Demand side policies (HL and SL)

Examination paper 2

This data response paper on demand side policies can be completed as a homework or class work exercise and should be completed in around 105 minutes.  The question and mark scheme is based on the IB approach to setting paper 2 data response questions. The question is based on data and text that the students need to use to answer the different sub-questions.

Canada can't spend its way out of recession, says Fraser report

Trying to kickstart the Canadian economy into recovery from the COVID-19 recession through federal and provincial stimulus spending will fail, warns a new report by the Fraser Institute.

The result will be weak economic growth, rising unemployment levels and substantial increases in already soaring government deficits and debt, thus prolonging the recession, according to the study by the fiscally-conservative think tank,Is Fiscal Stimulus an Effective Policy Response to a Recession?

Study authors Jake Fuss and Tegan Hill say economic research in both Canada and the U.S. indicates stimulus programs to recover from recessions built around such initiatives as subsidizing the construction of new infrastructure projects generate less than $1 of new economic growth for every $1 spent by governments.

By contrast, giving broad-based, long-term tax relief to individuals and businesses generates up to $5 of economic growth for every $1 spent.

“In the coming months, as governments contemplate trying to kickstart the economy with more spending, they should recognize that evidence indicates (stimulus spending) is ineffective and results in more government debt,” said Fuss, potentially making things even worse.

The Fraser Institute study does not classify the $169 billion the Trudeau government is spending on programs like the Canada Emergency Response Benefit, which provides $2,000 a month in income support to people who have lost their employment because of COVID-19, as stimulus spending.

“The federal government’s spending up to this point is largely an emergency response to COVID-19, including income stabilization measures, in an effort to help Canadians who lost jobs or work hours due to the lockdown,” said Hill.

The Fraser Institute’s concern, she said, is that as federal and provincial governments shift their focus from emergency funding to economic recovery, they will turn to inefficient and costly stimulus initiatives.

“Before implementing any fiscal stimulus package,” Hill said, “policy-makers must consider the potential implications on both the economy and government balance sheets, particularly as governments across Canada face large deficits and mounting debt.”

The Fraser Institute study concludes the best way to speed up Canada’s economic recovery coming out of the COVID-19 recession is through deficit-financed, broad-based tax cuts, paid for by reducing government spending over the long term, as opposed to deficit-financed stimulus programs, paid for by increased government spending and higher taxation over the long term.  The institute also states that where increased government is necessary is in supply side policies, leading to ‘increased productivity and increased investment in research and development'. 

“Past history suggests that stimulus (spending) will not improve the Canadian economy and may even be a detriment to it,” the study concludes, while “fiscal stimulus based on tax cuts is ‘much more likely’ to be growth enhancing.”

Parliamentary budget officer Yves Giroux predicted last week the federal deficit this year will hit $256 billion and the worst decline in economic growth since the 1981-1982 recession.

On Wednesday, Fitch Ratings, one of the three major U.S. credit agencies — the others are Moody’s and S&P Global — downgraded Canada’s credit rating from AAA to AA+ because of the amount of new debt the government has taken on to fight the COVID-19 recession.

The rating agency said it still considers Canada’s long-term economic outlook to be “stable.”

Prime Minister Justin Trudeau has promised to give Parliament and Canadians an economic “snapshot” of the country on July 8.

But he has added it won’t be a full budget, or even an economic statement, because there is still too much global uncertainty about the long-term global financial impact of COVID-19.

Original article accessed from the Toronto Sun on 29th December 2020.

Macroeconomic data for Canada (table 1)

GDP $ billionUnemployment %Inflation %Current account $BFiscal balance $B
20191,763.45.52.2-9,697-19.8
2020 (estimate)1,5588.50.9-7,528-256.0

Questions

(a) Define the following words from the passage:

i. Recession (line 1) [2 marks]

Responses should include the notion that a recession consists of a period of declining economic activity for two consecutive 3 month periods.

ii. Unemployment (line 4) [2 marks]

The number of economically active people (sometimes called the labour force or working population) that are without paid employment.  This is usually expressed as a %.  An answer that simply states that it is a member of the population without work should only receive one mark.

(b) i. Calculate the % change in the rate of economic growth and unemployment for Canada in 2020. [3 marks]

GDP fall 11.64%

Unemployment rise 55%

ii. The growth of which type of unemployment is likely to be represented by the rise in the nation's unemployment rate from 5.5 to 8.5%. [2 marks]

Cyclical or demand deficient unemployment.

(c) Explain using an appropriate diagram why the covid-19 pandemic will have caused the Canadian economy to fall into recession. [4 marks]

2 marks for a correctly drawn AD curve showing a left shift in AD, leading to lower average prices and a fall in real economic output, real GDP or national income levels.

2 marks for explaining that this fall in AD and output is caused by a fall in private consumption (C) and investment (I) as confidence collapses to the economy and many workers lose their jobs, reducing their ability to spend.

(d) Provide two reasons why the government deficit might have risen to $256 billion as a result of the economic problems facing the country? [4 marks]

The fall in economic growth will reduce tax revenues paid to the government, through lower sales taxes, corporation and income taxes.

A rise in transfer payments e.g. the income stabilization measures, implemented by the government to help 'Canadians who lost jobs or work hours due to the lockdown'.  Paragraph 7. 

(e) Explain using an AD / AS curve the likely impact of stimulus policies designed to recover from recessions 'built around such initiatives as subsidizing the construction of new infrastructure projects.’ (line 10) [4 marks]

2 marks for a correctly drawn AD curve showing a shift in AD, leading to higher average prices and a rise in real economic output, real GDP or national income levels.

2 marks for explaining that this rise in AD and output is caused by a rise in government spending (G) and likely rises in private consumption (C) and investment (I) as confidence returns to the economy.  Responses may also recognize that the rise in C and I is the result of what Keynesian economists call the multiplier.  

(f) Illustrate using an AD / AS curve the impact of ‘supply side policies’, leading to ‘increased productivity and increased investment in research and development’. (Line 35-36) [4 marks]

2 marks for a correctly drawn AD/AS curve showing a right shift in AS, leading to a rise in real economic output, real GDP or national income levels, but without the inflationary pressures associated with rises in AD.  Candidates that illustrate their responses using a PPF diagram should not be rewarded as the question specifically requests for students to respond using an AS / AD diagram.

2 marks for a definition which states that policies leading to ‘increased productivity and increased investment in research and development’ will increase the productive capacity of the country – improving the quality and number of goods and services produced in the economy.

(g) Using extracts from the passage as well as your knowledge of economics, evaluate the view that the Canadian government cannot spend their way towards economic recovery. [15 marks]

Command term: Evaluate the merits and weaknesses of the decision to adopt fiscal stimulus policies as a way of getting the economy out of recession.  Responses must consider arguments in support of this statement followed by counter arguments, followed by a suitable conclusion based on the evidence provided.

Responses should include some of the following:

Definition of fiscal policy budget deficit, supply side policies.

Candidates should identify at least two arguments in support of this policy as well as two counter arguments.  Arguments in support of this policy include:

Any solution via higher levels of government spending will only be short term.  Long term the economy can only recover by increases in ‘productivity and increased investment in research and development’ (Line 10).

The trickle down effect from government spending is likely to be limited as projects are chosen for their political, rather than economic impacts leading to 'inefficient and costly stimulus initiatives' (line 27).  Evidence for this can also be found in the research within Canada and USA indicating that 'subsidizing the construction of new infrastructure projects generate less than $1 of new economic growth for every $1 spent by governments'. (lines 11-13)

Due to a lack of tax revenues because of declining economic activity any rise in expenditure would have to come from a high budget deficit, i.e. borrowing more money.  Paragraph 9 states that: ‘governments across Canada face large deficits and mounting debt.'  In response to the size of new debt the government has taken on to fight the COVID-19 recession, three major U.S. credit agencies — the others are Moody’s and S&P Global have downgraded Canada’s credit rating from AAA to AA+.  This is likely to lead to higher interest charges in the future.

Fiscal policy may also lead to inflation later on due to cost push and demand pull factors.  The government also needs to consider whether the creation of new public sector jobs will really create new jobs or simply ‘crowd out’ private sector jobs.

On the other hand, arguments against the statement:

An alternative policy outlined in the passage to reduce individual income taxes to raise personal spending may not work due to the insecurity in the jobs market.  Instead consumers may simply save any additional income they receive.  

Monetary policy i.e. reducing interest rates even further is no longer an option as Canada, like many other economies in the Western world, already has near zero interest rates.  

Increased government spending on ‘infrastructure’ as well as offsetting the lack of private spending (C) would also increase AS or the long-term productive capacity in the economy.

Adopting a neo-liberal, laissez faire approach in the form of "automatic stabilisers" will have only a limited effect. At best they will reduce the size of the downturn.  This is because the size of the recession is so deep that it requires more drastic measures.

Responses for question (g) should be graded according to the following markbands:

Marks

Level descriptor

0The response is below the standards described below.

1-3

The response indicates little understanding of the demands of the question

The response uses little relevant theory

Little attempt is made to make use of the text/data.

4-6

The response indicates some understanding of the demands of the question

The response makes limited use of demand side / supply side policies. 

There is limited evaluation contained in the response

The response makes limited use of the text/data to support their arguments.

7-9

The response indicates an understanding of the demands of the question

Some relevant theory is used in the response

The response contains some evaluation

The response makes some use of the text/data.

10-12

The response indicates an understanding of the demands of the question

The response uses relevant theory appropriately

Evaluation is used appropriately

There is appropriate use of the text/data.

13-15

The response indicates an understanding of the demands of the question

The response makes effective use of relevant theory

Evaluation is used effectively

The response makes effective use of the text/data.

The question and markscheme are available as a PDF file at:  Demand side policies  

 Mark scheme demand side policies 

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