GRADE XI ECONOMICS

MARKING SCHEME (DATA RESPONSE & ESSAY)

Answer the following questions:

1. In 2010, to promote the expansion of renewable energy sources, the government of

Vietnam introduced subsidies for firms, manufacturing solar panels. (8)

Explain, with an appropriate diagram, the effect of producer subsidy on price and supply
of solar panels.

Subsidies are direct payments made by governments to producers of goods and services.

When paid to a producer, it results in a fall in costs of production for the producers and a
result of which the prices of goods and services can be competitively fixed and is likely to
result in an increase in demand and the consequent increase in the quantity supplied.

This results in a rightward shift of the supply curve. A reduction in a subsidy payment will
result in a leftward shift of the supply curve

Diagram: fig 3.7

Explanation:

The figure above shows that introducing a subsidy in the market results in a fall in price
from P to P1 and an increase in quantity demanded from Q to Q1.

As a result of an increase in the quantity demanded the supply curve will shift to the right
from S to S1.

Subsidies may be paid to producers for many reasons such as to stabilise the market prices
of essential goods and services, to encourage greater consumption of demerit goods,
equitable distribution of income, to reduce dependence on imports and generally raise the
producer’ income.

2. With the help of a diagram, discuss whether consumers will benefit from an
introduction of an effective maximum price control. (12)

A maximum price level also referred to as a price ceiling or a price cap is a form of a
government regulation, enforced to keep prices below the equilibrium price or market price
that is determined by the market mechanism.
The price that can been legally charged by the sellers or producers for certain commodities
must not be any higher than the maximum price level imposed by the government such as
staple foodstuffs, rents in certain types of housing, essential utility services such as gas,
electricity and fuel and subsidised transport fares and avoiding monopoly exploitation.

To be effective a maximum price or a price ceiling would have to be set below the
equilibrium price and the quantity demanded may exceed the quantity supplied creating a
shortage.

When the government imposes a price ceiling, the quantity produced may not be sufficient
to satisfy consumer requirement and unless the item is very much price inelastic, the
quantity supplied will be far less than the quantity demanded.

This could mean that some system of rationing needs to be in place to allocate the available
supply or the available supply has to be allocated on some other basis such as queuing
which may result in long queues because of shortage of commodities.

Diagram: fig 3.1

Explanation for the diagram:

The advantage of maximum price is that they will lead to lower prices for consumers. This
may be important if the supplier has monopoly power to exploit consumers.
For example, a landlord who owns all the property in an area can charge excessive prices.
Maximum prices are a method to bring prices closer to a ‘fair’ and ‘competitive equilibrium
and are usually reserved for socially important goods, such as food and renting .

However these may inevitably lead to an informal or a shadow market as some consumers
are unable to obtain the product and may end up paying inflated prices well above the
ceiling price, reducing the consumer surplus

3. After the Second World War, nationalisation gained support in the UK with the Labour
Party and some social democratic parties throughout Western Europe.

The justification for this step was to protect and develop industries perceived as being
vital to the nation’s competitiveness or to protect jobs in certain industries.

Discuss whether nationalisation leads to benefits to an economy. (12)

Nationalisation is the process through which governments take a private business into
public ownership. Decisions on prices, the scale of operations and investment are taken by
bodies set up and responsible to the government.

Many countries in the world, for example the UK and parts of Central and Eastern Europe
had extensively nationalised their key strategic industries such as transport, fuel, power
generation, iron and steel and telecommunication industries.
Nationalisation of certain strategic services and activities such as railways, bus services,
airports, electricity and water supply ensures provision of uniform services and services to
different corners of the country.

Such services if owned by the public sector will lead to protection of public interest and
prevent unhealthy competition among industrial monopolists.

Prevents monopolies as nationalisation makes the economy more equitable and opens
strategic services to even people without connections.

Under state ownership the profit earned by nationalised firms can be utilised for greater
public good and help in supporting the Government’s economic policies.

Economies of large scale can be gained that would not be available to smaller, privately
owned enterprises.

Employees feel a sense of ownership and work hard to ensure financial viability. Labour
unions often favour nationalisation because they feel they may be better treated by the
government – rather than a profit maximising monopoly.

Nationalised industries will be more likely to provide loss-making services for social reasons.

Some of the nationalised industries have had significant positive externalities. For example,
public transport plays a key role in reducing pollution and congestion.

Some industries play a key role in the welfare of consumers and citizens. For example, gas
and water can be considered necessities for basic living standards and not luxuries.
Government provision means that needy groups can be looked after and provided with
basic necessities.

In spite of the advantages offered by nationalisation listed as above, it has led to certain
disadvantages for economies such as:

Adverse effects on business investment by local producers and overseas companies.

The public sector activities tend to be inefficient and ineffective in operating and fulfilling
the needs of the public. Managers of these utilities are generally not required to meet any
efficiency objectives set by the state and because these industries are protected from
competition, they become increasingly inefficient.

Lack of competition can reduce the quality of goods and services as publicly owned utilities
are not required to meet any efficiency objectives set by the state and these industries
were protected from competition.
Due to the large government bodies the decision making process may slow down due to
existence of bureaucracy and red tape leading to prolonged periods of under investment
and slow economic growth.

Nationalised industries are also prone to suffer from moral hazard, which occurs whenever
individuals or organisations are insured against the negative consequences of their own
inefficient behaviour. For example, if a particular nationalised industry made operating
losses, the government would simply cover those losses with subsidies.

If the activity is loss-making, it will be subsidised heavily using a higher proportion of the
tax revenue earned by the government in covering up losses rather than other economic
growth and development objectives. Thus nationalisation also involves an opportunity cost
for the government.

There is a danger of using financial resources for political purposes rather than productive
purposes as governments are motivated by political pressures rather than sound economic
and business sense.

4. Explain the difference between transfer payments and direct provision of goods and
services. 8

Transfer payments are payments from tax revenue that are received by certain vulnerable
members of the community such as the elderly, the disabled, the unemployed and the very
poor. They are not made through the market as no production of goods and services takes
place.

For ex: old age pensions, unemployment benefits, housing allowances, food coupons, child
care benefits and the like.

The function of transfer payments is to promote a more equitable distribution of income

and the extent to which they can be disbursed depends upon the tax revenue collected by
the government.

The benefits of transfer payments include reducing poverty and a more fair distribution of
income.

However, they can act as a disincentive to work, as in the case of unemployment benefits
and poverty benefits, creating inefficiencies and reducing total economic output (GDP) of
the economy.

Direct provision of goods and services are the provision of certain important services
provided free of charge to the consumers by the government. Such services are also
financed through the tax system and reach consumers directly.
For ex: education and health care

The aim of direct provisions are to reduce inequalities in society where such services are
provided equally to every individual in the society and those lowest on incomes gain most
as a percentage of their income

These services provided universally free ensure that everyone has equal access to a certain
level of education and healthcare and they are the material equivalent of monetary
universal benefits

The criticism of this government measure is that markets have a tendency to overprovide
because direct charges are not made and may like result in inefficient allocation of
resources. Many consumers who benefit from these services can actually afford the charges
and the reduced tax revenue burden could be put to better alternative uses.

5. Explain why a government may seek to avoid a current account deficit. (8)

Meaning of a current account deficit - The combined debit items on the four parts of the
current account exceed the combined credit items on the four parts of the current account.

More focus is placed on a deficit on the current account of the BOP because:

1. A current account deficit indicates that the quantity of imported goods exceed the
quantity of exports which has led to the problem of a deficit or shortfall. It means that the
exports make a negative contribution to the total demand for the country’s products, which
may lead to a reduction in AD in the future and impact economic growth (reduction in GDP)

2. A current account deficit may also arise due a fall in demand for the country’s exports
that may not be of the standard or quality required for overseas markets or may have fallen
in quality.

3. A current account deficit may arise due to inflationary situation prevailing in the
country’s economy. Inflation which is an increase in the general price level of goods and
services may increase the costs of production, leading to higher prices of goods and
services produced by the country. Rise in export prices is likely to curtail demand for them
which may lead to a fall in the quantity of exports.

4. A current account deficit can also put downward pressure on the exchange rate which
may lead to a demand for exports and reduce a deficit but the associated risk is that the
domestic firms may become reliant on such depreciation or devaluation in the exchange
rate to restore their price competitiveness and increases in export levels.

5. A current account deficit that leads to downward pressure on the exchange rate also may
give rise to inflationary pressures because of a rise in the net exports as they become
cheaper. As demand for exports increase, resources may become scarce and their prices
will bid up which will also increase prices of products bought by domestic consumers.

6. A current account deficit also indicates that the country is living beyond its means, in the
sense that it enjoys more goods and services than it currently produces. This situation can
lead the country into greater debt which may prove difficult to repay and other countries
may be reluctant to continue to lend to the country.

7. A current account deficit may reduce confidence in the currency and the strength of the
economy which could lead to an outflow of direct and portfolio investment.

6. Discuss whether a fall in the country’s exchange rate will improve its macroeconomic
performance. (12)

A fall in the country’s exchange rate will reduce the price of the country’s exports in terms
of foreign currency and raise the prices of imports in terms of domestic currency.

A fall in the price of exports should make them more price competitive and lead to higher
demand but it depends on the price elasticity of demand for goods and services.

If the demand is price elastic, a fall in price will cause a greater percentage rise in quantity
demanded for exports, leading to an increase in export revenue. Similarly a rise in import
prices due to a fall in exchange rate should reduce the demand for them if the demand for
imports is price elastic.

The importance of price elastic demand is emphasised by the Marshall – Lerner condition
that states that a fall in the value of the currency or the exchange rate will lead to reduction
in current account deficit only if the sum of the combined price elasticities of imports and
exports is greater than 1.

The J-curve further suggests that a fall in the exchange rate may further worsen(deficit may
increase) before it is reduced because in the short term the demand for imports and
exports may be relatively inelastic and it takes time for household and firms to notice price
changes and search for substitutes.

As time progresses to long term, and alternative sources are discovered, demand is likely to
become more elastic which may cause a rise in the export revenue, a decrease in import
expenditure and the deficit balance to reduce as well.

For an economy operating with spare capacity, an exchange rate fall may lead to a
reduction in the current account deficit. However, if the economy is operating close to full
capacity, a fall in the exchange rate leading to higher demand for exports runs the risk of
inflationary pressures. Higher AD demand may lead to shortages in availability of resources
and push up price levels. In addition imported products still being purchased will be more
expensive and reduce pressure on domestic firms to keep prices low.

An outcome of a fall in the exchange rate on the current account deficit therefore depends
on the interplay of many factors in the economy such as the price elasticities of demand for
imports and exports, the level of spare capacity and the behaviour of domestic firms.

7. One of the advantages of a floating exchange rate system is that it allows the
government to focus on other aims.

Considering the above advantage discuss whether adopting a floating exchange rate
system will mean that a government should neglect its BOP position and focus on its
policies of domestic problems instead.

A floating exchange rate system is where the value of the country’s currency is determined
by the forces of demand for and supply of the currency in the foreign exchange market.

A government does not intervene in the foreign exchange market to influence the exchange
rate because the floating exchange rate system works automatically to correct the deficit or
surplus in the current account of the BOP.

For ex: A current account deficit because of higher spending on imports as compared to
export revenue will lead to increase in the supply of currency, causing the currency to
depreciate or fall in its value. Depreciation of currency will lower the prices of export
products and increase the price of imported goods which will lead to more exports and less
of imports being demanded and an improvement in the current account deficit of the BOP.

This will occur without government intervention, and thus a government wishing to
concentrate on raising employment levels may not regard the BOP position as a constraint
when it decides to increase demand. However, a floating exchange rate whilst giving more
opportunity to the government to concentrate better on its other macroeconomic aims
does not in practice allow the government to neglect the state of the BOP.

A floating exchange rate may not always guarantee a BOP equilibrium and movements of
the exchange rate also have effects on the economy as well.

For ex: A deficit on the current account of the BOP may lead to fall in the exchange rate. But
the depreciation in the exchange rate will not restore its value if the demand for imports
and demand for exports is inelastic.

A deficit in the current account may also arise due to higher outflows from the financial
account because of higher interest rates abroad, lower taxation rates or better economic
prospects causing direct and portfolio investment to leave the country which is a cause of
concern to the government as unemployment levels may increase and economic growth
may slow down.

A fall in the exchange rate value may increase prices of imported raw materials and firms
and consumers reliant on imports for their production and consumption may experience
rising costs of production and consumption. This may stimulate wage demands and so firms
using imported raw materials may be compelled to push their price levels up. Increase in
demand for exports due to a fall in the currency value is likely to motivate domestic
producers to raise their prices too causing inflationary pressures on the economy.

Sometimes, a government may be compelled to lower the exchange rate to stimulate

demand end economic growth in times of recessionary periods to increase AD, raise output
and create more jobs.

Therefore, although a floating exchange may be used to achieve a policy objective, the
government cannot ignore the BOP position and nor can it assume that a floating exchange
rate automatically restores the BOP position by itself. The government also has to consider
the decisions made by producers, consumers, workers and the overseas conditions as well.

8. Discuss the causes of an increase in aggregate demand. Assess whether such an

increase will always cause inflation. Use diagrams to support your answer. [12]

Aggregate demand is the total spending on an economy’s goods and services at a given
price level in a given time period.

Aggregate demand consists of four components consumption ©, investment(I),

government spending (G) and net exports(X-M).

Consumption also known as consumer expenditure consists of spending by households on

goods and services. Investment is spending by private sector firms on capital goods.
Government spending covers expenditure by the government on capital goods and
services. Net exports cover the difference between the value of exports of goods and
services and the value of imports of goods and services.

The aggregate demand curve shows the different quantities of total demand for the
economy’s products at different prices. A rise in the price level will cause a contraction in
aggregate demand while a fall in the price level will result in an extension of demand.
Changes in the price level are represented by a movement along the aggregate demand
curve.

A change in the non - price factors that influence aggregate demand will cause the
aggregate demand curve to shift from its original position. A shift to the left indicates a
decrease in the aggregate demand while a shift to the right shows an increase in aggregate
demand.

A rise in consumer confidence or a cut in taxation rates may cause in increase in consumer
expenditure. Similarly reduction in rates of corporation tax or advances in technology may
lead to increased investment by private sector firms.

A desire to stimulate the general economy will cause a rise in government spending and a
fall in the exchange rate or improved quality of export products will improve the export
levels of a country, leading to increased net exports.

Fig 4.2 page 82

If aggregate demand increases, the economy could experience a demand pull inflation
which is when aggregate demand outpaces the aggregate supply of goods and services.

The equilibrium level of output and the price level are determined where the aggregate
demand is equal to aggregate supply. It is a point where the aggregate demand and
aggregate supply intersect as shown in the figure below:

Fig 4.7 page 84

However, when the aggregate demand in an economy strongly outweighs the aggregate
supply, the prices go up causing inflation. This happens when the aggregate demand level
attempts to push the economy past the potential output (aggregate supply) and as a
consequence the economy would experience inflation.

This is the most common cause of inflation but an increase in aggregate demand may not
always cause inflation if aggregate supply increases correspondingly to match the rise in the
aggregate demand levels.

Changes in aggregate supply are brought about by changes in the quantity and quality of
resources that may increase the productive potential of an economy such as increased net
investment, discovery of new resources, advances in technology, improved education and
training and net immigration.

Thus an increase in aggregate demand may not cause inflation if the imbalance is matched
by increases in aggregate supply. The key policy implication for either situation is that
government needs to step in and close the gap, using expansionary and supply side
measures during recessions and contractionary and supply side measures during inflation,
to return aggregate demand to match the aggregate supply.
9. Discuss how governments might attempt to increase the elasticity of supply of an
agricultural product. Consider whether they are likely to be successful. [12]

Price elasticity of supply is a numerical measure of the responsiveness of the quantity

supplied to a change in the price of the product, ceteris paribus.

It is a measure of how much producers of a product change the quantities they are willing
to sell in response to a change in price. If the change in sales is large compared to a unit
change in price, supply is said to be elastic.

Conversely, if the change in the quantity supplied is small relative to a unit change in price,
supply is said to be relatively inelastic. The relationship between the price and quantity
supplied is normally a direct one and therefore the PES will take on a positive value.

The main factors influencing the PES (supply flexibility in response in price changes) are the
ability to accumulate or reduce stocks, the ease of increasing production levels, the ease of
changing from the production of one product to another, cost structure of producers, the
time period involved(short term or long term) and technological advances.

The ability of a product to be stored affects how much a producer can offer for sale in a
given time period. For example, a product like grain, which is easily storable and in one
crop year, a producer may offer for sale both this year's crop and also what is in storage
from previous years. Conversely, if a product is perishable, like lettuce, market supply will
be limited to what is currently produced.

The price elasticity of supply also depends on the nature of the product being produced and
supplied. In case of agricultural products, in the short-term, responsiveness of quantity
supplied to price change tends to be small as changes cannot be made quickly.

The short-term is that length of time over which only a few inputs can be changed. For
example, once land is allocated to a crop and the crop is seeded, changes in planned output
are limited and farmers have limited ability to alter the quantities they can produce and
sell. Therefore in the short term market supply for agricultural products tends to be
relatively inelastic or unresponsive to changes in demand.

As the length of time or the production time period grows, supply tends to become more
elastic or more responsive to price changes because in the long term all factors such as
land, seeds, livestock and equipment are variable and available to alter the production
quantities.
The ease of switching inputs to different uses is related to the influence of cost structures
on supply elasticity. Some inputs or set of inputs may not be used for anything other than
one product. If that is the case, then the supply of that product will be relatively inelastic
compared to a product produced with inputs that can be used in a variety of ways.

For example, a corn harvester has little use other than harvesting corn. Once the corn
harvester has been purchased, the flexibility in switching output to wheat is more limited;
the farmer is more locked into corn. On the market, corn supply thus becomes less elastic,
or less responsive to price changes.

If individual producers can expand easily by quick or easy access to agriculture inputs or
resources, then the supply will be relatively elastic where it is possible that a small increase
in price could be enough to generate a large supply response in total. Market gardens
provide an example of an industry with this type of supply curve elasticity. Due to the small
land base required and low capital investment, entries into and exits from this business
occur very regularly. It only takes a small movement in local prices to encourage or
discourage production.

Technological advances are an important factor in agriculture supply and have contributed
greatly to the ability of producers to grow more. Technology has been used to improve the
performance of almost everything in agriculture, from seeds to livestock to equipment.
Over time, the adoption of technology in the production of agricultural products has been a
prime factor shifting the supply curve to the right, increasing supply.

The adoption of technology in agriculture has expanded agricultural output over a range of
prices. In other words, applying new technology to agricultural production has lowered
costs, so at each price more production is offered for sale. Thus, advances in technology
also determine the elasticity of supply of agricultural products.

One of the major supply shifters for farm products is weather and the supply of agricultural
products is often influenced by weather conditions. Adverse weather can lead to a dramatic
reduction in supply, whereas good weather conditions can result in a bumper harvest for
producers.

Using supply side policies such as labour reforms the government might increase the
elasticity of supply of an agricultural product by alleviating labour shortages. They might
also make provision for stocks to be held that can be drawn upon if prices
increase. .Whether these policies are successful depends upon the funds available for
training or for accumulating stocks. In the case of some policies, attempts to increase the
elasticity could be prevented by a bad harvest.

Thus the elasticity of supply is influenced by a number of factors. Those factors include the
price of the product in question, the number of producers, the input costs, the
technological changes, the price of other possible products, and unpredictable factors such
as weather, especially in case of agricultural products.

10. Explain, with the help of a diagram, how a free market would react if a minimum price
which had been set above the equilibrium is removed.

Minimum Price (Price floor) is the market price that is fixed above the normal equilibrium
price (as determined by the market forces of demand and supply). It means that the price
that can be legally charged by suppliers or producers must not be any lower than this price
floor. To be effective, a minimum price must always be fixed above the equilibrium price.

Minimum price controls often lead to surplus as price floors which are set above the
equilibrium price lead to supply greater than demand as suppliers are willing to supply
more products than are demanded by consumers.

However with the price floor benefits, it is likely that the producers turn inefficient because
firms with high costs of production have little incentive to reduce their operating costs as
the minimum price protects them from lower cost and efficient producers.

There is also a danger of development of informal markets especially for demerit and
addictive goods such as imported alcohol and cigarettes because consumers can buy these
from dealers offering these goods at less than the minimum regulated price.

Fig 3.2 pg 69.

When the guaranteed minimum price or price floor set above the equilibrium is removed,
it would lead to the excess supply disappearing as now the producers and consumers
would be able to trade at a price lower than the minimum regulated price.

With a fall in the price of commodities, the market would revert to an equilibrium position,
because of an increased in the quantity traded than before during the implementation of
the price floor. There would neither be an excess supply nor an excess demand in the free
market: the quantity demanded will increase and the quantity supplied will reduce, so
eliminating the excess(quantity demanded will match the quantity supplied – equilibrium
position)

A market clearing position would be established as consumers are attracted to buy goods
and commodities at lower prices, increasing consumer surplus. However, the impact on the
producer revenue will depend on the elasticity of supply.

Market equilibrium price diagram showing the equilibrium position after the surplus is
eliminated – Fig 2.12 pg 55

11. Discuss whether indirect taxes and subsidies could be used to improve the
consumption of merit and demerit goods if the demand for both of these goods is price
inelastic.

Demand is said to be price inelastic when a change in price causes a smaller percentage
change in demand. It occurs where there is a price elasticity of demand (PED) less than one.

Goods which are price inelastic tend to have fewer substitutes and are considered
necessities by users.

Merit goods are more beneficial for the consumer than they realise and as a result are
under produced and under-consumed because of information failure.

Demerit goods are more harmful to the consumer than they realise and as a result are over
produced and over-consumed because of information failure.

A subsidy is a form of government intervention, it usually involves a payment by the

government to suppliers that reduce their costs of production and encourages them to
increase output of a good or service. The subsidy causes the firm's supply curve to shift to
the right.

The more inelastic the demand curve the greater the consumer's gain from a subsidy.
When demand is perfectly inelastic the consumer gains most of the benefit from the
subsidy since all the subsidy is passed onto the consumer through a lower price.

An indirect tax is imposed on producers (suppliers) by the government. Examples

include duties on cigarettes, alcohol and fuel and also VAT. A carbon tax is also an
indirect tax. Indirect taxes are:
 a. Specific taxes: A specific tax is where the tax per unit is a fixed amount – for example
the duty on a pint of beer or the tax per packet of twenty cigarettes. Another example is air
passenger duty.

b. Ad valorem taxes: Where the tax is a percentage of the cost of supply – for
example VAT currently levied @20%.

An indirect tax increases the costs of production causing an inward shift in the supply
curve. With an indirect tax, the supplier may be able to pass on some or all of this tax onto
the consumer through a higher price and this is known as shifting the burden of the tax.

However the ability of businesses to do this depends on the price elasticity of demand and
supply. The Government would rather place indirect taxes on commodities where demand
is inelastic because the tax causes only a small fall in the quantity consumed and as a result
the total revenue from taxes will be greater. An example of this is the high level of duty on
cigarettes and petrol.

Merit goods are under-consumed and demerit goods are over-consumed in a free market.
This is because of information failure. Merit goods are more beneficial than consumers
realise and demerit goods are more harmful than consumers realise. If the price elasticity of
demand for merit and demerit goods is inelastic then the response of demand to the
change in price is less than proportionate because the products under consideration are
deemed as necessities. This may weaken the impact of the subsidies and indirect taxes, but
they could still be used to improve consumption because there will be some rise in the
consumption of merit goods and some fall in the consumption of demerit goods as a result
of their imposition.

12. China’s terms of trade index fell from 102.1 in March 2018 to 99.7 in April 2018.

a. State how the terms of trade are measured, and explain three possible causes of the
fall in China’s terms of trade shown above. [8]

The terms of trade represents the ratio between exports prices and its import prices. It is a
numerical measure of the relationship between export prices and import prices, that is, the
number of units of export required to purchase a single unit of imports.

The ratio is found out from the average prices of many goods and services that are traded
internationally. The prices are weighted by the relative importance of each product traded.

The ratio is calculated by dividing the price of the exports by the price of the imports
and multiplying the result by 100.
Terms of trade index = index of export prices x 100.

index of import prices

If the index increases, it is a favourable movement or an improvement in the TOT as fewer

exports will have to be sold to buy any given quantity of imports.

An unfavourable movement or deterioration in the TOT means that the index number has
fallen and more exports will have to be exchanged to gain the same quantity of imports. It
occurs when there is a fall in export prices relative to import prices, for example, import
prices may fall by less than export prices or import prices may rise and export prices may
fall.

The possible causes of a fall in the terms of trade include a fall in the price of China’s
exports or a rise in the price of China’s imports.

For example:

1. A fall in the value of China’s currency will lead to a rise in the price of imports and the
fall in the exchange rate could be caused by falling interest rates in China as it might lead to
capital outflows out of the country due to falling interest rates and making it potentially
unattractive for investment.

2. A reduction in the costs of production in China’s export industries would lead to a fall in
the price of China’s exports and this reduction in costs could be caused by an increase in
export subsidies or any other protection methods used by the Chinese government to
protect domestic economy.

3. A higher rate of inflation in China’s trading partners would lead to the relative price of
China’s exports falling and this higher rate of inflation in other countries could be caused
by excess government spending or lower rates of taxation in those countries.

4. If the reciprocal demand for China’s exports changes from inelastic to elastic. The
reciprocal demand signifies the intensity of demand for the product of one country by the
other. If the demand for China’s exportable commodities is more intense (or inelastic) in
other countries, the China will offer more of its exportable products to import a given
quantity of imports. On the contrary, if the demand for China’s exports in other countries is
less intense (elastic), then exports may fall while imports may increase following a change
in the exchange rate.

b. Discuss whether a rise in the terms of trade or a fall in the terms of trade is more likely
to be of benefit for an economy. [12]

Terms of trade are defined as the ratio between the index of export prices and the index of
import prices. If the export prices increase more than the import prices, a country has
positive terms of trade, as for the same amount of exports, it can purchase more imports.
For example: export prices may rise by more than import prices or import prices may fall
while export prices remain unchanged.

On the other hand, a worsening TOT indicates that a country has to export more to
purchase a given quantity of imports which means that there is a fall in the export prices
relative to import prices. In this case, it will be a fall in the TOT.

Causes of changes in the Terms of Trade

1. changes in demand conditions for exports and imports
2. changes in global supply of key inputs (such as oil)
3. changes in relative inflation rates
4. changes in relative exchange rates.

A rise in the terms of trade means that a given quantity of exports can purchase a greater
quantity of imports and the opposite is true for a fall in the terms of trade. If the terms of
trade rise exports might become uncompetitive however there is a potential rise in living
standards. If there is a fall in the terms of trade exports become competitive, but inflation
might rise as imports become expensive giving rise to cost-push inflation.
analysis of potential benefits of supply-side policies to increase employment in an economy, using appropriate
examples (up to 4 marks) • analysis of potential limitations of supply-side policies to increase employment in an
economy, using appropriate examples (up to 4 marks) (AN: up to 8 marks) • assessing whether supply-side policies
are likely to be effective in increasing employment in an economy – it is possible that such policies might actually
increase unemployment (up to 3 marks); and a concluding comment (1 mark) (EV: up to 4 marks)