Flipped Economics

How the economy works

Name

Answer all questions. For questions 1 to 12, circle one letter.

Which one of the following is an injection into the circular flow of income?

A household saving

B income tax payments

C spending by foreign tourists in the UK

D spending by UK households on imported cars

In an economy, injections total £420bn and withdrawals total £450bn. Other things being equal, national income will:

A rise, because injections are positive

B stay the same, because the economy is in equilibrium

C rise, because withdrawals exceed injections

D fall, because withdrawals exceed injections

Aggregate demand is made up of:

A consumption, investment, government spending and exports, with imports added

B consumption, investment, government spending and net exports

C consumption, saving, taxation and imports

D wages, profit, rent and interest

Other things being equal, which one of the following would shift the aggregate demand curve to the right?

A a fall in interest rates

B a rise in the exchange rate that makes exports dearer

C a rise in income tax that reduces households' disposable income

D a fall in the price level

The aggregate demand curve slopes downwards because a lower price level:

A reduces the real value of wages

B raises the real value of money, lowers interest rates and helps exports

C means firms are willing to supply more output at every level of demand

D causes the government to cut taxes

In an economy the marginal propensity to save is 0.1, the marginal rate of tax is 0.2 and the marginal propensity to import is 0.1. The value of the multiplier is:

A 4	B 1.25
C 5	D 2.5

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The government raises its spending by £10bn and the multiplier is 1.5. Assuming no other changes, the final increase in national income is:

A £15bn	B £25bn
C £6.7bn	D £10bn

The multiplier will be larger when:

A the economy is at full employment

B the marginal propensity to import is high because consumers prefer foreign brands

C households spend more of any extra income on domestic goods

D the marginal rate of tax is high

Which one of the following would be most likely to shift the short-run aggregate supply curve to the left?

A an increase in the size of the labour force

B a rise in the world price of oil and gas

C a rise in labour productivity

D a cut in corporation tax

Which one of the following would be most likely to shift the long-run aggregate supply curve to the right?

A investment in new technology that raises productivity

B a cut in interest rates

C an increase in government spending on pensions

D a rise in consumer confidence

On a Keynesian aggregate supply curve, an increase in aggregate demand when the economy has a large negative output gap will most likely cause:

A a fall in real output

B a large rise in the price level and no change in real output

C a rise in unemployment

D a large rise in real output and little change in the price level

An economy's actual output is £2,100bn and its potential output is £2,200bn. The output gap as a percentage of potential output is:

A +4.8%	B +4.5%
C −4.5%	D −4.8%

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In 2022 wholesale gas prices in Europe rose to many times their pre-pandemic level after Russia cut supplies, and UK consumer price inflation reached 11.1% in October 2022, its highest for forty years. The government capped household energy bills, at a cost of tens of billions of pounds, and the Bank of England raised Bank Rate from 0.1% at the end of 2021 to 5.25% by August 2023. Real GDP barely grew in 2023. Table 1 shows illustrative figures for the UK economy.

Table 1: Illustrative UK figures (£bn, 2019 prices)
	2021	2022	2023
Consumption	1,350	1,400	1,395
Investment	390	410	405
Government spending	510	500	505
Exports	650	700	690
Imports	700	760	740

(a)

Using Table 1, calculate aggregate demand in 2022 and the percentage change in aggregate demand between 2022 and 2023.

[2]

(b)

The energy price cap added about £40bn to government spending. Explain, using the multiplier, why the final effect on national income might have been larger than £40bn, and one reason why it might have been smaller than the simple multiplier suggests.

[4]

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(c)

With the aid of an AD/AS diagram, explain how the rise in energy prices affected the UK's price level and real output in 2022 and 2023.

[6]

(d)

Explain two ways in which the rise in Bank Rate from 0.1% to 5.25% would be expected to reduce aggregate demand.

[6]

Evaluate the view that an increase in government spending will always lead to a rise in real national income.

[25]

Answer on lined paper.

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Answers

AO1 knowledge, AO2 application, AO3 analysis, AO4 evaluation.

	Answer	Why
1	C	Tourists' spending is an export of services; saving, taxes and imports are the three withdrawals.
2	D	When more leaks out of the flow than is injected, spending and therefore output and income contract until the two are equal.
3	B	AD = C + I + G + (X − M); imports must be subtracted because they are spending on foreign output.
4	A	Lower interest rates raise C and I; a change in the price level moves the economy along the AD curve rather than shifting it.
5	B	The wealth, interest-rate and international trade effects all raise the quantity of real output demanded when the price level falls.
6	D	Multiplier = 1 ÷ marginal propensity to withdraw = 1 ÷ (0.1 + 0.2 + 0.1) = 1 ÷ 0.4 = 2.5.
7	A	Change in national income = multiplier × initial injection = 1.5 × £10bn = £15bn.
8	C	Fewer withdrawals at each round of spending mean more of the injection is passed on; at full employment extra demand raises prices rather than real income.
9	B	Higher input costs raise firms' costs at every level of output, so less is supplied at each price level.
10	A	LRAS depends on the quantity and quality of factors of production; the other three affect aggregate demand.
11	D	With spare capacity firms can expand output without bidding up wages and prices; the AS curve is almost horizontal.
12	C	(2,100 − 2,200) ÷ 2,200 = −0.045: a negative output gap of 4.5%, spare capacity.

13 (a) Using Table 1, calculate aggregate demand in 2022 and the percentage change in aggregate demand between 2022 and 2023. [2: AO2 2]

AO2 (1) 2022: 1,400 + 410 + 500 + (700 − 760) = £2,250bn
AO2 (1) 2023: 1,395 + 405 + 505 + (690 − 740) = £2,255bn; change = 5 ÷ 2,250 = +0.2%

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13 (b) The energy price cap added about £40bn to government spending. Explain, using the multiplier, why the final effect on national income might have been larger than £40bn, and one reason why it might have been smaller than the simple multiplier suggests. [4: AO1 1, AO2 1, AO3 2]

AO1 (1) The multiplier: an injection raises incomes, part of which is spent, raising other incomes, and so on; the final rise in national income is the injection × 1 ÷ (marginal propensity to withdraw)
AO3 (1) Households whose bills were capped had more income left to spend on other goods, so shops, restaurants and their suppliers saw higher demand and incomes in further rounds
AO3 (1) Smaller than the simple multiplier because much of the saved money went on imports or into saving by worried households, because taxes take a share of each round, and because the Bank of England raised interest rates at the same time, offsetting the stimulus
AO2 (1) Application: with a marginal propensity to withdraw of, say, 0.6 the multiplier is only 1.67, so £40bn would raise income by about £67bn at most; the near-zero growth in 2023 suggests the net effect was modest

13 (c) With the aid of an AD/AS diagram, explain how the rise in energy prices affected the UK's price level and real output in 2022 and 2023. [6: AO1 2, AO2 1, AO3 3]

AO1 (2) Diagram: AD and SRAS with the price level and real output on the axes; SRAS shifts left from SRAS1 to SRAS2; the price level rises from PL1 to PL2 and real output falls from Y1 to Y2; LRAS may be shown to indicate a negative output gap opening
AO3 (1) Energy is an input for almost every firm, so higher gas and electricity prices raised costs of production at every level of output: a leftward shift of SRAS, cost-push inflation
AO3 (1) At the old price level firms are no longer willing to supply as much, so prices rise and output falls: stagflation, with inflation at 11.1% while real GDP stagnated
AO3 (1) Second-round effects: higher prices cut real incomes and consumption, shifting AD left as well, which lowers output further but limits the rise in the price level; higher interest rates reinforced this
AO2 (1) Application: the energy price cap limited the SRAS shift for households but at a fiscal cost; as gas prices fell back in 2023 and 2024 SRAS shifted right again and inflation fell towards the 2% target

Levels: 1 to 2 for a description with a partly correct diagram; 3 to 4 for a correct diagram with the SRAS shift and its effects explained; 5 to 6 for second-round effects and application to the UK figures.

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13 (d) Explain two ways in which the rise in Bank Rate from 0.1% to 5.25% would be expected to reduce aggregate demand. [6: AO1 2, AO2 2, AO3 2]

AO1+AO2+AO3 (3) Consumption: higher mortgage and loan rates raise repayments for borrowers (about 1.5 million fixed-rate mortgages were re-priced each year), leaving less disposable income, and higher returns on saving raise the reward for not spending, so C falls; house prices soften, reducing the wealth effect
AO1+AO2+AO3 (3) Investment: a higher cost of borrowing means fewer projects have an expected return above the interest rate, so firms postpone investment; higher rates also attracted capital inflows that raised the pound, making exports dearer and imports cheaper, lowering net exports
AO1+AO2+AO3 (3) Or: expectations, as higher rates signal that the Bank will bring inflation down, moderating wage demands and spending; the transmission takes 18 months to two years, which is why growth stalled in 2023

Maximum 6: two channels, each explained as a chain from Bank Rate to a component of AD and applied to the period.

14 Evaluate the view that an increase in government spending will always lead to a rise in real national income. [25: AO1, AO2 and AO3 16, AO4 9]

Knowledge and analysis (AO1 to AO3)

Government spending is a component of aggregate demand and an injection into the circular flow; a rise shifts AD right and, through the multiplier, raises national income by more than the initial spending (define the multiplier and the marginal propensity to withdraw).
Diagram: a Keynesian AS curve with AD shifting right; on the flat section (large negative output gap) real output rises with little change in the price level; near full capacity the same shift raises the price level and real output barely moves. In 2009 and 2020 fiscal expansion raised real output; in 2022, with unemployment under 4%, extra spending added more to inflation.
Crowding out: spending financed by borrowing can raise interest rates and reduce private investment and consumption; spending financed by taxation cuts private spending directly, so the net rise in AD is smaller (the balanced-budget multiplier is still positive).
The type of spending matters: capital spending on infrastructure, education and research shifts LRAS as well as AD; transfer payments affect only demand, and spending with a high import content leaks abroad.
Monetary policy response: an inflation-targeting central bank may raise interest rates to offset the stimulus, as in 2022 and 2023, so the net effect on real income may be close to zero.
Confidence: large deficits can raise bond yields and borrowing costs across the economy (the September 2022 mini-budget); well-targeted spending in a recession can instead restore confidence and crowd in private spending.

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Evaluation (AO4)

It depends on the output gap: the view is close to true when there is spare capacity and false near full employment, when the rise is in nominal rather than real income.
It depends on how it is financed and what the central bank does: borrowing with accommodating monetary policy gives the largest effect; tax-financed spending or an offsetting rate rise gives little.
It depends on the time horizon: in the short run demand effects dominate; in the long run only spending that raises productive capacity raises real income permanently, and debt interest may require higher taxes later.
It depends on the size of the multiplier: in an open economy with high taxes and imports (the UK's multiplier is usually estimated below 1.5) the boost is modest, and 'always' overstates even the favourable case.
Measurement: real national income can rise while living standards do not, if the spending is on things people do not value; and the rise may be temporary if it is not followed by private demand.

Judgement

A supported judgement might conclude that an increase in government spending usually raises real national income in the short run when there is spare capacity and monetary policy does not offset it, but not always: near full employment, with crowding out, or when financed in ways that cut private spending, the gain is small or shows up as inflation, so the effect depends on the state of the economy and the type of spending rather than on the spending itself.

Marking

Levels, out of 25 (Edexcel splits them as knowledge, application and analysis 16, evaluation 9; AQA marks the whole answer against one set of levels). Top level (21 to 25): a range of points developed in full chains of reasoning, supported by accurate diagrams and real examples, with evaluation that weighs the arguments against each other and reaches a judgement that depends on stated conditions. Middle level (11 to 20): some developed chains, a relevant diagram, evaluation present but one-sided or asserted. Bottom level (1 to 10): points listed or described, little use of theory or examples, judgement missing or unsupported. WJEC: a 20-mark question with AO1 6, AO3 6 and AO4 8.

Exam boards

WJEC / Eduqas: Question 14 would be a 20-mark question on your papers.