Explain how aggregate demand might be affected by an increase in interest rates.

Discuss whether the use of fiscal policy is the most effective way to bring an economy out of a recession.

Answers may include:

• definitions of AD, interest rates
• diagram(s) showing the decrease in AD due to the increase in interest rates
• explanation of how an increase in interest rates will decrease consumption and investment as borrowing decreases or any other transmission mechanism
• examples of countries that have increased interest rates.

Award a maximum of level 2 if the response fails to link the increase in interest rates to at least two components of AD.

Marks should be allocated according to the Paper 1 markbands for May 2013 forward, part A.

Answers may include:

• definitions of fiscal policy, recession
• diagram to show how an increase in AD will increase real GDP
• explanation of how fiscal policy involves an increase in government spending or a decrease in taxes or both; how an increase in government spending might create a multiplier effect on the economy leading to an increase in real GDP
• examples of the use of fiscal policy
• synthesis or evaluation (discuss).

Discussion may include: the limitations of fiscal policy like the effect on the government budget, time lags, the difficulty of promoting economic activity in a recession and the significance of the multiplier effect. There may also be reference to alternative policies like monetary and supply-side.

Marks should be allocated according to the Paper 1 markbands for May 2013 forward, part B.