Evaluate monetary-policy transmission, effectiveness and trade-offs across inflation, growth, unemployment, exchange rates and time.
Read the extracts and answer the questions that follow.
Text A — India-United Kingdom trade agreement negotiations
Read the extracts and answer the questions that follow.
Text A — India-United Kingdom trade agreement negotiations
(1) India is a country located in South Asia. India's government predicts 7 % annual economic growth and it is expected to become the third-largest global economy by 2030. To support growth, India is establishing trade agreements to diversify trade partners, and reduce the impact of global political and economic shocks. However, the annual inflation rate increased from 4 % in 2021 to 7.8 % in 2022 due to supply chain issues and oil price increases. In response, India's government has reduced taxes on fuel while the central bank has tightened monetary policy.
(2) The United Kingdom (UK), a country in Europe, needs trade agreements with countries in Asia as this area contains some of the world's fastest-growing economies and represents over 40 % of global gross domestic product (GDP). It is currently negotiating a free trade agreement (FTA) with India, which aims to double trade between the two countries by 2030. The agreement is also expected to increase labour movement and job opportunities and protect intellectual property. The Indian government is negotiating easier access to UK work permits and student visas but is concerned that some of its citizens may not return home with their skills.
(3) The India-UK FTA would reduce trade protection, including tariffs and quotas, and administrative barriers. India expects to increase its exports of textiles, leather goods, footwear, and pharmaceutical products, whereas the UK aims to boost its exports of British cars, wine, spirits and vinegar. Additionally, foreign direct investment (FDI) between the two countries is expected to increase. The FDI inflows could help to finance India's large current account deficit, which has increased as worker remittances from abroad have fallen. However, the current account deficit may decrease anyway because of recent increases in portfolio investment outflows, which could also impact the value of the rupee (India's currency).
(4) Increased competition from UK imports may threaten the growth of infant industries in India. An example is the local wine industry in India, which has grown by 30-40 % in recent years. However, to protect infant industries, the reduction in tariffs will be gradual and business taxes will be lowered.
(5) Another discussion area in India-UK trade negotiations is the possible privatization of essential services in India, such as healthcare, education, and water. There has been encouragement from the UK for India to open these markets to foreign investment and competition.
(6) Increased trade and competition could lower prices, forcing firms to cut labour costs. Indian labour protection groups want the UK to stop trade talks until India changes a law restricting labour unions. They believe the trade agreement should include regulations to protect against poor working conditions and low pay, which impact gender inequality and child welfare.
Text B - India-UK trade negotiations and Sustainable Development Goals
(1) India and the UK recognize the relationship between trade and sustainable development and are committed to supporting the sustainable development goals (SDG).
(2) The India-UK FTA negotiations are encouraging collaborative research and development projects in the following areas:
- Clean energy and green technologies; decreasing the market failure associated with fossil fuel energy, developing electric vehicles, and waste management practices.
- Gender inequalities; improving access to credit and markets for women, improving education opportunities, and increasing labour participation rate of females in India.
- Human and labour rights; supporting programmes that create work opportunities and better working conditions.
- The agricultural sector and food security; addressing India's low productivity rates, which are blamed on ineffective fertilizer subsidies, lack of infrastructure, and flooding and drought problems from climate change.
- The healthcare sector; developing pharmaceutical products.
Table 1: Development data for India
(3) India-UK's previous health sector collaboration resulted in global vaccine development and helped decrease the market failure in the industry. However, possible FTA intellectual property rules may limit India's ability to produce low-price medication, resulting in reduced export opportunities and possibly creating monopolies. On the other hand, targeted research and development could lead to cheaper medication, and the UK's insurance expertise may improve India's health insurance programme.
(4) Growth in India-UK trade may increase carbon emissions, deforestation, and air and water pollution. Experts estimate the FTA could increase trade-related transport emissions by up to 36 %. Environmental experts believe this is significant as the UK continues cutting solar panel subsidies, slowing the conversion to clean energy.
Table 2: India and UK SDG data in 2021
Table 3: India's SDG progress in 2021
Table 4: Economic data for India
Define the term monetary policy indicated in bold (Text A, paragraph 1).
Sketch an AD/AS diagram to show the possible impact on India's inflation rate of a tighter monetary policy (Text A, paragraph 1).
Table 1 shows the gross domestic product (GDP) of the United States of America (USA) economy from 2020 to 2023. The USA is not the fastest growing economy in the world, but it is the largest. It also has the largest budget deficit and the largest current account deficit in the world.
As a result, the actions of its central bank, the Federal Reserve, always make news.
Table 1
Table 2 shows the current account and capital account of the balance of payments, quarterly, for the USA in 2023. It shows that the USA has a persistent current account deficit, and that the main component of that deficit is the balance of trade in goods and services. The country's relatively high labour costs, labour unions and skills shortages in STEM (science, technology, engineering and mathematics) all contribute to the trade deficit.
Table 2
The USA recorded a trade deficit of USD 819 billion in 2023. This was a slight reduction from 2022, when it was USD 951 billion. One of the reasons for the fall in the trade deficit could be the exchange rate. In the final four months of the year, the USD depreciated against the Chinese Yuan (CNY). China is the USA's largest trading partner, even though recent trade relations between the two countries have been characterized by tariffs and retaliatory measures. Figure 1 shows the price of the USD in terms of the CNY from September to December 2023.
Figure 1
To try and achieve the macroeconomic goals of monetary policy, the Federal Reserve significantly increased the money supply in the USA between 2008 and 2023. It also conducted four rounds of quantitative easing from 2008, totalling USD8900 billion.
Economists and policymakers hold different views on how the current account deficit affects the USA's economy. Some highlight positive outcomes, suggesting that, as the economy grows, citizens can enjoy increased access to goods and services from abroad. Others express concerns about potential negative consequences, including fewer job opportunities and slower economic growth.
The Federal Reserve has a target inflation rate of 2 %.
The US Bureau of Labor Statistics, however, recorded that the inflation rate from January 2023 to January 2024 was 3.1 \%, well above the target rate. Over the same period, households in the USA could borrow money from a commercial bank at a nominal interest rate of 8.5 %.
Calculate the real interest rate for households between January 2023 and January 2024.
Explain how commercial banks create money.
Outline what is meant by the term quantitative easing.
Sketch a diagram to show how an increase in the money supply is expected to affect the equilibrium interest rate.
Text A - Overview of Vietnam
(1) Economic reforms in Vietnam during the past 30 years have led to rapid economic growth, which has transformed a poor nation into a lower middle-income economy. The percentage of the population with an income of less than US$1.90 a day declined from 38% in 2002 to below 2 % in 2018.
(2) Vietnam used to be a food-insecure nation, in which many people sometimes lacked access to affordable food, but it is now a leading exporter of basic food commodities. It also aims to become an exporter of high quality and processed food products. However, agricultural production only accounts for 18 % of gross domestic product (GDP), although it uses 40 % of the land and employs 43 % of the labour force. Due to the growing rural population, land is often divided up between a greater number of farmers, causing some farms to become smaller. These farms have fewer opportunities to benefit from economies of scale and lower average costs of production.
(3) Vietnam's rapid growth and industrialization, focused on export-oriented manufacturing, have had a harmful impact on the environment. Electricity consumption has tripled since 2010, growing faster than GDP. Electricity generation, which mainly uses fossil fuels, accounts for approximately 60 % of Vietnam's carbon emissions. Demand for water continues to increase. Unsustainable exploitation of natural resources, such as land, fisheries, and timber, could negatively affect prospects for long-term growth. In addition, Vietnam's primary sector is highly vulnerable to the climate and is therefore subject to supply shocks.
(4) Vietnam has signed several free trade agreements (FTAs). Its first FTA was a partnership with Japan in 2008. Both Vietnam and Japan are members of the Comprehensive and Progressive Agreement for Trans-Pacific Partnership (CPTPP), which took effect at the beginning of 2019. These FTAs also promote inward foreign direct investment (FDI). In addition, Vietnam has introduced policies to attract foreign investment, such as tax incentives and spending on infrastructure.
(5) Japan is the biggest provider of foreign aid to Vietnam and the largest source of FDI. Japanese firms and aid agencies are jointly financing large-scale projects, including port infrastructure and a high-speed railway, which will reduce the Hanoi to Ho Chi Minh journey time from about 35 hours to under six hours. Other Japanese-funded aid projects are in the areas of health care, education, and the environment.
Text B - Trade and investment flows between Vietnam and Japan
(1) Japan imports seafood and consumer products such as textiles, leather shoes and processed foods from Vietnam, because Vietnam has a comparative advantage in such items. Conversely, Vietnam imports machinery, technology, and raw materials for production from Japan. Gradually barriers to trade are being removed. In 2020, Vietnam began exporting lychees (a luxury fruit) to Japan after five years of negotiations on quality standards. The improved access to the Japanese market has increased the number of consumers and the revenue earned by Vietnamese lychee farmers.
(2) Japanese firms invest in Vietnam, particularly in urban areas, because wages are low and they can export from Vietnam to other CPTPP members and to China and Indonesia. Panasonic, a Japanese multinational company (MNC), relocated a major factory, which manufactures refrigerators and washing machines, from Thailand to Vietnam in 2020. The construction of a coal-fired power plant is mainly funded by Japanese firms. The Japanese government is promoting further investment by subsidizing over 30 firms that are relocating from China to Vietnam. Most of these firms are food processors or producers of manufactured goods (for example, medical equipment).
Text C - Roles of the central bank in Vietnam
(1) The central bank in Vietnam has been lowering interest rates since mid-2019. However, it has kept the minimum reserve requirement at 3 % of commercial bank deposits, despite suggestions that this requirement could be lowered.
(2) The central bank also regulates the exchange rate of the dong (Vietnam's currency). It actively intervenes in the foreign exchange market to stabilize the rate when necessary. In April 2020, there was downward pressure on the dong due to the lower interest rates and fewer foreign tourists. However, the central bank has a large amount of reserve assets, which were used to prevent the dong from depreciating.
Table 1: Economic data for Vietnam
* 2018 figure
Table 2: Development data for Vietnam
* 2018 figure
Using a demand and supply of money diagram, explain the likely effect on interest rates of a reduction in the minimum reserve requirement for banks (Text C, paragraph 1).
Read the extracts and answer the questions that follow.
Text A — India-United Kingdom trade agreement negotiations
Read the extracts and answer the questions that follow.
Text A — India-United Kingdom trade agreement negotiations
(1) India is a country located in South Asia. India's government predicts 7 % annual economic growth and it is expected to become the third-largest global economy by 2030. To support growth, India is establishing trade agreements to diversify trade partners, and reduce the impact of global political and economic shocks. However, the annual inflation rate increased from 4 % in 2021 to 7.8 % in 2022 due to supply chain issues and oil price increases. In response, India's government has reduced taxes on fuel while the central bank has tightened monetary policy.
(2) The United Kingdom (UK), a country in Europe, needs trade agreements with countries in Asia as this area contains some of the world's fastest-growing economies and represents over 40 % of global gross domestic product (GDP). It is currently negotiating a free trade agreement (FTA) with India, which aims to double trade between the two countries by 2030. The agreement is also expected to increase labour movement and job opportunities and protect intellectual property. The Indian government is negotiating easier access to UK work permits and student visas but is concerned that some of its citizens may not return home with their skills.
(3) The India-UK FTA would reduce trade protection, including tariffs and quotas, and administrative barriers. India expects to increase its exports of textiles, leather goods, footwear, and pharmaceutical products, whereas the UK aims to boost its exports of British cars, wine, spirits and vinegar. Additionally, foreign direct investment (FDI) between the two countries is expected to increase. The FDI inflows could help to finance India's large current account deficit, which has increased as worker remittances from abroad have fallen. However, the current account deficit may decrease anyway because of recent increases in portfolio investment outflows, which could also impact the value of the rupee (India's currency).
(4) Increased competition from UK imports may threaten the growth of infant industries in India. An example is the local wine industry in India, which has grown by 30-40 % in recent years. However, to protect infant industries, the reduction in tariffs will be gradual and business taxes will be lowered.
(5) Another discussion area in India-UK trade negotiations is the possible privatization of essential services in India, such as healthcare, education, and water. There has been encouragement from the UK for India to open these markets to foreign investment and competition.
(6) Increased trade and competition could lower prices, forcing firms to cut labour costs. Indian labour protection groups want the UK to stop trade talks until India changes a law restricting labour unions. They believe the trade agreement should include regulations to protect against poor working conditions and low pay, which impact gender inequality and child welfare.
Text B - India-UK trade negotiations and Sustainable Development Goals
(1) India and the UK recognize the relationship between trade and sustainable development and are committed to supporting the sustainable development goals (SDG).
(2) The India-UK FTA negotiations are encouraging collaborative research and development projects in the following areas:
- Clean energy and green technologies; decreasing the market failure associated with fossil fuel energy, developing electric vehicles, and waste management practices.
- Gender inequalities; improving access to credit and markets for women, improving education opportunities, and increasing labour participation rate of females in India.
- Human and labour rights; supporting programmes that create work opportunities and better working conditions.
- The agricultural sector and food security; addressing India's low productivity rates, which are blamed on ineffective fertilizer subsidies, lack of infrastructure, and flooding and drought problems from climate change.
- The healthcare sector; developing pharmaceutical products.
Table 1: Development data for India
(3) India-UK's previous health sector collaboration resulted in global vaccine development and helped decrease the market failure in the industry. However, possible FTA intellectual property rules may limit India's ability to produce low-price medication, resulting in reduced export opportunities and possibly creating monopolies. On the other hand, targeted research and development could lead to cheaper medication, and the UK's insurance expertise may improve India's health insurance programme.
(4) Growth in India-UK trade may increase carbon emissions, deforestation, and air and water pollution. Experts estimate the FTA could increase trade-related transport emissions by up to 36 %. Environmental experts believe this is significant as the UK continues cutting solar panel subsidies, slowing the conversion to clean energy.
Table 2: India and UK SDG data in 2021
Table 3: India's SDG progress in 2021
Table 4: Economic data for India
Define the term monetary policy indicated in bold (Text A, paragraph 1).
Study the following extract and answer the questions that follow.
South Korea's current account surplus
(1) South Korea, Asia's fourth-largest economy, has experienced a current account surplus since 2012. South Korea's large working-age population, which tends to save a large portion of its income for retirement, contributes to the surplus. The South Korean government has expressed concerns about the impact of the high savings on domestic demand and the level of imports. However, it has been predicted that as the population ages the surplus will gradually disappear by 2042 .
(2) The South Korean won (South Korea's currency) recorded the second highest appreciation against the United States dollar (US$) in 2017 among currencies of the G20* nations. The current account surplus, the improved economic conditions and the expectations of an interest rate rise have all helped increase the South Korean won's value.
(3) The South Korean won officially operates under a floating exchange rate system, but the central bank would intervene if there were major fluctuations in the market that needed to be managed. The US is monitoring the exchange rate policy of South Korea due to the significant trade imbalance between the two countries. If the US identifies that a major trading partner like South Korea tries to limit an appreciation of its currency, then the US may consider tariffs to reduce the imbalance.
(4) South Korea's financial account in the balance of payments recorded a deficit of US$13 billion in 2018, as Koreans have invested extensively in other countries. Furthermore, foreigners have been reluctant to invest in South Korea due to the trade disputes and the potential of a trade war erupting between the US and China. The US and China are South Korea's largest trading partners, and South Korea, with its export-oriented economy (exports amount to 43 % of gross domestic product [GDP]), is sensitive to external demand shocks.
(5) South Korea's domestic investment in key areas (such as manufacturing, construction and machinery) fell during 2018, and GDP grew by less than expected. Additionally, private consumption increased only by 0.3 % in 2018 , the slowest growth for 4 years. There is also concern about the level of unemployment, especially the high rates of youth unemployment.
(6) Normally, in a situation of low growth, the central bank would implement expansionary monetary policy. However, the US Federal Reserve (the central bank of the US) and the European central bank are considering monetary tightening. If the South Korean central bank does not raise interest rates in line with the US and the European Union it runs the risk that the South Korean won may depreciate. Therefore, the South Korean government has begun discussions on using fiscal policy to help revive the job market and support domestic demand.
* G20 members include: Argentina, Australia, Brazil, Canada, China, France, Germany, India, Indonesia, Italy, Japan, Republic of Korea (South Korea), Mexico, Russia, Saudi Arabia, South Africa, Turkey, the United Kingdom, the US and the EU
Define the term interest rate indicated in bold in the text (paragraph 2).
Read the extracts and answer the questions that follow.
Text A - Overview of the economy and government policies in Kenya
Read the extracts and answer the questions that follow.
Text A - Overview of the economy and government policies in Kenya
(1) Kenya, in East Africa, is achieving high annual economic growth rates, averaging above 5 %. Living standards are improving and employment is increasing in the manufacturing, tourism, construction, and education sectors. Kenya's high growth is also changing the distribution of income and affecting the environment. However, climate change, high levels of inequality and youth unemployment may reduce future growth rates.
(2) Floods and droughts are severe and frequent. In 2022-2023, droughts caused agricultural output to fall, affecting the employment of 40 % of the population and doubling the number of people with insufficient food. The government took measures to increase food supplies, such as reducing the tariff on imports of rice. It did not impose a price ceiling for essential food, as food shortages might result.
(3) The rising price of food is the main cause of inflation in Kenya. The central bank used a contractionary monetary policy in 2022 and 2023 to reduce inflation and to prevent the depreciation of the country's currency (Kenyan shilling, KES).
(4) The budget deficit as a percentage of gross domestic product (GDP) became smaller in 2023 because government expenditure grew more slowly than GDP. Moreover, economic growth resulted in higher tax revenue from both income tax and a 16 % indirect tax on goods and services. The government is also receiving revenue from the sale of some state-owned enterprises (SOEs). A World Bank programme, aimed at an expansion of "green" energy in Kenya, provides financial and technological support to the Kenya Power and Lighting Company, an SOE that has been making losses.
(5) The currency depreciation in 2022 boosted exports. Services, which are approximately 38 % of total exports and include tourism and financial services, are growing faster than exports of goods. Manufactured goods account for 37 % of total exports and agricultural goods account for 25 %. Revenue from exports of tea, flowers, vegetables, meat, and coffee are volatile and unpredictable. The droughts in 2022-2023 reduced output, which lowered export revenue from vegetables and flowers by almost 20 %.
Text B - Unequal distribution of the benefits of economic growth in Kenya
(1) Although economic growth has reduced absolute poverty, inequality remains a problem, particularly between the formal and informal sectors and between the urban and rural areas. Rural poverty is caused by low agricultural productivity and farmers' limited access to markets, finance, and technology.
(2) However, the level of education has improved significantly, with a literacy rate of over 90 %. Secondary school attendance rates have increased from 13 % in 2003 to 49 % in 2022, despite the costs of attending school. In 2022, the government introduced a fund (the Hustler Fund), partly financed by foreign aid. The fund provides low-interest loans to women, young people, and small firms, for education or investment.
Text C - Reducing and adapting to climate change in Kenya
(1) Global warming is affecting the Kenyan economy. Consequently, agricultural output and tourism, which account for 70 % of employment and most exports, will probably decline. Therefore, GDP could fall by 2 % annually. However, Kenya has relatively low carbon emissions, particularly because renewable resources generate 90 % of electricity, a figure that is planned to rise to 100 % by 2030.
(2) Measures taken by other economies to reduce carbon emissions provide opportunities for Kenya because the markets for "green" goods are expanding. Kenya is able to sell tradable permits (carbon credits) to high-emitting countries due to its reforestation programmes.
(3) The International Monetary Fund (IMF) recommends that climate-related considerations should be part of macroeconomic and infrastructure policies. It also recommends that carbon taxes should be imposed to reduce the use of fossil fuels by manufacturing firms. Rapid urbanization is increasing the need for electric vehicles and improved public transport. Energy efficiency measures, fuel substitution, and switching to rail transport will not only lower transportation costs but also reduce the trade deficit. This is because fossil fuels used for transportation and manufacturing are imported.
(4) Kenya is able to obtain finance and technology for investment in climate-related projects, such as renewable energy and forestry programmes, through foreign aid and partnerships with the private sector. Overall, these policies will reduce environmental disasters and increase economic growth and jobs in the formal sector.
Table 1: Balance of payments accounts for Kenya in billions of USA dollars (USD)
Table 2: Economic data for Kenya
Table 3: Development data for Kenya
Using an AD/AS diagram, explain why a contractionary monetary policy may reduce inflation in Kenya (Text A, paragraph 3).
Using real-world examples, evaluate the effectiveness of monetary policy in reducing a large deflationary (recessionary) gap.