GCE A'Level CSQ 2022 Question 1- Suggested Answers
(ai) Using a supply and demand diagram in each case to explain why:
(i) the price of fresh fruit and vegetables in Australia has risen as a result of the drought. [2]
The drought would have affected crop yields of fresh fruits and vegetables by destroying arable land necessary for agriculture. This seasonal season would have caused the supply of fresh fruits and vegetables to fall. When the supply curve shifts leftwards from S0 to S1, at the initial price, P0 there would be a shortage as the quantity supplied is less than the quantity demanded. This exerts an upward pressure on prices that would cause prices to increase from P0 to P1.
(ii) international tourist arrivals into Australia are expected to fall as a result of the bushfire. [2]
According to Extract 1, the bushfires have “brought about smoke haze and uncertainty about safety” to international travelers. There would be a shift in taste and preferences toward visiting Australia as tourists feel unsafe and do not wish to incur potential healthcare costs implicated by the smoke haze. The demand for visits to Australia would fall causing the demand curve to shift leftwards from D0 to D1. Through the market adjustment process, the new market equilibrium quantity of international tourists would fall from Q0 to Q1.
(b) With reference to the data, explain one possible reason for the change in Australia’s budget balance from February to June 2020. [2]
Between Feb 2020 to June 2020, Australia’s budget balance went from a budget surplus to a significant budget deficit.
The budget balance is the difference between government spending and revenue. As the COVID-19 pandemic took its toll on the economy, aggregate demand would have fallen which resulted in a fall in real national income and a loss of jobs. The amount of taxable corporate and income tax would have fallen which reduced government tax revenue. Assuming government expenditure remained unchanged and is larger than the government tax reveneue, the previous budget balance surplus would have turned into a deficit.
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At the same time, the Australian government has pledged “A$70 to A$90 billion on stimulus and support measures” to prop up the economy during the crisis and cushion the fall in the standard of living for its citizens. This would have caused government expenditure to rise. Assuming tax revenue remained unchanged and is smaller than the government expenditure, the previous budget balance surplus would have turned into a deficit.
(c) With reference to Extract 2, explain why a nominal rate of interest of 0.25% in March 2020 would be described as being ‘negative’ in real terms. [2]
The real interest rate is calculated by taking the nominal interest rate and subtracting it from the inflation rates. In March 2020, the nominal rate of interest rate was 0.25% while the inflation rate was 2.2%. This means that the real interest rate is -1.95%, which is negative.
(d) Explain how a negative real interest rate is likely to affect savings by consumers and the exchange rate in Australia. [4]
To a saver, the returns on savings would have been negative. The accrued monthly interest earnings on savings would not be able to cover the higher cost of purchasing goods and services in the economy. There would be an opportunity cost of consumption incurred when individuals save and thus would be inclined not to save.
As real interest rates become negative, the returns on short-term capital are also negative. Short-term investors would likely liquidate their holdings in Australia and prefer to shift their capital elsewhere which provides positive returns. This causes capital outflow that would increase the supply of the Australian dollar in the forex market. At the same time, the demand for the Australian dollar would fall as short-term capital investors would not want to allocate funds to an environment that produces negative returns. A simultaneous fall in demand and a rise in the supply of the Australian dollar would cause a surplus. This would exert downward pressure on the value of the Australian dollar respective to another foreign currency, causing it to depreciate.
(e) Given the weakening of Singapore’s exchange rate, discuss whether a strong exchange rate would be of overall benefit to Singapore when ‘the global economy is in deep recession’ (Extract 4). [8]
Due to Singapore’s unique nature of being a small and open economy that is heavily reliant on its export and import sector for growth, the managed float regime is an important monetary tool to allow Singapore to achieve its macroeconomic aims; depending on the economic situation it is in. Whether a strong exchange rate would be an overall benefit to Singapore as opposed to its current zero appreciation stance would be discussed in this essay.
The strengthening of the Singapore dollar would cause the price of imports to be relatively cheaper in terms of SGD. Given Singapore’s poor resource nature and having a very high import content in her exported goods, this would cause the unit cost of production of exported goods to fall. This causes the SRAS to rise and shift upwards from SRAS0 to SRAS1. Producers would be more willing and able to produce more output, thus resulting in an increase in real national income from Y0 to Y1. There will also be an increase in derived demand for labour, thus providing more job opportunities. Furthermore, lower cost of production can be passed on to consumers in the form of lower prices, resulting in deflation as GPL falls from P0 to P1. Greater price stability can also increase the price competitiveness of her exports, which would help increase the quantity demanded of exports, thus boosting AD and growth. This can potentially alleviate the negative consequences of the COVID-19 pandemic that resulted in a deep global recession.
However, the strengthening of SGD would also cause the price of exports to be more expensive in terms of foreign currencies. Assuming the Marshall-Lerner condition holds where PEDx+m > 1, there will be a more than proportionate decrease in the quantity demanded of exports and a more than proportionate increase in the quantity demanded of imports, ceteris paribus. This would cause export revenue to fall while import expenditure to rise, resulting in a fall in net exports and a fall in AD. The fall in AD would cause an unplanned fall in inventories, causing producers to cut back on production and reduce derived demand for labor. This results in a fall in real national income from Y0 to Y1 via the reverse multiplier effect and causes demand-deficient unemployment. This would worsen the economic impacts that were brought about by the COVID-19 pandemic.
In conclusion, the strengthening of the SGD would not bring about overall benefits to Singapore in alleviating the effects of the deep recession. This is because Singapore's net export value is derived from the exporting of services instead of goods. A stronger SGD would hurt the price competitiveness of her service sector which would cause AD to fall which would hurt her macroeconomic aims. Given that the deep global recession has hurt the income levels of her trading partners, boosting the price competitiveness of exports via weakening the currency would help to compensate for the fall in demand for her exports due to income factors, thereby producing an overall beneficial effect compared to the strengthening of the SGD.
(f) Discuss whether fiscal policy is the most effective way to bring unemployment down in Australia. [10]
In light of the COVID-19 pandemic coupled with drought and bushfires, it had worsened consumer, and investor sentiments and tourist visits, causing Australia’s AD to overall fall where the economy contracted by 0.3% in the first three months of the year. Thus, Australia would face demand-deficient unemployment in the current context.
With reference to Extract 3, the Australian government has pledged to spend ‘A$70billion to A$90 billion on stimulus and support measures’ by spending on services, infrastructure, and social housing construction. This increased government expenditure would increase AD which would cause the AD curve to shift rightwards from AD0 to AD1, causing an unplanned fall in inventories, which would cause producers to increase their output and thus increase their derived demand for labor thereby reducing demand-deficient unemployment.
However, the effectiveness of this policy might be limited due to the long time lag required for this policy to take effect. During the COVID-19 pandemic, in fears of contracting the virus and suffering health issues, individuals might be reluctant to return to work. Furthermore, the global shortage of factors of production would cause such infrastructure projects to be delayed. Thus, for the fiscal policy to actually raise AD and translate to more output and hiring more workers would incur a significant response lag. Additionally, the high government expenditure would further strain the government’s budget balance as shown in Figure 1 where it experienced a deficit that is worsening.
The government also announced other forms of economic stimulus including rent assistance and childcare subsidies. Childcare subsidies can help defray the cost of living for Australian families and rent assistance that reduces the cost of production to firms would and would have a more direct impact on a firm’s profitability and thus be able to retain workers and reduce unemployment rates. This fiscal policy seems to have a shorter time lag and be more effective in keeping jobs compared to infrastructure spending.
Alternatively, the Australian Reserve Bank is also “prepared to use monetary policy tools more aggressively”. This can be done by increasing the money supply and reducing the interest rates and thus the cost of borrowing. This increases the consumer's ability to afford big-ticket items and consumption expenditure increases. Furthermore, previous unprofitability investment projects become more profitable and thus increase investment expenditure. Since C & I are components of AD, they will cause AD to rise and the unplanned fall in inventories would spur higher derived demand for labor, thus bringing down demand-deficient unemployment.
However, “Australia’s bushfires and the COVID-19 pandemic” would have evidently hurt consumer and investor confidence. They are likely to be more prudent in investing and consuming and would prefer to save money for rainy days. Investment projects might not be profitable as producers expect demand for their goods to fall and thus revenue to fall. Investors would thus be less responsive to changes in interest rates when deciding to increase investment expenditure. This causes C & I and thus AD to increase marginally and would not be effective in combating rising demand-deficient unemployment.
In conclusion, fiscal policy is the most effective way to bring unemployment down in Australia, especially if funds are managed and channeled in the right way. Fiscal transfer payments would have an immediate positive impact on consumption expenditure and thus reduce demand-deficient unemployment. Similarly, rent subsidies directly impact a firm’s willingness to retain workers in light of the pandemic. The government though would incur huge government budget deficits by implementing such policies is less of a concern. The Australian government states that “it is not the time to panic about increasing government debt levels” which suggests healthy government reserves or they have prioritized keeping jobs at the cost of incurring government debts. On the other hand, though an interest rate policy might help boost AD and increase employment, there is a limit to which interest rates can fall. Since interest rates have fallen to negative, it suggests that the cost of borrowing may be a less important economic variable in determining investment and consumer spending decisions. Instead, fear of the uncertain future is driving decisions. Thus, it would be less effective compared to fiscal policies in bringing unemployment down.