NO.

104/2
SOUTH PACIFIC BOARD FOR
EDUCATIONAL ASSESSMENT

Marking
Schedule
2010

© South Pacific Board for Educational Assessment, 2010

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All rights reserved. No part of this publication may be reproduced by any means
without the prior permission of the South Pacific Board for Educational Assessment.
 2
SECTION A: SHORT-ANSWER QUESTIONS
(50 marks)

Answer ALL ten questions in this section.

Each question is worth 5 marks.
As a guide, spend no more than 90 minutes on this section.

QUESTION ONE: THE PRODUCTION POSSIBILITY CURVE (5 marks)

Graph 1: The Production Possibilities of Coral Island

X
Agricultural
Goods
Y Z

0
Manufactured Goods
1. On Graph 1, clearly mark the following points:
(a) a point where resources are under utilised (Label W)
(b) the point where all resources are used to produce agricultural goods (label X)
(c) a productively efficient point where both types of goods are produced (label Y)
(d) an unobtainable combination of the two types of goods (label Z).

[4 correct = 2 marks; 2 – 3 correct = 1 mark; 0 – 1 correct = 0 marks] (2 marks)

2. On Graph 1, illustrate the temporary effect of the destruction of a significant quantity of

both agricultural and manufacturing resources being destroyed by a tropical cyclone.
(1 mark)
Curve redrawn as above (moved in along both axes). Arrows optional

3. Explain why a production possibility curve is drawn with a rounded or concave shape
and state the implications of this on costs of production.

Concave because resources are not perfectly transferrable from one type of production to
another idea (1mark). Costs: diminishing returns and therefore increasing (marginal)
costs occur as increasing amounts of one product are produced / or there is an increasing
opportunity cost as more of a good is produced (1 mark). (2 marks)
 3.
QUESTION TWO: CONSUMER DEMAND (5 marks)

1. (a) State the only cause of a change in the quantity demanded for a consumer good.

A change in the price [of that good]. (1mark)

(b) For your answer to 1(a) to be the only cause of a movement along a demand curve,
what simplifying assumption do Economists make?

Ceteris paribus / all other factors of demand are held constant [idea] (1mark)

2. On Graph 2, illustrate and label the effect on quantity of a fall in the price of golf balls.

Graph 2: Demand Curve for Golf Balls

Price $

P1 Dotted lines essential

Labels OR arrow ok

P2
D

Q1 Q2 Quantity (1mark)

3. On Graph 3, illustrate and label the effect on quantity of a fall in the price of golf clubs.

Graph 3: Demand Curve for Golf Balls

Price $
D1 OR arrows to show
the shift in demand.
P1 Dotted lines needed
Labels or arrow ok.

D D1

Q1 Q2 Quantity (1mark)

4. Using appropriate economic terms, explain your answer to Question 3 above.

Golf clubs are a complementary good to golf balls, therefore if the price of golf clubs
falls, there will be an increase in demand for golf balls / demand curve for golf balls
shifts to right / more golf balls are demanded at each price [complementary + 1 other
idea]. (1mark
 4.

QUESTION THREE: REVENUE AND COSTS (5 marks)

1. Define marginal revenue. Marginal Revenue is the additional revenue earnt by a firm
by selling one more unit of output [idea].
(1mark)

2. Calculate and complete the missing values in Table 1. (2 marks)

Table 1: Revenue and Costs for a Firm

Units of Total Average Marginal Total Marginal and

Output Cost Cost Cost Revenue Average
Revenue
$ $ $ $ $

2 170 85 25 100 50

3 190 63.33 20 150 50

4 220 55 30 200 50

5 270 54 50 250 50

[5 - 6 correct = 2 marks; 3 – 4 correct = 1 mark; 0 - 2 correct = 0 mark]

3. Is the Firm in Table 1 a perfectly competitive firm or a monopoly? Justify your answer.

Perfectly Competitive Monopoly (circle your choice) [no mark]

Justification: MR and AR are the same ($50) / AR curve is linear or flat, signifying a
horizontal demand curve for a perfectly competitive firm / TR is a constant slope –
again representative of the perfectly competitive firm. [Any one of these ideas to score
1 mark]. [Must get both parts correct to score 1 mark]
(1mark)

4. At what level of output in Table 1 is the firm maximising profit? Justify your answer.

Level of Output: 5 ; [no mark] Justification: At output level 5, MC ($50) = MR ($50)

which is the profit maximising level of output.
[Must get both parts correct to score 1 mark] (1 mark)
 5.

QUESTION FOUR: MARKETS AND ALLOCATIVE EFFICIENCY (5 marks)

1. Define allocative efficiency: All resources are allocated to their most efficient use /
All markets are in equilibrium (and the economy is operating on its PPF) / It is not
possible to make someone better off without making someone else worse off . [1 idea]
(1mark)

Graph 4: The Market for Bread

m
Price S

a
b c
k j
d e f

g h
D1
i D

Quantity

2. Using the letters from Graph 4, identify:

(a) the area of consumer surplus at price b abc

(b) the area of producer surplus at price b b c h i [both to score 1 mark] (1mark)

3. Referring to Graph 4, use economic terms to describe each of the following

(a) Area c f h at price g: Area of Deadweight Loss / Loss of Allocative Efficiency

(b) Area a f i at price d: Allocative Efficiency / CS and PS maximised

[(a) and (b) both required to score 1 mark] (1mark)

4. Referring to Graph 4, if market forces shift the Demand Curve from D to D1, and
market equilibrium from point f to point j, explain clearly what will happen to
consumer and producer surpluses and allocative efficiency.

Consumer and producer surpluses will both increase ( or CS to mjk and PS to kji) and
continue to be maximised / there will be no deadweight loss / because there has been no
intervention in the market. Allocative efficiency is therefore retained at the new market
equilibrium (point j on Graph 4). [idea]
[correct comment (or letters) re CS and PS and AE = 1 mk; correct explanation = 1mk]
(2marks)
 6

QUESTION FIVE: SALES TAXES AND THEIR IMPACT (5 marks)

Graph 5: Imposition of a Sales Tax on a commodity

Price $
Supply + Tax
100 Supply

80

60
Demand
40

20

100 200 300 400 500 600 700 Quantity

1. With reference to Graph 5, state the:

(a) equilibrium price after the tax has been imposed: $ 80

(b) per unit value of the tax at the equilibrium quantity of 300 units: $ 30

(c) proportion (incidence) of the per unit tax paid by the consumer: 33.3 %

(d) proportion (incidence) of the per unit tax paid by the supplier: 66.7 %
[ 0-1 correct = 0 mk; 2-3 correct = 1 mk; 4 correct = 2 mks] (2marks)

2. (a) Using data from Graph 5, calculate the total tax revenue: $9000

(b) On Graph 5, clearly shade the area that shows the total tax revenue. (1mark)
[both 2a and 2b correct to score 1 mark]

3. (a) The product illustrated above has relatively elastic demand. If the demand for the
product had been relatively inelastic, how would the sales tax incidence be different?

There will be a greater burden on the consumer/ or less on producer [idea] (1mark)

(b) Explain why a product with inelastic demand may have this different tax incidence.

Inelastic demand suggests the good is a necessity, consumers only reduce purchases
by a small % when the tax is imposed, hence they pay the greater share of the tax.
[idea] (1mark)
 7

QUESTION SIX: EXTERNALITIES (5 marks)

1. State TWO characteristics of mixed goods:

(i) Consumption or Production Externalities exist / price signals are distorted

(ii) Mixture of private and public characteristics / not produced or consumed in

socially desirable quantities [any 2 of above] (1mark)

2. Match an appropriate example of an externality from List 1 with the type of externality
in List 2. Write each appropriate letter from List 1 in the relevant box beside List 2.

List 1 List 2 (Types of Externalities)

A. A bee keeper is located close to (i) Negative Externality H

an orchard of Production

B. Eating a sandwich
A
C. Drinking a bottle of soft drink (ii) Positive Externality
Of Production
D. Employing an extra worker

E. Fewer cars on the road because (iii) Negative Externality F

more people are using buses of Consumption

F. Smoking in public places

E
G. The production of T – shirts (iv) Positive Externality
Of Consumption
H. Air pollution from a factory (2 marks)
[ 0-1 correct = 0 mk; 2-3 correct = 1 mk; 4 correct = 2 mks]

3. What does it mean to internalise an externality? Whoever generates the externality,

pays, or is rewarded for it [idea] / bringing together the (marginal ) social and private
costs (or benefits) / or appropriate example of internalisation e.g govt. regulations to
ensure a factory cleans its polluted air / water. [any 1 idea] (1mark)

4. How would establishing appropriate property rights help to control over-fishing in

Pacific Island waters?
Allocation of quota to establish property rights will limit catches
Or : non quota holders excluded / poachers prosecuted, therefore catch is limited
Or: PR’s give an incentive to conserve stocks for future profit / employment
Or: PR’s held reduce wastage of the resource by reducing/ controlling the catch
[any ONE clear idea that links property rights to conserving fish stocks] (1mark)
 8

QUESTION SEVEN: NATURAL MONOPOLIES (5 marks)

1. With the use of an example, describe what is meant by a natural monopoly.

A firm that can supply an entire market at a lower price / due to economies of scale,
than if there were two or more firms in the market [idea] ;often to be found in
infrastructure or networks such as telecommunications, electricity distribution, etc.
[description AND example required].
(1 mark)

Graph 6: A Natural Monopoly

Pm

AC
MC

Qm AR
MR Output

2. Draw and label on Graph 6:

(a) a relevant Average Cost (AC) curve and Marginal Cost (MC) curve and
[AC must fall at least to where MR = 0; MC below AC, only to cross AC at Min AC]
[Both correct = 1 mark]

(b) the profit maximising output (Qm) and the associated price (Pm).
[Qm at output where MC =MR; Pm then horizontal off AR (D) curve]
[both correct = 1 mark] (2 marks)

3. Explain how economies of scale can lead to natural monopolies.

High fixed costs (sunk costs) are required to established the network but once set up the
marginal costs of adding new consumers is low, hence AC curve falls and economies of
scale are achieved (in long run). Or duplication (2 or more firms) more costly [idea]
(1 mark)

4. Explain why a natural monopoly may be socially desirable.

Society benefits by allowing the natural monopolist to increase output, provided the
benefits of economies of scale are passed on to the consumer via lower prices.
OR, in this case, competition (duplication of networks) would be wasteful [idea].
(1 marks)
 9

QUESTION EIGHT: THE MONEY SUPPLY (5 marks)

1. Describe what is meant by the narrow money supply or M1.

This consists of notes and coins held by the public, plus transaction account (cheque)
balances held at registered banks and non-bank financial institutions. [idea] (1 mark)

2. Explain why company shares are classified as illiquid income earning assets or wealth.

Because it takes time and effort to convert such an asset into cash or liquid form [idea].
(1 mark)

Graph 7: A Money Market

Interest Rate S of money

Or Price of Money

D for money

Quantity of Money

3. Accurately label the two axes on Graph 7. [Both required to score 1 mark] (1 mark)
[ NOT price and quantity on own]

4. Explain how a single cash deposit of $1000 into a bank may cause the money supply to
increase over time to $5000.

The new cash deposit represents a primary expansion of the money supply and will
result in the banks holding more reserves as a percentage of total deposits (their reserve
ratio) than prudence requires. This extra money can lead to a secondary expansion of the
money supply when it is lent out to new customers as loans – a process known as credit
creation. The eventual increase in the money supply will be a multiple of the original
cash deposit. In the example above the $1000 deposit creates $4000 of additional
credit (a credit multiplier of 4), resulting in a total money supply increase to $5000.

[Reference to the primary/secondary expansion or reserve ratio/credit creation process

= 1mark]
[Reference to the credit multiplier idea and/or the numerical example given = 1 mark]

(2 marks)
 10

QUESTION NINE: NATIONAL INCOME (5 marks)

Circular Flow Diagram (Figures in $ millions)

Financial
Sector

S I=$60 (includes change in stocks)

Household C=$150 Producer M=$35 Overseas

Sector Sector X =$30 Sector

IT= $25
G = $40

Tr =$25 Government T
Sector

1. Use the diagram above to calculate GDP using the Expenditure Approach.
Show your workings below, using the appropriate symbols and formula.

Formula: Y (AD) = C (150) + I (60) + G (40) + (X-M) (-5) GDP = $245 million.
[Correct Formula = 1 mark; Correct figures and/or total = 1 mark (2 marks)

2. (a) Calculate (to 1 decimal place) and complete the following table.

Year Nominal GDP CPI Real GDP ($m) Growth Rate %

($m)
2008 250 1000 250 __
2009 255 1026 248.5 -0.6
2010 265 1035 256 3
[ 3 or 4 calculations correct = 1 mark; 1 -2 = 0] ( 1 mark)

(b) Referring to the table above, explain why real GDP is a better measure of economic
growth than nominal GDP

Real GDP is measured using constant prices, therefore any change in GDP
represents economic growth, positive or negative (as shown in column 5) – an
actual increase in goods and services produced; whereas nominal GDP uses current
prices / exaggerated by inflation (column 2 shows positive ‘growth’ in both 2009 and
2010 compared with positive real growth in 2010 only) - therefore Real GDP is a
better measure.
[clear explanation = 1 mark; any relevant reference to figures in the table = 1 mark]
(2 marks)
 11

QUESTION TEN: THE BALANCE OF PAYMENTS (5 marks)

1. (a) With the use of some specific examples, distinguish between the Balance of
Payments on Current Account and Balance of Payments on Financial Account
(previously known as the Capital Account).

A clear distinction [1 mark] with use of some examples [1 mark] required.

The Current A/c records a country’s short term transactions (< 1 yr) with the rest of
the world e.g. export receipts; whereas the Financial A/c records long term flows
(> 1 yr) between that country and the rest of the world e.g. foreign investments [idea].
(2 mark)
Table 2: Selected International Transactions

Transaction $ millions
A Machinery imports 1000
B Foreign aid given to cyclone ravaged Pacific neighbour 10
C Dividends received from investments in foreign country 100
D Exports of copra and sugar 800
E Interest paid to foreign banks for development loans 350
F Premiums paid to insurance companies in other countries 60
G Immigrants deposit their savings in domestic banks 40
H Receipts from foreigners enjoying local tourist resorts 200

(b) Using the capital letters in the left-hand column in Table 2, identify:

(i) a Goods (visibles) $ receipt Letter: D

(ii) an Investment Income $ payment Letter: E (1 mark)

(c) Using the figures in Table 2, calculate the Current Account Balance. Show all
workings. (Suggestion: use the letters in Column 1 to help you).

Bal. Goods. + Bal. Services. + Bal. Investment Income. + Bal. Transfers = C/A Bal

D-A + H–F + C–E + G–B

- 200 + 140 + -250 + 30

= $ -280 million

[some appropriate workings = 1 mark; correct answer = 1 mark ( note the deficit)]

( 2 marks)
 12

SECTION B: ECONOMIC ANALYSIS

(50 marks)

Answer BOTH questions in this section. Each question is worth 25 marks.

Be brief and to the point in your answers.
As a guide, spend no more than 90 minutes on this section.

QUESTION ELEVEN: MICROECONOMIC ANALYSIS (25 marks)

Part A: Internationally Traded Commodities and Perfect Competition

For a number of reasons, e.g. falling world prices, severe crop damage from numerous
tropical cyclones, many island nations have reduced their reliance on copra as an export
commodity and diversified into other products. Despite this trend, copra has remained a
significant export crop in several countries, with producers supported by subsidies.
Adapted from: httpwww.adb.orgDocumentsbookstuvalu_2002_Economic_PSR chap6.

Graph 8: The Market for Copra* in Tuvalu (hypothetical figures)

Price
($/tonne) S
1100
S + Subsidy
1000

800

600
D
400

200

100 200 300 400 500 600 700 800

Quantity (tonnes)

* Copra is a commodity produced from coconuts

 13

1. With reference to Graph 8, assume that the initial world price was $800, but then it
falls to $500 per tonne:

(a) What is the producer subsidy required per unit, to maintain a price of $800 per
tonne for copra producers?
$ 300 (1 mark)

(b) If 300 tonnes are produced, calculate the total cost to the Tuvalu government
of the subsidy payment. Show your workings.

$300 per unit subsidy x 300 q

$ 90000 (1 mark)

(c) Frequent cyclones damage the copra crop, reducing the contribution to world
supply from the South Pacific region. Suggest a reason why the world price
continues to FALL?

Increasing supply from other countries, OR falling world demand (1mark)

2. Assume that individual copra producer’s businesses are perfectly competitive.

(a) List TWO characteristics of perfect competition that could apply to a copra firm.

Price takers / no one firm can influence price / horizontal D curve /

PED of firm = perfectly elastic / homogeneous product / many firms in the industry /
no or weak barriers to entry/exit of industry / excellent knowledge of market
resources mobile [any TWO to score 1 mark]
(1mark)
(b) Perfect competition is a model. Why are models useful in economics?

Real world is complex – models are simplifications of reality that enable economists
help explain or understand economic relationships / problems / predict change or
effects of change [any ONE idea]
(1 mark)

(c) Describe the difference between a copra firm and the copra industry.

A copra firm is an individual producer of copra, whereas the copra industry

comprises the total output of all the individual copra firms in the market [idea]
(1mark)
 14

Graph 9: An Individual Copra Firm Graph 10: The Market for Copra

Price $ MC AC $ S
MC1 AC1

P1 MR/AR

D
D1

Q1 Q2 Q Q

(d)On Graph 10, show and label a decrease in the market demand for copra. D1(1 mark)

(e) On Graph 9, using the new equilibrium price from Graph 10, accurately draw and
label appropriate revenue (AR/MR) and cost (MC and AC) curves to show: [1 mk]
[MCs to bisect minimum ACs. Allow ‘slip of pen’]

(i) an individual copra firm making a sub-normal profit at the new market price.
Shade the area [rectangle] of sub-normal profit. [1 mk] (2 marks)

(ii) the profit maximising (or loss minimising) price (P1) and output (Q1). [both]
(1 mark)
[Quantity lines must bisect MC=MR]

(iii) the effect of a per unit subsidy that allows the firm to break even (label the new
output Q2). [plus MC1 and AC1 or indication of subsidy] (1 mark)
[AC1 minimum must just touch AR at Q2]

(f) If producers did not receive a subsidy, explain the market forces that will, in the
long-run, result in copra firms making normal profits.

Copra firms making sub-normal profit will leave the industry, [1 mk] resulting in a
decrease in market supply and increase in price (and a possible fall in the cost curves
optional), [1 mk] which will, in the long run reach equilibrium where remaining firms
make normal profit.[a discussion of super-normal outcomes not necessary] (2 marks)

3. (a) If copra production were a monopoly industry, how would your answer to question
2(f) above be different?

As there is only one firm in a monopoly industry, if the firm is making subnormal
profits, in the long run it must correct this problem or shut down, leaving no industry.
[OR some equivalent statement that indicates that there is no competition in a
monopolistic industry to force market price to change in order to eliminate the losses
or reach a normal profit outcome – idea]
(1 mark)
 15

Graph 11: A Perfectly competitive Copra Firm Graph 12: A Monopolistic Firm

$ $

Q Q

(b) Describe and explain the price elasticity of demand of the Demand Curve in:

(i) Graph 11: Perfectly elastic [1 mk] because the individual firm is a price taker in
a perfectly competitive industry, where a firm altering output creates zero
responsiveness to the price – idea. [1 mk]
[can score for explanation even if description incorrect – and vice versa]

(ii) Graph 12: Price elasticity of demand changes all the way along the curve (from
infinity at the top to zero at the bottom – optional) [1mk] because the
monopolistic firm’s demand curve is equal to the market demand curve
(or is negatively sloped) and therefore a change in output will create some
reponsiveness with price (to varying degrees – optional). [1 mk]
[can score for explanation even if description incorrect – and vice versa]
(4 marks)

Part B: Market Failure

In many countries today, producer subsidies such as those used in the copra industry,
are not favoured by governments unless it can be demonstrated that there has been
some form of market failure that justifies the government intervention.

1. (a) If the private copra market worked perfectly, explain why economists would
consider a subsidy to be undesirable.

The subsidy would result in a loss of allocative efficiency or dead weight loss.
OR: government spending on the subsidy tends to be greater than the gain in
consumer or producer surpluses and is effectively a loss of ‘welfare’ to the
economic system [idea].
(1mark)
 16

(b) Using the concepts of private and social preferences, explain a possible market
failure in the copra market that could justify a government introducing a producer
subsidy.
The private market is under producing and over pricing copra compared to the
social preference if it were discovered that EITHER: there were positive
externalities resulting from copra production; OR copra was considered a merit
good (e.g. positive health benefits); OR if there were situations where the copra
market leads to inequitable or unfair outcomes (maybe regarding employment).
Given such situations, a subsidy would increase output at lower prices – the social
preference.
[One possible market failure = 1 mark; correct link to private and social
preference = 1 mark] (2 marks)
Graph 13: Positive Externalities of Production

Costs / Benefits ($) MC

MSC

PME

PSE

MB = MSB

QME QSE Output

2. On Graph 13:
(a) Label:
(i) The private market equilibrium price and output PME and QME respectively;
(ii) The social equilibrium price and output PSE and QSE respectively. (1 mark)

(b) (i) Clearly indicate the spill-over benefit at the market equilibrium with an arrow.
(ii) Shade the area of deadweight loss at the private market equilibrium. (1 mark)
[compensation: any 2 or 3 correct from (a) and (b) combined – score 1 mk]

3. (a) What does it mean to internalise a positive externality of production?

This involves the producer being compensated for the savings in costs that other
producers (third parties) have received / allowing output to increase and price to
fall to the social equilibrium where MSC = MSB [1 idea] (1 mark)

(b) Describe ONE way of achieving the social preference in Graph 13 other than
through the use of a subsidy.
Regulations to increase output (or decrease price) / rewards such as tax write-offs
[1 idea] (1 mark)
 17

QUESTION TWELVE: MACROECONOMIC ANALYSIS (25 marks)

Part A: Fiscal Policy

1. What is fiscal policy?

A government’s decisions about its revenue and expenditure (that can influence the
level of economic activity). [idea] (1 mark)

2. What does a government being required to be fiscally responsible mean?

Government’s should aim to run their fiscal policy in a prudent manner / keep debt
levels ‘under control’ (to say less than 20% GDP) - unless there are exceptional
circumstances / aim to run a balanced budget over the business cycle.
[any one idea] (1 mark)

3. What is a budget surplus?

Where planned government spending is less than planned government revenue

for the next financial year (T < G) (1 mark)

The Impact of the Global Economic Crisis on Pacific Island Economies

[With some exceptions] fiscal sectors have been particularly hard hit, especially in
countries with underlying structural problems. Declines in imports and consumption have
reduced tax bases and growth [significantly] below budget assumptions. This has resulted in
cash shortages, expenditure cutbacks and significant increases in [budget] deficits in a number
of countries (Solomon Islands, Fiji, Samoa, Tonga). These problems have been particularly
severe in countries that were already grappling with structural issues before the onset of the
global recession.

Source: September 2009. IMF Country Report No. 09/292, page 5

4. With reference to the article above, name two specific taxes that are likely to have
collected less revenue as a result of “declines in imports and consumption”.

(i) Tariffs [on imports] (ii) Indirect taxes on consumption e.g. sales; GST; excise.
[both tariffs - and one consumption tax required to score]
(1 mark)

5. As a direct result of the global financial crisis, what type of budget did many South
Pacific governments’ tend to implement in 2009?

Budget for a deficit (T < G) / run expansionary budgets or fiscal policy

(1 mark)
 18

Graph 14: A South Pacific Economy in 2009

Price Level
AS

PL2
PL1
AD1

AD

Y1 Yf Real GDP (Y)

Y2
6. On Graph 14, illustrate appropriately:
(a) (i) the national income equilibrium price level (PL1) and output level (Y1)
(ii) the extent of the recessionary gap. Or YI - Yf (1 mark)
[both (i) and (ii) required to score 1 mark]

(b) the effect of an increase in government deficit spending sufficient to eliminate

unemployment. Label any curve shifts and changes made to PL or Y.
Must increase in AD to AD1 (may increase AS as well) and label. [Y2 optional]
[New equilibrium may go beyond full employment] (1 mark)

7. Suggest why inflationary pressures are not of particular concern in the short term as a
consequence to the changes you made in question 6(b).

Economy still on relatively flat section of AS curve / lot of excess capacity has been
present / PL has not increased much (relative to increase in AD) [any 1 idea]
(1 mark)
8. Suggest TWO categories of increased expenditure governments’ felt might bring
about the expansionary fiscal results desired in question 6(b).

(1) New public infrastructure eg. roads and (2) producer subsidies etc.
[any 2 categories likely to result in increased employment of resources] (1 mark)

As a consequence of the expansionary policies of 2009, many governments in 2010

are having to tighten their budgets to meet their fiscal responsibilities.

9. What TWO major options do governments have to achieve greater fiscal balance if
their budgets are in deficit?
Increase taxes / revenues and /or decrease expenditure. [both to score 1mk] (1 mark)
 19

Graph 15: A South Pacific Economy in 2010

Price Level
AS

PL

PL1
AD
AD1

Y1 Y Yf Real GDP (Y)

10. (a) Make necessary changes to Graph 15 to allow you to (b) analyse the effects of
contractionary fiscal policy on the price level, output and employment.

Correct changes to the Graph – as indicated above (arrows optional) = 1 mark

Effects: as a consequence of the fall in government expenditure (or increased
tax receipts), AD decreases, output, employment and price level ALL fall = 1 mark
(2 marks)

11. Describe what the negatively sloped Aggregate Demand curve shows.

The AD curve shows the real output/GDP purchased at each price level.
Or: It is made up of points representing equilibrium real income (Y), output,
or the level of employment, at each price level. (1 mark)

12. Define Aggregate Supply (AS).

Aggregate Supply is the total output of a country resulting from producers’

production decisions at each price level. [Idea] (1 mark)

13. State TWO reasons for an increase in Aggregate Supply (a shift to the right)

An increase in AS result from exogenous changes: such as a reduction in nominal

labour cost / a fall in imported material costs / improvements in productivity /
improvements in technology [any TWO reasons to score 1 mark]
(1 mark)
 20

Part B: Monetary Policy and The Balance of Payments

1. What type of monetary policy tended to be used to complement the fiscal stimulus
packages announced in many 2009 South Pacific government budgets?

Expansionary (or loose) monetary policy (1 mark)

2. Currently, most official interest rates are relatively low. Explain how low interest
rates will help stimulate real growth in an economy.
Low interest rates:
Will encourage borrowing for new investment spending (I) which will have and
expansionary (positive multiplier effect) on real economic activity;
Will encourage borrowing for additional consumption (C) spending which will have
an expansionary on real economic activity or output;
May lead to a depreciation of a floating exchange rate which in turn will encourage
exports (and discourage imports) / increase (X-M) or net exports – leading to growth.
[any 2 ideas explained or elaboration of 1 idea for 2 marks) (2 marks)

Graph 16: The ‘Pasifika Island’ Economy in 2010-11

Price Level
AS

PL1

PL
AD1

AD

Y Y1 Real GDP

3. (a) Show the effects of the lower interest rates on Graph 16.
(b) Analyse the graph and explain why Pasifika’s Reserve Bank may need to tighten
its monetary policy to increase retail interest rates in the near future.

Lower interest rates increase C + I and therefore AD. (May briefly go beyond full
employment). Because close to full employment the increase in AD won’t increase real
output much, instead the PL will rise / maybe an inflationary gap will appear / OR on
steep part of AS curve - near full capacity, so an increase in AD tends to be inflationary.
[1 mark for correctly illustrating and labelling the graph ; 1 mark for explaining the
inflationary problems as a need to tighten monetary policy] (2 marks)
 21

4. (a) Identify and explain the impact of an increase in domestic interest rates on
Pasifika’s floating (or flexible) exchange rate.

Increasing domestic interest rates will tend to appreciate the exchange rate because
foreign investors increase demand for the currency to earn greater returns from the
higher interest rates. ( If decrease in Supply of FE included as well, accept). [Idea]
(1 mark)

Graph 17: Pasifika Island’s Foreign Exchange Market

Price of
Pasifika $ S of FE

D FE1

D for FE
Quantity of Pasifika $

(b) On Graph 17:

(i) Accurately label the two curves. [S of Pasifika $/ $ / FE]
[D for Pasifika $ / $ / FE] NOT: S and D on own [1 mark]

(ii) Illustrate and label the change to the exchange rate, based on your answer to
Question 4(a).
[D – D1 (and decrease in S acceptable) and arrow or labels on y axis]
[1mark]
(2 marks)

5. With reference to the trade (goods) balance in the Current Account of the Balance of
Payments, explain why a government might prefer a depreciating exchange rate in
2010.

A depreciating exchange rate makes a country’s exports less expensive for foreigners
(increasing sales) and imports more expensive (reducing purchases), helping to
reduce a deficit (or increase a surplus) in the Trade Balance of the BoP [idea].
[1 mark commenting on the export side; 1 mark referring to the import side]
(2 marks)