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CAPE Economics, June 2004, Unit 2, Paper 2 suggested answer by Edward Bahaw

CAPE Economics, June 2004, Unit 2, Paper 2 suggested answer by Edward Bahaw

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    CAPE Economics, June 2004, Unit 2, Paper 2 suggested answer by Edward Bahaw CAPE Economics, June 2004, Unit 2, Paper 2 suggested answer by Edward Bahaw Document Transcript

    • EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS CAPE ECONOMICS June 2004 Unit 2 Paper 2 EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS
    • EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS June 2004 – Unit 2 – Paper 2 1 a i) Percentage increase in Nominal Gross Domestic Product (1990 – 2002) 5672.6 - 2708.0 100 = × = 109.5% 2708.0 1 1 a ii) Percentage increase in Real Gross Domestic Product (1990 – 2002) 4848.8 - 3776.3 100 = × = 28.4% 3776.3 1 1 b i) 1 b ii) Real GDP Real Potential Nominal (1997 GDP (1997 Growth in Growth in Year GDP Price) Price) Output Gap Nominal GDP Real GDP 1990 2708 3776.3 3912.9 -136.6 1992 3149.6 3760.5 4090.9 -330.4 16.3% -0.4% 1994 3777.2 4148.3 4267.9 -119.6 19.9% 10.3% 1996 4268.6 4404.5 4499.8 -95.3 13.0% 6.2% 1998 4900.4 4718.6 4658.4 60.2 14.8% 7.1% 2000 5513.8 4884.9 4966 -81.1 12.5% 3.5% 2002 5672.6 4848.8 5092.7 -243.9 2.9% -0.7% 1 c i) 1 c ii) Year Output Gap Recessionary Gap/Inflationary Gap 1990 -136.6 Recessionary Gap 1992 -330.4 Recessionary Gap 1994 -119.6 Recessionary Gap 1996 -95.3 Recessionary Gap 1998 60.2 Inflationary Gap 2000 -81.1 Recessionary Gap 2002 -243.9 Recessionary Gap 1 c iii) Inflationary Gap An inflationary gap existed in the year 1998. 1 d) Given the decline in real GDP between 2000 and 2002, the economy is in the recession stage of the business cycle. EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS
    • EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS 2 a i) Real Income Consumption Savings 0 800 -800 2500 2800 -300 5000 4800 200 7500 6800 700 10000 8800 1200 2 a ii) Marginal Propensity to consume (MPC) MPC = ∆C/∆Y = 2000/2500 = 0.8 2 a iii) The Multiplier (K) K = 1 /(1 − MPC ) = 1 /(1 − 08) = 1 / 0.2 = 5 2 a iv) Equilibrium Level of Income AE = C + I + G + X - M C = 800 + 0.8Y I = 500 G = 200 X=0 M=0 ∴ AE = 800 + 0.8Y + 500+ 200 AE = 1500 + 0.8Y At Equilibrium: Y = AE ∴ Y = 1500 + 0.8Y Y - 0.8Y = 1500 0.2Y = 1500 Y = 1500/0.2 = 7500 The equilibrium level of national income is $7,500 million. 2 a v) Closed economy. This is because exports and imports are zero meaning that the country does not take part in international trade. 2 b i) Inverse relationship between aggregate demand (AD) and the average price level. As the average price level increase or decreases, there is a movement along the downward sloping AD curve. Changes in the price level typically affect aggregate EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS
    • EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS demand indirectly via its influence over intermediary variables. There are basically three main intermediary variables and their effects on each of the components of aggregate demand are now outlined. 1. Interest rate: If the price level rises, then the demand for money increases and as a consequence the rate of interest rises. As a result consumers are faced with higher expenses. In particular higher interest rates would make consumers’ loan more costly and it would therefore make it more expensive for consumers to buy ‘big ticket’ items such as consumer durables e.g., new cars, which are typically bought by consumer loans or through hire purchase. Similarly, increased interest rates would make it more expensive for firms to borrow funds and thus private investments are likely to decrease as well. 2. Relative prices between domestic and foreign goods and services: As the domestic price level rises, home produced goods become more expensive relative to goods produced in foreign countries. This has the effect of lowering export competitiveness which leads to a fall in exports. Furthermore, higher prices in the domestic economy, with foreign prices unchanged, would encourage consumers to purchase more imported goods and services. Conclusively, higher prices would cause exports to fall and imports to rise thus casing the level of aggregate demand to decrease. 3. Changes in real wealth: As the average price level increases, the real value of a person’s wealth may fall. As a result, people may feel less well off, and this may prompt them to consume fewer goods and services which reduce aggregate demand. 2 b ii) Three Other factors which affect aggregate demand 1. Taxation 2. Government spending 3. Business confidence or expectations 2 b iii) Three Other factors which affect aggregate demand 1. Taxation – A decrease in the rate of taxation, whether direct or indirect will have the effect of increasing AD whatever the price level, as consumers would have more disposable income to spend. Reduced corporation taxes or businesses taxes may make previously unfeasible investments profitable and thus result in higher investment. 2. Government spending – An increase in Government expenditure, one of the components of aggregate expenditure in the economy at unchanged prices would certainly increase aggregate demand causing it to shift to the right. 3. Business confidence or expectations – A major determinant of investments is expectations on the part of entrepreneurs. Expectations about the future can have a significant bearing on the overall level of business confidence. Regardless of the price level or rate of interest, firms will invest if they are optimistic about the future and will not invest if they have a pessimistic outlook. Thus, if firms are very confident about the future, then investments would rise and the aggregate demand would shift to the right. EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS
    • EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS 2 b iv) Difference between Keynesian and Classical Aggregate Supply Curve The classical aggregate supply (AS) curve makes a distinction between the short run and the long run while the Keynesian does not. Short Run Classical Aggregate Supply Curve According to the Classical AS curve in the short run, firms suffer from diminishing returns from their fixed factor, which contributes towards rising costs of production. These higher costs of production would induce firms to increase prices as output expands in order to pass on cost increases to consumers. This means the short run aggregate supply curve (SRAS) would be upward sloping in the short run. Classical Short Run Aggregate Supply Price Level (P) SRA S P2 P1 Y1 Y2 Y = Real Output Long Run Classical AS Curve According to Classical economic theory, in the long run the economy would be at a point on its production possibility frontier producing at its potential or full employment output level with its given resources. Classical economists therefore contend that the long run aggregate supply (LRAS) curve is vertical at the full employment level of output (YF). In these circumstances there is absolutely no spare capacity in the economy and any increase in aggregate demand leads to increased prices with no increase in output. Classical Long Run Aggregate Supply P LRAS B P2 A P1 YF Y=Real Output EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS
    • EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS Keynesian Aggregate Supply Along the Keynesian aggregate supply curve there is a horizontal portion which signifies that there is excess capacity in the economy and idle resources exist. Over this section of the aggregate supply curve shown in red, output can be expanded without the average level of prices increasing. In the blue section, the aggregate supply curve is upward sloping which implies that the economy as a whole is approaching maximum capacity. In this situation there would be increased pressure on the labour market, as nearly everyone has a job, and wages will begin to rise as firms have to offer more to attract workers. This in turn will cause cost of production to increase which leads to an increase in the prices of final output. The aggregate supply curve then becomes vertical as shown in green which depicts the attainment of full capacity by all firms. This is where output has reached its maximum and cannot be increased any further. This evidently occurs when the full employment level of income (YF) exists in the economy. Keynesian Aggregate Supply P AS P4 E P3 D C P2 A B P1 Y1 Y2 Y3 YF Y 3 a i) Money can be defined as anything that is generally accepted in payment for goods and services and in repayment of debts. 3 a ii) Two Types of Money  Commodity money. This is any money which has intrinsic value. That is the money is made from a commodity itself which has value. Examples of EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS
    • EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS commodities that have been used as mediums of exchange include gold, silver, copper, salt, peppercorns, large stones, decorated belts, shells, cigarettes etc.  Representative money. Instead of money being made from a commodity, a token such as a paper note can be used as a symbol of the commodity. Such money is referred to as representative money is. Representative money is therefore backed by an underlying commodity which is where it derives its value. The name of the commodity which the token represents is usually stated on it. Representative money replaced commodity money as the later presented challenges mainly in terms of portability. 3 a iii) Motives for demanding Money 1. Transactionary motive – this refers to amount of money held for daily use to carry out routine transactions. 2. Precautionary motive – this accounts for money held for unforeseen expenditures or unforeseen contingencies. 3. Speculative motive – this is any money held in excess of the transactionary and precautionary motive and accounts for any money held in the hope of either making a speculative gain, or avoiding a possible loss as a result of a change in the interest rate and hence the price of financial assets. 3 a iv) Transactionary motive – As an individual receives his monthly income, say at the end of January, he would spend some immediately and hold a portion of it throughout the month of February in order to carry out daily expenditure over that period. In economic jargon, the timing of the receipt of income and daily expenditure are not perfectly synchronized. As a result individuals must hold a proportion of their income throughout the month in order to fulfil daily transactions. In general, money held for the transactionary motive tends to increase with income. It is however, not affected by changes in the interest rate which means that the transactionary demand for money is perfectly interest inelastic. These characteristics are shown in panel A and B of the figure. Panel A: Positively related to Pane B: Not affected by the Income Interest Rate M IR TB TB Y M Speculative motive – this is any money held in excess of the transactionary and precautionary motive. For example, if the total amount of money held by an individual is $1,100 and his transactionary and precautionary balances are $500 and $200 respectively, EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS
    • EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS then his speculative balance is $400. The speculative motive for holding money, is distinct from the other two, in that it accounts for any money held in the hope of either making a speculative gain, or avoiding a possible loss as a result of an expected change in the interest rate and hence the price of financial assets. There is an inverse relationship between the demand for money for speculative purposes and the rate of interest as shown in the figure. IR (% 1 0 5 SB M 400 600 3 b i a) Commercial banks, accepts deposits from savers and uses these funds to make loans to borrowers. In the banking system though as money is lent to a borrower it is subsequently used to purchase a good or a service. As it changes hands from the borrower/buyer to the seller, it might subsequently be deposited back into the bank by this person. In other words the initial deposit of money is lent out, spend and is subsequently re-deposited by another party. This means the initial deposit of money has created a secondary or derivative deposit of money. Each time money is lent and re- deposited in the form of a derivative deposit a smaller and smaller amount is available for lending. Given an initial deposit of $100 and cash reserve ratio of 10 percent the credit creation process can be shown by the following table. The commercial bank would lend out $90 to a borrower then subsequently the $90 would be returned to the bank by another party in the form of a derivative. As this is collected, 10 percent is kept as reserves at the commercial bank and the remaining $81 is lent out. Eventually $81 would be re- deposited into the bank and $72.90 is lent out. This process continues until the commercial bank has no more funds available for lending. Deposit/Money Creation by Commercial Banks Depositor Deposits Loans Reserves Initial Deposit 1st $100.00 $90.00 $10.00 Derivative Deposit 2nd $90.00 $81.00 $9.00 Derivative Deposit 3rd $81.00 $72.90 $8.10 Derivative Deposit 4th $72.90 $65.61 $7.29 Derivative Deposit . . . EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS
    • EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS Derivative Deposit . . . Derivative Deposit ∞ . . . Total Deposits $1,000.00 $900.00 $100.00 3 b i b) The total deposits would comprise of the sum of the initial deposit and all derivative deposits. From the table this would be $100 + $90 + $81 + $72.90 + … The table shows that this adds up to $1,000. To determine this amount the money multiplier is used. The money multiplier refers to ratio of the total deposits at a commercial bank to the initial deposit and is calculated by the following formula. Money Multiplier = 1 / (Cash Reserve Ratio) = 1/10% = 10 This means that if the initial deposit is $100 then total deposits created by the credit creation process would be 10 times or $1,000. 3 b ii) Inverse relationship between the rate of interest and the demand for money. Both the transactionary and precautionary demand for money are perfectly interest inelastic. The inverse relationship between the rate of interest and the demand for money arises entirely from the speculative motive. If, for some reason, the actual rate of interest in the economy was say 5 percent but speculators anticipated that is would rise to 8 percent then individuals would prefer to hold their wealth in the form of money since as the interest rate rises, the price of financial assets fall. This is because if wealth was held in the form of financial assets are then a capital loss would be incurred On the converse side, if the actual rate of interest in the economy was say 10 percent, speculators contended that it would fall to 8 percent then individuals would hold less of their wealth in the form of money and thus more in the form of financial assets. This is because if the rate of interest falls, the price of financial assets would rise and the holders of such assets would earn a capital gain. In short, the analysis simply suggests that if the interest rate is low and expected to rise then individuals would hold more money in speculative balances. On the other hand if the interest rate is high and expected to fall then the speculative demand for money would be low. This is shown in the figure which demonstrates an inverse relationship between the rate of interest and the speculative demand for money. EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS
    • EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS The Speculation Demand for Money IR 10 5 SB M $4B $10B 3 b iii) An increase in the supply of money. As the money supply increases a surplus of money is created in the money market. In order for the money market to clear, the rate of interest must fall to entice individuals to hold larger money balances. As the figure shows an increase in the money supply results in the establishment of a new equilibrium in the money market at a lower rate of interest. This represents expansionary monetary policy as the lower interest rate would lead to an increase in the level of output and employment in an economy. IR SM1 SM2 E1 IR1 E2 IR2 LP= DM M 4 a i) National Debt and the Budget Deficit 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. EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS
    • EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS The budget deficit refers to the difference between government spending and taxation revenue. This short fall can be met by printing money or by borrowing. If the government chooses to borrow, then the national debt increases. 4 a ii) Three Fiscal Measures to increase employment 1. Increased government spending on projects which create direct employment 2. Increased government spending on education 3. Decreases taxation. 4 a iii) Three Fiscal Measures to increase employment 1. Increased government spending on projects which create direct employment. The government can increase its expenditure on projects such as infrastructure which directly creates employment opportunities. Such expenditure would also result in an increase in the productive capacity of the economy. Furthermore given the multiplier effects, aggregate expenditure throughout the economy would expand as income rises. Such increases in the demand for goods and services would also encourage entrepreneurs to produce greater output and more labour is employed. This means the increase in government spending also creates indirect employment. This type of measure would be suitable in reducing cyclical unemployment. 2. Increased government spending on education. As the government spends more on education whether in terms of facilities or financial aid, the level of human capital in the economy would rise. This means the productivity of labour would be boosted and those who were previous unemployed would be able to obtain jobs. New industries would develop and a greater proportion of the labour force would be absorbed by employment opportunities. This type of fiscal measure would be applicable to solving structural and technological unemployment. 3. Decreases taxation. Sometimes if direct taxation is too high it may be a major discouragement to economic activity. A reduction in taxation would enable workers to take home more disposable income and companies to earn greater after tax profits. Both of these factors would increase the incentives to productive activities and encourage more individuals to seek employment as well as firms to hire more workers. This can be a very effective measure to reduce cyclical unemployment as well as voluntary unemployment. 4 b i) Effect of an increase in lump sup taxes All other variables held constant an increase in taxation which is withdrawal from the circular flow of income would result in a fall in aggregate expenditure. As a result national income would fall via the multiplier principle resulting in a fall in the equilibrium level of output. 4 b ii) Effect of an Increase in Government Spending All other variables held constant an increase in government spending which is an injection into the circular flow if income would result in an increase in aggregate EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS
    • EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS expenditure. As such, the production would expand and national income would rise via the multiplier principle. The end result is an increase in the equilibrium level of output. 4 b iii) Effect of an Increase in Government Spending and Lump sum taxes. An increase in government spending and taxation of equal magnitude all other variables held constant would affect the level of national income via the balanced budget multiplier. This principle asserts that the equilibrium level of output would increase in equal magnitude to the increase in government spending. 4 c) Burden of Public Debt on Future Generations 1. Recurrent vs Capital Expenditure - The money borrowed may be used for recurrent expenditure by the government which benefits only the current populations and the not the future generation. If however the borrowed funds is used for capital expenditure in the form of improvements to infrastructure which last several decades then this can benefit future generations. 2. Interest Payments - interest payments and the repayment of principal on debt reduces the amount of money which the government has to devote towards other uses such as spending on educational facilities for instance. This may also result in an increase in taxes which may not be favoured by tax payers. 3. Foreign exchange drain - The repayment of interest and principal on external has to be made using foreign currency. This causes a significant drain of foreign exchange which negatively affects the balance of payments. 5 a i) Two Difference between Economic Growth and Development The term "economic growth" refers to the increases in the level of national income usually expressed in constant prices. The term "economic development," refers to a sustainable improvement in the standard of living of a country. As such in addition to national income economic development takes other factors into consideration. Two of these factors are literacy rates and life expectancy. 5 a ii) Three factors which Allow Economic Growth 1. Increases in Capital Resources- investments in infrastructure such as a rapid rail transportation network in Trinidad and Tobago. 2. Increases in Natural Resources – the discovery of new unscathed hydrocarbon fields on the offshore territories in the Trinidad and Tobago. 3. Increases of Labour Resources – an increase in the productivity of the labour force through expenditure on human capital formation. In Trinidad and Tobago for instance spending on tertiary level education by the government has seen a significant increase. 5 a iii) Two Benefits of Economic Growth 1. An Increase in Income – economic growth is defined as an increase in the level of real national income. This is beneficial as individuals are able to consume more goods and services which increases their standard of living. EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS
    • EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS 2. Poverty reduction – economic growth also enable an increase proportion of the labour force to be employed which also assists in reducing poverty within the society. 5 a iii) Two Cost of Economic Growth 1. Increased inequality – as national income increases only the high income earners may benefit while the low income earners may enjoy an improvement in the standard of living. This means that the distribution of income might worsen as inequality widens. 2. Negative externalities –economic growth means more output is being production but this may be achieved at the expense of increased noise, congestion, pollution and other negative externalities which undermine economic welfare. 5 b i) Unequal distribution of World Income Column 6 and 7. 5 b ii) Columns 1, columns 6 and columns 7. Column 1 shows that there are 4 categories of countries based on GDP per capita. Column 6 shows that the bulk of the world population resides in low income countries. Column 7 indicates that high income countries earn 79.9 percent of world GDP. 5 b iii) Income grouping of Most CARICOM Countries Most Caribbean countries would fall in the upper middle income category since although many challenges are faced in the region living standards and GDP per capita is much higher compared to the poorer countries across the world but still les than that in the developed economies. 5 b iv) Two Consequences of low income 1. Low consumption – A low level of income means that households would not be able to afford a lot of goods and services which they desire. If income is so low that basic goods such as food, clothing and shelter cannot be afforded then a life of poverty would be experienced. 2. Low savings – low income also means that households would have limited funds available for savings. With low savings, there will not be enough funds available for investments. Consequently, there will be less economic growth and the country remains poor. The cycle of poverty therefore continues. 5 b v) Three Constraints to development 1. Lack of natural resources – in some developing countries natural resources may be scare as a lot of land may be desert and non arable. Furthermore, other natural resources such as minerals and fisheries may be non existent or extremely limited and this places a major constraint on economic development as basic inputs for the production process would be lacking. EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS
    • EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS 2. Lack of human capital – in addition to natural resources, developing countries may face constraints in terms of the skills possess by the workforce. Spending on human capital formation may be minimal and the productivity of labour would be low as a consequence. This effectively prevents such countries from reaching efficiency levels sufficient for international competition in export market. 3. Lack of physical capital or infrastructure – investments in infrastructure may also be inhibited due to lack of savings to finance such expenditure. As a result the productive capacity of such economies remains backward and the achievement of economic development is impeded. 6 a i) Definition of the Exchange Rate An exchange rate is simply the price at which one currency can be traded for another. This is sometimes referred to as the external value of a country’s currency. In 1996, the nominal exchange rate between the Trinidad and Tobago dollar and the United States dollar was: TT$6.00 = US$1.00 or TT$1.00 = US$0.17 6 a ii) Two Types of Exchange Rate Systems 1. Fixed Exchange Rate 2. Floating Exchange Rate 6 a iii) The Fixed Exchange Rate The fixed exchange rate or pegged exchange rate is one means by which an exchange rate can be determined. Under the fixed exchange rate system, the exchange rate is set by the Government and maintained by Government intervention in the foreign exchange markets. In Barbados for instance, a fixed exchange rate is adopted with the United States dollar where Bds$2 = US$1. If the official rate coincides with the equilibrium rate in the foreign exchange market, then there is no need for Government intervention. This is shown in the figure which presents a hypothetical illustration of the official exchange rate set by the Government of Barbados coinciding with the rate at which the demand for foreign exchange in Barbados is equal to its supply. EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS
    • EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS The Fixed Exchange Rate Bds$/US$ D S Bds$2 = US$1 Official Rate S D QUS$ If, however, the official rate differs from the equilibrium rate, then Government intervention is necessary through the manipulation of the foreign exchange reserves of foreign currency or even foreign exchange control measures. If at the official rate is higher then the equilibrium, then the demand for foreign exchange would be lower then the supply of foreign exchange. Given market forces, such a surplus would result in a decrease in the exchange rate. This however does not occur, as the rate is fixed. Instead, the Government intervenes in the market and gets rid of the surplus by purchasing the excess foreign exchange from the market. In the reverse instance, where the official rate is below the market equilibrium, a shortage is created in the foreign exchange market. Normally this would lead to upward pressure on the exchange rate. However, since the rate is fixed, the Barbados authorities would have to intervene in the foreign exchange market by increasing the supply of foreign exchange. This is done by the release of foreign exchange reserves held at the Central Bank of Barbados to the foreign exchange market. There is however a limit on the amount of official foreign exchange reserves which a country possesses and thus the use of reserves to defend the currency in this way cannot be sustained indefinitely. Another solution to the shortage of foreign exchange under a fixed rate system is the use of exchange controls. Exchange control refers to restrictions placed upon the ability of domestic households to purchase foreign currencies which effectively decreases the demand for foreign exchange. 6 a iii) The Floating Exchange Rate Under the floating exchange rate system, the exchange rate between the domestic currency and the foreign currency is determined by the demand and supply in the foreign exchange market. The demand for foreign currency arises whenever there is need to exchange domestic currency in return for foreign currency. The supply of foreign currency arises from all inflows of foreign exchange in the balance of payments. EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS
    • EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS Floating Exchange Rate in Jamaica Jam$/US$ D S E Jam$40 = US$1 S D QE QUS$ The figure shows the demand and supply for US dollars in Jamaica which has a floating exchange rate. This shows that equilibrium in the foreign exchange market occurs at point E, where the overall demand for US dollars is equal to the supply of US dollars. In 2000, the exchange rate in Jamaica was J$40 = US$1 which implied that the external value of a Jamaican dollar was about US$0.025 which is about 2.5 US cents. 6 b i) An increase in price of US videos with elastic demand As the price of US videos increases, the demand for such by the British would fall. Since the demand is elastic there would be a decrease in the value imported videos from USA to Britain. As a result there would be a decrease in the demand for US dollars. This is shown in the figure. £/US$ D1 S D2 E1 £1.00 = US$1 £0.80 = US$1 E2 S D2 D1 Q2 Q1 QUS$ EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS
    • EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS As shown the exchange rate changes from £1.00 = US$1 to £0.80 = US$1. This means the value of the British pound has increased relative to the US dollar. 6 b ii) An increase in price of US videos with inelastic demand As the price of US videos increases, the demand for such by the British would fall. Since the demand is inelastic there would be an increase in the value imported videos from USA to Britain. As a result there would be an increase in the demand for US dollars. This is shown in the figure. £/US$ D2 S D1 £1.50 = US$1 E2 £1.00 = US$1 E1 S D2 D1 Q1 Q2 QUS$ As shown the exchange rate changes from £1.00 = US$1 to £1.50 = US$1. That is the value of the British pound has decreased relative to the US dollar. 6 b iii) Inflation in Britain. If there is inflation in Britain, then there would be an increase in imports from USA to Britain which increases the demand for US dollars. In addition there would also be a decrease in exports from Britain to USA which decreases the supply of US dollars. These two effects are shown in the figure. £/US$ S2 D2 S1 D1 E2 £3.00 = US$1 E1 £1.00 = US$1 S1 S2 D1 D2 Q2 Q1 QUS$ EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS
    • EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS As shown the exchange rate changes from £1.00 = US$1 to £3..00 = US$1. This implies that the value of the British pound has decreased relative to the US dollar. 6 b iv) Increase financial investments from Britain to USA An increase in investments from Britain to USA increases the demand for US dollars. This is shown in the figure. £/US$ D2 S D1 £1.50 = US$1 E2 £1.00 = US$1 E1 S D2 D1 Q1 Q2 QUS$ As shown the exchange rate changes from £1.00 = US$1 to £1..50 = US$1. As such the value of the British pound has decreased relative to the US dollar. EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS