2023 Cambridge IGCSE Economics (0455) Practice Paper with Answers

To calculate the current account balance, we sum the balance of trade in goods, the balance of trade in services, the primary income balance, and the secondary income balance:

1. **Balance of trade in goods** = \(\text{Exports of goods} - \text{Imports of goods} = 120 - 140 = -20\) billion.
2. **Balance of trade in services** = \(\text{Exports of services} - \text{Imports of services} = 80 - 65 = +15\) billion.
3. **Current account balance** = \(\text{Trade in goods balance} + \text{Trade in services balance} + \text{Primary income balance} + \text{Secondary income balance}\)
\(= -20 + 15 + (-15) + 5 = -15\) billion.

Therefore, Country X has a current account deficit of $15 billion (or a balance of -$15 billion).

1 mark for the correct calculation of -$15 billion (accept: -15, -$15bn, or a deficit of $15 billion).

Based on the provided extract, the two methods of trade protectionism mentioned are: 1. Tariffs (used by Country X on imported steel) and 2. Quotas (used by trading partners on Country X's agricultural exports).

Award 1 mark for each correct identification from the extract, up to a maximum of 2 marks. Correct answers: - Tariffs (1 mark) - Quotas (1 mark). Note: Do not accept methods of protectionism not explicitly mentioned in the extract (e.g., subsidies, embargoes).

Higher interest rates increase the cost of loans and credit, while increasing the return on savings. This reduces disposable income for borrowers and encourages households to save rather than spend. Consequently, overall demand in the economy falls, which slows down the rate of price increases.

1 mark for identifying that higher interest rates make borrowing more expensive, saving more attractive, or discourage spending/investment. 1 mark for explaining that this reduction in demand reduces pressure on prices (reducing demand-pull inflation).

The explanation should follow these steps based on the extract: 1. Identify that higher interest rates encourage saving and discourage borrowing. 2. Explain that this reduces consumer spending (consumption) because borrowing is expensive and saving yields higher returns. 3. Explain that investment by firms falls because the cost of borrowing for expansion rises. 4. Conclude that the decline in consumption and investment leads to lower aggregate demand, which reduces demand-pull inflation.

Award 1 mark for each of the following up to a maximum of 4 marks: 1 mark for identifying from the extract that higher interest rates encourage saving or discourage borrowing. 1 mark for explaining that this leads to a reduction in consumer spending / consumption. 1 mark for explaining that higher borrowing costs reduce investment by firms. 1 mark for explaining that the decrease in consumption and/or investment reduces total / aggregate demand, which lowers demand-pull inflation.

1. Draw and label the vertical axis as Price (P) and the horizontal axis as Quantity (Q).
2. Draw a downward-sloping demand curve (D) and an upward-sloping supply curve (S), indicating the initial equilibrium price (\(P_1\)) and quantity (\(Q_1\)) where they intersect.
3. Since lithium is an input, the rise in its price increases the cost of production for electric cars, causing a decrease in supply. Draw a new supply curve shifted to the left (labelled \(S_1\)).
4. Identify the new equilibrium point where D intersects \(S_1\), showing that the equilibrium price has increased to \(P_2\) and the equilibrium quantity has decreased to \(Q_2\).

Award 1 mark for each of the following (up to a maximum of 4 marks):
- Correctly labelled axes (Price and Quantity) and original equilibrium shown (D, S, \(P_1\), \(Q_1\)).
- Shift of the supply curve to the left (labelled \(S_1\)).
- New equilibrium price shown as higher (labelled \(P_2\) or indicating a rise from \(P_1\)).
- New equilibrium quantity shown as lower (labelled \(Q_2\) or indicating a fall from \(Q_1\)).

1. **Identify the relationship (1 mark):** Clearly state that there is an inverse (negative) relationship between the real GDP growth rate and the unemployment rate (as economic growth increases, unemployment falls).
2. **Support with data (up to 3 marks):**
- Identify the extremes: Astoria has the highest GDP growth of \(4.5\%\) and the lowest unemployment of \(3.2\%\) (1 mark).
- Identify the other extreme: Caladon has the lowest GDP growth rate of \(-0.5\%\) (contraction) and the highest unemployment of \(9.8\%\) (1 mark).
- Provide comparative intermediate data: For example, Elysia has a higher growth rate of \(3.5\%\) and lower unemployment rate of \(4.1\%\) compared to Bravia, which has a lower growth rate of \(1.2\%\) and higher unemployment rate of \(7.5\%\) (1 mark).
3. **Provide economic explanation (1 mark):** Explain the economic reasoning: higher real GDP growth indicates expanding national output. To increase production, firms must hire more workers, which reduces the level of unemployment.

**Award up to 5 marks:**
- **1 mark** for identifying that there is an inverse / negative relationship.
- **1 mark** for supporting with Astoria's data (highest growth at \(4.5\%\) and lowest unemployment at \(3.2\%\)).
- **1 mark** for supporting with Caladon's data (lowest growth at \(-0.5\%\) and highest unemployment at \(9.8\%\)).
- **1 mark** for comparing other data points to show the consistent pattern (e.g., Elysia vs. Bravia).
- **1 mark** for providing the underlying economic reasoning (higher growth leads to higher production, requiring firms to hire more labour, which reduces unemployment).

An increase in personal income tax reduces workers' disposable income. This leads to a reduction in consumer expenditure, which is a key component of aggregate demand (AD). As AD falls, the upward pressure on price levels decreases, reducing demand-pull inflation. Additionally, a decrease in consumption may lead to lower imports, improving the trade balance. On the other hand, higher income tax may not reduce inflation if the inflation is caused by rising costs of production (cost-push inflation), such as high raw material costs. Furthermore, workers might demand higher wages to maintain their disposable income, which increases firms' costs of production and leads to cost-push inflation. High taxes can also act as a disincentive to work, causing workers to reduce their hours or leave the workforce, which reduces productive capacity (aggregate supply) and causes prices to rise.

Up to 4 marks for explaining why an increase in personal income tax will reduce inflation: Higher income tax reduces disposable income (1 mark). This leads to lower consumer spending/consumption (1 mark). Aggregate demand (AD) falls (1 mark). This reduces demand-pull inflation/reduces pressure on prices (1 mark). Up to 4 marks for explaining why it might not reduce inflation: It will not solve cost-push inflation/inflation caused by supply-side factors (1 mark). Workers may demand higher wages to compensate for the tax (1 mark), which increases firms' costs of production (1 mark) leading to cost-push inflation (1 mark). High taxes can reduce the incentive to work (1 mark), reducing aggregate supply/output and raising prices (1 mark). Note: Maximum of 4 marks for a one-sided answer.

Imposing tariffs raises the price of imported agricultural goods, making domestic agricultural products relatively cheaper. This increases demand for domestic food, protecting domestic farmers' revenues and preserving agricultural jobs in Country Y. The tariff also generates tax revenue for the government, which can be spent on public services or infrastructure. Additionally, spending on imports decreases, which can improve the current account balance. Conversely, tariffs reduce consumer surplus and lead to higher food prices, disproportionately affecting low-income households who spend a large percentage of their income on food. Domestic agricultural firms may also become inefficient as they are protected from foreign competition. Furthermore, trading partners may retaliate by imposing tariffs on Country Y's exports, hurting other sectors of the economy.

Up to 4 marks for explaining why imposing tariffs will benefit the economy: Tariffs make imported goods more expensive, shifting demand to domestic goods (1 mark). This protects domestic jobs and farm revenues in the agricultural sector (1 mark). The government gains tariff/tax revenue (1 mark). Imports fall, which can improve the current account position (1 mark). Up to 4 marks for explaining why it might not benefit the economy: Consumers face higher prices for food/agricultural products (1 mark), reducing their real incomes (1 mark). Domestic firms face less competition and may become inefficient (1 mark). Foreign partners may retaliate with their own tariffs (1 mark), hurting Country Y's export industries (1 mark). Note: Maximum of 4 marks for a one-sided answer.

An external cost (also known as a negative externality) is a cost incurred by a third party who is not directly involved in the production or consumption of a product. For example, air pollution from a factory affects nearby residents. Formally, External Cost = Social Cost - Private Cost.

1 mark for stating it is a cost or negative impact imposed on third parties (those outside or not involved in the transaction). 1 mark for explaining it is the difference between social cost and private cost, or for providing a valid example (e.g., noise pollution, passive smoking).

Progressive taxation is a method of taxation where the percentage of income paid in tax (the tax rate) increases as the taxpayer's income increases. This shifts the tax burden more towards higher-income earners, helping to reduce income inequality.

1 mark for noting that the rate of tax / percentage of income paid increases. 1 mark for linking this directly to an increase in income / ability to pay. Note: Do not award marks for simply saying the rich pay more cash amount.

Currency depreciation occurs when the value of a currency decreases relative to another currency. This happens within a floating exchange rate system and is caused by market forces, specifically an increase in the supply of the currency or a decrease in its demand on the foreign exchange market.

1 mark for identifying that it is a fall or decrease in the value of a currency. 1 mark for stating that it occurs within a floating exchange rate system or is determined by market forces / demand and supply.

Medium of exchange: Money simplifies trade by eliminating the need for a double coincidence of wants. It is widely accepted as a standard payment for goods and services. For example, a consumer can use a $5 banknote to purchase a coffee. Store of value: Money allows people to save wealth and defer consumption to the future because it generally retains its purchasing power over time (assuming low inflation). For example, an individual can save money in a bank savings account to purchase a car next year.

1 mark for explaining the medium of exchange function (e.g., widely accepted for trade / avoids double coincidence of wants).
1 mark for a valid example of medium of exchange.
1 mark for explaining the store of value function (e.g., retains purchasing power over time / can be saved for future use).
1 mark for a valid example of store of value.

1. Low membership density: If only a small percentage of the firm's workforce belongs to the trade union, the firm can continue to operate and maintain output during industrial action, reducing the union's bargaining leverage. 2. High unemployment in the economy: An excess supply of labor means that there are many unemployed workers willing to accept the existing wage rate. This makes it easy for employers to replace union members, meaning the union cannot credibly threaten the firm with labor shortages.

1 mark for identifying a reason (e.g., low membership density / high unemployment / firm making losses).
1 mark for explaining how this reason reduces bargaining power.
1 mark for identifying a second reason.
1 mark for explaining how this second reason weakens the union's leverage.

An import tariff is a tax levied on foreign goods entering a country. This tax increases the domestic retail price of imported goods, making them more expensive relative to domestically produced alternatives. Consequently, domestic consumers will decrease their demand for imported goods. This causes a decrease in total import expenditure \(M\). Assuming export revenues remain constant, this improvement in the trade balance reduces the current account deficit.

1 mark for defining/explaining that a tariff is a tax on imports.
1 mark for explaining that tariffs increase the price of imported goods.
1 mark for explaining that higher prices reduce the demand/expenditure on imports.
1 mark for linking the reduction in import expenditure to an improvement in the trade balance / current account deficit.

To show how a subsidy reduces market failure:

1. **Diagram**: Draw a demand and supply diagram for bus travel.
- Axis labels: Price on the vertical axis, Quantity on the horizontal axis.
- Draw a downward-sloping demand curve (D) and an upward-sloping supply curve (S).
- Show the initial equilibrium price \(P_1\) and quantity \(Q_1\).
- Shift the supply curve vertically downwards / to the right to \(S_1\) to represent the subsidy.
- Show the new equilibrium price \(P_2\) (lower) and quantity \(Q_2\) (higher).

2. **Analysis**:
- Explain that a subsidy is a financial payment by the government to firms (bus operators) to lower their costs of production.
- Because of lower production costs, firms are willing and able to supply more at any given price, shifting supply from \(S\) to \(S_1\).
- This leads to a lower market price (from \(P_1\) to \(P_2\)) and an increase in the quantity demanded and consumed (from \(Q_1\) to \(Q_2\)).
- Bus travel is a merit good that generates positive externalities (e.g., less traffic congestion, lower air pollution from fewer private cars on the road).
- By increasing the consumption of bus travel towards the socially optimum level, the market failure of underconsumption is reduced.

**Diagram [3 marks]**:
- 1 mark for correctly labeled axes (Price and Quantity) and initial equilibrium (D, S, \(P_1\), \(Q_1\)).
- 1 mark for showing a rightward/downward shift of the supply curve to \(S_1\).
- 1 mark for showing the new lower equilibrium price (\(P_2\)) and higher equilibrium quantity (\(Q_2\)).

**Analysis [3 marks]**:
- 1 mark for explaining that a subsidy reduces the costs of production for bus operators.
- 1 mark for explaining that lower prices encourage consumers to increase their consumption of bus transport.
- 1 mark for linking increased bus usage to a reduction in market failure (e.g., fewer cars, reduced negative externalities like pollution/congestion, or correcting the underconsumption of a merit good).

To analyze this scenario:

1. **Diagram**: Draw a production possibility curve (PPC) diagram.
- Axis labels: Label the axes with two different categories of output, such as 'Consumer Goods' and 'Capital Goods' (or Good X and Good Y).
- Draw an initial downward-sloping, concave PPC (labeled \(PPC_1\)).
- Draw a second curve shifted outwards to the right (labeled \(PPC_2\)).
- Indicate the direction of the shift with an arrow pointing outwards.

2. **Analysis**:
- Labor is a key factor of production. An increase in net migration of skilled workers increases the total size of the workforce (quantity of labor).
- Since the incoming workers are 'skilled', this also improves the average productivity and education level of the workforce (quality of labor).
- An increase in the quantity and quality of factors of production expands the economy's productive capacity (potential output).
- This expansion of potential output causes the PPC to shift outwards to the right, representing long-run economic growth.

**Diagram [3 marks]**:
- 1 mark for correctly labeled axes (e.g., consumer goods/capital goods or Good X/Good Y) and an initial downward-sloping PPC.
- 1 mark for drawing a new PPC to the right of the original one.
- 1 mark for showing a clear outward shift (e.g. arrows, \(PPC_1\) to \(PPC_2\)).

**Analysis [3 marks]**:
- 1 mark for identifying that skilled migration increases the quantity and/or quality of labor (factor of production).
- 1 mark for explaining that this increases the productive capacity/potential output of the economy.
- 1 mark for linking this expansion of capacity to long-run economic growth (the ability to produce more of both goods).

To analyze the effects of a depreciation on the current account:

- Define depreciation as a fall in the value of a currency within a floating exchange rate system.
- **Effect on Exports**:
- When a currency depreciates, foreigners need less of their own currency to purchase the domestic currency.
- This makes domestic exports cheaper in terms of foreign currencies.
- As a result, the competitiveness of exports increases, leading to a rise in the demand for and quantity of exports sold.
- Assuming demand is price-elastic, export revenue (in domestic currency) will increase.
- **Effect on Imports**:
- Conversely, domestic buyers must pay more of their domestic currency to purchase foreign currencies needed for imports.
- This makes imports more expensive in terms of the domestic currency.
- This leads to a decrease in the demand for and quantity of imports.
- Assuming demand is price-elastic, total spending on imports will decrease.
- **Overall Current Account Impact**:
- The current account of the balance of payments records trade in goods and services.
- With export revenue rising and import expenditure falling, the trade balance improves.
- This will reduce a current account deficit or increase a current account surplus.

**Analysis [6 marks]**:
- 1 mark for explaining that depreciation is a decrease in the value of the currency.
- 1 mark for explaining that depreciation makes exports cheaper for foreign consumers.
- 1 mark for explaining that this leads to an increase in export demand / export volume / export revenue.
- 1 mark for explaining that depreciation makes imports more expensive for domestic consumers.
- 1 mark for explaining that this leads to a decrease in import demand / import volume.
- 1 mark for concluding that the improvement in net trade (export revenue > import expenditure) improves the current account position (reducing a deficit or expanding a surplus).

Here is a model response:

**Arguments that a tariff will benefit the economy:**
* **Protection of infant industries:** Emerging industries can be shielded from cheaper foreign competition, allowing them to grow, gain market share, and eventually achieve economies of scale.
* **Employment protection:** Protecting domestic firms from cheap imports can prevent business closures and safeguard jobs in key sectors.
* **Current account improvement:** By making imports more expensive, demand for foreign goods falls, which can reduce a trade deficit.
* **Government revenue:** Tariffs generate tax revenue for the government, which can be reinvested into public infrastructure or education.

**Arguments that a tariff will not benefit the economy:**
* **Higher prices and inflation:** Consumers face higher prices for imported finished goods, and domestic firms face higher costs for imported raw materials, contributing to cost-push inflation.
* **Retaliation:** Trading partners may respond by imposing their own tariffs on the country's exports, leading to trade wars and damaging export-oriented industries.
* **Inefficiency:** Without international competition, domestic firms have less incentive to innovate, reduce costs, or improve quality, leading to long-term economic inefficiency.
* **Reduced consumer choice:** Consumers have access to fewer varieties of goods.

**Conclusion:**
Whether a tariff benefits the economy depends on the duration of the tariff (temporary protection is better than permanent), the risk of retaliation by trading partners, and the specific industries targeted.

**Level 3 (6-8 marks):**
* Analytical discussion of both sides of the issue (benefits and drawbacks of tariffs).
* The response is well-structured, using precise economic terminology.
* A balanced conclusion is reached based on the analysis.

**Level 2 (3-5 marks):**
* Explains one side of the discussion in detail (e.g., only benefits or only drawbacks), OR
* Explains both sides but lacks analytical depth or clear economic reasoning.

**Level 1 (1-2 marks):**
* Simple identification of points (e.g., 'tariffs save jobs' or 'tariffs raise prices') without development.

**Accept/Reject Notes:**
* Accept diagrams (such as a tariff diagram) to support the analysis, though they are not strictly required for maximum marks.
* Reject arguments that discuss quotas or embargoes unless directly compared to the effects of tariffs.

Here is a model response:

**Arguments that spending on education is effective:**
* **Reduces structural unemployment:** Education and retraining schemes equip workers with the skills needed in growing industries (e.g., technology, green energy), reducing occupational immobility.
* **Increases productivity:** A more educated workforce is more productive, lowering average costs for firms and making exports more competitive, which can stimulate economic growth and job creation.
* **Attracts foreign investment:** Multinationals are attracted to countries with highly skilled labour pools, leading to new business setups and employment opportunities.

**Arguments that spending on education is not effective / other policies are better:**
* **Time lags:** It takes many years for education reforms to yield results, meaning it cannot address short-term unemployment crises.
* **Opportunity cost:** Funds spent on education could have been used for direct job creation (e.g., infrastructure projects) or health services.
* **No guarantee of jobs:** High qualifications do not guarantee employment if there is a general lack of aggregate demand in the economy (cyclical unemployment).
* **Alternative policies:** In a recession, demand-side policies (cutting interest rates or reducing taxes) are much faster and more effective at restoring employment levels.

**Conclusion:**
While education is highly effective for reducing structural unemployment in the long term, it must be paired with demand-side policies when unemployment is caused by low demand, making it only part of a comprehensive economic strategy.

**Level 3 (6-8 marks):**
* Balanced discussion of the effectiveness of education spending versus its limitations and alternative policies.
* Demonstrates a clear understanding of different types of unemployment (structural vs. cyclical).
* Coherent structure with logical economic analysis.

**Level 2 (3-5 marks):**
* Good explanation of why education reduces unemployment, with limited discussion of why it may not be effective or alternative policies, OR vice versa.

**Level 1 (1-2 marks):**
* Basic points identified without explanation (e.g., 'education helps people get jobs').

**Accept/Reject Notes:**
* Accept references to other supply-side policies (e.g., deregulation, infrastructure investment) as alternative solutions.
* Reject general discussions on education that do not link back to employment/unemployment.

Here is a model response:

**Arguments in favour of subsidising public transport:**
* **Positive externalities:** Increased public transport usage reduces car traffic, leading to lower congestion, faster travel times for commercial vehicles, and less environmental pollution.
* **Equity and social inclusion:** Low-income earners benefit from cheaper travel, allowing them to access jobs, education, and services further from home, which improves labour mobility.
* **Affordability:** Lowers the cost of living for commuters, leaving them with more disposable income to spend elsewhere in the economy.

**Arguments against subsidising public transport:**
* **Opportunity cost:** Subsidies require significant government expenditure, which could have been allocated to other critical public sectors like hospitals or schools, or used to reduce the national debt.
* **Inefficiency:** Subsidies can make state-owned or private transport monopolies inefficient, as guaranteed funding reduces the incentive to innovate, improve service quality, or manage costs.
* **Inelastic demand:** In some areas, commuters may refuse to switch to public transport regardless of price cuts due to poor route coverage, inconvenience, or unreliability, leading to wasted government expenditure.

**Conclusion:**
Governments should subsidise public transport if the positive external benefits outweigh the financial costs and potential inefficiencies. To ensure success, subsidies should be combined with quality improvements to attract car users.

**Level 3 (6-8 marks):**
* Balanced discussion that evaluates both the benefits (e.g., positive externalities, equity, labour mobility) and drawbacks (e.g., opportunity cost, inefficiency, inelasticity) of public transport subsidies.
* Employs precise economic terms such as market failure, externalities, and opportunity cost.

**Level 2 (3-5 marks):**
* Explains either the benefits of public transport subsidies or the drawbacks in detail, but not both, OR
* Explains both sides in a descriptive manner with limited economic analysis.

**Level 1 (1-2 marks):**
* Outlines basic points (e.g., 'buses will be cheaper' or 'it costs the government money') without further development.

**Accept/Reject Notes:**
* Accept external cost/benefit diagrams to illustrate market failure correction, but they are not mandatory for full marks.
* Do not reward discussions of subsidising private car production.