Worked Solutions
Topic 3: Economic Issues — Worked Solutions (HSC Economics)
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Worked examples for HSC Economics Topic 3: Economic Issues. Each shows where the marks are awarded, the key idea, and the full solution explained by your choice of tutor — Stella, Ella or Cassie.
How to use these
Try each question first, then check your working against the model answer. Use the tutor tabs to read the response in the style that suits you: Stella is direct and challenging, Ella is warm and explains the why, and Cassie is concise and analytical. For calculation questions, always show the formula, the substitution and a one-line interpretation — the interpretation often carries a mark.
Example 1 — The expenditure multiplier
Question
In an economy the marginal propensity to consume (MPC) is 0.8. Calculate the value of the simple expenditure multiplier, and determine the change in national income that results from a $5 billion increase in government investment spending. Interpret your result.
Solution
The simple multiplier depends on how much of each extra dollar is spent again. The leakage is the marginal propensity to save, $\text{MPS} = 1 - \text{MPC} = 1 - 0.8 = 0.2$.
$$k = \frac{1}{1 - \text{MPC}} = \frac{1}{\text{MPS}} = \frac{1}{0.2} = 5$$
Now apply it to the injection:
$$\Delta Y = k \times \Delta I = 5 \times \$5\text{b} = \$25\text{ billion}$$
Interpretation: the initial \$5b of spending becomes income for others, who spend 80% of it, and so on. The total rise in national income (\$25b) is five times the initial injection — that's the multiplier effect.
The multiplier captures a simple idea: when someone spends money, it becomes someone else's income, and they spend part of that, and the cycle repeats. The MPC (0.8) tells us 80 cents of every extra dollar gets spent again.
What doesn't get spent leaks out — that's saving. The marginal propensity to save is $\text{MPS} = 1 - \text{MPC} = 1 - 0.8 = 0.2$. The multiplier is one divided by that leakage:
$$k = \frac{1}{1 - \text{MPC}} = \frac{1}{0.2} = 5$$
Now we put the \$5b injection through it:
$$\Delta Y = k \times \Delta I = 5 \times 5 = \$25 \text{ billion}$$
So national income rises by \$25 billion. The why is that successive rounds of re-spending add up: a smaller MPC would mean more leaks out each round and a smaller multiplier, while a larger MPC means more keeps circulating and a bigger multiplier.
Multiplier from MPC:
- $\text{MPS} = 1 - \text{MPC} = 1 - 0.8 = 0.2$
- $k = \dfrac{1}{1 - \text{MPC}} = \dfrac{1}{0.2} = 5$
Apply to injection:
- $\Delta Y = k \times \Delta I = 5 \times \$5\text{b} = \$25\text{b}$
$$\Delta Y = \$25 \text{ billion}$$
Interpretation: the \$5b injection generates a total \$25b rise in national income (5×) through successive rounds of re-spending.
Where the marks go
- 1 mark: Uses the correct multiplier formula $k = 1/(1-\text{MPC})$
- 1 mark: Correctly calculates the multiplier as 5
- 1 mark: Correctly calculates the change in national income as $25b
- 1 mark: Interprets the result (the multiplier effect via successive rounds of re-spending)
Key idea
The multiplier $k = 1/(1-\text{MPC})$; the change in income is $\Delta Y = k \times$ the initial injection.
Example 2 — Inflation and unemployment
Question
Explain how demand-pull inflation can arise, and analyse the effects it may have on unemployment and income distribution.
Solution
How it arises: demand-pull inflation occurs when aggregate demand grows faster than the economy's ability to supply. When the economy is near full capacity, extra spending — from low interest rates, rising confidence, or expansionary fiscal policy — bids up prices rather than lifting real output. "Too much money chasing too few goods."
Effect on unemployment: in the short run, the link can be inverse (the Phillips curve relationship) — strong demand that raises prices also raises output and employment, so unemployment falls as inflation rises. But this is a short-run trade-off; if inflation becomes entrenched, it can force contractionary policy that later raises unemployment.
Effect on income distribution: inflation tends to worsen inequality. It erodes the real value of fixed incomes and savings (hurting pensioners and low-income earners), while those with assets like property or shares, and borrowers on fixed-rate debt, can gain. Wage earners without strong bargaining power fall behind rising prices.
So demand-pull inflation reflects excess demand near capacity; it may lower unemployment in the short run but typically worsens the distribution of income.
Let's begin with the mechanism. "Demand-pull" tells you the cause is on the demand side. When aggregate demand rises faster than aggregate supply — and especially when the economy is already near full capacity — there simply aren't enough goods to go around. Sellers respond by raising prices. The classic phrase is "too much money chasing too few goods." Triggers include low interest rates, rising consumer and business confidence, or government spending increases.
Now, how does this connect to unemployment? In the short run there's often an inverse relationship — the Phillips curve idea. The same strong demand that pushes prices up also pushes firms to produce more and hire more, so unemployment tends to fall as inflation rises. It's important to flag that this is a short-run trade-off, not permanent: if high inflation forces the central bank to tighten policy, unemployment can rise again later.
Then there's income distribution, where inflation usually does harm. People on fixed incomes — pensioners, those on set wages — find their money buys less, and savers see the real value of their savings erode. Meanwhile, owners of assets like property and shares, and borrowers whose real debt burden shrinks, tend to do relatively well. So inflation quietly redistributes from the cash-holders to the asset-holders, widening inequality.
Putting it together: demand-pull inflation comes from excess demand near capacity; it can lower unemployment short-term but tends to worsen how income is shared.
How it arises:
- AD grows faster than AS, especially near full capacity
- "Too much money chasing too few goods"
- Triggers: low rates, high confidence, expansionary fiscal policy
Effect on unemployment:
- Short-run inverse link (Phillips curve): higher demand → higher output/employment → lower unemployment as inflation rises
- Trade-off is short run; entrenched inflation may force tightening that later raises unemployment
Effect on income distribution:
- Erodes real value of fixed incomes and savings → hurts pensioners/low-income earners
- Asset holders (property, shares) and fixed-rate borrowers can gain
- Net: tends to worsen inequality
Conclusion: excess demand near capacity → may lower unemployment short run but worsens distribution.
Where the marks go
- 2 marks: Explains how demand-pull inflation arises (AD outpacing AS near full capacity)
- 2 marks: Analyses the effect on unemployment (short-run inverse Phillips-curve relationship)
- 1 mark: Analyses the effect on income distribution (erodes fixed incomes/savings, tends to worsen inequality)
Key idea
Demand-pull inflation is excess AD near capacity; it can lower unemployment in the short run but typically worsens income distribution.