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 sector consumption and Investment “sparked off” by public sector pump-priming measures initiated by the government to brighten up economic outlook and restore confidence in the economy. Unlike pump-priming, the knock on effects in this context have a negative impact on private C +I because of fiscal austerity. In other words, fiscal austerity dampens or causes “loss of confidence” in private sector spending ] No (1m) Case evidence: Extract 1, para 3 Analysis: Fiscal multipliers are weaker in open economies such as Britain due to higher MPM. Accept other reasonable contextualised arguments such as tax cuts will lead to an even larger debt which the UK will have more problems clearing in the future. (c) Explain the statement in extract 1 ‘austerity is still having a dampening effect on the economy, and is making it harder for the Fi nance Minister to hi t his deficit reduction targets’. [2]  A reduction in government spending and higher taxes reduce AD and causes national income to contract that leads to cyclical unemployment. (1m)  When income falls, lesser income taxes are collected due to progressive taxation system and higher unemployment benefits pay-outs due to cyclical unemployment. (1m) [ FYI : This question test on automatic stabilisers] (d) Based on Extract 2, explain how austerity meas ures have adversely impacted the standard of living in some countries. [2]  Evidence: Countries that practice austerity me asures: cut in health-care e.g. Greece, USA: Suicide, depression, HIV + rising crime issues (1m)  Theory: Intangible dimension of living st andards or quality of life worsens. (1m) (e) Discuss how inflation has affected differe nt types of households in post-crisis UK. [8]

3    Introduction  Define inflation as a sustained or persistent rise in general price level  The data provides information on the impact of inflation on rich and poor households in UK.  Inflation caused a redistribution of income amongst different types of households resulting in ‘losers’ and ‘gainers’. Body A. Losers (Thesis) Explain why the poorer households are worse off with inflation. a. Incomes Case evidence: ‘Stagnating wages, cuts to benefits and tax credits’ due to austerity measures have reduced purchasing power of households. b. Household expenditure pattern ie consumer basket Case evidence: From Figure 2, rising food, rented apartments and energy prices, formed a bigger proportion of the spending of poorer households than the rich. Explain why pensioners are hit hardest.  Pensioners had been hit hardest with 4.2% increases in their costs compared with the 2.4% rise as indicated by the CPI.  Pensioners have fixed income; spend more on food and energy.  Benefits delinked to inflation. Evaluative comments: The impact on poor were mitigated by government policies. Case evidence: ‘increasing the tax-free personal allowance to £10,000; freezing council tax for five years; and freezing fuel duty.’ B. Gainers (Anti-Thesis) Explain why rich households benefit. a. Incomes Asset prices and investment income rising e.g. property income. Such assets appreciate in value in times of inflation. b. Expenditure pattern The rich has benefited from cheaper mortgage rates (dropped by 40% since 2008) Case evidence: According to Figure 2, rich households spend a much larger proportion on MIP. Debtors (borrowers) gain because a fall in the va lue of money (due to inflation) means that the payments of their debts will be less in real te rms: real interest rate = nominal interest rate – inflation + Figure 1 shows interest rates have fallen. Large part of their consumption is on non-essentials (e.g. luxury cars, fine dining, expensive

4    overseas holidays) of which prices were not the culprits of rising COL in the UK. c. Shoe-leather costs ’the rich having bank account for direct payments, or access to buy online or compare prices across a wide range of suppliers. The rich have access to resources which allowed them to shop for the ‘best deal’ ie Stretch their Consumer dollar or spending power. Conclusion Whilst all households suffered a fall in real disposable incomes in post-crisis UK, the poor were hit hardest. It can be said that the poor househol ds were the ‘losers’ and the rich households were the gainers. Stagnating wages of the poor and rising COL affecting key items such as food and energy, which accounted for a substantial proportion of the expenditure pattern of poor households, led to widening “poverty gap” or income disparity between the rich and poor. Mark Scheme Band Band Descriptors Marks L3 Answer will provide in-depth and accurate analysis that links consumption pattern of rich and poor households in UK to the impact on their respective purchasing power as well as differences in sources and change in the level of inc