Practise HL exchange-rate calculations and diagrams, then evaluate intervention, interest rates, inflation, trade competitiveness and external-balance effects.
Country X and Country Y are capable of producing both apples and bananas. Assume a two-country, two-product model.
Country Y has absolute advantage in the production of both apples and bananas, and comparative advantage in the production of bananas.
The market for oranges in Country Z is illustrated on Figure 5.
Figure 5
The domestic demand and supply for oranges are given by the functions
where P is the price of oranges in dollars per kilogram ( per kg ), Q d is the quantity of oranges demanded (thousands of kg per month) and Qs is the quantity of oranges supplied (thousands of kg per month). The world price of oranges is per kg.
Due to increased awareness of the possible health benefits of vitamin C , the demand for oranges in Country Z increases by 60000 per month at each price.
Explain two possible economic consequences for the eurozone if the euro appreciates.
Tanya exchanges her US$ for EU€.
Calculate the quantity of EU€ she will receive for her US .
The EU€ depreciates by 10 % against the US$. Fearing further depreciation of the EU€, Tanya exchanges her EU€ for US$.
Calculate, in US$, the loss made by Tanya as a result of these transactions.
Explain two reasons why a government might prefer a floating exchange rate system for its currency.
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.
Table 1: Economic data for Tanzania
Table 2: Development data for Tanzania
* Estimate
Using an exchange rate diagram, explain what could happen to the value of the Tanzanian shilling if there is increased inward foreign direct investment (FDI) in Tanzania (Text B, paragraph 4 ).
Study the extract below and answer the questions that follow.
Gulf banks debating currency peg to US dollars
(1) Qatar's central bank suggests some Gulf States* should consider moving from a fixed exchange rate, with their currencies pegged to the US dollar, to a floating exchange rate system. Bankers and economists throughout the region are debating this issue.
(2) Qatar's central bank governor said the country planned no change to its peg to the dollar, with the exchange rate now fixed at QAR3.64/US$1. However, "with increasing integration in international trade, services, and asset markets, a higher degree of exchange rate flexibility may become more desirable" he said. Qatar is battling against higher rates of inflation in 2013. Inflation is at the highest level since 2009.
(3) Saudi Arabia and the United Arab Emirates (UAE) have pegged their currencies to the dollar for decades. They have been able to do this because their inflation rates have been low and stable, and they have had substantial oil export revenues giving them large reserves of foreign currency.
(4) As a result there has been no need to change official exchange rates, said the chief economist at National Bank of Abu Dhabi: "Fixing the currency gives stability and visibility for business contracts". There are good arguments for pegging the currency to the US dollar. However, it can result in imported inflation from other economies. In 2007, the US was cutting interest rates. This meant that, in order to maintain the fixed exchange rate, the UAE also had to cut its interest rates. This was at a time when the UAE was booming and experiencing high inflation.
(5) Currently there is no pressure on the pegged rate and if necessary a central bank can revalue or devalue its currency when required. It is commonly agreed that the best time to change a fixed currency regime is when there is no pressure.
(6) A senior economist at a commercial bank agrees that the UAE should consider dropping its currency peg to the US dollar and moving to a floating exchange rate for the dirham (the UAE currency). He says that the US dollar's weakness relative to other currencies was a positive stimulus for economic growth. However, growth in the UAE is already quite strong and so having its currency pegged to a weak currency could harm the economy by leading to higher inflation. http://www.albawaba.com/business/qatars-currency-peg-here-stay-514355, 'Qatar's currency peg here to stay', 18 August 2013, permission conveyed through Copyright Clearance Center, Inc. Extracts from The National, Abu Dhabi: http://www.thenational.ae/business/industry-insights/finance/uae-should-drop-dirhams-
peg-to-us-dollar-says-economist\#ixzz2cfjYpl71, 22 November 2011 http://www.thenational.ae/business/industry-insights/economics/gulf-banks-debating-currency-peg-to-us-dollar\#ixzz2cfivZBbz, 7 June 2013]
* Gulf States: include Bahrain, Iraq, Kuwait, Oman, Qatar, Saudi Arabia, United Arab Emirates
Define the term fixed exchange rate indicated in bold in the text (paragraph (1)).
Using an exchange rate diagram, explain how the United Arab Emirates (UAE) could maintain a fixed value of its dirham to the US dollar if there were upward pressure on the dirham.
Distinguish between a devaluation and a depreciation of a currency.
Using information from the text/data and your knowledge of economics, discuss the view that some Gulf States "should consider moving from a fixed exchange rate" to "a floating exchange rate system" (paragraph (1)).
Country X and Country Y are capable of producing both apples and bananas. Assume a two-country, two-product model.
Country Y has absolute advantage in the production of both apples and bananas, and comparative advantage in the production of bananas.
The market for oranges in Country Z is illustrated on Figure 5.
Figure 5
The domestic demand and supply for oranges are given by the functions
where P is the price of oranges in dollars per kilogram ( per kg ), Q d is the quantity of oranges demanded (thousands of kg per month) and Qs is the quantity of oranges supplied (thousands of kg per month). The world price of oranges is per kg.
Due to increased awareness of the possible health benefits of vitamin C , the demand for oranges in Country Z increases by 60000 per month at each price.
Explain two possible economic consequences for the eurozone if the euro appreciates.
Tanya exchanges her US$ for EU€.
Study the extract below and answer the questions that follow.
South Korea quietly intervenes on the won to support economy
(1) South Korea's foreign exchange authorities have been engaged in a quiet war in the foreign exchange market in recent months. This has been in order to hold down the value of the country's currency, the won, against the US dollar to support exports and help keep the economy on its fragile recovery track.
(2) The government has been keen to stimulate domestic consumption and reduce the country's reliance on trade. However, domestic demand has been damaged by a ferry accident that killed more than 200 passengers earlier this year. The accident damaged consumer confidence and harmed economic activity in a number of sectors, including retail and travel. Exports have also suffered from slow growth in China, South Korea's biggest export market.
(3) South Korea's central bank reduced its growth forecast for the coming year noting that economic growth is below the economy's potential rate. The finance minister has said that the country needs to implement fresh policies to stimulate the economy. He promised to look into "all possible steps" across fiscal and monetary policies. Low inflation gives the central bank room to support the economy. Consumer prices rose 1.7 % in June from a year earlier, below the central bank's target range of 2.5 % to 3.5 %.
(4) The rapid increase in the value of the won is a concern to producers in the country. Both Hyundai Motor Company and Samsung Electronics Limited blame the stronger currency for threatening their profits in the last year. They also complain that many countries, including China and Japan, have engineered weaker currencies to help make their goods more competitive. A spokesperson from Hyundai Motor Company said that Japanese rivals had benefited from a 30 % depreciation of the Japanese yen over the past two years.
(5) Many analysts have downplayed manufacturers' concerns about the strengthening won arguing that Hyundai Motor Company and Samsung Electronics Limited both manufacture most of their products outside South Korea. They also note the positive impact on South Korea's steel and chemical manufacturers of cheaper raw material imports in a country that has almost no oil and iron ore.
(6) Despite a commitment to free markets, South Korean authorities have often intervened in currency markets, which has caused tension with the United States (US) and the International Monetary Fund (IMF). The IMF has warned against excessive intervention. It said that the won is still undervalued after falling sharply following the global financial crisis. The IMF argues that movements in the won should be determined by the market and that South Korea holds enough reserves of US dollars. www.ft.com, 24 July 2014 and www.bloomberg.com, 10 July 2014]
Using an exchange rate diagram, explain how the authorities have been able to "hold down" the value of the won against the US dollar (paragraph (1)).
Country X and Country Y are capable of producing both apples and bananas. Assume a two-country, two-product model.
Country Y has absolute advantage in the production of both apples and bananas, and comparative advantage in the production of bananas.
The market for oranges in Country Z is illustrated on Figure 5.
Figure 5
The domestic demand and supply for oranges are given by the functions
where P is the price of oranges in dollars per kilogram ( per kg ), Q d is the quantity of oranges demanded (thousands of kg per month) and Qs is the quantity of oranges supplied (thousands of kg per month). The world price of oranges is per kg.
Due to increased awareness of the possible health benefits of vitamin C , the demand for oranges in Country Z increases by 60000 per month at each price.
Explain two reasons why a government might prefer a floating exchange rate system for its currency.