IB Economics HL 3.6 Demand management - fiscal policy Question Bank

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

(1) Mexico, with its abundant natural resources, is the second largest economy in Latin America. However, compared to other Latin American countries, Mexico has underperformed. Its annual economic growth rate averaged 2.5 % between 1994 and 2019. Per capita income rose more slowly, at an average rate of less than 1 % annually.

(2) Government expenditure has been rising, while taxation revenue has been stable or falling. Therefore, there is concern about the increasing government debt. If there is a recession, automatic stabilizers will increase the budget deficit, further raising the level of government debt. However, the International Monetary Fund (IMF) forecasts that government debt will stabilize in the mid-2020s, at around 65 % of gross domestic product (GDP).

(3) The oil sector makes an important contribution to Mexico's economy. Earnings from this sector were about 30 % of total government revenue in 2019. However, as countries increase their use of alternative energy sources, the long-term trend of falling oil prices will probably continue.
4

(5) Since 1994, the exchange rate for the peso (Mexico's currency) has been floating. In March 2020, the rate changed from 18 pesos per United States (US) dollar to 25 pesos per US dollar. During 2020, the deficit on the balance of trade in goods continued to widen. However, by April 2021 the trade balance had changed to a surplus as exports of manufactured goods rose strongly. The deficit on the current account has also been narrowed by rising net remittances.
Text B - Free trade agreements

(1) The North American Free Trade Agreement (NAFTA) was a three-country accord negotiated by the governments of Canada, Mexico, and the United States that entered into force in January 1994. NAFTA eliminated most tariffs on products traded between the three countries, with a major focus on liberalizing trade in agriculture, textiles, and automobile manufacturing. The deal also sought to protect intellectual property, establish dispute resolution mechanisms, and through side agreements, implement labor and environmental safeguards. Trade among the NAFTA members tripled over the following 25 years, partly due to trade disputes between the US and China.

(2) Following the establishment of NAFTA, productivity increased in Mexico. US and Canadian firms viewed Mexico as a low-cost location for factories, which could improve their competitiveness. Therefore, foreign direct investment (FDI) into Mexico grew significantly throughout the 1990s and early 2000s. In the industrial north of Mexico, high-tech manufacturing factories were established and wages increased. However, the agricultural south did not benefit from the FDI. Agricultural exports from Mexico did increase, but Mexican farmers, especially corn producers, faced competition from subsidized US agriculture.

(3) The wage differential between the US and Mexico was predicted to decrease significantly, but a large wage gap remains. NAFTA's effect on employment has been mixed. Some workers became unemployed when their firms lost market share due to increased competition, while others gained from the creation of new market opportunities.

(4) In 2020, NAFTA was renegotiated as the US-Mexico-Canada Agreement, which kept elements of NAFTA, while adding provisions regarding digital trade and financial services. The requirement that a high proportion of the inputs used in exported goods must come from member countries may mean that the cheapest inputs cannot be used. There are also additional rules to protect the environment and support labour rights. For example, 40 % of the value of the components in each vehicle exported from Mexico must come from factories paying a wage of at least US$16 per hour. As a result, the incomes of Mexicans who find industrial employment are raised.
Text C - Access to banking and finance in rural areas

(1) The persistence of income inequality in Mexico is partly due to domestic factors, such as underdeveloped financial institutions and low productivity in the large informal sector. Improving access to banking and finance could significantly benefit low-income households and small firms.

(2) The Expanding Rural Finance Project aims to provide finance for women, young people, and small firms in rural areas where there are no commercial banks. Over 170000 loans (averaging US$1850 per loan) were provided from 2016 to 2020. Among the recipients, 76 % lived in rural areas and 81 % were women.

*estimate

Read the extracts and answer the questions that follow.
Text A — Costa Rica: Economic growth and development strategies

(1) In the early 1990s, Costa Rica, a Central American country with a population of approximately 5 million people, was considered an economic development success story. This stable democracy has experienced consistent economic growth (approximately 4 % annually) for the last 20 years. Some experts say this has been due to moving from a failed import substitution policy to outward-oriented economic policies. The outward-oriented policies included export promotion, diversification, trade liberalization and inward foreign direct investment (FDI). During the same period, social and environmental policies were implemented. Public education and healthcare were guaranteed for all citizens, social programmes were improved to include extensive transfer payments and minimum wages were increased. This helped the reduction in absolute poverty rates and Costa Rica became known as a global leader in environmental conservation efforts.

(2) The Dominican Republic-Central America-United States Free Trade Agreement (CAFTA-DR), was a significant move towards trade liberalization. In addition to reducing trade barriers, it established a secure and predictable environment for foreign investors. This agreement also led to the breakup of the state-owned monopolies in the telecommunication and insurance industries in Costa Rica. Additionally, trade agreements with Canada, China, the European Union (EU), Mexico, Peru and Singapore were established.

(3) Costa Rica encouraged inward FDI by lowering regulations and providing tax incentives in manufacturing industries. In 1997, Intel, a large multinational tech company from the United States (US) invested US$300 million in building a computer parts factory. Intel's investment helped diversify Costa Rica's main exports away from coffee and bananas to electronics. Moreover, the FDI allowed Costa Rica to benefit from production externalities, as multinational companies provided training to local employees. Manufacturing and services overtook agriculture in terms of contribution to gross domestic product (GDP), and Costa Rica experienced its first trade surplus in 50 years. The increase in real GDP from the FDI was significant, as the marginal propensity to consume (MPC) was 0.8 at the time.

(4) To promote diversification, export subsidies for companies in the manufacturing sector were granted. Agricultural diversification was also encouraged through subsidising farmers who were adopting new technology to produce higher value-added products, such as roasted coffee beans.
Text B - Current concerns

(1) Despite earlier successes, income inequality in Costa Rica has remained high and poverty levels have remained unchanged for several years. This has been blamed on insufficient transfer payments due to a tax system that is not progressive enough and tax exemptions offered to foreign firms. Unemployment has consistently risen, and despite high levels of spending in education, a significant number of young people have not completed secondary or higher education. The focus on higher value-added sectors did not create jobs for low skilled workers, which had a disproportionate impact on women and youth. Additionally, the social programmes have often failed, and still fail, to reach the very poor.

(2) High social and environmental spending, large increases in public sector wages, and insufficient revenue have resulted in very large government (national) debt. Most of the debt is domestic, which is raising concerns about possible crowding out.

(3) FDI has historically supported economic growth, however, domestic investment and further FDI have slowed down due to rising costs and outdated infrastructure. Additionally, the appreciating colón (Costa Rica's currency) has lowered export competitiveness, and Costa Rica remains heavily dependent on one major trading partner, the US.
Text C - "Green Trademark" environmental policy
The "Green Trademark" policy has reversed deforestation and has resulted in Costa Rica becoming one of the countries with the greatest level of biodiversity in the world. However, it is difficult to maintain the environmental focus due to pressure on government resources and the high opportunity costs associated with land use. The consistent economic growth has made it difficult for Costa Rica to reduce carbon emissions from fossil fuels. Increasing urbanization and the growth in the manufacturing sector have increased air and water pollution. Moreover, the overuse of chemicals in farming has caused river pollution, and the intensive use of land for agriculture has generated concern for environmental conservation.

\footnotetext{
*2011 figure
}

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

The following table presents national income statistics for selected variables related to Country Z for 2012 and is expressed in millions of dollars.

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

Explain how fiscal policy can be used to reduce the level of unemployment.