May 2001 Q2 :
Examine the impact of a decision to raise interest rates in an economy where there is both a high rate of inflation and a large current account deficit. Specific reference should be made to the exchange rate in your answer.
A rise in interest rates will reduce (candidates may use either the level, or the rate of growth of) aggregate demand. Consideration of likely transmission mechanisms: candidates should consider the impact on at least two elements of C+I+G+X-M.
- An appropriate AD/AS diagram is also required.
- Identifying income effects on inflation/current a/c
- Identifying exchange rate effects on inflation/current a/c
Evaluation points might include:
- More extended analysis of the impact of the changes already
- The relative strengths of the various income and price effects identified
- Other things may not be equal,
- The shape of the AS curve (elasticities).
May 2001 Q1 :
Examine the extent to which demand side policies designed to reduce the rate of inflation might cause a rise in the level of unemployment.
Candidates should identify at least two methods of dampening the level of, or growth in (accept either approach), aggregate demand (e.g. higher taxes, reduced government spending, higher interest rates). An appropriate AD/AS diagram, correctly labelled. Analysis of move to a new equilibrium.
A variety of approaches may be taken by candidates in explaining the conflict – any reasonable set of arguments should be rewarded e.g. a description of a multiplied contraction of output leading, via the labour market, to a fail in employment, and/or a correctly labelled short-run Phillips curve with a brief explanation of the trade-off it represents.
Evaluation marks should be awarded for the candidate’s recognition of the “extent to which” in the question:
- State of the economy (recession or boom), or recognition of the importance of the initial position on the AS curve (i.e. AS may be very inelastic at near full employment so there may be little unemployment cost of reducing inflation). Alternatively, some contrast between different assumptions about the AS curve.
- Other things may not be equal with AD e.g. other factors affect AD, such as exchange rate movements.
- That there may be other factors affecting AS at the same time as the policy, so perhaps allowing lower inflation (fall in AD) and rising employment (exogenous rise in AS).
- That there might be some offsetting effects on expectations (low inflation environment positively changing expectations.
- Any standard caveats about the effectiveness of demand management, e.g. resistance of demand to the policy changes, crowding out effects, exchange rate effects.
- Any supporting reasons why the dampening of demand may cause higher than expected rises in unemployment e.g. the sensitivity of the UK economy to exchange rate changes brought about by tighter monetary policy.