TMJC 2023 A Level H2 EQ6 AP Answers

6. The use of expansionary demand -side policies designed to achieve economic growth or to lower unemployment may lead to undesirable consequences. (a) Explain why expansionary fiscal policy designed to achieve economic growth or lower unemployment may lead to undesirable consequences. [10] (b) Discuss whether expansionary supply -side policies would be effective in achieving the macroeconomic policy aims of an economy. [15] ………………………………………………………………………………………………………. Suggested Answers to part (a): Introduction: Discretionary fiscal policy involves the change in government spending (∆G) and/or taxation (∆T) to influence the level of economic activities and living standards. An expansionary fiscal policy will involve raising government expenditure (G) and/or reducing taxes (T) to increase aggregate demand (AD). Requirement 1: Explain briefly how EFP works and expla in one undesirable consequence a. Briefly explain how EFP works to achieve economic growth and lower unemployment: [Reduction in taxation] A government can reduce personal income tax and/or corporate income tax to increase consumption expenditure (C) by households or investment expenditure (I) by firms. For example, a reduction in corporate income tax rates will increase firms’ post-tax profits which raises the expected yields from investments. Firms are more willing to invest which in turn increases investment expenditure. [Increase in government spending] A government can also increase spending on public projects like building of roads, healthcare, or education. With an increase in C, I and/or G, this will lead to an increase in AD, ceteris paribus. Assuming the economy operates with spare capacity as shown in Figure 1 below, the increase in AD will result in a rise in real output by a multiplied amount due to the working of the multiplier where one’s spending becomes another’s income. As real output increases from Y1 to Yf, actual growth is attained. The increase in production would mean that firms would increase their demand for factors of production, including labour. ADL increases and thus, demand-deficient unemployment is reduced.

Figure 1 b. Explain one undesirable consequence of EFP → conflict with other macroeconomic goals (e.g. price stability and favourable BOT position) Expansionary fiscal policy may have the unintended effect of conflicts with other goals. Impact on Inflation: If the economy is at or near full employment, excessive increases in AD which are persistently greater than AS cause demand-pull inflation where the excess total demand cannot be met because existing resources are fully or almost fully employed. Assuming that the economy is operating near full employment where the initial equilibrium is at E1 and expansionary fiscal policy is implemented to increase AD. The increase in AD causes total spending to exceed total output resulting in a shortage at OP1. This leads to a fall in inventories which provides an incentive for producers to increase output to meet demand. As there are limited spare resources, firms will have to bid up factor prices causing GPL to rise. There is a movement up along the AD & AS curve. The rise in income arising from the initial rise in AD causes a rise in income -induced consumption that results in a further increase in AD. As one’s spending becomes another’s income, there will be multiple increases in AD until a new equilibrium is reached at E2 where AD2 = AS. Real output increases by a multiple from Y1 to Y, while GPL rises from P1 to P2. However, AD continues to increase from AD2 to AD3, due to for example, greater consumer confidence which leads to an increase in consumer expenditure on domestic goods and services (Cd). This causes a further increase in GPL from P2 to P3. The persistent increase in AD creates a situation of sustained excess demand in the economy and brings about a sustained increase in general price level and hence demand -pull inflation, which would have an adverse impact on the country’s standard of living. High and rising inflation can be destabilising for an economy because it results in rising costs for households and businesses and can cause a loss of competitiveness for

domestic businesses in international markets. This could conflict with the government’s objective of price stability and a favourable balance of trade position. Requirement #2: Explain another undesirable consequence of EFP → crowding out effect and its impact on the economy Besides inflation and its negative consequences, expansionary fiscal policy may have another unintended effect in the form of crowding out effect. Should the government budget be in deficit and the increase in government spending financed by borrowing , it will be competing with the private sector for loanable funds. When demand for loanable loans increases, it drives up the price of loans, which is interest rate. Higher interest means higher cost of borrowing which in turn will discourage firms from investing (reducing I) and individuals from buying on credit (reducing C). Thus, government expenditure crowds out private expenditure. In figure 2 below, the intended effect of an expansionary fiscal policy EFP via borrowing to increase G was to increase AD to AD2, hence increasing real output to Y2 thus achieving actual growth. However, with the crowding out effect, AD2 falls to AD3 due to fall in C and I. Thus, the net effect on AD is that AD only increases to a smaller extent from AD1 to AD3, lowering the extent of increase in real output (Y1 to Y3 only) and hence actual growth. Figure 2 In the extreme case, the fall in consumption and investment expenditure may completely offset the rise in government expenditure, with the result that AD does not rise at all and remains at AD1. Hence, government’s attempt to tackle negative growth may be rendered ineffective as there is no change in real output (remain at Y1). 1) Effect of ↑G 2) Effect of ↓I and ↓C due to crowding out effect.

Mark Scheme Level Descriptors Marks L3 For a response which shows strong economic analysis in terms of how EFP works briefly to achieve EG and low unemployment AND two undesirable consequences . 8 – 10 L2 For an under -developed explanation. Appropriate economic concepts and analysis are used but application is lacking. 5 – 7 L1 For an undeveloped answer with a listing of points 1– 4

(b) Discuss whether expansionary supply -side policies would be effective in achieving the macroeconomic policy aims of an economy. [15] ………………………………………………………………………………………………………. Suggested Answers to part (b): Introduction: Governments usually aim to achieve growth and stability in the econ omy. Aside from expansionary fiscal policy es explained in (a), expansionary supply-side policies can also help to achieve government aims such as non -inflationary growth and lower unemployment. Requirement #1: Explain how SS -side policies work to achieve non -inflationary growth Unlike expansionary fiscal policy which can bring about demand-pull inflation (explained in part a) when used to achieve growth, supply-side policies are useful in achieving non- inflationary growth. [What it is] The government can use long-term supply-side policies targeted at increasing the productive capacity of the economy. This will cause a rightward shift of the vertical segment of the AS curve. [How it works] Policies targeted at raising productivity level s through government spending on research & development improves the quality of factors of production in an economy, hence an increase in the efficiency in the use of these FOPs . This causes an increase in productive capacity of the Singapore economy, hence shifting LRAS to the right. There is potential growth as full employment output increases. Assuming economy is opera