HCI_H2_ECONS_Case_Study_Q2

1    Mark Scheme & Suggested Answers (a) (i) Use the concept of opportunity cost to explain the theoretical relationship between interest rates and level of savings [2] State the theoretical relationship: Direct/positive Explain using O.C. concept O.C. is cost measured in terms of the next best alternative forgone. Interest rates affect choices made by households between saving and consumption. When interest rates fall, O.C. measured in terms of interest forgone falls thus making saving less attractive or consumption more attracti ve (1m). Therefore, rational households spend more and save less (1m). Marking policy: Wrong relationship but correct explanation - Can award 2 marks Correct relationship but wrong explanation - Can award 1 mark Accept alternative approaches touching on the key elements:  Interest rate linked to choice between S and C  OC of S is higher the lower the i/r  OC of C is lower the lower the i/r  Rational decision is C more and save less, if i/r falls. (ii) Comment on whether the rela tionship is shown in Figure 1 from 2009. [2]  No: Graph shows a clear divergence of saving and interest rate. Interest rate was very low (close to zero and remain flat) yet saving rate rose sharply and remain relatively high (1m)  Financial crisis: households are pessimistic about the economic outlook and they will tend to save more (paradox of thrift). (1m) [ FYI: Test is on the psychological impact on S and C or so-called pessimism or loss of confidence to spend in bad times] Marking policy: Not required to state explicitly the concept paradox of thrift. Correct explanation with indirect reference e.g. psychological impact on consumption and saving in bad-times is sufficient. (b) Using the data provided in Extract 1, explain whether the call by IMF for a reassessment of the UK austerity policy is justified. [4] Yes (1m for evidence and 2m for explanation) – Extract 1, para 2:  Case Evidence: Austerity measures are believed to ‘ derail growth due to larger multiplier (k>2) during recession and the strong ‘knock-on effects’. (1m) Analysis:  Larger k: Higher than expected negative or downward K ef fect generated by a cut in G spending as a result of fiscal austerity. The size of the K is determined by the marginal propensity to consume (mpc) or withdraw

2    (mpw). Since, interest rate is close to zero ( using case evidence) this elevates k by increasing the propensity to consume (bigger MPC) rather than save (smaller MPS). (1m) [ FYI: The value for UK multiplier =1.28, Source: Colin Bamford 26 August 2015]  Knock-on effects *: Knock on effects further reinforced the negative K effects due to the austerity measures. Government cutting back on spending and higher taxes further DISCOURAGES autonomous consumption and investment by the private sector (1m) [FYI: *The knock on effects refer to the positive impact on PRIVATE se