RVHS H2 ECONS P2 Essay Q4 Soln

2017 RVHS Y6 H2 Prelims II Essay Question 4 Answer The prospect that the US Federal Reserve will decide to start raising interest rates has raised fears about the effects it will have on the economies of emerging markets. (a) Explain how the decision to raise interest rate s in the US might affect the economic agents in the domestic sector and its economy. [10] (b) Discuss whether the fears are justified. [15] Suggested Answer for part (a) The interest rate is defined as the cost of borrowi ng, typical expressed as an annual percentage of an outstanding loan. The decision to raise interest rates, a form of contractionary monetary policy, can be used to slowdown the increase in AD and thus dampen infl ation. It also has wide-ranging effects on the diff erent economic agents, consumers, firms and the government, and consequently the domestic economy itself. The increase in interest rates will discourage cons umers to spend. With an increase in interest rates, consumers are likely to decrease consumption and in crease saving as the reward of saving increases. Consumers will also be discouraged from spending on big-ticket items such as cars, as the purchase of such goods are typically financed on loans which are aff ected by the increase in interest rates. Furthermor e, consumers with outstanding mortgages would have to make higher payments, reducing disposable income for consumption. The increase in interest rates will also discourage firms from investing. An increase in interest rate s will increase the cost of borrowing for firms. As a resu lt, projects that were initially viable due to lowe r interest rates are now unviable, leading to a decrease in investment. The increase in interest rates will also affect the consumption and investment by the government. The increase in interest rates will increase debt payme nts on US government debt, which is incurred financ ing government fiscal policies, and such spending will become further constrained, such as by delaying pub lic infrastructure projects. The effects on the economic agents have consequent effects on the US domestic economy. Consumption, investment and government spending are all components of aggregate demand (AD). With a decrease in all three components, AD will fall from AD 0 to AD 1 as shown in Figure 1. This would lead to a fall in national income through the multiplier effect. More likely, the decrease in consumption and investment is coupled with the an increase in both due to strong economic conditions, leading to a dampening of actual economic growth. With a fall in investment, potential economic growt h will also be dampened. If firms and the governmen t reduce investment, there will be a fall in capital growth. If the rate of capital growth falls below the replacement rate (due to depreciation and wearing out of capital), the productive capacity of the economy will be reduced. This leads to a fall in aggregate supply (AS) and potential economic growth. At the same time, with a fall in AD, the general pr ice level falls from P 0 to P1 as shown in Figure 1. A fall in aggregate demand leads to firms reducing production and thus competing less for resources for production. This leads to a fall in prices of raw materials and consequently the general price level. This lowers the inflation rate and ensures price stability for the US domestic economy. Finally, with a fall in AD, unemployment may increa se. A fall in aggregate demand leads to firms reduc ing production which leads to firms reducing employment of labour for production. This may lead to a rise in unemployment in the US domestic economy.

Figure 1: Increase in real GDP through increase in AD Marking Scheme Knowledge, Application, Understanding and Analysis L3 Consequences on all three economic agents as well as at least two macroeconomic goals well explained in the context of the US domestic economy . 8-10 L2 Consequences on at least two economic agents as well as at least one macroeconomic goal well explained. OR Consequences on all three economic agents as well as at least two macroeconomic goals explained but with errors or descriptively explained. 5-7 L1 Smattering of points 1-4 Suggested Answer for part (b) Emerging economies, such as the BRICS economies (Br azil, Russia, India, China and South Africa), have significant economic links with the US. Globalization has led to greater exports to developed economies such as the US, leading to economic growth for the emerg ing market economies. For example, China holds a significant trade surplus against the US. Thus, the increase in interest rates in the US may have sign ificant impact on these economies and their macroeconomic goals. The rise in interest rates will cause hot money inflows into the US by investors seeking higher returns, leading to an increase in demand for the US dollar. This le ads to an appreciation of the US dollar and thus a depreciation of the currencies of the emerging mark et economies. With an increase in the value of the US dollar vis-à-vis the currencies of the emerging eco nomies, exports from the emerging economies become relatively cheaper compared to domestic goods in th e US. This would lead to an increase in demand for exports from emerging economies by US consumers, in creasing net exports for emerging economies. An increase in net exports would increase AD for emerg ing economies, leading to an increase in demand-pul l inflation. The increase in capital outflows would also worsen the balance of payments (BOP) for the emerging economies. The balance of payments records capital flows under the financial account. Thus, with an increase in capital outflows, the financial account and consequently the BOP would also worsen. GPL Real Output P1 AD 0 AD 1 AS Y1 YF P0

Fears of inflation may be dampened by the fact that the policy would have contractionary effects on the US economy. Over time, as interest rates continue to i ncrease, there would be a moderation in the economi c growth of the US, thus reducing the increase in dem and of US consumers for exports from emerging economies. However, there may also be benefits for emerging economies. The increase in demand for emerging market exports by US consumers would lead to an increase in AD and consequently an increase in national income through the multiplier effect. This would lead to actual economic growth for the emerging economies. Demand for coffee from Brazil would thus increase, increasing AD and economic growth in Brazil. Similarly, the increase in AD would lead to an incr ease in employment in the emerging market economies . The increase in demand for emerging market exports would increase production by the export sectors in these countries, leading to firms in these sectors employing more labour for production. As these labour earn income, through the multiplier effect, production and thus employment in other sectors of the economy would also increase. This leads to an overall fall in unemployment for the emerging market economies. The improvement in the BOP is dependent on the rela tive elasticities of the exports and imports of the emerging market economies. In this case, it is like ly that the demand for emerging market exports is p rice elastic, as they have many substitutes. For example , Brazil exports only accounts for 15% of the world ’s coffee exports, signifying that there are many substitutes from other countries. The increase in inflation can be weighed against th e increase in economic growth and employment due to an increase in net exports. Both factors are dependent on the size of the export sector in these econo mies, which are significant as a proportion of national i ncome at the moment, but may decrease over time as the economies mature. For example, the Chinese governme nt has implemented policies to focus on domestic consumption and