imposed.
u For instance, when a trade union successfully negotiated a new labour contract that entitles workers to
higher wages, the increase in wage rate makes it more costly to produce at every level of output.
Hence, current production becomes less profitable. Firms will also raise price level to cover increased
cost. As a result, SRAS falls and shifts left.
l Diagram: AD/AS model – fall in SRAS; SRAS shifts left, real output falls but APL increases

l Link: A rise in COP reduces SRAS, causing cost-push inflation.

Conclusion
v Summarize key points in content: Both demand-pull and cost-push inflation indicate a rise in APL in the economy,
affecting households’ purchasing power.
v Reaffirm stand/main point: However, both types of inflation are caused by different factors, with demand-pull
inflation resulting from a rise in AD, and cost-push inflation resulting from a fall in SRAS.
v Suggest some possible trends/implications: Inflation may lead to loss of purchasing power as income remains
constant but APL increases, leading to fall in real income and hence lower living standards.
Inflation may also encourage consumption and discourage savings, as people have to spend more to sustain their
present SOL with rising price levels, which further increases AD and inflation.
v Provide additional insight: As such, the government need to control inflation to minimize the negatives impacts of
high inflation on the economy, such as by using demand-side policies (contractionary fiscal and monetary policies)
to tackle demand-pull inflation and supply-side policies to address cost-push inflation.
2b. Using real-life examples, evaluate the effectiveness of fiscal policy as a means of
achieving economic growth. [15]
Introduction
v Economic growth refers to an increase in real GDP over a period of time.
v Fiscal policy refers to changes made to government spending (G) and taxation (T) designed to influence AD in
order to achieve gov’s macroeconomic aims.
v There are 2 types of growth: actual and potential growth.
v Actual growth refers to an increase in real output resulting from increased employment and/or efficiency of
existing FOPs. It occurs over relatively short periods of time.
v Potential growth refers to an increase in real output resulting from increase in potential output or productive
potential. It occurs over relatively long periods of time.
v Expansionary FP may promote economic growth both in the short-run and long-run.
v However, it may not necessarily always be effective in achieving growth.

Point 1: Expansionary FP can help promote actual economic growth

l Since AD = C+I+G+(X-M), increasing G raises AD directly.
l Meanwhile, lower personal income tax increases disposable income, resulting in greater purchasing power and
hence increased C by consumers. Cut in corporate tax increases firms’ after-tax profits, acting as an incentive for
firms which raises I. Hence, cut in T raises AD.

l Real-world example – US (2008-2010)

n During the Great Recession in 2008, there was a sharp decline in economic growth in the United States (US),
in which real GDP growth rate fell from 2.1% in 2007 to 0.12% in 2008.
n In response, the American Recovery and Reinvestment Act (ARRA) was introduced in 2009, which raised
government spending (G) to $787 billion. This increase in G increased AD directly.
n In order to raise disposable income such that higher consumption (C) is possible, average federal tax rates for
all households decreased from 19.6% (2008) to 18.6% (2009), cutting federal revenue by around $120 billion
in fiscal years 2008 and 2009.
n Average federal income tax decreased from 9.2% (2007) to 7.2% (2009).
n Moreover, the federal government also provided tax reliefs and benefits to businesses such as a tax benefit of
$8 billion to business investment which would hopefully help to increase investment (I).
n The increased C and I increased AD leading to higher output, in which real GDP growth rate increased from
0.12% in 2008 to 2.71% in 2010.
l Link: Expansionary FP through increase in G and fall in T may directly raise AD, promoting actual economic growth
in the short-run.

Point 2: Expansionary FP can help promote potential economic growth

l Increase in G and fall in T may indirectly increase Keynesian AS and raise economic growth in the long-run.
l For instance, the increased government spending (G) could be spent on infrastructure, technology, R&D, and
human capital, which could give rise to technological advancement and increased quantity and quality of FOPs.
l Meanwhile, tax reductions (T) act as incentives for firms to invest, which could create more employment
 opportunities, improving efficiency of resource allocation and further increasing quantity and quality of factors.
l Diagram:
[Refer to Figure 1] Increase G & Reduce T à AD shifts rightwards
As a result, expansionary FP lead to increased quantity and quality of FOPs, LRAS increases and shifts rightwards.
PPC model – PPC shifts outwards.

l Real-world example – US (2008-2010)

n In the aforementioned ARRA programme introduced to promote growth during the 2008 Great Recession, the
government spending (G) which was at $787 billion include $138 billion spent on healthcare and $85 billion
on public infrastructure such as expanding mass transit.
n Meanwhile, the tax benefit of $8 billion provided to business could also help to increase investment (I).
n The increased G and cut in T, as such, help to increase quantity and quality of FOPs, enabling increase in LRAS
in the long run.
l Link: Expansionary FP may indirectly raise LRAS via increase in G & cut in T, promoting potential growth in the LR.

Synthesis/Evaluation

FP is especially effective in promoting growth for 2 strengths.

1) Firstly, as explained previously, FP can help to raise not only actual growth but also potential growth, which makes
it more effective and sustainable in the LR in dealing with economic issues such as recession.

a) Real-world example: During the 2008 Great Recession, increased government spending gave the US
government enough funds to spend on infrastructure, healthcare, education etc., which created and saved up
to 3.5 million jobs by 2010, increasing overall economic growth as unemployment was reduced.

2) Secondly, increase in G can increase AD directly, thus giving FP a more certain impact. G is more likely to be
effective in helping lift the economy out of deep recession & reduce cyclical UE.

a) Real-world example: During the 2008 Great Recession, government spending (G) was raised to $787 billion,
which acted as a direct stimulus to AD, boosting real GDP by 2.5%.

However, the drawbacks of FP is also evident in 2 main ways.

1) Firstly, the use of FP involves trade-off between gov macroeconomic aims. For instance, raising G while lowering T
creates a budget deficit in which spending is greater than revenue. This has an adverse impact on government
budget. Gov may have to raise borrowing to finance this deficit, which increases government debt.

a) Real-world example: As part of the ARRA programme, G was raised to $787 billion which increased federal
debt from $12.4 trillion in Dec 2009 to $14.3 trillion in Feb 2010, raising the US debt-to-GDP ratio from
62.6% in 2007 to 105.2% in 2016.

2) Secondly, FP is not effective in dealing with macroeconomic issues unrelated to AD, such as frictional, structural
and seasonal UE. Moreover, it is difficult to finely adjust FP as G&T are large and impact many different economic
agents and areas. It is possible to set the desired direction but difficult to precisely predict the outcome.
Furthermore, expansionary monetary policies and supply-side policies can also be used to promote economic growth.

1) Expansionary MP increases money supply which lowers interest rates. This results in reduced cost of borrowing,
causing households and firms to borrow more, leading to increased C&I. Also, lower i/r lowers returns from savings,
which causes consumers to reduce savings and increase C. As such, expansionary MP directly raises AD, leading to
actual economic growth.

2) Whereas supply-side policies aim at increasing LRAS, such as through government investing in human capital,
infrastructure, R&D and/or implementing policies that encourage competition, reduce labour market rigidity and
increase incentives of people to work and invest.

Conclusion
v Summarize key points in content: Expansionary FP may effectively help a country to achieve economic growth by
directly raising AD and/or indirectly raising LRAS.
v Reaffirm stand/main point: However, FP may not always be effective in doing so as it could involve trade-offs
between government’s macroeconomic aims and is only effective when targeted at AD-related economic issues.
v Suggest some possible trends/implications: Expansionary FP will to an extent be effective in achieving economic
growth, but the right size and nature of FP need to be framed as a fiscal policy that is too strong or too weak could
instead worsen the situation.
v Provide additional insight: Thus, to achieve a steady, sustainable economic growth, the government should use a
combination of expansionary fiscal policy, monetary policy and supply-side policies to promote both actual and
potential growth in the economy.
4b. Using real-life examples, discuss the view that the best way to achieve greater equity in
the distribution of income in a country is to use a progressive tax system. [15]
Background info: Inequality stems from differences in income and wealth resulting in differences in living conditions
and opportunities such as in terms of education and health. There are two types of economic inequality: income
inequality and wealth inequality, in which -
Income inequality arises from differences in how evenly income is distributed in a population, and is present when
there is a gap between the rich and poor.
Overview: There are policies that can be implemented to redistribute income.
For instance, progressive taxation, which takes away a greater proportion of income from those with higher income
than those with lower income. As income increases, fraction of income paid as taxes increases.
Some indications of conclu: Progressive taxation can effectively redistribute income, but it is not necessarily the best way.

Content
Point 1: Progressive taxation is the best way to reduce income inequality.

Explain: How? (Note: focus is on progressive taxes)

l Taxation refers to a financial obligation imposed by the government on residents.
l Gov collects taxes to raise revenue for government spending, as a fiscal tool to influence the level of AD, or to
reduce inequality in income and/or wealth distribution.
l There are 2 categories of taxes: direct and indirect taxes, while there are 3 principles of taxation: progressive,
proportional and regressive taxation.
l Progressive taxation aims to tax the rich proportionately more than the poor, so that the after-tax (disposable)
income distribution will be more equal, thereby reducing income inequality between the rich and poor.

Diagram: Lorenz curve shifts inwards

Real-world example:

For instance, Hong Kong grapples with widening income gap mainly due to its predominantly market-oriented economy
and low-tax regime. As a result, its Gini coefficient has climbed from 0.525 in 2001 to 0.539 in 2016. Amidst the
pandemic, when the poorest decile experienced a more than 20% decline in median monthly income, the more
affluent deciles saw a 6.3% increase.

To address this, Hong Kong follows a progressive salary tax rate system, in which the 0–50,000 HKD tax bracket is
subject to 2% marginal tax, whereas the above 200,001 HKD tax bracket is subject to 17% tax. This allows the rich to
be taxed proportionally more than the poor, aiming to make the after-tax distribution of income & wealth more equal.

Link: Progressive taxation is the best way to reduce income inequality.

Synthesis/Evaluation

*Discuss ‘best way’. Consider when progressive taxes is NOT the best way to promote a more equal distribution of income
– it may FAIL to redistribute income or result in other issues. Evaluate the strengths & weaknesses of such a tax system.
However, progressive taxes may not necessarily be the best way to promote equity in income distribution.

ü Progressive taxation improves equity, narrows the gap between high and low income earners and allows for more
equitable income distribution.

ü Progressive taxes also help to raise govt revenue which can be used to finance necessary expenditures
like public and merit goods, and to further redistribute income such as via provision of transfer payments.

û However, taxation is an incredibly complicated process, with ample room for error and manipulation.
Government may earn less revenue than expected as people find ways to avoid paying taxes.

û Also, progressive taxes promote equity at the expense of potential disincentive effects on working and
investment, as high income tax rates discourage people from working harder, moving into higher paid jobs while
corporate taxes and wealth taxes may become disincentives to investment.

l Real-world example: For instance, the aforementioned progressive taxation implemented in Hong Kong has not
been effective in bridging the wealth gap, as seen from its increasing Gini coefficient from 0.525 in 2001 to 0.539
in 2016. While simply implementing a more progressive taxation system would help to alleviate the income gap, it
could discourage foreign investment and high-income earners from settling in the city, restricting Hong Kong SAR’s
economic growth. Thus, despite the persisting income inequality in HK, the government has been reluctant to
make the income taxes more progressive, worrying that doing so could reduce HK’s economic competitiveness.

l Consideration of alternative approaches to promote more equal distribution of income

n Transfer payments are payments made by the government to individuals specifically for the purpose of
redistributing income away from certain groups and towards other groups. It transfers income from those
who work and pay taxes towards those vulnerable groups who cannot work and need assistance, including
the elderly, the sick, families in poverty, the unemployed etc.

u For instance, Brazil has historically faced significant income inequality, with its Gini coefficient standing at
0.58 in 2002. Hence, Bolsa Família, a conditional cash transfer program, has been implemented in Brazil
since 2003.

l The program aims to alleviate poverty and reduce income inequality by providing cash transfers to
low-income families, with certain requirements such as children attending school and receiving
regular health check-ups.

ü Increasing transfer payments can reduce poverty & inequality as it reaches those who clearly need support.

l Bolsa Família has been recognized internationally as an effective poverty reduction program. It has
reached millions of Brazilian families, reducing poverty rate from 24.7% in 2003 to 7.4% in 2014.

l It has also helped to reduce income inequality in Brazil, lowering Gini coefficient from 0.54 in 2004
to 0.49 in 2014.

û However, compared to progressive taxes which helps gov to raise revenue, transfer payments represents
a burden on gov budget and incurs opportunity costs.

l Bolsa Família has cost the Brazilian government R$12.3 billion or 0.4% of GDP, representing a
significant portion of its annual social spending (1.1% of GDP as of 2018).

û Moreover, it may create incentives for people to not work, as people could grow reliance on payments
like unemployment benefits and housing allowances.

n Targeted govt spending on merit goods is another approach that the government could adopt to promote
equity, in which gov uses tax revenue to provide directly or subsidize merit goods (and services) that are
socially desirable with positive consumption externalities.
 u It ensures lower-income households have access to essential G&S and achieve economic development.

u It also includes investments in infrastructure such as clean water supplies, sanitation and sewerage
which can improve human capital.

u However, similar to transfer payments, provision of G&S represents a burden on gov budget and entails
opportunity costs, making progressive taxes which helps to raise revenue a better option.

Conclusion
l Summarize key points in content: Progressive taxes is the best way to reduce inequality in income distribution as it
enables more equitable disposable income distribution while helping gov to raise revenue, unlike other
approaches like transfer payments that add on to gov expenditure.
l Reaffirm stand/main point: However, it is not necessarily the best way as there are ample room for error,
manipulation and tax evasion, and that it could become a disincentive for people to work hard to earn more.
l Suggest some possible trends/implications: Progressive taxation, despite its limitations, helps to achieve equity in
income distribution without incurring much opportunity costs and adding on to gov spending.
l Provide additional insight: In promoting greater equity in income distribution, gov could consider using a
combination of policies, maximizing the strengths of each and minimizing impact of the drawbacks, such as direct
provision of merit goods using tax revenue collected from the higher-income earners.

3 Benefits of Free Trade

v Increased competition – Foreign competition forces domestic firms to become more efficient and competitive.
This raises incentive to cut costs, increase efficiency in production, innovate and be more responsive to consumer
needs. à which may result in lower prices, better quality goods and greater variety, in which consumers gain
better living standards.

v Lower prices – Free trade leads to lower product prices (both domestic and imports) due to better quality
resources (labour force/capital) or technology, as well as access to natural resources. Consumers benefit from
cheaper products and producers are able to purchase cheaper raw materials.

v Greater choices – Trading enables countries to import a variety of G&S, and products of higher quality.
Consumers have more choices as they have access to both domestic & imported goods.

v Difference in resources – Countries may require natural resources or capital goods that are not available
domestically for their production. Trade enables countries to acquire the resources they need but lack by importing.

v Enhances employment – Free trade increases job opportunities, especially in exporting industries. As the domestic
market expands, demand for G&S rises. Larger labour force may become necessary, more jobs available increases
income, which raises purchasing power, raising living standards and reducing poverty.

3 Limitations of using real GDP in assessing SOL

v GDP does not account for income distribution – distribution of income may be uneven in the economy, which
means the benefits of an increase in real GDP is not enjoyed equally by all residents but this is not shown in the
rise in GDP value.

v Increase in real GDP does not reflect the composition of output – there may be higher military spending or
spending on capital goods, but no increase in spending on health and education. These forms of spending may not
improve living standards.

v An increase in real GDP may be accompanied by reduced leisure time/freedom – longer working hours reduces
living standards which is not shown in the rise in GDP value due to higher output produced by these workers.
Why does NI Statistics not measure the true value of output?
v GDP may understate true changes in output, since it does not take into account output that is non-marketed or
sold in parallel markets. Due to such unrecorded and underrecorded economic activities, GDP does not reflect
the actual quantity of G&S. This includes output sold in the hidden economy: illegal activities like drug trafficking
and prostitution, concealed legal activities like unreported self-employment income, as well as non-marketed
output that took place without money exchange, such as do-it-yourself work and subsistence farming. These
economic transactions are unrecorded, undeclared and therefore untraceable.

v GDP does not account for improvement in G&S – GDP measures quantity produced but not quality of goods.
Quality of products may have improved over time, yet this is not accounted for in calculating the value of total
output. Whereas output could have risen but if quality falls, living standards would worsen.

v GDP could give a highly misleading picture of SOL in different countries as different domestic price levels across
countries are not taken into account. This could be dealt with by using Purchasing Power Parity (PPP) to convert
GDP and GNI of different countries into a single common currency.
2b. Using real-life examples, discuss the view that the use of fiscal policy is the most
effective way of reducing the rate of inflation in an economy. [15]
Introduction:
l Inflation is the sustained increase in average price level of G&S in an economy over a period (usually a year).
l Fiscal policy (FP) refers to changes to government spending (G) and taxation (T) designed to influence AD in order
to achieve government’s macroeconomic aims.
l There are 2 main causes of inflation: demand-pull & cost-push. Rising demand-pull inflation may be reduced using
a contractionary fiscal policy, a demand-side policy that reduces G and raises T.
l Some indications of conclusion: Contractionary FP will to an extent, be effective in reducing inflation.

Content:
(P) Contractionary FP can reduce demand-pull inflation.
(E) Since AD = C+I+G+(X-M), lowering G lowers AD directly. Meanwhile, higher personal income tax lowers disposable
income, resulting in lower purchasing power and hence lower C by consumers. Increased corporate tax reduces firms’
after-tax profits, acting as a disincentive for firms which lowers I. Hence, increase in T reduces AD, bringing APL down.

Diagram: AD/AS diagram to show how contractionary FP leads to a fall in demand-pull inflation

For example, UK had experienced strong economic recovery following the COVID-19 pandemic, in which the demand
for G&S had increased significantly, beating up APL, leading to demand-pull inflation. In response, the UK gov
implemented a series of contractionary FP. The National Insurance (NI) rate for employees has been increased by
1.25%, and the corporation tax rate has been increased from 19% to 25%. Meanwhile, the UK government has frozen
public sector pay (no pay rise) since September 2021. The government has also reduced spending on capital projects
by £10 billion per year through delaying projects including the HS2 high-speed rail project and the construction of
new hospitals. These policies have helped to slow the economy and reduce demand for G&S, leading to a fall in
inflation rate from 5.4% in Dec 2021 to 10.1% in July 2022.

Strengths of FP in reducing inflation

l FP can target specific economic sectors that requires the most help. Gov can raise spending more on areas where
unemployment is worst hit.
l Also, FP can impact AD directly through increase in G. Impact is more certain (unlike tax cuts). G is more likely to be
effective in helping· lift the economy out of deep recession & reduce demand-deficient unemployment.

(L) Contractionary FP can help lower demand-pull inflation.

Synthesis/ Evaluation: Ultimately, the effectiveness of FP on reducing inflation rate depends on the cause of inflation. In
case of cost-push inflation which is caused by increased COP, neither contractionary FP nor MP would be effective as they
both tackle AD only. SSP which focuses on COP and LRAS should be used instead.

Limitations of FP in reducing inflation

l Time lags refers to a delay between an economic action & a consequence. Because of time lags, FP may only affect
the economy when economic conditions have improved, making the FP implemented inappropriate.
l Use of FP involves trade-off between gov macroeconomic objectives. Contractionary FP implemented to reduce
inflation not only lowers AD but also increases cyclical UE, slowing down economic growth. Moreover, higher
income tax could create disincentives to work.
n For example, in the aforementioned UK demand-pull inflation, there was a trade-off between gov’s
macroeconomic objectives. The increase in T and reduction in G not only lowered AD but also gave rise to
increased unemployment rate from 3.5% in Aug 2022 to 4.0% in May 2023, slowing down economic growth.

Conclusion: Contractionary FP can help reduce inflation, but it may only be effective if the cause of inflation is
increased AD (demand-pull). Even with a contractionary FP being implemented, APL will continue to rise if there is
rising COP, causing cost-push inflation. Thus, to address the issue of rising price level, the gov may use a combination of
both demand-side & supply-side policies.