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 poten