IBDP Economics 3.2 Variations in economic activity—aggregate demand and aggregate supply HL Paper 2 - New Syllabus
Question
Read the extracts and answer the questions that follow.
Text D — Overview of Papua New Guinea
Papua New Guinea (PNG) consists of hundreds of small islands near Australia. Over 50 % of the labour force is employed in agriculture, forestry and fishing. The extraction sector, which mines non-renewable minerals (gold and copper) and extracts energy products (oil and gas), provides 30 % of the gross domestic product (GDP). The mining operations, usually carried out by foreign-owned firms, sometimes cause environmental damage and disputes over land rights.
The lack of substitutes and the difficulty of extracting gold, copper and gas cause both global demand and supply to be price inelastic. Consequently, changes in global demand result in volatile prices, which lead to macroeconomic instability because the extraction sector in PNG is so large. Fiscal policies have been unable to reduce the business cycle fluctuations. Tax revenue has declined as a percentage of GDP partly due to lower commodity prices and thus business tax revenue. The government could get more revenue from the extraction sector through ownership or part-ownership of the firms. Alternatively, taxes on the use of natural resources or higher business taxes could be imposed. However, such revenues are unpredictable and probably unsustainable.
After the rapid depreciation of the Papua New Guinea kina (PGK), PNG’s currency, between 2012 and 2015, the central bank moved away from a floating exchange rate system to a managed exchange rate system. It used reserve assets in the foreign exchange market to prevent excessive currency depreciation, thereby lowering cost-push inflationary pressures. However, this intervention caused the PGK to become an overvalued currency. Therefore, the International Monetary Fund (IMF) recommended less intervention in the foreign exchange market so the PGK would gradually depreciate.
Official development assistance (ODA) is providing funds and technical assistance to improve infrastructure and therefore assist economic growth, which is one of the objectives of aid. The other two objectives are promoting effective governance and improving health and education. The World Bank’s aid programme provides advice and funds for investment in human capital, especially for women and children’s education. The government provides subsidies for schools, but they are inadequate, and government spending per student has declined due to the growing population. Many women work in the informal sector where they earn lower wages, contributing to rising gender inequality in PNG.
The IMF’s aid is in the form of loans at low interest rates. Its programme aims to support growth that also benefits women and minorities, while improving the management of government (national) debt. It sets performance criteria, including reductions in the government’s budget deficit.
There is criticism that too much aid is for improving governance and more should be allocated to infrastructure, including transportation networks, water, sanitation and electricity, which is accessible to only 21 % of the population.
Text E — Papua New Guinea’s balance of trade
The surplus on PNG’s balance of trade in goods is due to the extraction sector, which earns 90 % of its export revenues. Less than 10 % of export revenues come from agriculture, forestry and fishing, although these sectors employ more people. Studies show that PNG exports have a high income elasticity of demand (YED = +3.0), but price elasticities of demand are low, particularly for mineral exports such as copper (PED = –0.18).
PNG has relatively low tariffs on most imports. However, tariffs on manufactured items, including machinery for palm oil production, were increased in 2019 to protect local manufacturing companies.
Text F — Foreign direct investment and Papua New Guinea
The capital and financial accounts on the balance of payments have large deficits. The outflows are mainly due to the repayment of loans that were used to develop the extraction sector. Most inward foreign direct investment (FDI) has been for mining and energy extraction projects. The FDI inflows fall once the project is completed.
FDI into other sectors is low due to regulations and inadequate infrastructure. The regulations limit certain economic activities and restrict land purchases to PNG citizens and state-owned enterprises. However, increased competition from foreign firms could raise efficiency in some industries.
PNG is setting up special economic zones in certain regions, which provide tax exemptions and eased regulations. The aim is to encourage FDI into tourism and industries that process agricultural and fishing products. Aid agencies recommend using FDI for renewable energy and environmental projects.
Table 4: Economic and development data for Papua New Guinea
| Indicator | 2012 | 2022 |
|---|---|---|
| Real GDP per capita (United States dollars (USD)) | 2154.10 | 2462.50 |
| Government expenditure (% of GDP) | 27.50 | 22.00 |
| Government taxation revenue (% of GDP) | 20.10 | 14.80 |
| Government revenue from resources (mining, oil, gas) (% of GDP) | 5.50 | 3.90 |
| Population (million) | 8.03 | 10.14 |
| Human Development Index (HDI) | 0.561 | 0.558 |
| Gender Inequality Index (GII) | 0.59 | 0.72 |
| Official development assistance (ODA) received (USD million) | 670 | 1180 |
Table 5: Balance of payments data for Papua New Guinea
| Indicator | 2022 (USD million) |
|---|---|
| Balance of trade in goods | 10 153 |
| Balance of trade in services | −1829 |
| Income (net) | −1388 |
| Current transfers (net) | 239 |
| FDI (inflows) | 327 |
(a) (i) Define the term overvalued currency indicated in bold (Text D, paragraph 3). [2]
Show Answer
An overvalued currency is a currency whose value or exchange rate is higher than its market equilibrium value. It may occur because of central bank intervention in the foreign exchange market.
(a) (ii) Define the term infrastructure indicated in bold (Text D, paragraph 4). [2]
Show Answer
Infrastructure refers to large-scale public systems, physical capital, facilities and services necessary for the functioning of an economy, such as transport, electricity, water and sanitation networks.
Infrastructure adds to the capital stock of a country and can generate positive externalities.
(b) (i) Calculate the expected percentage change in the quantity of PNG’s exports if world incomes rise by 3.5 % (Text E, paragraph 1). [2]
Show Answer
The income elasticity of demand for PNG’s exports is \(YED = +3.0\).
\(\%\Delta Q_d = YED \times \%\Delta Y\)
\(= 3.0 \times 3.5 = 10.5\%\)
Answer: The quantity demanded for PNG’s exports is expected to increase by 10.5%.
(b) (ii) Using information from Table 4, calculate PNG’s real GDP in millions of USD in 2022. [1]
Show Answer
Real GDP per capita in 2022 = USD 2462.50
Population in 2022 = 10.14 million
\(\text{Real GDP} = 2462.50 \times 10.14\)
\(= 24\,969.75\text{ million USD}\)
Answer: Real GDP = USD 24 969.75 million.
(b) (iii) Sketch an externalities diagram and indicate the socially optimum output of copper when mining in PNG causes environmental damage (Text D, paragraph 1). [2]
Show Answer
Mining causes a negative externality because environmental damage imposes external costs on third parties.
Therefore, marginal social cost (MSC) is greater than marginal private cost (MPC). The socially optimum output is where MSC intersects MSB/MPB, giving \(Q_{so}\).
(c) Using a demand and supply diagram, explain why an increase in demand for copper causes a greater change in the price of copper when PNG’s supply is price inelastic than when its supply is price elastic (Text D, paragraph 2). [4]
Show Answer
An increase in demand for copper shifts the demand curve to the right, from \(D\) to \(D_2\), increasing the equilibrium price.
When the supply of copper is price inelastic, producers are unable to increase quantity supplied significantly in response to the higher price. Therefore, the increase in demand produces a relatively large increase in price and a relatively small increase in quantity.
When supply is price elastic, producers can respond more significantly by increasing quantity supplied. Consequently, the same increase in demand produces a smaller increase in price and a larger increase in quantity.
Thus, the more price inelastic the supply, the greater the price effect of an increase in demand.
(d) Using an AD/AS diagram, explain why there were inflationary pressures when PNG’s currency depreciated between 2012 and 2015 (Text D, paragraph 3). [4]
Show Answer
A depreciation of the PNG kina makes imported goods more expensive when measured in domestic currency. This is particularly important for firms that use imported raw materials, energy or capital goods.
The higher price of imported inputs increases firms’ costs of production. This causes short-run aggregate supply (SRAS) to shift upwards/leftwards from \(SRAS_1\) to \(SRAS_2\).
With aggregate demand unchanged, the new equilibrium occurs at a higher general price level. Therefore, the depreciation created cost-push inflationary pressures.
(e) Using a production possibilities curve (PPC) diagram, explain the impact of investment in human capital on production possibilities in PNG (Text D, paragraph 4). [4]
Show Answer
Investment in human capital, such as education and training, increases the quality and productivity of labour.
Higher labour productivity means that the same quantity of resources can produce a greater quantity of goods and services. This increases the economy’s productive capacity and potential output.
Therefore, the PPC shifts outwards, showing an increase in PNG’s production possibilities and potential for long-run economic growth.
(f) Using an international trade diagram, explain how producer surplus for PNG producers changed when the tariff on imports of machinery into PNG was raised (Text E, paragraph 2). [4]
Show Answer
An increase in the tariff on imported machinery raises the domestic price above the world price.
The higher domestic price allows PNG’s domestic producers of machinery to supply a larger quantity. Their revenue per unit also increases because they can charge the higher domestic price.
As a result, the area representing producer surplus increases. Therefore, PNG’s domestic producers benefit from the higher tariff, although consumers and industries using machinery may face higher costs.
(g) Using information from the text/data and your knowledge of economics, discuss the view that foreign aid is more beneficial than foreign direct investment (FDI) for economic growth and economic development in PNG. [15]
Show Answer
Introduction
Foreign aid and foreign direct investment (FDI) can both contribute to economic growth and economic development, but through different channels. Economic growth refers to an increase in real output, while economic development involves broader improvements in living standards and welfare. Whether aid is more beneficial than FDI depends on the type of investment, how funds are used, and the long-run effects on PNG.
Benefits of foreign aid
Foreign aid can take the form of grants, technical assistance or concessional loans. It can provide PNG with funds when domestic tax revenue is insufficient. This is particularly relevant because government taxation revenue fell from 20.1% of GDP in 2012 to 14.8% in 2022.
Aid can finance infrastructure such as transport, electricity, water and sanitation. Better infrastructure can reduce firms’ costs of production, increase productivity and encourage private investment. This can shift the PPC outwards and increase long-run productive capacity.
Aid can also improve human capital through investment in education and health. The World Bank’s programmes support education, particularly for women and children. This can increase labour productivity and employment opportunities and improve development indicators.
A further advantage is that aid can support environmental and renewable-energy projects. Such investment may help PNG achieve more sustainable development rather than relying entirely on non-renewable resource extraction.
Limitations of foreign aid
However, aid is not necessarily more beneficial in the long run. Some aid takes the form of loans, which must be repaid with interest. This can increase future debt burdens and potentially reduce future economic growth.
In addition, IMF loans may require PNG to meet conditions such as reducing the budget deficit. Such conditions can restrict the government’s policy choices and may reduce spending available for development projects.
There is also criticism that too much aid is directed towards governance rather than infrastructure. If aid is not allocated towards productive investment, its contribution to economic growth may be limited. Increasing dependence on foreign aid may also create a long-term reliance on other countries or aid agencies.
Benefits of FDI
FDI can provide substantial capital for investment without requiring the PNG government to finance the entire project. In PNG, FDI has been particularly important in large-scale mining and energy projects. The extraction sector contributes significantly to GDP and export earnings and has helped generate a trade surplus.
FDI can therefore increase aggregate demand and real output in the short run. Foreign firms may also introduce new technology, management expertise and training, raising productivity. Increased competition from foreign firms may encourage domestic firms to become more efficient.
FDI could also promote economic diversification. PNG’s special economic zones aim to attract investment into tourism and industries processing agricultural and fishing products. This could create employment and reduce the economy’s dependence on the extraction sector.
Foreign firms can also provide employment and training, potentially moving workers from the informal sector into higher-paid formal employment. This may improve household incomes and living standards.
Limitations of FDI
However, FDI in PNG has been concentrated heavily in mining and energy extraction. These projects may create environmental damage and disputes over land rights. This can reduce the development benefits and create problems for sustainable development.
FDI inflows also fall sharply when large projects are completed. This can make economic growth unstable, particularly because PNG is heavily dependent on commodities whose prices are volatile.
Furthermore, foreign-owned firms may repatriate profits and interest payments. Table 5 shows a negative net income balance of USD 1,388 million, indicating an outflow of income from PNG. This can reduce the national income retained within the economy.
FDI may also cause local firms to become less competitive and potentially leave the market. In addition, foreign firms may employ overseas workers rather than local labour. Tax concessions provided to attract FDI may also reduce the government’s tax revenue.
Evaluation
Overall, foreign aid may be more beneficial for broad economic development when it is targeted towards infrastructure, education, healthcare, renewable energy and other areas with significant positive externalities. These investments can improve living standards and productive capacity even when they do not immediately generate large increases in GDP.
However, FDI may be more effective for rapid economic growth because it provides large amounts of capital, creates employment and generates export earnings. PNG’s extraction sector demonstrates this potential, but its concentration in commodities also exposes the economy to price volatility and environmental costs.
Therefore, it is difficult to conclude that foreign aid is always more beneficial than FDI. The greatest benefits are likely to occur when well-targeted aid complements FDI: aid can improve infrastructure, human capital and institutions, while FDI can provide capital, technology, employment and access to international markets.
For PNG, diversifying FDI beyond mining and directing aid towards productive infrastructure and human capital would make both sources of external finance more supportive of sustainable economic development.
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