Explain how the size of the circular flow of income in an economy is likely to be affected by a decrease in the rate of interest.

Evaluate the effectiveness of fiscal policy as a means of achieving long-term economic growth.

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

Answers may include:

• definitions of circular flow of income, rate of interest
• diagram of the circular flow of income, showing a decrease in saving and an increase in investment or use of an AD/AS diagram to explain the impact of the decrease in the rate of interest on the circular flow of income
• explanation that a decrease in the rate of interest is likely to reduce saving, and increase business investment; hence a decrease in a leakage and an increase in an injection will exert an upward impact on income and output and increase the size of the circular flow of income
• examples of changes in the rate of interest affecting the circular flow of income in practice, such as the reduction of interest rates to near 0% in many countries at present.

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

Answers may include:

• definitions of long-term economic growth, fiscal policy 
• diagram to show LRAS and/or the production possibility curve shifting to the right/outwards
• explanation of how fiscal policy can promote long-term economic growth through government spending on infrastructure, technology, R&D and human capital, tax reductions/incentives for firms to invest
• examples of the use of fiscal policy to promote long-term economic growth
• synthesis or evaluation.

Evaluation may include: the various advantages and disadvantages of fiscal policy, including both the demand- and supply-side effects on the economy, consideration of alternative (supply-side and monetary) policies.

This proved to be a difficult question for candidates and was certainly the least popular. Most were unable to provide an accurate circular flow diagram and to explain the circular flow model and, all too often, the key concepts of injections and leakages were completely ignored or simply glossed over. Thus, usually, candidates did not link the lowering of interest rates to a decrease in a leakage (saving) and an increase of an injection (investment). Many briefly mentioned that the size of the circular flow would increase but were not able to properly explain why. Examples were almost never provided. Many candidates appeared to be much more at ease with the AD/AS model, which they often launched into at an early stage of their answer to this question. Some credit was given for this where appropriate, but this approach was often not explicitly related to leakages and injections.  

Although some candidates confused fiscal policy with monetary policy, many displayed a good understanding of what fiscal policy is and how expansionary fiscal policy is achieved. However, few candidates were able to explain what long-term economic growth is in comparison to short-term economic growth and to specifically explain how it might be achieved. Thus, typically, answers tended to be more general nature in relation to fiscal policy and economic growth, with diagrams showing how AD shifts rightwards, causing SR economic growth, without the shift rightwards of LRAS on account of the supply-side effects of fiscal policy. Many could evaluate fiscal policy in general, but not specifically as it relates to increasing long-term economic growth. A few candidates did compare fiscal policy to supply-side policies but often failed to recognise that certain aspects of fiscal policy are in effect supply-side policies.