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CAPE Economics, June 12th, Unit 2, Paper 2 suggested answer by Edward Bahaw

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CAPE Economics, June 12th, Unit 2, Paper 2 suggested answer by Edward Bahaw

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CAPE Economics, June 12th, Unit 2, Paper 2 suggested answer by Edward Bahaw

1. 1. EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS CAPE ECONOMICS th June 12 2008 Unit 2 Paper 2 EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS
2. 2. EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS June 2008 Non-Trinidad (Rest of Caribbean) – Unit 2 – Paper 2 1 a i) Inflation can be defined as a sustained increase in the average or general level of prices which results in a fall in the purchasing power of money. 1a ii) Two causes of Inflation • Demand-pull inflation • Cost-push inflation 1 a iii) Measuring Inflation • Consumer Price Index The consumer price index (CPI) measures the weighted average price changes of a range or a “basket” of goods and services consumed by the average household. Increases in the CPI from one year to next means that there is inflation • Inflation Rate The rate of inflation is calculated by taking the percentage change in the CPI over the last twelve months. This is given by the following formulae: [Current CPI − Last CPI ] Rate of Inflation = ×100 Last CPI 1 b i) Unemployment rate is defined as the proportion of individuals from the labour force who are unemployed. This is therefore given by the following formula: Number Unemployed Unemployment Rate = ×100 Labour Force 1 b ii) Three causes of unemployment 1. General or Cyclical unemployment - this is unemployment which is traditionally associated with the trade cycle which refers to the tendency of national income to fluctuate both upwards and downwards in a sequential fashion. As economic activity varies in this fashion, so too does the level of employment, since labour requirements in production processes adjust to suit aggregate demand levels in the economy. Particularly during a recession, when aggregate demand is low, this type of unemployment would be high, while in times of recovery when aggregate demand is high, cyclical unemployment would be low. 2. Structural unemployment - this occurs when there is a mismatch between the skills required to perform a job and the skills possessed by workers. This could be the result of structural changes in the economy where the industrial composition changes. An imbalance is therefore caused in terms of the demand for different types of labour from the decline of a certain industry and the rise of another. Unemployment results when new industries do not create enough jobs to employ those made redundant or EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS
3. 3. EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS because the new industry is in a different area or requires different skills. Most economists agree that production processes and other operations in many industries which previously required manual skills, now require labour with a higher mental capacity. 3. Technological - this occurs when an improvement in technology reduces the demand for labour and hence many workers become unemployed. New technologies affect unemployment in two ways: Firstly, new technology makes certain jobs redundant and unemployment increases as a result. Secondly, new technology creates new jobs that require different skills, which many of the unemployed do not possess and are incapable of doing. In this case technological progress perpetuates unemployment similar to structural unemployment. 1 b iii) Classical or disequilibrium unemployment – this is a temporary or short term source of unemployment caused by wage rates being held above market clearing levels. As wages remain above the equilibrium level, firms hire a smaller amount of labour. This surplus of labour or unemployment eventually leads to a market clearing equilibrium where wages have fallen. This is why classical unemployment is considered to be only temporary. 1 b iv) Keynesian analysis of the economy reveals that an equilibrium level of income could occur at a range of possible outcomes which may not necessarily coincide with the Government’s macroeconomic objectives of full employment and low inflation. 1 c) The nominal interest rate is the actual rate of interest in the economy. The real rate of interest is the nominal rate of interest adjusted for the rate of inflation. This adjustment is necessary because inflation erodes the purchasing power of money. Therefore the real rate of interest gives the return on capital after inflation is taken into consideration. 1 d) The accelerator model is based on an assumption of a fixed capital to output ratio. That is to say, the principle asserts that a fixed capital to output ratio has to be maintained in an economy. Thus, according to the accelerator principle investments are induced by income. That is as income rises, investments are necessary in order to maintain the fixed capital to output. Accordingly, in the accelerator model, investments can be expressed as a function of income as follows: I t = φ (Yt − Yt −1 ) where It = Investment in time t φ = The capital to output ratio Yt = Output in time t Yt −1 = Output in the year before time t 1 e) The marginal efficiency of capital (MEC is a percentage which gives the return on capital employed. The marginal efficiency of investment (MEI) is a percentage which EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS
4. 4. EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS gives the return on investment. In this case the level of investment is given by the change in the amount of capital employed. 2 a i) The consumption function depicts the relationship between total consumption and the level of income. The consumption function is upward sloping since as income increases consumers’ expenditure tends to rise. 2 a ii) The Consumption Function C (\$M) Consumption Function 80 65 50 35 20 45° 25 50 75 100 Y \$M 2 a iii a) The marginal propensity to consume (MPC) is the proportion of any change in income that is devoted to consumption of goods and services and is calculated as: ∆C/ ∆Y. 2 a iii b) The average propensity to consume (APC) is the proportion of income devoted to consumption of goods and services and is calculated as: C/Y. 2 a iii c) The point at which the consumption function cuts the vertical axis represents the level of consumption where income is zero. This simply the amount of goods and services that have to be consumed whether the consumer has income or not e.g. food and is termed autonomous consumption. 2 a iii d) The marginal propensity to save (MPS) is the proportion of any change in income that is devoted to saving and is calculated as: ∆S/∆Y. EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS
5. 5. EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS 2 a iv) Keynesian assumptions about consumption • When income is zero, APC is ∞ due to autonomous consumption. The consumption function therefore meets the vertical axis above the origin. • MPC is less than one since as income increases not all of the increase is devoted to consumption • MPC is assumed to be constant i.e. the consumption function has a constant slope. • APC declines continuously as income increases. This means the greater a households income the smaller the proportion devoted to consumption. 2 b) Factors which affect the households division of income between consumption and savings 1. Income – the greater a households income the smaller the percentage devoted to consumption and the greater the percentage that is saved. Low income earners tend to save a smaller proportion of their income and in some case may even dissave. High income earners on the other hand would tend to save a larger proportion of their income even though the absolute level of consumption may be higher than that of lo income earners. 2. Interest rate - a change in the rate of interest can significantly affect consumers’ expenditure at unchanged income. To a large extent, the purchase of most consumer durables such as refrigerators and automobiles are made on credit or hire purchase terms. As the interest rate decreases, the cost of borrowing decreases and this may entice consumers to increase their spending especially at acquiring consumer durables. Thus a decrease in interest rates may result in an upward shift of the consumption function and a downward shift of the saving function. 3. Expectations - Consumers’ expectations play an important role in determining consumer expenditure and saving. Expectations of rising prices, product shortages or future increases in income may induce consumers to increase spending and reduce saving in the current period. This is because quite naturally consumers would attempt to avoid the future shortages or future price increases by buying more beforehand. In addition, higher future income may give consumers the feeling of security of and this would encourage them to spend more. In these cases there would be an upward shift of the consumption function and the saving function would shift downward. 4. Tax incentives on saving - government may offer tax incentives on saving plans of households. As taxes are reduced when consumers increase their savings, this would discourage consumption as more individuals would have more reasons to save. This means that tax incentives would lead to more income being saved rather than consumed. 5. Inflation - as the price level increases at unchanged income levels, consumer would need to increase their expenditure levels so that they would be able to afford the same volume of goods and services that they previously consumed. This may require a cut back in saving and an increase in consumption expenditure EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS
6. 6. EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS even though the same quantity of goods and services are being purchased except at higher prices. 6. Wealth - wealth consists of real assets such as, a house, automobiles, television sets and other consumer durables as well as financial assets such as cash, a savings account balance, stocks, bonds, insurance policies and pension plans which are possessed by consumers. As wealth increases there might be a tendency for individuals to consume more out of disposable income. Accordingly, as households’ wealth increases, the consumption increases and saving declines. 2 c) Permanent incomes refer to income which is expected to persist over the long term income. This would cover income sources such as a person’s salary from permanent employment. Transitory income accounts for all sources of income which are unexpected or of a short term nature. This would include income a person earns from overtime payments during a busy month, or a single bonus payment received from extraordinary business performance. 2 d) The life cycle hypothesis states that consumers aim to allocate lifetime income in such a way so as to achieve the smoothest possible path of consumption over their entire life. As such, consumption is independent of current income. Given that income may vary systematically over a person’s life, savings and borrowing would bridge the gap between current income and consumption expenditure. 3a i) Narrow money also called M1, covers money which is immediately available for spending. That is, it comprises the monetary base and all short term deposits. This measure of money fulfils the medium of exchange function. Broad money also known as M2 measures the total amount of money in the economy. Broad money is therefore narrow money plus long term deposits held at financial institutions. This monetary aggregate fulfils the store of value function. 3 a ii) The velocity of money represents the number of times a unit of money is used to purchase final goods and services in an economy. 3 a iii) The equation of exchange is given by: M ×V = P × Y where: M represented the total supply of money, V measured transaction velocity of circulation P depicted the average price level Y accounted for the total volume of goods and services produced The right hand side, PY gives the average price level times the total volume of final output. This is evidently the value of all final output produced in the economy or GDP. EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS
7. 7. EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS The left hand side MV gives the total amount of money times the amount of times each unit it is used to purchase a good or a service. This is also gives the total value of output produced in the economy. Both sides of the equation of exchange give national income. 3 b) Inflation and the Functions of Money Function Impact of Inflation As money loses value due to inflation, it becomes less acceptable as a medium of payment in the exchange of Medium of Exchange goods and services. People may even stop using money on the whole and revert to barter. Debtors benefit as the real value of money borrowed falls. This is to the detriment of creditors who suffer losses as the Standard of Deferred Payment real value or purchasing power of the amount lent declines due to inflation. Inflation means that prices are subject to variability. This makes it difficult to establish a constant value of a good or Unit of Account service over time. In addition, as prices change, the relative value of different goods and services would also be distorted. 3 c ) If in an economy, the full employment volume of output (Y) is 50,000,000, the velocity of circulation (V) is 15 and the money supply (M) is \$10,000,000, then using MV = PY we have: \$10,000,000 x 15 = P x 50,000,000 therefore P = (\$10,000,000 x 15)/50,000,000 i.e. P = \$3 and GDP = \$150,000,000. If the money supply is doubled to \$20,000,000 then using MV = PY we have \$20,000,000 x 15 = P x 50,000,000 therefore P = (\$20,000,000 x 15)/50,000,000 i.e. P = \$6 and GDP = \$300,000,000. Clearly it can be seen that a doubling of the money supply has lead to an equivalent doubling of the price level. That is, an increase in the money supply of 100 percent has led to a 100 percent rate of inflation. Interestingly, national income has also increased by a 100 percent even though it was assumed that the volume of output was fixed at the full employment level. The explanation is that the higher prices instigated by the increase in the money supply has caused the nominal value of national income to increase even though real output is unchanged. This is referred to as the classical dichotomy, which states that average price level is determined by the quantity of money but that the EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS
8. 8. EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS quantity of money has no effect on real macroeconomic variables such as the output of goods and services and employment. 3 d) Currency substitution - In a large number of emerging and developing economies local currencies do not adequately fulfil the functions of money and as a consequence individuals partially switch to foreign currencies. This is referred to as currency substitutions. 3 e i) The relationship between the speculative demand and rate of interests is based on the normal or notional rate of interest. If the interest rate is higher than the normal rate, then speculators would expect it to fall. This expectation also asserts that the price of financial assets would be on the rise. This encourages speculators to use money to purchases these assets in order to earn a capital gain which leads to a decline in the speculative demand for money. On the other hand, if the interest rate is lower than the normal rate then individuals would anticipate that the interest rate would rise which is coupled with the assumption that the price of financial assets would be on the decline. In this case speculators would dispose of such assets and hold more money in speculative balances. Conclusively at high rates of interest, the speculative demand for money is low and at low rates of interest the speculative demand for money is high. 3 e ii) The demand for money can be divided into three components 1. Transactionary - this refers to amount of money held for daily use to carry out routine transactions. 2. Precautionary - this accounts for money held for unforeseen expenditures or unforeseen contingency. 3. Speculative - this is any money held by individuals as they aim to take advantage of capital gains and avoid capital losses as the price of financial assets change. As income increase the amount of money held for the transactionary and precautionary motives increases while the speculative balance remains unchanged. This means that overall the total demand for money increases as income increases. 4 a) Keynesian liquidity preference theory introduced by Keynes, holds that the interest rate is determined by the interaction between the demand and supply of money. The demand for money also known as Liquidity preference refers to the amount of money individuals hold which is inversely related to the rate of interest. The supply of money on the other hand is fixed by the monetary authority which is the Central Bank. As such the supply of money can be represented by a vertical supply curve. The equilibrium in the money market is shown by point E which gives a market interest rate depicted by RE. Liquidity Preference Theory of Interest Rate Determination EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS
9. 9. EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS IR SM E RE LP= DM M 4 b) As interest rates decrease, investment projects which were previously unprofitable at the higher rate of interest would become profitable and the end result is an increase in the rate of investment. On the graph, a fall in the rate of interest from 18 percent to 6 percent leads to a movement along the MEI curve, which brings about an expansion in investment in the economy from \$2billion to \$14billion. Marginal Efficiency of Investments 4 c i) There are three lags that present major problems for effective demand management policy: EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS
10. 10. EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS 1. Recognition lag – this refers to the time it takes to recognize that there is a problem such as a recession or inflation, which needs correction. This is because economic data usually takes time to compile which leads to a delay in the analysis of the economy. 2. Administrative/legislative Lag – this refers to the takes time it takes to implement an appropriate policy after the economic authorities have recognized that policy action is needed. This lag arises from the legislative procedures required before any policy can be enacted to correct the course of the economy. It can be stated that monetary policy is generally flexible as the discount rate can be changed each month on the discretion of the monetary authorities. This implies that monetary policy generally involves a relatively short administrative/legislative lag. 3. Impact lag – this is the time it takes for the policy measure to work and achieve the macroeconomic objective. Since investment requires planning for the future, it may take some time before decreases in the rate of interest are translated into increased investment spending. This means that the impact lag might be long for monetary policy. 4 c ii) The potency of monetary policy refers to the extent to which its implementation can achieve the desired. The recognition lag does not affect the potency of monetary policy since it does not influence the monetary transmission mechanism. The monetary transmission mechanism refers to all the channels and intermediary stages between the change in the interest rate and the resulting change in the level of national income or other macroeconomic variable. In terms of the administrative lag of monetary policy, since this is small this it would not affect the potency of monetary policy. The impact lag however can negatively affect the potency of monetary policy since it may take a considerable length of time before the effects are felt onto the economy. This is undesirable since by the time monetary policy has full effect the variable targeted by the policy may have already been corrected by the nature working of the economy. This means that the existence of this lag may cause monetary policy to cause additional volatility in the economy. 4 d i) Fiscal policy is the management of the economy through the level of Government expenditure and taxation. That is, the Government can use this demand management tool to achieve its macroeconomic objectives by manipulating the fiscal budget. Fiscal policy can be used in various ways to achieve different objectives. 4 d ii) Suppose the Government wants to spend an additional \$20 billion on infrastructural improvements but wants to raise the money by increasing taxes by the same amount. In such a case the increase in Government expenditure of \$20B is exactly matched by an increase in autonomous taxation of \$20B. In this case, national income increases by the same magnitude as the increase in Government spending and taxation is \$20B. This is known as the balance budget multiplier which occurs whenever there are equal increases in both autonomous Government spending and taxation. Conclusively since the increase in Government expenditure of \$20B couples with an increase in taxation by this equivalent amount leads to an increase in national income by the same magnitude i.e. \$20B the balanced budget multiplier is therefore equal to 1. EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS
11. 11. EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS 4 d iii) Automatic stabilizers are mechanisms that automatically increase the injections and decreases withdrawals from the government sector during recessions. In other words an automatically stabilizer offsets the current economic climate without any active policy decision by the government. Unemployment benefits which are grants given by the government to the unemployed is an automatic stabilizer as it automatically increases during a recession. In addition during a recession income tax revenue falls and this would also abate the recession in the economy. If there is inflationary pressure in the economy arising from excess aggregate demand, then unemployment would be low and the government would automatically spend less on unemployment benefits. In addition, income tax revenue would automatically rise. This decrease in government spending and the increase in taxation would also have a dampening effect on inflation. 4 d iv) National debt and Debt Service Ratio National Debt The National Debt also known as the public sector debt is the accumulated debt built up by the Government over a number of years that has not yet been repaid. It represents the total amount owed by the Government to its citizens, which is domestic debt as well as the amount owed to foreigners which is external debt. Debt Service Ratio Debt service refers to the amounts required to cover the payment of interest and principal on debt for each year. The debt service ratio is the ratio of debt service (interest and principal payments due) during a year, expressed as a percentage of exports (typically of goods and services) for that year. It gives the proportion of export revenue used to cover debt servicing requirements. The smaller this ratio the more manageable would be the commitments on public debt. The debt service ratio can also be stated in terms of internal and external debt. The internal debt service ratio is based on the debt service on domestic debt as a ratio of export earnings. The external debt service ratio is based on the debt service on foreign debt as a percentage of export earnings. 4 e) Methods of financing a budget deficit without increasing taxes 1. Printing Money - The Central Bank can print more money to finance to government expenditure. This is seldom used because of the inflationary consequences. 2. Issuing Government Securities - The issue or sale of Government treasury securities represent loans undertaken by the government. The individuals who buy the securities effectively lend the government the amount that he or she pays for it. The buyer also receives interest as specified in the security contract (certificate) and is repaid after a specified period which is called the maturity. There are three different types as determined by the maturity. • Government Treasury bills which have short term maturities usually 3 month, 6 months or 1 year. • Government Treasury notes which have medium term maturities of between 1 to 5 years. • Government Treasury bonds which have long term maturities in excess of 5 years. EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS
12. 12. EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS 3. Borrowing from international lending institutions - The Government can also borrow directly from institutions such as the World Bank and the International Monetary Fund as well as from private international lending institutions. 4. The sale of public corporations – the government can also divest its interest in publicly owned companies to private investors. 5 a Four advantage of Foreign Direct Investment 1. FDI generates capital to meet deficiencies in savings in developing countries Foreign direct investments are a means of introducing new resources to developing countries which typically lack savings for domestic capital formation. Deficiencies in domestic savings in such countries are met without having to channel resources away from other uses such as consumption. The economy therefore benefits from capital formation which augments its productive capacity without any opportunity cost of forgone consumption. 2. Generates employment Foreign direct investments like any other type of investment in the local economy generates multiplier effects to the overall economy as forward and backward linkages between multinational and host economy firms are netted. In terms of the circular flow, FDI increases the level of injections which results in an overall heightened level of economic activity and hence the generation of increased employment opportunities. In this respect, FDI inflows in times of economic recession can help to curb the decline in economic activity and eliminate cyclical unemployment. In addition, foreign direct investments may revitalize certain sectors of the economy which may have been on the decline, thereby creating employment for the structurally unemployed. 3. Generates foreign exchange Foreign direct investment is also beneficial, as it generates valuable foreign exchange for its host economy. This could be quite advantageous, especially where other sources of foreign exchange are limited and are therefore supplemented by foreign direct investment flows. Foreign exchange is of vital importance in developmental programs which may require the importation of foreign capital, technology or even raw materials. Foreign direct investment therefore serves to bridge the gap between foreign exchange earnings and foreign exchange requirements. It must also be pointed out that foreign direct investments can also serve to continually generate foreign exchange apart from the initial investment inflow in the case where the investment targets the export sector. 4. Generates government taxation revenue Another beneficial aspect of foreign direct investments is its role in generating taxation revenue for host Governments. The operations of multinational corporations generate significant economic activity which increases the tax base for Government taxation purposes. This increase in the tax base which otherwise would be unattainable provides increased taxation revenue to LDC Government coffers. Such increased revenue may be a valuable in financing developmental projects undertaken by Government policy makers. 5 a Four disadvantage of Foreign Direct Investment EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS
13. 13. EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS 1. Repatriation of profits The fact that foreign direct investments originate from non local investors implies that the rate of return on such would accrue to their foreign proprietors. If such profits are repatriated by the countries of origin, then there is a drain of valuable foreign exchange. In the balance of payments, this would be seen as outflows in the current account section in the form of outflows of profits, interest, dividends, royalties, management fees, and other funds. In addition to the ramifications on foreign exchange and balance of payments, repatriated earnings are also disadvantageous as they represent a leakage of funds which could have been reinvested in the host economy. 2. Increased imports In addition to the outflow of property income, foreign direct investments in a host economy may have further adverse impact on the country’s balance of payments as a result of a higher importation. This particularly occurs when the initial investment involves significant importation of capital equipment from aboard or when the nature of the business operation requires large amounts of imported raw materials and other intermediate products in its production processes. Furthermore, there is also a tendency on the part of multinational companies which operate in a developing country to procure much of their raw materials from foreign affiliates as opposed to domestic producers in the host economy. Such lack of linkages with the economies in which they operate tend to inhibit the expansion of indigenous firms that might supply them with raw materials and other intermediate products. All things considered, the end result is a huge import bill which can be avoided by greater vertical integration on the part of transnational corporations with the host economy. In some cases, due to the nature of the operations of the transnational corporation, backward linkage with the rest of the economy may be limited e.g. an alumina smelter located in T&T which converts bauxite into aluminium ore would result in a rise in imports in that country as bauxite is not produced there and has to be imported. 3. Economic concessions Although it has been identified that encouragement of foreign direct investment generates significant revenue for host Governments, it must be recognized that this may not always because of economic concessions granted by host Governments. At times, due to their economic size and might, multinational companies are able to negotiate significant economic concessions as Governments in developing countries compete to attract foreign investments to their economy. These economic concessions may include: tax concessions, tax holidays and tax rebates. 4. Transfer Pricing Transfer pricing practices of multinational firms. Multinational companies may be able to reduce their tax disbursement to Government tax collectors by creative accounting practices. This is particularly applicable where corporate tax rates differ from one country to the next, a possibility which is highly likely given the different tax structures amongst countries. The tax savings is achieved by shifting reported profits away from high tax economies towards tax havens or countries with lower taxation structures where affiliated corporations conduct operations. Specifically, the practice in high tax countries would be to artificially increase the price paid for intermediate products purchased from an affiliated company in a foreign low taxed country. In so doing, profits in the high tax country would be artificially understated on account of the inflated cost of production EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS
14. 14. EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS reflected in its accounts. Conversely, in the low tax country, reported profits would be overstated as a result of the increased revenue recorded from the sale of overpriced output to related companies in high tax countries. In this manner the overall eligibility to pay tax is reduced for the multinational corporation as a whole and the high tax country suffers from unduly low tax revenue. 5 bi) The balance of payments is a record of all transactions conducted between a country and the rest of the world for a given time period, usually one year. Transactions which result in monetary receipts or inflows into the country are entered as positive numbers called credits, whilst payments or outflows from the country are entered as negative numbers called debits. The balance of payments, in effect, indicates the difference between the amount of money flowing into a country and that flowing out of the country. 5 b ii) The balance of payments is divided into two sections in order to distinguish between two different categories of transactions. These sections are:  Current Account – this records all items relating to imports and exports of goods and services, net property income and current transfers between a country and the rest of the world.  Capital Account - this records all movement of capital from both private sources as well as official government sources between a country and the rest of the world. The private movement of capital could be in the form of direct investments, foreign portfolio investments and hot money flows. 5 c) Causes of balance of payments crises The current account deficit occurs when imports of goods and services, investment income outflows and outward transfers exceed the exports of goods, services, investment income inflows and inward transfers. Some of the causes of a current account deficit are:  Low competitiveness. If a country’s manufacturing and service industries lack competitiveness then exports would be curtailed. In addition, consumers would be encouraged to purchase products from foreign more efficient producers. This would lead to a high level of imports which combined with low exports would result in a current account deficit. Domestic industries may lack competitiveness if needed resources are simply unavailable. It may also arise if small scale production is employed which prevents the attainment of economies of scale. Even if there is large scale production, the employment of obsolete technology may also result in high costs and hence low competitiveness. Finally high domestic inflation could also lead to an erosion of domestic competitiveness.  Rapid economic growth in income. As income increases, consumption rises and as such the level of imports increase. If exports remain unchanged, then a rise in income would result in a rise in imports and hence a deficit in the current account. Solutions to the two causes of balance of payments crises Export Subsidies. An export subsidy is a payment to a domestic producer who exports a good abroad. This can also be used independently or in conjunction with other policies for the purpose of eliminating a current account deficit. By subsidizing domestic exports, producers are able to reduce production cost which improves the competitiveness of their EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS
15. 15. EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS output in the international markets. This should therefore serve to boost export earnings and thereby eliminate the current account deficit. Expenditure Reducing Measures - deflationary or contractionary measures that decrease national income. This is because imports are said to be induced i.e. rise as income increases and likewise fall as income decreases. Exports on the other hand are said to be autonomous to the level of national income. Hence, as income decreases, imports fall while exports remain unchanged causing the deficit to be eliminated. This is shown by a movement along the import schedule in figure 36-1 from point A to point B. As a result of the decrease in the level of imports, the current account improves, possibly resulting in an overall balance. 6 a i) The term "economic growth" refers to the increases in the level of national income usually expressed in constant prices. Economic growth implies a rise in the productive capacity of an economy, which results in an outward shift of the production possibility frontier. 6 a ii) Factors Influencing Economic Growth Economic growth implies a rise in the productive capacity of an economy, which results in an outward shift of the production possibility frontier. Three factors which can lead to an increase in the productive capacity of the economy are: 1. Increase in Labour Resources Economic growth depends on the quality and size of the labour force. Increasing the quality of the workforce through better education and training increases the value of human capital and makes workers more productive. Also as the labour force becomes larger, the productive deployment of the additional workers enables more output to be produced. 2. Increase in Capital Resources Increasing, the stock of physical capital such as new factories, machinery and equipment, is critical in achieving economic growth as it enables a more efficient use of other factors of production such as labour. Investments in human capital formation enable the quality of labour to improve. This implies that labour productivity rises, enabling greater output from labour resources. 3. Improvements in Technology Technological advances enable the production of more output from a given amount of resources. This means that scarce resources are more productively utilized which reduces the real costs of supplying goods and services and this leads to an outward shift in a country’s production possibility frontier. This means that technological progress accelerates economic growth for any given rate of growth in the labour force and the capital stock. 6 a iii) Benefits of Economic Growth 1. An Increase in Income – as economies grow the average level of income earned by individuals would increase. This is beneficial as individuals are able to EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS
16. 16. EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS consume a greater variety of goods and services which increases their standard of living. 2. Increase employment – economic growth also enable an increase proportion of the labour force to be employed which also assists in reducing poverty within the society. 6 b) Indicators of Economic Development 1. Economic growth - One of the primary indicators of improvements in the standard of living is an increase in the per capita income of every citizen. This is because as income increases individuals are able to afford more goods and services. This indeed occurs when there is economic growth. 2. Life Expectancy - This refers to the average life expectancy from birth in a country. A number of factors would affect this such as the stability of food supplies, the extent to which an area is hampered by war, and the incidence of disease are all important. Economic development is achieved when life expectancy is on the rise. 3. Literacy Rates - This refers to the percentage of those aged 15 and above who are able to read and write a short, simple, statement on their everyday life. In order for economic development to take place the literacy rate of a country needs to be improved. 4. Poverty Rates - In chapter 16 the concepts of absolute and relative poverty were outlined. Absolute poverty occurs when households are unable to afford basic necessities such as food, clothing and shelter. Relative poverty means that the level of income earned is less than the average level of all households. Economic development requires that poverty rates be reduced. This means that absolute poverty and relative poverty needs to be lowered. Of course in order to decrease the rate relative poverty requires a more even distribution of income. 6 d) Difference between economic growth and development Economic development is a sustainable increase in the standards of living of the people of a country. Economic growth on the hand is only concerned with an increase in the level of real national income. The two concepts are different because the achievement of economic growth by itself does not necessarily imply that living standards are improved. This is because in addition to economic growth, improvement in literacy rates, life expectancy, and poverty rates are needed to achieve an increase in national welfare. Economic growth is therefore just one aspect of economic development. EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS