CAIE A-Level Economics 11.5.5 External debt

Use Table A: AO1 Knowledge and understanding and AO2 Analysis and Table B: AO3 Evaluation to mark candidate responses to this question.

AO1 and AO2 out of 14 marks. AO3 out of 6 marks.

Indicative content

Responses may include:

AO1 Knowledge and understanding and AO2 Analysis

- Definition and explanation of long-term economic growth as a function of more inputs such as labour, land, and equipment creating an outwards shift of the productive possibility curve. Economic growth is measurable in terms of increases in real GDP.

- Many developing countries are characterised by low incomes which prevent savings and the funds needed to finance investment and economic growth. Funding is needed to finance the investment and technological aspects of economic growth which comes from internal sources (savings) or from foreign lending/investment.

- Foreign investment may be from governments (e.g. China's Belt and Roads initiative), international agencies (e.g. International Bank for Reconstruction and Development (IBRD)) or sovereign wealth funds. Governments borrow from other governments and international agencies to invest in infrastructure and other development projects which under lie economic growth.

- Private capital investment via multinational corporations (e.g. Toyota, Intel). MNC investment is usually in factories, plant and machinery which increase output directly.

- Candidates may analyse the effects of the increase in investment through aggregate supply and demand analysis.

- Successful investment requires a return (marginal efficiency of capital (MEC)) which exceeds the rate of interest that has been relatively easy to obtain.

- The effects of rising interest rates on developing countries: Many developing countries will suffer from falling exchange rates, especially if US$ interest rates rise this will increase the US$ funding cost of borrowings. The balance of payments (X-M) will deteriorate.

- Accept references to IMF and World Bank lending investment funds.

5

AO3 Evaluation

- Impact depends on the proportion of funding which comes from abroad and how much is locally sourced. If domestic funds are not available, then how else will the growth be funded.

- The quality of the investment projects and the likelihood of realising a profit will affect the ability to cover the increase in interest rates. In some cases 'vanity projects' with little long-term economic benefit are funded (Roads to Nowhere) which enhance the standing of the government amongst its supporters but have no economic benefit.

- The short-term effects of the project in terms of raising aggregate demand may be of limited benefit to the borrower if the lender requires much of the construction and materials to be sourced from them. This will have a negative effect on the current account of the balance of payments.

- Higher interest rates in high income countries will raise the cost of borrowing by the low-income country. This means the cost of financing projects has risen representing an opportunity cost for borrowing. The balance of payments current account will deteriorate as the higher interest is paid.

- Many low-income countries may be affected by a commodity price slump which reduces export earnings and depreciates a floating exchange rate making interest rate and capital repayment more expensive.