2012 NYJC Prelim H1 CSQ 2 (Mark Scheme)

Extract 1 India’s inflation problem eases Lower inflation should allow the Reserve Bank of India to cut rates within months – so long as the eurozone crisis doesn’t bring capital flight risks to the fore There’s no doubt about the Reserve Bank of India’ s (RBI) desire to cut interest rates to support the slowing economy: RBI deputy governor Subir Gokarn said as much two weeks ago. WPI (Wholesale Price Index) inflation in last month was 6.55% year-on-year, down significantly from 9.5% in November and at its lowest for more than two years. The speed of the turnaround has not been quite as great as that implies, since base effects and food prices accounted for most of the fall. As Capital Economics puts it: “Two factors explain why the annual inflation rate has fallen so steeply. Firstly, large price rises in December and January the previous year have dropped out of the annual comparison. Secondly, food prices have been declining as a result of a good harvest: vegetable prices alone have fallen by more than 30% in the past two months, and overall food price inflation is now near zero.” Still, with underlying trends looking favourable – over the last three months, prices of non -food manufactured goods increased at an annualised rate of less than 5%, says Capital Economics – a first rate cut looks possible within the next three months. That should be good news for an economy that is showing the combined effects of the RBI’s 13 rate hikes this cycle, a slowing global economy, a eurozone c risis-induced nervousness in global markets about providing financing to emerging market companies and poor sentiment over corruption scandals and the slow pace of reforms. GDP growth in the July -September quarter was 6.9% year-on-year and the fourth quarter figure due out soon may well be significantly lower. So hints that cuts are on the way aren’t coming a moment too soon. That said, inflation is not the central bank’s only headache: the country’s large current account deficit and resulting dependence on foreign investment inflows is also a persistent worry. So while the RBI’s bias is clearly towards cutting rates as soon as possible – by far the m ost likely outcome – it’s still conceivable that another twist in the eurozone crisis might yet hold it back www.emergingmarkets.org – 14 February 2012 Extract 2 Japan’s Central Bank Marks a Goal for Higher Inflation TOKYO — Hoping to win its long -futile battle against falling prices, Japan’s central bank on Tuesday said it would try to kindle inflation, setting a goal of 1 percent, by pumping tens of billions more dollars into the economy. The Bank of Japan on Tuesday said it would expand a program of buying government bonds as a way to inject additional money into the economy. And it set a goal of continuing the effort until inflation had reached 1 percent. The government said Monday that the Japanese economy shrank at a 2.3 percent annual rate in the October-to-December quarter, reversing robust gains in the previous three months, as weak overseas demand and a strong yen hurt manufacturing. Prices in Japan have not risen at an annual pace above 1 percent since 1997, when deflation set in. As widely expected, the bank left its benchmark interest rate unchanged at a range of zero to 0.1 percent. “We welcome the Bank of Japan’s policy measures, which constitute aggressive steps to beat deflation,” the finance minister, Jun Azumi, told reporters after the decision. “We hope the bank’s bold monetary easing will boost the economy.” Case Study Question 2

Tokyo stocks r ose modestly, yields on Japanese bonds fell and the yen weakened against the dollar on the news. A weaker yen is good news for Japan ’s economy because it strengthens the competitiveness of its exports. The yen’s recent strength has battered the country’s exporters like Panasonic, which predicts record losses for the year. The bank’s message was also clouded because it maintained expect ations for a moderate recovery, causing confusion among some analysts over why bank officials had chosen to act now. The yen has recently come off record highs and economists expect better numbers this quarter as reconstruction demand takes off in earnest. Comments from Masaaki Shirakawa, governor of the Bank of Japan, appeared to further play down the actions’ significance. He told reporters after the decision that the bank merely wished to better communicate its anti-deflationary stance to markets. Mr. Shirakawa has long argued that monetary policy alone cannot bring an end to deflation in Japan, a situation that he says is caused by a lack of demand. Economists say the bank is running out of options, since interest rates are already effectively at zero a nd because it has little leeway to expand its asset-buying program. No amount of money can energize a recovery, Mr. Shirakawa has said, without measures to restructure and expand the real economy. But the Japanese government, saddled with a debt twice the size of its economy, has struggled to spend enough to sustain strong economic growth, and economic reforms have fallen short. Adapted from www.nytimes.com – 14 February 2012 Extract 3 Singapore exchange rate policy losing anti-inflationary mojo? Emilyn Yap (Business Times, 9 Mar 2012) (Adapted) A debate on the effectiveness of Singapore’s exchange rate policy in controlling inflation has surfaced as the country restructures its economy to boost productivity. The restructuring – a large part of which involves capping the expansion of the foreign workforce – is likely to lead to higher inflation from rising wages. At least one economist believes this limits the centra bank’s ability to keep price increases in check through a strong Singapore dollar, since this works mainly by making imports cheaper. ‘If inflation is being driven by domestic supply -side pressures, in particular those owing to tight foreign labour supplies or policies, then the ability of the exchange rate policy to curb inflation will be muted or less effective than in the past,’ said DBS economist Irvin Seah in a report yesterday. But there are market watchers who think that a strong currency still helps by containing domestic price pressures indirectly. A nd with oil prices creeping up, the spectre of imported inflation remains. Credit Suisse economist Wy Kun Lung noted that the economic restructuring has, to some extent, made Singapore’s exchange rate policy more challenging to manage, but the ‘mechanism still works’. The DBS report threw the spotlight on how the measures could affect exchange rate management. Mr Seah support a ‘slightly softer’ monetary policy stance as it could facilitate restructuring. There wold be more pain for the export sector if the policy is tightened further, he said. And if the growth momentum turns out to be slower than expected, an even more gradual pace of appreciation would support the economy, he added.

In any case, a robust Singapore dollar wold be less effective in capping inflation that is driven by tight labour supplies at home, not high import prices, said Mr Seah. But Citigroup economist Kit Wei Zheng pointed out that Singapore’s exchange rate policy works through another indirect channel, by restriciting external dema nd. This effectively reduces demand for labour and other factors of production here so that, in the long run, ‘the exchange rate will help to temper some of the wage pressures.’

Questions (Macro CS H1 & H2) # Question Marks Level a) Describe the trends in the inflation rates for Singapore, India and Japan, from January 2010 to Januay 2012. 3m L1 1. Singapore: Inflation rates are generally rising 2. India: Inflation rates are generally falling 3. Japan: A change from from deflation to slight inflation OR –ve to +ve (1m for each trend) b)i) Using economic theory explain why economic growth is often accompanied by inflation. 3m L1