Practise IB Economics SL 3.6.3 by explaining expansionary and contractionary fiscal policy and their effects on macroeconomic objectives with marked exam evidence.
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.
Table 4: Economic and development data for Papua New Guinea
Table 5: Balance of payments data for Papua New Guinea
Figure 1: Real GDP annual growth rates in Papua New Guinea between 1996 and 2022
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).