CB2 Sept 2023

[Greg Raine]

Hi,

I've gone through the last exam and am a bit unsure of my understanding for questions 21 and 24, which have answers in the examiner's report of A and D respectively.

For Question 21, I thought that the inflationary gap refers to the difference between actual output and potential output at full employment. My thought process was therefore looking for policies to increase employment, to try and achieve full employment, and in turn reducing this gap. I thought reducing income tax would incentivise more people to work, due to a potential substitution effect between leisure and work, so answered C for this.

For Question 24, my understanding is that a tariff is an ad velorum tax on an imported good or service. So if the tariff was removed, then consumers would pay lower prices, thus narrowing my choices between B and D. I thought that if tariff was removed, then producers of the good/service would receive the lower price (as the tax has been removed). My only thought after seeing the answer was that maybe the question was referring to domestic producers?

Please could someone explain the rationale behind the answers, as I feel my understanding for both solutions is slightly off.

Many thanks,
Greg

 

[Richie Holway]

Hi Greg,

For Question 21, an inflationary gap occurs when aggregate expenditure exceeds national income (or injections exceed withdrawals) at the full-employment level of national income (ie if the full employment level of national income is to the left of equilibrium output on a 45 degree diagram). This excess demand creates demand-pull inflation. To reduce demand, an appropriate policy response would be to reduce government expenditure. Although Option C (a decrease in the rate of income tax) might incentivise people to work, it would also likely increase demand, rather than decrease, as people spend their higher disposable incomes.

For Question 24, I agree with your logic for narrowing it down to B or D. At that point, when thinking about the impact on producers, we need to think about domestic producers (as the question gives no indication to consider foreign ones instead). Domestic producers selling the good to domestic consumers will only be impacted by the imposition of a tariff due to the impact the tariff has on the market price: when a tariff is introduced, the effective price that consumers pay to buy the good from another country increases (by the amount of the tariff), and therefore domestic producers can also get away with increasing the price they charge. When the tariff is removed, the opposite happens: consumers will be able to buy the good from abroad for less, so domestic producers will have to reduce their price in order to attract sales. Hence the answer is Option D.

I hope this helps and good luck for the exam.

Richie

 

[Greg Raine]

Thanks for the explanations Richie, I understand the logic now for each.

Just for clarity, if a question on international trade simply states "producers" or "consumers", then we should always assume it to be domestic producers and consumers?

Thanks,
Greg

 

[Richie Holway]

That sounds like a sensible rule of thumb in the absence of any further wording or information that might suggest the focus should be on consumers or producers abroad instead.