2017 Paper 2 Flashcards
(5 cards)
a) With reference to Figure 1, calculate the percentage change in the value of the euro in pounds from the start of 2009 to the start of 2015. (5)
With reference to the information provided and your own knowledge, examine two factors which might explain the change in the rate of Eurozone inflation as shown in Figure 2. (8)
The rate of Eurozone inflation has fallen from just over 3% in 2011 [Ap] to under 0.25% in 2015 [Ap]. One reason for this fall is a reduction in government spending across the Eurozone [K] which this causes aggregate demand to fall, reducing demand-pull inflation
Another reason may be falling oil prices. This reduces transport costs for many products in the economy, reducing cost-push inflationary pressure [An].
However, Mario Draghi has called for looser fiscal policy among member states’ and oil prices are very volatile so rising demand and costs could mean inflation rises in the future
Since mid-2015 the euro has appreciated.Assess the likely impact of an appreciation of the euro on the current account of the balance of payments for Eurozone countries. (10)
Since mid-2015 the euro has appreciated against the pound from £0.70 to £0.77 [Ap]. One impact will be that the current account of the balance of payments worsens for Eurozone countries [K]. As the euro has risen in value, by “3% against the dollar” [Ap], imports to the Eurozone will be cheaper in euro terms. As the quantity of imports rise, the total value of imports is likely to rise [An]. This leads to greater outflows of money increasing a current account deficit [An] Level 3 KAA
Exports to the UK will become more expensive in sterling. This leads to the quantity of exports falling, reducing the total value of exports [An]. This reduces injections so the current account of the balance of payments worsens for Eurozone countries
However, the effects depend on the price elasticity of demand for imports and exports [E]. The more price elastic they are, the more significant the effects will be [E]. The Marshall-Lerner condition states that an appreciation will lead to a worsening in the current account if the sum of the price elasticities of demand for imports and exports is greater than 1 [E]. The J-curve effect shows that an appreciation may initially improve the current account in the short term while buyers are locked into contracts[E]. However, over time buyers adapt their spending to purchase more imports, so the current account will worsen over time
Discuss the likely success of the ECB’s quantitative easing programme in moving Eurozone inflation closer to ‘the central bank’s ceiling of 2%’ (12)
The ECB’s quantitative easing (QE) programme aims to increase lending by banks [K], boosting consumption and investment, which raises aggregate demand from AD1 to AD2 [An]. This leads to higher economic growth from Yl to Y2 and inflation from PL1 to PL2 [An]. By purchasing €1.1 trillion worth of bonds, the ECB increases the money supply, encouraging lower interest rates and more borrowing [Ap]. As firms and consumers take advantage of cheaper credit, spending rises, pushing inflation closer to the 2% target [An] Level 3
KAA
However, “monetary policy alone could not restore the Eurozone to economic health” [Ap]. Fiscal and supply-side policies can be combined skilfully to counteract the expansionary monetary policy [E]. Many economists have argued that QE has not worked because the money has been held by the High Street banks rather than used for lending
Another way QE could help is through currency depreciation, making
Eurozone exports more competitive
[K]. A weaker euro means that European goods become cheaper abroad, boosting the value of exports and increasing net exports (X-M), which raises AD1 to AD2 [An]. With higher demand for goods and services, firms may increase production and hire more workers, leading to economic growth and rising wages, which further fuels inflation from PL1 to PL2
However, QE may not be enough to restore inflation alone [E]. Inflation remained below 1% in November 2015, even with QE [Ap], suggesting that other factors, such as low oil prices, may have a greater impact on keeping inflation low [E]. If businesses fear weak future demand, they may hoard cash instead of investing, limiting the effectiveness of QE in raising inflation
Discuss‘ looser fiscal
policy and ‘supply-side reforms that may be used by governments of Eurozone countries to increase economic growth. (15)
“Looser fiscal policy” could be used by Eurozone governments to achieve economic growth [K]. The use of government spending, taxation and borrowing can be used to control AD in order to achieve the macroeconomic objectives. A looser fiscal policy would involve increasing AD [K]. Mario Draghi called for looser fiscal policy “to support aggregate demand” to “reap the full benefits” from the expansionary monetary policy he was implementing [Ap]. This could be implemented by member states increasing government spending on public services, which would cause a rise in AD from AD, to AD, [An] with further rounds of spending increasing to AD3 through the multiplier.
Alternatively, cuts to income tax would lead to higher disposable incomes, so consumption would rise, again causing a rise in AD. Cuts to corporation tax would lead to an increase in retained profits, which would also cause a rise in Investment, which would also lead to a rise in AD
However, this leads to a conflict of objectives [E]. Although there is increased growth, which would also reduce cyclical unemployment, it comes at the cost of increased inflation, shown by the rise in price level from PL1 to PL2 [E]. However, this is not a significant concern because inflation was well below target at 0.1% in November 2015 and “predicted to rise by just 1% in 2016 and 1.7% in 2017”
Another policy is “supply-side reforms” that would also increase potential economic growth [K]. Mario Draghi called for “more rapid implementation of supply-side reforms” [Ap] Supply-side reforms aim to boost the productive capacity of the economy, thus causing long-run economic growth [K]. An example of a supply-side reform would be deregulation. By reducing ‘red tape’, or excessive rules and bureaucracy that causes an obstruction to firms, this will increase the productivity of firms and raise the productive capacity of the economy.
This will cause LAS to increase from
LRAS, to LRAS2 [An]. Increased infrastructure spending should allow the economy produce more at Y2
However, whilst free-market economists such as Hayek would favour supply-side reforms that increase the freedom of markets, interventionist economists such as Keynes would prefer supply-side reforms such as infrastructure spending or education spending in order to increase economic growth [E].
In calling for “rapid implementation” of supply-side reforms, it appears that Draghi would favour interventionist reforms [Ap] so that they would have a quicker impact on economic growth.
Free-market reforms would take more time to have a significant impact
