CAPE Economics, June 12th, Unit 2, Paper 2 suggested answer by Edward Bahaw

EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS

CAPE
ECONOMICS
th
June 12 2008
Unit 2
Paper 2



June 2008 Non-Trinidad (Rest of Caribbean) – Unit 2 – Paper 2

1 a i) Inflation can be defined as a sustained increase in the average or general level of
prices which results in a fall in the purchasing power of money.

1a ii) Two causes of Inflation
• Demand-pull inflation
• Cost-push inflation

1 a iii) Measuring Inflation
• Consumer Price Index
The consumer price index (CPI) measures the weighted average price changes of a range
or a “basket” of goods and services consumed by the average household. Increases in the
CPI from one year to next means that there is inflation

• Inflation Rate
The rate of inflation is calculated by taking the percentage change in the CPI over the last
twelve months. This is given by the following formulae:

[Current CPI − Last CPI ]
Rate of Inflation = ×100
Last CPI

1 b i) Unemployment rate is defined as the proportion of individuals from the labour
force who are unemployed. This is therefore given by the following formula:

Number Unemployed
Unemployment Rate = ×100
Labour Force

1 b ii) Three causes of unemployment
1. General or Cyclical unemployment - this is unemployment which is traditionally
associated with the trade cycle which refers to the tendency of national income to
fluctuate both upwards and downwards in a sequential fashion. As economic activity
varies in this fashion, so too does the level of employment, since labour requirements
in production processes adjust to suit aggregate demand levels in the economy.
Particularly during a recession, when aggregate demand is low, this type of
unemployment would be high, while in times of recovery when aggregate demand is
high, cyclical unemployment would be low.
2. Structural unemployment - this occurs when there is a mismatch between the skills
required to perform a job and the skills possessed by workers. This could be the result
of structural changes in the economy where the industrial composition changes. An
imbalance is therefore caused in terms of the demand for different types of labour
from the decline of a certain industry and the rise of another. Unemployment results
when new industries do not create enough jobs to employ those made redundant or



because the new industry is in a different area or requires different skills. Most
economists agree that production processes and other operations in many industries
which previously required manual skills, now require labour with a higher mental
capacity.
3. Technological - this occurs when an improvement in technology reduces the demand
for labour and hence many workers become unemployed. New technologies affect
unemployment in two ways:
Firstly, new technology makes certain jobs redundant and unemployment increases as a
result.
Secondly, new technology creates new jobs that require different skills, which many of
the unemployed do not possess and are incapable of doing. In this case technological
progress perpetuates unemployment similar to structural unemployment.

1 b iii) Classical or disequilibrium unemployment – this is a temporary or short term
source of unemployment caused by wage rates being held above market clearing levels.
As wages remain above the equilibrium level, firms hire a smaller amount of labour. This
surplus of labour or unemployment eventually leads to a market clearing equilibrium
where wages have fallen. This is why classical unemployment is considered to be only
temporary.

1 b iv) Keynesian analysis of the economy reveals that an equilibrium level of income
could occur at a range of possible outcomes which may not necessarily coincide with the
Government’s macroeconomic objectives of full employment and low inflation.

1 c) The nominal interest rate is the actual rate of interest in the economy. The real rate of
interest is the nominal rate of interest adjusted for the rate of inflation. This adjustment is
necessary because inflation erodes the purchasing power of money. Therefore the real
rate of interest gives the return on capital after inflation is taken into consideration.

1 d) The accelerator model is based on an assumption of a fixed capital to output ratio.
That is to say, the principle asserts that a fixed capital to output ratio has to be maintained
in an economy. Thus, according to the accelerator principle investments are induced by
income. That is as income rises, investments are necessary in order to maintain the fixed
capital to output. Accordingly, in the accelerator model, investments can be expressed as
a function of income as follows:
I t = φ (Yt − Yt −1 )

where
It = Investment in time t
φ = The capital to output ratio
Yt = Output in time t
Yt −1 = Output in the year before time t

1 e) The marginal efficiency of capital (MEC is a percentage which gives the return on
capital employed. The marginal efficiency of investment (MEI) is a percentage which



gives the return on investment. In this case the level of investment is given by the change
in the amount of capital employed.

2 a i) The consumption function depicts the relationship between total consumption and
the level of income. The consumption function is upward sloping since as income
increases consumers’ expenditure tends to rise.

2 a ii) The Consumption Function
C ($M)
Consumption
Function
80

65

50

35

20

45°

25 50 75 100 Y $M

2 a iii a) The marginal propensity to consume (MPC) is the proportion of any change in
income that is devoted to consumption of goods and services and is calculated as: ∆C/
∆Y.

2 a iii b) The average propensity to consume (APC) is the proportion of income devoted
to consumption of goods and services and is calculated as: C/Y.

2 a iii c) The point at which the consumption function cuts the vertical axis represents the
level of consumption where income is zero. This simply the amount of goods and
services that have to be consumed whether the consumer has income or not e.g. food and
is termed autonomous consumption.

2 a iii d) The marginal propensity to save (MPS) is the proportion of any change in
income that is devoted to saving and is calculated as: ∆S/∆Y.



2 a iv) Keynesian assumptions about consumption
• When income is zero, APC is ∞ due to autonomous consumption. The
consumption function therefore meets the vertical axis above the origin.
• MPC is less than one since as income increases not all of the increase is devoted
to consumption
• MPC is assumed to be constant i.e. the consumption function has a constant slope.
• APC declines continuously as income increases. This means the greater a
households income the smaller the proportion devoted to consumption.

2 b) Factors which affect the households division of income between consumption and
savings
1. Income – the greater a households income the smaller the percentage devoted to
consumption and the greater the percentage that is saved. Low income earners
tend to save a smaller proportion of their income and in some case may even
dissave. High income earners on the other hand would tend to save a larger
proportion of their income even though the absolute level of consumption may be
higher than that of lo income earners.
2. Interest rate - a change in the rate of interest can significantly affect consumers’
expenditure at unchanged income. To a large extent, the purchase of most
consumer durables such as refrigerators and automobiles are made on credit or
hire purchase terms. As the interest rate decreases, the cost of borrowing
decreases and this may entice consumers to increase their spending especially at
acquiring consumer durables. Thus a decrease in interest rates may result in an
upward shift of the consumption function and a downward shift of the saving
function.
3. Expectations - Consumers’ expectations play an important role in determining
consumer expenditure and saving. Expectations of rising prices, product shortages
or future increases in income may induce consumers to increase spending and
reduce saving in the current period. This is because quite naturally consumers
would attempt to avoid the future shortages or future price increases by buying
more beforehand. In addition, higher future income may give consumers the
feeling of security of and this would encourage them to spend more. In these
cases there would be an upward shift of the consumption function and the saving
function would shift downward.
4. Tax incentives on saving - government may offer tax incentives on saving plans
of households. As taxes are reduced when consumers increase their savings, this
would discourage consumption as more individuals would have more reasons to
save. This means that tax incentives would lead to more income being saved
rather than consumed.
5. Inflation - as the price level increases at unchanged income levels, consumer
would need to increase their expenditure levels so that they would be able to
afford the same volume of goods and services that they previously consumed.
This may require a cut back in saving and an increase in consumption expenditure



even though the same quantity of goods and services are being purchased except
at higher prices.
6. Wealth - wealth consists of real assets such as, a house, automobiles, television
sets and other consumer durables as well as financial assets such as cash, a
savings account balance, stocks, bonds, insurance policies and pension plans
which are possessed by consumers. As wealth increases there might be a
tendency for individuals to consume more out of disposable income. Accordingly,
as households’ wealth increases, the consumption increases and saving declines.

2 c) Permanent incomes refer to income which is expected to persist over the long term
income. This would cover income sources such as a person’s salary from permanent
employment. Transitory income accounts for all sources of income which are unexpected
or of a short term nature. This would include income a person earns from overtime
payments during a busy month, or a single bonus payment received from extraordinary
business performance.

2 d) The life cycle hypothesis states that consumers aim to allocate lifetime income in
such a way so as to achieve the smoothest possible path of consumption over their entire
life. As such, consumption is independent of current income. Given that income may vary
systematically over a person’s life, savings and borrowing would bridge the gap between
current income and consumption expenditure.

3a i) Narrow money also called M1, covers money which is immediately available for
spending. That is, it comprises the monetary base and all short term deposits. This
measure of money fulfils the medium of exchange function. Broad money also known as
M2 measures the total amount of money in the economy. Broad money is therefore
narrow money plus long term deposits held at financial institutions. This monetary
aggregate fulfils the store of value function.

3 a ii) The velocity of money represents the number of times a unit of money is used to
purchase final goods and services in an economy.

3 a iii) The equation of exchange is given by:

M ×V = P × Y

where:
M represented the total supply of money,
V measured transaction velocity of circulation
P depicted the average price level
Y accounted for the total volume of goods and services produced

The right hand side, PY gives the average price level times the total volume of final
output. This is evidently the value of all final output produced in the economy or GDP.



The left hand side MV gives the total amount of money times the amount of times each
unit it is used to purchase a good or a service. This is also gives the total value of output
produced in the economy.

Both sides of the equation of exchange give national income.

3 b) Inflation and the Functions of Money

Function Impact of Inflation
As money loses value due to inflation, it becomes less
acceptable as a medium of payment in the exchange of
Medium of Exchange
goods and services. People may even stop using money on
the whole and revert to barter.
Debtors benefit as the real value of money borrowed falls.
This is to the detriment of creditors who suffer losses as the
Standard of Deferred Payment
real value or purchasing power of the amount lent declines
due to inflation.
Inflation means that prices are subject to variability. This
makes it difficult to establish a constant value of a good or
Unit of Account service over time. In addition, as prices change, the relative
value of different goods and services would also be
distorted.

3 c ) If in an economy, the full employment volume of output (Y) is 50,000,000, the
velocity of circulation (V) is 15 and the money supply (M) is $10,000,000, then using
MV = PY we have:

$10,000,000 x 15 = P x 50,000,000
therefore P = ($10,000,000 x 15)/50,000,000
i.e. P = $3 and GDP = $150,000,000.

If the money supply is doubled to $20,000,000
then using MV = PY
we have $20,000,000 x 15 = P x 50,000,000
therefore P = ($20,000,000 x 15)/50,000,000
i.e. P = $6 and GDP = $300,000,000.

Clearly it can be seen that a doubling of the money supply has lead to an equivalent
doubling of the price level. That is, an increase in the money supply of 100 percent has
led to a 100 percent rate of inflation. Interestingly, national income has also increased by
a 100 percent even though it was assumed that the volume of output was fixed at the full
employment level. The explanation is that the higher prices instigated by the increase in
the money supply has caused the nominal value of national income to increase even
though real output is unchanged. This is referred to as the classical dichotomy, which
states that average price level is determined by the quantity of money but that the



quantity of money has no effect on real macroeconomic variables such as the output of
goods and services and employment.

3 d) Currency substitution - In a large number of emerging and developing economies
local currencies do not adequately fulfil the functions of money and as a consequence
individuals partially switch to foreign currencies. This is referred to as currency
substitutions.

3 e i) The relationship between the speculative demand and rate of interests is based on
the normal or notional rate of interest. If the interest rate is higher than the normal rate,
then speculators would expect it to fall. This expectation also asserts that the price of
financial assets would be on the rise. This encourages speculators to use money to
purchases these assets in order to earn a capital gain which leads to a decline in the
speculative demand for money. On the other hand, if the interest rate is lower than the
normal rate then individuals would anticipate that the interest rate would rise which is
coupled with the assumption that the price of financial assets would be on the decline. In
this case speculators would dispose of such assets and hold more money in speculative
balances. Conclusively at high rates of interest, the speculative demand for money is low
and at low rates of interest the speculative demand for money is high.

3 e ii) The demand for money can be divided into three components
1. Transactionary - this refers to amount of money held for daily use to carry out
routine transactions.
2. Precautionary - this accounts for money held for unforeseen expenditures or
unforeseen contingency.
3. Speculative - this is any money held by individuals as they aim to take advantage of
capital gains and avoid capital losses as the price of financial assets change.

As income increase the amount of money held for the transactionary and precautionary
motives increases while the speculative balance remains unchanged. This means that
overall the total demand for money increases as income increases.

4 a) Keynesian liquidity preference theory introduced by Keynes, holds that the interest
rate is determined by the interaction between the demand and supply of money. The
demand for money also known as Liquidity preference refers to the amount of money
individuals hold which is inversely related to the rate of interest. The supply of money on
the other hand is fixed by the monetary authority which is the Central Bank. As such the
supply of money can be represented by a vertical supply curve. The equilibrium in the
money market is shown by point E which gives a market interest rate depicted by RE.

Liquidity Preference Theory of Interest Rate Determination



IR
SM

E
RE

LP= DM

M

4 b) As interest rates decrease, investment projects which were previously unprofitable at
the higher rate of interest would become profitable and the end result is an increase in the
rate of investment. On the graph, a fall in the rate of interest from 18 percent to 6 percent
leads to a movement along the MEI curve, which brings about an expansion in
investment in the economy from $2billion to $14billion.

Marginal Efficiency of Investments

4 c i) There are three lags that present major problems for effective demand management
policy:



1. Recognition lag – this refers to the time it takes to recognize that there is a problem
such as a recession or inflation, which needs correction. This is because economic data
usually takes time to compile which leads to a delay in the analysis of the economy.
2. Administrative/legislative Lag – this refers to the takes time it takes to implement an
appropriate policy after the economic authorities have recognized that policy action is
needed. This lag arises from the legislative procedures required before any policy can be
enacted to correct the course of the economy. It can be stated that monetary policy is
generally flexible as the discount rate can be changed each month on the discretion of the
monetary authorities. This implies that monetary policy generally involves a relatively
short administrative/legislative lag.
3. Impact lag – this is the time it takes for the policy measure to work and achieve the
macroeconomic objective. Since investment requires planning for the future, it may take
some time before decreases in the rate of interest are translated into increased investment
spending. This means that the impact lag might be long for monetary policy.

4 c ii) The potency of monetary policy refers to the extent to which its implementation
can achieve the desired. The recognition lag does not affect the potency of monetary
policy since it does not influence the monetary transmission mechanism. The monetary
transmission mechanism refers to all the channels and intermediary stages between the
change in the interest rate and the resulting change in the level of national income or
other macroeconomic variable. In terms of the administrative lag of monetary policy,
since this is small this it would not affect the potency of monetary policy. The impact lag
however can negatively affect the potency of monetary policy since it may take a
considerable length of time before the effects are felt onto the economy. This is
undesirable since by the time monetary policy has full effect the variable targeted by the
policy may have already been corrected by the nature working of the economy. This
means that the existence of this lag may cause monetary policy to cause additional
volatility in the economy.

4 d i) Fiscal policy is the management of the economy through the level of Government
expenditure and taxation. That is, the Government can use this demand management tool
to achieve its macroeconomic objectives by manipulating the fiscal budget. Fiscal policy
can be used in various ways to achieve different objectives.

4 d ii) Suppose the Government wants to spend an additional $20 billion on
infrastructural improvements but wants to raise the money by increasing taxes by the
same amount. In such a case the increase in Government expenditure of $20B is exactly
matched by an increase in autonomous taxation of $20B. In this case, national income
increases by the same magnitude as the increase in Government spending and taxation is
$20B. This is known as the balance budget multiplier which occurs whenever there are
equal increases in both autonomous Government spending and taxation. Conclusively
since the increase in Government expenditure of $20B couples with an increase in
taxation by this equivalent amount leads to an increase in national income by the same
magnitude i.e. $20B the balanced budget multiplier is therefore equal to 1.



4 d iii) Automatic stabilizers are mechanisms that automatically increase the injections
and decreases withdrawals from the government sector during recessions. In other words
an automatically stabilizer offsets the current economic climate without any active policy
decision by the government. Unemployment benefits which are grants given by the
government to the unemployed is an automatic stabilizer as it automatically increases
during a recession. In addition during a recession income tax revenue falls and this would
also abate the recession in the economy. If there is inflationary pressure in the economy
arising from excess aggregate demand, then unemployment would be low and the
government would automatically spend less on unemployment benefits. In addition,
income tax revenue would automatically rise. This decrease in government spending and
the increase in taxation would also have a dampening effect on inflation.

4 d iv) National debt and Debt Service Ratio

National Debt
The National Debt also known as the public sector debt is the accumulated debt built up
by the Government over a number of years that has not yet been repaid. It represents the
total amount owed by the Government to its citizens, which is domestic debt as well as
the amount owed to foreigners which is external debt.

Debt Service Ratio
Debt service refers to the amounts required to cover the payment of interest and principal
on debt for each year. The debt service ratio is the ratio of debt service (interest and
principal payments due) during a year, expressed as a percentage of exports (typically of
goods and services) for that year. It gives the proportion of export revenue used to cover
debt servicing requirements. The smaller this ratio the more manageable would be the
commitments on public debt. The debt service ratio can also be stated in terms of internal
and external debt. The internal debt service ratio is based on the debt service on domestic
debt as a ratio of export earnings. The external debt service ratio is based on the debt
service on foreign debt as a percentage of export earnings.

4 e) Methods of financing a budget deficit without increasing taxes
1. Printing Money - The Central Bank can print more money to finance to government
expenditure. This is seldom used because of the inflationary consequences.
2. Issuing Government Securities - The issue or sale of Government treasury securities
represent loans undertaken by the government. The individuals who buy the securities
effectively lend the government the amount that he or she pays for it. The buyer also
receives interest as specified in the security contract (certificate) and is repaid after a
specified period which is called the maturity. There are three different types as
determined by the maturity.
• Government Treasury bills which have short term maturities usually 3 month, 6
months or 1 year.
• Government Treasury notes which have medium term maturities of between 1 to
5 years.
• Government Treasury bonds which have long term maturities in excess of 5
years.



3. Borrowing from international lending institutions - The Government can also
borrow directly from institutions such as the World Bank and the International
Monetary Fund as well as from private international lending institutions.
4. The sale of public corporations – the government can also divest its interest in
publicly owned companies to private investors.

5 a Four advantage of Foreign Direct Investment
1. FDI generates capital to meet deficiencies in savings in developing countries
Foreign direct investments are a means of introducing new resources to developing
countries which typically lack savings for domestic capital formation. Deficiencies in
domestic savings in such countries are met without having to channel resources away
from other uses such as consumption. The economy therefore benefits from capital
formation which augments its productive capacity without any opportunity cost of
forgone consumption.
2. Generates employment
Foreign direct investments like any other type of investment in the local economy
generates multiplier effects to the overall economy as forward and backward linkages
between multinational and host economy firms are netted. In terms of the circular flow,
FDI increases the level of injections which results in an overall heightened level of
economic activity and hence the generation of increased employment opportunities. In
this respect, FDI inflows in times of economic recession can help to curb the decline in
economic activity and eliminate cyclical unemployment. In addition, foreign direct
investments may revitalize certain sectors of the economy which may have been on the
decline, thereby creating employment for the structurally unemployed.
3. Generates foreign exchange
Foreign direct investment is also beneficial, as it generates valuable foreign exchange for
its host economy. This could be quite advantageous, especially where other sources of
foreign exchange are limited and are therefore supplemented by foreign direct investment
flows. Foreign exchange is of vital importance in developmental programs which may
require the importation of foreign capital, technology or even raw materials. Foreign
direct investment therefore serves to bridge the gap between foreign exchange earnings
and foreign exchange requirements. It must also be pointed out that foreign direct
investments can also serve to continually generate foreign exchange apart from the initial
investment inflow in the case where the investment targets the export sector.
4. Generates government taxation revenue
Another beneficial aspect of foreign direct investments is its role in generating taxation
revenue for host Governments. The operations of multinational corporations generate
significant economic activity which increases the tax base for Government taxation
purposes. This increase in the tax base which otherwise would be unattainable provides
increased taxation revenue to LDC Government coffers. Such increased revenue may be
a valuable in financing developmental projects undertaken by Government policy
makers.

5 a Four disadvantage of Foreign Direct Investment



1. Repatriation of profits
The fact that foreign direct investments originate from non local investors implies that the
rate of return on such would accrue to their foreign proprietors. If such profits are
repatriated by the countries of origin, then there is a drain of valuable foreign exchange.
In the balance of payments, this would be seen as outflows in the current account section
in the form of outflows of profits, interest, dividends, royalties, management fees, and
other funds. In addition to the ramifications on foreign exchange and balance of
payments, repatriated earnings are also disadvantageous as they represent a leakage of
funds which could have been reinvested in the host economy.
2. Increased imports
In addition to the outflow of property income, foreign direct investments in a host
economy may have further adverse impact on the country’s balance of payments as a
result of a higher importation. This particularly occurs when the initial investment
involves significant importation of capital equipment from aboard or when the nature of
the business operation requires large amounts of imported raw materials and other
intermediate products in its production processes. Furthermore, there is also a tendency
on the part of multinational companies which operate in a developing country to procure
much of their raw materials from foreign affiliates as opposed to domestic producers in
the host economy. Such lack of linkages with the economies in which they operate tend
to inhibit the expansion of indigenous firms that might supply them with raw materials
and other intermediate products. All things considered, the end result is a huge import bill
which can be avoided by greater vertical integration on the part of transnational
corporations with the host economy. In some cases, due to the nature of the operations of
the transnational corporation, backward linkage with the rest of the economy may be
limited e.g. an alumina smelter located in T&T which converts bauxite into aluminium
ore would result in a rise in imports in that country as bauxite is not produced there and
has to be imported.
3. Economic concessions
Although it has been identified that encouragement of foreign direct investment generates
significant revenue for host Governments, it must be recognized that this may not always
because of economic concessions granted by host Governments. At times, due to their
economic size and might, multinational companies are able to negotiate significant
economic concessions as Governments in developing countries compete to attract foreign
investments to their economy. These economic concessions may include: tax
concessions, tax holidays and tax rebates.
4. Transfer Pricing
Transfer pricing practices of multinational firms. Multinational companies may be able to
reduce their tax disbursement to Government tax collectors by creative accounting
practices. This is particularly applicable where corporate tax rates differ from one country
to the next, a possibility which is highly likely given the different tax structures amongst
countries. The tax savings is achieved by shifting reported profits away from high tax
economies towards tax havens or countries with lower taxation structures where affiliated
corporations conduct operations. Specifically, the practice in high tax countries would be
to artificially increase the price paid for intermediate products purchased from an
affiliated company in a foreign low taxed country. In so doing, profits in the high tax
country would be artificially understated on account of the inflated cost of production



reflected in its accounts. Conversely, in the low tax country, reported profits would be
overstated as a result of the increased revenue recorded from the sale of overpriced output
to related companies in high tax countries. In this manner the overall eligibility to pay tax
is reduced for the multinational corporation as a whole and the high tax country suffers
from unduly low tax revenue.

5 bi) The balance of payments is a record of all transactions conducted between a country
and the rest of the world for a given time period, usually one year. Transactions which
result in monetary receipts or inflows into the country are entered as positive numbers
called credits, whilst payments or outflows from the country are entered as negative
numbers called debits. The balance of payments, in effect, indicates the difference
between the amount of money flowing into a country and that flowing out of the country.

5 b ii) The balance of payments is divided into two sections in order to distinguish
between two different categories of transactions. These sections are:
 Current Account – this records all items relating to imports and exports of goods and
services, net property income and current transfers between a country and the rest of
the world.
 Capital Account - this records all movement of capital from both private sources as
well as official government sources between a country and the rest of the world. The
private movement of capital could be in the form of direct investments, foreign
portfolio investments and hot money flows.

5 c) Causes of balance of payments crises
The current account deficit occurs when imports of goods and services, investment
income outflows and outward transfers exceed the exports of goods, services, investment
income inflows and inward transfers. Some of the causes of a current account deficit are:
 Low competitiveness. If a country’s manufacturing and service industries lack
competitiveness then exports would be curtailed. In addition, consumers would be
encouraged to purchase products from foreign more efficient producers. This would
lead to a high level of imports which combined with low exports would result in a
current account deficit. Domestic industries may lack competitiveness if needed
resources are simply unavailable. It may also arise if small scale production is
employed which prevents the attainment of economies of scale. Even if there is large
scale production, the employment of obsolete technology may also result in high
costs and hence low competitiveness. Finally high domestic inflation could also lead
to an erosion of domestic competitiveness.
 Rapid economic growth in income. As income increases, consumption rises and as
such the level of imports increase. If exports remain unchanged, then a rise in
income would result in a rise in imports and hence a deficit in the current account.

Solutions to the two causes of balance of payments crises
Export Subsidies. An export subsidy is a payment to a domestic producer who exports
a good abroad. This can also be used independently or in conjunction with other policies for
the purpose of eliminating a current account deficit. By subsidizing domestic exports,
producers are able to reduce production cost which improves the competitiveness of their



output in the international markets. This should therefore serve to boost export earnings and
thereby eliminate the current account deficit.
Expenditure Reducing Measures - deflationary or contractionary measures that
decrease national income. This is because imports are said to be induced i.e. rise as income
increases and likewise fall as income decreases. Exports on the other hand are said to be
autonomous to the level of national income. Hence, as income decreases, imports fall while
exports remain unchanged causing the deficit to be eliminated. This is shown by a
movement along the import schedule in figure 36-1 from point A to point B. As a result of
the decrease in the level of imports, the current account improves, possibly resulting in an
overall balance.

6 a i) The term "economic growth" refers to the increases in the level of national
income usually expressed in constant prices. Economic growth implies a rise in the
productive capacity of an economy, which results in an outward shift of the production
possibility frontier.

6 a ii) Factors Influencing Economic Growth
Economic growth implies a rise in the productive capacity of an economy, which results
in an outward shift of the production possibility frontier. Three factors which can lead to
an increase in the productive capacity of the economy are:
1. Increase in Labour Resources
Economic growth depends on the quality and size of the labour force. Increasing the
quality of the workforce through better education and training increases the value of
human capital and makes workers more productive. Also as the labour force becomes
larger, the productive deployment of the additional workers enables more output to be
produced.
2. Increase in Capital Resources
Increasing, the stock of physical capital such as new factories, machinery and equipment,
is critical in achieving economic growth as it enables a more efficient use of other factors
of production such as labour. Investments in human capital formation enable the quality
of labour to improve. This implies that labour productivity rises, enabling greater output
from labour resources.
3. Improvements in Technology
Technological advances enable the production of more output from a given amount of
resources. This means that scarce resources are more productively utilized which reduces
the real costs of supplying goods and services and this leads to an outward shift in a
country’s production possibility frontier. This means that technological progress
accelerates economic growth for any given rate of growth in the labour force and the
capital stock.

6 a iii) Benefits of Economic Growth
1. An Increase in Income – as economies grow the average level of income earned
by individuals would increase. This is beneficial as individuals are able to



consume a greater variety of goods and services which increases their standard of
living.
2. Increase employment – economic growth also enable an increase proportion of
the labour force to be employed which also assists in reducing poverty within the
society.

6 b) Indicators of Economic Development
1. Economic growth - One of the primary indicators of improvements in the
standard of living is an increase in the per capita income of every citizen. This is
because as income increases individuals are able to afford more goods and
services. This indeed occurs when there is economic growth.
2. Life Expectancy - This refers to the average life expectancy from birth in a
country. A number of factors would affect this such as the stability of food
supplies, the extent to which an area is hampered by war, and the incidence of
disease are all important. Economic development is achieved when life
expectancy is on the rise.
3. Literacy Rates - This refers to the percentage of those aged 15 and above who
are able to read and write a short, simple, statement on their everyday life. In
order for economic development to take place the literacy rate of a country needs
to be improved.
4. Poverty Rates - In chapter 16 the concepts of absolute and relative poverty were
outlined. Absolute poverty occurs when households are unable to afford basic
necessities such as food, clothing and shelter. Relative poverty means that the
level of income earned is less than the average level of all households. Economic
development requires that poverty rates be reduced. This means that absolute
poverty and relative poverty needs to be lowered. Of course in order to decrease
the rate relative poverty requires a more even distribution of income.

6 d) Difference between economic growth and development
Economic development is a sustainable increase in the standards of living of the people
of a country. Economic growth on the hand is only concerned with an increase in the
level of real national income. The two concepts are different because the achievement of
economic growth by itself does not necessarily imply that living standards are improved.
This is because in addition to economic growth, improvement in literacy rates, life
expectancy, and poverty rates are needed to achieve an increase in national welfare.
Economic growth is therefore just one aspect of economic development.


CAPE Economics, June 12th, Unit 2, Paper 2 suggested answer by Edward Bahaw

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CAPE Economics, June 12th, Unit 2, Paper 2 suggested answer by Edward Bahaw