IB Economics HL 3.6 Demand Management Fiscal Policy Questions

Read the extracts and answer the questions that follow.

Text C - Overview of the economy and government policies in Malaysia

(1) Malaysia, located in Southeast Asia, is an upper-middle-income country. While aiming to increase incomes further, mainly through trade and foreign direct investment (FDI), the government also has the objectives of reducing carbon emissions and inequality. Annual rates of economic growth have been averaging between 4 % and 5 % in the early 2020 s .

(2) Inflation in the early 2020s has been low, despite rising global prices. However, unemployment is high, particularly among young people. Real wages in many jobs are lower than four years ago. Therefore, a deflationary (recessionary) gap exists and real gross domestic product (GDP) is below its potential. Fiscal policy could be more expansionary, because government debt is not very large.

(3) Absolute poverty has been eliminated, but income inequality remains high because there are many low-income and unskilled workers in the informal sector. In addition to spending on education and health, the government provides subsidies for necessities, such as gasoline, flour and electricity. However, high-income households often benefit more from subsidies than low income households. For example, high-income households represent 10 % of electricity users, but they receive over 50 % of the energy subsidies. There are also concerns that subsidies for gasoline add to government spending and have caused external costs to rise due to cars being used more.

(4) The government is considering targeted measures, such as providing electricity subsidies only to low-income households. In addition, from May 2022, the minimum wage was increased by 30 %. Although there were concerns that this might increase unemployment, research studies into the effects of a previous rise in the minimum wage in Malaysia show that it increased labour productivity by motivating workers, reduced unemployment by increasing consumption, and increased the labour force participation rate, particularly for females.

(5) Government spending is promoting growth by spending on infrastructure, accelerating innovation, and providing subsidies or loans with low interest rates for agriculture and fishing. In addition, the government is increasing growth in potential output by raising labour productivity through investment in human capital, with measures to improve schooling and nutrition.

(6) Malaysia has consistently had a current account surplus through the early 2000s. Import tariffs have been reduced, because Malaysia is a member of two large free trade areas. However, administrative barriers to trade are high and the International Monetary Fund recommends their removal.

(7) The central bank of Malaysia manages the exchange rate of the ringgit (Malaysia's currency) by using reserve assets. Some trading partners suggest that the ringgit is an undervalued currency. There are financial market regulations affecting the inflows and outflows of FDI and portfolio investment, because the flows are large and volatile. However, transactions on the capital and financial accounts of the balance of payments are gradually being liberalized.

Text D - Environmental policies in Malaysia

(1) The Malaysian government is committed to a 55 % reduction in carbon emissions, which are mostly due to electricity generation and private transportation. Therefore, many government investments are in green projects.

(2) The government is implementing measures to encourage the use of renewable energy, rather than fossil fuels, to generate energy so that the output of energy becomes closer to the socially optimum output. A tradable permits scheme for emissions is being considered and the subsidies on gasoline may be restricted. Carbon taxes, which could generate up to 3 % of GDP in revenue, may also be implemented. Low-income households would be provided with transfer payments as compensation for the resulting higher energy prices.

(3) Although environmental regulations on firms exist, there is concern that such regulations may be weakened when the government encourages investment by firms. However, the government could make support for investment conditional on firms meeting environmental standards.

Text E - The taxation system in Malaysia

The 2023 budget in Malaysia contained measures to raise more government revenue through additional taxes on luxury goods and e-cigarettes. A study has shown that a 10 % increase in price leads to a 24 % reduction in demand for e-cigarettes by teenagers. Therefore, the tax on e-cigarettes is impacting the markets for other goods, such as tobacco cigarettes. The budget also raised income tax rates for high-earners and reduced the rates for low-earners. Corporate income tax rates were lowered for small and medium-sized firms.

Read the extracts and answer the questions that follow.
Text D - Overview of Papua New Guinea

(1) Papua New Guinea (PNG) consists of hundreds of small islands near Australia. Over 50 % of the labour force is employed in agriculture, forestry and fishing. The extraction sector, which mines non-renewable minerals (gold and copper) and extracts energy products (oil and gas), provides 30 % of the gross domestic product (GDP). The mining operations sometimes cause environmental damage and disputes over land rights.

(2) The lack of substitutes and the difficulty of extracting gold, copper and gas cause both global demand and supply to be price inelastic. Consequently, changes in global demand result in volatile prices, which lead to macroeconomic instability because the extraction sector in PNG is so large. Fiscal policies have been unable to reduce the business cycle fluctuations. Tax revenue has declined as a percentage of GDP partly due to lower commodity prices and thus business tax revenue. The government could get more revenue from the extraction sector through ownership or part-ownership of the firms. However, such revenues are unpredictable and probably unsustainable.

(3) After the rapid depreciation of the kina (PGK), PNG's currency, between 2012 and 2015, the central bank moved away from a floating exchange rate system to a managed exchange rate system. It used reserve assets in the foreign exchange market to prevent excessive currency depreciation, thereby lowering cost-push inflationary pressures. However, this intervention caused the PGK to become an overvalued currency. Therefore, the International Monetary Fund (IMF) recommended less intervention in the foreign exchange market so the PGK would gradually depreciate.

(4) Official development assistance (ODA) is providing funds and technical assistance to improve infrastructure and therefore assist economic growth. The World Bank's aid programme provides advice and funds for investment in human capital, especially for women and children's education. The government provides subsidies for schools to correct the welfare loss that occurs in the education market, but they are inadequate.
Text E - Papua New Guinea's balance of trade and trade strategies

(1) The surplus on PNG's balance of trade in goods is due to the extraction sector, which earns 90 % of its export revenues. When global commodity prices were high, exports generated growth. Less than 10 % of export revenues come from agriculture, forestry and fishing, although these sectors employ more people. Over 85 % of PNG's exports go to just five countries. Studies show that PNG exports have a high income elasticity of demand (YED =+3.0 ), but price elasticities of demand are low, particularly for mineral exports such as copper (PED =-0.18 ).

(2) PNG has been attempting various trade strategies, including export promotion, import substitution and economic integration. PNG has relatively low tariffs on most imports. However, tariffs on manufactured items, including machinery for palm oil production, were increased in 2019 to protect local manufacturing companies. Unfortunately, the tariffs on machinery harmed some exporting industries by raising production costs. Additionally, there are restrictions on the exports of some primary goods. For example, exports of logs are restricted in order to encourage timber processing within PNG. However, the tax on log exports caused some logging companies to close down.

(3) PNG has large trade surpluses (based on gas, minerals, and timber exports) with Australia and China, but it wants to diversify and promote agricultural exports. Therefore, it is now negotiating free trade agreements with both countries.

(4) The overall trade surplus will possibly decrease. Exports of gold and copper are not growing strongly. The main agricultural and forestry exports are palm oil, coffee, cocoa and timber, but PNG's shares in the global markets for these items have declined. PNG's vulnerability to climate change is particularly concerning, due to its need to promote agriculture for future export growth and to raise rural incomes.
Text F - Foreign direct investment and Papua New Guinea

(1) The capital and financial accounts on the balance of payments have large deficits. The outflows are mainly due to the repayment of loans that were used to develop the extraction sector. Most inward foreign direct investment (FDI) has been for mining and energy extraction projects. The FDI inflows fall once the project is completed.

(2) PNG is setting up special economic zones in certain regions, which provide tax exemptions and eased regulations. The aim is to encourage FDI into tourism and industries that process agricultural and fishing products. Aid agencies recommend using FDI for renewable energy and environmental projects.

Using an AD/AS diagram, explain the likely fiscal policy used by the PNG government in response to the real GDP growth rate in 1997 (Figure 1).

Table 1 provides information required for the calculation of a consumer price index (CPI). It shows a typical basket of goods purchased by the citizens of Country Alpha and the prices of these goods for two consecutive years. Assume 2015 is the base year, when the cost of the typical basket was $45.00.

Read the extracts and answer the questions that follow.

Text C - Overview of the economy and government policies in Malaysia

(1) Malaysia, located in Southeast Asia, is an upper-middle-income country. While aiming to increase incomes further, mainly through trade and foreign direct investment (FDI), the government also has the objectives of reducing carbon emissions and inequality. Annual rates of economic growth have been averaging between 4 % and 5 % in the early 2020 s .

(2) Inflation in the early 2020s has been low, despite rising global prices. However, unemployment is high, particularly among young people. Real wages in many jobs are lower than four years ago. Therefore, a deflationary (recessionary) gap exists and real gross domestic product (GDP) is below its potential. Fiscal policy could be more expansionary, because government debt is not very large.

(3) Absolute poverty has been eliminated, but income inequality remains high because there are many low-income and unskilled workers in the informal sector. In addition to spending on education and health, the government provides subsidies for necessities, such as gasoline, flour and electricity. However, high-income households often benefit more from subsidies than low income households. For example, high-income households represent 10 % of electricity users, but they receive over 50 % of the energy subsidies. There are also concerns that subsidies for gasoline add to government spending and have caused external costs to rise due to cars being used more.

(4) The government is considering targeted measures, such as providing electricity subsidies only to low-income households. In addition, from May 2022, the minimum wage was increased by 30 %. Although there were concerns that this might increase unemployment, research studies into the effects of a previous rise in the minimum wage in Malaysia show that it increased labour productivity by motivating workers, reduced unemployment by increasing consumption, and increased the labour force participation rate, particularly for females.

(5) Government spending is promoting growth by spending on infrastructure, accelerating innovation, and providing subsidies or loans with low interest rates for agriculture and fishing. In addition, the government is increasing growth in potential output by raising labour productivity through investment in human capital, with measures to improve schooling and nutrition.

(6) Malaysia has consistently had a current account surplus through the early 2000s. Import tariffs have been reduced, because Malaysia is a member of two large free trade areas. However, administrative barriers to trade are high and the International Monetary Fund recommends their removal.

(7) The central bank of Malaysia manages the exchange rate of the ringgit (Malaysia's currency) by using reserve assets. Some trading partners suggest that the ringgit is an undervalued currency. There are financial market regulations affecting the inflows and outflows of FDI and portfolio investment, because the flows are large and volatile. However, transactions on the capital and financial accounts of the balance of payments are gradually being liberalized.

Text D - Environmental policies in Malaysia

(1) The Malaysian government is committed to a 55 % reduction in carbon emissions, which are mostly due to electricity generation and private transportation. Therefore, many government investments are in green projects.

(2) The government is implementing measures to encourage the use of renewable energy, rather than fossil fuels, to generate energy so that the output of energy becomes closer to the socially optimum output. A tradable permits scheme for emissions is being considered and the subsidies on gasoline may be restricted. Carbon taxes, which could generate up to 3 % of GDP in revenue, may also be implemented. Low-income households would be provided with transfer payments as compensation for the resulting higher energy prices.

(3) Although environmental regulations on firms exist, there is concern that such regulations may be weakened when the government encourages investment by firms. However, the government could make support for investment conditional on firms meeting environmental standards.

Text E - The taxation system in Malaysia

The 2023 budget in Malaysia contained measures to raise more government revenue through additional taxes on luxury goods and e-cigarettes. A study has shown that a 10 % increase in price leads to a 24 % reduction in demand for e-cigarettes by teenagers. Therefore, the tax on e-cigarettes is impacting the markets for other goods, such as tobacco cigarettes. The budget also raised income tax rates for high-earners and reduced the rates for low-earners. Corporate income tax rates were lowered for small and medium-sized firms.

Define the term fiscal policy indicated in bold (Text C, paragraph 2).

The information in Table 1 refers to Country A (base year: 2011).

Explain two reasons why fiscal policy may prove effective in lifting an economy out of a deep recession.

Read the extracts and answer the questions that follow.
Text A - Overview of Tanzania

(1) Tanzania is one of Africa's fastest growing economies with an average of 7 % annual economic growth since 2000. It is a politically stable country, rich in wildlife and natural resources. However, the growth has been concentrated in urban manufacturing, using capital intensive production. The benefits from this growth have not reached all people and significant inequalities exist between urban and rural areas. Although the relative poverty rate has fallen over the last 15 years, the number of people living in absolute poverty has increased.

(2) Most people are employed in the slow-growing agricultural sector that relies on unskilled labour. Although incomes increased from 2008 to 2018, the demand for agricultural goods only increased by 21 % during this time period. Over 70 % of Tanzania's population lives in rural areas, relying on subsistence farming with limited tradable crops. Only 30 % of land is being used for agricultural production. With investment, the remaining unused land could be developed and generate income for farmers.

(3) The rural sector struggles to meet Tanzania's food requirements due to low levels of skilled labour and productivity. Additionally, high youth unemployment leads to large numbers of unskilled rural youth migrating to the cities, often finding employment in the informal sector where wages and working conditions are poor. Insufficient investment and lack of government support for diversifying the agriculture sector have been blamed for the persistent inequalities and poverty.

(4) Tanzania's cities have experienced a growing middle class with strong purchasing power and political influence who have placed demands on the government for cheaper electricity, better infrastructure, and more imported goods. In response, the government provided subsidies for electricity in city centres and tax benefits to foreign companies operating in Tanzania. There is concern that these measures may worsen inequality and lead to social unrest.

(5) The growth of Tanzania's manufacturing and service sector was funded through aid and large government borrowing, resulting in high national debt. Most of the government borrowing was from foreign sources and in US dollars (US$), which is a concern due to a recent depreciation of the Tanzanian shilling (Tanzania's currency) against the US$. Some of the debt was borrowed domestically and placed upward pressure on interest rates. Higher interest rates have resulted in crowding out but helped keep inflation under control.
Text B - Strategies and opportunities for Tanzania

(1) Previous governments have used interventionist supply-side policies to improve access to water, education, and health services. However, the health service improvements are not keeping up with population growth and many young people are still not completing secondary school. Infrastructure has improved, but it is still insufficient as producers in the rural sector find it difficult to reach markets and access supplies.

(2) Aid organizations are currently supporting new sustainable businesses in rural areas through training programmes, especially for women and young people, who make up most of the unemployed in rural areas. Economists have advised the government to improve access to credit through microfinance organizations and to simplify regulations to make it easier to start new businesses.

(3) The government is establishing property rights in rural areas to provide security for farmers. Historically, farmers could easily lose their land, which reduced their incentive to invest in productive farming methods. The government wants to develop Tanzania's land resources and lower its reliance on imported food. To reduce food imports, a subsidy will be granted to dairy farmers to allow them to compete against imported dairy products.

(4) Tanzania is a member of the East African Community (EAC) customs union and common market. However, Tanzania needs to improve human capital and encourage diversification so that the benefits of regional integration can reach the poor. These policies can also help attract foreign direct investment (FDI). Opportunities for growth through trade will expand as the EAC works towards becoming a monetary union in 2024.
Text C - Oil pipeline to be constructed
Tanzania and Uganda plan to construct a major oil pipeline from Uganda through Tanzania, ending at a port in Tanzania. This will attract FDI which could help fund infrastructure and generate jobs. However, environmentalists are concerned about potential ecological damage due to the waste created during the construction of the pipeline. Economists have suggested the waste could be avoided through a circular economy approach in the planning and construction stage.

* Estimate

Using an AD/AS diagram, explain how crowding out may help control inflationary pressure in Tanzania (Text A, paragraph 5).