JC Econs Essay Domestic & External Factors and Macroeconomic Aims Answers
Governments around the world aim to achieve low unemployment and inflation, along with a high and sustained growth. To do so, one needs to know the main factors or sources of all 3 macro economic goals.
Governments have aims in relation to unemployment and inflation.
(a) Explain why these sims are significant to the government of a country.
(b) Discuss how for the failure to achieve these aims is caused by external factors.
Macroeconomic Aims & Consequences
Explain the government’s aims in relation to unemployment and inflation – low unemployment (attain full employment) & low inflation (price stability) Reasons why these aims are significant to the government arises from the economic & social benefits enjoyed by the country through the attainment of these macroeconomic goals
While answer is mainly generic to countries, specific advantages arising from these goals can be expounded on when candidates apply to some country examples, eg Singapore
Low unemployment rate (attaining full employment or FE)
Unemployment Rate % of unemployed workers in the labour force
The unemployed are people of legal working age who are actively looking but unable to find work. The actual unemployment rate could be due to cyclical unemployment caused by insufficient demand for goods and services (low AD); structural unemployment caused by skills mismatch between the labour force and the job vacancies in the economy, and frictional unemployment due to imperfect info regarding job vacancies A low unemployment rate occurs when cyclical unemployment is zero and the economy is producing at its potential output, Yf, (full employment level of output). Hence the goal of FE means to keep cyclical unemployment level at zero, and minimize structural & frictional unemployment as the latter two are unavoidable types of unemployment due to the workings of the economy.
Low unemployment or full-employment is significant to an economy as it is desirable that the economy is producing the maximum output possible with the utilisation of all its available resources, ensuring that there is no wastage of scarce resources eg labour resource, thereby maximizing the country’s material standard of living since more goods and services are produced for consumption purposes. With higher consumption levels, this has the effect of raising AD and hence raising real NY through the multiplier effect hence helping the country attain actual growth.
With low unemployment levels, there will be less burden on the government’s budget since there will be less unemployed people who require welfare benefits unemployment benefits. At the same time, the government also gets to receive higher tax revenues eg from income taxation, since more people are employed and have to pay income taxes This is significant to an economy since less strain on the government’s budget will free up resources to finance more government spending on areas such as education/healthcare/infrastructural development, which can lead to increases in AD and AS, hence achieving actual and potential growth for the country. Such spending can also improve the resident’s quality of life (non-material SOL) Low unemployment also benefits an economy by indirectly resulting in less social costs eg crime and suicides and hysteresis (loss of skills) due to long periods of unemployment, which may dampen a country’s economic growth. With lowered unemployment level, less social problems persist in the economy, hence resulting in an improvement in non-material SOL.
Apart from achieving full employment, a country also strives to lower its natural rate of unemployment so as to increase its potential output through an increase in productive labour supply, which can result in an increase in AS over time. With an increase in the ability to produce goods/services, SOL will rise over time.
Low and stable inflation rate
Inflation rate annual % change in the GPL, measured by the CPI or GDP deflator. Low inflation occurs when the economy experiences low demand-pull (inflation that arises due to excessive increases in AD when the economy is operating close to Yf) and / or cost push inflation (inflation that results from increases in COP). Low inflation is significant to an economy as it promotes efficiency and certainty. Price signals transmit revenue/cost information accurately and resources are efficiently allocated by the price mechanism, thereby helping the economy attain allocative efficiency. Price stability in the economy also encourages households to consume goods and services, thereby raising C, which raises AD.
Low inflation (price stability) ensures that rates of return on potential investment projects can be accurately estimated, thereby reducing uncertainty, raising business confidence and hence encourages investments (FDI & local investments), which can result in increases in I, hence AD. Low inflation and the consequent relatively lower COP than its trading partners, enhances a country’s export competitiveness, boosting export revenue (assuming PEDx > 1), at the same time, M expenditure falls if households reduce demand for M due to relatively cheaper domestic substitute goods/services. This increase in net export revenue improves the country’s BOT and hence current account balance. Together with the encouragement of FDI that improves the capital and financial account, the country’s BOP tends to strengthen.
As previously mentioned, with low inflation, the increased C, I/FDI & X will stimulate AD, resulting in more than proportionate increase in real NY (assuming economy operates below Yf) via the multiplier effect, helping the economy to attain higher employment levels and actual economic growth as well as rising SOL. The increase in I (which is a result of higher investor confidence, as well as lowered interest rates due to the expansion in the supply of loanable funds caused by the encouragement of savings in a low inflation environment) leads to an increase in more spending on K goods and R&D. Such K accumulation raises the country’s productive capacity and increases the maximum potential output. This leads to an increase in AS over time, helping the economy attain potential growth.
Hence low inflation helps a country to achieve its other macro goals of sustained economic growth, low unemployment and strong BOP and is therefore very significant to an economy.
(Sketch suitable diagram(s) on your own, as an exercise.)
Low inflation and low unemployment are desired by an economy due to benefits an economy can enjoy with the attainment of these goals. Between the two, which is more significant depends on the economic conditions a country faces.
JC Econs Tutor’s Remarks:
While this is a straightforward question, many candidates were unable to score well in this question as a result of the adoption of an indirect approach to answer the question, ie. Candidates wrote at length about the costs associated with high unemployment levels as well as high inflation rates for a country, then used these disadvantages as justification for the need to keep inflation and unemployment low in countries. Candidates are reminded to read and understand the requirements of the question before attempting to answer it. The reason behind why low inflation and low unemployment are significant macroeconomic goals for a government must be a result of the advantages/benefits they bring to the country, rather than the disadvantages / costs they bring about.
Teething problems among answers include the failure to establish clear linkages between low inflation and low unemployment to the attainment of other macroeconomic goals of sustained economic growth and healthy BOP position with the use of clearly established economic framework such as AD/AS analysis. Many candidates did not score well in terms of analysis due to their blind pursuit of quantity rather than quality of arguments. Many candidates penalised themselves by producing answers that contained a mere listing of relevant points but under developed in terms of economic analysis.
Common errors include the erroneous application of the Marshall-Lerner Condition in the analysis of the positive effects of low inflation on a country’s BOP. An example of this analysis would be: “Low inflation/price stability helps to lower a country’s COP, resulting in relatively cheaper exports compared to its trading partners, assuming that the latter suffer from relatively higher inflation rates. Since its exports are now more price competitive, quantity demanded of its exports will rise. At the same time, its households will demand for fewer imports as they switch to consuming relatively cheaper domestically produced substitutes. Assuming that the Marshall-Lerner condition holds, ie PEDx + PEDm > 1, the country’s BOT will improve, resulting in an improvement in its current account and hence BOP” Candidates need to understand that the MLC is only used under the circumstances that relative exchange rates change, that will in turn alter both the prices of X and M of countries. In the event of a change in relative inflation rates, only the price of X from the country is altered since its COP is altered, leaving the price of its imports unchanged! Hence, the MLC cannot be used under such circumstances.
A-level Economics Essay Marking Scheme:
L1: An answer that contains mere listing of points, without use of economic framework eg. AD/AS analysis etc, OR Answer is mostly irrelevant with smattering of few valid points that lack economic analysis. Glaring conceptual errors present in the answer.
L2: An answer that makes use of relevant economic theory- ADIAS framework &/OR BOP framework, OR Some elaboration of how the attainment of the aims of low unemployment and price stability is beneficial to a country in terms of the ability to achieve other macro aims of the economy.
Depth lacking in some areas of analysis and some conceptual errors present in answer, OR For an answer that only touches on significance of the attainment of low unemployment OR low inflation/price stability; For an answer that addresses the question indirectly ie. explains the costs of high unemployment and high inflation
L3: For an answer that demonstrates excellent use of economic theory, with clear linkages of points to economic frameworks of analysis such as AD/AS framework. BOP etc, OR Sufficient depth of analysis with regards to how the attainment of the aims of low unemployment and low inflation/price stability is beneficial to a country in terms of the ability to attain other macro aims of the economy, without conceptual errors.
– Realistic examples are used and diagrams are well-drawn and well-explained to enhance economic analysis.
Domestic & External Factors of Macroeconomic Goals
Failing to attain the aims of low unemployment and low inflation/price stability would mean that the country experiences macroeconomic problems of high unemployment and high inflation. As previously ascertained, an economy can suffer from high unemployment that arises from different causes such as cyclical, structural and frictional mainly. Also, high inflation can be demand-pull or cost-push in nature.
While external factors such as global economic downturns & free trade as well as exchange rate changes of our trading partners can result in high unemployment and high inflation, these are certainly not the only factors that can result in such impact. Other domestic/internal factors can also be responsible for the failure to attain the macroeconomic goals of low inflation and low unemployment.
Thesis – Agree that the failure to attain the aims of low unemployment and low inflation/price stability is caused by external factors
In the case of high unemployment, a global economic downturn that reduces national incomes and hence purchasing power in trading partner countries, will lead to a fall in consumption of goods and services, including imported goods from other countries. This creates a significant fall in X for countries that are highly export-oriented eg. Singapore, hence a large fall in its AD. Global recessions also bring about uncertainty in projection of future profits from investments and reduce investor confidence, resulting in a possible outflow of FDI for many countries. The fall in X and FDI will lead to a fall in AD for trade-dependent and FDI dependent countries like Singapore, leading to a more than proportionate fall in NY via the multiplier effect ie. adverse effect on actual growth. The fall in AD also leads to firms cutting back on production and hence reducing their derived demand for labour, causing a rise in cyclical unemployment for such countries.
Cyclical unemployment can also result from a fall in AD caused by a fall in demand for an economy’s X due to the weakening of exchange rates of its trading partners, ceteris paribus. A weakened currency from its trading partner will result in a loss of export competitiveness for the exporting country, since its X are now relatively more pricey in terms of the foreign currency. This reduces the quantity demanded for its X. At the same time, its relatively stronger currency causes imports from its trading partner country to be relatively cheaper, when valued in its own currency. This raises quantity demanded of imports. Assuming that the MLC holds, PEDX + PEDm > 1, its balance of trade will deteriorate, adding to a fall in net X, ceteris paribus. This has the effect of reducing its AD, hence raising cyclical unemployment, as previously explained.
Free trade encourages specialisation & production based on the theory of Comparative Advantage, after which countries engage in trade & exchange for goods/services that they do not produce (due to their comparative disadvantage), hence benefitting from trade. However, the freedom of trade also results in countries losing comparative advantage in production of goods/services due to the emergence of other low-cost countries and this loss of X competitiveness will lead to a cut back in the production in such sunset industries, thereby creating structural unemployment as the retrenched labour do not possess relevant skills (skills mismatch) for them to be re-employed into other jobs created in sunrise sectors.
In the case of high inflation, excessive increases in X from an economy and increases in FDI into an economy during a global economic boom that leads to increases in national incomes as well as a rise in consumer and investor confidence levels, can result in excessive increases in AD, which in turns leads to demand-pull inflation if the domestic economy operates close to or at Yf. This happens due to the scarcity of resources as the economy approaches Yf, causing firms to compete for scarce resources and bid up factor prices, which in turn results in them passing on the higher costs to consumers as higher prices of final goods demand-pull inflation.
In the same way, free trade that helps to expand a country’s X markets can also result in excessive increases in X, while the removal/reduction in capital restrictions can result in excessive inflows of FDI. The increases in X and FDI result in increases in AD and hence demand-pull inflation, as previously mentioned. The strengthening of the exchange rates of a country’s trading partner can also result in excessive increases in its X since its X would become relatively cheaper in terms of the trading partner’s currency. At the same time, imports into the country also become relatively more expensive in terms of its own domestic currency, leading to a fall in quantity demanded of M. Assuming that the MLC holds, PEDx + PEDm > 1, the country will experience an improvement in its BOT, hence a rise in net X and AD, leading to demand-pull inflation, if the economy operates at near Yf.
(Sketch suitable diagram(s) on your own, as an exercise.)
External factors such as inflation in its trading partner countries can also lead to a rise in inflationary pressures in the importing country since it runs a greater risk of suffering from import-price push inflation (cost-push inflation). This happens especially for resource-barren countries like Singapore, which has a very high import-reliance. In the above circumstances, a rise in Pm raw materials will raise the COP for domestic producers, ceteris paribus leading to a fall in profits, causing producers to cut production at every price level, ie AS falls and GPL increases since import-price push inflation has occurred.
(Sketch suitable diagram(s) on your own, as an exercise.)
Anti-thesis – Disagree that the failure to attain the aims of low unemployment and low inflation/price stability is caused by external factors ie. external factors are NOT the only factors leading to high unemployment and high inflation
While external factors mentioned can result in high unemployment and high inflation, there are other factors that can also create the same effects on an economy. Domestic factors can include either increases/decreases in components of AD (ie. C, I, G) due to domestic boom/recessions that either raise/reduce national incomes and confidence levels domestically, hence leading to high inflation (dd-pull) /high unemployment (cyclical unemployment) respectively. This happens because AD falls as a result of fall in C and I resulting in firms cutting back on production and hiring less FOP including labour → cyclical unemployment occurs and economy moves away from Yf. With lower employment levels, factor incomes fall and results in fall in induced C, which generates more rounds of fall in incomes and spending until eventually real NY falls more than proportionately via the multiplier effect → adverse effect on actual growth.
Domestic factors such as increases in factor prices such as wages/prices of raw materials can also result in increases in domestic COP and hence cause firms to cut AS high inflation (wage-push/cost-push) and rise in unemployment. Domestic factors such as restructuring efforts by the government of an economy can also result in increases in structural unemployment as retrenched labour from sunset industries do not possess relevant skills to be re-employed in sunrise industries. Also, information imperfection can also result in rise in frictional unemployment since the time taken for the job search process is lengthened due to imperfect flow of information between the job seekers and where the job vacancies are.
Lastly, domestic factors such as government policies can result in high inflation and high unemployment. Eg. Expansionary DD management policies undertaken by governments in order to achieve growth and expand employment levels can result in high inflation (dd-pull) especially when the economy is operating close to Yf. For example, an expansionary fiscal policy that is meant to facilitate growth will involve the government raising government expenditure, G &/or lowering income/corporate taxes. This has the effect of raising disposable incomes hence raising C or raising post-tax profits that raise I, hence raising AD in the economy. This rise in AD can lead to demand-pull inflation if there are bottlenecks in production, causing firms to compete for scarce resources and bidding up factor prices that eventually translate into higher GPL→ demand-pull inflation. In contrast, contractionary demand management policies undertaken to reduce inflationary pressures in an economy can compromise the macroeconomic goal of low unemployment, since AD would have fallen ⇒ rise in cyclical unemployment as previously explained.
. The extent to which external factors can cause a failure to attain the macroeconomic aims of low inflation and low unemployment depends largely on the nature of the economy in question as well as the state of the economy. The significance of external vs domestic factors causing high unemployment and high inflation varies for different economies, with external factors being more important than internal ones for small, open economies like Singapore since they tend to be very externally-oriented. By contrast, internal factors carry more significance for larger, less open economies such as the USA, since they tend to possess larger domestic bases. And depending on the root causes of the unemployment and inflation problem, the government can formulate more appropriate policies to resolve such problems.
L1: An answer that lacks use of economic framework of AD/AS in analysis. Answer is mostly irrelevant with smattering of few valid points, OR One-sided answer if answer focus only on how external factors lead to problems of high unemployment and high inflation. Glaring conceptual errors.
L2: A balanced answer (that considers both external factors and other factors eg. Internal/Domestic tors causing high unemployment and high inflation) with appropriate use of AD/AS framework, OR Answer may be limited in scope and depth of analysis
• Did not consider various types of unemployment and inflation problems; Some conceptual errors present, OR For an answer that is balanced but incomplete, ie. Explained both external and internal factors causing either high unemployment OR high inflation.
L3: A well-balanced answer with good use of relevant economic framework – AD/AS analysis; There is good scope and depth of analysis, OR Answer that considers how both external and domestic factors can lead to various types of unemployment (at least 2) as well as both types of inflation problems
Good use of examples and well-explained diagrams that enhance overall analysis.
E1: Mainly unexplained judgement /comment
E2: Evaluative assessment supported by economic analysis Eg. Evaluating the relative significance of external factors in causing problems of high unemployment and high inflation in an economy, with reference to the characteristics of the economy, eg. For Small open economies, external factors may be more significant than large economies with large domestic bases, where internal factors may be more significant than external.
Econs Tuition teacher’s Remarks:
1. Most students should expect at least 20 out of 25m for this simple essay question. More on this in our Econs revision lessons.)
2. Part (b) appears to be relatively well-attempted compared to the previous part as majority of the candidates appear to have a better understanding of the requirements of the question. Most candidates were able to distinguish between external and internal factors causing high unemployment and high inflation.
A common mistake as mentioned in the previous part, is the erroneous use of the Marshall Lerner condition. Candidates had used the MLC in their analysis of the effect of global recessions on a country’s BOT and ceteris paribus net X and in turn AD. And, as previously explained, the MLC was again used in the analysis of the effect of relative inflation rates between countries. Other common mistakes include the erroneous use of elasticity concepts. eg, using PEDx to analyse the effect of recessions on the extent of fall in demand for a country’s X, instead of using YEDX.
3. Many JC Economics pupils also penalized themselves by analysing indirect factors that result in high unemployment and inflation. An example would be, writing at length about how the failure to attain the goal of low inflation was a result of government failure in implementing supply side policies to expand the productive capacity of the country, leading to bottlenecks in production and hence demand-pull inflation. Another example is the occurrence of high structural unemployment being a result of the failure of governments to employ supply side manpower policies to put in place retraining and education policies to ensure that the labour force possesses relevant skills to be employed in sunrise industries. Candidates need to know that direct causal factors (both internal and external, as given in the suggested answer) are more relevant in answering this question.
4. Some candidates have also gone on to misinterpret the question as one that required them to expound on various macroeconomic policies to counter the effects of high inflation and high unemployment!