CAPE Economics, June 2007, Unit 2, Paper 2 suggested answer by Edward Bahaw

EDWARD BAHAW CAPE ECONOMICS PAST PAPER SOLUTIONS

CAPE
ECONOMICS
th
June 14 2007
Unit 2
Paper 2


June 2007 – Unit 2 – Paper 2

1.a Gross Domestic Product (GDP) is a measure of the value of all final goods and
services produced in an economy over a specific period of time. Gross National Product
(GNP) is a measure of the total level of income earned by nationals of a country over a
specific period of time. GNP is derived by adjusting GDP for the inflow of income from
foreign countries and the outflow of income to foreign countries. This is the net property
income from abroad adjustment. The essential difference is that GNP includes net
property income from abroad while GDP does not.

GNP = GDP + Income inflows from abroad - Income outflows to abroad

Or

GNP = GDP + Net Property Income from Abroad

1bi) Purely financial transactions such as the issue of shares or bonds by companies are
not included in GDP calculations as these do not directly reflect the production of goods
and services. Instead, the use of such finance to purchase capital such as machinery and
equipment in a plant would be recorded as this is an element of physical investment.

1bii) The calculation of GDP is based only on goods and services produced in the current
period. Second sales are not counted in GDP calculations as this transaction does not
represent the production of a good or a service in the current period.

1c) The expenditure approach in calculating national income focuses on summing all
expenditures on goods and services generated within an economy. This includes:
consumption expenditure, investment expenditure, Government expenditures as well as
expenditure by foreigners in the form of exports.

By using the expenditure approach, National Income = E = C + I + G + X − M

Imports are deducted as this represents goods and services which are consumed
domestically but produced in foreign countries.

Under the income approach national income is measured by summing all forms of
income throughout the economy. This basically consists of the factor incomes of: wages,
rent, interest, and profit

By using the income approach, National Income = wages + rent + interest + profit

The main difference between the two is that the expenditure approach gives GDP at
market prices while the income approach gives GDP at factor cost.

d i) Net Domestic Product = GDP − Capital Consumption



The total value of final output produced within an economy over a specific period of time
less an allowance for capital consumption or the depreciation of capital.

d ii) National Income = Net National Product (NNP) at factor cost

NNP at factor Cost = GDP at factor cost + Net Property Income from Abroad - Capital Consumption
The total income earned by all nationals of an economy from the factors of production
they own less an allowance for capital consumption or the depreciation of capital.

d iii) Personal Income = National Income - Retained Earnings and Corporate Taxes

This gives the total level of income earned and received by households after retained
earnings and corporate taxes.

d iv) Disposable Income = Personal Income - Income Taxes

The part of income which remains with households after the payment of personal income
taxes.

1 e) The consumer price index (CPI) is a price index which measures the weighted
average price of a range or a “basket” of goods and services consumed by the average
household. For example, food, clothing and transport are included in the basket among
other goods and services. A base year is selected which has in index value of 100. As the
price of goods and services in the ‘basket’ change over time the CPI changes to reflect
the new prices based on a weighted average.

1 f) The GDP deflator is the price index used to convert nominal GDP to real GDP or
GDP at constant prices. The price index is a measure of the average price level in the
economy compared to a base year. The base year is a selected year which is used to
compare prices in other years. If the year 1990 is chosen to be the base year and by 1999
prices on average have increased by 50 percent, then the price index for 1990 and 1999
would be 100 percent and 150 percent respectively. The formula shows the simple
calculation involved in using the GDP deflator to convert nominal GDP into real GDP.

Nominal GDP 100
Real GDP = ×
GDP Deflator 1

1 g) Four Reasons why GDP is not a true measure of well being of an economy:
1.Income distribution. In some countries a small proportion of the population enjoys a
large share of the country’s national income. In such a country increases in national income
only benefits the wealthy minority. This wide inequality in income is clearly depicted in
countries where the rich live in wealthy areas while the poor live in ghettos and slums.
2.Working hours. Despite their high national income, the Japanese have to work long
hours. In this case a higher national income does not necessarily mean a higher standard of



living is attained if people are more stressed out by the longer working hours. This also
means people will not be able to enjoy as much time with their family and friends as
before.
3.Negative externalities. Despite an increase in national income, there is usually a price
to be paid for higher growth in the form of negative externalities. In highly industrialized
nations like Germany and Taiwan, pollution and traffic congestion are part of daily life.
Environmental pollution will have adverse effects on the health of the people.
4.Government expenditure. Some governments spend a lot of money on military
equipment and weapons, e.g. North Korea and Iran. Expenditure on those goods will lead
to a high national income figure but this would involve a high opportunity cost in terms of
consumer goods foregone. The people in such countries will have alot of national defence
capabilities but not be able to enjoy a high standard of living as they lack more important
goods and services.

2 a) Four Major Determinants of Aggregate Demand (AD)
1. The price level: As the average price level changes, there is a movement along the
AD curve. For instance as the average price level increases the purchasing power of
nominal income decreases and as a result households consume fewer goods and
services.
2. Taxation – A decrease in the rate of taxation, whether direct or indirect will have the
effect of increasing AD whatever the price level, as consumers would have more
disposable income to spend. Reduced corporation taxes or businesses taxes may make
previously unfeasible investments profitable and thus result in higher investment.
3. Government spending – An increase in Government expenditure, one of the
components of aggregate expenditure in the economy at unchanged prices would
certainly increase aggregate demand causing it to shift to the right.
4. Interest Rates – A change in the rate of interest can also cause a shift in the AD curve,
when the change in the rate of interest happens independently of a change in the price
level. If for instance there is an increase in the money supply, such that interest rates
decrease, then both consumer expenditure and private investment decreases and this
would bring about a fall in aggregate demand at unchanged prices.

2 b) Four Major Determinants of Aggregate supply
1. The average level of prices – as the average price level increases production within
the economy increases in the short run making use of idle resources. Although
diminishing returns are experienced, the higher prices of final goods and services
enable producers to feasibly produce more output
2. Changes in the stock of human and physical capital – investments in machinery or in
the skills of people enable more output to be produced more efficiently. As a result
aggregate supply expands.
3. Exploitation of unscathed natural resources – as countries channel resources toward
the exploration for mineral resources such as hydrocarbons, new fields might be
discovered. This would indeed lead to an increase in the productive capacity of the
economy.



4. Improvements in technology – as new technological breakthroughs are achieved the
total amount of goods and services produced by the resources of the economy
expands and this shifts the AS curve to the right.

2c) Factors which account for the volatility of Investments - there are many factors which
influence decisions by investors. These factors affects profitability which makes
investments very volatile. Three of these factors are:
1. The rate of interest - The rate of interest is a key factor in investment decisions. In
general, a fall in the interest rate decreases the cost of investment and as a result
planned capital investment projects which were previously unfeasible become
profitable. This would therefore lead to an increase in investments as entrepreneurs
take advantage of opportunities to earn greater profits. Conversely, if interest rates
were to increase then some investments would become unprofitable. As a result, a
smaller amount of investments would be undertaken as entrepreneurs bypass the
unprofitable projects.
2. Expectations – Investors’ expectations about the future have a very important impact
on their preparedness to undertake investments. This comes about because of the
nature of investments which usually has a lifespan exceeding more than one year.
This makes expected yields on investments highly vulnerable to businessmen
expectations about the future, which may depend on a plethora factors such as the
domestic, political climate or even stock market conditions. If investors are generally
pessimistic about the future prospects of the economy, then expected profitability
would be lower than usual and it is likely that under this scenario investment would
be low. In contrast, if investors are generally optimistic about the outlook of the
future, then investments would be high.
3. Government Influences – Another important determinant of investment is the impact
of Government influences. There are many instances where Government policies
such as tax exemption or even subsidies may encourage entrepreneurs to undertake
investments. Similarly, if the marginal rate of tax were to be increased, then after tax
profitability of investment would lowered and this would tend to dissuade
investments. Other government influences may include other incentives which
encourage investments. In Trinidad and Tobago for instance, government initiatives
in the formation of industrial estates has been a major catalyst in the growth of
investments in the country.

2 d) Relationship between Savings and Investments
The relationship between savings and investment is given by the loanable fund theory. In
this market, the demand for loanable funds is determined by investment, while the supply
is derived from savings. The relevant price in this market is the rate of interest.

If investments are greater than savings then interest rates would increase. As a result
savers are encouraged to increase their savings as the return on saving deposits increase.
Interest rates continue to increase until the level of savings is sufficient to finance all
investments.



If savings were greater than investment then the rate of interest would decline and this
would encourage entrepreneurs to invest more. The rate of interest would stop declining
when investments become equal to the level of savings.

2 e) Difference between inflationary and deflationary Gaps
The inflationary and deflationary gaps exist whenever the equilibrium income level for
the economy does not correspond to the full employment level of income. At this point,
the full employment level of income is the level of income where basically all productive
resources are utilized.

Panel A: Inflationary Gap Panel B: Deflationary Gap
E
E FE
FE Y=E
Y=E

E AE1
X
F
Y AE2
G
E

45° 45°
YF Y YE2 YF Y
YE1

Panel A shows the equilibrium level of income coinciding with Y E1 which exceeds the
full employment level of income YF. This occurs in a situation where people are trying to
buy more goods and services than the economy can potentially produce when all
resources are fully employed. The excess demand results in higher prices or inflation.
The vertical distance XY represents the inflationary gap attributable to excessive demand
in the economy. If the aggregate expenditure curve is shifted downwards by this vertical
distance then this would eliminate the inflationary pressure.

In panel B the equilibrium level of income is YE2, which falls short of that required for
full employment. This is because there is insufficient demand in the economy relative to
potential output. As such this implies that there are unemployed or idle resources in the
economy. The vertical distance FG, corresponds to the deflationary gap, which represents
the amount by which the aggregate expenditure must be shifted upwards to achieve full
employment in the economy.

3 a ) Creation of Money by Commercial Banks



Commercial banks, accepts deposits from savers and uses these funds to make loans to
borrowers. In the banking system though, as money is lent to a borrower it is
subsequently used to purchase a good or a service. As it changes hands from the
borrower/buyer to the seller, it might subsequently be re-deposited back into the bank by
this person.

This can be demonstrated in tabular form as shown below. For example, if a new bank
receives a primary of initial deposit of $1000 and it lends out $800 to a borrower then
subsequently the $800 would be returned to the bank by another party in the form of a
secondary or derivative deposit. Here the $200 or the 20 percent not lent out is called the
cash reserve ratio or the proportion of a deposit which is kept in the form of cash at the
bank.

Deposit/Money Creation by Commercial Banks

Depositor Deposits Loans Reserves
Initial Deposit 1st $1,000 $800 $200
Derivative Deposit 2nd $800 $640 $160
Derivative Deposit 3rd $640 $512 $128
Derivative Deposit 4th $512 $410 $102
Derivative Deposit . . .
Derivative Deposit . . .
Derivative Deposit ∞ . . .
Total Deposits $5,000 $4,000 $1,000

As the $800 derivative deposit is collected, 20 percent is kept in liquid form at the
commercial bank. This amounts to $160 and the remaining $640 is lent out. Eventually
the remaining $640 lend out, is re-deposited at the commercial bank of which $512 is lent
out and $102 kept in liquid form. This process whereby banks use deports to make loans
which are re-deposit back into the bank in a continuous fashion demonstrates how they
create money.

3 b) The money multiplier refers to ratio of the total deposits at a commercial bank to the
initial deposit. The total deposits would comprise of the sum of the initial deposit and all
derivative deposits. From the table this would be $1000 + $800 + $640 + $512 + $410 +
…

The ratio of these total deposits to the initial deposit can be calculated by the following
formula.

Money Multiplier = 1 / (Cash Reserve Ratio)

3 c i) Fiat Money



In most modern economies money issued by Central Banks is neither commodity money
nor representative money but rather fiat money. Fiat money or fiat currency is money
which has no intrinsic value and is not backed by any physical commodity. Despite this,
such money is still acceptable in settlement of a debt because the Government declares it
as legal tender. That is fiat money fulfills the functions of money as the Government
officially stipulates that it must be accepted in settlement of a debt.

3 c ii) Three Functions of Money
1. Medium of exchange
2. Standard of deferred payment
3. Unit of account

3 c iii) Three Desirable Characteristics of Money
1. Homogeneity
2. Durability
3. Divisibility

3 c iv) Three Reasons why people hold money
1. Transactionary motive – this refers to 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 contingencies.
3. Speculative motive – this is any money held in excess of the transactionary and
precautionary motive and accounts for any money held in the hope of either making a
speculative gain, or avoiding a possible loss as a result of a change in the interest rate
and hence the price of financial assets.

3 d) Four Main Instruments of Monetary Policy
1. Repo Rate – this is the rate at which the Central Bank is prepared to provide
overnight financing to commercial. As the Repo rate is increased, the rate of
interest in general increases throughout the economy. This is likely to be quite
effective as practically all interest rates within the financial sector tend to move in
line with the rate. As such it is the principal instrument used by the Central Bank
to influence the rate of interest in the economy.
2. Reserve Requirements –This is a banking regulation which requires that a
percentage of commercial banks’ deposits must be kept at the Central Bank. As
the reserve requirement ratio changes, so too does the banking multiplier. 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
lead to a contraction of aggregate expenditure. This may not have any impact on
the banking multiplier if commercial banks kept excess reserves. As such as
reserves requirements commercial banks would be able to meet the new level



without reducing lending. This can therefore make the use of this instrument
ineffective.
3. Open Market Operations – Open Market Operations involve 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 an increase in the
money supply. The rate of interest consequently decreases and the aggregate
expenditure expands. If however, as the Central purchases securities and the
recipients of the money invests it abroad instead then the domestic money supply
would not increase rendering this tool ineffective.
4. 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. If
commercial banks choose to comply then this would lead to a decrease in the
money supply and a reduction the level of aggregate expenditure. It is likely
though that as commercial banks are not obligated to comply with such requests
this tool may not be an effective monetary policy weapon.

3 e) Savings in US dollars (Foreign Currency) vs. Domestic Currency
When residents of a country save in a foreign currency rather than their own currency this
is referred to as currency substitution. This applies when local currencies do not
adequately fulfil the functions of money. One of the prime factors responsible for
currency substitution is high domestic inflation. 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.

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.

4a) Monetary Policy and Increases in the Level of Output and Employment
The stages involves 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.
These impacts of an increase in the money supply are demonstrated in the figure.

Monetary Transmission Mechanism

A. Money Market B. Investment Market
IR IR
(%) M1 M2 (%)
20 20

8 8
DM MEI

1 2 QM ($M) 6 11 QM ($M)
.2

C. Aggregate Economy
E
FE Y=E

E2 AE2

AE1
E1

45°
30 70 YF Y ($M)

 Panel A shows a $1M increase in the money supply as displayed by the rightward
shift of the supply curve from M1 to M2. As a result there is a significant fall in the
rate of interest from 20 percent to 8 percent due to the high interest elasticity of the
demand for money. Accordingly, the fall in the rate of interest has the direct effect of
increasing consumer expenditure by $3M as consumers buy more consumer durables.
 Panel B shows that as the rate of interest falls from 20 percent to 8 percent there is a
movement along the Marginal Efficiency of Investment curve which brings about the
indirect effect of an increase in investments by $5M from $6M to $11M.



 Panel C shows that the increase in consumers’ expenditure (direct effect) of $3M and
the increase in investments (indirect effect) of $5M shift the aggregate expenditure
curve upwards by $8M. Given an assumed multiplier of 5 this increasing national
income by $40M from $30M to $70M. This corresponds with a more than doubling
of the level of output produced in the economy. Furthermore, the equilibrium level of
income moves closer to the full employment level of income which means the level
of employment has increased.

4b ) Fiscal Policy Tools to increase Output and Employment.
Expansionary Fiscal Policy
 Increase in government spending (G)
 Reduction in taxation (T)

Expansionary or Reflationary Fiscal Policy
As governments implement expansionary fiscal policy this would lead to an upward shift
of the aggregate expenditure curve as shown in the figure.
Reflationary Fiscal Policy

FE Y=E
E

AE2
E2
F AE1

E1 G

45°
0
Y1 YF = Y2 Y

As shown in the figure, the initial equilibrium position occurs at point E1 where income is
Y1. If the government implements expansionary fiscal policy, this has the effect of
shifting the aggregate expenditure curve upward from AE1 to AE2. As a result this brings
about a new equilibrium at E2 where the level if income has risen to Y2 which corresponds
to the full employment level of income. This means that there is an increase in both the
level of output and employment in the economy.

Fiscal Policy Tools to decrease Output and Employment.
Expansionary Fiscal Policy
 Increase in taxation (T)



 Reduction in government spending (G)

Deflationary or Contractionary Fiscal Policy
As governments implement deflationary fiscal policy this will reduce the level of demand
in the economy and therefore the level of aggregate expenditure falls as shown in the
figure.
Contractionary Fiscal Policy

FE Y=E
E
AE1
E1

AE2

E2

45°
0
Y2 Y1 Y

If the Government reduces its expenditure or increases taxation or both, this would shift
the aggregate expenditure curve downwards from AE1 to AE2 which reduces the level of
income from Y1 to Y2. This fall in income implies that both output and employment has
fallen.

5 a) Economic Integration - The term economic integration means the integration of the
economies of different countries or economies. As barriers to trade and the movement of
factors of production are reduced among economies they become more integrated
economically. The various stages of economic integration are:
 Free Trade Areas
 Customs Unions
 Common Market
 Economic Union

Economic integration also implies that the respective economies would become more
interdependent on one another for supplies of raw materials and other imports, markets
for finished goods and other exports, the supply of capital, labour and even technology.

5 b) Three Benefits of economic integration
1. Larger Markets for goods and services – as a collection of economies remove
trading barriers among each other a new economic domain is formed. As such



producers in any one economy would be able now have free access to larger
export markets as they market their output to the other economies of the trading
agreement. This would also enable producers to increase their scale of operation
and benefits such as economies of scale can be attained.
2. Access to more labour, capital and technology. Another benefit to producers from
economic integration is easier to access to more factors of production from within
the trading block. This would enable resources from various countries in the
economic membership to be deployed in the most productive uses. Such efficient
allocation of resources would promote greater efficiency and lower production
costs.
3. Access to more products. Consumers in integrated economies also benefit as they
can purchase goods and services within the group of countries without any
restrictions. This is beneficial as consumers have access to a wider range of goods
and services at prices unaffected by tariffs and quotas etc.

Two Costs of Economic Integration
1. Trade Diversion – usually when countries form trading agreements this would
entail the removal of trade barriers among member countries and the erection of
protectionist policies to non member countries. This can be a cost if this
transition encourages countries to import from within the membership and cease
trading with non member countries even if such countries are more efficient
producers. As countries end up switching from efficient low cost producers to less
efficient producers within the trading block, this is referred to a trade diversion.
2. Loss of economic independence – another cost of economic integration is the
increase level of economic dependence on foreign countries. This simply means
that countries would no longer have independence in terms of producing the
products which are consumed domestically. In addition to dependence on foreign
produced final goods and services, countries would also be heavily dependent on
foreign countries for raw materials and other factors of production. This is a
problem as it means that if supplies or market access were to be cut off for some
unprecedented reasons then economic turmoil can be triggered.

5 c) Stages of Economic Integration of the Caribbean
CARIFTA
The Caribbean Free Trade Association was 1965 when most of the Caribbean countries
had recently become independent. This essentially was a free trade area by the removal of
tariffs and quotas on goods produced and traded within the area. The intention of this
regional agreement was to unite the economies of the region and to give them a joint
presence on the international arena.

CARICOM - the Caribbean Community
In 1973, Caribbean Community (CARICOM) came into begin which upgraded the status
of the Caribbean Free Trade Association to a customs union. As such counties which
signed this agreement maintain free trade among each other and apply a common external
tariff on imports from outside of the membership. The majority of the islands of the
English speaking Caribbean are members of CARICOM.



CSME – The Caribbean Single Market and Economy
In 1989, the CARICOM Heads of State took the decision to form the Caribbean Single
Market and Economy (CSME), which is essentially geared to be a common market type
of agreement. The decision was driven by the need to deepen the integration process and
strengthen the Caribbean Community in all of its dimensions. The formation of the
CSME will allow CARICOM goods, services, people and capital to move throughout the
Caribbean Community without tariffs or barriers and without restrictions, so as to create a
single large economic domain.

5 d) Factors Driving Globalization.
In an economic sense, globalization refers to the increasing integration of economies of
countries across the globe in terms of production, trade and financial flows. Globalization
has made the world a smaller place. Consumers in any country can purchase goods and
services from producers in foreign countries. Items such as clothing in retail stores, food
items in supermarkets or best selling novels may all come from abroad. Some of the
factors which have facilitated the increasing degree of interdependence among countries
are:
 Reduced cost of transportation between countries. Improved efficiency in air and
sea freight has made it cheaper to transport products to different countries.
 Improvements in communications as a result of the Internet. Easy and low cost
communication between countries via telephone and the internet has increase the
level of business which take place between countries.
 Reduction in barriers to international trade. Globally, countries throughout the
world have embarked upon the removal of protectionist measures and promotion of
free trade. These initiatives have been guided by the World trade organization which
points to the gains to be derived from international trade. The removal of protectionist
policies also applies to preferential trading agreements between countries as covered
later in this chapter.
 Freer movement of labour and capital among countries. Workers are presently
more able to move to a foreign country for employment than in the past. Investors are
also able to invest money in foreign countries, for instance investors in New York or
London can make investments in Trinidad or any other country they so desire.

6 a) Five Arguments against Imports.
Protectionism or import controls are barriers imposed by Governments which restrict the
purchase of goods and services from foreign countries. The motives for such are:
1.Avoiding current account deficits. The imposition of protectionist measures has the
effect of reducing imports of both goods and services. As chapter 36 outlines, this can be a
successful means of reducing a current account deficit of the balance of payments.
2.Establishing Infant industries and creation of domestic jobs. Newly established
industries need to be protected from foreign competition until sufficient time has elapsed for
the industry to mature. This is necessary in order for such industries to attain production and
costs levels which allow them to compete with already established foreign industries. If
foreign goods are kept out of the domestic economy, it is argued that domestic firms will



produce the goods that otherwise would have been imported. This therefore encourages
greater production and thus creates employment in the domestic economy.
3.Government Revenue creation. Tariffs and other forms of taxes on imports are a
source of Government revenue which is used to finance government expenditures.
4.Strategic Trade Policy. To protect the manufacture of essential goods - Reliance on
foreign countries for essential commodities such as food or even national defence
equipment, puts a country at risk, because such commodities may not be available should
trade disputes arise. Such dependence and vulnerability may easily be avoided through the
implementation of protectionist measures, which foster domestic production and curtail
dependency on imports.
5.Dumping. This refers to cases in which goods are sold in a foreign market, below their
cost of production with the aim of capturing the market away from local producers.
Dumping is a form of unfair competition for local industries and Governments should
impose protectionist measures as a safeguard to domestic industries.

6 b i) Determination of the 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. This is shown in the figure which
presents a hypothetical illustration of the official exchange rate set by the Government of
Barbados coinciding with the rate at which the demand for foreign exchange in Barbados
is equal to its supply.



The Fixed Exchange Rate

Bds$/US$
D S

Bds$2 = US$1 Official
Rate

S D

QUS$
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.

If at the official rate is higher then the equilibrium, then the demand for foreign exchange
would be lower then the supply of foreign exchange. Given market forces, such a surplus
would result in a decrease in the exchange rate. This however does not occur, as the rate
is fixed. Instead, the Government intervenes in the market and gets rid of the surplus by
purchasing the excess foreign exchange from the market.

In the reverse instance, where the official rate is below the market equilibrium, a shortage
is created in the foreign exchange market. Normally this would lead to upward pressure
on the exchange rate. However, since the rate is fixed, the Barbados authorities would
have to intervene in the foreign exchange market by increasing the supply of foreign
exchange. This is done by the release of foreign exchange reserves held at the Central
Bank of Barbados to the foreign exchange market.

There is however a limit on the amount of official foreign exchange reserves which a
country possesses and thus the use of reserves to defend the currency in this way cannot
be sustained indefinitely. Another solution to the shortage of foreign exchange under a
fixed rate system is the use of exchange controls. Exchange control refers to restrictions
placed upon the ability of domestic households to purchase foreign currencies which
effectively decreases the demand for foreign exchange.

6 b ii) Three 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 fluctuation 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. This action of speculators
which leads to an increase in demand for commodities which are anticipated to have a
price increase, actually causes the prices of such commodities to increase. 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. Theoretically, fixed exchange rates should eliminate such speculation in the
foreign exchange market because there is no point buying and selling currencies that
will not change in value.
3. Prevents inflation - In a floating exchange rate system if a change in the demand or
supply of foreign exchange leads to a deprecation of the exchange rate, then this
cause inflation as the price of imported goods would rise. A fixed exchange rate
would be able to avoid such inflation especially from temporary decreases in the
external value of a country’s currency due to market.

6 b ii) Three Disadvantages of a Fixed Exchange Rate System
1. The loss of monetary policy - Commitment to a fixed exchange rate results in a loss
in control of the money supply. As such the government can no longer implement
monetary policy as a means of controlling aggregate demand.
2. The need for a large pool of reserves - To maintain a fixed exchange rate typically
involves exchange rate intervention by the Central Bank which requires a large pool
of reserves. Some countries may find it difficult to accumulate sufficient stocks of
official foreign exchange reserves to support their currency.
3. Un-competitiveness - under a freely floating currency, a current account deficit
should automatically cause the exchange rate to depreciate. This in turn would
improve the competitiveness of domestic exporters which helps improve the current
account balance. If the exchange rate remains fixed, then the un-competitiveness
would be perpetuated and this would cause permanent job losses and economic
recession.

6 b iii) Determination of the 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.



Floating Exchange Rate in Jamaica

Jam$/US$
D S

E
Jam$40 = US$1

S
D

QE QUS$

The figure shows the demand and supply for US dollars in Jamaica which has a floating
exchange rate. This shows that equilibrium in the foreign exchange market occurs at
point E, where the overall demand for US dollars is equal to the supply of US dollars. In
2000, the exchange rate in Jamaica was J$40 = US$1 which implied that the external
value of a Jamaican dollar was about US$0.025 which is about 2.5 US cents.

6 b iv) Three Advantages of a Floating Exchange Rate System
1. Theoretical elimination of current account imbalances - As was pointed out
before, floating exchange rates should adjust automatically to current account deficits
and surpluses. That is, all other variables held fixed 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. Apart from exchange rate management under a fixed
exchange rate, Governments will also maintain foreign exchange reserves to cover
imports in case of a crisis in its export sector .
3. More freedom over domestic policy - 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.

6 b iv) Three Disadvantages of a Floating Exchange Rate System
1. Speculation – As long as exchange rates can freely fluctuate in response to market
conditions, then there would always be speculators who anticipate exchange rate
movements. Such speculation about expected exchange rate movements usually
results in exchange rate volatility.



2. Uncertainty - The biggest disadvantage of floating exchange rate systems is their
uncertainty. Such uncertainty leads to lower investment and trade which negatively
affects economic growth.
3. Inflation - In a floating exchange rate system if a change in the demand or supply of
foreign exchange leads to a deprecation of the exchange rate, then this leads to
inflation as the price of imported goods would rise. This can have very negative
consequences especially when the country in question relies heavily on foreign
countries for supplies of food and raw materials.


CAPE Economics, June 2007, Unit 2, Paper 2 suggested answer by Edward Bahaw

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CAPE Economics, June 2007, Unit 2, Paper 2 suggested answer by Edward Bahaw