PJC_H1_ECONS_P1_Q4

Pioneer Junior College (Economics Department) 1 PJC 2017 H 1 Prelim Exam Paper 1 Question 4: a) Explain how weakening of a country’s foreign exchange rate can cause inflation rates to rise. [10] b) Discuss whether the use of supply side policy as a means of solving the problem of inflation is likely to be effective. [15] a) Explain how weakening of a country’s foreign exchange rate can cause inflation rates to rise. [10] Inflation is a situation where there is a sustained increase in the general price level. There are mainly two types of inflation, namely demand-pull and cost-push inflation. A weakening of a country’s foreign exchange rate causes prices of exports in foreign c urrencies to fall and prices of imports in domestic currency to rise. This can cause both demand-pull (rising AD) and cost-push (falling AS) inflation. Weakening of the exchange rate causes demand pull i nflation. When a currency weakens, it means that the decrease in value of the currency in foreign currencies. Thus, with depreciation, the prices of exports fall in foreign currency while the price of imports in domestic currency rise. With a fall in price of exports, trading partners will increase their qu antity demanded for exports. Assuming that the demand for exports is price elastic (PEDx>1), quant ity demanded of exports will rise more than proportionately. Hence, export earnings in foreign currency will rise. Imports are more expensive to the locals. This will result in a fall in quantity demanded for imports. Assuming that the demand for imports is price elastic (PEDm>1), quantity demande d of imports will decrease more than proportionately. Thus, expenditure on imports will decrease following appreciation. The rise in export earnings and the fall in import expenditure will mean that the current account wil l improve. Based on the explanation above, current ac count will improve if elasticities of demand of imports and exports (PEDx>1 and PEDm >1) are present. With a rise in (X-M), it causes a rise in AD resulting in higher utilization of resources. This increase in utilization soon leads to firms having to pay more for factor inputs such as office space. The increase in rentals and demand for office spaces thus depletes the scarce resources even more resulting in demand-pull inflation. The rise in AD when the economy is at or near full employment will cause a rightward shift in AD curve, from AD1 to AD2 and thus will cause a rise i n the GPL, assuming AS remains unchanged. This leads to a rise in the quilibirum general pric e level from P1 to P2. As resources in the economy are utilized,, the shortage of unemployed resources drives up prices that producers pay for factor inputs and they expect higher prices to produce the real output Yf. Thus, demand pull inflation occurs. Weakening of the exchange rate causes cost-push inf lation th