This page contains model answers for 5, 8, 10, 12 and 15 mark questions for Edexcel Economics A style Section B questions.
These questions are from a practice paper linked below. The rest of the page contains the model answers for each question.
Link to the full question paper here.
Contents
5 mark question and answer
6(a) With reference to Figure 1, explain one possible reason for the trend in public sector spending from 2018-19 to 2023-24. (5 marks)
UK public sector spending as a percentage of GDP increased from about 39.5% in 2018-19 to about 44.8% of GDP in 2023-24, an increase of 5.3 percentage points. One possible reason is the downturn during the Covid-19 pandemic. Restrictions about contact and a loss of consumer confidence reduced consumer spending, leading to aggregate demand falling and a downturn. This led to an increase in government spending on automatic stabilisers, such as welfare benefits for the unemployed, as well as a discretionary increase in government spending on furlough. A downturn with negative GDP growth also increases the “denominator” in public spending as a percentage of GDP.
12 mark question and answer
(b) Assess the likely effects of contractionary monetary policy. Refer to Extract A in your answer. (12 marks)
Quantitative tightening (QT), the reverse of quantitative easing (QE), involves the Bank of England selling government bonds to the secondary bond market. This could reduce the Bank of England’s £895 billion in assets it owned under QE in 2020. This means commercial banks buying the bonds have less cash available, so commercial banks may reduce lending. By making it harder to borrow, firms may find it harder to borrow to invest. So investment falls. As investment is a component of aggregate demand (AD = C + I + G + X – M), AD shifts left from AD to AD1. This results in a fall in the price level from PL to PL1, signalling that QT can help to reduce the inflation rate.
However, if commercial banks are confident, for instance because the economy is booming, then these banks may not reduce lending. So investment and AD may not fall as much, leading only to a smaller fall in the rate of inflation.
Contractionary monetary policy could reduce asset prices. Indeed a decade of expansionary monetary policy may have contributed to “inflated asset prices”, so higher interest rates could reverse this. Higher interest rates increase the cost of borrowing, reducing demand for mortgages. This could reduce house prices, leading to a negative wealth effect among homeowners. Feeling less confident as their wealth has fallen, homeowners may consume less, so AD shifts left. This reduces the equilibrium price level further and lowering the rate of inflation.
However, there is a tradeoff when bringing down inflation. Higher interest rates, shifting AD left, may lead to falling real GDP, falling from Y to Y1 in the diagram. As there is less AD, there is less demand for labour needed to produce goods and services due to derived demand. So the unemployment rate could rise to 10% to keep inflation at the 2% target.
[Link to notes on monetary policy for further reading.]
8 mark question and answer
c) With reference to Extract B, examine the impact of fiscal policy announcements made in September to October 2022 on the cost of borrowing. (8 marks)
The UK Government announced cuts to taxes and an increase in government “spending to support the energy price cap”. This increases the budget deficit, leading to higher borrowing. The government’s debt-to-GDP ratio was set to increase by 15 percentage points over five years. This increases the demand for loanable funds, shifting demand right from D to D1 in the diagram below. As a result, interest rates rise to i1 to ration the excess demand of loanable funds. The interest rate is the cost of borrowing, so the cost of borrowing rises.
Also, the policy announcements could increase uncertainty among bondholders. Bondholders may worry about the increased risk of the government not paying its debt. To compensate for extra risk, bondholders may demand higher interest rates, increasing the cost of borrowing further.
However, if income tax rates are above their revenue-maximising rate, then an income tax cut could increase tax revenue. Workers would be more incentivised to work due to lower tax rates. So the budget deficit may be reduced, so borrowing falls and borrowing costs fall.
10 mark question and answer
d) Assess the effect of tax cuts on the productive capacity of the UK economy. Refer to Extract B in your answer. (10 marks)
In September 2022, “tax cut promises” were made such as a planned cut to the top marginal income tax rate from 45% to 40%. A cut to income tax rates could increase the incentive to work, as workers keep a greater proportion of their income as disposable income. The opportunity cost of leisure is greater, so workers may reduce demand for leisure and increase supply of labour (known as the substitution effect). Particularly, this tax cut could increase worker motivation, increasing productivity. An increase in the quantity and quality of labour boosts productive capacity.
OECD corporation tax rates have fallen from nearly 50% in the 1980s to just over 30% in 2016.
A cut to corporation tax rates leaves firms with more profits available after tax. So firms have more funds to invest in new, higher quality capital, boosting investment. An increase in the quality of capital could increase productivity. Higher productivity could be shown with the LRAS shifting right from LRAS to LRAS1 in the diagram below, increasing productive capacity.
However, the tax cut could decrease government revenue. So the government may have less money to spend on “education, training and infrastructure projects”. Less education spending could reduce workers’ human capital. So productivity may fall, shifting LRAS left.
Also, firms may not invest the extra profits received from the corporation tax cut. Instead the extra profits may go to shareholders as dividends. So investment in higher quality capital may not increase, so productive capacity may not rise after a tax cut.
[Links to notes on fiscal policy and supply-side policies for further reading]
15 mark question and answer
e) Using the extracts and your own knowledge, evaluate the reasons why the value of the pound, relative to other currencies, may vary over time. (15 marks)
One reason is the UK economic growth rate being lower than US economic growth rates. This could lead investors to expect the Federal Reserve, the central bank in the US, to raise interest rates more quickly than the Bank of England. This could contribute to the pound falling to its lowest value since 1985 of US$1.035 per pound in September 2022. Rising US interest rates relative to UK interest rates could lead to hot money outflows out of the UK into the US, as the reward for saving has increased in the US relative to that in the UK. As more people sell pounds to buy dollars, the supply of pounds increases, shifting right from S to S1. At the same time, there may be reduced inward flows of funds to the UK due to the lower (relative) rate of return. This reduces demand for the pound, shifting left from D to D1. Altogether the value of the pound against the dollar falls from p to p2.
However, the Bank of England may also engage in its own contractionary monetary policy during this time. Multiple countries could face the same risk from rising oil prices for example, which could drive up inflation, forcing central banks around the world to raise interest rates. Quantitative tightening was indeed being used in the UK to reduce the £895bn of assets held, which could raise bond yields, and prevent hot money outflow to the US. So the £ may not depreciate.
Another factor is uncertainty from UK fiscal policy. According to Rabobank, investors may be “lacking confidence about the government’s fiscal plans”. Investors may be more worried that there is a greater risk that the UK government will not be able to make its debt interest payments. This could be because of the increase in the budget deficit, which requires more government borrowing to fund, increasing the national debt. This increased risk could lead to investors selling UK government bonds and moving their money abroad to buy other governments’ bonds. This would increase the supply of pounds due to the sale of UK government bonds, in order to buy foreign currency to buy foreign government bonds. This increase in the supply of the £ reduces the value of the pound against other currencies, in other words causing a depreciation.
However, “significant parts of the UK government’s budget were later reversed”. For example planned tax cuts to high income workers did not proceed. This could be because of the government wanting to avert a rise in bond yields. As a result, the budget deficit did not increase as much and so government borrowing did not rise as much. This may help to reduce the extent of uncertainty about UK fiscal policy, making it only a temporary factor influencing the value of the pound.
[Link to notes on exchange rates for further reading]
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