Exchange rates Paper 2| IBDP Economics HL |

IBDP Economics HL – The global economy – Exchange rates -Paper 2 Exam Style Practice Questions

Exchange rates Paper 2?

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Current account deficit poses a challenge to Pakistan’s economy

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.
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.
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”.
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.
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

Using an exchange rate diagram, explain how the central bank might depreciate the value of the rupee (paragraph [3]).

▶️Answer/Explanation

For drawing a correctly labelled exchange rate diagram showing a rightward shift of the supply curve (leftward shift of the demand curve) and a fall in the exchange rate AND for an explanation of one of the following:

the central bank may reduce (domestic) interest rates,
inducing domestic (financial) investors to increase the supply of the rupee (as they demand more foreign currency) in order to save abroad, and so lowering its value
the central bank may reduce (domestic) interest rates, inducing foreign (financial) investors to decrease the demand for the rupee (as they demand less domestic currency) in order to save in Pakistan, and so lowering its value
the central bank may purchase foreign currencies in the foreign exchange market, increasing the supply of the rupee and so lowering its value.

Turkey’s rising current account deficit

According to forecasts from the International Monetary Fund (IMF), Turkey’s current account deficit is expected to rise from 4.4 % of gross domestic product (GDP) in 2016 to 5.6 % of GDP in 2017, with real GDP growth falling from 3.3 % in 2016 to 2.9 % in 2017. The current account deficit is perceived to be the biggest problem for Turkey’s economy. An international credit agency has reduced Turkey’s credit rating to “negative” because risks to the country’s credit profile have risen significantly in recent months.
Economic activity has been further damaged by several factors, including political uncertainty, conflicts in neighbouring countries and trade protection by its trading partners. Turkey’s tourism revenues, which contribute 10 % to the country’s GDP, have fallen significantly due to security concerns related to terrorist attacks.
The current account deficit has contributed to a massive depreciation of the Turkish lira (Turkey’s currency), which dropped by 20 % against the United States dollar (US$$$) over the previous year. This is a significant problem for Turkey, which relies on a steady inflow of overseas investment to finance its current account deficit.
Part of the problem is Turkey’s dependence on imports, especially energy. Higher import costs for energy will further worsen Turkey’s current account deficit and create further pressure on inflation (Figure 4).
The Turkish government has blamed the currency collapse on speculators. The president of Turkey has asked Turkish citizens to help. There is approximately US$$$140 billion worth of foreign currency being held in foreign currency savings accounts in Turkey. The president wants Turkish people to use their foreign currency saving to support the Turkish lira. However, Turkish citizens seem to have ignored his wishes, and bought US$$$1 billion worth of foreign currency in September 2018.
Analysts believe that the only solution to the falling value of the Turkish lira and the current account deficit is an increase in the official interest rate by the central bank. However, Turkey’s president has made it clear that he will not accept higher interest rates. In fact, he has demanded lower interest rates to stimulate the economy.

Question

Define the term depreciation indicated in bold in the text (paragraph [3]).

▶️Answer/Explanation

An explanation that it is a decrease in the value (price) of one currency plus one of the following:

due to changes in market forces
in a floating exchange rate system.

Turkey’s rising current account deficit

According to forecasts from the International Monetary Fund (IMF), Turkey’s current account deficit is expected to rise from 4.4 % of gross domestic product (GDP) in 2016 to 5.6 % of GDP in 2017, with real GDP growth falling from 3.3 % in 2016 to 2.9 % in 2017. The current account deficit is perceived to be the biggest problem for Turkey’s economy. An international credit agency has reduced Turkey’s credit rating to “negative” because risks to the country’s credit profile have risen significantly in recent months.
Economic activity has been further damaged by several factors, including political uncertainty, conflicts in neighbouring countries and trade protection by its trading partners. Turkey’s tourism revenues, which contribute 10 % to the country’s GDP, have fallen significantly due to security concerns related to terrorist attacks.
The current account deficit has contributed to a massive depreciation of the Turkish lira (Turkey’s currency), which dropped by 20 % against the United States dollar (US$$$) over the previous year. This is a significant problem for Turkey, which relies on a steady inflow of overseas investment to finance its current account deficit.
Part of the problem is Turkey’s dependence on imports, especially energy. Higher import costs for energy will further worsen Turkey’s current account deficit and create further pressure on inflation (Figure 4).
The Turkish government has blamed the currency collapse on speculators. The president of Turkey has asked Turkish citizens to help. There is approximately US$$$140 billion worth of foreign currency being held in foreign currency savings accounts in Turkey. The president wants Turkish people to use their foreign currency saving to support the Turkish lira. However, Turkish citizens seem to have ignored his wishes, and bought US$$$1 billion worth of foreign currency in September 2018.
Analysts believe that the only solution to the falling value of the Turkish lira and the current account deficit is an increase in the official interest rate by the central bank. However, Turkey’s president has made it clear that he will not accept higher interest rates. In fact, he has demanded lower interest rates to stimulate the economy.

Question

Using an AD/AS diagram, explain how Turkey’s reliance on energy imports is putting “further pressure on inflation” (paragraph [4]).

▶️Answer/Explanation

For drawing an accurate, labelled AD/AS diagram showing a decrease in AS and an increase in the average price level AND an explanation that higher import costs for energy result in an increase in the costs of production for Turkish firms, causing a decrease in AS and an increase in the average price level.

Turkey’s rising current account deficit

According to forecasts from the International Monetary Fund (IMF), Turkey’s current account deficit is expected to rise from 4.4 % of gross domestic product (GDP) in 2016 to 5.6 % of GDP in 2017, with real GDP growth falling from 3.3 % in 2016 to 2.9 % in 2017. The current account deficit is perceived to be the biggest problem for Turkey’s economy. An international credit agency has reduced Turkey’s credit rating to “negative” because risks to the country’s credit profile have risen significantly in recent months.
Economic activity has been further damaged by several factors, including political uncertainty, conflicts in neighbouring countries and trade protection by its trading partners. Turkey’s tourism revenues, which contribute 10 % to the country’s GDP, have fallen significantly due to security concerns related to terrorist attacks.
The current account deficit has contributed to a massive depreciation of the Turkish lira (Turkey’s currency), which dropped by 20 % against the United States dollar (US$$$) over the previous year. This is a significant problem for Turkey, which relies on a steady inflow of overseas investment to finance its current account deficit.
Part of the problem is Turkey’s dependence on imports, especially energy. Higher import costs for energy will further worsen Turkey’s current account deficit and create further pressure on inflation (Figure 4).
The Turkish government has blamed the currency collapse on speculators. The president of Turkey has asked Turkish citizens to help. There is approximately US$$$140 billion worth of foreign currency being held in foreign currency savings accounts in Turkey. The president wants Turkish people to use their foreign currency saving to support the Turkish lira. However, Turkish citizens seem to have ignored his wishes, and bought US$$$1 billion worth of foreign currency in September 2018.
Analysts believe that the only solution to the falling value of the Turkish lira and the current account deficit is an increase in the official interest rate by the central bank. However, Turkey’s president has made it clear that he will not accept higher interest rates. In fact, he has demanded lower interest rates to stimulate the economy.

Question

Using an exchange rate diagram, explain what is likely to have happened to the Turkish lira when Turkish citizens “bought US$$$1 billion worth of foreign currency” (paragraph [5]).

▶️Answer/Explanation

For drawing an accurate, labelled exchange rate diagram for the Turkish lira, showing an increase in supply for the Turkish lira and a decrease in the exchange rate
AND
an explanation that in order to buy US dollars, Turkish citizens would have had to exchange their Turkish lira, resulting in an increase in the supply of the Turkish lira and a depreciation of the Turkish lira.

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

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”.
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.
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.
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.
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 fixed exchange rate indicated in bold in the text (paragraph [1]).

▶️Answer/Explanation

An explanation that a currency’s (value) is fixed against any one of the following:

the value of another currency
a basket of other currencies
gold
fixed by the central bank of a country, and is not permitted
to change in response to changes in currency supply and demand.

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

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”.
The value of the renminbi has fallen 9 % against the US dollar (US$$$) in the past six months. Expansionary domestic monetary policy, concerns about economic growth and an escalating trade war continue to put downward pressure on the renminbi. Allowing the value of the renminbi to fall suggests that the central bank is currently maintaining a managed exchange rate rather than a fixed peg to the US dollar.
The cause of the lower value of the renminbi—aside from a slowdown in Chinese economic growth—is a shrinking current account surplus. The US has imposed tariffs on US$$$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.
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.
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

Using an exchange rate diagram, explain why the “widening trade deficit in services” could lead to a depreciation of the renminbi (paragraph [3]).

▶️Answer/Explanation

For a correctly labelled exchange rate diagram, with a shift of the supply curve to the right and/or shift of the demand curve to the left
AND
for an explanation that a widening trade deficit in services will lead to an increase in supply (selling) of RMB due to higher imports and/or decrease in demand (buying) for the RMB due to lower exports (causing the RMB to depreciate).

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

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”.
The value of the renminbi has fallen 9 % against the US dollar (US$$$) in the past six months. Expansionary domestic monetary policy, concerns about economic growth and an escalating trade war continue to put downward pressure on the renminbi. Allowing the value of the renminbi to fall suggests that the central bank is currently maintaining a managed exchange rate rather than a fixed peg to the US dollar.
The cause of the lower value of the renminbi—aside from a slowdown in Chinese economic growth—is a shrinking current account surplus. The US has imposed tariffs on US$$$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.
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.
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

Using information from the text/data and your knowledge of economics, discuss the view that a depreciating currency is good for the Chinese economy.

▶️Answer/Explanation

Responses may include:

definitions of depreciation, managed exchange rate.

Economic analysis may include:

Marshall-Lerner and J curve
AD / AS
exchange rate theory
balance of payments
government macroeconomic objectives.

Arguments supporting the claim may include:

increased AD by decreasing relative price of exports, increasing export revenue if X PED>1
increases relative price of imports, decreasing import expenditure if M PED>1
increasing export revenue increases current account surplus (paragraph [3])
increase in net export component of AD leading to increasing economic growth (paragraph [4])
increases in foreign exchange reserves (assuming export revenue is increasing and is greater than import expenditure)
increases Chinese ownership of foreign assets and foreign debt
China exports to countries other than the US
protects Chinese exporters from US tariff costs (paragraph [4]).

Arguments against the claim may include:

the claim that the depreciating RMB is good for the Chinese economy is made by a US official who may be justifying the punitive US tariff regime (paragraph [1])
depreciation of the RMB could compromise the market-based reforms to the exchange rate (paragraph [1])
main cause of depreciation is “shrinking current account surplus” caused by trade war – falling demand for the RMB (paragraph [3])
normal benefits of depreciating currency (lower relative price of exports) cancelled out by US tariffs hence no increase in export revenue on current account (paragraph [3])
depreciation increases relative import prices therefore increasing import expenditure (“widening trade deficit”) and reducing the current account surplus – increasing supply of Renminbi (paragraph [3])
export sector needs government help to compete as depreciation not sufficiently offsetting effect of US tariffs (paragraph [4])
depreciation will increase relative price of imported components therefore decreasing SRAS
slower economic growth due to lower net export component causing slowdown in AD
rising US interest rates could lead to capital flight from China (paragraph [5])
depreciating currency could cause capital flight as speculators seek out the strengthening US dollar therefore “negatively affecting China’s financial account” (paragraph [5])
indebted Chinese firms harmed if interest rates rise to support the Renminbi and prevent capital flight (paragraph [5])
depreciating exchange rate tends to cause political tensions with US (China’s biggest trade partner).

The strong Thai baht

Thailand’s currency, the Thai baht, ended 2019 at its highest value in more than six years. With a 7.8 % gain against the United States dollar (US$$$), it was the currency that appreciated the most among major Asian currencies.
The Thai baht’s appreciation was caused by several factors. Many foreign investors are attracted by Thailand’s economic stability, high levels of foreign reserves, low inflation rate and low unemployment (Table 1). However, the inflation rate is below the central bank’s target.
Initially, the central bank of Thailand (BoT) was not too concerned, as the strong Thai baht was helping Thai importers and those who had foreign debts. Additionally, Thai producers could afford to import new technology and capital equipment. An appreciating currency could also help improve the country’s terms of trade.
However, a strong currency can have severe consequences on an export-oriented country like Thailand. Exports account for 65 % of gross domestic product (GDP), and in 2019 exports declined by 7 %. Additionally, the tourism industry, which makes up approximately 20 % of GDP and accounts for 16 % of employment, started to express concern. Economic growth in 2019 was 3 %, down from 4.1 % in 2018.
Therefore, towards the end of 2019, the BoT implemented measures to prevent further appreciation of the Thai baht. The BoT reduced controls on capital outflows to make it easier for Thai citizens to move money abroad. Additionally, restrictions were placed on the amount of money foreigners could hold in Thai bank accounts.
The BoT is considering further measures including the use of foreign reserves, a decrease in the interest rate, and imposing controls on capital inflows, to prevent speculative inflows. However, these controls may impact the country’s credibility and financial markets. Expansionary monetary policy may also increase household debt which, at 78.6 % of GDP, is among the highest in Asia.
The BoT is concerned about using foreign reserves, as this may result in Thailand being labelled a currency manipulator* by the US. Currently, Thailand’s overall large current account surplus is the only requirement it meets to be labelled a currency manipulator. However, Thailand’s bilateral trade surplus with the US is currently US$$$19 billion, which means it is close to meeting a second requirement. Thailand wants to avoid being labelled a currency manipulator as the US may use trade protection in retaliation.

Question

Using an exchange rate diagram, explain how a decrease in the interest rate might influence the value of the Thai baht (paragraph [6]).

▶️Answer/Explanation

For an exchange rate diagram showing a shift of supply to the right, with a decrease in price of Thai baht.
AND
For an explanation that a reduction in the interest rate will cause Thai citizens to move financial/portfolio investments abroad This will lead to an increase in supply of the baht, resulting in a depreciation/decrease in its value/price.

Text A — Overview of Tanzania

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.
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.
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.
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.
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

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.
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.
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.
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 exchange rate diagram, explain what could happen to the value of the Tanzanian shilling if there is increased inward foreign direct investment (FDI) in Tanzania (Text B, paragraph [4]).

▶️Answer/Explanation

For a correct foreign exchange diagram showing a shift of demand to the right, with an increase in price of the Tanzanian currency (shilling).
AND
For an explanation that as foreign firms invest in Tanzania they will demand more of Tanzania’s currency/shilling [1] which increases the price/value of the currency / appreciation [1].

Text A — Overview of Vietnam

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.
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.
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.
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.
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

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.
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

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.
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 an exchange rate diagram, explain how the central bank in Vietnam could prevent the dong from depreciating by using its reserve assets (Text C, paragraph [2]).

▶️Answer/Explanation

For an exchange rate diagram, with the demand curve shifting right and the equilibrium price of the dong rising
AND
for an explanation that the central bank would buy the dong with its reserve assets/foreign reserves [1], increasing the demand for the dong (resulting in the exchange rate to rise / prevent the dong depreciating) [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.
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.
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.
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.
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

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.
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.
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 exchange rate diagram, explain how a reduction in the current account deficit could affect the exchange rate for the kwacha (Text D, paragraph [5]).

▶️Answer/Explanation

For an exchange rate diagram, with the demand curve shifting right (or the supply curve shifting left) and the equilibrium price of the kwacha rising
AND
for an explanation that a reduction in the deficit could be caused by increased demand for the currency due to more exports/greater inflows (and/or a reduced supply of the currency due to fewer imports/fewer outflows) [1] which causes the exchange rate to rise / appreciate [1].

Text D — Overview of Lebanon

Lebanon is in the Middle East, bordering the Mediterranean Sea, and is home to nearly 7 million people. Lebanon is in an economic crisis, facing a recession, huge government debt and rising income inequality, poverty and inflation. Corruption and poor governance have been blamed for misallocation of funds that has led to low levels of investment and extensive capital flight. Additionally, Lebanon has one of the most unequal distributions of wealth in the world. In 2019, the top 10% of income earners owned over 70% of personal wealth in Lebanon.
Infrastructure in Lebanon is poor, water and sewerage systems are basic, and roads are inadequate. Electricity supply is unreliable with people going without power for much of the day. In 2020, major buildings including food storage buildings, schools and hospitals were damaged in Beirut (the capital city of Lebanon). This was concerning as 85% of the country’s food arrives through Beirut. Fortunately, humanitarian aid was given by the international community to help rebuild the damaged buildings.
Despite a history of inflows from luxury tourism and remittances (money sent by a foreign worker to their home country), there is a persistent current account deficit. To help with this, the Lebanese central bank has used high interest rates to attract financial inflows. Additionally, the government has borrowed funds from overseas. However, the misuse of these funds and overspending have contributed to one of the highest foreign debts in the world. Lebanon recently defaulted on foreign debt repayments worth 1.2 billion euros, which damaged its international credit rating, making it difficult to access loans needed to help solve its current economic problems.

Text E — Further challenges facing Lebanon

Social unrest is prevalent and intensified when the government suggested raising revenue by imposing an indirect tax on social media applications such as WhatsApp. As the government struggles to pay its debts, people are concerned that subsidies on necessities such as wheat, medicine and fuel will be removed.
Mismanagement of the state-run electricity and telecommunications sectors has resulted in unreliable services and high telecommunication prices. The state-run monopoly firms make losses, and the electricity sector relies heavily on government subsidies, putting pressure on the budget deficit.
Lebanon currently has a managed exchange rate system with the Lebanese pound (Lebanon’s currency) linked to the US dollar (US$$$). However, the government is finding it difficult to maintain the exchange rate at the desired level due to insufficient reserve assets. Recent falling remittances, low levels of exports and lack of foreign direct investment (FDI) are placing downward pressure on the Lebanese pound. Lebanon has limited natural resources and a small manufacturing industry, thus relies heavily on imports. As a consequence, the gradual depreciation of the Lebanese pound has led to cost-push inflation.

Text F — Reforms and strategies for economic recovery

The Lebanese government is seeking help from the International Monetary Fund (IMF) to restructure the government debt and develop its infrastructure. However, loans from the IMF will require the following conditions to be met:
- procedures and processes established to ensure good governance, including enforcement of anti-corruption laws
- financial sector reforms implemented to build confidence in the banking system and laws to control capital flight
- government spending reduced and revenue increased through higher corporate, wealth and personal income taxes for high-income earners. Introduction of a tax on imported luxury goods and an increase of indirect taxes
- partially privatizing the electricity and telecommunications sectors to increase efficiency and encourage the exploration of new energy sources
- transitioning from a managed to a floating exchange rate system.
Other organizations are offering development aid to rebuild infrastructure and support small to medium-sized businesses to develop the manufacturing sector and attract FDI. Currently, the manufacturing sector accounts for only 12.5% of gross domestic product (GDP). Some experts recommend that Lebanon decreases its reliance on food imports by developing its own food industry. However, Lebanon must commit to establishing good governance systems before aid organizations will provide their support.
Lebanon has resisted seeking help from the IMF and other agencies in the past due to concerns about high levels of interference and imposed conditions that may conflict with their own government objectives.

Question

Using an exchange rate diagram, explain how Lebanon’s current account balance could affect the Lebanese pound (Text D, paragraph [3]).

▶️Answer/Explanation

For a correct exchange rate diagram with appropriate labelling showing a shift of supply to the right and/or demand to the left, with a decrease in the price of the pound.
AND
For an explanation that as there is a current account deficit, caused by increased import value and/or decreased export value [1],
Lebanese are supplying pounds to pay for the imported products and/or foreigners are demanding less pounds to pay for exports, resulting in a decrease of the price of the pound/depreciation [1].

Exchange rates Paper 2?

IBDP Economic HL- All Topics

Exam Style Question for IBDP Economics HL- Exchange rates -Paper 2