IB Economics HL 3.5 Monetary Policy Question Bank

Evaluate monetary-policy transmission, effectiveness and trade-offs across inflation, growth, unemployment, exchange rates and time.

Covered syllabus points

3.5.1—Monetary policy 3.5.2 (HL)—Money creation and monetary tools 3.5.3 (HL)—Money market equilibrium 3.5.4—Real and nominal interest rates 3.5.5—Expansionary and contractionary monetary policy 3.5.6—Effectiveness of monetary policy

[Maximum number: 6]

Study the extract below and answer the questions that follow.
Indonesia's current account deficit

(1) Bank Indonesia, the central bank of Indonesia, kept its main interest rate steady, because a large current account deficit limited its ability to lower borrowing costs to support a slowing economy. The current account deficit is expected to reach US $\$ 27$ billion by the end of the year. The deficit widened due to seasonal factors, such as foreign debt payments and the transfers of funds overseas by multinational corporations (MNCs) repatriating earnings.

(2) Indonesia's current account has been in deficit for 11 consecutive quarters as the slump in commodity prices in recent years has reduced export revenues, while import expenditure has remained high as a consequence of the country's strong economic expansion.

(3) In mid-2013, the current account deficit was even bigger, inflation neared 10 %, and the exchange rate of the rupiah (Indonesia's currency) rapidly decreased by 21 %. In response, Bank Indonesia tightened monetary policy. This slowed down inflation, but also slowed economic growth. The value of the Indonesian rupiah has increased by more than 4 % this year, although it is still undervalued.

(4) This year, the economy has been growing at 5.1 %, the slowest pace since 2009. A weaker rupiah is hurting some businesses, and so a continued appreciation in the currency could help strengthen the economy by reducing import prices.
5 The governor of the central bank said that the current interest rate level, in place since November 2013, was consistent with its 3.5 % to 5.5 % inflation target. He also predicted that the current account deficit for the second half of 2014 would be smaller due to the increase in exports of mineral ores.

(6) Economists have suggested that the best way to lower the deficit would be to cut oil imports by raising domestic oil prices. It has been suggested that the central bank has done its job by tightening monetary policy and now it is the government's job to raise fuel prices, by reducing fuel subsidies. This would help to reduce both the current account deficit and the budget deficit.

(7) There are also future threats as the United States is expected to raise its interest rates in the coming year. This could intensify capital flows from fast growing developing economies to developed economies, and further fuel price increases are likely in world markets. "Indonesia's Current Account Deficit Widens in Q2 to 4.27 \% of GDP", Jakarta Globe, 14 August 2014 and "RI back in 'fragile' condition", The Jakarta Post, 15 August 2014]
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(a)

Define the term monetary policy indicated in bold in the text (paragraph (3).

[ 2 ]

(b)

Using an AD/AS diagram, explain why "tightened monetary policy" may have "slowed down inflation" and "slowed economic growth" (paragraph 3).

[ 4 ]

Approach 1
Level Marks
0 The work does not reach a standard described by the descriptors below. ..... 0
1 There is a correct diagram or an accurate written response. ..... 1-2
For drawing a correctly labelled AD/AS diagram, showing a shift of the AD curve to the left with a fall in the average price level and a fall in real GDP or for an explanation that "tightened monetary policy" (increasing interest rates and/or reducing the money supply) should reduce AD (C + + G + [X-M]), lowering the inflation rate (inflationary pressure) in the economy and reducing real GDP or slowing economic growth.
2 There is a correct diagram and an accurate written response. ..... 3-4
For drawing a correctly labelled AD/AS diagram, showing a shift of the AD
curve to the left with a fall in the average price level and a fall in real GDP
and for an explanation that "tightened monetary policy" (increasing interest
rates and/or reducing the money supply) should reduce $\mathrm{AD}(\mathrm{C}+\mathrm{I}+\mathrm{G}+[\mathrm{X}-\mathrm{M}])$ ,
lowering the inflation rate (inflationary pressure) in the economy and
reducing real GDP or slowing economic growth.

Approach 2
Level Marks
0 The work does not reach a standard described by the descriptors below. ..... 0
1 There is a correct diagram or an accurate written response. ..... 1-2
For drawing a correctly labelled AD/AS diagram, showing a shift of the AD curve to the right or for an explanation that "tightened monetary policy" (increasing interest rates and/or reducing the money supply) should lead to a smaller increase in AD than would have been the case without the "tightened monetary policy" thus reducing inflationary pressures and slowing economic growth.
2 There is a correct diagram and an accurate written response. ..... 3-4
For drawing a correctly labelled AD/AS diagram, showing a shift of the AD curve to the right and for an explanation that "tightened monetary policy" (increasing interest rates and/or reducing the money supply) should lead to a smaller increase in AD than would have been the case without the "tightened monetary policy" thus reducing inflationary pressure and slowing economic growth.

Figure for Answer to Question (b) — IB Economics HL

Candidates who incorrectly label diagrams can be rewarded with a maximum of [3].
For AD/AS, the vertical axis may be price level or average price level. The horizontal axis may be real output, national output, real national output, national income, or GDP. Abbreviations of these terms are satisfactory. A title is not necessary.

[Maximum number: 9]

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

(a)

Calculate the real interest rate for households between January 2023 and January 2024.

[ 1 ]

(b)

Explain how commercial banks create money.

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.

[ 4 ]

(c)

Outline what is meant by the term quantitative easing.

[ 2 ]

(d)

Sketch a diagram to show how an increase in the money supply is expected to affect the equilibrium interest rate.

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

[ 2 ]

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Covered syllabus points

3.5 Demand management - monetary policy question 1

Question (a)

Question (b)

3.5 Demand management - monetary policy question 2

Question (a)

Question (b)

Question (c)

Question (d)