Cambridge IGCSE and O Level Economics

Section 4: Government and the

macroeconomy
Part 1 Definitions
1 p 2 t 3 s 4 h 5 i
6 l 7 f 8 b 9 e 10 m
11 r 12 k 13 c 14 q 15 o
16 j 17 y 18 a 19 d 20 w
21 v 22 g 23 z 24 n 25 u
26 x

Part 2 Missing words

1 low, inflation 2 potential, production possibility
3 rich, poor, taxes 4 deficit, tax
5 fiscal, total (aggregate), taxes, government 6 tax
spending/expenditure
7 customs duties/import tariffs 8 multiplier
9 increase, decrease/reduce 10 progressive, percentage
1
11 monetary, reflationary/expansionary, fiscal 12 base, burden
13 inflation 14 right, actual, potential
15 increase, subsidise 16 base, weights
17 inflation, capacity/employment 18 borrowers, weak, strong
19 benefits, labour force 20 cyclical, frictional/structural, structural/
frictional
21 higher, longer 22 deficit, fall/decrease, unemployment benefits
23 constant, inflation 24 increase, sustainable
25 demand-pull, cost-push 26 government/state, private
27 long, technology, methods 28 reduce/decrease, increase/raise
29 automatic stabilisers 30 shoe-leather

Part 3 Calculations
1 a The unemployment rate is the number unemployed divided by the labour force. In this case,
2m
this is × 100 = 16%.
12.5 m
b The unemployment rate is: unemployed/labour force × 100. The labour force consists of both
the unemployed and the employed. In this case, the labour force is 3 m + 21 m = 24 m and the
3m
unemployment rate is × 100 = 12.5%.
24 m

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2 a $8 bn (40% of $20 bn).

b The total tax which will be deducted will be $7000. ($5000 × 0% = 0, + $5000 × 20% = $1000,
+ $20 000 × 30% = $6000, $1000 + $6000 = $7000).
3
3 a 2% × 100.
150
b

Category Weight Price Weighted

change price change
Food 1/2 × 5% = 2.5%
Clothing 1/4 × 10% = 2.5%
Leisure goods 1/4 × 16% = 4.0%
9.0%
The change in the price level is 9%.

Part 4 Interpreting diagrams

1 a Unemployment of resources.
b Long-run growth or an increase in the productive potential of the economy.
2 a ( This question is stretch content) AD is aggregate demand, which is the total demand for
the country’s products at a given price level. AS (aggregate supply) is the total output of a
country’s producers at a given price level. Real GDP is a measure of the country’s output that
has been adjusted for inflation.
b Two possible causes of a shift in the AD curve are an increase in business optimism and a cut
2
in income tax. An increase in business optimism would be likely to result in firms undertaking
more investment. A cut in income tax would raise people’s disposable income and so would
probably result in an increase in consumption.
c Figure 1 shows an economy operating at less than full capacity but relatively close to full
capacity. In such a circumstance, an increase in AD would be likely to raise employment as
output would increase. It would also be likely to result in inflation as the economy would be
experiencing shortages of labour, raw materials and capital equipment. Figure 2 shows both
real GDP and the price level increasing.

Price AS
level
AD

AD
0 Y Real GDP

Figure 1

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AD1
Price AD AS
level

P1
P

AD1
AD
0 Y Y1 Real GDP

Figure 2

Part 5 Drawing diagrams

1 a Price
D

S1
S
P1

P
S1
S

0 Q Quantity

Figure 3 3

b As demand is perfectly inelastic, the whole of the tax can be passed on to the consumer
without reducing the quantity sold. The consumer bears all of the tax.

2 a Price
D
S
S1

P
P1

S
S1 D

0 Q Q1 Quantity

Figure 4

b The more elastic supply is, the more of the subsidy will go to the consumer and the less to the
producer. With elastic supply, firms will be able to produce significantly more, which will drive
the price down and benefit consumers.
3 a A
 n increase in unemployment will move a country’s output further away from its maximum
possible output. Figure 5 shows the production point moving from A to B, which results in a
fall in output of both capital goods and consumer goods.

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Capital
goods
(m)

80 A
50 B

0 70 100 Consumer
goods (m)

Figure 5

b Capital
goods
(m)

90 B
A
60

0 100 130 Consumer

goods (m)

Figure 6
4
Actual economic growth occurs when a country’s output increases. Figure 6 shows the output
of both capital and consumer goods increasing as the production point moves to the right
from A to B.

c Capital
goods
(m) Z

0 Y Z Consumer
goods (m)

Figure 7

Potential economic growth occurs when the productive capacity of an economy increases.
Figure 7 shows the output potential of the economy increasing from YY to ZZ.

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Part 6 Multiple choice questions

1 B
Public goods have to be financed by the state as the private sector has no financial incentive to
produce these products. This is because people can enjoy such goods without paying for them.
The government would only finance unprofitable goods if it believes they are beneficial or would
be underprovided if left to market forces. It would not want to finance goods that have higher
social costs than private costs as these will be generating negative externalities. Luxury items will
be produced by the private sector if there is sufficient demand. If there is not sufficient demand,
the government will not feel obliged to finance them.
2 A
Increasing employment will raise incomes, output and bring other benefits. B may be a
microeconomic policy objective. While a government may seek to reduce inflation, it is unlikely
to try to lower the price level. A government is also more likely to want to increase rather than
reduce economic growth.
3 B
An increase in savings will be accompanied by a fall in consumption, given an unchanged level
of income. A will directly increase aggregate (total) demand. C may increase total demand if it is
the result of the government cutting taxes. D will increase net exports and so contribute to total
demand.
4 B
A subsidy will shift the supply curve to the right, which in turn will cause price to fall and demand
to extend.
5 B
Fiscal policy covers government decisions on taxation and government spending. Cutting the 5
rate of taxation will increase disposable income, which, in turn, is likely to increase consumption
and so total demand. Increasing the budget surplus (the positive gap between tax revenue and
government spending) is a fiscal policy measure but one that will reduce total demand. A and D
are monetary policy measures.
6 A
A limit on bank lending will influence the money supply and may act to reduce aggregate (total)
demand. B is a monetary policy measure but one that will be likely to increase total demand.
C and D are fiscal policy measures.
7 D
A government’s budget position is concerned with government spending and taxation. For
instance, if government spending exceeds tax revenue, a government is said to have a budget
deficit.
8 C
Supply-side policy measures are always designed to increase the maximum potential output a
country can produce and so increase the country’s total supply curve and PPC.
9 D
Fiscal policy is concerned with government decisions on taxation and government spending. A
and B are examples of monetary policy and C is a direct control measure.
10 B
A cut in taxation would be expected to increase total demand. Higher total spending should
reduce cyclical unemployment as such unemployment is caused by a lack of total demand. A, C
and D would all be likely to benefit from a rise rather than a cut in taxation.

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11 D
A decision on government spending can be classified as fiscal policy. If it is designed to increase
total supply, it may also be classified as a supply-side measure. C is a fiscal policy measure but
one that would be more likely to reduce rather than increase AS – and so would not be classified
as a supply-side measure. A and B are monetary policy measures.
12 A
A budget surplus would mean a government is receiving more in tax revenue than it is spending.
In the other cases, it is not possible to determine the relationship between government spending
and taxation without more information.
13 A
The incidence of taxation is concerned with who bears the cost of a tax.
14 D
A regressive tax falls more heavily on the poor. This is because it takes up a higher percentage
of their income than of the income of the rich. The poor are likely to pay less as tax in total but
nevertheless a higher percentage with such a tax. For instance, a tax that takes US$2 from a poor
person spending US$10 and US$4 from a rich person spending US$40 is regressive. In this case,
the poor person is paying 20% in tax, while the rich person is paying 10%.
15 C
Income tax is usually a progessive tax. It can then take not only more in total in tax from the rich
than the poor but also a higher percentage. Such a tax is likely to reduce income inequality. A and
D are likely to be regressive taxes. In the case of B, the impact of the tax will depend on what type
of product the import duties are imposed.
16 D
A progressive tax may act as a disincentive to work as some people may be reluctant to take 6
promotion or work long hours, knowing that a higher percentage of their income will be taken in
tax, the more they earn.
17 A
A good tax is one that is easy to pay and collect. B, C and D are some of the characteristics an
item needs to possess to act as money.
18 B
Most sales taxes are regressive, falling more heavily on the poor. Therefore, their removal should
reduce the gap between the rich and the poor. The removal would increase rather than reduce
total demand. It would reduce the tax base as there would be fewer sources of tax revenue.
Disposable income is income minus direct taxes rather than indirect taxes.
19 C
Labour productivity is output per worker hour. If each worker can produce more, the maximum
potential output of the economy will increase.
20 D
The changes would move income from the rich to the poor, i.e., it would redistribute income. The
effect on the balance of payments and economic growth is uncertain. The changes may increase
inflation. This is because they may raise consumer expenditure, as the rich spend more than the poor.
21 B
An increase in government spending on training may reduce unemployment if workers become
more productive and their skills more closely match vacancies. More productive workers may
reduce firms’ costs, which would make the country’s firms more internationally competitive. This
should increase export revenue and lower import expenditure. A and C would be likely to reduce
total demand, which may cause cyclical unemployment. D would raise export prices and lower
import prices. This may increase a current account deficit and raise unemployment.

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22 (This question is stretch content) A

A lower exchange rate may increase net exports. The higher demand for the country’s products
could increase employment. In contrast, a rise in the exchange rate may reduce inflationary
pressure by lowering the price of imports and putting competitive pressure on domestic firms
to keep prices low. In terms of B, no government aim will benefit from a decrease in aggregate
supply. C – full employment may actually require an increase in aggregate demand and if inflation
is high, price stability would benefit from a decrease in aggregate demand. D – again it is likely to
be the other way round, with full employment benefiting from a decrease in the rate of interest
whereas if there is high inflation, price stability might be achieved by a rise in the rate of interest.
23 A
A decrease in corporation tax would enable firms to keep more of any profits earned. This would
give them a greater incentive to increase production and would provide them with more finance
to expand production. Lower income tax would be likely to raise consumer expenditure. With
more demand for their products, firms would be expected to raise their output.
24 B
A consumer prices index measures the price change of a sample of products that people spend
most on.
25 A
Money loses its value with inflation. Each US $ will buy less. Property, land and shares are likely to
lose less of their value with inflation and may even gain value.
26 C
When there is a low level of spare capacity in the economy, an increase in total demand will be
likely to push up the price level as firms will be competing for scarce resources.
27 D 7
Cost-push inflation is caused by an increase in the costs of production. A, B and C may cause
demand-pull inflation.
28 C
A rise in the budget deficit would mean that the gap between government spending and taxation
is increasing. It could be the result of a rise in government spending and/or a fall in taxation. In
either case, total demand would increase. B and D would reduce total demand and A would
increase costs of production.
29 B
If other countries’ price levels rise at a more rapid rate, this country’s products will become
more internationally price competitive. A, C and D would all reduce the country’s price
competitiveness.
30 C
People are said to be economically active if they are in the labour force; that is, working or
seeking to work. A, B and D are economically inactive.
31 C
Frictional unemployment occurs when people are in-between jobs sometimes because of a lack
of information about job vacancies. A is a cause of cyclical unemployment and B and D are a
cause of structural unemployment.
32 A
If people are ashamed to admit they are unemployed, they will not register as unemployed and
this will mean the official figures will give a lower than accurate figure for unemployment. B, C
and D would all give an artificially high figure for unemployment.

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33 B
As noted before frictional unemployment arises when people have left one job but have not
yet taken up another job. A occurs because of a lack of total demand and C and D because of
changes in the structure of the economy.
34 D
If consumers switch from buying domestic products to buying imports, demand for home
produced products will fall. This is likely to result in a loss of jobs. A, B and C will increase total
demand and so are likely to reduce unemployment.
35 A
If there are more people in work, total demand will rise and there will be greater competition for
workers, which may bid up their wages. Both factors may push up the price level. The first effect
may result in demand-pull inflation and the second effect, cost-push inflation.
36 A
Structural unemployment is caused by the decline of particular industries and occupations.
Increased government spending on training should make labour more occupationally mobile.
This should make it easier for them to transfer from one occupation or industry to another.
37 C
The payments that are included in the measurement of GDP are those made in return for
producing a good or service and which are declared to the authorities. A would not be recorded
and B and D are transfer payments.
38 C
An economy may be able to produce a higher output with higher unemployment, if the existing
labour force produces more per head. If occupational mobility increases, better use can be made
of those in employment. 8
39 D
Economic growth brings about change. Such change may result in some industries declining
while others are expanding. Those workers who lack the skills to switch to a new industry may
become unemployed.
40 B
There are three ways of measuring GDP. These are the expenditure, income and output methods.
41 D
A consumer prices index is a weighted price index. Weights are attached to a basket of products
based on the proportion of household expenditure that is devoted to them. The weights are then
multiplied by the price changes of these products.
42 D
If wages rise by more than prices, people will be able to afford to buy more goods and services.
If the exchange rate depreciates, people’s purchasing power will fall as now imports will be more
expensive to purchase. The money supply increasing by more than output is a cause of inflation.
Tax bands rising by more than inflation will again reduce purchasing power as people will
experience a fall in their disposable income.
43 C
If total demand and total supply both increase, output can continue to grow over time.
44 B
Deflation is a sustained fall in the price level. A is referred to as a depreciation or devaluation
depending on whether it is caused by market forces or government action. C is called a
recession if it occurs over a period of six months or more. D is known as depreciation or capital
consumption.

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45 C
Deflation increases the burden of debt as the amount that has to be repaid increases in value.
This is because each unit of currency is able to buy more goods and services as prices will be
lower.

Part 7 Similarities and differences

Similarities
1 Both occur when the price level rises by a small percentage.
2 They are both macroeconomic aims.
3 Both seek to influence total demand.
4 They are both monetary policy measures.
5 Both are direct taxes.
6 In both cases, price will change by more than quantity.
7 These are two qualities of a good tax.
8 Both measures would be expected to increase total demand.
9 They are both supply-side policy measures.
10 Both are designed to reduce spending.
11 Both involve decisions on government spending and taxation.
12 Each is a harmful effect of inflation.
13 These are two measures of unemployment.
14 Both groups are likely to benefit from inflation.
15 These are two forms of frictional unemployment. 9

16 Both are costs of unemployment.

17 These are two of the three ways of measuring GDP.
18 Both will lead to potential economic growth.
19 These are both transfer payments.
20 These are different terms for money GDP; that is, GDP unadjusted for inflation.

Differences
1 Employment involves the use of resources, whereas unemployment means that resources are
not being used.
2 Deflation is a fall in the price level. In contrast, a fall in the inflation rate occurs when the price
level rises more slowly.
3 The budget position is a comparison between government spending and tax revenue whereas
the balance of payments is a record of a country’s economic transactions with other countries.
4 Macroeconomic policies are designed to influence the whole economy. An example would
be fiscal policy, which may be used to alter total employment in the country. In contrast,
microeconomic policies are intended to influence particular industries and products.
5 Actual economic growth is how much an economy’s output is increasing by, whereas potential
economic growth is how much it is capable of growing by.
6 With progressive taxes, the tax rate increases as income rises and so these types of taxes take a
higher percentage of the income of the rich. Regressive taxes, however, fall more heavily on the
poor as with these taxes, the tax rate falls as income rises.

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7 Fiscal policy covers government decisions on government spending and taxation whereas
monetary policy covers government and central bank decisions on the rate of interest, the
money supply and the exchange rate.
8 Subsidies are government payments to producers and sometimes consumers. In contrast, taxes
are government charges on producers, workers and savers.
9 Income tax, as its name suggests, is a tax on income whereas inheritance tax is a tax on wealth.
10 Direct taxes are a tax on income or wealth whereas indirect taxes are taxes on spending. Another
difference is that the burden of a direct tax cannot be shifted on to anyone else. In contrast, the
burden of an indirect tax, or some of the burden, can be shifted from the seller to the consumer.
11 Cost-push inflation is a sustained rise in the general price level caused by an increase in the costs
of production. Monetary inflation is also a sustained rise in the general price level but this time
caused by an excessive growth of the money supply.
12 A budget deficit occurs when government spending exceeds government revenue, whereas a
budget surplus occurs when government revenue exceeds government spending.
13 Private sector employment covers those working for privately owned firms whereas public sector
employment covers those working for the government.
14 The labour force participation rate is the proportion of people of working age who are either
in employment or seeking employment. The employment rate only includes those who are of
working age and are in employment. In other words, it does not include the unemployed.
15 Structural unemployment affects part of the economy whereas cyclical unemployment affects
the whole economy. Structural unemployment is caused by a decline in particular industries and
occupations whereas cyclical unemployment arises due to a lack of total demand.
16 The employed work for someone else whereas the self-employed work for themselves.
17 Demand-side deflation arises when the fall in the price level is caused by a reduction in total 10
demand. It has harmful effects on the economy. In contrast, supply-side deflation occurs when
the price level is reduced because total supply increases. This form of deflation may have
beneficial effects on the economy.
18 Cost of living is a measure of the price of products purchased by the average consumer whereas
the standard of living reflects the products enjoyed by people.
19 Economic growth is an increase in a country’s output over a period of time whereas a recession is
a fall in a country’s output over a period of six months or more.
20 Labour market reforms is a supply-side policy measure whereas a change in the money supply is
a monetary policy measure.

Part 8 Data response questions

1 a 1% (the rise in real GDP).
100
b 22 m (5.72 m × ).
26
c The South African government is also aiming to achieve price stability (low inflation). It seeks
to keep the inflation rate below 6% and above 3%.
d The source material mentions that South Africa’s income tax system is progressive. This
means that the rich pay a greater percentage of their income in tax. This might be seen as
meeting the principle of equity.
The source material also mentions that people can submit their tax forms online. This may be
seen as meeting the principle of convenience as it is easier for some people to submit their tax
forms this way.

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e Table 4.2 (in the Workbook) shows that government spending rose throughout the period. Its
rate of growth, however, fluctuated and there was not much change. It rose from 2010 to 2012,
but the rate of growth fell between 2012 and 2015 and then rose in 2016.
Unemployment also did not change (Figure 4.3 in the Workbook) much over this period.
Between 2010 and 2013, it stayed at between approximately 24.6% and 24.8% and then rose
continuously to 26% in 2016.
Over the whole period, the rise in government spending did not reduce unemployment. It
might have done this as higher government spending should have increased total demand. It
might be that the slower growth in government spending may have contributed to the slight
rise in unemployment. This is because the rise in government spending on education may
not have kept pace with more unskilled workers entering the labour force. This might partly
explain the rise in unemployment between 2013 and 2015 but the relative lack of changes in
both sets of data makes it difficult to establish a relationship.
f The source material suggests that the causes of unemployment in South Africa are linked
to structural unemployment and cyclical unemployment. It mentions that some of the
unemployed lack the necessary skills. This would make them occupationally immobile and
unattractive to employers.
The source material also mentions that unemployment increased due to a fall in total
demand for goods and services. This would have caused workers in a range of industries to
lose their jobs as firms would have reduced their output.
In addition, the source material mentions that cyclical unemployment may have made
structural unemployment worse. Some workers may have lost their jobs because of a lack of
total demand for goods and services. The experience of being unemployed may have reduced
the chances of getting another job. This is because by the time demand has picked up, their
skills might have become out of date as they will not have received training recently. They may
11
also have lost confidence and so may be less impressive at interviews.
g It would be expected that a reduction in unemployment would cause economic growth. If it
involves more people being in employment, firms should be able to produce more goods and
services. Demand for that extra output should increase as more people will be gaining income
from employment. Also as more people are working, a shortage of labour may occur, which
would push up wage rates.
Lower unemployment may increase firms’ confidence, which may increase investment, which
would be expected to cause actual and potential economic growth.
Unemployment, however, can fall without employment rising, and in this case, economic growth
may not occur. Unemployment may decline as a result of the unemployed retiring, emigrating,
entering education or giving up seeking employment. If unemployed adults enter education,
output may not rise in the short run but may increase in the long run. Net emigration may result
in a fall in potential output, especially if some of the unemployed who leave are skilled workers.
Economic growth will also not occur if the fall in unemployment is accompanied by a fall in
the use of capital goods. The unemployed who gain jobs may be replacing capital goods. In
practice, however, it is more common for more capital goods to be employed over time.
h Supply-side policy measures may raise a country’s output and reduce unemployment.
Education and training, by raising workers’ skills and mobility, may make employers more
willing to employ them. Cutting direct taxes and state benefits will provide a greater incentive
for people to take up the jobs on offer. This is because the gap between earned income and
benefits will have widened. Reforming trade unions may increase employment if unions had
been pushing the wage rate above the equilibrium level and imposing restrictive practices.
Privatisation and deregulation may also raise employment if they result in firms producing
more efficiently and attracting more customers.

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How successful supply-side policy measures are in reducing unemployment will, however,
depend on the cause of unemployment and how well-designed the policy measures are.
If the cause of unemployment is a lack of total demand, supply-side policy measures will
not necessarily work. If there are no job vacancies, improving the quality of labour and
increasing the incentives to work will not work. Indeed, cutting unemployment benefit in such
circumstances may increase cyclical unemployment. This is because the unemployed will
have less money to spend. If reform of trade unions involves reducing their power when trade
unions are doing a good job by counterbalancing the power of employers, providing training
and acting as a channel for communication, this may again increase unemployment. There
is no guarantee that privatisation and deregulation will increase output and employment.
Selling firms to the private sector and removing rules and regulations may not reduce
unemployment if such measures increase rather than reduce inefficiency.
2 a The destruction of the rainforest/environmental damage.
b $676 bn ($632 bn − ? = −$44 bn).
c One way in which taxes place a burden on Brazilian firms is through the administration,
time and effort their workers have to spend filling out tax forms. Indeed, the source material
mentions that the average firm in the country spends 2600 hours to process the tax. (Another
way is that the high level of taxation discourages investment. A higher rate of corporation tax,
in particular, would reduce both the ability and willingness of firms to invest.)
d One reason why a Brazilian may prefer to work for the government rather than a private sector
firm is better pay. A higher average wage rate would enable the worker to purchase more
goods and services and may, for instance, enable them to enjoy a better quality of housing.
The second reason is that people who work for the Brazilian government receive generous
pensions. This may enable them to enjoy a better quality of life than private sector workers
when they retire. (Also, better working conditions, e.g., working hours and safety at work).
12
e The expected relationship between the unemployment rate and changes in the wage rate
would be an inverse one. If the unemployment rate falls, there may be upward pressure on the
wage rate as firms might be experiencing greater difficulty recruiting new staff. In contrast, if
the unemployment rate rises, the wage rate rises may fall or even turn negative. This is because
workers may be prepared to accept a lower wage rise or even a wage cut to retain their jobs.
Firms may also be experiencing a fall in demand for their products and so may seek to reduce
their costs. Figure 4.4 (in the Workbook) supports this relationship throughout the whole period.
From 2010 to 2012, the unemployment rate fell and the average wage rose more quickly. After
2012, unemployment rose and the average rate at first rose more slowly and then fell.
f A government may impose a national minimum wage in order to reduce poverty. One reason
why people are poor is because they receive low wages. Low-paid workers may have little
power in negotiating with their employers, particularly with private sector employers, as
appears to be the case in Brazil. They may not be members of trade unions and are likely to
be unskilled workers. An employer may be able to pay low wages knowing that if the current
workers are not happy, they can be replaced by other unskilled workers. In this situation, the
imposition of a national minimum wage may be needed to drive up the pay of those whose
labour is in high supply and as a result have weak bargaining power.
g In the short run, an increase in government spending on education will increase a budget deficit
as the gap between government spending and tax revenue will rise. Spending on education
tends to be a relatively large component of government spending. The government may spend
more on, for instance, building schools, hiring more teachers and buying more equipment.

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The higher government spending will, however, create employment and extra income.
More teachers will be in employment and the firms building the schools and supplying the
equipment will earn more and so would be likely to increase their output and take on more
workers. As a result, tax revenue should increase. People will be earning more and spending
more and so both direct and indirect tax revenue should increase.
In the long run, there is a further reason why it may reduce a budget deficit. This is because a
more educated labour force should be more skilled and productive. This should increase output
and income and so should again raise both direct and indirect tax revenue. The more skilled and
productive labour force is less likely to be unemployed, so the government may be able to cut its
spending on unemployment benefit and policy measures to reduce unemployment.
h In making this decision, a number of factors would have to be considered. These include
the state of the government’s finances, the state of the Brazilian economy, how firms and
households will react to the change in taxation and other countries’ tax rates.
If the government has a budget surplus, it may be able to reduce tax rates or remove some taxes
and still raise enough in tax revenue to cover its spending. It might not be recommended to cut
taxes if the government has a large budget deficit. In this case, a cut in taxes would increase
the size of the budget deficit and may put pressure on the government to cut its spending on,
for instance, education and healthcare. In the longer run, however, a cut in taxes may lead to a
balanced budget or even a budget surplus if it stimulates an increase in economic activity. For
instance, a cut in income tax will lower revenue from this source in the short term. In the longer
run, even with people paying less in tax per US $ earned, if more people are working and earning
higher wages, more will be received in income tax revenue.
A cut in taxes may be beneficial if the economy is experiencing high unemployment and slow
economic growth or a recession. This is because a cut in income tax, for instance, would
increase disposable income and so would be expected to raise consumption and so increase
13
total demand. Higher spending in such circumstances would raise the country’s output and
could be expected to increase employment.
The source material mentions that the tax burden is high and is discouraging investment.
If tax rates are discouraging firms from spending on capital goods, a cut in corporation tax
would be expected to raise investment, which, in turn, would be expected to increase both
total demand and total supply.
A cut in income tax should also be made if it is believed that it would provide an incentive for
workers to work more hours and more people to enter the labour force. There is, however, a
risk that if people are satisfied with their current level of disposable income, they may work
fewer hours if tax rates are cut.
A cut in Brazilian taxes may be undertaken if the tax rates are above other countries and
the difference is discouraging foreign direct investment, tourism and the sales of domestic
products. A number of countries have recently been cutting their tax rates and simplifying
their tax systems to encourage multinational companies to set up in their countries.
Lower indirect taxes may attract more tourists, particularly those on shopping trips and may
encourage the country’s consumers to buy more domestic products rather than imports.
If, however, the Brazilian economy starts to grow again, total demand will be rising and the
economy will be working closer to full capacity. In this situation, the extra demand generated
by lower taxes may result in demand-pull inflation.
Taxes are also not set just to influence economic activity. A government may be reluctant to
reduce taxes on demerit goods including cigarettes, which are overconsumed.
3 a Consumer expenditure/government spending.
1.89
b 1.8% (106.89 − 105 = × 100).
105

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Cambridge IGCSE and O Level Economics

c Cost-push inflation as it is predicted that fuel prices will rise. This increase would raise
the costs of producing and transporting goods. The introduction of VAT would impose an
additional cost on producers.
d The source material mentions that inflation has reduced the international competitiveness of
the UAE’s products. If a country’s inflation rate is rising more rapidly than rival countries, it is
likely that it will export less and import more.
The source material also implies that savers have lost out. Inflation can cause a random
redistribution of income with some groups gaining, including lenders, while other groups,
including savers, are losing.
e Increases in the money supply may cause demand-pull inflation if they result in higher
spending. The evidence in Figure 4.5 (in the Workbook), however, suggests that increases
in the money supply were not a strong influence on the inflation rate between 2012 and
2015. The money supply increased most rapidly in 2013 but that was also the year in which
the inflation rate was lowest. The inflation rate was highest in 2015 when the growth in the
money supply was at its second lowest rate. Of course, there could be a time lag with the
large increase in the money supply in 2013 contributing to the rise in the inflation rate in
2014. However, even allowing for a time lag, there is not a clear relationship between the two
variables.
f A maximum price on food in the context of rising food prices is likely to be set below the
equilibrium price. Figure 8 shows that this will result in a shortage with demand Qd exceeding
supply Qs.

Price D S
of food

14

Px Price limit

D
S
0 Qs Qd Quantity of food

Figure 8

Some people will be able to buy food more cheaply but others, willing and able to pay the
price of Px, will be unable to purchase it. The excess demand is likely to result in rationing
having to be introduced. Food may also be sold illegally above the maximum price.
g An increase in government expenditure will not always cause inflation. It will depend on the
initial level of economic activity and what the government is spending money on.
Government spending (G) is a component of total demand and so a rise in G will increase
in total demand. Higher total demand will not cause inflation if the economy was initially
producing with considerable spare capacity. A government may increase its spending
specifically to raise the level of output in such a circumstance. In contrast, if the economy
was initially producing close to full capacity, an increase in total demand is likely to result in
inflation.
Even if the economy is operating at or close to full capacity, an increase in total demand may
not cause inflation in the long run if the government spending also results in an increase
in total supply. For example, if the government increases its spending on training, labour
productivity and potential output should increase.

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h Whether inflation is more harmful than deflation will depend on its rate and its cause.
Hyperinflation will be more harmful than a low rate of deflation. If the price level is rising
by more than 50%, the country’s products are likely to be becoming less internationally
competitive, purchasing power will be falling if wages do not rise in line with the price level
and menu and shoe leather costs will be high. There is also the risk that if inflation is very high
and accelerating, people may stop using the country’s currency as money.
If inflation is caused by increasing total demand while deflation is caused by decreasing
total demand, inflation may be less harmful than deflation. Demand-pull inflation may be
accompanied by rising output and employment. In contrast, a sustained fall in the price level
caused by a decrease in total demand is likely to be accompanied by decreasing output and
rising unemployment.
High rates of inflation and deflation can both cause uncertainty and may result in households
and firms making inefficient choices. This is why governments aim for price stability.
4 a VAT is an indirect tax. It is a tax on spending.
$900
b 15% ( × 100).
$6000
c An increase in bank lending is a major cause of increases in the money supply. When banks
lend money, the loans they create count as money.
d The proportion of workers employed in agriculture has declined. This is a common pattern.
As economies grow, productivity in agriculture rises faster than demand for agricultural
products. This frees workers to work in the manufacturing and tertiary sectors where demand
usually rises more quickly. Eventually most workers tend to be employed in the tertiary sector.
The source material also mentions that the proportion of workers in the public sector was
declining. This is likely to be the result of the relative expansion of the private sector. Private
sector firms may have been expanding and some firms may have been transferred from the 15
public sector by means of privatisation.
e Among the factors that influence consumption are disposable income and the rate of interest.
People with higher disposable income tend to spend more than those with lower disposable
income. They have more purchasing power. They often, however, spend a smaller proportion
of their income.
If the rate of interest increases, people are likely to spend less. This is because saving will
become more rewarding, which may encourage some people to forego some spending for a
while. Borrowing to buy items such as cars will also become more expensive. This will reduce
people’s willingness and ability to borrow. In addition, anyone who has borrowed in the past
will have less money to spend.
f Figure 4.6 (in the Workbook) indicates a relatively strong positive relationship between the
inflation rate and the interest rate. Generally, the countries with the highest inflation rates
had the highest interest rates. South Korea had both the lowest inflation rate and the lowest
interest rate and Turkey had both the highest inflation rate and the highest interest rate.
The Philippines was somewhat of an outlier. It might be expected that countries with a high
inflation rate would set a high interest rate to reduce demand.
g Whether an increase in consumption will benefit an economy will depend on whether the
higher spending goes on foreign or domestic products and on the initial state of the economy.
If the spending goes on imports, it is other countries that will benefit from the higher demand.
If the higher spending is devoted to domestically produced products and the economy has
spare capacity, the economy will benefit. Output and employment will rise.
If, however, the economy is operating at or close to full capacity, higher consumer expenditure
will cause demand-pull inflation. Of course, if the higher consumer expenditure stimulates
higher investment, in the longer run both total demand and total supply may increase,
causing the economy to benefit from long-run economic growth.

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h Monetary policy may be more effective in increasing economic growth in the short run if
there is spare capacity in the economy but supply-side policy measures are likely to be more
effective in the longer run.
A cut in the rate of interest would be likely to raise both consumption and investment.
Households may spend more, as saving would be less rewarding and borrowing would be
cheaper. Firms would find it cheaper to borrow and would expect higher sales. An increase in
total demand, if there are unemployed resources in the economy, will raise real GDP and so
cause economic growth.
Once full capacity is reached, however, an increase in total demand resulting from an
expansionary monetary policy will be ineffective in generating economic demand.
Some supply-side policy measures may take some time to have an effect but, if successful,
they cause potential economic growth and so should enable real GDP to increase over time.
For instance, extra government spending on education may, in ten years’ time, increase
productive potential as a result of increasing labour productivity. If increases in total demand
can keep pace with increases in total supply, the economy can experience both actual and
potential economic growth.
5 a Devaluation (a reduction in the exchange rate).
b Portugal’s employment rate was 7.8% points greater (89.8% − 82%).
c The source material mentions that with more people out of work during the periods of
recession, the government lost tax revenue. The fewer people who are in work, the less direct
and indirect tax revenue the government would receive as income and expenditure would be
lower.
d A recession involves a fall in real GDP over a period of six months or more. Falling output will
be likely to cause a rise in unemployment. Firms producing less will need resources and so
may make some of their staff redundant. 16
A recession may also be accompanied by deflation. If output declines, incomes will fall. This
will reduce total demand and put downward pressure on the price level. There is a risk that
this could result in a downward deflationary spiral, with households delaying their purchase
of goods and services in the expectation they will be cheaper in the future and as a result,
firms cutting back their output even more.
e It would be expected that economic growth rates and unemployment rates would be
inversely related. When the country is producing more goods and services, firms may
take on more workers. In contrast, during a recession, unemployment is likely to rise. The
information in the table largely supports this view. At the start of the period, output is falling
and unemployment is rising. It is interesting to note, however, that unemployment was at a
higher level in 2013 than in 2012, despite the fall in output being lower. This might be because
employers were waiting to see if the fall in output was going to continue before making some
of their workers redundant. Between 2014 and 2016, output rose each year, although more
slowly in 2016 than in 2015, and unemployment fell.
f House-building and economic growth are usually directly related. An increase in house-
building will add directly to output. It will also increase consumer expenditure as when people
buy a new house they usually buy new fixtures and fittings and furniture. Higher consumption
will be likely to increase output further.
Economic growth, in turn, is likely to encourage an increase in house-building. Higher output
will lead to higher incomes. Demand for new houses tends to increase as incomes rise. Some
people will buy a first house and others will move from a less expensive older house to a more
expensive new house.
Changes in house-building often indicate what is happening to confidence in an economy.
When households and firms are pessimistic about future economic growth, house-building
usually declines.

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g It is possible that the policy aims of economic growth and inflation may conflict in the short
run. This may be the case if the rise in output occurs as a result of higher aggregate (total)
demand when the economy is initially operating close to full capacity. For example, a rise in
consumer expenditure, such as that experienced in Spain, may encourage firms to produce
more goods and services. To do this, they will need more resources. If resources are becoming
scarce, their price will be pushed up. With higher demand, the firms may pass on the price
rises to their customers.
In Spain, however, there was a high level of unemployment. In this circumstance, it may be
possible for firms to attract more workers without having to raise the wage rate. Short run
economic growth may occur, without any increase in the price level.
In the long run, it may be possible for economic growth to be achieved without any upward
pressure on the price level, if there is an increase in the economy’s productive potential. This
could occur, for instance, if improvements in training result in increases in labour productivity
and if spending on research and development result in advances in technology. An increase in
both total demand and total supply can cause an increase in real GDP while leaving the price
level unchanged.
h To assess whether cutting tax rates would increase the economic growth rate, a range
of information should be assessed. This would include what type of tax rates are cut, the
state of the economy, government spending, how much the rates are cut by and people’s
expectations.
A cut in corporation tax would be likely to increase the willingness and ability of firms to
invest. Higher investment would increase both total demand and total supply and so would
lead to both actual and potential economic growth. A reduction in income tax may also lead
to higher total demand and higher total supply as it will increase people’s disposable income
and the incentive to enter the labour force. A cut in indirect taxes may increase consumption
17
and so result in higher total demand.
If the economy has spare capacity, an increase in total demand, resulting from lower indirect
tax, would increase real GDP and so cause actual economic growth. If, however, the economy
is operating at full capacity, an increase in total demand will result in inflation but will have no
effect on output and so economic growth will not occur. A cut in direct tax, however, might be
expected to increase economic growth as it would raise both spending and potential output.
A cut in any type of tax, however, may have no effect on economic growth if it is accompanied
by a fall in government spending. Lower government spending on, for instance, education
would reduce both total demand and total supply and may offset the effects of a cut in
taxation. A small cut in taxation would obviously have less effect than a large cut. A cut in
taxation may also not have much effect on total demand, total supply and economic growth.
If consumers and firms are pessimistic about the future, they may not spend more and may
not invest more, despite lower taxation.
6 a Cyclical unemployment.
b A fall in the unemployment rate is likely to push up the wage rate. With fewer people out of
work, firms wanting to expand may have to attract workers away from other jobs by offering
higher wages. Workers, knowing that employers may have difficulty replacing them, may also
be more prepared to push for wage rises.
c A ‘booming’ economy is one that is growing very rapidly. Consumer expenditure will be
increasing and unemployment will be falling. There may be demand-pull inflation as total
demand is likely to be increasing at a more rapid rate than total supply.
d A fall in unemployment would be expected to increase output. If more people are in work,
more should be produced. Higher output will enable people to enjoy more goods and
services.

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Another advantage of a fall in unemployment is the possibility that the government may be
able to spend more on healthcare. With more people working and spending, the government
will receive more revenue from both direct and indirect taxation. The extra tax revenue
could be spent on, for instance, more hospitals. Lower unemployment may also result in
less resources being spent on healthcare connected with unemployment; for example,
depression.
e Table 4.7 (in the Workbook) largely supports the view that a fall in unemployment will cause
a rise in the inflation rate. If more people are in work, total demand will be higher, which may
tempt firms to raise prices. There will also be an increased demand for workers, which may
push up wages and costs of production. From 2012 to 2015, unemployment fell consistently
and this was accompanied by a consistent rise in the inflation rate. The exception to this
inverse relationship is 2016 when both unemployment fell, although only by a smaller amount
in percentage terms, and so did the inflation rate.
f A government could try to attract investment from abroad by cutting corporation tax,
improving education and improving healthcare. Lowering corporation tax would mean
that firms, including foreign firms, would be able to keep more of any profits they earn. This
would provide an incentive for foreign firms to produce in the country, especially if Chile’s
corporation tax falls below that of other countries.
Improving education would also tend to attract foreign firms. This is because the firms would
expect labour productivity to rise, which, in turn, would reduce unit labour costs including
their training costs. Improving healthcare would have a similar effect. Labour is likely to
be fitter and so more productive. They will lose fewer days off work and will be able to
concentrate more when at work.
g A cut in tax rates would be expected to reduce tax revenue in the short run but may increase
it in the longer run. When tax rates are first cut, people will not have to change their spending,
18
the hours they work and whether they work or not and firms will not have had sufficient time
to alter their scale of production. With the same level of expenditure, output and income, tax
revenue will fall.
However, a cut in indirect taxes and a rise in disposable income resulting from lower income
tax is likely to encourage people to spend more. If people pay less tax per unit but purchase
significantly more products, indirect tax revenue will rise.
The higher spending is likely to increase demand for labour and the greater incentive to
work and work longer hours is likely to encourage people to take advantage of greater work
opportunities. With more people working and some people working longer hours, income tax
revenue should rise. Of course, there is the chance that some workers, who are content with
their living standards, may work fewer hours as a result of lower income tax.
A cut in corporation tax would probably encourage firms to use retained profits to expand
their business and may persuade more firms from abroad to produce in the country. Higher
output and higher profits in the future would increase revenue from corporation tax.
h The Chilean economy did generally have a better economic performance in 2016 than the
other three Latin American countries shown. Its economic growth rate was low but was still
higher than the other three. Indeed, Argentina and Venezuela were experiencing a recession,
while Argentina was experiencing a serious recession.
Chile also had the lowest inflation rate. A rate of 2.7% would be regarded as acceptable in
most countries as it comes close to price stability. Venezuela was experiencing hyperinflation,
which would have been very destabilising.
Mexico’s economic performance in terms of unemployment, however, was better than Chile’s:
4.1% comes close to full employment. It is rather surprising, given Venezuela’s large fall in
output and hyperinflation, that its unemployment rate was not even higher.

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In judging the economic performance of the Chilean economy relative to other Latin
American economies, however, far more information would be needed. Data on the economic
growth rate, inflation rate and unemployment rate over time would be useful. For instance,
unemployment might have been falling in Argentina more rapidly than in Chile. Other
economic data would also be useful on, for example, the position of the current account of
the balance of payments over a number of years.
It would also be necessary to check that the same measures have been used in measuring
inflation and unemployment in the other countries and whether there is any difference in the
size of the informal economy between the countries.

Part 9 Four-part questions

1 a Income tax is a tax on the income people earn. It is a direct tax. The tax has to be paid by the
people on whom it is levied.
b A progressive tax is one that increases in both absolute and percentage amounts as income
rises. For example, it may take 10% of the income of someone earning US$10 000 or less but
20% of the income of someone earning US$30 000. Such a tax falls more heavily on the rich.
In contrast, a regressive tax places a greater burden on the poor. This is because, this time, the
tax rate falls as income rises. For example, while someone earning US$10 000 may pay 30% in
tax, someone earning US$20 000 may only pay 15% in tax.
c The qualities of a good tax are equity, certainty, convenience, economy, flexibility and
efficiency. A good tax should be seen as fair, with those most able to pay or those benefiting
the most from government spending paying the most in tax. For instance, in many countries
the rich pay the most in income tax and university graduates sometimes pay a tax based on
how much they earn after their studies have been completed.
19
Certainty means that it should be clear how much people and firms will have to pay in tax. A
convenient tax is one that is easy to pay and an economical one is one that collects noticeably
more revenue than it costs to administer.
Flexibility is useful because the level of economic activity changes and government aims alter.
It can take time to change income tax rates, for instance, but at least the revenue earned from
income tax adjusts automatically to offset economic booms and downturns. During a period
of rapid economic growth, income tax revenue will rise, which will help to slow down the
growth of total demand.
A good tax should also aim to improve the efficiency of markets or, at least, have a neutral
effect on markets.
d Relying less on direct taxes and more on indirect taxes may increase incentives for people
to work and firms to invest. Lower income tax may persuade existing workers to work longer
hours and accept promotion and encourage some homemakers and retired people to seek
work. There is a risk, however, that with higher disposable income per hour, some workers
may choose to work fewer hours.
Lowering corporation tax may increase firms’ spending on capital goods as they will be able
to keep more of any profits earned. Investment may also be stimulated by lower income tax
as firms are likely to expect spending to rise.
Reducing taxes on the income earned on savings may be seen as being fairer, as such income
is effectively taxed twice. Taxes on income may also be difficult to collect if there is a large
informal sector and if levels of literacy are low. Indirect taxes are more difficult to evade and
can be cheaper and quicker to change.
There are, however, possible disadvantages of shifting the tax burden from direct to indirect
taxes. One is the regressive nature of indirect taxes, which means that the burden of taxation
is likely to fall more heavily on those least able to pay.

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A high sales tax may discourage consumption and tourism and high tariffs may lead to
retaliation with other countries raising their tariffs.
2 a F ull employment does not mean zero unemployment but the lowest level of unemployment
possible. This may be, for instance, 3%. Even in periods of very high total demand, some
people will be unemployed as they will be in-between jobs.
b Two other government macroeconomic objectives are price stability and economic growth.
Price stability is usually taken to be a low and stable rate of inflation. Most governments
would be content with an inflation rate of around 2%. They do not aim for zero inflation as
measures of inflation tend to overstate the rate at which the price level is rising.
Governments also want steady and sustainable economic growth. Economic growth occurs
when a country’s output increases. Governments want to avoid fluctuations in output, with
economic booms and downturns, and want to ensure that the growth is achieved in a way
that does not endanger future governments’ ability to grow.
c Investment is spending on capital goods. These goods include machinery, other equipment
and buildings. If investment increases, unemployment is likely to fall. This is because firms
are likely to take on more workers to work with the extra capital goods to produce more
products.
There is a chance, however, that labour may be a substitute to rather than a complement to
capital. New machinery, incorporating advanced technology, may reduce the need for labour.
In this case, structural unemployment will rise.
d The unemployment of any factors of production can be serious but the unemployment of
labour is probably the most serious. The unemployment of any factor of production involves
an opportunity cost in the form of forgone output. When all resources are not used, a country
will be producing less than its potential output and so its inhabitants will not be enjoying as
high a standard of living as possible. 20
Not using some parts of land for a period of time may, in fact, be beneficial. It may give time
for agricultural land to regain its fertility and for fishing stocks to build up. If capital equipment
is not used, it may deteriorate and become obsolete.
Entrepreneurs who are made redundant tend to find work again relatively quickly. This is
because they are usually resourceful and both occupationally and geographically mobile.
Some may set up new businesses and others may move to take up jobs in other types of
business or in other countries.
Unemployed workers can lose touch with developments in training and technology. They
can also lose the work habit. The longer people are out of work, the harder they usually find
it to gain another job. The reason why the unemployment of workers may be considered to
be more serious than the unemployment of other resources is the human cost involved. The
unemployed experience a fall in income and may experience a number of other problems
including a deterioration in their physical and mental health.
3 a Fiscal policy is government decisions on government spending and taxation.
b Unemployment arises when either there is a lack of job vacancies or when people are unable
to fill the vacancies. A lack of job vacancies may arise due to an economic downturn. There
may not be enough demand in the economy to employ all the people who are willing and
able to work.
People may not be able to take up any job vacancies on offer because they lack the skills
available, and so are occupationally immobile, or because they lack geographical mobility.
They may also lack information about the job vacancies.
c The main disadvantage of unemployment to an economy is lost output. When people are
out of work, they are not producing. The economy will be producing inside its production
possibility curve as shown in Figure 9.

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Cambridge IGCSE and O Level Economics

Capital
goods
(m)

B
80 A

0 100 Consumer
goods (m)

Figure 9

Output and living standards would be higher if the economy moved towards, for instance,
production point B. With lower than potential output, tax revenue will be lower than possible.
People and firms will be earning and spending less than if more people were in work. With
more tax revenue, the government could spend more on education, healthcare, reducing
poverty and on other areas.
As well as lowering tax revenue, unemployment places a burden on government spending.
Governments of many countries pay out unemployment benefits, such as housing benefits,
claimed by the unemployed. This involves an opportunity cost – the money could have been
spent on, for instance, education.
Unemployment can also give rise to a range of social problems. These include increased
crime, mental and physical health problems and family breakdowns. These, in turn, can place
a burden on government spending and lower living standards.
d A rise in total demand will usually be expected to increase employment. Higher demand 21
should encourage firms to expand their output. To produce more, they are likely to hire more
workers and so increase employment. Demand for labour is a derived demand, dependent on
demand for the goods and services workers produce.
There are, however, a number of reasons why higher demand may not increase employment.
The first is that the higher demand may not be expected to last. If this is the case, firms will
not take on extra workers. They will cope with what they expect to be a temporary higher
demand by asking workers to work overtime.
A second reason is that firms may be able to increase their output by making greater use of
machinery or by replacing existing machinery by more technologically advanced equipment.
Firms may also want to take on more workers to produce more products but if the economy is
operating at full employment, they may not be able to do so. Even if there is unemployment,
firms may have difficulty taking on more workers, if the unemployed are occupationally and
geographically immobile.
In addition, while higher demand may increase the number of people employed, it may not
increase the employment rate. If the size of the labour force grows at a more rapid rate than
the numbers employed, the employment rate will fall.
4 a 
A consumer prices index is a measure of changes in the price of a representative sample of
consumer products. It is a weighted price index.
b Governments aim for a stable inflation rate as an unstable inflation rate will make it difficult
for not only them but also firms and households to plan. Government and firms’ staff will have
to spend time and effort estimating future costs and prices. The uncertainty created by the
instability may discourage investment and so reduce potential economic growth. It can also
make it difficult for both firms and households to judge whether a product is expensive or not.
This may result in inefficient decisions being made. Governments, firms and households may
pay more for products and raw materials than necessary.

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Cambridge IGCSE and O Level Economics

c Firms might benefit from an increase in government spending on education and

infrastructure in a variety of ways. One is that some of the extra spending may go directly
to private sector firms. The government may order, for instance, books from some of the
country’s publishers and computers from some of the country’s producers. In the majority
of countries, most government spending on infrastructure goes to domestic producers. For
example, governments often hire private sector firms to build roads.
Improved infrastructure reduces firms’ transport costs and costs of communication. Lower
costs of production can increase firms’ profits. They also increase firms’ price competitiveness.
Capturing more demand away from rival foreign firms can enable them to expand.
If the increased government spending on education results in a more educated labour force,
firms will be able to employ more productive workers. These more productive workers are likely
to be able to work with more advanced technology and produce more and higher quality output.
The rise in productivity is likely to lower costs of production and enable the firms to lower their
prices. Lower prices and higher quality products should enable firms to sell more products.
A more educated labour force may also reduce firms’ training costs and make their training
more effective.
d In assessing whether an industry should be privatised or not, it should be considered whether
the industry would perform better in the private sector and how much money would be
raised.
If an industry is not working well in the public sector, perhaps because of too much
bureaucracy and lack of competition, the government may increase economic growth and
employment by selling it to the private sector. Subjecting the industry to market forces may
make it more responsive to changes in consumer demand and more determined to keep its
costs low. This may be particularly the case if the industry is broken down into several firms,
thereby generating competition.
22
Another reason why privatisation might be recommended is if a large amount of revenue
could be raised from the sale and the government is in need of the money. A government
may, for instance, want to spend more on education and healthcare but may be reluctant
to raise taxation. In such a situation, privatisation may be a possible option, especially if the
industry has been making losses.
If, however, the industry is making a regular profit for the government and is expected to do so
in the future, privatisation would lower government revenue.
In addition, it would be necessary to consider what type of products the industry is making.
If it produces a public good, a good of strategic importance or a merit good, it might suggest
that the industry should stay in the public sector. A public good has to be financed by the
government and to ensure that this money is used efficiently, the state may wish to maintain
control. A government may also wish to control an industry that is vital for the economy and
one that would be underproduced or would be sold at too high a price in the private sector.
5 a E
 conomic growth is measured by the percentage change in real GDP. For instance, real GDP
was $20 bn last year and is $21 bn this year, the economic growth rate is 5%.
b Real GDP is a country’s output in a particular year while its economic growth rate is the
percentage change in its output from the previous year. A country may have a higher output
than another country but its output may be rising more slowly. The country may even be
experiencing a negative economic growth rate; that is, its output may be falling. A lower or
negative economic growth rate will narrow the gap in real GDP between the two countries. Its
economic growth rate may also be less stable, which can discourage investment and reduce
future economic growth.
c A rise in the rate of interest, for instance, is likely to harm private sector firms. Those private
sector firms that have taken loans will experience an increase in their costs and so may
reduce their profits.

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An increase in the rate of interest is also likely to reduce demand for firms’ products. This is
because it will encourage households to save more and take out fewer loans. Firms selling
highly priced products, such as houses and cars that people often buy, will be particularly
hard hit.
In addition, a rise in the interest rate may raise the exchange rate, as it is likely to attract hot
money flows. A higher exchange rate will raise export prices and lower import prices. This
will have an adverse effect on firms that export a significant proportion of their output and
on firms that compete with imported products. Of course, those firms that use imported raw
materials may gain.
d On the surface, it would appear that an economy experiencing 8.5% inflation would face
more serious problems than one facing 1.7%. This is because it would mean that the value of
money in the country would be falling more rapidly. The difficulties associated with inflation
such as loss of international competitiveness, menu costs and shoe leather costs may be
greater.
The situation, however, is somewhat more complex. An economy with an 8.5% inflation rate
may actually have a more stable inflation rate than one with a current 1.7% inflation rate. If
this is the case, it would be easier for firms, households and workers to adjust to the inflation
rate and plan ahead.
In deciding which economy would face the more serious problems, the cause of the inflation
in both countries would have to be considered. Cost-push inflation tends to be more harmful
than demand-pull inflation. This is because it is often associated with a fall, or slowdown,
in economic growth, while demand-pull inflation is often combined with positive economic
growth.
It also has to be remembered that a low inflation rate can cause some major economic
problems. As measures of inflation tend to overstate price rises, a very low rate of inflation
23
may mean that the price level is actually falling. If deflation is occurring, a downward spiral
of economic activity may be setting in. Households, seeing that prices are falling, may delay
their purchases. The fall in total demand may lower employment and the price level, which
again would push down total demand.
It is interesting to note that while inflation caused by increases in the costs of production
tends to be more harmful than that caused by total demand increasing too rapidly, the
opposite is true with deflation. A fall in the price level may be beneficial if it is due to lower
costs of production.
For example, advances in technology can make a country’s products more internationally
price competitive. As a result, such deflation may be associated with rising economic activity.
In contrast, as mentioned above, deflation caused by falling total demand is likely to be
accompanied by a reduction in economic activity.
6 a Frictional unemployment and structural unemployment.
b The basket of goods and services is used to attach weights to price changes. The basket is a
representative sample of products that households buy. The greater the proportion of total
spending that goes on an item, the more importance is attached to any change in its price.
For instance, if people spend $20 out of a total weekly spend of $100 on a particular category
of products, that category would be given a weighting of 1/5.

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Cambridge IGCSE and O Level Economics

c In deciding how to reduce inflation, a government would first consider the cause of the
inflation. If it is demand-pull inflation, it will seek to reduce the growth of total demand. It may
do this by raising income tax. This will reduce people’s disposable income and so their ability
to buy goods and services. The government, or the country’s central bank, may also raise
the rate of interest to slow down the rise in the price level. A higher interest rate may reduce
consumption as it will be more rewarding to save and it will be more expensive to borrow. It
may also reduce investment as it will be more expensive for firms to borrow, may encourage
firms to save their retained profits and may reduce their expectations of future consumer
demand.
If it is thought that inflation is caused by cost-push factors, a government may consider
reducing corporation tax and any regulations that push up firms’ costs. It may also introduce
supply-side policies, for instance, a privatisation programme may reduce inflation if firms
work more efficiently in the private sector. A training programme may also lower inflationary
pressure if it raises labour productivity and so cuts unit labour costs. Indeed, successful
supply-side policies can reduce inflationary pressure over time by allowing total demand to
rise without encountering a supply constraint.
d Economic growth is usually, but not always, considered to be desirable. Economic growth has
the potential to raise the living standards of the population, increase employment, raise tax
revenue, reduce poverty and improve health care and education.
An increase in a country’s output makes more products available for its inhabitants. Over
time, economic growth has changed the quality of people’s lives in many countries. It has
provided them with more and better-quality products.
Economic growth, especially actual economic growth, may be accompanied by a rise in
employment. A higher output may require more workers to produce that output.
With rising incomes and expenditure, more tax revenue will be earned. Some of this can be
24
spent on benefits to the poor and on measures to reduce poverty. In the absence of economic
growth, a government wanting to help the poor would either have to raise taxation or switch
government spending away from some other area.
Some of the higher tax revenue, resulting from economic growth may be spent on healthcare
and education. This should improve living standards and raise economic growth in the future.
Economic growth, however, may not be desirable if it is unsustainable, the benefits are
restricted to a few and it is imposing stress on workers. Unsustainable growth that results in
the depletion of non-renewable resources and creates pollution will threaten future economic
growth and may reduce the quality of people’s lives.
If income is unevenly distributed, only a few people may benefit from economic growth.
Economic growth can be associated with a widening in the gap between the rich and the
poor and this may result in social unrest. Economic growth involves change and may involve
longer working hours. Both effects may place stress on workers and so reduce the quality of
their lives.

© Cambridge University Press 2018