PRIORITY

Question 1

Disadvantages of inflation (6)

Answer 1

1. Reduction in net export
   - Price competitiveness decreases, demand by other countries decreases, export revenue decreases
2. Menu cost
3. Fiscal drag
   - Income and revenue increases (bonus payouts), push to higher tax brackets, income tax increases
4. Discouragement of investment
   - Unanticipated investment causes uncertainty, firm is unable to plan long term production, hesitate to invest
   - Business confidence decreases, because prices keep changing, cannot make decisions for prices
5. Inflationary noise
   - Confusion over relative prices caused by inflation
   - A rise in the price of a product may not mean that it has become more expensive relative to other products; the product may have risen in price by less than inflation and so may have become cheaper in real terms.
   - Consumers and producers may make wrong decisions
   - e.g. producers increase output because price increases, but price increase is due to inflation, this may cause misallocation of resources (overproduction)
6. Inflation causing inflation
   - Workers demand higher wages, firm rises prices to cover expected higher costs.

Question 2

Advantages of inflation (3)

Answer 2

A low and stable rate of inflation can bring advantages to the economy.\
1. Stimulating output
- Increasing demand may make firms feel optimistic about the future
- Price increase is more than cost increase, profits increase, investment increases

2. Reduce debt burden
   - Real interest rate may fall due to inflation
   - Those who borrowed money to buy a house may experience fall in their mortgage interest payments.
   - Debt decreases, consumption increases, output and employment increases
3. Prevent some unemployment
   - With zero inflation, firms ma have to cut labour force
   - Inflation enables firms to reduce reeal costs of labour either by keeping nominal wages constant or not raising them in line with inflation
   - During inflation, workers with strong bargaining power are likely to resist cuts in real wages.

Question 3

Factors affecting consequences of inflation (5)

Answer 3

1. Cause of inflation
   - Demand-pull inflation: output increases
   - Cost-push inflation: output decreases
2. Rate of inflation
   - High rate causes more damage
3. Accelerating or stable inflation rate
   - Can cause uncertainty, investment decreases
4. Anticipated or unanticipated inflation
   - Unanticipated inflation may cause firms and consumers to delay their investment and consumption
   - If anticipated inflation, can take measures to adapt and avoid harmful effects
5. Inflation rate compared to other countries
   - If inflation rate is below main competitors, goods and services price competitiveness increases

Question 4

How to use fiscal and monetary policy to lower unemployment and its difficulties

Answer 4

• Increase AD
• Monetary: Decrease interest rate, increase money supply
• Fiscal: Decrease indirect taxes, increase government spending
• Difficulties: Higher inflation in short term, could increase national debt

Question 5

How to use fiscal and monetary policy to lower rate of inflation and its difficulties

Answer 5

• Decrease AD
• Monetary: Increase interest rate, decrease money supply
• Fiscal: Increase direct taxes, decrease government spending
• Difficulties: Unemployment increase, output decreases
• Unpopular with voters (people get angry with GOV if interest rate increases)

Question 6

How to use fiscal and monetary policy to solve current account deficit on BOP and its difficulties

Answer 6

• Decrease AD
• Monetary: Increase interest rate
• Fiscal: Increase taxation
• Difficulties: Effectiveness depends on PED for imports and export

Question 7

Give some examples of supply-side policy. (8)

Answer 7

1. Cutting corporate tax
2. Cutting income tax
3. Reduction in welfare payments
4. Increase spending on education and training
5. Increase spending on infrastructure
6. Privatisation
7. Deregulation
8. Subsidies

Question 8

Benefits of free trade (6)

Answer 8

1. Competition created can lower prices and raise quality for consumers
2. Allows people to access great range of products
3. Firms have wider choice of raw materials and may reduce costs of production
4. Firms have larger market, enable them to take greater advantage of economies of scale
5. Allows efficient allocation of resources with countries being able to concentrate on producing products that they have comparative advantage.
6. Allow countries to specialisem increases output, higher employment and ultimately improve living standards.

Question 9

Causes of changes in terms of trade (4)

Answer 9

1. Demand and supply of imports and exports
   - If price of exports increase, ToT improves
2. Price level
   - Inflation increases, export prices higher than import prices, ToT improves
3. Exchange rate
   - Devaluation reduces export price
   - Increases export price competitiveness
   - ToT worsens
4. Prebisch
   - In the long run, price of primary goods decreases in proportion to manufactured goods.
   - ToT moves against primary producing countries
   - Demand for manufactured goods increases more than demand for primary goods when income increases
   - In recent years, relative price of agricultural products decreases, volatility in commodity prices increases

Question 10

Explain favourable and unfavourable rise in ToT

Answer 10

1. Favourable rise in ToT: If price of exports increases because of demand increase, overall export revenue increases (more domestic products sold)
2. Unfavourable rise in ToT: If price of exports increases because cost of production increases, overall expot revenue decreases (demand for country’s products fall)

However, unfavourable rise in ToT may reduce current account deficit. If Marshall-Lerner condition is met, fall in export prices relative to import prices should increase export revenue relative to import expenditure.

Question 11

Impacts of change in terms of trade (4)

Answer 11

1. Living standards
   - When ToT increases, country can buy more imports for any given quantity of exports.
   - When ToT decreases, means more domestic output has to be exported to pay for imports.
2. Impact on BOP
   - If price of exports increase because demand from trading partners increases, exports earnings increases, current account improves
   - If price of exports increases because cost of production increases, exports’ price competitiveness decreases, exports earnings decreases
   - If price of exports decreases because world demand decreases, can lead to current account deficit (export revenue decreases, amount of foreign currency flowing into the country decreases, country;s net exports decreases, current account balance decreases)
   - Changes in import prices can cause improvement or worsening of the current account
3. Impact on inflation
   - If ToT improves due to falling import prices, this could result in lower inflation because domestic producers may have to lower prices to compete with imports
   - If ToT worsens, this could cause rising inflation as workers may seek pay increases due to increasing import prices, leading to an escalation of the wage price ‘spiral’.
4. Impact on growth and employment
   - If ToT improves because export demand increases, growth and employment levels will be maintained or improved.
   - But if ToT improves due to import prices decreasing or price of exports increase due to costs increase, it is likely that growth and employment decreases

Question 12

Causes of current account deficit (4)

Answer 12

1. Growing domestic economy
   - Imported raw materials increases, output increases
   - Likely to be short-term and self-correcting (output increases, exports increases)
2. Declining economic activity in trading partners
   - Trading partners experience economic recession, imports decreases
   - Also known as cyclical deficit
   - Short-term and self-correcting
3. Structural problem
   - Domestic firms are not internationally competitive becaue of overvalued exchange rate, relatively high inflation rate and low labour or capital productivity.
   - Not self-correcting over time
4. For primary-producing countries:
   - They need to import high prices of oil, raw materials and manufactured goods
   - Export primary products: Agricultural where it has to continue to export in large quantity to get high revenue

Question 13

Consequences of current account deficit (3)

Answer 13

1. Country consumes more products than it produces (spend more on imported goods)
   - Country has to finance the deficit by attracting investment into the country or by borrowing
   - This will involve outflow of money in the future in the form of investment income.
2. Reduce AD
   - Demand for domestic currrency decreases, depreciation happens, price of imports increases, price of exports decreases, demand for domestic goods decreases, demand for foreign goods increases
   - Slow down economic growth
   - Causes unemployment
3. Lenders might think borrowers are unable to repay the loan, stop lending

Question 14

Consequences of current account surplus (2)

Answer 14

1. Living standards decreases
   - Demand increases, money supply increases, inflation increases
2. Cause friction between countries
   - Deficit countries put pressure on surplus countries to change its policies

Question 15

Advantages of floating exchange rate (2)

Answer 15

1. Restore balance on current account in BOP
   - If there is current account deficit:
   - Demand for currency decreases, supply of currencyy increases which leads to depreciation
   - Exports become cheaper, imports expensive
   - In the long run, deficit moves towards surplus
2. Governments are assumed not to intervene in foreign exchange markets through their central banks
   - Since GOV has no exchange rate target, it is free to pursue other policy objectives
   - Independence in economic policy making

Question 16

Disadvantages of floating exchange rate (3)

Answer 16

1. Exchange rates may fluctuate greatly
   - Create uncertainty
2. Remove pressure on GOV to maintain price stability
3. No guarantee that floating exchange rate will eliminate current account surplus or deficit
   - If there is speculation that currency will rise in the future, foreign exchange value may still increase in the future

Question 17

Advantages of fixed exchange rate (4)

Answer 17

1. Promote international trade and investment
   - Reduce uncertainty in currency fluctuation
2. Imposes discipline on government to keep inflation low so that a loss of international price competititveness does not put downward pressure on exchange rate
3. Need to keep high reserves
   - There is opportunity cost in keeping reserves, which could be usedd for other purposes
4. Over time, market pressures may push government to set higher fixed exchange rate.

Question 18

Factors underlying changes in exchange rates

Answer 18

1. Change in demand and supply for a currency will cause a change in the price of the currency under floating exchange rate. / put downward or upward pressure on fixed exchange rate.
2. Demand for the currency will rise if export increases.
   - Include foreigners buying share into local firms, invest into local country due to high interest rate or rise in labour productivity, as well as speculation.
3. Increase in supply of the currency will cause a fall in its value.
   - Could due to higher imports, increase in foreign travelling (demand for foreign currency increase, supply of domestic currency decreases), set up firms abroad.
4. Value of fixed or managed floating exchange r ate may change by pressure of market floats.
   - Government may decide to revalue its currency if they think their currency is undervalued, vice versa.
5. Government may change the value to achieve macroeconomic aim.
   - Devalue its currency to increase price competitiveness, improve current account position. (export increases, reduces deficit)

Question 19

Effects of depreciation/devaluation on domestic and external economy (3)

Answer 19

1. Make exports cheaper in terms of foreign currencies
   - Imports become more expensve in terms of domestic currency.
   - This may enable domestic firms to sell more products both at home and abroad.
2. Rise in exports will increase AD
   - As economy approaches full capacity, resources will become increasingly scarce and prices will bid up.
   - Imported products become more expensive and impact consumer price index. (inflation)
   - Cost of production will be pushed up due to higher import raw materials costs. (cost-push inflation)
3. Lower exchange rate will reduce current account deficit.
   - Outcome depends on price elasticities of demand for both exports and imports. (Satisfy Marshall-Lerner condition)
   - In short term, PED for exports and imports is relatively inelastic, causing current deficit to worsen after devaluation.
   - Over time, people will respond to the price changes. (J-curve effect)

Question 20

Effects of appreciation/revaluation on domestic and external economy

Answer 20

1. Makes export more expensive in terms of foreign currencies and imports cheaper in terms of domestic currency.
   - This result faill in demand for domestic demand; lower AD may result rise in unemployment and slowdown in economic growth.
2. Cause a reduction in inflationary pressure if the economy is operating close to or at its maximum capacity.
   - In the absence of rise in exchange rate, AD may increase causing price level to rise.
   - A rise in exchange rate may reduce growth of AD hence inflation rate is lower than it would be.
3. A higher exchange rate may reduce inflationary pressure by shifting the AS curve outward due to lower cost of imported raw materials.
   - Price of imported finished products will fall as well, tehre would be pressure on domestic produced firms to restrict price increase in order to maintain the competitiveness at home and aboard.
4. It may reduce current account surplus and make it replaced by current account deficit.
   - Marshall-Lerner condition and J-curve would work in reverse.
   - Curent account surplus would only be reduced if PED for exports and imports is less than 1. (inelastic)

Question 21

Impact of expenditure-switching policies (2)

Answer 21

1. Fall in import expenditure - fall in supply of country’s currency on forex market
2. Rise in export earnings - rise in demand for country’s currency in forex market

Question 22

Impact of expenditure-dampening policies (2)

Answer 22

1. A reduction in spending will mean that there will be fewer purchases on imported goods and services.
2. Domestic producers will find that their domestic market is dampened. As a result, they will try to offset the decrease in domestic sales with increase in sales abroad.

Overall impact: Fall in imports, rise in exports

Question 23

How to use fiscal policy to correct current account deficit and its limitations.

Answer 23

• Government could raise tax and reduce government spending.
• Rise in income tax reduces disposable income, resulting less income for household to spend on both imports domestically produced products.
• Lower government spending (reduce subsidies to the people) will directly reduce demand for goods and services.
• Fiscal policy measures may change a country’s current position in the short term but are unlikely a long term solution.

Limitations:
- Raising income tax reduces overall demand, discourages supply (lower AS), increase unemployment and slow economic growth.
- Imposing trade restrictions on other countries may provoke retaliation, limit innovativeness on domestic firms to be more efficient.

Question 24

How to use monetary policy to correct current account deficit and its limitations.

Answer 24

• If economy has a low inflation rate and current account deficit, its central bank may reduce the interest rate to put downward pressure on a floating exchange rate.
• A lower exchange rate may result in the country’s produce becoming more price competitive internationally (reducing current account deficit), but there is a risk in generating inflationary pressure.
• A higher interest rate may act as expenditure dampening policy measures, reducing demand for imported goods and reducing inflationary pressure. (Decrease domestic demand)
• It may raise a floating exchange rate that could reverse the fall in demand for imports.
• Government may change its exchange rate as an expenditure switching policy measure.
• If an economy is experiencing current account surplus and has a fixed exchange rate, the government may decide to revalue its currency.
• In recent decades, monetary policy has become more popular because it is independent from any political influences.

Limitations:
- There is a time lag between changing interest rate and full effect being transmitted to the macro economy.
- A rise in interest rate benefits the savers but harms borrowers.
- High cost of borrowing could lead to unemployment and slow down economic growth.
- High interest rates also discourage foreign direct investments as this raises foreign firm’s costs.
- Also, if a country reduces its interest rates noticeably lower than its rival countries, this could create hot money.

Question 25

How to use supply side policy to correct current account deficit.

Answer 25

• Makes domestic products more competitive and more attractive to invest in.