AQA A level Economics The National and International Economy

Unit4 Section A Context 1: THE GLOBAL CONTEXT

Extract A: Value of US Dollar and UK Pound Sterling to the Chinese Yuan, August 2015

AQA A level Economics Unit 4 image 1

Extract B: Currency wars

After China’s recent devaluation of its currency (the yuan), several other emerging economies followed and reduced the value of their own currencies in an attempt to retain their international competitiveness. This sent shockwaves around global markets and increased fears of a currency war (nations engaging in successive devaluations in order to gain a competitive advantage). However, the most important change appears to be that caused by the Central Bank of China. The perception that the world’s single biggest customer for raw materials is in economic difficulties has created fears for the stability of big commodity producing economies and damaged investor confidence. These economies include Kazakhstan, Russia, Brazil, South Africa and Malaysia.

“The appearance of China deliberately devaluing its exchange rate to boost growth has added urgency for policymakers elsewhere to do what they can to gain more export revenue”, said an analyst. However, the devaluation of the exchange rate in China may also threaten the economic growth of many developed economies such as the UK and the USA. As these economies begin to reach their productive capacities, they are likely to increase their interest rates, which may appreciate their own exchange rates, thereby worsening the situation.

The US government, in particular, has been angered. Although China claims to be trying to manage the yuan’s value against a basket of currencies, the yuan is still, in practice, loosely pegged to the dollar. If the dollar appreciates, then so does the yuan. As a result, this may prompt China to peg the value of their currency at an even lower value against the dollar as a result. It is argued that the Chinese should float their currency freely to make global trade fairer, rather than manipulate its value. However, devaluation of the yuan has allowed Chinese exporters to further improve competitiveness and, by raising the price of imports, has also helped China to stave off deflation.

Extract C: Exchange rate systems

The UK has allowed market forces to determine its exchange rate for over 20 years but, in the face of growing global competition, this may be damaging to the UK’s prosperity. Is it time the UK considered manipulating its currency directly and managing its exchange rate in order to reduce the ever-increasing trade deficit and to help improve its performance?

Monetary policy has generally focused on the control of inflation using interest rates and, in recent times, quantitative easing has been used to help revive the economy. Much less attention has been paid to the exchange rate. If the UK did attempt to manage its exchange rate, it would not be the first European economy to do so. In 2011, Switzerland introduced what it called a ‘currency ceiling’ to try to block the steep appreciation of the Swiss franc, which had become a safe haven for investors frightened by the Eurozone debt crisis. The Swiss government realised that to allow the Swiss franc to appreciate might damage domestic exporters and plunge Switzerland into a long period of deflation.

To keep the value of the Swiss franc against the euro below the ceiling, the Swiss National Bank created new francs and sold them, accumulating foreign currency reserves. This was very costly to the Swiss government and some feared that it might ultimately lead to inflation. Managed currencies also make it difficult to use the other monetary policy instruments effectively, which is why most economies have moved to allowing their currency’s value to be determined solely by market forces. That being said, when the Swiss returned to a freely floating system, their exchange rate increased by nearly 30% in one day. Having a managed exchange rate could, however, lead to more stability for the UK, boosting both trade and investment from abroad. This could help to improve the UK’s macroeconomic performance, despite the growing global uncertainties.

Q.1. Using the data in Extract A, calculate (to one decimal place) the percentage change in the exchange rate between the US dollar and the Chinese Yuan between 1 August 2015 and 13 August 2015, and identify one significant comparison between the exchange rates of the US dollar and the UK pound sterling with the Chinese Yuan over the period shown.

Answer: Exchange rate between US dollar and Chinese Yuan on 1st August 2015= 6.21
This means 1 US dollar is equal to 6.21 Chinese Yuan.

Now, the exchange rate between US dollar and Chinese Yuan on 13th August 2015= 6.40 which means 1 US dollar is equal to 6.40 Chinese Yuan.

Thus, the percentage change in exchange rate between the US dollar and Chinese Yuan = (6.40 – 6.21)/ 6.21 × 100 = 3.05%

Another significant comparison between the exchange rates of the US dollar and the UK pound sterling with the Chinese Yuan over the period shown is between 1st August to around 10th August the dollar-Yuan exchange rate was at the same level while during that phase the pound-Yuan exchange rate was falling. Also, after 25th August, the fall in exchange rate of the pound-Yuan is at a faster rate than the dollar-Yuan. A fall in the exchange rate happens because of the devaluation of Yuan and thus, the exports become cheaper and imports become expensive i.e. China increased its competiveness.

Q.2. Extract B states: ‘the devaluation of the exchange rate in China may also threaten the economic growth of many developed economies such as the UK and the USA.’ Explain the phrase ‘devaluation of the exchange rate’ and analyze how a devaluation of the Chinese currency (the Yuan) may affect economic growth in the UK.

Answer: Devaluation of exchange rate is a monetary tool used by countries which have fixed or semi-fixed exchange rate and it is used for downward adjustment of one country with respect to other currencies. Devaluation is the fall in the value of currency. Countries go for devaluation, if they want to increase the competitiveness and boost growth.

The exchange rate of an economy affects the aggregate demand of the economy through changes in exports and imports. And China will go for devaluation of Yuan because, lowering exchange rates will raise the aggregate demand because of higher export demand; this in turn increases the national income. The increase in AD leads to demand pull inflation. Thus, higher aggregate demand means demand for jobs increases, firms hire more workers to meet up the higher demand. Therefore, there is job creation in the economy. Also, as the demand for exports and imports are price elastic, there is a development in the balance of payments which causes inflation. Due to the increase in imports of China, exports of UK decreases, decrease in their competitiveness, fall in growth.

Overall, in the long run, China can enhance its productivity and competitiveness leading to job creation and increased exports demand and this will help in reducing the unemployment problem in the economy and strengthen the exchange rate and this may work negatively for UK.

Q.3. Extract C asks: ‘Is it time the UK considered manipulating its currency directly and managing its exchange rate in order to reduce the ever-increasing trade deficit and to help improve its performance?’ Using the data and your knowledge of economics, evaluate the view that the UK should focus its monetary policy on managing the exchange rate in order to improve macroeconomic performance.

Answer: Real interest rate is one of the most important factors in determining the exchange rates. High real interest rates causes an appreciation in currency and cutting interest rates tends to cause depreciation. The demand and supply of currency gets affected with change in interest rates. Also, some currencies are subject to exchange rate restrictions and here, the central banks guided the buying and selling of currency by lowering or raising the interest rates. Small changes in interest rates can also make a major impact on exchange rates and due to this increased capital mobility, money can be moved easily. However, interest rate is solely not responsible for the change in exchange rates, other determinants like inflation, balance of payments, competitiveness in the economy, speculation about the future etc.

Thus, UK should also focus on its monetary policy on managing exchange rates to improve its macroeconomic performance and exchange rates can be manipulated by the monetary policy committee to stimulate growth. Firstly, lowering rates will stimulate exports and discourage imports, the combined effect will increase aggregate demand and improve UK’s balance of payments. Exchange rates can be altered by the sale of currencies in foreign exchange market and this is regarded as a type of monetary policy.

Context 2: THE EUROPEAN UNION CONTEXT

Extract D: Selected economic data for Spain

2010 2011 2012 2013 2014
Population (millions) 46.6 46.7 46.8 46.8 46.5
Real GDP (€, bn) 1081 1075 1055 1049 1058
Unemployment Rate (%) 19.9 21.4 24.8 26.1 24.4
Current Account Balance (€, bn) -42.4 -34.0 -3.0 15.1 8.5

Source: Official statistics, 2015

Extract E: Is the crisis over in Spain?

The Spanish economy has been benefiting from an upturn in the economic cycle within the Eurozone. The European Central Bank’s (ECB’s) adoption of quantitative easing has given a boost to the Eurozone. The sharp fall in energy prices caused by the recent collapse in the price of oil has also acted like a tax cut, but Spain seems to have been doing much better than the single currency bloc as a whole, which grew at a much lower rate during this period.

The Spanish government claims that the recent recovery is partly due to the supply-side labour market reforms it has carried out since being elected in 2012. These reforms include: making it less expensive for employers to dismiss permanent workers; allowing firms to opt out of pay setting agreements within industries; allowing employers to set their own conditions of employment with their employees; and also reducing ‘red tape’. At the same time, tax on firms’ profits has been cut from 30% to 25%.

As a result of these and other measures, Spain has moved up the World Bank’s ‘ease of doing business’ rankings from 52nd to 33rd during the last two years (in comparison, the UK has moved from 7th to 8th over the same period).

Economists’ views on the impact of the reforms vary. Some suggest that they help to explain why Spain has been recovering better than other countries such as Italy and Portugal. Some estimates have suggested that unemployment would have peaked at 20%, rather than 26%, if the reforms had taken place earlier. However, others have argued that the source of the recovery has not been the structural reforms but rather the adjustments forced upon businesses and workers in coping with the severe recession, in particular through lower wages.

The Spanish economic recovery, however, needs to be put into perspective. Despite the improvement in growth and the decline in unemployment, Spain’s unemployment rate is still the second highest in Europe, with only Greece having a higher rate.

Extract F: Unemployment in the UK – as good as it gets?

The UK labour market is showing some healthy signs. A significant number of new jobs are continuing to be created and the unemployment rate stood at 5.7% at the end of 2014, in comparison to a Eurozone average of 11.1%. Economic growth has increased the demand for labour. However, some are now arguing that further improvements in the unemployment statistics can only be gained through improvements in the supply-side of the economy, rather than relying on demand.

Wages are growing at their highest rate for over three years and inflation is at its lowest level on record. Consumers are in a much stronger position and the prospects for the UK economy have improved. At the same time, some European economies are showing signs of growth, which is likely to boost UK exports. However, further efforts to reduce the unemployment rate may prove difficult. Some argue that there are jobs out there, but some people are not willing or able to take them.

Labour market programmes are in place in the form of training, subsidies for private employers and help for individuals to find work. However, the UK government has also embarked on a number of policy changes in an attempt to force the unemployed back to work and to deal with the rising costs of welfare. Measures such as the creation of the benefits cap (which limits the maximum amount that people of working age can receive in benefits) and restricting the uprating of Jobseeker’s Allowance to the rate of inflation or 1% (whichever is lower) are all part of an attempt to encourage the unemployed to seek work. However, some would say that this is punishing the unemployed. The announcement of the introduction of a National Living Wage in the recent budget is claimed by the government to offset the effect of the changes to the benefits system.

Q.4. Using the data in Extract D, calculate (to the nearest whole number) the real GDP per capita in Spain for 2014 and identify one significant comparison between the unemployment rate and real GDP over the period shown.

Answer: Real GDP per capita = Real GDP/ Total Population
Thus, real GDP per capita in Spain for 2014 = real GDP in 2014/ Population in 2014
As, the population of Spain is in millions and real GDP is in €, billions. Thus, after conversion i.e. 1000 million = 1 billion
Real GDP per capita = 1058000 (€, millions)/46.5 (millions) = 22753 €
THUS, real GDP per capita in Spain for 2014 is € 22753.

Another significant comparison between the unemployment rate and real GDP over the period shown is that through the years as the unemployment rate was rising, real GDP was falling and during the year 2014, when the unemployment rate fell, real GDP increased. This, data clearly shows an inverse relationship between unemployment rate and real GDP in Spain.

Q.5. Extract E states: ‘The Spanish economy has been benefiting from an upturn in the economic cycle within the Euro zone.’ Explain the term ‘upturn in the economic cycle’ and analyze why this may have caused Spain’s unemployment rate to fall.

Answer: Upturn in the economic cycle occurs when real GDP increases from the low point of the trough during the period of recession. It is the upward shift in economic cycle. This generally takes place to increase the aggregate demand. An economic upturn leads to cut in interest rates so that companies can afford to finance the projects. The consumers’ confidence increase and there is increase in productivity due to the increase in aggregate demand in the economy.

An upturn in economic cycle leads to rise in government borrowing and there is quantitative easing to pump more money into the banking system so that supply of loans could increase.

Due to more supply of loans at lower interest rates, companies invest more into the projects leading to increase in production and this stimulates the firms to employ more workers. This same mechanism helped Spain to decrease its unemployment rate. Because an upturn in the economic cycle in Euro zone increased production process in Spain, increase in aggregate demand resulting in demand for more workers and thus, unemployment rate fell. Due to all of this, income of consumers increased, people now could afford to buy capital goods. Therefore, profit margins of companies also increased and the economy’s output started to rise. This is the reason why Spain performed well after an upturn in economic cycle.

Q.6. Extract F states: ‘some are now arguing that further improvements in the unemployment statistics can only be gained through improvements in the supply-side of the economy, rather than relying on demand.’ To what extent do you agree that a further reduction in the UK’s unemployment rate is most likely to be achieved by improvements in the supply-side rather than the demand-side of the economy? Use the data and your own knowledge of economics, to justify your answer.

Answer: Demand-side measures decrease the demand-deficient unemployment which is generally causes due to recession i.e. it reduces the cyclical unemployment. Demand-side measures are taken by the government such as expansionary fiscal policy (lowering taxes, increasing government expenditure), expansionary monetary policy (quantitative easing, lowering interest rates) which increases the aggregate demand which thus, increase in the demand for workers by firms leading to decrease in unemployment rate.

However, such measures cannot solve the unemployment problem because there exists frictional and structural unemployment and these policies may not be able to solve such problems. Here, in such types of unemployment, the main reason is lack of skills and training which cannot be solved by a country’s fiscal policy and here, supply side measures will reduce the unemployment rate.

Supply side measures include increased education and training because better education can improve labor productivity and increase AS, reducing the power of trades unions so as to increase efficiency of firms and increase employment, reducing state welfare benefits to encourage the unemployed to take jobs, increasing flexibility in labor markets etc. All these measures help in reducing structural, frictional and natural rate of unemployment.

Thus, the UK government should first recognize the type of unemployment and then decide to take demand or supply side measures. However, in an economy, for the policies should work together for optimum results.

Section B Essay 1

‘George Osborne talks about boosting exports and rebalancing the economy, but the Chancellor is not nearly as worried about the trade deficit as he is about the budget deficit.’ Source: The Guardian: Economics Blog, 30 June 2015

Q.7. Explain the factors which are likely to cause a large budget deficit.

Answer: Budget deficit occurs when spending increases more than the revenue collected. It occurs when the expenditures exceed revenues and this determines the financial health of a country. It is also known as the annual amount that the government borrows to meet the shortfall between current receipts and government spending.

The factors causing budget deficit are increase in government expenditure, high levels of tax avoidance or tax evasion by the people (low revenue collection from taxes), demographic pressures such as increase in population leads to more burden on the government, high levels of government subsidies, and inefficiencies of the working of government, cyclical spending and lost tax revenues due to recession, high levels of spending on public services etc.

Q.8. To what extent do you agree that a persistent trade deficit is more damaging to the UK’s macroeconomic performance than a persistent budget deficit? Justify your answer.

Answer: Yes, a persistent trade deficit is more damaging to the UK’s macroeconomic performance than a persistent budget deficit. Trade deficit appears when the value of imports (of goods, services and investment incomes) is larger than the value of exports. A budget deficit implies more aggregate demand due to lower taxes and more government spending. This rise in aggregate demand increases the GDP of the country and thus, stimulating growth and productivity.

However, a consistent trade deficit can be harmful for the economy because large trade deficit creates jobs outsourcing resulting in more goods is imported rather than buying domestically, thus local companies are worse off and the domestic industry becomes less competitive leading to fewer jobs in home for that industry. Persistent large trade deficit impact the economy’s stability and growth negatively. Also, due to the fall in demand for exports, the value of the currency of UK falls too and UK will experience a greater degree of foreign direct investment and foreign ownership of government debt. Overall, a persistent budget deficit does not make UK uncompetitive whereas a persistent trade deficit does so.

Essay 2

After a period of inflation below the target rate, the Consumer Price Index (CPI) inflation rate was recorded as −0.1% in early 2015. The Governor of the Bank of England wrote: ‘A temporary period of falling prices, driven by large adjustments in a few specific components of the CPI, is a fundamentally distinct phenomenon from ‘deflation’...The UK is not experiencing ‘deflation’.’ Source: Bank of England: Letter to the Chancellor, Mark Carney, 12 February 2015

Q.9. Explain the possible causes of deflation in an economy.

Answer: Deflation is the fall in general price level i.e. negative rate of inflation. The main cause of deflation is fall in aggregate demand. Deflation occurs during a deep and prolonged recession when there is continuous fall in demand and output and eventually firms start to cut prices in a desperate attempt to boost spending. Other factors causing deflation are fall in the money supply, tight monetary policy i.e. higher interest rates, reduction in consumer spending.

Deflation is also caused by slow growth and a high level of spare capacity that was driving prices lower and there are some supply side factors which also cause deflation such as improved productivity, technological advances, significant fall in wage rates etc.

Q.10. Evaluate the possible consequences for the performance of the UK economy of the actual rate of inflation being below the Monetary Policy Committee’s (MPC’s) target rate.

Answer: The Monetary Policy Committee target inflation rate due some reasons, because some level of inflation is good for the economy. Such low levels of inflation around 0% cause many problems such as rising real value of debt i.e. it becomes difficult for people to pay back their debts, discourage spending because people expect things to be cheaper in the future.

Low inflation also leads to rise in real interest rates making it less attractive to borrow and invest and encourage savings. And, real wage unemployment too increases during period of low inflation. All these consequences will hold back normal economic growth.

Essay 3

In 2014, the UK’s contributions to the European Union (EU) budget rose by £2.7bn, making it the second largest net contributor. However, it is argued that the UK benefits much more from the trade and the job creation that EU membership brings.

Q.11. Explain how membership of a customs union, such as the EU, affects the pattern and volume of trade between countries.

Answer: The trade agreements within the EU countries help in improving the economies of scale and there is more ease of doing business within the EU because there are no barriers in trade. Trade is considered as the engine of growth and if all nations have better pattern and volume of trade, then it is good for all. The single market of EU facilitates free flow of goods, services, capital and people.

EU has a common regulatory framework which means it does not give a particular company or country any competitive advantage. Countries implement common rules which raise their standards and help in smooth functioning of business. Due to these policies, the trade costs are reduced and markets are opened up. Free trade within EU creates jobs and increases income. Due to this membership of countries, trade and tourism sector have improved making it easier and cheaper. There is harmonization of taxes and other industrial and economic laws which helps in trade.

Q.12. Evaluate the extent to which individuals and firms in the UK benefit from membership of the EU.

Answer: The firms and individuals in UK benefit from the membership of the EU because there is exchange of goods and services across nations without any hindrance, competitiveness of the firms’ increases and due to which consumers enjoy the competitive price which is cheaper and they are not exploited by the domestic firms. Also, it gives the consumers a greater variety of goods available for consumption. UK people enjoy lower mobile roaming charges, lower credit card fees, cheaper flights etc. within EU. UK’s membership with EU has helped for its country’s high GDP.

The firms are benefitted due to the inward investment by the European countries. Also, they enjoy economies of scale from specialization and due to the free movement of labor and flexible labor laws within EU, UK have been able to reduce the labor shortages leading to more output and more employment. Therefore, UK benefits a lot from the membership with EU.

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