2.6.2 Policy Instruments — Practice Questions

Seven original multiple-choice questions on policy instruments: how fiscal policy, monetary policy, supply-side policies and a floating exchange rate work, and their impact on firms and other economic agents. One is a calculation.

7 questions Edexcel B A-Level Multiple choice Model answers included

Not read the notes yet? Start with the 2.6.2 Policy Instruments revision notes.

1. 1. The government announces a large rise in its spending on upgrading railway lines and stations. Table 1 describes four UK firms.
   Using Table 1, the firm most likely to see the earliest and largest rise in its orders is

   Data interpretation

   Table 1: Four UK firms

   	What it sells	Its main customers
   Firm 1	Coach travel between cities	Travellers who could take the train instead
   Firm 2	Kitchen appliances	Households across the UK
   Firm 3	Steel rails and signalling equipment	Contractors who build and repair railways
   Firm 4	Accounting software	Small firms across the UK

   Select one answer

   A Firm 1.

   B Firm 2.

   C Firm 3.

   D Firm 4.
   Show model answer

   Answer: C (Firm 3.). Higher government spending is expansionary fiscal policy. Its first effect falls on the firms the government's money is spent with.
   Spending on railways → contracts for the builders → orders for their suppliers of rails and signalling equipment → more output and more jobs at Firm 3.
   Other firms gain only later, and by less, as the extra income is spent across the economy.

   Why the other options are wrong

   • A — Coach travel competes with rail. Once the upgrades are finished, better trains are more likely to take passengers from the coach firm than to bring it orders.
   • B — Households may spend a little more as the railway workers' pay is spent. But that effect comes later and is spread thinly across every shop and product.
   • D — Small firms may buy a little more as the extra spending works through the economy. That is an indirect effect, smaller and slower than the direct one at Firm 3.

2. 2. The government offers manufacturers a grant covering 30% of the cost of new, more productive machinery. This counts as a supply-side policy, not only as fiscal policy, because it

   Definition in context

   Select one answer

   A Lowers interest rates, so firms can borrow cheaply.

   B Lowers the cost of investing, so capacity grows.

   C Makes imports dearer, so UK firms win more sales.

   D Reduces government spending, so taxes can fall.
   Show model answer

   Answer: B (Lowers the cost of investing, so capacity grows.). A supply-side policy raises the economy's capacity to produce.
   The grant pays part of the cost of the machinery → investing costs firms less → more firms buy the machines → output per worker rises and the economy can produce more.
   That effect on capacity is what makes it supply-side.

   Why the other options are wrong

   • A — Interest rates are set by the Bank of England through monetary policy. A grant from the government leaves them unchanged.
   • C — A grant does not change the price of imports. That would need a tariff, which is a different policy altogether.
   • D — A grant adds to government spending; it does not reduce it. That extra spending is the fiscal side of the policy. What makes it supply-side is its effect on the economy's capacity, not on the size of the budget.

3. 3. A brewery makes £800,000 a year in profit before tax. The government cuts the rate of corporation tax from 25% to 20%, and the brewery's profit before tax stays the same. To one decimal place, its profit after tax rises by

   Calculation

   Select one answer

   A 5.0%

   B 6.3%

   C 6.7%

   D 20.0%
   Show model answer

   Answer: C (6.7%). Profit after tax before the cut: £800,000 × (100% − 25%) = £600,000.
   Profit after tax after the cut: £800,000 × (100% − 20%) = £640,000.
   Change: £640,000 − £600,000 = £40,000.
   Percentage change, measured against the original value: £40,000 ÷ £600,000 × 100 = 6.67% = 6.7%.
   This is the profit the brewery keeps, and so has available to invest.

   Why the other options are wrong

   • A — This is the cut in the tax rate, in percentage points: 25 − 20 = 5. The question asks for the percentage change in profit after tax, which needs the money figures.
   • B — This divides by the new value: £40,000 ÷ £640,000 = 6.25%. A percentage change is measured against the original value, £600,000.
   • D — This is the fall in the brewery's tax bill: from £200,000 to £160,000, which is 20%. The question asks about the profit it keeps after tax, not the tax it pays.

4. 4. A UK maker of machine tools has no borrowing and £2 million in the bank. It sells most of its output abroad, at prices set in pounds. The Bank of England raises Bank Rate by one percentage point. The most likely effects on the firm are

   Applied reasoning

   Select one answer

   A Higher interest income, and more export orders.

   B Higher interest income, and fewer export orders.

   C Lower interest income, and more export orders.

   D Lower interest income, and fewer export orders.
   Show model answer

   Answer: B (Higher interest income, and fewer export orders.). Rates on savings follow Bank Rate, so the firm's £2 million earns more interest. With no borrowing, it pays no extra interest on loans. It gains on this side.
   Higher UK rates attract savings from abroad → the pound tends to rise → each machine priced in pounds costs more in foreign currency → foreign buyers order fewer. It loses on this side.
   The same rate rise helps the firm in one way and hurts it in another.

   Why the other options are wrong

   • A — This misses the effect through the exchange rate. Higher rates tend to push the pound up, which makes the firm's machines dearer for foreign buyers.
   • C — Both effects are reversed. Savings rates rise with Bank Rate, and a stronger pound makes UK exports dearer abroad.
   • D — The export side is right, but rates on savings rise with Bank Rate, so a firm with cash in the bank earns more interest, not less.

5. 5. A café chain's bank lends to it at 4 percentage points above Bank Rate. Bank Rate then rises from 3% to 5%. Table 1 shows four projects the chain could pay for with a loan, and the yearly return each is expected to earn on its cost. A project is worth borrowing for only if its expected return is higher than the interest rate on the loan.
   Using Table 1, the number of projects still worth borrowing for is

   Data interpretation

   Table 1: The café chain's possible projects

   Project	Expected yearly return
   Refitting three cafés	8%
   A delivery app	4%
   A new roastery	10%
   New coffee machines	6%

   Select one answer

   A 1

   B 2

   C 3

   D 4
   Show model answer

   Answer: A (1). The chain pays 4 percentage points above Bank Rate.
   After the rise, its loan rate is 5% + 4 = 9%.
   Only the roastery, at 10%, earns more than 9%. So 1 project is still worth borrowing for.
   Before the rise the loan rate was 7%, and two projects passed. Higher interest rates mean fewer projects are worth borrowing for, which is how a rise in Bank Rate cuts investment.

   Why the other options are wrong

   • B — This uses the old loan rate, 3% + 4 = 7%, which the roastery and the refit both beat. After the rise, the loan costs 9%.
   • C — This compares the returns with the new Bank Rate, 5%. The chain does not borrow at Bank Rate; it pays 4 percentage points above it.
   • D — This compares the returns with the old Bank Rate, 3%. That ignores both the rise and the 4 points the bank adds on top.

6. 6. The UK's spending on imports rises well above its earnings from exports. The pound floats, and neither the government nor the Bank of England acts. Sketching the market for pounds, the most likely result is that the pound

   Applied reasoning Sketch to solve

   Select one answer

   A Falls, making UK exports cheaper abroad.

   B Rises, making imports cheaper in the UK.

   C Rises, making UK exports dearer abroad.

   D Stays steady, as no one intervenes.
   Show model answer

   Answer: A (Falls, making UK exports cheaper abroad.). To buy imports, UK buyers sell pounds for foreign currency. Spending on imports rising above export earnings means more pounds are being sold than foreign buyers want to buy.
   On the sketch, the supply of pounds shifts right → the price of the pound falls.
   A cheaper pound makes UK exports cheaper abroad and imports dearer in the UK, so the gap between them narrows. Under a floating exchange rate, this adjustment happens with no action from the government or the Bank.

   Why the other options are wrong

   • B — A rising pound would make imports cheaper, but the pound does not rise here. Spending on imports above export earnings means more pounds are sold than foreign buyers want, so the pound falls.
   • C — A rising pound would make UK exports dearer abroad, but here more pounds are sold than foreign buyers want to buy, so the pound falls, not rises.
   • D — Under a floating rate, no one needs to intervene for the pound to move. More pounds are sold than foreign buyers want, so the market pushes the pound down.

7. 7. To help firms fill their vacancies, a government cuts the benefits paid to people who are out of work. The policy is least likely to raise employment in a town where

   Applied reasoning

   Select one answer

   A Firms have many vacancies that the unemployed could fill.

   B Many jobs on offer pay only a little more than benefits.

   C Most of the unemployed live close to the firms hiring.

   D The few vacancies need skills that the unemployed lack.
   Show model answer

   Answer: D (The few vacancies need skills that the unemployed lack.). Cutting benefits works on the people looking for work: a bigger gap between income in and out of work → more people look for jobs → firms find it easier to recruit.
   That raises employment only if there are jobs the unemployed can do. Where vacancies are few and need skills the unemployed lack, looking harder creates no jobs and no skills → employment barely rises → the unemployed are simply left poorer.
   Training, not a benefit cut, tackles that kind of mismatch.

   Why the other options are wrong

   • A — This is where the policy works best. The jobs exist and the unemployed could do them, so a bigger gap between income in and out of work pushes more people to take them.
   • B — This is the case the policy is aimed at. When a job pays little more than benefits, cutting benefits makes working clearly pay, so more people take the jobs.
   • C — Living near the firms that are hiring means nothing stops the unemployed taking those jobs once looking for work pays more. The policy can work here.