Explain how aggregate demand is likely to be affected by an increase in the wealth of consumers and an increase in business confidence.

Evaluate the effectiveness of monetary policy in reducing an economy’s rate of unemployment.

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

Answers may include:

• definitions of aggregate demand, wealth, business confidence
• diagram to show the AD curve shifting to the right
• explanation that an increase in the wealth of consumers may have a positive wealth effect whereby consumption increases as consumers feel richer and are more willing to spend, or can borrow more on the basis of their greater wealth; that an increase in business confidence in relation to being more optimistic about future sales and profits is likely to increase investment; and that the increase in C and I will increase AD
• examples of an increase in consumers’ wealth and/or business confidence increasing AD in practice.

Award a maximum of [6] if only wealth or only business confidence is addressed.

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

Answers may include:

• definitions of monetary policy, rate of unemployment
• diagram to show AD shifting to the right as a result of expansionary monetary policy
• explanation of how expansionary monetary policy may help to reduce cyclical (demand-deficient) unemployment in terms of the mechanisms by which lower interest rates increase AD via the effect on consumption, investment and/or net exports
• examples of expansionary monetary policy being used in practice
• synthesis or evaluation.

Evaluation may include: the implications of monetary policy in terms of the ability to implement changes in interest rates relatively quickly and incrementally, the limited political constraints, the possible conflicts with other objectives of economic policy, time lags, the independence of the central bank, the ineffectiveness of monetary policy in relation to structural unemployment / the natural rate of unemployment, its possible ineffectiveness during a recession, the possibility that alternative policies (e.g. supply-side policy) may be more effective.

Most responses to this question were disappointing in the sense that a certain level of understanding was usually shown but not to the level required to achieve a high mark. The main problem was that, while most candidates understood the concept of aggregate demand and its components, the concepts of wealth and business confidence were usually not well understood. Wealth was commonly equated with income and so an increase in wealth was often simply seen as an increase in disposable income, which would increase AD. Only in relatively few cases was the increase in consumption and thus AD explained in terms of the wealth effect. Business confidence was not well-understood and was often confused with consumers' confidence in business, but candidates did usually make the connection with increased investment and AD, although the reasons given were not always correct and, invariably, no examples were provided. 

Candidates were reasonably successful in explaining the nature of expansionary monetary policy, which seemed to be a concept that is well-understood. Many were able to explain that it involves the lowering of interest rates and other devices as well. However, the mechanisms by which these different aspects of monetary policy would lead to an increase in aggregate demand, greater economic growth and eventually a decrease in the rate of unemployment were often not fully developed. Monetary policy was sometimes evaluated on its own, drawing on a standard set of pre-learned points, but not usually in terms of its effectiveness in specifically lowering the rate of unemployment. Thus, answers given were often too general and generic, without sufficient focus on reducing unemployment.