RVHS H1 ECONS P1 CSQ 2 Soln

1 © RVHS 2017 8819/01 2017 RVHS H1 Prelims II Question 2 Problems in the European Union (suggested answers) (a) Compare the pattern s of the government debt to GDP ratio in Greece and Germany between 2010 and 2015. [2] Government debt to GDP ratio in Greece increased while it decreased in Germany. [1] Government debt in Greece is consistently more than 100% of GDP while that of Germany is less than 100% of GDP. [1] (b) Extract 7 suggests that austerity measures were impo sed on Greece to help reduce its debt. Explain the likely factors th at may influence the effectiveness of these measures. [4] Debt is incurred when the government borrows to fun d a budget deficit. Austerity measures aim to increase tax revenue while decreasi ng government spending. The effectiveness of austerity measures imposed on Gree ce to reduce its debt is thus dependent on its ability to increase tax revenue and decrease government spending. 1. Consumers and investors’ confidence in the Greek economy If Greece succeeds in decreasing its debt, consumer s and investors’ confidence might be raised thereby increasing consumption (C) and in vestment (I) and increasing national income (NY) and employment in the future. This will help to increase tax revenue and reduce government spending, thus helpin g to reduce the debt / avoid more borrowing and chalking up debt, rendering austerity measures effective. Or With a decrease in consumers and investors’ confide nce when Greece’s debt is high, austerity measures may dampen C & I which will result in a fall in tax base and a fall in tax revenue. This reduces the effectiveness of aust erity measures in trying to reduce the debt. 2.Ability of the government to reduce government spending It may be difficult to reduce some forms of governm ent spending such as healthcare. These may be strongly resisted. Hence, failure to reduce government spending with no corresponding increase in tax revenue may mean that the debt is not reduced, rendering austerity measures ineffective. Note: 2 marks for each point well explained.

2 © RVHS 2017 8819/01 (c) Extract 5 mentions that German chancellor Angela Me rkel had refused to put a cap on refugee numbers into Germany. (i) With the help of an AD/AS diagram, explain the impa ct in both the short and the long run of an influx of refugees on the Germany’s economy. [6] The influx of refugees will lead to an increase in consumption (C) as they will also be spending on daily necessities within Germany. In addition, in order to house the refugees, the government will need to spent more on public investment expenditure (G) to construct more housing infrastructure. [1] I n the short run, the increase in C and G will then lead to an increase in aggregate de mand (AD) from AD 0 to AD 1 and a multiple increase in national income (NY) from Y 0 to Y 1, as shown in Figure 1, achieving actual economic growth [1]. In the long run, the refugees will be trained and are ready to join the workforce. This increase in quantity of labour in Germany will caus e an increase in long run aggregate supply from AS 0 to AS 1 as shown in Figure 1. [1] Potential economic growth is achieved as productive capacity increased from Yf 0 to Yf 1. Figure 1: Impact on Germany’s economy Graph showing short-run impact [0.5], showing long- run impact [0.5]

3 © RVHS 2017 8819/01 (i i) Explain how Germany’s government budget could possi bly be affected with the influx of refugees. [4] Government budget position is derived from governm ent revenue minus government expenditure. Possible impact on government revenue In the long run, as mentioned in part ci, as more r efugees become educated and join the workforce, they will also be contributing income tax. Assuming that there is no change in government’s expenditure, government’s budget position is likely to improve. [2] Possible impact on government expenditure In the short run, government expenditure is likely going to increase as more funds will be spent to build more housing infrastructure for the refugees. Thus assuming no change in government revenue collected, government’s budget position is likely to worsen. [2] Note: 2 marks for each possible impact. To obtain t he full 4 marks, both government expenditure and government revenue needs to be mentioned (even if it’s assuming that either of them remain constant). (d) Analyse and comment on whether the problems posed by Germany’s trade surplus or Greece’s debt will be more serious to the European Union. [6] Thesis: The problems posed by Germany’s trade surpl us is detrimental to the European Union Impact on BOP position of Germany’s trading partners in the EU Germany’s trade surplus is likely due to its lower cost of production through wage competitiveness as pointed out in Extract 6. This r esults in lower prices of its export and enabled Germany to divert export demand from other EU countries to its economy instead. These chronic surpluses in Germany are a w ay of stealing demand from elsewhere and may result in a persistent balance of trade (BOT) deficit for other EU countries. Secondly, the German regulatory and tax structure i s geared in favour of output and exports and against consumption. Taken together, th ese will lead to a fall in demand for many EU countries’ exports leading to a fall in their net exports, worsening their BOT and balance of payment (BOP) position. Impact on economic growth and unemployment of other EU countries The fall in net exports will lead to a fall in aggr egate demand (AD) and national income (NY) via reverse multiplier effect. This leads to i ncreased unemployment levels in the other EU countries. This may weaken consumer and in vestor’s confidence, lowering consumption and investment, thereby worsening natio nal income and unemployment levels further in the other EU countries. Impact on economic growth and general price level of other EU countries To match up to Germany’s competitiveness, a few EU countries such as France, Spain and Greece tried to lower their wages as mentioned in Extract 6. The fall in wages will

4 © RVHS 2017 8819/01 lead to a fall in disposable income, decreasing consumption, leading to a fall in AD and NY. This will lead to a multiple fall in national i ncome via reverse multiplier effect and a dampening/deflationary effect on general price leve l, which explains the deflationary slump as mentioned in Extract 6. Anti-Thesis: The problems posed by Greece’s debt is detrimental to the European Union Impact on economic growth, unemployment and general price levels of other EU countries (opportunity cost of lending money to Greece) As noted in Extract 7, Greece received several bail outs from the EU since 2010 and she has benefitted from a large write-off of debt o wed to private banks in 2012. In addition, the true creditors of much of Greece’s re maining large debt are German, Dutch, French and other European taxpayers. If Gree ce were to default on her debt or if the debt is written off as bad debt just like in 2012, it will be of a high cost to other EU countries. This is because the money loaned to Gree ce will not be recovered and as a result, there will be less reserves and funds avail able for future government expenditure in other EU countries. These funds used to bail out Greece could have been used by other EU countries to increase their fiscal spending which will help brin g about economic growth in their own country instead. For example, bailing out Greece by other EU countries will limit the amount of funds available for other uses such as building infrastructure, which will then