Download INTERNATIONAL M ONETORY ECONOMI CS SOLUTIONS NO V

INSTITUTE OF BANKERS MALAWI
INTERNATIONAL ECONOMICS NOVEMBER 2012
SUGGESTED SOLUTIONS
SECTION A
Question 1
(a) 3 ways in which GDP is measured:
(i)
Income approach, Value added approach and expenditure approach. The
candidate should be able to explain these and each one carries 3 Marks 9 Marks
(ii)
3 Challenges in the calculation of GDP
(i)
Double counting
(ii)
Work done by self is not included e.g farming
(iii)
Illegal activities like drugs, prostitution etc. are excluded in the accounts
(iv)
Each method of calculating is imprecise leading to inaccuracies
Other points can be considered and each point carries 2 marks
Question 2
(a) 4 roles of the IMF’s existence to developing countries.
(i) Providing policy advise to its member countries
(ii) Promoting economic stability in developing countries by working towards
poverty reduction strategies
(iii)Lending money to these countries to tackle BoP payment problems
(iv)
They assist in unlocking other financial lenders and donors by acting as a
catalyst e.g the Malawi scenario in 2012
Other points can be considered and each point carries 2 marks
(b) Difference between the IMF and the World Bank
1.
2
IMF
oversees the international monetary
system
Assists all members, both industrial
and developing countries, that find
themselves in temporary balance of
World Bank
seeks to promote the economic
development of the world's poorer
countries
Assists developing countries through
long-term financing of development
projects and programs
3
4
payments difficulties by providing
short- to medium-term credits
Supplements the currency reserves
of its members through the
allocation of SDRs (special drawing
rights); to date SDR 21.4 billion has
been issued to member countries in
proportion to their quotas
Draws its financial resources
principally from the quota
subscriptions of its member
countries
Provides to the poorest developing
countries whose per capita GNP is
less than $865 a year special financial
assistance through the International
Development Association (IDA)
Acquires most of its financial
resources by borrowing on the
international bond market
Consider any 2 points, each comparison for 2 Marks. Any other points may be
considered.
(c) 3 types of loans: extended credit facility, the rapid credit facility and, the standby credit
facility each carries 1 Mark
Question 3
(a) The current account records trade in goods and services, transfers in the form of income
from abroad and interest payments abroad, and grants such as foreign aid. The current
account is commonly used to illustrate the trade balance, that is, the difference between
exports and imports. The capital account records inflows and outflows of financial
assets and direct investment from abroad, including bank loans from abroad, foreign
direct investment, trade credit, and holdings of foreign currency.
4 Marks
(b) Malawi is a predominantly importing economy striving to become an exporting economy
(i)
3 ways in which the country can improve its Bop status
1. Availability of natural resources that can be exported
2. Sound Macroeconomic policies like currency devaluation to encourage trade
etc.
3. Donor Aid availability
Any other points may be considered and for 2 markseach
(ii)
Why do countries sometimes devalue their currency when they have a current
account deficit?
1. To make their exports cheaper so as to encourage trade
2. It also discourages imports hence secure forex
3. To attract aid from international financing institutions as sometimes this is a
conditionality for aid
Each point 1 mark
(iii)
Devaluation is the loss in value of a currency as compared to another currency
Question 4
(a) The end of Bretton wood system:
1) The rising capital mobility; Markets inevitably recover from WWII thus
domestic financial deregulation made it harder to stop capital flows at the
borders e.g., the rise of Eurodollar market, in which dollar denominated
assets were traded in Europe
2) Lack of monetary discipline in the US causing imbalances
Each point carries 2 marks, any other points may be considered
(b) Advantages of a fixed exchange rate system as it was in the Bretton Wood system
1. With the dollar pegged to gold, there was a stable nominal anchor. Commitment
to convert dollars to gold compelled the U.S. to follow policies of price stability.
Because other countries were linked to the dollar, they too followed policies of price
stability
2. Built-in flexibility which entailed adjustable exchange rates meant that persistent
BOP imbalances could be avoided
Each carries 2 Marks, other factors could be considered
(c) The possibility and sustainability of introducing the Bretton wood system in present
day global economy:
The 'dollar-gold' or 'Bretton Woods' arrangement was an era in which currencies
were linked to the US dollar, and the dollar in turn held a steady value to gold. With
the world relying on the dollar, the US must maintain a current account deficit in
order to maintain the level of liquidity required for global trade and growth. But
when it runs such deficits, feeding the global appetite for dollar liquidity, it
accumulates liabilities to the extent that confidence in, and the value of, the dollar
can be negatively affected.
If that happens, restoration of confidence and resisting inflationary pressure would
require rising interest rates in the US. But that would mean falling deficits and a
reduction in global economic activity. Thus, while it seems that the US, as the issuer
of the global reserve currency, has the flexibility to finance its deficits, it actually takes
on unique restrictions to its monetary policy autonomy, since to preserve the global
growth it relies on it must balance the requirement of running deficits with the risk of
declining confidence in its currency.
The difficulties of maintaining that balance doomed the Bretton Woods arrangement;
the world went from struggling with a dollar shortage after World War II - for which
the creation of the Special Drawing Right (SDR) was one of the solutions - to a glut
when the US started printing money to finance the combination of its expansive
social programmes and the Vietnam War in the 1960s. That glut finally forced the US
to break the dollar-gold convertibility in the early 1970s, leading to the collapse of the
Bretton Woods system and the introduction of the system of floating exchange rates
and currency trading we have today.
Therefore the candidate should be able to state reasons why the Bretton
would system did not work and link it to present day in the sense that having
totally fixed exchange rates will not work in the global world . 7 Marks will be
awarded to any such brief articulation
SECTION B
Question 5
After experiencing an economic down turn, Malawi was advised by the IMF to devalue its
currency and float its currency
(a) floating exchange rate regime means the government does not intervene in the foreign
exchange market but allows market forces to determine the level of a currency2 Marks
(b) Disadvantages of a floating exchange rate to a developing country like Malawi.
1. They cause useless transaction costs which could have been avoided.
2. They produce avoidable risks especially in international trade and international
investments.
3. They reduce transparency on goods markets thus they encourage price discrimination
and manipulation of prices on the market.
4. They produce unnecessary adjustment burdens and adjustment pressures.
5. They can encourage inflation
Any other points may be considered for
(c) Factors that can affect the exchange rate of an economy
1. Availability of natural resources in the country like oil etc.
2. Political stability can enhance trade and investment
3. Good government policies that can strengthen the currency
4. Speculation pressure by traders
Any other factors could be considered for 2 marks each
(d) Interest rate parity is when the interest rate differential between two countries is equal to
the differential between the forward exchange rate and the spot exchange rate2 Marks
Question 6
(a) European Monetary Union (EMU) is an event, whereby national currencies are abolished
and replaced by a single European currency
2 Marks
(b) Major functions of the EMU and how it benefits its member states 12 Marks
1. They have fixed exchange rates hencethe risks of exchange rates are excluded. With
flexible exchange rates the actual exchange rates can follow a course that is
completely unexpected. That is an economic danger for those sectors of the
economy which export and import. Fixed exchange rate are therefore preferred by
the producers and the consumers of an economy
2. Free capital movements permit the markets, to direct the economic resources into
their optimal uses. Therefore, the common market in Europe provides for free
movements of capital. The Single European Act prohibits restrictions also of short
run capital movements.
3. They have an independent national monetary policy enabling each country
can choose the inflation rate that suits its preferences
4. They have no exchange rate problems, providing price transparency,
creating a single financial market and price stability
Any other points can be considered and each is 3 marks
(c) If the African Union (AU) would establish a single currency for Africa:
1. Institutional challenges in Africa are much greater than the Euro zone. Existing
national central banks generally are not independent and countries with their own
currencies have often suffered periods of high inflation because the central banks are
forced to finance public deficits or other quasi-fiscal activities.
2. High levels of corruption and the tendency of satisfying self needs could also be a
limiting factor
3. Other regional unions in Africa like have not really fared well to expectations
4. Different external shocks of the different nations could also be a discouraging factor
e.g. compare Malawi and South Africa
Any other points may be considered for 3 marks each
Question 7
Malawi is among one of the Heavily Indebted Poor Countries (HIPC). The HIPC Initiative was
launched in 1996 by the IMF and World Bank, with the aim of ensuring that no poor country
faces a debt burden it cannot manage.
(a) Reasons why poor nations get into serious debts
1. Poor economic governance thus over expenditure, corruption etc.; borrowed money
is used in ways contrary to the people’s interest
2. Lack of tradable goods/resources, most developing countries trade in raw material
and get peanuts out of the sales
3. Poor implementation of the harsh conditions of IMF structural adjustment policies
4. Conventional wars that destroy their resources
Any other points may be considered 2 marks each
(b) National debt is the amount of debt owed by the central government of a country to its
various creditors, usually nationals.
4 Marks
(c) benefits that would accrue to a nation if all its debts were cancelled
1. In future, the country can borrow money to other IFC without any problems because
it would have a good credibility
2. The budgetary position of the economy would improve hence improvements in
development sectors
3. Money used to pay back interest would be ushered into other areas
4. Tax burdens could be reduced hence improved livelihoods and increased investments
5. Crowding out of investors would be reduced/removed and so boosting economic
growth through increased borrowing (reduced interest rates) and also increased
employment.
Any point for 2 Marks, any other points can be considered
Question 8
(a) International liquidity is a combination of a country's ability to have a readily available
supply of foreign currency, and the degree to which its assets may be used as a form of
payment or converted to the currency of the country with which it is trading. 4 Marks
(b) 3 forms of international capital movement
1. Labour migration
2. Transfer of capital via international borrowing and lending
3. International linkages involved in the formation of multinational corporations in the
form of Foreign Direct Investment (FDI).
Each point carries 2Marks
(c) How do many developing countries supplement or maintain liquidity levels?
1. by capital inflows in terms of development aid assistance
2. Foreign direct investments from developed nations
3. Trading with other countries
4. Having good government policies of maintaining a good liquidity level by
controlling aggregate demand
Explanation of each point carries 2 marks
(d) What 2 factors can cause capital movement?
1. Macroeconomic instability
2. Political instability
3. Financial market constraints and underdevelopment
Any other points can be considered, each carries 2 marks