3.2 Aggregate demand and aggregate supply questions for IB Economics

Using the circular flow of income model, explain how changes in leakages and injections affect the level of national income.

Using real-world examples, discuss the effectiveness of expansionary fiscal policy in reducing unemployment.

Define the term capital indicated in bold in the text (Text A, paragraph 1).

Using information from Text A, paragraph 2, calculate the percentage change in Velmaris's real GDP between 2023 and 2024.

Sketch a production possibilities curve (PPC) diagram to show the effect of the destruction of capital on Velmaris's production possibilities (Text A, paragraph 1).

Using a PPC diagram, explain how hiring workers who lost their jobs to rebuild roads and power lines could lead to actual growth in Velmaris (Text A, paragraphs 2 and 3).

Using an AD/AS diagram, explain the likely effect of the earthquake on Velmaris's real GDP (Text A, paragraphs 1 and 2).

Using Table 1, calculate the percentage change in the power sector's actual emissions between 2021 and 2025.

Using Table 1, calculate the government's revenue from auctioning permits in 2025.

Using Table 1, outline why the permit price was low in 2021.

Two generating firms, A and B, each emit 10 million tonnes of CO₂ a year. The government wants their combined emissions to fall by 6 million tonnes. Firm A can cut up to 8 million tonnes of emissions at a constant cost of US$20 per tonne. Firm B can cut emissions at a constant cost of US$60 per tonne.

Calculate the total cost of the reduction if a regulation requires each firm to cut its emissions by 3 million tonnes.

Show that, if the firms can trade permits, the reduction of 6 million tonnes can be achieved at a total cost of US$120 million.

Firm B buys 3 million permits from Firm A at US$40 per permit. Calculate the net gain to each firm compared with the regulation in part (a)(iv).

Using a diagram of the market for permits, explain why the permit price might fall during an economic recession.

Explain two reasons why Castellan's cap-and-trade scheme may not lead to an equal fall in global CO₂ emissions.

Further information on policy options

• Coal generates 58 % of Castellan's electricity and renewable sources 24 %. Household electricity prices rose by 9 % between 2021 and 2025.

• The cap could be reduced by 6 % a year instead of the current 4 %. Generators warn that this would raise electricity prices further.

• All permits could be auctioned instead of 40 %. This would raise more revenue, but generators that received free permits would lose a valuable asset.

• A minimum (floor) price of US$30 per permit would protect the incentive to invest during recessions.

• The scheme could be replaced by a carbon tax of US$35 per tonne.

• Subsidies for wind and solar generation would cost about US$800 million a year.

• Two neighbouring countries supply electricity to Castellan through cross-border power lines and have no carbon price.

Using the information provided and your knowledge of economics, recommend a policy the government of Castellan could introduce to reduce CO₂ emissions from its power sector.

Explain how the financial sector and the foreign sector create interdependence between decision-makers in the circular flow of income.

Using real-world examples, discuss the effectiveness of lower interest rates in increasing investment and real GDP.

Define the term factors of production indicated in bold in the text (Text A, paragraph 2).

Using information from Text A, paragraph 2, calculate the percentage increase in Varrenland's labour force between 2022 and 2025.

Sketch a production possibilities curve (PPC) diagram to show the effect of the larger labour force on Varrenland's production possibilities (Text A, paragraph 2).

Using a PPC diagram, explain why Varrenland's actual output may not rise as much as its production possibilities (Text A, paragraph 3).

Using an AD/AS diagram, explain how the increase in the labour force could help to reduce labour shortages without causing inflation (Text A, paragraphs 1 and 2).

Using Table 1, calculate the change in government debt as a percentage of GDP between 2024 and 2025, in percentage points.

Using Table 1, calculate the cost of the bank rescue as a percentage of GDP in 2025.

Calculate the cost of the bank rescue per person in Country X.

Using Table 1, calculate the real interest rate in Country X in 2025.

Define the term moral hazard.

Using the information provided, explain two reasons why the rescue of Arvel Bank and Tremont Bank may increase risk-taking in Country X's banking sector in the future.

After the crisis, investment in Country X is expected to fall by US$6 billion. The marginal propensity to save is 0.08, the marginal rate of taxation is 0.20 and the marginal propensity to import is 0.12.

Calculate the maximum change in real GDP that could result from the fall in investment.

Using an AD/AS diagram, explain the likely effect of the fall in investment on real GDP and unemployment in Country X.

Outline how requiring part of bankers' bonuses to be paid several years later, and to be cancelled if losses occur, could reduce moral hazard.

The financial regulator of Country X is considering the following measures:

• Higher capital requirements: large banks would have to hold capital (shareholders' funds) equal to 13 % of their risk-weighted assets instead of 8 %; banks warn that lending to small firms could fall by up to 6 %.

• Bail-in rules: in any future failure, the banks' bondholders and large depositors (above US$100 000) would bear losses before any taxpayer money is used; critics say a government may not keep this promise in a crisis.

• Limits on property lending: loans to property developers could not exceed 15 % of a bank's total lending; Arvel Bank's share reached 34 % in 2023.

• Bonus rules: at least half of senior managers' bonuses would be deferred for five years and could be cancelled if losses occur; senior staff might move to banks in other countries.

• Breaking up the largest banks: each would be split into two or more smaller banks; this would take several years and could raise banks' costs.

Using the information provided and your knowledge of economics, recommend a policy that the financial regulator of Country X could introduce to reduce moral hazard in the banking sector.