Macroeconomic policy
55 marks: 12 multiple choice questions, a data response and an essay. Answers are at the end.
WJEC / Eduqas: Question 14 would be a 20-mark question on your papers.
Multiple choice online
The test
1Expansionary fiscal policy involves:
- A cutting interest rates to encourage borrowing by households and firms
- B increasing the money supply through quantitative easing
- C reducing the budget deficit
- D raising government spending or cutting taxes
2Which one of the following is an automatic stabiliser?
- A unemployment benefit payments rising in a recession
- B a cut in the rate of VAT announced in the Budget
- C a rise in Bank Rate
- D a decision to build a new high-speed railway to raise demand in a downturn
3A government's spending is £1,200bn and its tax revenue £1,100bn in a year when GDP is £2,500bn. The budget deficit as a percentage of GDP is:
- A 9.1%
- B 4.0%
- C 8.3%
- D 44%
4The national debt as a percentage of GDP will fall if:
- A the government runs a budget deficit larger than GDP growth
- B interest rates on government bonds rise
- C nominal GDP grows faster than the debt
- D the government borrows to fund investment
5A rise in Bank Rate is most likely to reduce inflation because it:
- A increases the money supply, which raises the price level in the long run
- B raises firms' costs of production
- C increases government spending
- D raises borrowing costs, cutting consumption and investment
6The nominal interest rate on a savings account is 4% and inflation is 6%. The real interest rate is approximately:
- A −2%
- B +10%
- C −6%
- D +2%
7Quantitative easing was intended to stimulate aggregate demand mainly by:
- A printing money to pay for government spending directly
- B buying government bonds to lower long-term interest rates
- C increasing the reserve requirements of commercial banks
- D raising Bank Rate to attract foreign capital into the UK banking system
8One limitation of cutting interest rates to boost aggregate demand is that:
- A lower rates always raise the exchange rate, which makes exports less competitive in world markets
- B it has no effect on asset prices
- C when confidence is low, households and firms may not borrow however cheap credit is
- D it increases the budget deficit directly
9Which one of the following is a market-based supply-side policy?
- A building a new motorway
- B cutting the top rate of income tax to sharpen incentives
- C subsidising research and development
- D government spending on apprenticeships and further education colleges
10A successful supply-side policy, with aggregate demand unchanged, is most likely to:
- A leave real output unchanged
- B increase real output and raise the price level
- C reduce real output and the price level
- D increase real output and reduce the price level
11The short-run Phillips curve suggests that:
- A inflation and unemployment always rise together
- B there is no relationship at all between inflation and unemployment in the short run
- C lower unemployment comes only at the cost of higher inflation
- D a rise in interest rates reduces unemployment
12Rapid economic growth driven by consumer borrowing is most likely to conflict with the objectives of:
- A low inflation and a sustainable current account
- B low unemployment and economic growth
- C a balanced budget and low unemployment
- D low inflation and low unemployment
13Between December 2021 and August 2023 the Bank of England raised Bank Rate fourteen times, from 0.1% to 5.25%, to bring inflation back to the 2% target, and from August 2024 cut it in steps to 3.75% as inflation fell. Over the same period the government's spending on energy support and debt interest kept borrowing high, and public sector debt approached 100% of GDP. The Chancellor's fiscal rules require debt to be falling as a share of GDP within five years, which has limited the room for tax cuts or spending rises. Table 1 shows UK figures at the end of each financial year (March).
| March 2022 | March 2023 | March 2024 | March 2025 | March 2026 | |
|---|---|---|---|---|---|
| Bank Rate (%) | 0.75 | 4.25 | 5.25 | 4.50 | 3.75 |
| CPI inflation (%, 12 months to March) | 7.0 | 10.1 | 3.2 | 2.6 | 3.0 |
| Public sector borrowing in the year (% of GDP) | 5.1 | 5.1 | 4.4 | 5.3 | 4.5 |
| Debt interest in the year (£bn) | 70 | 111 | 103 | 105 | 110 |
(a)Using Table 1, calculate the real interest rate (Bank Rate less inflation) in March 2023 and in March 2025. [2]
(b)Explain how the rise in Bank Rate affected the government's fiscal position. [4]
(c)With the aid of a diagram, explain how raising Bank Rate was expected to reduce inflation, and why the effect took time. [6]
(d)Explain two supply-side policies that could raise the UK's growth rate without adding to inflation, and one drawback of each. [6]
14Evaluate the view that monetary policy is more effective than fiscal policy in managing the UK economy. [25]
Answers
Show the answers
AO1 knowledge, AO2 application, AO3 analysis, AO4 evaluation.
| Answer | Why | |
|---|---|---|
| 1 | D | Fiscal policy works through the government's own spending and taxation; interest rates and the money supply are monetary policy. |
| 2 | A | Automatic stabilisers change with the cycle under existing rules; discretionary policy needs a decision. |
| 3 | B | Deficit = £100bn; 100 ÷ 2,500 = 4.0%. |
| 4 | C | The ratio depends on both parts: a debt that grows more slowly than the economy shrinks as a share of GDP even if it rises in cash terms. |
| 5 | D | Each channel lowers aggregate demand, and a stronger pound cuts import prices directly. |
| 6 | A | Real rate ≈ nominal rate − inflation = 4 − 6 = −2%: the purchasing power of the savings is falling. |
| 7 | B | Central-bank purchases push bond prices up and yields down, lowering borrowing costs and encouraging lending and spending. |
| 8 | C | The transmission mechanism depends on willingness to borrow and lend; after 2008 rates near zero had a weak effect. |
| 9 | B | Market-based policies free up markets and incentives; the other three are interventionist, using government spending. |
| 10 | D | LRAS shifts right along a given AD curve: more output can be sold only at a lower price level. |
| 11 | C | The original curve showed an inverse relationship; the long-run curve is vertical at the natural rate, so the trade-off is temporary. |
| 12 | A | Demand-led growth pulls up prices and sucks in imports; it helps employment rather than conflicting with it. |
13 (a) Using Table 1, calculate the real interest rate (Bank Rate less inflation) in March 2023 and in March 2025. [2: AO2 2]
- AO2 (1) March 2023: 4.25 − 10.1 = −5.85%, negative
- AO2 (1) March 2025: 4.50 − 2.6 = +1.9%, positive: policy had become restrictive in real terms
13 (b) Explain how the rise in Bank Rate affected the government's fiscal position. [4: AO1 1, AO2 1, AO3 2]
- AO3 (1) Higher interest rates raise the cost of servicing the national debt as maturing bonds are refinanced at higher yields and index-linked debt rises with inflation: debt interest rose from £70bn to over £100bn a year
- AO3 (1) Higher debt interest is spending the government cannot avoid, so borrowing stays high or other spending must be cut or taxes raised to meet the fiscal rules; it crowds out spending on services
- AO1 (1) Higher rates also slow growth, which cuts tax revenue and raises benefit spending through the automatic stabilisers, widening the deficit
- AO2 (1) Application: borrowing stayed around 5% of GDP despite the end of energy support, debt interest alone exceeded £100bn a year, and the Chancellor had little room for tax cuts; monetary tightening made fiscal policy tighter too
13 (c) With the aid of a diagram, explain how raising Bank Rate was expected to reduce inflation, and why the effect took time. [6: AO1 2, AO2 1, AO3 3]
- AO1 (2) Diagram: AD shifts left from AD1 to AD2 along SRAS; the price level falls from PL1 to PL2 (or rises more slowly) and real output falls from Y1 to Y2, opening a negative output gap
- AO3 (1) Transmission: higher Bank Rate raises mortgage, loan and saving rates, so households cut consumption and firms postpone investment; it also raises the exchange rate, cutting export demand and import prices
- AO3 (1) Lower aggregate demand reduces firms' pricing power and slows wage growth, so inflation falls; expectations of lower inflation reinforce this
- AO3 (1) Lags: most mortgages are on fixed rates for two to five years, so higher rates reach borrowers gradually; firms' investment plans take time to change; the Bank estimates the full effect takes 18 months to two years, so rates had to rise before inflation peaked
- AO2 (1) Application: inflation peaked at 11.1% in October 2022, only months into the tightening, and did not reach 2% until mid-2024; part of the fall was lower energy prices (SRAS shifting back) rather than policy
Levels: 1 to 2 for a description with a partly correct diagram; 3 to 4 for a correct diagram and the transmission mechanism; 5 to 6 for lags explained and applied to the period.
13 (d) Explain two supply-side policies that could raise the UK's growth rate without adding to inflation, and one drawback of each. [6: AO1 2, AO2 2, AO3 2]
- AO1+AO2+AO3 (3) Planning reform to speed up house building and infrastructure: raises the capital stock and labour mobility, shifting LRAS right; drawback: takes years to show results, faces local opposition, and construction capacity is itself a constraint
- AO1+AO2+AO3 (3) Investment in skills and training (apprenticeships, further education) or in health to cut long-term sickness: raises labour productivity and participation; drawback: costs money up front when the fiscal rules are tight, and the returns are uncertain and slow
- AO1+AO2+AO3 (3) Or: tax incentives for business investment (full expensing), which raise the capital stock but cost revenue and may reward investment that would have happened anyway; deregulation or trade deals, which raise competition but may lower standards
Maximum 6: two policies, each linked to LRAS and with a drawback.
14 Evaluate the view that monetary policy is more effective than fiscal policy in managing the UK economy. [25: AO1, AO2 and AO3 16, AO4 9]
Knowledge and analysis (AO1 to AO3)
- Define monetary policy (Bank Rate, quantitative easing, forward guidance, set by the independent Monetary Policy Committee to hit the 2% inflation target) and fiscal policy (government spending, taxation and borrowing, set by the Chancellor); managing the economy means hitting the objectives of stable inflation, growth, employment and sound public finances.
- Strengths of monetary policy: quick decisions free of electoral pressure; independence gives credibility that anchors expectations, which is why inflation fell from 11% to 2% without mass unemployment; reversible and finely adjustable. Weaknesses: lags of up to two years; blunt, hitting mortgage holders and investment hardest; weak at the zero lower bound (2009 to 2021); it cannot offset a supply shock without lowering output.
- Strengths of fiscal policy: it can be targeted at groups, regions or sectors (furlough, the energy price guarantee), works directly on demand with a multiplier, and is the only tool that raises long-run capacity through investment in infrastructure, skills and research; automatic stabilisers act without any decision.
- Weaknesses of fiscal policy: political and implementation lags; a bias towards deficits; crowding out when financed by borrowing at high interest rates; the fiscal rules and debt near 100% of GDP limit room for manoeuvre; the September 2022 mini-budget showed how markets punish unfunded expansion.
- Diagram: AD shifting on a Keynesian AS curve shows that either policy raises output with spare capacity and prices without it. In 2022 to 2023 fiscal energy support and monetary tightening pulled in opposite directions; in 2020 they worked together.
Evaluation (AO4)
- It depends on the objective: for controlling inflation monetary policy is clearly the better tool, as the independent target framework shows; for long-run growth, distribution and public services only fiscal policy can act.
- It depends on the state of the economy: at the zero lower bound and in a deep recession fiscal policy is more powerful; with inflation above target and full employment monetary policy dominates.
- It depends on the type of shock: a demand shock suits monetary policy; a supply shock such as 2022 leaves monetary policy choosing between inflation and output, while targeted fiscal support can cushion the losers.
- Monetary policy's advantage is institutional (independence), which stronger fiscal rules could partly match; fiscal space, not fiscal theory, was the binding limit after 2022.
- The two are not substitutes but complements: the best outcomes (2020) came when they worked together, and the worst (autumn 2022) when they conflicted, so 'more effective' misstates the choice.
Judgement
A supported judgement might conclude that monetary policy is the more effective tool for day-to-day demand management and inflation control, because it is fast, credible and independent, but that fiscal policy is more effective in deep recessions, at the zero lower bound and for anything on the supply side; managing the UK economy well requires both, with the balance shifting according to the objective and the state of the economy.
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.