June 2009 unit 2 paper 2 answer

EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS

CAPE
ECONOMICS
th
May 28 2009
Unit 2
Paper 2



June 2009 – Unit 2 – Paper 2

1 a i) Inflation can be defined as a sustained increase in the average or general level of
prices which results in a fall in the purchasing power of money. The average level of
prices is measured using the consumer price index (CPI) which is the weighted average
price changes of a range or a “basket” of goods and services consumed by the average
household. After determining the CPI, the rate of inflation is calculated by taking the
percentage change in the CPI over the proceeding twelve months. This is given by the
following formulae:

[Current CPI − Previous CPI]
Rate of Inflation = ×100
Previous CPI

1 a ii) The term economic growth refers to an increase in the level of national income
expressed in constant prices. Economic growth implies a rise in the productive capacity
of an economy. The rate of economic growth is determined by taking the annual
percentage increase in real GDP.

[Current RealGDP − Previous RealGDP]
Rate of Economic Growth = ×100
Previous RealGDP

1 a iii) The unemployment rate is defined as the proportion of individuals from the labour
force who are unemployed. This is therefore given by the following formula:

Number Unemployed
Unemployment Rate = ×100
Labour Force

That is, the labour force constitutes all individuals within an economy who are of
working age who are either working or in search of a job.

1 a iv) The balance of payments is a record of all transactions conducted between a
country and the rest of the world for a given time period, usually one year. Transactions
which result in monetary receipts or inflows into the country are entered as positive
numbers, whilst payments or outflows from the country are entered as negative numbers.
The balance of payments, in effect, indicates the difference between the amount of
money flowing into a country and that flowing out of the country. The balance of
payments is divided into two sections in order to distinguish between two different
categories of transactions. These sections are:
1. Current Account – This records all items relating to imports and exports of goods
and services, net property income and current transfers between a country and the rest
of the world.
2. Capital Account - This records all movement of capital from both private sources as
well as official government sources between a country and the rest of the world.



1 b i a) The expenditure approach focuses on aggregating all expenditures on final goods
and services produced within an economy to determine GDP. In any economy aggregate
expenditure would consist of consumers’ expenditure, investment expenditure,
government expenditures and net expenditure from the foreign trade sector as given by
exports minus import.

GDP = C + I + G + X −M

where:
C = Consumers’ expenditure
I = Investment expenditure
G = Government expenditure
X = Exports
M = Imports

1 b i b)

C = 600
I = 150
G = 200
X = 300
M = 275

GDP = 600 + 150 + 200 + 300 – 275 = $975 million

1 b ii a) Gross domestic product could also be measured by summing all components of
income throughout the economy. This basically consists of the factor incomes of: wages,
rent, interest, and profit.

GDP = Wages + Profit + Rent + Interest

Wages = 800
Profit = 200
Rent = 75
Interest = x

GDP = 800 + 200 + 75 + x = $975 million

x = -$100 million

1 c i)

Used Textbooks – not included in current GDP calculation as production took place in a
previous year.
Black Market transactions – not included as illegal activities are not formally recorded
and reported in the country.



New Factory – this is a component of investment and is included in the GDP calculations

1 d ) Living standards refer to the quality of life enjoyed by people. An increase in GDP
per capita indicates that individuals are on average earning a higher level of income and
hence can afford a large quantity of goods and services. This should lead to a high
standard of living however there are a number of other factors which needs to be taken
into consideration such as:
1. Inflation – an increase in GDP per capita would not enable consumers to purchase
more goods and services if the price level has increased more than proportionately.
Using real GDP per capita is a better indicator of living standards as it overcomes the
inflation limitation.
2. Income distribution – an increase in GDP per capita would not enable consumers to
purchase more goods and services if income is unevenly distributed. This is because
although on average income is on the increase, only some individuals in society
would earn higher income while the rest would become relatively poorer.
3. Negative externalities – an increase economic activity is often accompanied with an
increase in pollution, environmental degradation and other negative externalities.
These all result in lower living standards to those affected. Since GDP per capita
does not take into consideration these impacts, it would adequately measure living
standards in a country.
4. Leisure – if an increase in GDP per capita is achieved by individuals working longer
hours, then the reduction in leisure may have a negative effect on the quality of life.
Since leisure is not taken into consideration in the calculation of GDP per capita then
it would not accurately reflect the standard of living enjoyed by individuals of a
country.
5. Accuracy – the calculation of national income statistics involves the assimilation of
vast amounts of data about the economy. As a result there may be some level of
inaccuracy in GDP per capita figures and hence living standards may be
misrepresented.

2 a i)
The average propensity to consume (APC) is the proportion of income devoted to
consumption of goods and services.
The marginal propensity to consume (MPCD) is the proportion of any change in income
that is devoted to consumption of goods and services.

2 a ii)
APC = C/Y.
MPC = ∆C/∆Y.

2 b) Average Propensity to Consume and Marginal Propensity to Consume
Y C APC MPC
0 $20M ∞
$25M $35M 1.4 0.6
$50M $50M 1 0.6



$75M $65M 0.87 0.6
$100M $80M 0.8 0.6

As income increase, APC falls continuously, but MPC remains constant.

2 c i) Autonomous consumption – gives the level of consumption when income is zero.
This covers the amount of goods and services that have to be consumed whether the
consumer has income.

2 c ii) The Consumption Function
45° line where
C ($M) Consumption = income
The consumption function as shown in the figure depicts the relationship between total
Consumption
consumption and the level of income. The consumption function is upward sloping since
as income increases, consumers’ expenditure tends to rise. The pointFunction the
at which
consumption function cuts the vertical axis represents the level of consumption where
80
income is zero. This means autonomous consumption is $20 million.
65
2 d i) Determinants of consumption
1. Interest rates
2. 50 Inflation
3. Wealth
4. 35 Indebtedness
5. Expectations
6. Taxation
20
2 d ii) Determinants of consumption – Impacts
1. Interest rates – A change in the rate of interest can significantly affect
consumers’ expenditure at unchanged income. To a large extent, the purchase of
45°
most consumer durables such as refrigerators and automobiles are made on credit
or hire purchase terms. As the interest rate decreases, the cost of borrowing
decreases and25 may entice consumers to increase their spending, especially for
this 50 75 100 Y $M
acquiring consumer durables. A decrease in the interest rate would therefore result
in an upward shift of the consumption function and a downward shift of the
saving function. Furthermore, it can also be stated that the rate of interest gives
the opportunity cost of consumption. This is because, if income is saved and
hence not spent, interest is earned. If consumers choose to spend and not save,
then such interest is forgone. Once again if the interest rate is lowered, then the
opportunity cost of spending money decreases and consumers spend more and
save less.
2. Inflation – As the price level increases at unchanged income levels, consumers
would need to increase their expenditure levels so that they would be able to
afford the same volume of goods and services that they previously consumed.
This may require a cut-back in saving and an increase in consumption
expenditure, even though the same quantity of goods and services are being
purchased, except at higher prices. This therefore implies that inflation leads to an



upward shift of the consumption function. There is however, a counterargument
which states that saving would tend to increase instead when the average price
level increases. This is because as inflation lowers the real value of savings,
households would tend to save more to replenish the purchasing power of their
saved wealth. This relationship therefore seems to suggest that an increase in the
price level would lead to an upward shift of the saving function and a downward
shift of the consumption function. In summary, the exact effect of inflation on
consumption and saving depends on whether consumers prefer to maintain the
current standard of living by consuming the same basket of goods by cutting back
on saving or if they prefer to maintain the purchasing power of their savings by
reducing consumption.
3. Wealth – Wealth consists of real assets such as, a house, automobiles, television
sets and other consumer durables as well as financial assets such as cash, a
savings account balance, stocks, bonds, insurance policies and pension plans
which are possessed by consumers. As wealth increases, there is a tendency for
individuals to consume more out of disposable income. Accordingly, as
households’ wealth increases, the consumption function shifts upwards.
4. Indebtedness – The amount of debt which consumers accumulate can also affect
consumers’ expenditure patterns in exactly the reverse manner in which the level
of wealth does. If households incur a large amount of debt such that a sizable
proportion of their income is committed to the repayment of debt, then consumers
may tend to reduce consumption in an attempt to cut-back on their indebtedness.
This would shift the consumption function downwards. Conversely, if consumers
incur a low level of debt, then they may be more inclined to spend a larger
proportion of income. Furthermore, it is quite plausible that a low level of
indebtedness may actually encourage consumers to borrow for spending purposes
and this shifts the consumption function upwards.
5. Expectations – Consumers’ expectations play an important role in determining
consumers’ expenditure and saving. Expectations of rising prices, product
shortages or future increases in income may induce consumers to increase
spending and reduce saving in the current period. This is because quite naturally
consumers would attempt to avoid the future shortages or future price increases
by buying more beforehand. In addition, higher expected future income may give
consumers the feeling of security and this would encourage them to spend more.
In these cases there would be an upward shift of the consumption function and the
saving function would shift downward.
6. Taxation - A change in direct taxation directly impacts consumers’ disposable
income even though consumers’ income is unchanged. For example, if someone’s
gross income is $100,000 per year and the income tax rate is 15 percent, then
$15,000 would have to be paid in taxes and only $85,000 would be available for
spending. If the rate of income tax were to be increased to say 25 percent, then
taxation would increase to $25,000 leaving only $75,000 in disposable income.
Due to this effect on disposable income, an increase in taxation would lead to a
decrease in both consumption and saving, shifting both functions downwards.
Conversely, a decrease in direct taxation would increase disposable income and



this would be distributed towards higher consumption as well as higher saving,
shifting both curves in an upward direction.

3a i
Narrow money, also called M1, covers money which is immediately available for
spending. That is, it comprises the monetary base and all short term deposits. This
measure of money fulfils the medium of exchange function.

3a ii
Broad money, also known as M2, measures the total amount of money in the economy.
Broad money is therefore narrow money plus long term deposits held at financial
institutions. This monetary aggregate fulfils the store of value function.

3a iii
The stages involved from the implementation of expansionary monetary policy to an
increase in output and employment is called the monetary transmission mechanism. As
the money supply increases, a surplus of money is created in the money market. In order
for the money market to clear, the rate of interest must fall to entice individuals to hold
larger money balances. Following a reduction in the rate of interest, monetarist classify
two independent effects:
Direct effects – This accounts for the effect of a fall in the interest rate which leads to an
increase in consumer spending on goods and services. This increase in consumer
expenditure when the interest rates changes is also known as the wealth effect.
Indirect effects – This refers to the impact of the fall in the interest rate on investments
which is assumed to be quite elastic, since monetarist believe that the rate of interest
plays an important role in determining investments.

3a iv
V is referred to as the velocity of circulation which gives the number of times per year
each dollar is spent on goods and services. The product between the money supply and
the velocity of circulation gives the total level of expenditure in the economy for the
entire year.

3a v
Currency substitution - In a large number of emerging and developing economies, local
currencies do not adequately fulfil the functions of money and as a consequence
individuals partially switch to foreign currencies. This is referred to as currency
substitutions. One of the prime factors responsible for currency substitution is high
domestic inflation.1 When this occurs, holding domestic money becomes quite costly, as
the purchasing power or real value is eroded. In an attempt to avoid such losses,
individuals react by switching to foreign currencies as a store of value. Here, the foreign

1
This can be expected when governments that resort to financing their deficits through inflation (printing
money) force their people to respond to the expected inflation by reducing their holdings of domestic
currency and by substituting foreign currencies for the domestic ones.



currency, such as the US dollar, is used as a medium of exchange instead of the local
currency. There are different degrees to which a foreign currency takes the role of the
local currency. There can be partial currency substitution where local currency is
partially substituted by a foreign currency or there can be full dollarization where
individuals switch entirely away from domestic currency in favour of the US dollar. In
this case, the monetary authorities totally will lose the ability to manage the money
supply as the Central bank of any country only has jurisdiction over the local money
supply. For instance, the Central Bank of Trinidad and Tobago can only print and issue
TT dollars but it cannot print and issue US dollars. Thus, currency substitution limits the
Government’s control over the domestic component of money and this reduces the
effectiveness of monetary policy.

3b
1. Transactionary motive – this refers to the amount of money held for daily use to
carry out routine transactions.
2. Precautionary motive – This accounts for money held for unforeseen expenditures
or unforeseen events or contingencies.
3. Speculative motive – This is any money held by individuals as they aim to take
advantage of capital gains and avoid capital losses due to changes in the price of
financial assets.

3c
Contractionary Monetary Policy

Higher Interest Rate or Decrease in
the money Supply

Decrease in Consumption
Decrease in Investment

Decrease in Aggregate
Expenditure
1. Repo Rate and the Discount Rate
• The Repo rate is the rate at which the Central Bank is prepared to provide
overnight financing to commercial banks. On various occasions, commercial
banks may need to borrow from the Central Bank for just one day or an
overnight period. This might apply at the end of a particular month when
commercial banks might need additional cash reserves to meet the withdrawal
requirements of customers who cash their pay cheques on that day. As the



Repo rate is increased, commercial banks are subjected to more cost and
respond by increasing the rate of interest charged to borrowers.
• The Discount Rate is the rate charged to commercials banks on short term
loans from the Central Bank. Commercial banks may also need to borrow from
the Central bank for short term purposes when they are temporarily unable to
meet their liquidity requirements over such periods. Similar to the Repo rate, as
the discount rate is increased the rate of interest charged by commercial banks
increases and vice versa.
2. Reserve Requirements and Special reserve deposits – This is a banking
regulation which requires that a percentage of commercial banks’ deposits must be
kept in the form of cash. As the reserve requirement ratio changes, so too does the
banking multiplier (see chapter 27). As the reserve requirement ratio is increased, the
banking multiplier decreases, as banks are obligated to keep a larger proportion of
their deposits in liquid form. As a consequence, less money is lent and the credit
creation process is diminished. As a result, the money supply contracts and this
causes the rate of interest to increase leading to a contraction of aggregate
expenditure. In addition to the reserve requirement ratio, the Central Bank can
institute special reserve deposits onto financial institutions. For example, in 2005, the
Central Bank of Trinidad and Tobago required that commercial banks make special
deposits at the Central Bank in addition to the reserve requirement ratio. It must be
noted that an increase in the reserve requirements may not have any impact on the
banking multiplier if commercial banks keep excess reserves. In this scenario,
commercial banks would be able to meet the new reserve requirements without
reducing lending. This can therefore make the use of this instrument ineffective.
3. Open Market Operations – This is the principal tool of monetary policy. This
involves the buying and selling of government securities in the open capital market.
If the Central Bank purchases securities from the public, then this increases the
amount of money in circulation which eventually finds itself into the commercial
banking system. This therefore leads to a multiple expansion of deposits and hence a
further increase in the money supply. The rate of interest consequently decreases and
aggregate expenditure expands. In contrast, the sale of securities does the opposite, as
money is withdrawn from the banking system resulting in a higher interest rate and a
contraction of aggregate expenditure. It must be noted that if the Central Bank
purchases securities and the recipients of the money invest it abroad, then the
domestic money supply would not be increased, rendering this tool ineffective under
this circumstance.
4. Issue of notes and coins (M0) – The Central Bank of any country can easily control
the amount of cash in circulation in the economy as it has the sole responsibility for
minting coins such as a 25 cent piece and printing bank notes such as a $1 bill and
$10 bill and so. As such, the Central Bank is also able to increase the money supply
by simply minting more coins and printing more bank notes and releasing them into
circulation. Of course, this cash would be released into circulation as the government
spends the newly created money.
5. Moral suasion – the Central Bank may attempt to extend its monetary policy stance
on the economy by simply communicating its wishes to the financial sector. If the
Central Bank wanted to effect a monetary contraction, the monetary authorities may



request, without any compulsory consequences, that commercial banks increase their
liquidity ratio or reduce the amount of loans issued. These actions would definitely
result in a decrease in the money supply and a reduction in the level of aggregate
expenditure. In this situation, commercial banks are not obligated to comply with
such requests and as such, this tool may not be an effective monetary policy weapon.
3d
As the money supply increases, a surplus of money is created in the money market. In
order for the money market to clear, the rate of interest must fall to entice individuals to
hold larger money balances.

IR
SM1 SM2

E1
IR1

E2
IR2

LP= DM

M
As the figure shows, an increase in the money supply results in the establishment of a
new equilibrium in the money market at a lower rate of interest. This represents
expansionary monetary policy, as the lower interest rate would lead to an increase in the
level of output and employment in an economy.

3e
The Elasticity of the Demand for Investment – The effectiveness of monetary policy
depends on the impact of changes in the rate of interest on investment spending (and
consumer spending) in the economy. In the previous section, the monetary transmission
mechanism was demonstrated under different assumptions. According to the Keynesian
transmission mechanism, if the demand for investments (MEI) is highly inelastic, then a
change in the rate of interest may not have a profound effect on the level of investments.
This may occur for interest insensitive investments which may be dependent on other
factors such as business expectations or Government incentives and taxation In this
situation, the effectiveness of monetary policy would be weak.
Changes in the Velocity of Circulation – Referring back to the equation of exchange
where:

MV = PY.



The product between the money supply and the velocity of circulation gives the total
level of expenditure in the economy for the entire year. The value of V is said to be
inversely proportional to the level of money demand, in that if the demand for money is
high, money would slowly circulate in the economy. If the demand for money is low,
then a given supply of money in the economy would circulate or change hands at a
relatively faster rate. If it assumed that the velocity of circulation of money is constant,
then the demand for money is expected to be stable. As such, any change in the money
supply, M, would directly result in a change in total expenditure, MV.
If the velocity of circulation of money were to vary and move in the opposite direction to
a change in the stock of money, then it is likely that there would be no change in the level
of aggregate expenditure in the economy. Thus, if for instance the monetary authorities
reduced the supply of money, but the public responded by holding less money, then there
would be an increase in the circulation of money. This means that as the supply of money
shifts to the left, the demand for money curve also shifts to the left. As a result, the rate of
interest remains constant and there is no impact on aggregate expenditure.

4a i
The Balanced Budget Multiplier applies in the case where the increase in government
expenditure of is exactly matched by an increase in taxation. In this situation, national
income increases by the same magnitude, as the increase in government spending and
taxation. The balanced budget multiplier is therefore equal to 1.

4a ii
Fiscal policy is the management of the economy through the level of government
expenditure and taxation. That is, the government can use this demand management tool
to achieve its macroeconomic objectives by manipulating the fiscal budget. Since it
involves public spending and taxation, the arm of government which is in charge of this
policy option is the Ministry of Finance.

4a iii
Every year the government of a country announces it fiscal budget to be used over the
upcoming twelve months. Sometimes the budget would be balanced which means that
government spending is equal to government revenues in the form of taxation.

4a iv
In other instances, the budget would be unbalanced if its spending is not equal to its
taxation revenue. If the government’s taxation revenue is less than the planned level of
spending then it has a budget deficit. This deficit or shortfall of funds is called the public
sector borrowing requirement (PSBR). This is also referred to as the public sector net
cash requirement (PSNCR) which can be met by:
Occasionally, government’s overall expenditure may be less than the amount of revenue
it receives. In this case, the surplus could be used to repay debt that has accrued due to
borrowing in previous years. Such repayment of government debt is commonly referred
to as Public Sector Debt Repayment.



4b
Suppose the government wants to spend an additional $20 billion on infrastructural
improvements but wants to raise the money by increasing taxes by the same amount. In
such a case the increase in government expenditure of $20 billion is exactly matched by
an increase in autonomous taxation of $20 billion. In this situation, national income
increases by the same magnitude, as the increase in government spending and taxation.
That is, national income grows by $20 billion. This is known as the balance budget
multiplier, which occurs whenever there are equal increases in both autonomous
government spending and taxation. This scenario seems counter intuitive, as it would be
expected that if both government spending and taxes increase, there would be no net
injection into the economy and national income would be unchanged. The $20 billion tax
imposed on households, increases withdrawals in the economy and hence lowers
disposable income of households by this amount. If the MPC is 0.8, it means that only
$16 billion is spent on consumer goods and services. Thus the impact of the increase in
taxes is a decrease in consumption of $16 billion. Overall, the decrease in consumption of
$16 billion and the increase in Government spending of $20 billion results in a net
injection of $4 billion into the circular flow of income. The MPC of 0.8 implies that the
multiplier is 5 [1/(1-0.8)], which means that the net injection of $4 billion results in an
increase in national income of $20 billion ($4 billion x 5). Conclusively, although the
government has a balanced budget, there is still a net injection into the economy which
results in an increase in the level of national income. Conclusively, since the increase in
government expenditure of $20 billion coupled with an increase in taxation by this
equivalent amount leads to an increase in national income by the same magnitude, the
balanced budget multiplier is therefore equal to 1.

4ci
Increases in Government borrowing might lead to increases in the domestic rate of
interest as the demand for finance goes up.

4cii
As a result, the higher interest rate may discourage or ‘crowd out’ the potentially more
efficient domestic private sector investment. To a large extent, private sector investments
may make more efficient utilization of resources due to the existence of the profit motive,
whilst public sector investments may lack such efficiency due to the existence of
alternative Government objectives.

4ciii
Government spending financed by borrowing may result in inflationary consequences on
the domestic economy. This type of inflation is known as ‘demand pull’.

4civ
The repayment of interest and principal on external debt has to be made using foreign
currency. This causes a significant drain of foreign exchange which negatively affects the
balance of payment and the exchange rate.

4d



As the rate of interest increases, some private sector investment projects would become
unfeasible. This is shown by the movement along the MEI curve (contraction) as the rate
of interest increases from 8% to 15%. Overall, private sector investments decrease from
$7M to $5M.

Rate of
Interest

15%

8%

MEI

$5M $7M Investment

4e
The National Debt, also known as the public sector debt, is the accumulated debt built up
by the government over a number of years that has not yet been repaid. Interest payments
and the repayment of principal on debt is on burden from public debt. This is because it
reduces the amount of money which the government has, to devote towards other uses
such as spending on educational facilities for instance. This may also result in an increase
in taxes which may not be favoured by taxpayers.

5 a i) Determinants of Economic Growth
1. Increase in Labour Resources - Economic growth depends on the quality and size
of the labour force. Increasing, the quality of the workforce, through better
education and training, increases the value of human capital and makes workers more
productive. Also as the labour force becomes larger due to population growth or other
reasons such as immigration, the productive deployment of the additional workers
enables more output to be produced.
2. Increase in Capital Resources - Increasing, the stock of physical capital such as
new factories, machinery and equipment, is critical in achieving economic growth as
it enables a more efficient use of other factors of production such as labour. In
Trinidad and Tobago, investments in infrastructure such as the proposed rapid rail
network may result in increased transportation efficiency. Investments in human



capital formation enable the quality of labour to improve. This implies that labour
productivity rises, enabling greater output from labour resources. In Trinidad and
Tobago for instance, spending on tertiary level education by the government has seen
a significant increase.
3. Improvements in Technology - Technological advances enable the production of
more output from a given amount of resources. This means that scarce resources are
more productively utilized which reduces the real costs of supplying goods and
services and this leads to an outward shift in a country’s production possibility
frontier.
4. Increases in Natural Resources – Natural resources account for all the free gifts of
nature which can be used as inputs in the production process. This includes resources
such as agricultural land, surface water, forests, minerals, and other natural resources.
Countries which successfully harness the productive potential of their natural
resources are able to achieve rapid growth. The discovery of new oil and gas fields on
the offshore territories in Trinidad and Tobago would constitute an increase in natural
resources.

5 a ii) Economic development is a sustainable increase in the standards of living of the
people of a country.

5 a iii) The human development index as measured by the United Nations Development
Programs seeks to gauge the standard of living of a country by taking into consideration
both economic and non-economic factors.

5 a iv) The Human Development Index uses the following factors:
1. Real GDP per capita – this is calculated by dividing GDP by the population. It gives
an average measure of the amount of income attributable to each person in the
economy, which gives an idea about the amount of goods and services which can be
afforded.
2. Longevity or life expectancy at birth in years - This refers to the average life
expectancy from birth in a country. A number of factors would affect this, such as the
stability of food supplies, the extent to which an area is hampered by war, and the
incidence of disease, are all important. Economic development is achieved when life
expectancy is on the rise.
3. Literacy rate- this refers to the percentage of those aged 15 and above who are able to
read and write. In order for economic development to take place the literacy rate of a
country needs to be improved.

5 b) Cost of Economic Growth
1. Exhaustion of resources – As economies grow, the increased use of resources may
result in the depletion of available natural non-renewable resources.
2. Negative externalities – Economic growth means more output is being produced but
this may be achieved at the expense of increased noise, congestion, pollution and other
negative externalities which undermine economic welfare.



3. Increased inequality – As national income increases, only the high income earners
may benefit, while the low income earners may not enjoy an improvement in the standard
of living. This means that the distribution of income might worsen as inequality widens.
4. Inflation risk – In the case of demand induced growth, if the economy grows too
quickly there is the danger of inflation. This type of inflation is called demand pull
inflation, as aggregate demand races ahead of the ability of the economy to supply goods
and services.

5 c) Impediments to growth in the Caribbean
1. Limited Improvement in Technology – One reason why Caribbean countries may
not always have high rates of growth is because of limited improvements in
technology. Caribbean countries mostly rely on foreign more developed countries for
technological improvements. As such, technology would always have to be imported
and be limited by the availability of foreign exchange. Furthermore, since the
technology is created in more developed economies, it would not always be
appropriate to the conditions of the Caribbean.
2. Limited Savings for Capital formation – Another reason for slower growth in
Caribbean countries is limited resources for capital formation. This is because in most
Caribbean countries income and savings are limited which places a major restriction
on the amount of capital which can be accumulated.

6a)

1) Tariffs or Import Duties - These are taxes on imported goods which are used to
restrict imports and raise revenue for the Government. If a country levies tariffs on
various imports, then the prices of imports would rise relative to the home produced
goods. This would make them less attractive and so the demand for imports should fall as
consumers switch to domestically produced goods. In addition to improving the current
account deficit of the balance of payments, domestic producers would benefit from
increased business.
2) Import Quotas. An import quota directly reduces the quantity of a product that is
imported into a country. The main beneficiaries of quotas are the domestic producers who
face less competition. Quotas restrict the actual quantity of an import allowed into a
country. Note that a quota which reduces the volume of imports, leads to a rise in price of
imports as well, due to its curtailed supply. This therefore encourages demand for
domestically made substitutes.
3) Non- Tariff Barriers
• Exchange controls. This policy works by restricting the ability of households from
purchasing foreign currencies. This prevents domestic residents from acquiring sufficient
foreign currency to pay for imports, which decreases importation of goods and services.
• Administrative regulations - Government can discriminate against the importation
of foreign produced commodities by setting regulations pertaining to health and safety for
instance which are met by domestic, but not foreign, producers. As such, the importation
of foreign produced goods which do not meet the administrative rules would be
restricted.



6b) Factors which determine a country’s export revenue.
1. The price of exported goods as determined in international markets
2. World income or the level of income in export markets which influences the quantity
of goods and services exported
3. The exchange rate as this would affect the price of domestic goods and services in
foreign markets
4. Competition from foreign producers. As other countries produce goods and services
which directly compete with the exportable goods and services produced by the
home economy, export revenue would decline.

6 c) Free -Floating Exchange Rate
Under the free-floating exchange rate system, the exchange rate between the domestic
currency and the foreign currency is determined by the demand and supply in the foreign
exchange market. The demand for foreign currency arises whenever there is need to
exchange domestic currency in return for foreign currency. The supply of foreign
currency arises from all inflows of foreign exchange in the balance of payments. Jamaica
is one county which ahs adopted the floating exchange rate.

Fixed Exchange Rate
The fixed exchange rate or pegged exchange rate is one means by which an exchange rate
can be determined. Under the fixed exchange rate system, the exchange rate is set by the
Government and maintained by Government intervention in the foreign exchange
markets. In Barbados for instance, a fixed exchange rate is adopted with the United States
dollar where Bds$2 = US$1.

If the official rate coincides with the equilibrium rate in the foreign exchange market,
then there is no need for Government intervention. If, however, the official rate differs
from the equilibrium rate, then Government intervention is necessary through the
manipulation of the foreign exchange reserves of foreign currency or even foreign
exchange control measures.

6d)
Advantages of a Floating Exchange Rate System
1. Elimination of current account imbalances - As was pointed out before,
floating exchange rates should adjust automatically in response to current account deficits
and surpluses. That is, all other variables held constant a current account deficit should
lead to a depreciation of the exchange rate while a current account surplus would result in
an appreciation of the exchange rate. These changes in the floating exchange rate would
affect a country’s international competitiveness which would help to achieve balance in
the current account.
2. No need to manipulate reserves - Official foreign exchange reserves are used to
help maintain the external value of a country’s currency within a predetermined level. If a



currency is freely floating, then there is no need to use foreign exchange reserves to
influence the exchange rate.
3. Monetary policy can be implemented - If the Government allows the exchange
rate to freely float, then it would have full control over the money supply and hence the
rate of interest. As such monetary policy could be implemented as a means of influencing
the level of aggregate demand in the economy in order to achieve a particular
macroeconomic objective.

Advantages of a Fixed Exchange Rate System
1. Stability - Economists would argue that this is the most significant advantage of a
fixed exchange rate. If exchange rates are stable over a given period of time, then this
offers certainty to exporting firms in terms of the actual price their products would
fetch in foreign markets. Also, a stable exchange rate would also enable the prices of
imported commodities to be unaffected by a fluctuating exchange rate. Such certainty
would therefore promote greater trade and investments between countries, both of
which are important if economies are to grow in the long term.
2. Avoid speculation - Speculators typically enter markets where commodities are mis-
priced. If the commodity is under-priced they would buy the good or service hoping
to earn a capital gain when prices eventually increase. As speculators buy up such
commodities, they increase the demand for them. This action on the part of
speculators in markets which are anticipated to have a price increase actually causes
the prices of such commodities to rise. Similarly, if it is assumed that the price of a
commodity will decrease, then speculators would sell in order to avoid the loss
associated with the fall in price of the commodity. This action thus results in an
increase in supply which brings forth the anticipated decrease in price. Speculation
can therefore cause volatility in a floating exchange rate system. Under a fixed
exchange rate system however, there is no point of speculative buying and selling of
currencies since the exchange rate is expected to remain fixed.
3. Prevents inflation - In a floating exchange rate system, if a change in the demand or
supply of foreign exchange leads to a depreciation of the exchange rate, then this
would cause inflation as the price of imported goods would rise. A fixed exchange
rate on the other hand would be able to avoid such inflation, as the external value of a
country’s currency remains constant.

6e) A devaluation occurs under a fixed exchange rate system where the central bank
decreases the value of the domestic currency by increasing the price of foreign
currencies. One advantage of a devaluation is that is helps to decrease the level of
imports. This is because, as the price of foreign currencies increase, the price of imported
goods and services would become more expensive in terms of domestic currency. If the
demand for imports is elastic, then the increase in price would lead to a more than
proportionate decrease in quantity demanded so as to decrease the overall level of
expenditure on imported goods and services. This would be beneficial if the country is
faced with a current account deficit.



A major disadvantage of a devaluation is that it can have inflationary effects on the
economy especially when essential goods and services are imported. This is because a
devaluation causes the price of imports to rise. In the case of countries which import
fossil fuels for instance as the price increases, the cost of energy would increase and this
can cause the price of all other goods and services produced locally to increase as well.


June 2009 unit 2 paper 2 answer

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