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Demand management—fiscal policy Paper 2

IBDP Economics  HL – Macroeconomics – Demand management—fiscal policy -Paper 2 Exam Style Practice Questions

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Demand management—fiscal policy Paper 2? 

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Exam Style Question for IBDP Economics HL- Demand management—fiscal 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

Define the term fiscal policy indicated in bold in the text (paragraph [5]).

▶️Answer/Explanation
For any two of the following:
  •  a demand-side policy (conducted by the government) 
  • using changes in government expenditure (spending) 
  • using changes in taxation
  • used to achieve economic objectives relating to inflation, unemployment and long-term economic growth.

South Korea’s current account surplus

  1. South Korea, Asia’s fourth-largest economy, has experienced a current account surplus since 2012. South Korea’s large working-age population, which tends to save a large portion of its income for retirement, contributes to the surplus. The South Korean government has expressed concerns about the impact of the high savings on domestic demand and the level of imports. However, it has been predicted that as the population ages the surplus will gradually disappear by 2042.

  2. The South Korean won (South Korea’s currency) recorded the second highest appreciation against the United States dollar (US$) in 2017 among currencies of the G20* nations. The current account surplus, the improved economic conditions and the expectations of an interest rate rise have all helped increase the South Korean won’s value.

  3. The South Korean won officially operates under a floating exchange rate system, but the central bank would intervene if there were major fluctuations in the market that needed to be managed. The US is monitoring the exchange rate policy of South Korea due to the significant trade imbalance between the two countries. If the US identifies that a major trading partner like South Korea tries to limit an appreciation of its currency, then the US may consider tariffs to reduce the imbalance.

  4. South Korea’s financial account in the balance of payments recorded a deficit of US$13 billion in 2018, as Koreans have invested extensively in other countries. Furthermore, foreigners have been reluctant to invest in South Korea due to the trade disputes and the potential of a trade war erupting between the US and China. The US and China are South Korea’s largest trading partners, and South Korea, with its export oriented economy (exports amount to 43 % of gross domestic product [GDP]), is sensitive to external demand shocks.

  5. South Korea’s domestic investment in key areas (such as manufacturing, construction and machinery) fell during 2018, and GDP grew by less than expected. Additionally, private consumption increased only by 0.3 % in 2018, the slowest growth for 4 years. There is also concern about the level of unemployment, especially the high rates of youth unemployment.

  6. Normally, in a situation of low growth, the central bank would implement expansionary monetary policy. However, the US Federal Reserve (the central bank of the US) and the European central bank are considering monetary tightening. If the South Korean central bank does not raise interest rates in line with the US and the European Union it runs the risk that the South Korean won may depreciate. Therefore, the South Korean government has begun discussions on using fiscal policy to help revive the job market and support domestic demand.

Question

Using an AD/AS diagram, explain how the use of fiscal policy could lower “the high rates of youth unemployment” in South Korea (paragraph [5]).

▶️Answer/Explanation
An AD/AS diagram showing a shift of the AD curve to the right with an increase in real output/GDP.
AND an explanation that expansionary fiscal policy shifts AD to the right, resulting in an increase in real output/GDP, which would require more workers, therefore youth unemployment may decrease.

Text D — Overview of Malawi

  1. Malawi is a landlocked country in southern Africa. Its development plans contain 169 targets, based on the Sustainable Development Goals. Ineffective institutions and inequalities, however, make it difficult to reach every target. Although poverty in urban areas has declined, the level of absolute poverty has been increasing in rural areas where 85 % of the population lives. Causes of poverty include land degradation (80 % of the land is eroded or lacks nutrients), poor healthcare and rapid population growth. There is also a lack of human capital, which is often due to the difficulties that households have in obtaining loans for education or training. Approximately 75 % of households do not have access to formal banking services.

  2. Aid agencies are providing assistance. The World Bank’s Human Capital Project will increase investment and encourage reforms, such as promoting the education of teenage girls. In 2020, the World Bank also approved US$157 million (50 % as a loan and 50 % as a grant) for a government project. This project aims to increase sustainable land management practices and build water-related infrastructure, such as small dams and irrigation schemes.

  3. The government has encouraged the establishment of microfinance groups that act as rural banks. They provide some finance and guidance for programmes that introduce new types of crops and techniques in order to improve agricultural efficiency.

  4. Although 2019 was a difficult year due to drought, insect infestations, and a tropical cyclone, Malawi’s real gross domestic product (GDP) grew by 4.5 %. There is a large budget deficit and the amount of government debt (at approximately 60 % of GDP) is considered to be too high. Therefore, the government has announced plans to reduce its spending. Inflation had been forecast to increase to 14 % in 2020. Due to the planned contractionary fiscal policies, however, inflation may fall below 10 % from 2021 onwards.

  5. Export revenues account for over 30 % of GDP. Malawi aims to increase its exports of cotton, nuts, tea and sugar. Rising exports and lower fuel import prices could reduce the current account deficit. Despite the persistent trade deficit, Malawi is resisting calls for further trade protection. It has signed bilateral trade agreements with both South Africa and Zimbabwe. Tariffs are gradually being reduced, while other indirect and direct taxes are being raised.

Text E — Agricultural Production

  1. Approximately 80 % of the labour force is employed in agriculture, with few job opportunities available in manufacturing and services. Agricultural productivity is low for many reasons. The government promotes manufacturing industries and cultivation of crops for export by large-scale farms. However, small-scale and subsistence farmers have received little support in the past. Farmers use less fertilizer and irrigation than is typical in other countries. Only 3 % of cultivated land is irrigated, compared to the global average of 21 %. Other challenges are the inadequate road and rail links to markets and the limited availability of electricity and fuel.

  2. Maize is the most important staple food in Malawi. The government uses price controls when trying to ensure that maize is available at affordable prices for low-income households. However, the maximum price set by the government is often too low to persuade farmers to supply the maize or to provide them with sufficient revenue. In 2020, the maximum price was raised from 250 to 310 kwacha per kilogram. Even at the higher price, shortages remain.

  3. The government is planning to invest in commercial agriculture to improve productivity and promote diversification. The 2020 budget includes subsidies on fertilizer for 4.3 million small-scale farmers, which could possibly double maize output but may also pollute waterways. The support given to farmers will improve the nutrition of Malawians and stimulate the rural economy.

Text F — Tobacco Exports

Tobacco is Malawi’s major export, providing over 50 % of foreign currency earnings. Due to lower global demand and the purchasing policies of multinational tobacco firms, prices paid to farmers in Malawi are low and falling. To reduce costs, farmers resort to using child labour. Following allegations of labour exploitation, the United States has restricted tobacco imports from Malawi. There is concern that other importing countries might also impose restrictions.

Question

Using an AD/AS diagram, explain how a reduction in government spending may reduce inflation (Text D, paragraph [4]).

▶️Answer/Explanation

For an AD/AS diagram, with the AD curve shifting left (downwards) and the price level falling AND for an explanation that a reduction in government spending (as a component of AD) will lower AD, leading a fall in the price level 

Text A — Overview of Tanzania

  1. Tanzania is one of Africa’s fastest growing economies with an average of 7% annual economic growth since 2000. It is a politically stable country, rich in wildlife and natural resources. However, the growth has been concentrated in urban manufacturing, using capital intensive production. The benefits from this growth have not reached all people and significant inequalities exist between urban and rural areas. Although the relative poverty rate has fallen over the last 15 years, the number of people living in absolute poverty has increased.

  2. Most people are employed in the slow-growing agricultural sector that relies on unskilled labour. Although incomes increased from 2008 to 2018, the demand for agricultural goods only increased by 21% during this time period. Over 70% of Tanzania’s population lives in rural areas, relying on subsistence farming with limited tradable crops. Only 30% of land is being used for agricultural production. With investment, the remaining unused land could be developed and generate income for farmers.

  3. The rural sector struggles to meet Tanzania’s food requirements due to low levels of skilled labour and productivity. Additionally, high youth unemployment leads to large numbers of unskilled rural youth migrating to the cities, often finding employment in the informal sector where wages and working conditions are poor. Insufficient investment and lack of government support for diversifying the agriculture sector have been blamed for the persistent inequalities and poverty.

  4. Tanzania’s cities have experienced a growing middle class with strong purchasing power and political influence who have placed demands on the government for cheaper electricity, better infrastructure, and more imported goods. In response, the government provided subsidies for electricity in city centres and tax benefits to foreign companies operating in Tanzania. There is concern that these measures may worsen inequality and lead to social unrest.

  5. The growth of Tanzania’s manufacturing and service sector was funded through aid and large government borrowing, resulting in high national debt. Most of the government borrowing was from foreign sources and in US dollars (US$), which is a concern due to a recent depreciation of the Tanzanian shilling (Tanzania’s currency) against the US$. Some of the debt was borrowed domestically and placed upward pressure on interest rates. Higher interest rates have resulted in crowding out but helped keep inflation under control.


Text B — Strategies and opportunities for Tanzania

  1. Previous governments have used interventionist supply-side policies to improve access to water, education, and health services. However, the health service improvements are not keeping up with population growth and many young people are still not completing secondary school. Infrastructure has improved, but it is still insufficient as producers in the rural sector find it difficult to reach markets and access supplies.

  2. Aid organizations are currently supporting new sustainable businesses in rural areas through training programmes, especially for women and young people, who make up most of the unemployed in rural areas. Economists have advised the government to improve access to credit through microfinance organizations and to simplify regulations to make it easier to start new businesses.

  3. The government is establishing property rights in rural areas to provide security for farmers. Historically, farmers could easily lose their land, which reduced their incentive to invest in productive farming methods. The government wants to develop Tanzania’s land resources and lower its reliance on imported food. To reduce food imports, a subsidy will be granted to dairy farmers to allow them to compete against imported dairy products.

  4. Tanzania is a member of the East African Community (EAC) customs union and common market. However, Tanzania needs to improve human capital and encourage diversification so that the benefits of regional integration can reach the poor. These policies can also help attract foreign direct investment (FDI). Opportunities for growth through trade will expand as the EAC works towards becoming a monetary union in 2024.


Text C — Oil pipeline to be constructed

Tanzania and Uganda plan to construct a major oil pipeline from Uganda through Tanzania, ending at a port in Tanzania. This will attract FDI which could help fund infrastructure and generate jobs. However, environmentalists are concerned about potential ecological damage due to the waste created during the construction of the pipeline. Economists have suggested the waste could be avoided through a circular economy approach in the planning and construction stage.

 

Question

Using an AD/AS diagram, explain how crowding out may help control inflationary pressure in Tanzania (Text A, paragraph [5]).

▶️Answer/Explanation
For a correct AD/AS diagram with appropriate labelling showing a shift in the AD curve to the left and a decrease in the average price level.
AND
For an explanation that the government increases demand for loans/money (and):
  •  which increases interest rate/cost of borrowing 
  •  lowering investment/consumption, decreasing AD, and lowering inflationary pressure .

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