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Demand management (demand side policies)—monetary policy Paper 2

IBDP Economics  HL – Macroeconomics – Demand management (demand side policies)—monetary policy -Paper 2 Exam Style Practice Questions

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Demand management (demand side policies)—monetary policy Paper 2? 

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Exam Style Question for IBDP Economics HL- Demand management (demand side policies)—monetary policy -Paper 2

Current account deficit poses a challenge to Pakistan’s economy

  1. The president of Pakistan has expressed his concern at the significant increase in Pakistan’s current account deficit. The current account deficit grew to US$12.12 billion in the fiscal year of 2016/17 compared to US$4.86 billion in 2015/16. The deficit was caused by rising imports and falling exports. The increasing current account deficit may result in Pakistan having to request a new International Monetary Fund (IMF) loan to fund the deficit. To avoid this, the president is proposing that the importing of luxury, non-essential items needs to be reduced.

  2. The governor of Pakistan’s central bank agreed with the president’s concern. He said that the “rapidly growing current account deficit is the biggest challenge facing the country’s economy”. He agreed that the problem is made worse because many non-essential imports are being purchased, which requires borrowing from abroad. However, he stressed that while rising non-essential imports are a problem, “32 % of imports are capital goods” and are necessary for the continued growth of small to medium enterprises (SMEs), agriculture, housing and construction.

  3. Central bank advisors have also recommended depreciating the rupee (Pakistan’s currency) to reduce the trade deficit. The value of the rupee is currently controlled through a managed exchange rate system. It has been suggested that the rupee is overvalued by as much as 20 %. However, the central bank governor claims that a “depreciation has a number of negative effects”.

  4. In 2016, Pakistan’s economic growth reached 5.3 %, its highest point for 10 years. The government has estimated that it will be 6 % in 2017. According to the central bank governor, loans to SMEs are currently only 7 to 8 % of all loans to businesses in Pakistan. He believes that if loans to SMEs were increased to 15 to 17 % of all loans to businesses in Pakistan, there would be even higher economic growth.

  5. Along with the current account deficit, fiscal policy decisions have also led to a significant budget deficit. The budget deficit increased in 2016, resulting in greater public debt. The central bank recommends the government’s debt to be limited to 60 % of gross domestic product (GDP).

Question

List two functions of the central bank (paragraph [2]).

▶️Answer/Explanation
For listing any two of the following:
  • regulator of commercial banks/lender of last resort
  • banker to the government
  • control of interest rates
  • control of money supply
  • implementing monetary policies
  • maintenance of price stability
  • control of exchange rate policy
  • holder of foreign exchange reserves
  • provider and printer of notes and coins
  • maintain low rate of unemployment.

China’s increasing presence in Bolivia

  1. Between 2000 and 2014, annual bilateral trade between China and Bolivia increased dramatically from US$75.3 million to US$2.25 billion. China has become the fifth-largest market for Bolivian exports, which mostly consist of raw materials such as minerals, hydrocarbons, wood and soybeans.

  2. At the same time, China has become Bolivia’s main source of imports. China now supplies half of Bolivia’s clothing, cars, motorcycles, cell phones, computers and other electronics. Bolivia’s expenditure on Chinese imports significantly exceeds the revenue that is received from its exports to China. Since 2014, Bolivia has experienced significant current account deficits with China.

  3. In recent years, the Bolivian government has taken loans from Chinese banks to support the purchase of Chinese imports of goods and services, along with Chinese-built roads, bridges, railways, hydroelectric power plants and mining facilities. In 2015, the Bolivian government owed more than US$600 million to Chinese banks.

  4. The socialist Bolivian government wants to implement an ambitious Five-Year National Development Plan from 2016 to 2020. Faced with sharply declining export revenues and commodity prices, it will rely increasingly on foreign capital to fund its projects.

  5. All projects financed by Chinese loans must be awarded to Chinese companies, which come with their own materials, equipment and technology, and often their own labour. The new loans will have a combination of commercial interest rates, between 2.5 % and 4 %, and concessional interest rates, up to 1 %. The Bolivian government is expecting to be able to repay the loans through continued growth of the economy.

  6. China’s foreign direct investment (FDI) is mostly being aimed at energy and infrastructure development. Chinese firms are currently involved in major road-building projects, hydroelectric power station projects, expanding airports and developing a steel-producing plant. These projects have created problems for local communities in terms of water contamination and the overuse of Bolivia’s scarce water supply.

  7. This FDI strategy generates profits for Chinese firms in the short term, as they build and improve the infrastructure. Since Bolivia is a resource-rich country, Chinese firms will be looking to invest in profitable mining projects in the future, once the infrastructure is in place.

Question

Define the term interest rates indicated in bold in the text (paragraph [5]).

▶️Answer/Explanation
An explanation that it is one of the following:
  • the price or cost of borrowed money (credit)
  • the reward for saving
  • the percentage paid on borrowed (or saved) money.

The World Bank reports on economic growth in Kenya

  1. The World Bank’s recent overview of Kenya has given a positive assessment of Kenya’s growth prospects, based on domestic and international factors. The East African nation of Kenya has a population of approximately 46.1 million, which increases by an estimated one million per year. The World Bank projected 5.9 % economic growth in 2016, rising to 6 % in 2017. This positive outlook is based on continued low oil prices, growth in the agricultural sector, expansionary monetary policy and ongoing infrastructure investments.

  2. The World Bank has identified other key contributing factors to Kenya’s short-term growth. These include an expanding services sector, higher levels of construction, currency stability, low inflation, a growing middle-class and rising incomes, a surge in remittances (money sent by a foreign worker to their home country) and increased public investment in energy and transportation.

  3. Tourism, information and communications and public administration are among the sectors that have registered the highest growth. Inflation has been at an average of 6.3 %, which is within the Kenyan central bank’s target range.

  4. The World Bank also predicted that, of 82 countries investigated, Kenya would have the highest long-term growth and that its real gross domestic product (GDP) in 2050 should be seven times larger than it is today. Fast population growth, a modest improvement in the business environment, urbanization and fast-growing neighbouring countries are all contributing factors to the positive prediction.

  5. While the growing Kenyan economy is creating more jobs now than in the past, these are mainly in the informal services sector and are low productivity jobs. 9 million young people will join the labour market in the next 10 years. Given the scarcity of formal sector jobs, they will continue to find jobs in the informal sector. These jobs are usually in very small businesses, often run from homes.

  6. The World Bank suggests that there is a need to increase the productivity of jobs in the informal sector. It says that this could be achieved by increasing work-related skills through training schemes, increasing communication and learning between formal and informal firms, and helping small-scale firms to become suppliers for firms in the formal sector. To create more and higher-skilled jobs, it is also essential to reduce the cost of doing business.

  7. According to the World Bank, Kenya has made significant structural and economic reforms that have contributed to sustained economic growth in the past decade. However, economic growth does not always mean economic development. The main development challenges facing Kenya include poverty, inequality, climate change, low commodity prices and the vulnerability of the economy to internal and external shocks.

Question

Using an AD/AS diagram, explain how expansionary monetary policy might lead to economic growth (paragraph [1]).

▶️Answer/Explanation
An AD/AS diagram showing a shift of the AD curve to the right and an increase in the level of national income AND an explanation that an expansionary monetary policy (reduction in interest rates) will increase consumption/investment increasing AD. This leads to an increase in real GDP, and thus economic growth.

Text A — Overview of Vietnam

  1. Economic reforms in Vietnam during the past 30 years have led to rapid economic growth, which has transformed a poor nation into a lower middle-income economy. The percentage of the population with an income of less than US$1.90 a day declined from 38 % in 2002 to below 2 % in 2018.

  2. Vietnam used to be a food-insecure nation, in which many people sometimes lacked access to affordable food, but it is now a leading exporter of basic food commodities. It also aims to become an exporter of high quality and processed food products. However, agricultural production only accounts for 18 % of gross domestic product (GDP), although it uses 40 % of the land and employs 43 % of the labour force. Due to the growing rural population, land is often divided up between a greater number of farmers, causing some farms to become smaller. These farms have fewer opportunities to benefit from economies of scale and lower average costs of production.

  3. Vietnam’s rapid growth and industrialization, focused on export-oriented manufacturing, have had a harmful impact on the environment. Electricity consumption has tripled since 2010, growing faster than GDP. Electricity generation, which mainly uses fossil fuels, accounts for approximately 60 % of Vietnam’s carbon emissions. Demand for water continues to increase. Unsustainable exploitation of natural resources, such as land, fisheries, and timber, could negatively affect prospects for long-term growth. In addition, Vietnam’s primary sector is highly vulnerable to the climate and is therefore subject to supply shocks.

  4. Vietnam has signed several free trade agreements (FTAs). Its first FTA was a partnership with Japan in 2008. Both Vietnam and Japan are members of the Comprehensive and Progressive Agreement for Trans-Pacific Partnership (CPTPP), which took effect at the beginning of 2019. These FTAs also promote inward foreign direct investment (FDI). In addition, Vietnam has introduced policies to attract foreign investment, such as tax incentives and spending on infrastructure.

  5. Japan is the biggest provider of foreign aid to Vietnam and the largest source of FDI. Japanese firms and aid agencies are jointly financing large-scale projects, including port infrastructure and a high-speed railway, which will reduce the Hanoi to Ho Chi Minh journey time from about 35 hours to under six hours. Other Japanese-funded aid projects are in the areas of health care, education, and the environment.

Text B — Trade and investment flows between Vietnam and Japan

  1. Japan imports seafood and consumer products such as textiles, leather shoes and processed foods from Vietnam, because Vietnam has a comparative advantage in such items. Conversely, Vietnam imports machinery, technology, and raw materials for production from Japan. Gradually barriers to trade are being removed. In 2020, Vietnam began exporting lychees (a luxury fruit) to Japan after five years of negotiations on quality standards. The improved access to the Japanese market has increased the number of consumers and the revenue earned by Vietnamese lychee farmers.

  2. Japanese firms invest in Vietnam, particularly in urban areas, because wages are low and they can export from Vietnam to other CPTPP members and to China and Indonesia. Panasonic, a Japanese multinational company (MNC), relocated a major factory, which manufactures refrigerators and washing machines, from Thailand to Vietnam in 2020. The construction of a coal-fired power plant is mainly funded by Japanese firms. The Japanese government is promoting further investment by subsidizing over 30 firms that are relocating from China to Vietnam. Most of these firms are food processors or producers of manufactured goods (for example, medical equipment).

Text C — Roles of the central bank in Vietnam

  1. The central bank in Vietnam has been lowering interest rates since mid-2019. However, it has kept the minimum reserve requirement at 3 % of commercial bank deposits, despite suggestions that this requirement could be lowered.

  2. The central bank also regulates the exchange rate of the dong (Vietnam’s currency). It actively intervenes in the foreign exchange market to stabilize the rate when necessary. In April 2020, there was downward pressure on the dong due to the lower interest rates and fewer foreign tourists. However, the central bank has a large amount of reserve assets, which were used to prevent the dong from depreciating.

Question

Using a demand and supply of money diagram, explain the likely effect on interest rates of a reduction in the minimum reserve requirement for banks (Text C, paragraph [1]).

▶️Answer/Explanation

For a money demand and supply diagram, with a vertical money supply line shifting to the right  leading to a reduction in the interest rate  AND for an explanation that a reduction in the minimum reserve requirement will allow banks to lend more  which will increase the money supply and thus reduce interest rates .

Trade war with the United States puts pressure on China’s currency

  1. As a trade war between the United States (US) and China worsens, a central bank official has said that China will not use its currency to deal with trade conflicts and will continue with the market-based reforms of its exchange rate system. In the past, the US has accused China of being a currency manipulator that has maintained a fixed exchange rate to keep the renminbi (RMB, China’s currency) undervalued. According to a US trade official, “a depreciating currency is good for the Chinese economy”.

  2. The value of the renminbi has fallen 9 % against the US dollar (US$) in the past six months. Expansionary domestic monetary policy, concerns about economic growth and an escalating trade war continue to put downward pressure on the renminbi. Allowing the value of the renminbi to fall suggests that the central bank is currently maintaining a managed exchange rate rather than a fixed peg to the US dollar.

  3. The cause of the lower value of the renminbi—aside from a slowdown in Chinese economic growth—is a shrinking current account surplus. The US has imposed tariffs on US$250 billion worth of Chinese imports. The US president has also threatened to impose tariffs on the remaining imports from China. This, along with a widening trade deficit in services, caused mainly by the rise in Chinese tourists travelling abroad, would further reduce China’s current account surplus. In 2017, China’s current account surplus was 1.6 % of gross domestic product (GDP). By the first quarter of 2018, the surplus became a small deficit.

  4. There is international concern about the potential damage that a prolonged trade war with the US could cause to the Chinese economy. Central bank officials in China are concerned about the depreciating currency but are trying to avoid central bank intervention. To support the export sector, the Chinese government is considering measures such as subsidies and exemptions from some indirect taxes. These measures, along with a falling renminbi will allow Chinese exporters to avoid passing on some of the tariff costs to US consumers.

  5. To complicate matters for China, economic growth in the US is causing US interest rates to rise and the US dollar to strengthen. This, along with China’s first current account deficit in 20 years, is negatively affecting China’s financial account. Responding to the rising US interest rates with increases of its own is not a good option for China’s central bank, because Chinese companies have a heavy debt burden that is slowing economic growth. Recently, a government official advised against increasing China’s interest rate because of its impact on borrowing costs in China.

Question

Define the term monetary policy indicated in bold in the text (paragraph [2]).

▶️Answer/Explanation
An explanation that it is any two of the following:
  • demand-side policy
  • changes in interest rates
  • changes in money supply
  • changes in quantitative easing.
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