Test with marking scheem

Basic economic problem, Resource Allocating, PPC, Money, citrusperibus, Assignment 1 As1. The diagram shows an economys production possibility curve.

Why does the curve slope downwards?

A Agriculture and industry are subject to decreasing returns to scale.

B Agriculture and industry are subject to increasing returns to scale.

C Resources are shared equally between industrial and agricultural production.

D Total resources available to the economy are limited.

2. The diagram shows a countrys production possibility curve.

What could allow the economy to move from M to N?

A an increase in consumer spending

B an increase in demand for exports

C an increase in government spending on pensions

D an increase in investment3. Given a rate of interest of 10% per year, what is the opportunity cost to an individual of saving an additional $100 in year 1?

A an increase in consumption of $110 in year 2

B an increase in consumption of $10 in year 2

C consumption of $100 in year 1

D consumption of $110 in year 14. . In the diagram LM is the production possibility curve of a country that has a comparative

advantage in the production of good Y.

What might enable the country to consume the quantities of X and Y indicated by point R?

A increased specialisation in the production of good X

B international trade

C a reduction in unemployment

D increased specialisation in the production of good Y5.

6. A student decides to stay in her room to do some work rather than going to the cinema.

What is the opportunity cost of her decision?

A the enjoyment she would have derived from a visit to the cinema

B the improvement in the mark she obtains for her assignment

C the cost of the extra electricity she uses

D the money she would have spent in the cinema

7. The diagram shows a production possibility curve LM.What might cause the curve to shift to NP?

A technological progress B unemployment of resources

C the depletion of natural resources

D a reallocation of resources

8. The diagram shows shifts in an economys production possibility curve.

Which change could have come about as a result of an improvement in technology?

A S to Y B T to S C W to T D W to Y 9 What is the most abundant form of money (measured by value) in a developed economy?

A bank deposits

B cash

C cheques

D credit cards10. The diagram shows a production possibility curve for an economy which produces only two goods, X and Y. The economy produces 400 of good Y and produces on its production possibility curve. Which quantity of good X is given up?

A 600

B 800

C 1200 D 1600

11. The diagram shows two production possibility curves (EF and GH), before and after technological

progress has taken place.

After technological progress has taken place, what is the opportunity cost in capital goods of producing OX consumer goods?

A MH

B OH

C OM

D YF12. The diagram illustrates the production possibility curves for an economy in Year 1 (X1, Y1) and

Year 2 (X2, Y2)

What can be deduced from the diagram?

A The cost of production was lower in Year 2 than in Year 1.

B The full employment level of output was lower in Year 2 than in Year 1.

C The opportunity cost was lower in Year 2 than in Year 1.

D Unemployment rose between Year 1 and Year 2.1d, 2d, 3c, 4c, 5d, 6a, 7c, 8a, 9a, 10b, 11a, Basic economic problem, Resource Allocating, Money, citrusperibus, Assignment 2 As

1 The steel required for the construction of a new car-assembly plant in a fully employed economy

is obtained by increasing the output of the domestic steel industry. What is the opportunity cost of producing the steel?

A the alternative benefits forgone by diverting additional resources to steel manufacture

B the alternative benefits forgone by increasing the capacity of the car industry

C the alternative benefits that would have been obtained by putting the steel to other uses

D zero, since there is no reduction in the steel supplied to other steel users

2 What would prevent a firm gaining the maximum benefit from the division of labour?

A a high interest rate

B a small market

C high production costs

D low productivity3 What is meant by the ceteris paribus assumption?

A an assumption that is not supported by the facts B an assumption that consumers act rationally

C an assumption that two factors are in equilibrium D an assumption that other factors are held constant

4 What is the outcome for consumers and workers as a result of increased division of labour?

5. What is the opportunity cost to a fully employed economy of increasing capital investment?

A a fall in consumption

B a fall in income

C a rise in saving

D a rise in the rate of interest

6. Which group may be disadvantaged by the introduction of division of labour?

A consumers who prefer standardised goods

B companies where the production process has many sub-divisions

C the government, if the product is taxed

D workers who prefer a variety of tasks

7 What is an advantage of using the market mechanism to allocate resources between alternative uses?

A It ensures that resources will be allocated efficiently.

B It ensures that resources are allocated in accordance with need.

C It minimises the time required to make decisions.

D It gives all consumers an equal voice in deciding how resources should be allocated.8. In a market economy, what is the basis for determining the allocation of factors of production?

A the market share of companies

B the needs of the country

C the pattern of consumers spending

D the wealth of entrepreneurs9. What is meant by ceteris paribus in economic analysis?

A A normative approach is being adopted.

B The effect of a change of one variable is being considered in isolation.

C One good has to be sacrificed to obtain more of another.

D One factor of production is fixed.

10 Doctors should be paid highly because they have to undertake a long period of training.

What can be concluded about this statement?

A It is a normative statement because high pay does not always result from lengthy training.

B It is a normative statement because it expresses an opinion.

C It is a positive statement because doctors do have to train for a long period.

D It is a positive statement because greater skill results in higher pay. 1a, 2b, 3d, 4c, 5a, 6d, 7c, 8c, 9b, 10bBasic economic problem, Resource Allocating, Money, citrusperibus, Assignment 3 As

1. What is the main economic problem facing all societies?

A how to reduce unemployment

B how to reduce poverty

C how to allocate scarce resources

D how to control inflation

2 What is the opportunity cost to an unemployed worker who becomes employed?

A the leisure they would otherwise have had

B the value of the goods and services they produce

C the wages they are paid

D zero

3. Which of the following statements about trade unions is normative?

A Since trade unions exist to safeguard the interests of their members, they deserve the legal protection of the state.

B In countries where trade unions are strong, income distribution is more equal.

C Uneven trade union membership has resulted in a widening of the wage gap between different industries.

D In industries where trade unions are powerful, technical progress tends to be much slower.4. Which is a normative economic statement?

A Money is the least liquid form of wealth.

B Some firms are subsidised by the government.

C Some workers earn more than others.

D Taxes are the best way to discourage smoking.

5. What is an essential feature of a pure market economy?

A Buyers and sellers have perfect knowledge.

B External costs are taxed.

C Prices respond to the demands of consumers.

D The government provides public goods.

6. What is an example of the factor of production capital?

A a bank account held by a small firm to be used for future purchases

B a forest of hardwood trees ideal for furniture making

C the market value of a companys shares

D word processing software used by a writer to complete her new book

7 The workers in a factory currently earn $240 for a 40-hour week. The management offers them a

choice between either a 10 per cent wage increase or an increase in the weekly wage to $260

along with a reduction from 40 to 39 hours.

Disregarding the value of leisure time, what is the opportunity cost to each worker of opting for

the 39-hour week?

A $4

B $6

C $20

D $248. The table shows the levels of demand for silver in millions of ounces for different uses between

1999 and 2001.

1c, 2a, 3a, 4d, 5c, 6d, 7a,

Basic economic problem with marking scheme AsDiscuss the desirability of the worldwide movement towards the market economy and away

from the planned economy.

[12]Markscheme

The market economy has limited government intervention and relies on the profit motive and consumer sovereignty. It has proved more successful in raising living standards, economic growth and economic efficiency. Consumers benefit from more choice and lower prices. Planned economies were state-run with economic plans and large scale government intervention. The result was low living standards although

employment was usually available and a basic quality of life resulted. The move to market economies brought beneficiaries and casualties. Russia illustrates the increase in millionaires while unemployment and poverty grew. Some East European economies are making fast progress while some former USSR republics are struggling.

Candidates may consider the case of China.

Understanding of the features of economic systems (4)

Discussion of the benefits of the transition (4)

Discussion of the harm of the transition (4) [12](a) Explain the differences in the features of a market economy and a planned economy. [8]Markscheme

Individual actions and consumer sovereignty dominate in the market economy. Motivation is self interest. Private ownership, the profit motive and the operation of market forces are central features. In a planned

economy there are government ownership, planning bodies and the state direction of resources. Motivation is public interest. Decisions by the government dominate economic activity.

Explanation of the features of a market economy up to 4 marks

Explanation of features of a planned economy up to 4 marks2 (a) An economy is faced by the exhaustion of an important natural resource at a time when it is introducing improved technology.

Explain how these events will affect the economys production possibility curve. [8]

Markscheme

Improved technology gives greater efficiency and rising productivity(output per worker per time period) so should move the production possibility curve outwards, depending upon where the improvement impacts. The exhaustion of a resource should reduce an input and the resulting output and move the ppc inwards. The overall effect will depend on their relative strengths but results from the change in available inputs and their effect on production possibilities. These changes can be shown by diagrams.

Understanding of the ppc concept up to 2 marks

Awareness of the outcomes up to 4 marks

Balance of the effects/differentiated impact up to 2 marks

(b) Discuss whether the operation of a market economy always produces a desirable outcome. [12]

Markscheme

A properly functioning market economy should provide choice, quality and competition. It should make economic use of resources and avoid waste. It is an efficient system of resource allocation and has outperformed planned economies. However, it has drawbacks such as the production of externalities and demerit goods and the failure to provide public and merit goods. Knowledge of the nature of the market system up to 4 marks

Justification of desirable outcome up to 6 marks

Discussion of the failings of the market economy up to 6 marks, subject to maximum of 8 in

total for this and the previous line(a) Explain how production possibility curves might be used in assessing a country's economic performance. [8]

Markscheme

A ppc shows the possible combinations of two goods which can be produced by an economy when it uses all of its resources fully and efficiently. A ppc slopes down to the right and is usually drawn concave to the origin. Points within show unemployment and inefficiency, points without are unattainable. Shifts in the curve show growth or loss of productive potential. The larger the contained area the greater the level of production potential.

For knowledge of a ppc up to 2 marks

For explanation of static position up to 3 marks

For explanation of move in curve up to 3 marks

(b) Discuss whether a mixed economy is the best way for a country to deal with the basic

economic problem. [12]

Markscheme

The basic economic problem concerns limited resources, unlimited wants and scarcity. A mixed economy combines features of market and planned systems. Private ownership, profit motive and markets operate as well as government ownership, service provision and market intervention. The balance between the two varies between time and place. A mixed system should benefit from the advantages of the two systems. The market system should provide incentive and efficiency while equity and market failure should be dealt with by the government. However a mixed economy may suffer from the disadvantages of both alternatives producing inequality, inefficiency and low levels of welfare.

For understanding the mixed economy and economic problem up to 5 marks

For discussion of the mixed economy's benefits up to 5 marks ] max

For discussion of the mixed economy's drawbacks up to 5 marks(a) An economy can produce agricultural and industrial goods. Explain the possible

effects on its production possibility curve if there is an increase in the productivity of

its agricultural workers. [8]

A ppc shows an economys maximum output of two goods when using all of its resources. Productivity is the measure of output per worker. Assuming the production of agricultural goods and industrial goods, the ppc would be expected to pivot outwards, as workers produce more, indicating greater quantities of agricultural goods. Further possibilities include greater production of industrial goods as well because better food supplies increase overall productivity or as restriction on agricultural total output shifts resources to industrial

production, which in turn expands.

For knowledge of ppc and productivity up to 2 marks

For understanding of pivot with more agricultural output up to 4 marks

For explanation of alternative outcomes up to 2 marks (b) Discuss whether a market economy can solve the problem of scarcity more effectively

than a command economy. [12]

A market economy involves minimal government intervention and relies on private motives and ownership. A command economy is directed by the government with public motivation. Scarcity occurs when there is insufficient output to meet peoples wants at zero price. Scarcity arises because of limited resources and unlimited wants and is shown by the area outside of a ppc. The market economy may appear to reduce the extent of scarcity more by operating efficiently and improving the supply of goods and services, however the wants of consumers expand as more basic needs are satisfied so scarcity remains. The command economy has achieved lower living standards but with a more even distribution. Economic systems are unlikely ever to remove the problem of scarcity, although its nature may differ under different systems.

For understanding of the economic systems and scarcity up to 4 marks

For analysis of the ability of each to reduce scarcity up to 6 marks

For discussion of the meaning and solution of scarcity up to 6 marks

Basic economic problem TEST As1. What is the central problem for an economy?

A to achieve maximum growth in production

B to allocate resources between alternative uses

C to ensure all resources are fully exploited

D to overcome inequalities in income distribution

2 What are most likely to be disadvantages found in a market economy?

A economic growth and state-owned companies

B merit goods and free competition

C public goods and economic specialisation

D unemployment and external costs

3 The diagram shows the production possibility curve of an economy.

Which statement explains the shape of this curve?

A More efficient workers are drawn away from the production of consumer goods.

B Resources cannot be switched between producing capital and consumer goods.

C The economy is more efficient at producing capital than consumer goods.

D The opportunity cost of producing capital goods increases the more capital goods are made.

4. What is a correct statement about money?

A Its functions mean the characteristics that it possesses. B Its liquidity means its use as legal tender.

C Its supply means the total value of banknotes in circulation.

D Its value means its purchasing power.

5. The diagrams show the change in a countrys production possibility curve between Year 1 and Year 2. What can be deduced from the diagrams?

A Future growth prospects have been harmed.

B The level of unemployment has fallen.

C The opportunity cost of consumer goods has risen.

D The proportionate growth in production is greater in consumer goods.

6. What is likely to be greater in a planned economy than a market economy?

A efficiency

B flexibility

C innovation

D stability7. The diagram shows the production possibility curves of two economies, X and Y.

Which statement about the two economies is correct?

A Both economies always have the identical opportunity costs.

B Both economies have the same future growth prospects.

C The opportunity costs are constant in both economies.

D The two economies can never produce the same combination of products.8. The price of good X rises by 10 %. As a result, the demand for a complementary good Y changes

by 20 %. What is the cross elasticity of demand for good Y with respect to good X?

A +2 B +0.5 C 0.5

D 2

9. A good has unitary price elasticity of demand and at a price of $25 it sells 100 000 units.

Which price must the firm charge if it wants to sell 125 000 units of the good?

A $22

B $20

C $18

D $1510. Which of the following statements must be true if the use of resources involves an opportunity cost?

A. Not all wants can be satisfied

B. Firms are below optimum size

C. Opportunity cost ratios are constant D. The economy is operating below its production possibility frontier11. Which statement about income elasticity of demand over the range of income shown is true?

A For cola it is less than 1.

B For cola it is greater than 1.

C For nuts it is greater than 1.

D For nuts it is zero.

12. In which of the circumstances will consumer surplus be zero?

A. Demand is perfectly inelastic

B. Demand is perfectly elastic

C. Elasticity of demand is 1

D. Supply is perfectly elastic

13. The price elasticity of demand for commodity is 0.5. The price of the commodity is initially $5 and the initial quantity sold is 100. By how much would the price have to reduce to increase sales by 20 units?

A. $0.5

B. $1.00C. $2.00

D. $3.00

14. The price elasticity of demand for a good is unity. What will increase as result of reduction in the price?

A. expenditure on the good B. expenditure on the substitute. C. quantity demanded D. marginal revenue.

15. What is most likely to make the demand for Good X inelastic?

A Good X is a luxury good.

B Good X is habit-forming.

C The proportion of income spent on Good X is very high.

D There are a large number of substitutes for Good X.Economic Aspects of Cigarette Smoking

Smoking cigarettes is a controversial matter that illustrates a number of economic issues. As with

most products, the key influence on the level of consumption is the products price. United States

Fig. 1 US cigarette consumption and cigarette prices 19702006

A study of cigarette smoking in Malaysia estimated the short-run and long-run price elasticity of

demand (PED) and the income elasticity of demand (YED) for cigarettes between 1990 and 2004.

The results are shown in Table 1.

Table 1: Demand elasticities for cigarettes in Malaysia

In Europe, taxation of cigarettes is particularly heavy. In 2006 it was 76.4% of the final selling price in Germany, 77.1% in the UK and 80.4% in France. European countries are increasingly banning smoking in enclosed public areas and workplaces. Some anti-smoking campaigners are calling for the smoking of cigarettes anywhere to be made illegal.

(a) How far does the data in Fig. 1 confirm that the normal demand curve relationship exists between the price and the quantity demanded of cigarettes? [3]

(b) (i) What do the three elasticity values in Table 1 tell us about the elasticity of demand for cigarettes? [3]

(ii) What might explain these different elasticity values? [4]

c) Discuss whether a market economy can solve the problem of scarcity more effectively than a command economy. [12]2 Explain how a countrys production possibility curve depends upon its factors of production. [8]

3 With the help of examples, explain why different economic decision makers face the problem

of scarcity. [8]

Transition occurred in the centrally-planned economies mainly as a result of overwhelming international economic pressures. However, the process of transition itself was either triggered by internal policy shifts or public upheavals, or was kept under the tight control of the centrally-planned state (e.g. China). In the former situation, the speed towards reform was politically motivated, but relied heavily on the frustrated protests of the collective workers who were demoralized by years of secure, but less stimulating, working environments. In some countries, the major objective was mainly to demolish the old structure without planning for alternative measures. This led to disruptions in basic community structures and increased the suffering of the rural poor. Smallholder families were forced to trade their animals for food and other consumables. With advances in the barter system, the value of livestock as a means of saving and the accumulation of wealth increased, and the ownership of productive animals shifted in favour of the emerging community of wealthy herders.

Although the change under the tight control of the centrally-planned countries such as China was also triggered by external factors (e.g. international trade, the need for hard currency and improved technologies) as well as by internal factors (e.g. ecological and climatic factors, social changes), the transition has been smooth and well organized. The new livestock owners are not left to struggle for survival on their own. Services are gradually being privatized, starting with a progressive recovery of service costs. Rural financing has been developed under a well-organized banking and unsubsidized credit system. Transition under this model has been gradual and more effective and has provided donors such as IFAD with opportunities to support and improve smallholder livestock systems without measures that require drastic changes in the social structure of the village communities.

Indeed, and in spite of the abruptness of the transition, each country has had its own identity and features. For example, in some centrally-planned countries such as Laos, the chain of command was weak to start with because of the lack of resources and the poor infrastructure and poor communication between the central committee and rural communities. Under such conditions, the day-to-day management of the rural production systems (cooperatives or otherwise) was kept at the grass-roots level. Because the influence of the state was minimal, the problems during transition were primarily those with which the livestock producers were faced during the command economy period. In the case of Laos, the major constraint continues to be the lack of the capital needed for restocking the animals lost during the war or because of natural calamities, poor soil fertility, feed deficit, poor animal health services, poor technical skills and losses due to landmines.

The situation in Kyrgyzstan is an example of a violent transition that has demolished the social and economic fabric of a whole society in a merciless way. Five years after the collapse of the command economy, over 70% of the population was classified as poor. The former state-supported social and economic privileges (see Box 1) were not replaced by better alternatives under the command of either the private or the public sector; nor were there alternative community self-help activities. Typically, the poor lack money to buy food and other essentials. They are unable to produce what they could once produce or unable to sell what they produce.

On the other hand, the transfer of wealth and power to a small portion of society is moving in different ways, indicating the magnitude of diversity in the transition in this country and others in Central Asia. According to the six-month University of Wisconsin Land Tenure Study in Kyrgyzstan in 1995, groups of small farms were established around a large farm, and there was a symbiotic relationship for certain services. Also, some small private farms have developed close relationships with the former Solkhozes and Kolkhozes they have recently left. For example, one private farm has a long-term contract to raise heifers for a former collective farm, while another private farm mills grain and dips animals at cost for another Kolkhoz. According to the team of researchers for the USAID Collaborative Research Support Programme who visited Kyrgyzstan early 1997 some of the state and collective farms operate as modern businesses, while others have become subsistence farms and pay members with produce and barter with nearby enterprises. Some seemingly successful cooperative farms have been purchased by the 'Kolkhoz manager' and a few foreign partners.

The transition to the market economy did not accomplish most of its objectives, and countries remain in urgent need of support from the international community. Except under the controlled transition in China, the physical and institutional infrastructure as well as community institutions collapsed, leaving a vacuum at all levels. Social workers, researchers and professionals (veterinarians, animal production officers) became - in practice - jobless, while waiting for the evolution of new alternatives. The physical structure eroded, and productivity declined as a result of the collapse of irrigation systems, the unavailability of inputs and the collapse of the service delivery mechanism.

The problems of transition economies include:

Rising unemployment

Many transition economies experienced rising unemployment as newly privatised firms tried to become more efficient. Under communism, state owned industries tended to employ more people than was strictly needed, and as private entrepreneurs entered the market, labour costs were cut back in an attempt to improve efficiency. As the newly established private firms became subject to greater competition some were driven out of the market, which created job losses. In addition, a reduction in the size of the state bureaucracy also meant that many employees of the state also lost their jobs.

Rising inflation

Many transition economies also experienced price inflation as a result of the removal of price controls imposed by governments. When this happened, the newly privatised firms began to charge prices that reflected the true costs of production. In addition, some entrepreneurs exploited their position and raised prices in an attempt to profit from the situation.

Lack of entrepreneurship and skillsMany transition economies suffered from a lack of entrepreneurs and entrepreneurship, which make it more difficult to reform their economies and promote market capitalism. In addition, there was also a skills gap with few workers having the necessary skills required by employers in the newly privatised firms.

Corruption

It is alleged that corruption was widespread during the early years of transition in many former communist countries, and this inhibited the effective introduction of market reforms. Many products were poorly made and sold in unregulated and illegal markets, and many have claimed that criminal gangs and widespread racketeering filled the vacuum left by the deposed communist regimes.

Inequality

Economic transition also led to rapidly increasing inequality as some exploited their position as entrepreneurs and traders in commodities, while others suffered from unemployment and rising inflation.

Lack of infrastructure

The transition economies also suffered from a lack of real capital, such as new technology, which is required to produce efficiently. This was partly because of the limited development of financial markets, and because there was little inward investment from foreign investors. Clearly, this has changed as the transition economies have reformed, and joined the global market, which has encouraged inward investment (Foreign Direct Investment FDI) from around the world.

Lack of a sophisticated legal system

Under communism, the state owned all the key productive assets, and there was little incentive to develop a sophisticated legal system that protected the rights of consumers, and regulated the activities of producers. Market-driven economies will only develop when citizens are granted extensive property rights, and can protect these rights through the legal process. This was large absent in the former communist transition economies.

Moral hazard

The problem of moral hazard implies that inferior performance can arise when the risks associated with poor performance are insured against. For example, if individuals insure the contents of their house against theft, they are more likely to leave their windows open. In the context of transition economies, under communism people felt that the state would insure them against the risks associated with global competition, including the risk of losing their jobs. The consequence is that many workers remained inefficient and unproductive, knowing that employment prospects would not be reduced.

Fiscal Policy Effects

Fiscal policy decisions have a widespread effect on the everyday decisions and behaviour of individual households and businesses hence in this note we consider some of the microeconomic effects of fiscal policy before considering the links between fiscal policy and aggregate demand and key macroeconomic objectives.The microeconomic effects of fiscal policy1. Taxation and work incentivesCan changes in income taxes affect the incentive to work? This remains a controversial subject in the economic literature!

Consider the impact of an increase in the basic rate of income tax or an increase in the rate of national insurance contributions. The rise in direct tax has the effect of reducing the post-tax income of those in work because for each hour of work taken the total net income is now lower. This might encourage the individual to work more hours to maintain his/her target income. Conversely, the effect might be to encourage less work since the higher tax might act as a disincentive to work. Of course many workers have little flexibility in the hours that they work. They will be contracted to work a certain number of hours, and changes in direct tax rates will not alter that.

The government has introduced a lower starting rate of income tax for lower income earners. This is designed to provide an incentive for people to work extra hours and keep more of what they earn.

Changes to the tax and benefit system also seek to reduce the risk of the poverty trap where households on low incomes see little net financial benefit from supplying extra hours of their labour. If tax and benefit reforms can improve incentives and lead to an increase in the labour supply, this will help to reduce the equilibrium rate of unemployment (the NAIRU) and thereby increase the economys non-inflationary growth rate.

2. Taxation and the Pattern of DemandChanges to indirect taxes in particular can have an effect on the pattern of demand for goods and services. For example, the rising value of duty on cigarettes and alcohol is designed to cause a substitution effect among consumers and thereby reduce the demand for what are perceived as de-merit goods. In contrast, a government financial subsidy to producers has the effect of reducing their costs of production, lowering the market price and encouraging an expansion of demand.

The use of indirect taxation and subsidies is often justified on the grounds of instances of market failure. But there might also be a justification based on achieving a more equitable allocation of resources e.g. providing basic state health care free at the point of use.

3. Taxation and labour productivitySome economists argue that taxes can have a significant effect on the intensity with which people work and their overall efficiency and productivity. But there is little substantive empirical evidence to support this view. Many factors contribute to improving productivity tax changes can play a role - but isolating the impact of tax cuts on productivity is extremely difficult.

4. Taxation and business investment decisionsLower rates of corporation tax and other business taxes can stimulate an increase in business fixed capital investment spending. If planned investment increases, the nations capital stock can rise and the capital stock per worker employed can rise.

The government might also use tax allowances to stimulate increases in research and development and encourage more business start-ups. A favourable tax regime could also be attractive to inflows of foreign direct investment a stimulus to the economy that might benefit both aggregate demand and supply. The Irish economy is often touted as an example of how substantial cuts in the rate of corporation tax can act as a magnet for large amounts of inward investment. The very low rates of company tax have been influential although it is not the only factor that has underpinned the sensational rates of economic growth enjoyed by the Irish economy over the last fifteen years.

Capital investment should not be seen solely in terms of the purchase of new machines. Changes to the tax system and specific areas of government spending might also be used to stimulate investment in technology, innovation, the skills of the labour force and social infrastructure. A good example of this might be a substantial increase in real spending on the transport infrastructure. Improvements in our transport system would add directly to aggregate demand, but would also provide a boost to productivity and competitiveness. Similarly increases in capital spending in education would have feedback effects in the long term on the supply-side of the economy.

Fiscal Policy and Aggregate DemandTraditionally fiscal policy has been seen as an instrument of demand management. This means that changes in spending and taxation can be used counter-cyclically to help smooth out some of the volatility of real national output particularly when the economy has experienced an external shock.

Discretionary changes in fiscal policy and automatic stabilisersDiscretionary fiscal changes are deliberate changes in direct and indirect taxation and govt spending for example a decision by the government to increase total capital spending on the road building budget or increase the allocation of resources going direct into the NHS.

Automatic fiscal changes are changes in tax revenues and government spending arising automatically as the economy moves through different stages of the business cycle. These changes are also known as the automatic stabilisers of fiscal policy Tax revenues: When the economy is expanding rapidly the amount of tax revenue increases which takes money out of the circular flow of income and spending

Welfare spending: A growing economy means that the government does not have to spend as much on means-tested welfare benefits such as income support and unemployment benefits

Budget balance and the circular flow: A fast-growing economy tends to lead to a net outflow of money from the circular flow. Conversely during a slowdown or a recession, the government normally ends up running a larger budget deficit.

Estimates from economists at the OECD have found that the effects of the automatic stabilisers of fiscal policy can reduce the volatility of the economic cycle by up to 20%. In other words, if the government is prepared to allow the automatic stabilisers to work through fully, the fiscal policy can help to curb the excessive growth of demand during a boom, but also provide an important support for income and demand during an economic downturn.

Measuring the fiscal stance

The fiscal stance is a term that is used to describe whether fiscal policy is being used to actively expand demand and output in the economy (a reflationary or expansionary fiscal stance) or conversely to take demand out of the circular flow (a deflationary fiscal stance).

A neutral fiscal stance might be shown if the government runs with a balanced budget where government spending is equal to tax revenues. Adjusting for where the economy is in the economic cycle, a neutral fiscal stance means that policy has no impact on the level of economic activityA reflationary fiscal stance happens when the government is running a large deficit budget (i.e. G>T). Loosening the fiscal stance means the government borrows money to inject funds into the economy so as to increase the level of aggregate demand and economic activity.A deflationary fiscal stance happens when the government runs a budget surplus (i.e. G