Explain how in the Keynesian AD/AS model an economy can be in equilibrium while producing below the full employment level of output.

Evaluate the view that fiscal policy is the best way to reduce unemployment.

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

Answers may include:

• definitions of equilibrium, full employment level of output
• diagram to show the Keynesian model of an economy at equilibrium income below the full employment level of output
• explanation of how an economy can be in equilibrium income below full employment when AD falls, leading to a deflationary gap when wage and price rigidity keep the economy below the full employment level of output
• examples of when economies have experienced equilibrium income below the full employment level of output.

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

Answers may include:

• definitions of fiscal policy, unemployment
• diagram to show how fiscal policy leads to a fall in unemployment
• explanation of how expansionary fiscal policy leads to a rise in AD and real GDP, leading to a fall in unemployment as more workers are needed in production
• examples of where fiscal policy has been used to reduce unemployment
• synthesis or evaluation.

Evaluation may include: consideration of the problems of using fiscal policy to reduce unemployment such as; budget deficit, inflation and it is not as effective at reducing unemployment that is not demand-deficient (structural, frictional). There could also be coverage of alternative policies such as monetary and supply side.

A maximum of [12] should be awarded if a candidate has not considered an alternative policy.

The responses to this question were mixed in terms in terms of the standard. The best answers clearly focused on the reason why equilibrium national income can exist below full employment in the Keynesian model by focusing on the argument that wages and costs do not fall when the economy is operating below full employment. A common mistake was for students to simply explain equilibrium income below full employment without explaining why the equilibrium would stay at this level and not adjust back to full employment. Very good answers were supported by an effective real-world example.

There were some very good answers to this question. The best responses focused on how expansionary fiscal policy reduces demand deficient unemployment as aggregate demand increases when tax is reduced, and government expenditure is increased. Good responses would go on to evaluate the use of fiscal policy by discussing issues such as increasing inflation, the cost of financing the policy, and fiscal policy is not particularly effective at reducing frictional and structural unemployment. The highest-level responses would use effective real-world examples to support the points being made.