June 2009 unit 2 paper 2 answer


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June 2009 unit 2 paper 2 answer

  2. 2. EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONSJune 2009 – Unit 2 – Paper 21 a i) Inflation can be defined as a sustained increase in the average or general level ofprices which results in a fall in the purchasing power of money. The average level ofprices is measured using the consumer price index (CPI) which is the weighted averageprice changes of a range or a “basket” of goods and services consumed by the averagehousehold. After determining the CPI, the rate of inflation is calculated by taking thepercentage change in the CPI over the proceeding twelve months. This is given by thefollowing formulae: [Current CPI − Previous CPI]Rate of Inflation = ×100 Previous CPI1 a ii) The term economic growth refers to an increase in the level of national incomeexpressed in constant prices. Economic growth implies a rise in the productive capacityof an economy. The rate of economic growth is determined by taking the annualpercentage increase in real GDP. [Current RealGDP − Previous RealGDP]Rate of Economic Growth = ×100 Previous RealGDP1 a iii) The unemployment rate is defined as the proportion of individuals from the labourforce who are unemployed. This is therefore given by the following formula: Number UnemployedUnemployment Rate = ×100 Labour ForceThat is, the labour force constitutes all individuals within an economy who are ofworking age who are either working or in search of a job.1 a iv) The balance of payments is a record of all transactions conducted between acountry and the rest of the world for a given time period, usually one year. Transactionswhich result in monetary receipts or inflows into the country are entered as positivenumbers, whilst payments or outflows from the country are entered as negative numbers.The balance of payments, in effect, indicates the difference between the amount ofmoney flowing into a country and that flowing out of the country. The balance ofpayments is divided into two sections in order to distinguish between two differentcategories of transactions. These sections are:1. 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.2. 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. EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS
  3. 3. EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS1 b i a) The expenditure approach focuses on aggregating all expenditures on final goodsand services produced within an economy to determine GDP. In any economy aggregateexpenditure would consist of consumers’ expenditure, investment expenditure,government expenditures and net expenditure from the foreign trade sector as given byexports minus import.GDP = C + I + G + X −Mwhere:C = Consumers’ expenditureI = Investment expenditureG = Government expenditureX = ExportsM = Imports1 b i b)C = 600I = 150G = 200X = 300M = 275GDP = 600 + 150 + 200 + 300 – 275 = $975 million1 b ii a) Gross domestic product could also be measured by summing all components ofincome throughout the economy. This basically consists of the factor incomes of: wages,rent, interest, and profit.GDP = Wages + Profit + Rent + InterestWages = 800Profit = 200Rent = 75Interest = xGDP = 800 + 200 + 75 + x = $975 millionx = -$100 million1 c i)Used Textbooks – not included in current GDP calculation as production took place in aprevious year.Black Market transactions – not included as illegal activities are not formally recordedand reported in the country. EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS
  4. 4. EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONSNew Factory – this is a component of investment and is included in the GDP calculations1 d ) Living standards refer to the quality of life enjoyed by people. An increase in GDPper capita indicates that individuals are on average earning a higher level of income andhence can afford a large quantity of goods and services. This should lead to a highstandard of living however there are a number of other factors which needs to be takeninto consideration such as: 1. Inflation – an increase in GDP per capita would not enable consumers to purchase more goods and services if the price level has increased more than proportionately. Using real GDP per capita is a better indicator of living standards as it overcomes the inflation limitation. 2. Income distribution – an increase in GDP per capita would not enable consumers to purchase more goods and services if income is unevenly distributed. This is because although on average income is on the increase, only some individuals in society would earn higher income while the rest would become relatively poorer. 3. Negative externalities – an increase economic activity is often accompanied with an increase in pollution, environmental degradation and other negative externalities. These all result in lower living standards to those affected. Since GDP per capita does not take into consideration these impacts, it would adequately measure living standards in a country. 4. Leisure – if an increase in GDP per capita is achieved by individuals working longer hours, then the reduction in leisure may have a negative effect on the quality of life. Since leisure is not taken into consideration in the calculation of GDP per capita then it would not accurately reflect the standard of living enjoyed by individuals of a country. 5. Accuracy – the calculation of national income statistics involves the assimilation of vast amounts of data about the economy. As a result there may be some level of inaccuracy in GDP per capita figures and hence living standards may be misrepresented.2 a i)The average propensity to consume (APC) is the proportion of income devoted toconsumption of goods and services.The marginal propensity to consume (MPCD) is the proportion of any change in incomethat is devoted to consumption of goods and services.2 a ii)APC = C/Y.MPC = ∆C/∆Y.2 b) Average Propensity to Consume and Marginal Propensity to Consume Y C APC MPC 0 $20M ∞ $25M $35M 1.4 0.6 $50M $50M 1 0.6 EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS
  5. 5. EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS $75M $65M 0.87 0.6 $100M $80M 0.8 0.6As income increase, APC falls continuously, but MPC remains constant.2 c i) Autonomous consumption – gives the level of consumption when income is zero.This covers the amount of goods and services that have to be consumed whether theconsumer has income.2 c ii) The Consumption Function 45° line whereC ($M) Consumption = incomeThe consumption function as shown in the figure depicts the relationship between total Consumptionconsumption and the level of income. The consumption function is upward sloping sinceas income increases, consumers’ expenditure tends to rise. The pointFunction the at whichconsumption function cuts the vertical axis represents the level of consumption where 80income is zero. This means autonomous consumption is $20 million. 652 d i) Determinants of consumption1. Interest rates2. 50 Inflation3. Wealth4. 35 Indebtedness5. Expectations6. Taxation 202 d ii) Determinants of consumption – Impacts1. Interest rates – A change in the rate of interest can significantly affect consumers’ expenditure at unchanged income. To a large extent, the purchase of 45° 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 and25 may entice consumers to increase their spending, especially for this 50 75 100 Y $M acquiring consumer durables. A decrease in the interest rate would therefore result in an upward shift of the consumption function and a downward shift of the saving function. Furthermore, it can also be stated that the rate of interest gives the opportunity cost of consumption. This is because, if income is saved and hence not spent, interest is earned. If consumers choose to spend and not save, then such interest is forgone. Once again if the interest rate is lowered, then the opportunity cost of spending money decreases and consumers spend more and save less.2. Inflation – As the price level increases at unchanged income levels, consumers 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, even though the same quantity of goods and services are being purchased, except at higher prices. This therefore implies that inflation leads to an EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS
  6. 6. EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS upward shift of the consumption function. There is however, a counterargument which states that saving would tend to increase instead when the average price level increases. This is because as inflation lowers the real value of savings, households would tend to save more to replenish the purchasing power of their saved wealth. This relationship therefore seems to suggest that an increase in the price level would lead to an upward shift of the saving function and a downward shift of the consumption function. In summary, the exact effect of inflation on consumption and saving depends on whether consumers prefer to maintain the current standard of living by consuming the same basket of goods by cutting back on saving or if they prefer to maintain the purchasing power of their savings by reducing consumption.3. 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 is a tendency for individuals to consume more out of disposable income. Accordingly, as households’ wealth increases, the consumption function shifts upwards.4. Indebtedness – The amount of debt which consumers accumulate can also affect consumers’ expenditure patterns in exactly the reverse manner in which the level of wealth does. If households incur a large amount of debt such that a sizable proportion of their income is committed to the repayment of debt, then consumers may tend to reduce consumption in an attempt to cut-back on their indebtedness. This would shift the consumption function downwards. Conversely, if consumers incur a low level of debt, then they may be more inclined to spend a larger proportion of income. Furthermore, it is quite plausible that a low level of indebtedness may actually encourage consumers to borrow for spending purposes and this shifts the consumption function upwards.5. Expectations – Consumers’ expectations play an important role in determining consumers’ 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 expected future income may give consumers the feeling of security 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.6. Taxation - A change in direct taxation directly impacts consumers’ disposable income even though consumers’ income is unchanged. For example, if someone’s gross income is $100,000 per year and the income tax rate is 15 percent, then $15,000 would have to be paid in taxes and only $85,000 would be available for spending. If the rate of income tax were to be increased to say 25 percent, then taxation would increase to $25,000 leaving only $75,000 in disposable income. Due to this effect on disposable income, an increase in taxation would lead to a decrease in both consumption and saving, shifting both functions downwards. Conversely, a decrease in direct taxation would increase disposable income and EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS
  7. 7. EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS this would be distributed towards higher consumption as well as higher saving, shifting both curves in an upward direction.3a iNarrow money, also called M1, covers money which is immediately available forspending. That is, it comprises the monetary base and all short term deposits. Thismeasure of money fulfils the medium of exchange function.3a iiBroad 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 financialinstitutions. This monetary aggregate fulfils the store of value function.3a iiiThe stages involved from the implementation of expansionary monetary policy to anincrease in output and employment is called the monetary transmission mechanism. Asthe money supply increases, a surplus of money is created in the money market. In orderfor the money market to clear, the rate of interest must fall to entice individuals to holdlarger money balances. Following a reduction in the rate of interest, monetarist classifytwo independent effects:Direct effects – This accounts for the effect of a fall in the interest rate which leads to anincrease in consumer spending on goods and services. This increase in consumerexpenditure when the interest rates changes is also known as the wealth effect.Indirect effects – This refers to the impact of the fall in the interest rate on investmentswhich is assumed to be quite elastic, since monetarist believe that the rate of interestplays an important role in determining investments.3a ivV is referred to as the velocity of circulation which gives the number of times per yeareach dollar is spent on goods and services. The product between the money supply andthe velocity of circulation gives the total level of expenditure in the economy for theentire year.3a vCurrency substitution - In a large number of emerging and developing economies, localcurrencies do not adequately fulfil the functions of money and as a consequenceindividuals partially switch to foreign currencies. This is referred to as currencysubstitutions. One of the prime factors responsible for currency substitution is highdomestic inflation.1 When this occurs, holding domestic money becomes quite costly, asthe purchasing power or real value is eroded. In an attempt to avoid such losses,individuals react by switching to foreign currencies as a store of value. Here, the foreign1 This can be expected when governments that resort to financing their deficits through inflation (printingmoney) force their people to respond to the expected inflation by reducing their holdings of domesticcurrency and by substituting foreign currencies for the domestic ones. EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS
  8. 8. EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONScurrency, such as the US dollar, is used as a medium of exchange instead of the localcurrency. There are different degrees to which a foreign currency takes the role of thelocal currency. There can be partial currency substitution where local currency ispartially substituted by a foreign currency or there can be full dollarization whereindividuals switch entirely away from domestic currency in favour of the US dollar. Inthis case, the monetary authorities totally will lose the ability to manage the moneysupply as the Central bank of any country only has jurisdiction over the local moneysupply. For instance, the Central Bank of Trinidad and Tobago can only print and issueTT dollars but it cannot print and issue US dollars. Thus, currency substitution limits theGovernment’s control over the domestic component of money and this reduces theeffectiveness of monetary policy.3b1. Transactionary motive – this refers to the 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 events or contingencies.3. Speculative motive – This is any money held by individuals as they aim to take advantage of capital gains and avoid capital losses due to changes in the price of financial assets.3c Contractionary Monetary Policy Higher Interest Rate or Decrease in the money Supply Decrease in Consumption Decrease in Investment Decrease in Aggregate Expenditure1. Repo Rate and the Discount Rate • The Repo rate is the rate at which the Central Bank is prepared to provide overnight financing to commercial banks. On various occasions, commercial banks may need to borrow from the Central Bank for just one day or an overnight period. This might apply at the end of a particular month when commercial banks might need additional cash reserves to meet the withdrawal requirements of customers who cash their pay cheques on that day. As the EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS
  9. 9. EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS Repo rate is increased, commercial banks are subjected to more cost and respond by increasing the rate of interest charged to borrowers. • The Discount Rate is the rate charged to commercials banks on short term loans from the Central Bank. Commercial banks may also need to borrow from the Central bank for short term purposes when they are temporarily unable to meet their liquidity requirements over such periods. Similar to the Repo rate, as the discount rate is increased the rate of interest charged by commercial banks increases and vice versa.2. Reserve Requirements and Special reserve deposits – This is a banking regulation which requires that a percentage of commercial banks’ deposits must be kept in the form of cash. As the reserve requirement ratio changes, so too does the banking multiplier (see chapter 27). As the reserve requirement ratio is increased, the banking multiplier decreases, as banks are obligated to keep a larger proportion of their deposits in liquid form. As a consequence, less money is lent and the credit creation process is diminished. As a result, the money supply contracts and this causes the rate of interest to increase leading to a contraction of aggregate expenditure. In addition to the reserve requirement ratio, the Central Bank can institute special reserve deposits onto financial institutions. For example, in 2005, the Central Bank of Trinidad and Tobago required that commercial banks make special deposits at the Central Bank in addition to the reserve requirement ratio. It must be noted that an increase in the reserve requirements may not have any impact on the banking multiplier if commercial banks keep excess reserves. In this scenario, commercial banks would be able to meet the new reserve requirements without reducing lending. This can therefore make the use of this instrument ineffective.3. Open Market Operations – This is the principal tool of monetary policy. This involves the buying and selling of government securities in the open capital market. If the Central Bank purchases securities from the public, then this increases the amount of money in circulation which eventually finds itself into the commercial banking system. This therefore leads to a multiple expansion of deposits and hence a further increase in the money supply. The rate of interest consequently decreases and aggregate expenditure expands. In contrast, the sale of securities does the opposite, as money is withdrawn from the banking system resulting in a higher interest rate and a contraction of aggregate expenditure. It must be noted that if the Central Bank purchases securities and the recipients of the money invest it abroad, then the domestic money supply would not be increased, rendering this tool ineffective under this circumstance.4. Issue of notes and coins (M0) – The Central Bank of any country can easily control the amount of cash in circulation in the economy as it has the sole responsibility for minting coins such as a 25 cent piece and printing bank notes such as a $1 bill and $10 bill and so. As such, the Central Bank is also able to increase the money supply by simply minting more coins and printing more bank notes and releasing them into circulation. Of course, this cash would be released into circulation as the government spends the newly created money.5. Moral suasion – the Central Bank may attempt to extend its monetary policy stance on the economy by simply communicating its wishes to the financial sector. If the Central Bank wanted to effect a monetary contraction, the monetary authorities may EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS
  10. 10. EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS request, without any compulsory consequences, that commercial banks increase their liquidity ratio or reduce the amount of loans issued. These actions would definitely result in a decrease in the money supply and a reduction in the level of aggregate expenditure. In this situation, commercial banks are not obligated to comply with such requests and as such, this tool may not be an effective monetary policy weapon.3dAs the money supply increases, a surplus of money is created in the money market. Inorder for the money market to clear, the rate of interest must fall to entice individuals tohold larger money balances. IR SM1 SM2 E1 IR1 E2 IR2 LP= DM MAs the figure shows, an increase in the money supply results in the establishment of anew equilibrium in the money market at a lower rate of interest. This representsexpansionary monetary policy, as the lower interest rate would lead to an increase in thelevel of output and employment in an economy.3eThe Elasticity of the Demand for Investment – The effectiveness of monetary policydepends on the impact of changes in the rate of interest on investment spending (andconsumer spending) in the economy. In the previous section, the monetary transmissionmechanism was demonstrated under different assumptions. According to the Keynesiantransmission mechanism, if the demand for investments (MEI) is highly inelastic, then achange in the rate of interest may not have a profound effect on the level of investments.This may occur for interest insensitive investments which may be dependent on otherfactors such as business expectations or Government incentives and taxation In thissituation, the effectiveness of monetary policy would be weak.Changes in the Velocity of Circulation – Referring back to the equation of exchangewhere:MV = PY. EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS
  11. 11. EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONSThe product between the money supply and the velocity of circulation gives the totallevel of expenditure in the economy for the entire year. The value of V is said to beinversely proportional to the level of money demand, in that if the demand for money ishigh, money would slowly circulate in the economy. If the demand for money is low,then a given supply of money in the economy would circulate or change hands at arelatively faster rate. If it assumed that the velocity of circulation of money is constant,then the demand for money is expected to be stable. As such, any change in the moneysupply, M, would directly result in a change in total expenditure, MV.If the velocity of circulation of money were to vary and move in the opposite direction toa change in the stock of money, then it is likely that there would be no change in the levelof aggregate expenditure in the economy. Thus, if for instance the monetary authoritiesreduced the supply of money, but the public responded by holding less money, then therewould be an increase in the circulation of money. This means that as the supply of moneyshifts to the left, the demand for money curve also shifts to the left. As a result, the rate ofinterest remains constant and there is no impact on aggregate expenditure.4a iThe Balanced Budget Multiplier applies in the case where the increase in governmentexpenditure of is exactly matched by an increase in taxation. In this situation, nationalincome increases by the same magnitude, as the increase in government spending andtaxation. The balanced budget multiplier is therefore equal to 1.4a iiFiscal policy is the management of the economy through the level of governmentexpenditure and taxation. That is, the government can use this demand management toolto achieve its macroeconomic objectives by manipulating the fiscal budget. Since itinvolves public spending and taxation, the arm of government which is in charge of thispolicy option is the Ministry of Finance.4a iiiEvery year the government of a country announces it fiscal budget to be used over theupcoming twelve months. Sometimes the budget would be balanced which means thatgovernment spending is equal to government revenues in the form of taxation.4a ivIn other instances, the budget would be unbalanced if its spending is not equal to itstaxation revenue. If the government’s taxation revenue is less than the planned level ofspending then it has a budget deficit. This deficit or shortfall of funds is called the publicsector borrowing requirement (PSBR). This is also referred to as the public sector netcash requirement (PSNCR) which can be met by:Occasionally, government’s overall expenditure may be less than the amount of revenueit receives. In this case, the surplus could be used to repay debt that has accrued due toborrowing in previous years. Such repayment of government debt is commonly referredto as Public Sector Debt Repayment. EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS
  12. 12. EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS4bSuppose the government wants to spend an additional $20 billion on infrastructuralimprovements but wants to raise the money by increasing taxes by the same amount. Insuch a case the increase in government expenditure of $20 billion is exactly matched byan increase in autonomous taxation of $20 billion. In this situation, national incomeincreases by the same magnitude, as the increase in government spending and taxation.That is, national income grows by $20 billion. This is known as the balance budgetmultiplier, which occurs whenever there are equal increases in both autonomousgovernment spending and taxation. This scenario seems counter intuitive, as it would beexpected that if both government spending and taxes increase, there would be no netinjection into the economy and national income would be unchanged. The $20 billion taximposed on households, increases withdrawals in the economy and hence lowersdisposable income of households by this amount. If the MPC is 0.8, it means that only$16 billion is spent on consumer goods and services. Thus the impact of the increase intaxes is a decrease in consumption of $16 billion. Overall, the decrease in consumption of$16 billion and the increase in Government spending of $20 billion results in a netinjection of $4 billion into the circular flow of income. The MPC of 0.8 implies that themultiplier is 5 [1/(1-0.8)], which means that the net injection of $4 billion results in anincrease in national income of $20 billion ($4 billion x 5). Conclusively, although thegovernment has a balanced budget, there is still a net injection into the economy whichresults in an increase in the level of national income. Conclusively, since the increase ingovernment expenditure of $20 billion coupled with an increase in taxation by thisequivalent amount leads to an increase in national income by the same magnitude, thebalanced budget multiplier is therefore equal to 1.4ciIncreases in Government borrowing might lead to increases in the domestic rate ofinterest as the demand for finance goes up.4ciiAs a result, the higher interest rate may discourage or ‘crowd out’ the potentially moreefficient domestic private sector investment. To a large extent, private sector investmentsmay make more efficient utilization of resources due to the existence of the profit motive,whilst public sector investments may lack such efficiency due to the existence ofalternative Government objectives.4ciiiGovernment spending financed by borrowing may result in inflationary consequences onthe domestic economy. This type of inflation is known as ‘demand pull’.4civThe repayment of interest and principal on external debt has to be made using foreigncurrency. This causes a significant drain of foreign exchange which negatively affects thebalance of payment and the exchange rate.4d EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS
  13. 13. EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONSAs the rate of interest increases, some private sector investment projects would becomeunfeasible. This is shown by the movement along the MEI curve (contraction) as the rateof interest increases from 8% to 15%. Overall, private sector investments decrease from$7M to $5M. Rate ofInterest 15% 8% MEI $5M $7M Investment4eThe National Debt, also known as the public sector debt, is the accumulated debt built upby the government over a number of years that has not yet been repaid. Interest paymentsand the repayment of principal on debt is on burden from public debt. This is because itreduces the amount of money which the government has, to devote towards other usessuch as spending on educational facilities for instance. This may also result in an increasein taxes which may not be favoured by taxpayers.5 a i) Determinants of Economic Growth1. 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 due to population growth or other reasons such as immigration, 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. In Trinidad and Tobago, investments in infrastructure such as the proposed rapid rail network may result in increased transportation efficiency. Investments in human EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS
  14. 14. EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS capital formation enable the quality of labour to improve. This implies that labour productivity rises, enabling greater output from labour resources. In Trinidad and Tobago for instance, spending on tertiary level education by the government has seen a significant increase.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.4. Increases in Natural Resources – Natural resources account for all the free gifts of nature which can be used as inputs in the production process. This includes resources such as agricultural land, surface water, forests, minerals, and other natural resources. Countries which successfully harness the productive potential of their natural resources are able to achieve rapid growth. The discovery of new oil and gas fields on the offshore territories in Trinidad and Tobago would constitute an increase in natural resources.5 a ii) Economic development is a sustainable increase in the standards of living of thepeople of a country.5 a iii) The human development index as measured by the United Nations DevelopmentPrograms seeks to gauge the standard of living of a country by taking into considerationboth economic and non-economic factors.5 a iv) The Human Development Index uses the following factors:1. Real GDP per capita – this is calculated by dividing GDP by the population. It gives an average measure of the amount of income attributable to each person in the economy, which gives an idea about the amount of goods and services which can be afforded.2. Longevity or life expectancy at birth in years - 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 rate- this refers to the percentage of those aged 15 and above who are able to read and write. In order for economic development to take place the literacy rate of a country needs to be improved.5 b) Cost of Economic Growth1. Exhaustion of resources – As economies grow, the increased use of resources mayresult in the depletion of available natural non-renewable resources.2. Negative externalities – Economic growth means more output is being produced butthis may be achieved at the expense of increased noise, congestion, pollution and othernegative externalities which undermine economic welfare. EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS
  15. 15. EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS3. Increased inequality – As national income increases, only the high income earnersmay benefit, while the low income earners may not enjoy an improvement in the standardof living. This means that the distribution of income might worsen as inequality widens.4. Inflation risk – In the case of demand induced growth, if the economy grows tooquickly there is the danger of inflation. This type of inflation is called demand pullinflation, as aggregate demand races ahead of the ability of the economy to supply goodsand services.5 c) Impediments to growth in the Caribbean1. Limited Improvement in Technology – One reason why Caribbean countries may not always have high rates of growth is because of limited improvements in technology. Caribbean countries mostly rely on foreign more developed countries for technological improvements. As such, technology would always have to be imported and be limited by the availability of foreign exchange. Furthermore, since the technology is created in more developed economies, it would not always be appropriate to the conditions of the Caribbean.2. Limited Savings for Capital formation – Another reason for slower growth in Caribbean countries is limited resources for capital formation. This is because in most Caribbean countries income and savings are limited which places a major restriction on the amount of capital which can be accumulated.6a)1) Tariffs or Import Duties - These are taxes on imported goods which are used torestrict imports and raise revenue for the Government. If a country levies tariffs onvarious imports, then the prices of imports would rise relative to the home producedgoods. This would make them less attractive and so the demand for imports should fall asconsumers switch to domestically produced goods. In addition to improving the currentaccount deficit of the balance of payments, domestic producers would benefit fromincreased business.2) Import Quotas. An import quota directly reduces the quantity of a product that isimported into a country. The main beneficiaries of quotas are the domestic producers whoface less competition. Quotas restrict the actual quantity of an import allowed into acountry. Note that a quota which reduces the volume of imports, leads to a rise in price ofimports as well, due to its curtailed supply. This therefore encourages demand fordomestically made substitutes.3) Non- Tariff Barriers• Exchange controls. This policy works by restricting the ability of households frompurchasing foreign currencies. This prevents domestic residents from acquiring sufficientforeign currency to pay for imports, which decreases importation of goods and services.• Administrative regulations - Government can discriminate against the importationof foreign produced commodities by setting regulations pertaining to health and safety forinstance which are met by domestic, but not foreign, producers. As such, the importationof foreign produced goods which do not meet the administrative rules would berestricted. EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS
  16. 16. EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS6b) Factors which determine a country’s export revenue. 1. The price of exported goods as determined in international markets 2. World income or the level of income in export markets which influences the quantity of goods and services exported 3. The exchange rate as this would affect the price of domestic goods and services in foreign markets 4. Competition from foreign producers. As other countries produce goods and services which directly compete with the exportable goods and services produced by the home economy, export revenue would decline.6 c) Free -Floating Exchange RateUnder the free-floating exchange rate system, the exchange rate between the domesticcurrency and the foreign currency is determined by the demand and supply in the foreignexchange market. The demand for foreign currency arises whenever there is need toexchange domestic currency in return for foreign currency. The supply of foreigncurrency arises from all inflows of foreign exchange in the balance of payments. Jamaicais one county which ahs adopted the floating exchange rate.Fixed Exchange RateThe fixed exchange rate or pegged exchange rate is one means by which an exchange ratecan be determined. Under the fixed exchange rate system, the exchange rate is set by theGovernment and maintained by Government intervention in the foreign exchangemarkets. In Barbados for instance, a fixed exchange rate is adopted with the United Statesdollar 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. If, however, the official rate differsfrom the equilibrium rate, then Government intervention is necessary through themanipulation of the foreign exchange reserves of foreign currency or even foreignexchange control measures.6d)Advantages of a Floating Exchange Rate System1. Elimination of current account imbalances - As was pointed out before,floating exchange rates should adjust automatically in response to current account deficitsand surpluses. That is, all other variables held constant a current account deficit shouldlead to a depreciation of the exchange rate while a current account surplus would result inan appreciation of the exchange rate. These changes in the floating exchange rate wouldaffect a country’s international competitiveness which would help to achieve balance inthe current account.2. No need to manipulate reserves - Official foreign exchange reserves are used tohelp maintain the external value of a country’s currency within a predetermined level. If a EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS
  17. 17. EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONScurrency is freely floating, then there is no need to use foreign exchange reserves toinfluence the exchange rate.3. Monetary policy can be implemented - If the Government allows the exchangerate to freely float, then it would have full control over the money supply and hence therate of interest. As such monetary policy could be implemented as a means of influencingthe level of aggregate demand in the economy in order to achieve a particularmacroeconomic objective. Advantages of a Fixed Exchange Rate System1. Stability - Economists would argue that this is the most significant advantage of a fixed exchange rate. If exchange rates are stable over a given period of time, then this offers certainty to exporting firms in terms of the actual price their products would fetch in foreign markets. Also, a stable exchange rate would also enable the prices of imported commodities to be unaffected by a fluctuating exchange rate. Such certainty would therefore promote greater trade and investments between countries, both of which are important if economies are to grow in the long term.2. Avoid speculation - Speculators typically enter markets where commodities are mis- priced. If the commodity is under-priced they would buy the good or service hoping to earn a capital gain when prices eventually increase. As speculators buy up such commodities, they increase the demand for them. This action on the part of speculators in markets which are anticipated to have a price increase actually causes the prices of such commodities to rise. Similarly, if it is assumed that the price of a commodity will decrease, then speculators would sell in order to avoid the loss associated with the fall in price of the commodity. This action thus results in an increase in supply which brings forth the anticipated decrease in price. Speculation can therefore cause volatility in a floating exchange rate system. Under a fixed exchange rate system however, there is no point of speculative buying and selling of currencies since the exchange rate is expected to remain fixed.3. Prevents inflation - In a floating exchange rate system, if a change in the demand or supply of foreign exchange leads to a depreciation of the exchange rate, then this would cause inflation as the price of imported goods would rise. A fixed exchange rate on the other hand would be able to avoid such inflation, as the external value of a country’s currency remains constant.6e) A devaluation occurs under a fixed exchange rate system where the central bankdecreases the value of the domestic currency by increasing the price of foreigncurrencies. One advantage of a devaluation is that is helps to decrease the level ofimports. This is because, as the price of foreign currencies increase, the price of importedgoods and services would become more expensive in terms of domestic currency. If thedemand for imports is elastic, then the increase in price would lead to a more thanproportionate decrease in quantity demanded so as to decrease the overall level ofexpenditure on imported goods and services. This would be beneficial if the country isfaced with a current account deficit. EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS
  18. 18. EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONSA major disadvantage of a devaluation is that it can have inflationary effects on theeconomy especially when essential goods and services are imported. This is because adevaluation causes the price of imports to rise. In the case of countries which importfossil fuels for instance as the price increases, the cost of energy would increase and thiscan cause the price of all other goods and services produced locally to increase as well. EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS