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CAPE Economics, June 2005, Unit 2, Paper 2 suggested answer by Edward Bahaw

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CAPE Economics, June 2005, Unit 2, Paper 2 suggested answer by Edward Bahaw

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CAPE Economics, June 2005, Unit 2, Paper 2 suggested answer by Edward Bahaw

  1. 1. EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS CAPE ECONOMICS th June 16 2005 Unit 2 Paper 2 EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS
  2. 2. EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS June 2005 – Unit 2 – Paper 2 1 a i) Gross Domestic Production by the Expenditure Approach Consumption C 600000 Investment I 250000 Government purchases G 200000 Exports X 300000 Imports M 300000 GDP C+I+G+X-M 1050000 1 a ii) Gross Domestic Product by the Income Approach The income method requires all components of income based on the four factors of production: land labour, capital and enterprise which are rent, wages, interest and profit. Based on the information, only profits and wages are available which means GDP cannot be calculated by this method. 1 b) Transactions which will not be counted n Gross Domestic Product New Plant This is a component of physical investment and is included in GDP Although this represents output produced and is part of GDP, it is not Illegal Drugs recorded and is not included as a result New Dress This is included under consumers expenditure for new dress shirts which Shirts are produced during the year and is therefore included in GDP Used Text This is not produced in the current year and therefore should not be Books included in GDP Purchase of stocks This is purely a financial transactions and is not recorded in the GDP New This is a component of government physical investment and is included in equipment GDP 1 c) Double counting occurs when the value of intermediate goods and final goods are both included in the calculation of GDP. This should not be done since the value of intermediate goods is already included in the value of final goods and services which it was used to produce. This can be illustrated by considering the example of methanol production where natural gas is an intermediary good. If the value of methanol produced by a methanol plant is $10,000 and the value of natural gas utilized was $6,000 only the $10,000 would be used in the calculation of GDP. If both were used, then the value of the natural gas would be double counted. This is because the value of the natural gas used ($6,000) is already subsumed in the value of the methanol ($10,000). 2 a i) The Marginal Propensity to Consume EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS
  3. 3. EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS The marginal propensity to consume (MPC) is the proportion of any change in income that is devoted to consumption and is calculated as: ∆C/∆Y. Incidentally, this measures the gradient of the consumption function. 2 a ii) The Multiplier The multiplier principle states that a change in expenditure results in a more than proportionate (or multiple) change in the level of national income. The symbol K is typically used to represent the multiplier which is calculated by the formula: 2 a iii) Actual Investments Investment by definition refers to expenditure which results in an increase in the stock of capital goods. The nature of capital is that is can be used in the production of other goods and services in future years. Actual investment has two components. This includes both:  Gross fixed capital formation – This accounts for spending on new fixed assets such as machinery, factory plants, vehicles and other capital goods which enable increased production of goods and services in future time periods.  Increases in inventories – This is the value of increases in the stocks or inventories of finished goods, unfinished goods or work in progress which firms possess. This is considered as part of investment as it represents an outlay of resources in the current period on inventory which would be utilized in future periods. 2 a iv) Planned Investments Planned investment refers the intended expended by firms to the increase capital stock such as equipment and machinery. This is determined by a lot of factors but is primarily driven by the expectation of returns to be earned on such investment. 2 b i) Relationship between marginal propensity to consume and the multiplier. The multiplier can also be expressed as: K = 1 /(1 − MPC ) This means that the greater the marginal propensity to consume the greater the multiplier 2 b ii) Relationship between Actual Investments and Planned Investments The actual level of investment can be expressed as follows: Actual investment = Planned investment + Unplanned changes in inventory This means the level of actual investment in the economy would be given by the level of planned investment and the level of unplanned changes in inventories. Unplanned changes in inventories results when aggregate expenditures differ from aggregate output. This can be either positive when inventories increases which occurs when aggregate expenditure is less than aggregate output. Unplanned changes in inventories can be EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS
  4. 4. EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS negative when inventories decrease which arises when aggregate expenditure is greater than aggregate output. 2 c i a) Marginal Propensity to Consume (MPC) Given that C = 200 + 0.8γ Then MPC = 0.8 2 c i b) Marginal Propensity to Save (MPS) The information about country Z indicates that it is a closed economy with no government. That is: G = 0 T = 0 X = 0 M = 0 In this case MPC + MPS = 1 That is MPS = 1 – MPC Therefore MPS = 1 – 0.8 = 0.2 2 c ii) Aggregate Expenditure Function Y C I AE 0 200 100 300 500 600 100 700 1000 1000 100 1100 1500 1400 100 1500 2000 1800 100 1900 2500 2200 100 2300 3000 2600 100 2700 EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS
  5. 5. EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS Expenditure (E) 45 Line Diagram 3500 AE 3000 Y=E 2500 2000 E 1500 1000 500 0 0 500 1000 1500 2000 2500 3000 Income (Y) 2 c iii) In the graph the equilibrium level of income is $1500 2 c iv) Equilibrium Level of National Income At the equilibrium: Y = AE AE = C + I + G + X - M C = 200 + 0.8Y I = 100 G=0 X=0 M=0 AE = 200 + 0.8Y + 100 ∴ Y = 200 + 0.8Y + 100 = AE Y - 0.8Y = 200 + 100 0.2Y = 300 Y = 300/0.2 = 1500 The equilibrium level of national income is $1,500. 2 c v) The Multiplier (K) EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS
  6. 6. EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS K = 1 /(1 − MPC ) K = 1 /(1 − 0.8) K = 1 /(0.2) K =5 3 a i) Broad Money Broad money also known as M2 measures the total amount of money in the economy which fulfils the store of value function.. This covers the total amount of cash in the economy (monetary base), all short term deposits and plus long term deposits held at financial institutions. Broad money is therefore narrow money plus long term deposits held at financial institutions. 3 a ii) Monetary Policy Monetary policy is one of the tools that the Government can use to influence the level of aggregate demand in the economy. This is done through the control of the supply of money and the rate of interest. In the case of a lowering of the interest rate the level of aggregate demand in the economy to increase. This is because if the rate of interest is lowered, private investors are encouraged to increase investment spending. A lower interest rate also stimulates private consumption, especially expenditure on consumer durables which are typically purchased through hire purchase or borrowed funds. These two responses to the fall in the rate of interest would lead to an upward shift of the aggregate expenditure curve resulting in a higher level income. 3 a iii) Moral suasion Rhe 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 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 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. 3 a iv) Transactionary demand for money This refers to amount of money held for daily use to carry out routine transactions. 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. EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS
  7. 7. EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS 3 b) Foreign Investments and the Money Supply The purchase of bonds by the Central Banks is an example of open market operations. This is a tool of monetary policy which aims to increase the supply of money to the public. As the bonds are purchased by the Central Bank, the bond holders receive money in exchange. As more money begins to circulate the economy the rate of interest would decline and this should have an expansionary effect. If, however, as bond holders receive money for the bonds they sell to the Central bank, such funds are channelled to foreign bank accounts and investment funds then the domestic money supply would not be increased. This typically happens when there are attractive investment opportunities in foreign countries and when financial markets are liberal enables financial capital to move among countries without impediments. Trinidad and Tobago for instance has been a significant export of Capital to the region which means that attempts by the Central Bank of this country to increase the money supply can be thwarted by such leakages. 3 c) Equilibrium Rate of Interest in the Money Market Keynesian liquidity preference theory introduced by Keynes, holds that the interest rate is determined by the interaction between the demand and supply of money in the money market. 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. That is to say the supply of money is fixed or perfectly interest inelastic. In much the same way as other prices are determined, the equilibrium rate of interest occurs at the point of intersection between the demand for money curve and the supply of money curve as presented by the figure. The equilibrium in the money market is shown by point E which gives a market interest rate depicted by IRE. Liquidity Preference Theory of Interest Rate Determination IR SM E IRE LP= DM M EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS
  8. 8. EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS 3 d i) Shortening Pay Periods for Workers If the pay period is shortening this means that workers would receive wages more frequently though in smaller amounts. This means that less money would be held at any given time as income is received in more regular intervals. Overall the result would be a fall in the demand for money. This is shown in the figure. Increase in Demand for Money IR DM1 DM2 M 3 d ii) An Increase in Nominal GDP An increase in nominal GDP can be due to either more output being produced, a high price level or both. As a consequence individuals would have to hold more money to support the higher expenditure levels. This means that the demand for money would increase. This is shown in the figure. Increase in Demand for Money IR DM2 DM1 M EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS
  9. 9. EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS 4 a i) 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. Governments typically borrow to finance its expenditure when its revenue is insufficient. The national debt therefore represents the total amount owed by the Government which can be domestic debt as well as the amount owed to foreigners which is external debt. 4 a ii) Two ways of measuring national debt National debt can be measured in absolute value. For instance the national debt of Trinidad and Tobago in 2004 was about TT$37million. This simply gives the total amount owed in this case measured in Trinidad and Tobago Dollars. National Debt can also be measured by the debt to GDP ratio. This is a relative measure of debt which is computed by expressing national debt as a percentage of GDP. In 2004, GDP in Trinidad and Tobago was approximately TT$72 million. This means the debt to GDP ratio in that year was about 51 percent. 4 a iii) Debt retirement This is the paying off of a debt to avoid having to pay interest over the future. This can only be done if funds are available to clear of the outstanding balance of the debt. Debt forgiveness This refers to relief given by the lending institutions to heavily indebted countries where the amount outstanding is annulled. Usually this is done to help alleviate the debt burden faced by such countries. 4 b i) Government Borrowing and Domestic Interest Rates Governments can borrow form different sources to finance its budget deficit. If it borrows locally from lending institutions then the increased demand for borrowed funds would via loanable fund theory lead to an increase in the domestic interest rate. Also, if the government borrows from the public through the issue of government securities then this would reduce the money supply in circulation and through liquidity preference theory cause the rate of interest domestically to rise. 4 b ii) Government Borrowing and Domestic Investments As the government borrows to finance its deficit, the domestic interest rate increases. This may discourage private investments as the cost of raising capital increases. Furthermore, high government expenditure in the economy can also lead to increase in the prices of factor inputs which can further discourage investment by private entrepreneurs. 4 b iii) Government Borrowing and the Exchange Rate If the government borrows from domestic sources and the rate of interest increases, this can lead to an appreciation of the countries currency as hot money inflows increases. Should the government borrow from international sources, then the result would an increase in foreign exchange receipts which can also result in an appreciation of the local EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS
  10. 10. EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS currency. If however the higher level of government expenditure leads to an increase in imports then the result can actually be a depreciation of the countries currency. 4 c i) Fiscal Policy This 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 c ii) Determination of Fiscal Policy There are two type of fiscal policy; discretionary or automatic stabilizers. With discretionary fiscal policy the government takes an active decision on fiscal measures which needs to be implemented. Automatic stabilizers on the other hand work without an policy decisions by the government as automatically activate to meet the needs of the economy. 4 c iii) Aims of Fiscal Policy Fiscal policy can be expansionary which results in an increase in the level of national income or it can be contractionary when it leads to a fall in the level of national income. These two directions of fiscal policy can be applicable to different macroeconomic problems. The table shows which fiscal policy solution is appropriate for each macroeconomic problem. Macro-Economic Problem Fiscal Policy Solution Economic Recession Expansionary Cyclical Unemployment Expansionary Demand – Pull Inflation Contractionary Current Account Deficit Contractionary Current Account Surplus Expansionary 5 a ) Sources of 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. This can be shown by an outward shift of the production possibility curve depicted in the figure. EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS
  11. 11. EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS Economic Growth and the Outward Shift of the Production Possibility Curve Agricultural Goods P2 P1 P1 P2 Manufactured Goods Three factors which can lead to an increase in the productive capacity of the economy are: 1. Increase in Labour Resources 2. Increase in Capital Resources 3. Improvements in Technology 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. The size of the labour force depends to a large extent on the number of persons of working age (eighteen and older in the most countries). Population growth, and the associated increase in the labour force, has traditionally been considered a positive factor in stimulating economic growth. This is because as the labour force becomes larger, the productive deployment of the additional workers enables more output to be produced. Furthermore, a larger labour force provides a larger domestic market which enables large scale production and hence the attainment of economies of scale. It is important to note though, that if growth in the population outweighs growth in output, then real GDP per capita would decline. In addition to an increase in the size of the population, the Government could attempt to increase the participation rate. The labour force participation rate is the fraction of the population who belong to the labour force. To reiterate, the labour force only includes individuals who are either employed or unemployed. Those who are considered to be unemployed are those who are able to work, available for work and actively seeking employment but are unable to find a job. The labour force does not include those who are voluntarily unemployed. Voluntary unemployment exists when people have chosen not to work and thus remain unemployed. Policies aimed at reducing voluntary unemployment EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS
  12. 12. EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS may seem particularly attractive to Governments as this would increase the size of the labour force and the participation rate. 2. Increase in Capital Resources In a macroeconomic sense, capital is a factor of production that has two main components:  Physical capital – this accounts for all tangible assets such as plant and equipment and machinery which can be used in the production of other goods and services. 1 The growth of the nation’s stock of physical capital is driven by the level of investment. 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. These directly productive investments are supplemented by investments in what is known as social and economic infrastructure such as roads, electricity, water and sanitation, communications, facilitates which integrates economic activities.  Human capital – this is the stock of knowledge, skills and abilities embodied within an economy’s labour force arising from education, training, and experience. 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 A key determinant of economic growth is technology, which is defined as the application of scientific knowledge in combining resources to produce goods and services. New management techniques, scientific discoveries, and other innovations improve technology. Such 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. Technological change depends to a large extent on the educational and scientific endowment of the economy. The more educated a country’s population, the greater is its potential for technological advances. To this end, it must be pointed out, that industrial countries tend to have a relatively higher educational level than developing countries. This disparity gives industrial countries a substantial advantage over developing countries in creating and implementing technological innovations. As a result, developing countries depend mostly on developed countries for new technological developments, which are often expensive and place tremendous strain on available foreign exchange. 5 b i) Major Features of Globalization  Reduced cost of transportation between countries. Improved efficiency in air and sea freight has made it cheaper to transport products to different countries.  Improvements in communications as a result of the Internet. Easy and low cost communication between countries via telephone and the internet has increase the 1 The word "physical" is used only for clarity, to distinguish it from human capital and financial capital. EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS
  13. 13. EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS level of business which take place between countries.  Reduction in barriers to international trade. Globally, countries throughout the world have embarked upon the removal of protectionist measures and promotion of free trade. These initiatives have been guided by the World trade organization which points to the gains to be derived from international trade. The removal of protectionist policies also applies to preferential trading agreements between countries as covered later in this chapter.  Freer movement of labour and capital among countries. Workers are presently more able to move to a foreign country for employment than in the past. Investors are also able to invest money in foreign countries, for instance investors in New York or London can make investments in Trinidad or any other country they so desire. 5 b ii) Effects of Globalization on the Caribbean 1. Access to Foreign Good and Services Globalization has enabled consumers from all over the world to access an extensive range of products and services that were not easily available before. Caribbean people have found that they are able to access a wider variety of goods and services by purchasing products from abroad. This includes items such as clothes, jewellery, electronics, educational material and even food products. In most cases the prices they pay are much lower than the prices of locally produced goods. Firms can also purchase cheaper or higher quality raw materials from abroad to be used in the production process. This would enable producers to produce improved products at lower prices. The free movement of labour also presents an opportunity to Caribbean producers as much need skilled personnel could be brought in from abroad to be employed in domestic production processes. Globalization has also provided Caribbean governments with a more efficient access to pharmaceuticals, health aid apparatus and educational equipment such as computers. This has resulted in a general improvement in the provision of public and merit goods and services such as health care services and educational services. 2. Access to Foreign Markets Globalization has also made it easier for Caribbean producers to sell goods abroad. As a result Caribbean producers have a larger market to sell its products. This would enable production on a larger scale and the achievement of economies of scale. As cost is reduces competitiveness of Caribbean products would improve in foreign markets. Improvement in shipping and air transportation has also made it easier to transports goods to foreign countries. This has also reduced the shipping time it takes to get goods abroad. Perishable goods such as fruits and vegetables produced in the Caribbean can reach foreign destinations in a short period of time which prevents the cost associated with spoilage. 3. Access to Finance and Capital One of the problems faced by Caribbean economies is lack of finance for capital formation. Globalization and the free movement of finance from one country to a next presents many opportunities to such economies as money from foreign countries can be easily brought in for productive use. This can occur in the form of foreign direct investment. For instance foreign companies can use its finance to set up operations in the Caribbean to make use of the natural and human resources to produce goods for export. This would not only create employment but also earn foreign exchange for countries of EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS
  14. 14. EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS the Caribbean. For example a foreign multinational may set up a manufacturing plant in the Caribbean manned by personnel from the Caribbean. This plant may produce goods for exports and thus generate much needed foreign exchange. Such foreign exchange earnings could be subsequently used to purchase much needed imports of other goods and services. Caribbean countries have natural resources and labour but have a shortage of finance for capital formation. Due to improvements in communications technology business can now able to access finance from almost every part of the world. These improvements can also provide additional opportunities for businesses to access finance in the Caribbean. 6 a i) Currency Appreciation and Depreciation As the demand and supply for foreign exchange changes, so too would the equilibrium exchange rate. If the exchange rate changes under the floating system, such that the price of foreign currency increases this is termed a depreciation. That is to say a depreciation implies that the external value of the country’s currency has declined. For example, if the exchange rate in Jamaican depreciates from Jam$40 = US$1 to Jam$50 = US$1 then is implies that the external value of the Jamaican dollar has declined in value from Jam$1 = US$0.025 to Jam$1 = US$0.020. Conversely, if the external value of a country’s currency increases under a floating exchange rate, this is called an appreciation. In this case the amount of local currency that must be paid in order to obtain one unit of foreign currency falls. For example, if the exchange rate in Jamaica moves from Jam$40 = US$1 to Jam$30 = US$1, then this represents a rise in the external value of the Jamaican dollar from Jam$1 = US$0.025 to Jam$1 = US$0.033. 6 a ii) Flexible 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. This occurs primarily for importation purposes as foreign firms require that payments be made in their foreign currency and not in the domestic currency. There are other reasons for demanding foreign currency, such as for investments abroad or repayment of foreign debt. It turns out that all outflows in the balance of payments create demand for foreign currency. The supply of foreign currency arises from all inflows of foreign exchange in the balance of payments. The primary source of foreign exchange for developing countries is exports. However, in addition, foreign direct investments and Government borrowing from external lenders are also an important source of foreign exchange. Fixed Exchange Rate The fixed exchange rate or pegged exchange rate is another 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 EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS
  15. 15. EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS foreign exchange market, then there is no need for Government intervention. 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. 6 a iii) Balance of Payments Accounts 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. The balance of payments is divided into two sections in order to distinguish between two different categories of transactions. These sections are:  Current Account  Capital Account The current account records trade in goods and services as well as net property income from abroad and unilateral transfers. The Capital account records all movement of capital from both private sources as well as official government sources between a country and the rest of the world. 6 b i a) The balance of trade This is the difference between the monetary value of exports and imports in an economy over a certain period of time. Merchandise Exports 40 Merchandise Imports -30 Services Exports 15 Services Imports -10 Balance on Trade 15 6 b i b) The current account balance This is the difference between all inflows and outflows in the current account. Merchandise Exports 40 Merchandise Imports -30 Services Exports 15 Services Imports -10 Investment Income -5 Net Transfers 10 Current Account Balance 20 6 b i c) The capital account balance This is the difference between all inflows and outflows in the capital account. Capital Inflows 10 EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS
  16. 16. EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS Capital Outflows -40 Official Reserves 10 Capital Account Balance -20 6 b ii) The balance of payments position of Country X The balance of payments of every country always balances except for data discrepancies. Overall the current account balance and the capital account balance would always net to zero. Current Account Balance 20 Capital Account Balance -20 To determine if there is a deficit or surplus, the change in official reserves need to be analysed. The decrease in official reserves in the capital account is evidence that the balance of payments is in deficit as it means the Central Bank is using its official reserves to finance the short fall between inflows and outflows in the rest of the balance of payments. As such a decrease in official reserves is shown as a positive in the capital account. 6 c i) Meaning of + and – in the Balance of Payments Account Merchandise Exports 40 Revenue earned from the sales of good to foreigners Merchandise Imports -30 Payments made for the purchase of goods from foreigners Services Exports 15 Revenue earned from the sales of services to foreigners Services Imports -10 Payments made for the purchase of services from foreigners Net income earned from investments abroad (Income earned from Investment Income -5 abroad less income repatriated abroad) Net receipts from remittances or unilateral transfers. (Unilateral transfers Net Transfers 10 received from abroad less unilateral transfers sent abroad) Funding received from foreign sources for either FDI, Foreign Portfolio Capital Inflows 10 Investments or proceeds from loans Funding sent to foreign countries for either FDI, Foreign Portfolio Capital Outflows -40 Investments or loan repayment Official Reserves 10 A decrease in reserves of foreign exchange held by the Central Bank 6 c ii) One measure to bridge a current account deficit Expenditure Reduction - This refers to deflationary or contractionary policies that decrease national income. Since imports are said to be induced by income then as income falls imports would decrease. 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 current account to improve. This is shown by a movement along the import schedule in the figure from point A to point B. As a result of the decrease in the level of imports, the current account deficit is eliminated. EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS
  17. 17. EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS Contractionary Policy and the Current Account Balance X/M M Current A Account Balance Deficit B X O YB YA Y EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS

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