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9708 · 5.1

Government macroeconomic policy objectives — practice questions

Practice and worked examples for 9708 Government macroeconomic policy objectives. Short previews only — attempt the full question in MarkScheme against the official scheme.

Worked example 1

An economy has a GDP of $500bn. Its potential GDP (Yf) is estimated at $530bn. Current indicators are: unemployment 8%, inflation 6%, and a current account deficit of 20bn.20bn.

(a) Calculate the output gap as a percentage of potential GDP. (b) Given the negative output gap, recommend one fiscal policy and explain a potential conflict. (c) Calculate the current account deficit as a percentage of GDP and explain why the recommended fiscal policy might worsen it.

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(a) Output Gap Calculation

  • Formula: Output Gap = Actual GDP - Potential GDP
  • Calculation: 500bn−500bn - 530bn = -30bn.30bn.
  • As a % of potential GDP: (-30bn/30bn / 530bn) * 100 = -5.66%.
  • This is a negative (recessionary) gap of 5.66%.

(b) Policy Recommendation and Conflict

  • Policy: Expansionary fiscal policy, such as increasing government spending on infrastructure projects.
  • Effect: This directly increases Aggregate Demand (AD), boosting output and reducing cyclical unemployment.
  • Conflict: With inflation already at 6%, this increase in AD is likely to cause further demand-pull inflation, creating a conflict with the price stability objective.

(c) BOP Deficit Calculation & Conflict

  • Calculation: Deficit as % of GDP = (20bn/20bn / 500bn) * 100 = 4.0%.
  • Conflict Explanation: The expansionary fiscal policy will boost incomes. As incomes rise, consumers and firms will spend more on imported goods and services. This increase in import spending (M) will worsen the current account deficit, which is already at a significant 4.0% of GDP. This highlights the conflict between pursuing domestic growth/employment and maintaining a satisfactory balance of payments.

Worked example 2

The Consumer Price Index (CPI) in the country of Econland was 125.0 in 2024 and rose to 132.5 in 2025. The government's inflation target is 2.0%.

(a) Calculate the rate of inflation in Econland for 2025. (b) Based on your calculation, has the government achieved its price stability objective? (c) To combat this inflation, the central bank raises the base interest rate from 3% to 5%. Explain the likely short-run trade-off this creates with another macroeconomic objective.

Show solution outline

(a) Inflation Rate Calculation

  • Formula: Inflation Rate = [(CPI in Year 2 - CPI in Year 1) / CPI in Year 1] * 100
  • Calculation: [(132.5 - 125.0) / 125.0] * 100
  • = (7.5 / 125.0) * 100
  • = 0.06 * 100 = 6.0%
  • The inflation rate for 2025 is 6.0%.

(b) Achievement of Objective

  • The calculated inflation rate of 6.0% is significantly higher than the government's target of 2.0%.
  • Therefore, the government has not achieved its price stability objective.

(c) Policy Trade-off

  • Raising the interest rate is a contractionary monetary policy aimed at reducing inflation.
  • It works by increasing the cost of borrowing and the reward for saving, which reduces consumption (C) and investment (I), thus lowering Aggregate Demand (AD).
  • Trade-off: While this helps control inflation, the fall in AD is likely to slow down economic growth and increase unemployment. Firms may reduce output and lay off workers in response to lower demand. This illustrates the classic short-run trade-off between controlling inflation and maintaining low unemployment/high economic growth (the Phillips Curve relationship).
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