Pearson Edexcel IAL Economics: Fiscal and monetary policy and central banks (YEC11) – Practice Questions

These are original questions written for Marlbridge, for revision and practice on this content. They are not reproduced past-paper questions, and they do not replicate the exam’s exact structure, question count or mark tariffs – examination boards hold copyright in their own papers. Use these alongside the official past papers from your board or school.

These questions follow the Pearson Edexcel International Advanced Subsidiary/Advanced Level Economics specification (Issue 2, June 2018), section 2.3.6 item 4, demand-side policies. This is Unit 2 content, an International AS compulsory unit that also counts in the full International A Level. All data are invented for illustration: Countries B to F are not real, and each label names one economy only.

Read the study guide or the revision notes first. See also the course hub, the checklist and the free diagnostics.

Questions

1. Distinguish between fiscal policy and monetary policy. [2]

2. Explain why a rise in income tax rates combined with a cut in government spending is a deflationary policy. [3]

3. Country B has a marginal propensity to save of 0.2, to pay tax of 0.1 and to import of 0.2. The government raises its spending by 12bn.

(a) Calculate the multiplier and the total rise in national income. [2] (b) Calculate the net cost to the budget after extra tax revenue. [2]

4. Country C’s central bank cuts its policy rate from 6.0% to 4.5%. Inflation is 2.5% and does not change.

(a) Calculate the real interest rate before and after the cut. [2] (b) Explain one reason why the cut may not raise aggregate demand by much. [2]

5. A government bond pays 3 a year. Its price is 60 before the central bank starts buying bonds and 75 afterwards.

(a) Calculate the yield before and after. [2] (b) Explain how this change could affect investment. [2]

6. A house costs 300,000. The authorities cut the maximum loan-to-value ratio from 95% to 85%.

(a) Calculate the deposit a buyer needs before and after. [2] (b) Explain the likely effect on aggregate demand. [2]

7. A bank holds 18bn of liquid assets against deposits of 150bn. The required liquidity ratio rises from 12% to 15%. Calculate the shortfall and state one consequence for the bank’s lending. [3]

8. Explain two roles of a central bank, one of which must be lender of last resort. [4]

9. The price index in Country D was 108.0 last year and 111.2 this year. The inflation target is 2%.

(a) Calculate the inflation rate to one decimal place. [2] (b) Explain what the central bank is likely to do to its policy rate and why. [2]

10. Country E is in recession, its policy rate is close to zero and its government debt is already high. Evaluate whether fiscal policy or monetary policy is more likely to increase output. [8]

11. In Country F, mps is 0.1, mpt is 0.1 and mpm is 0.05. The government considers either raising spending by 6bn or cutting lump-sum taxes by 6bn.

(a) Calculate the multiplier and the rise in income from each option. [4] (b) Explain why the results differ and suggest one reason the tax cut may still be chosen. [2]

Answers

1. Fiscal policy is changes in government spending and taxation [1]. Monetary policy is changes in interest rates, the money supply or credit conditions, normally by the central bank [1]. [2] Examiner insight: Answers that name only the instruments, without saying who uses them or what they change, usually say too little for a distinction; give a difference.

2. Higher tax rates reduce disposable income, so consumption falls [1]. Lower government spending reduces an injection into the circular flow [1]. Both reduce aggregate demand, so it shifts left and the price level or output falls; this is deflationary policy, not deflation [1]. [3] Examiner insight: A chain from instrument to AD to the result is stronger than a statement that “demand falls”; write each link.

3. (a) Multiplier = 1 / (0.2 + 0.1 + 0.2) = 1 / 0.5 = 2 [1]. Income rises by 12 × 2 = 24bn [1]. [2] (b) Extra tax = 0.1 × 24 = 2.4bn [1]. Net cost = 12 − 2.4 = 9.6bn [1]. [2] Examiner insight: Show the withdrawal rates added together before dividing; a bare multiplier of 2 gives the reader nothing to check.

4. (a) Before: 6.0 − 2.5 = 3.5% [1]. After: 4.5 − 2.5 = 2.0% [1]. [2] (b) Households or firms may expect weak demand [1], so investment does not rise even with cheaper borrowing [1]. A different reason would also do: high existing debt means households use any saving to repay it rather than spend. [2] Examiner insight: A reason is strongest when it explains why the usual link breaks; “it might not work” alone is not an explanation.

5. (a) Before: 3 / 60 × 100 = 5.0% [1]. After: 3 / 75 × 100 = 4.0% [1]. [2] (b) Lower yields signal cheaper long-term borrowing [1]. Firms find more projects worthwhile at a lower interest cost, so investment may rise, raising AD [1]. [2] Examiner insight: Say that price and yield move in opposite directions; this link is the core of how quantitative easing works.

6. (a) Before: 5% of 300,000 = 15,000 [1]. After: 15% of 300,000 = 45,000 [1]. [2] (b) Fewer buyers can raise the larger deposit, so demand for housing and for mortgage credit falls [1]. Less house-related spending lowers consumption and AD [1]. [2] Examiner insight: Give the effect on spending, not just on house buyers; the question asks about aggregate demand.

7. Required liquid assets = 0.15 × 150 = 22.5bn [1]. Shortfall = 22.5 − 18 = 4.5bn [1]. The bank must hold more liquid assets, so it will have less to lend [1]. [3] Examiner insight: A ratio question needs the required amount first; compare it with the actual holding second.

8. Lender of last resort: it provides loans to a bank that has run out of other sources of funds [1]. This protects confidence and stops a run on one bank spreading to others [1]. Second role, banker to the government: it holds the government’s accounts and handles payments [1], and helps the government issue and manage its debt [1]. [4] Examiner insight: Each role needs a function and a purpose; naming roles in a list earns little by itself.

9. (a) (111.2 − 108.0) / 108.0 × 100 = 3.2 / 108.0 × 100 [1] = 3.0% [1]. [2] (b) Inflation is above the 2% target, so the bank is likely to raise the policy rate [1]. Dearer borrowing reduces consumption and investment, reducing demand-pull pressure [1]. [2] Examiner insight: Compare the figure you calculated with the target before choosing the direction of the rate.

10. Monetary policy: the policy rate is near zero, so a further cut is limited [1]. QE could lower long-term yields, but its effect on lending is uncertain when firms expect weak demand [1]. Lags also apply [1]. Fiscal policy: government spending is a direct injection, and the multiplier raises income more than the first-round spend [1]. In a recession there is spare capacity, so extra demand raises output more than prices [1]. Against this, the high debt limits room to borrow, and markets may demand higher interest [1]. Spending could also be slow to start, so the lag may be long [1]. Judgement: fiscal policy is more likely to raise output in this case, if the spending is targeted and its financing is credible, because monetary policy has little room [1]. [8] Examiner insight: Evaluation tends to gain credit when it uses the context given (near-zero rate, high debt) and ends in a reasoned judgement, rather than listing general pros and cons.

11. (a) Multiplier = 1 / (0.1 + 0.1 + 0.05) = 1 / 0.25 = 4 [1]. Spending: 6 × 4 = 24bn [1]. Tax cut: households spend 1 − 0.1 − 0.05 = 0.85 at home, so 6 × 0.85 = 5.1bn first round [1]; 5.1 × 4 = 20.4bn [1]. [4] (b) Part of the tax cut leaks into saving and imports in the first round, so the injection is smaller [1]. A tax cut may be chosen because it can be reversed more easily, or because the government wants to raise incentives and let households choose how to spend [1]. [2] Examiner insight: Show the first-round share for the tax cut before applying the multiplier; the difference of 3.6bn is the point of the comparison.

Where marks are usually lost

• Describing an instrument without linking it to aggregate demand.
• Confusing deflationary policy with deflation.
• Forgetting to add all withdrawals before taking the reciprocal.
• Treating a tax cut as if all of it were spent in the first round.
• Using nominal rates when the question gives inflation.
• Mixing up bond price and yield.
• Listing central bank roles without a purpose for each.
• Evaluating with general points that ignore the context supplied.
• Ending an evaluation with no judgement.

Next steps

• Re-read the study guide for any chain you missed.
• Use the revision notes for quick recall.
• Open the course hub and tick off the checklist.
• Try the free diagnostics.
• Book a free trial class: /trial/.

Official syllabus

Pearson Edexcel International Advanced Subsidiary/Advanced Level in Economics specification, Issue 2, June 2018, Pearson Education Limited, section 2.3.6 item 4.