Download 2011 ECN315111 Sample Exam suggested answers

T A S M A N I A N
Economics
C E R T I F I C A T E
Subject Code: ECN315111
O F
2011 Sample Exam Paper suggested answers
E D U C A T I O N
TASMANIAN QUALIFICATIONS AUTHORITY
SECTION A
Question 1
The free market answers the four economic questions as follows:
•
What to produce? The free market answers this question using the concept of consumer
sovereignty - businesses will produce goods/services that consumers demand. As
resources are relatively scarce this will assist in allocating resources efficiently.
•
How to produce? The free market answers this question using the concept of efficiency.
Goods/services will be produced using the most efficient and usually least cost method.
This is to gain the maximum output for a given amount of inputs and thereby assisting
to solve the problem of relative scarcity.
•
How much to Produce? The free market answers this question based on consumer
demand. If there is insufficient demand then too much is produced and there will be a
surplus. This will provide a signal to producers to reduce production. Conversely, if
demand is very high and not enough is produced the resultant shortage will provide a
signal to producers to increase production.
•
How to distribute or for whom to produce? The free market answers this question based
on income and willingness to buy. Goods/services will be allocated to those who have
the required income and are willing to buy.
Question 2
Any four of:
•
Income- this is a major determinant of demand. Increased income will increase the
demand for most goods and services (and vice-versa).
•
The price of substitute goods - If products A and B are substitute goods then an increase
in the price of product A will increase the demand for product B (and vice versa). For
example, an increase in the price of travel by boat from Tasmania to Melbourne will
increase the demand for air travel from Tasmania to Melbourne.
•
The price of complementary goods - if products A and B are complementary items then
a decrease in the price of good A will increase the demand for good B. For example, a
decrease in the price of air travel from Hobart to the Gold Coast will increase the
demand for tourist accommodation on the Gold Coast.
•
Population - an increase in the population will increase the demand for many products,
e.g. the demand for food and housing and vice-versa. In addition, the age structure of
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the population will affect the demand for particular products. For example, a higher
proportion of the population aged over 50 will increase the demand for medical
services.
•
Tastes and preferences- A change in preferences in favour of a good or service will
increase the demand for that good/service. For example, a change in preferences for
large, flat screen Televisions will increase the demand for such items.
Question 3
Payments for goods and services
Businesses
Households
Income rewards- wages, rent,
interest
Leakages
Savings
Finance
Sector
Government
Sector
Taxation
Imports
Overseas Sector
Investment
Government
Expenditure
Exports
The circular flow of income diagram shows the main sectors of the economy and the related
interconnections. The diagram shows that, in return for supplying the factors of production
(land, labour, capital, entrepreneurship), income is received by households. The income
received then continues to flow to other sectors of the economy. On average, a large part is
spent on consumption (shown as payments for goods and services.). This is directly injected
back into the business sector. The part not spent on consumption is leaked - temporarily
removed - into savings, taxation and imports. However, indirectly, funds can be injected back
into the economy by Government expenditure, investment (e.g. new factories, new roads,
new equipment etc.) and exports.
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Question 4
Structural Unemployment. This term refers to unemployment caused by changes in
production methods. For example, structural unemployment can be caused by particular
businesses using new, labour replacing, more efficient technology (e.g. the use of ATMs to
replace bank tellers). Structural unemployment can also be caused by businesses shifting
production to other countries where the labour costs are lower (e.g. Pacific Brands, maker of
Bonds, Berlei etc. shifting production of clothing from Australia).
Cyclical Unemployment. This term refers to unemployment caused by decreases in economic
output (i.e. decreases in GDP). As shown in the diagram (below) there were recessions (two
or more consecutive quarters where GDP is lower than the previous quarter) in periods 1 and
2. During these recessions economic output, by definition, is lower. As less is being produced
less employees will be required. The result is cyclical unemployment.
Real
GDP
% Change
+
–
Recession- Period 1
Recession- Period 2
Question 5
Automatic Stabilsers. This term refers to policy instruments - in particular unemployment
benefits and progressive income tax rates - that affect economic output without specific,
discretionary changes to fiscal policy. For example, during periods of recessions (two or
more consecutive quarters where GDP is lower than the previous quarter) cyclical
unemployment increases. Consequently, more individuals become unemployed and most will
be automatically eligible for unemployment benefits. The payment of extra unemployment
benefits automatically adds a stabilizing affect by adding an injection (unemployment
benefits) into the economy that otherwise would require discretionary government economic
stimulus.
Conversely, during ‘boom’ periods where GDP growth is very high, more individuals earn
higher income. Due to the use of a progressive income tax system the average rate of income
tax increases as taxable income increases. This automatically reduces disposable (i.e. after tax
incomes) to a point that is lower than would have been the case in the absence of the use of a
progressive income tax system. Consequently, demand -pull inflation pressures are
automatically (i.e. without the use of discretionary fiscal policy) lower than otherwise would
have been the case.
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Question 6
Cost-push inflation. Inflation refers to a consistent increase in the general price level, as
measured by a suitable index, such as the CPI. Cost-push inflation refers to inflation caused
by an increase in the cost price of major inputs to production. For example, oil is a major
input cost for transport and also the production of many items (e.g. plastic). An increase in
the price of fuel, such as occurred in the ‘oil shocks’ of the 1970s would increase the price of
many products and consequently increase cost-push inflation. Significant wage increases
could also result in cost-push inflation due to the fact that labour costs constitute a major cost
of production for most goods and services.
Question 7
Economic Development. This term refers to increasing the living standards of the general
population. There are various indicators of economic development. The Human Development
Index (HDI) is a composite indicator of economic development. The HDI includes real GDP
per capita, life expectancy at birth and levels of educational attainment. The HDI ranges from
0 (no economic development) to 1 (maximum levels of economic development). The main
components are each good indicators of economic development. High GDP per capita
countries are invariably countries with a high level of economic development. Higher output
can be allocated to increase living standards by better access to adequate food, shelter,
education and health services. However, GDP per capita can be misleading due highly
unequal distribution of income and insufficient resources allocated to health and education.
The HDI compensates for these shortcomings of GDP per capita by including life expectancy
at birth and educational attainment.
Question 8
An exchange rate is the rate at which one currency is sold/bought for another currency. For
example, $1.00 Aust= $0.95 U.S. means that one Australian dollar will buy ninety-five U.S.
cents. A floating exchange rate is an exchange rate set by the principles of demand and
supply. This is illustrated by the diagram shown below. D1 and D2 represent demand for
Australian dollars in the foreign exchange market. S1 represents the supply of Australian
dollars in the foreign exchange market. The diagram shows an increase in demand, D1 to D2,
due to an increase in demand for Australian minerals (many Australian companies will
require payment in Australian dollars - hence overseas buyers will need Australian dollars in
order to buy Australian commodities). Given no changes in the factors of supply, the
increased demand results in an appreciation (P1 to P2) of the Australian currency relative to
the U.S. currency.
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$ Aust. In terms
of $ U.S.
P2
S1
P1
D1
D2
Question 9
Australia trades with other countries for the following reasons:
•
To gain from comparative advantage- i.e. Specialising in production of goods, for
example minerals, where Australia has a comparative advantage (produce at a lower
opportunity cost) and purchasing imports from other countries that have a comparative
advantage in other goods.
•
To purchase goods and services that Australia cannot produce - hence increase the
variety of goods and services in Australia.
•
Increase export revenue and living standards.
SECTION B
Question 10
To change from P1 to P2 there has to be an increase in supply. Hence, two sound reasons for
an increase in supply. These include: (1) increase in technology that lowers the cost of
production; (2) new entrants to the market - i.e. more suppliers; (3) a decrease in the cost of
inputs.
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Question 11
Calculate the unemployment rate for Country A:
The unemployment rate for Country A is 9.09 %
i.e.
1,200,000
*100
= 9.09%
(1,200,000 + 12,000,000)
Calculate the participation rate for Country A:
The participation rate for Country A is 9.09 %
i.e.
12,000,000 + 1,200,000 *100 = 82.5%
16,000,000
Question 12
The imposition of a tariff (WP + T) will result in the following:
•
The price paid by domestic consumers will increase from WP to WP + T.
•
Imports will be reduced from Q2- Q1 to Q4-Q3.
•
Domestic Suppliers will increase production from Q1-0 to Q3-0.
•
Government revenue will be equal to (WP +T - WP) * (Q4-Q3) i.e. equal to the tariff
per item * the quantity of imports.
Question 13
The likely effect of a price floor would be a surplus. This is shown on the above diagram. At
PF (price floor) the quantity supplied is Q2. However, at PF the quantity demanded is Q1.
The result is a surplus of Q2-Q1.
Question 14
•
For product A is the price elasticity of demand is inelastic in the price range $50.00 to
$55.00. At $50.00 per unit the total revenue is $50,000. At $55.00 per unit the total
revenue is $52,800. Hence, the price increased and the revenue increased.
•
For product B is the price elasticity of demand is inelastic in the price range $60.00 to
$55.00. At $60.00 per unit the total revenue is $120,000. At $55.00 per unit the total
revenue is $115,500. Hence, the price decreased and the revenue decreased.
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Question 15
The Marginal Propensity to Consume (MPC) = 0.65
Let k = the multiplier
$20 Billion * k = $57.14 Billion
k = $57.14 Billion/ $20 Billion = 2.86
As k = 1/(1-MPC) = 1/MPS then 2.86= 1/MPS
MPS= 1/2.86 = 0.35
1-MPS = MPC. Hence, 1-0.35= MPC= 0.65
Question 16
Calculate the Growth rate of Country C:
The Growth rate of Country C is 4%. i.e.
(1,144 - 1,100)
* 100 = 4%
1,100
Calculate the inflation rate of Country C:
The inflation rate of Country C is 5.47 %
i.e. 135-128 * 100 = 5.47 %
128
Calculate the budget surplus/ (deficit) for 2010 and 2011:
•
For 2010 there was a budget deficit of $15 Billion ($330 Billion - $315 Billion)
•
For 2011 there was a budget surplus of $23 Billion ($401 Billion - $378 Billion)
Question 17
•
There would an extra cost for an Australian importer, that has a contract to purchase
goods, from the US, with a purchase price of $10 000 000 US of $1 764 706.
i.e. At $1.00 = $0.85 US the cost of importing goods that cost $10,000,000 US is
$10,000,000 / 0/85 = $11 764 706 Australian. Therefore, as previously,
at $1.00 Aust = $1.00 US the cost was $10 000 000 Aust there will an extra
$1 764 706 Aust.
•
There would an extra savings for a US importer, that has a contract to purchase goods,
from Australia with a purchase price of $8 000 000 Aust. of $1 200 000 US.
i.e. At $1.00 = $0.85 US the cost of importing goods that cost $8,000,000 Aust
is $8 000 000 * 0.85 = $ 6 800 000 US. Therefore, as previously, at $1.00 Aust = $1.00
U.S. the cost was $8 000 000 U.S. there will a savings of $1 200 000 U.S
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Question 18
Due the subsidies, paid to both the European Union (EU) and the United States of America
(US) domestic wheat producers, the world supply of wheat increases, S1 to S2. Given no
changes in the factors of demand the world wheat price decreases from P1 to P2.
SECTION C
Question 19
Market failure is a very broad term that refers undesirable outcomes caused by the free
market. Any two of:
•
Negative externalities. This results from individuals and businesses only factoring in
their private costs and not the total private costs plus social costs. The result is that
private costs are effectively passed onto other members of society. Air pollution and
noise pollution are good examples. The diagram below is an example of negative
externalities caused by wood heaters. The users of wood heaters only consider their
private costs (S1). However, when the social plus private costs are considered the true
costs show that the costs would be higher (S2) and the quantity consumed lower (Q1 to
Q2).
$
S2 (social +Private
Costs)
S1 (Private costs)
P2
P1
Q2
•
Q1
Qty
Unequal Distribution of Income and Wealth. Some commentators regard unequal
distribution of income and wealth (as distinct from the problem of absolute poverty) as
a problem. The free market increases unequal distribution of wealth and income income rewards are largely based on the revenue individuals can directly or indirectly
produce. Higher income will, in general, be received by those with high-level skills that
are in demand. Consequently, without Government intervention in the form of
progressive income taxes and social security payments many individuals would have
little, if any income (e.g. many recipients of unemployment benefits and old age
pensions would have no income in a free market).
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•
Significant Fluctuations in Economic Output. Even with Government intervention the
economy will experience fluctuations in economic output. However, in a free market it
is likely that the fluctuations would be more pronounced - recessions would be more
frequent, and more severe. Similarly, booms and associated demand-pull inflation
would also be more pronounced.
A business cycle diagram, such as the one shown below, should be presented and
explained.
+
‘Boom’ - Peak
Contraction
–
Recessions
NB the vertical axis shows percentage change in real GDP. The horizontal axis shows
time.
•
Public Goods. In a free market some goods/services that a community desires would
not be provided because the costs of providing the goods/services could not be
recouped, by the private sector, due to ‘free riders’ (those who gain benefits without
paying for the benefits). Defence is a good example, in a free market citizens who
refused to contribute funds to be protected would still be protected by a defence force
that ‘shot-down’ an enemy plane that was attacking. However, with many free riders
the private firm would not be a viable business. Hence, defence is a public good and the
government intervenes to provide a defence force (NB there are other reasons for
having a defence provided by a government).
Question 20
Any three of the following:
•
Opportunity Cost - the economy and living standards. Unemployment represents a
significant opportunity cost - a valuable resource is not being used in the production
process. Hence, the economy is not producing at a point closer to (or on) the production
possibility frontier. For example, as shown in the diagram below, Point A represents the
current output position with unemployment. If the resources were fully employed then
the economy could be producing at point B. The difference in output between point A
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and point B represents the opportunity cost. Due to unemployment economic output is
lower than would otherwise e be the case - hence, living standards are likely to be
lower than would other wise be the case.
Capital
Goods
B
A
Consumer Goods
•
Affect on the Government Budget. Although not all unemployed persons are entitled to
receive unemployment benefits a very high percentage of unemployed individuals will
qualify for government provided unemployment benefits. Consequently, as
unemployment increases government payments for unemployment benefits increase.
Simultaneously, government income taxation receipts decrease as more individuals
cease being employment. The combination of higher unemployment benefits and
reduced income taxation receipts results in a larger budget deficit/reduced surplus. This
further reduces the choices the government has to provide other community services.
•
Increased social problems. Areas with high unemployment rates often have increased
levels of social problems associated with low income, reduced opportunities for
advancement and boredom. Social problems that tend to increase in these
circumstances include; theft, vandalism, selling and taking of illegal drugs etc.
•
Personal Distress and Illness. For many individuals unemployment causes personal
distress. Unemployed individuals often lack the financial means to satisfy their desires
(e.g. purchasing a house, a car, a holiday etc) for themselves and their family members.
Unemployment also prevents many unemployed individuals from fulfilling nonfinancial goals that employment often provides, such as a sense of belonging,
friendship and status. Due to the above factors many unemployed suffer mental distress
and anguish which can lead to severe illness
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Question 21
•
A leakage and lower growth than otherwise would have been the case. By definition a
deficit on the current account means that leakages are exceeding injections regarding
trade, services, transfers, and interest/dividend transactions with other countries. Hence,
economic growth might be lower than otherwise would have been the case.
•
A very high current account deficit, as a percentage of GDP, can result in a lack of
international investor confidence. Consequently, this can lower international investment
and reduce domestic economic growth. A decrease in international confidence can also
lead to higher interest rates charged by international finance companies on Australian
foreign debt.
•
The deficit will most likely result in higher foreign debt. This will therefore increase
the deficit on the income section of the current account in future years - as interest
payments will need to be paid on the debt.
SECTION B
Question 22
•
The Government can intervene in the market to assist in solving the problem of an
insufficient supply of energy efficient houses by a combination of the following.
•
A subsidy. The Government could provide a subsidy to produce energy efficient
houses. As shown in the diagram below, a subsidy would increase supply from S1 to
S2. Consequently, given no changes in the factors of demand, the price would decrease
from P1 to P2. The lower price results in an expansion in quantity demanded, from Q1
to Q2.
Energy Efficient
Houses
S1
S2
P1
P2
D1
Q1 Q2
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•
A tax on new houses that do not meet minimum energy efficient standards. This is
shown in the diagram shown below. Due to the tax the supply is reduced, S1 toS2.
Given no changes in the factors of demand, the price increases from P1 to P2. The
higher price results in a contraction in quantity demanded from Q1 to Q2. The higher
price on low energy efficient houses should result in a switch to a substitute - more
energy.
Low Energy
Efficient Houses
S1
P2
P1
Q2
Q1
Question 23
Demand-pull inflation is caused by excess aggregate demand. Consequently, fiscal policy can
assist in reducing demand-pull inflation by reducing aggregate demand.
Aggregate demand = C+I+G+(X-M). Fiscal policy can be used to reduce C and I by
increasing income taxes and company taxes. By increasing income taxes consumers will have
less disposable income. This will reduce C as disposable income is the main factor that
affects consumption. Increasing company taxes will affect after tax cash flows for companies
and consequently reduce investment. The Government has direct control of G and hence can
reduce expenditure on government final goods and services. A reduction in C+I+G will
result in the multiplier working in reverse.
The final outcome should be a reduction in aggregate demand and an associated reduction in
demand-pull inflation.
Question 24
Globalisation can assist in the development of less developed countries by the following:
•
Gains from Comparative advantage and trade. Globalisation provides developing
countries with the opportunity to specialise in the goods/services where they have a
comparative advantage. The associated trade, with other countries, increases income
and wealth in developing countries. Indeed, increased trade has been and will continue
to be one of the main factors that increase economic development in developing
countries.
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•
Increased Foreign Investment. Globalisation enables developing countries to obtain
increased foreign investment - in the form of funds for new projects or direct
investment of new capital (e.g. new mines, new factories etc). Due to the early stage of
economic development most developing countries are lacking in funds and skills for
development. Consequently, foreign investment - a key component of globalisation can significantly increase GDP of developing countries.
•
Increased Tourism. Globalisation also involves tourism. This can assist developing
countries due to the increased funds tourists inject into the economy and the related
employment in the accommodation and tourist sector.
•
Information Technology and the Rapid Spread of Information and Ideas. Globalisation
also involves countries being interconnected by information technology. Modern
technology enables a rapid spread of information and ideas. This enables developing
countries to be aware of and adopt new, efficient production methods which assist with
development.
SECTION E
Question 25
There are arguments for and against the proposition that ‘there should be no Government
intervention in markets other than to raise taxes and, with the funds raised, provide defence,
public health care, public education and law and order’.
Arguments Against The Proposition
Some of the main arguments against the proposition are due to market failure - where the free
market produces undesirable outcomes. In particular, the proposition would not account for
the following market failure problems:
•
The business cycle- fluctuations in output. Business cycles have and are likely to
continue to occur. Without government intervention of economic stimulus (e.g.
increased government spending, subsidies to build roads, etc) it is likely that recessions
would be more severe. Similarly, the demand-pull inflation effects of ‘boom’ periods
would also be more extreme without government intervention.
•
Unequal Distribution of Income and Associated Poverty. The free market provides
income rewards to the factors of production. Some individuals, due to their personal
and socio-economic circumstances, lack the attributes required to earn income above
the poverty level. In order assist people in such situations government intention in the
form of transfer payments is required.
•
Negative Externalities. In a free market most businesses and individuals only take into
account their personal costs and benefits and not the total social costs. The use of wood
heaters is a good example. The cost to society of wood smoke is not taken into account
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by the producers of wood heaters and firewood nor by the consumers who use wood
heaters. Other examples of pollution, such as noise pollution from parties, air and noise
pollution from car ‘hoons’ and industrial businesses are also applicable. In such cases
government intervention in the form of penalties is required to overcome or reduce the
problem of negative externalities.
Arguments for the Proposition
•
Providing defence would overcome one of the main public goods that would not be
provided due to market failure. Due to the free rider problem a private defence business
would not be able to recoup sufficient funds to cover costs and make an adequate return
on funds invested.
•
Providing public education and public health care will assist in overcoming inequality
of income. One of the main ways for individuals to change their economic position
from a state of poverty to being above the poverty line is to obtain employment. In
relation to this the main way to obtain employment is by education and training. Hence,
public education is vital for providing opportunity for advancement and reducing
poverty. Similarly, without public health many individuals would have severe health
problems that would prevent them from earning income.
•
The proposition should increase efficiency. As the proposition would not allow for
tariffs and subsidies resources would be directed to the most efficient producers. Hence,
efficiency and output would increase.
•
Dubious Resource Allocation would be Reduced. The proposition does not allow for
price ceilings or price floors. This would be advantageous as there is rarely any sound
economic justification for price floors or price ceilings and when they are imposed
additional problems usually occur (e.g. a surplus with a price floor, set above
equilibrium and a shortage with a price ceiling set below equilibrium).
In addition, the proposition does not allow for government intervention to provide
subsidies for so called ‘merit goods’. As what constitutes a ‘merit good’ is highly
subjective this would again assist in resource allocation. For example, it is highly likely
that the majority of the population do not support taxpayer funds being used to
subsidize opera and symphony orchestras - such entertainment sectors should survive
or cease to exist based on free market principles.
Consequently, the proposition in question does have some significant advantages but
also several significant disadvantages.
Question 26
Fiscal policy has both the strengths and weaknesses. The main strengths of fiscal policy are
as follows:
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•
Can be targeted to affect particular States and sectors. Unlike monetary policy, which is
a blunt instrument that affects all States and sectors, fiscal policy can be directed to
affect particular States and sectors. For example, if the total GPD growth figures
showed that there was strong growth and associated demand-pull inflation pressures but
closer analysis showed that this was mainly due to strong growth in W.A. and
Queensland, with Tasmania and S.A. showing weak growth then fiscal policy could be
implemented to reduce growth in W.A. and Queensland and simultaneously increase
growth in Tasmania and S.A. Governments could do this by State governments
increasing taxes and decreasing spending in W.A. and Queensland while the Federal
Government increased spending in Tasmania and S.A. This can be compared to
monetary policy where interest rates would be increased which would lower growth in
W.A. and Queensland, as required, but also lower growth in Tasmania and S.A. when
the opposite is required.
In addition, fiscal policy can target particular sectors. For example, when the housing
sector has been experiencing a severe downturn Governments have provided grants to
first-time homebuyers. This has usually significantly increased demand and housing
output.
•
Short time lags. The effects of fiscal policy can occur relatively quickly - much quicker
than the effects of monetary policy. For example, during the recent Global Financial
Crisis one of the Federal Government’s policy was to provide a tax rebate of
approximately $800 to each of more than eight million taxpayers. A high proportion of
this was quickly spent by many taxpayers - hence providing a quick stimulus.
•
Governments of Sound Economies Usually Have Access to Funds for Economic
Stimulus. Expansionary fiscal policy that consists, to a large degree, on increased
government spending can occur despite the relevant government being in deficit and
not having a specific savings fund for economic stimulus. This is because governments
of sound economies can readily borrow from the public and international investors.
The main weaknesses of fiscal policy are as follows:
•
Predicting Human Behaviour is Problematic. Fiscal policy is aimed at affecting human
behaviour. Unfortunately, human behaviour cannot always be accurately predicted. For
example, expansionary fiscal policy that consists of income taxation reductions might
not be successful if business and consumer confidence is much lower than anticipated.
In this situation savings would increase - not consumption increasing - and hence the
anticipated stimulus would not be achieved.
•
The Current and Expected Debt Levels Limit the Scope of Fiscal Policy. Debt levels
limit the extent of expansionary fiscal policy. As debt has to be repaid, with interest,
there is a limit to the extent of government borrowing for expansionary fiscal policy. If
government debt, as a percentage of GDP, becomes too high then this will significantly
limit future government provision of basic services and future scope for expansionary
fiscal policy.
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•
International Economic Events can Thwart Domestic Economic Policy. As the extent
and pace of globalization increases international economic events can significantly
affect the domestic economy. For example, a government might be implementing
contractionary fiscal policy to overcome high domestic demand-pull inflationary
pressures only to have to quickly reverse the policy because of a global recession that
drastically reduces domestic exports.
Clearly, fiscal policy has both strengths and weaknesses and it is the role of the
government to maximize the strengths and limit the weaknesses.
Question 27
There are arguments for and against the proposition that a high current account deficit and
associated high foreign debt do not constitute problems.
•
Depends on what the debt has been used for. If the proceeds from foreign debt have
been used for sound investment projects, such as new factories, ports, mines, etc, then
this will have positive effects. In particular, future increased economic growth and
positive cash flow to enable debt and interest repayments. However, if a large
proportion of the foreign debt has been used for consumption goods then this will have
negative effects - as funds to repay the debt and interest will have to be sourced from
other areas.
•
Depends on the proportion of Government (Public) Debt to Private Debt. If a very large
percentage of the foreign debt is owed by the Government then this is a problem.
Current and future taxpayers will have to be taxed to repay the debt and interest and
this will also reduce the ability of the government to provide other desirable services,
such as health care and education. However, if the majority of the foreign debt is
private debt then this is not necessarily a problem. Although it represents a leakage
from the circular flow if a high proportion of the private debt cannot be repaid then
those unable to pay will be declared bankrupt. This will mean the respective debt will
legally be extinguished and foreign debt reduced.
•
Depends on movements in the exchange rate. Exchange rate movements will have an
effect. With a floating exchange rate a high current account deficit and high level of
foreign debt might result in a depreciation of the currency. This will increase the
required amount of local currency required to pay a given amount of foreign debt.
However, a depreciation of the currency will increase exports and tourism revenue.
•
Depends on cyclical factors. There are cyclical factors that affect the current account.
For example, the recent mining boom has assisted in increasing export revenue and
reducing the size of the current account deficit. However, mineral prices are volatile
and reductions in mineral prices can be severe and swift resulting in an increase in the
current account deficit.
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Sample Exam suggested answers (2011)
•
Possible to have a sound economy with a high current account deficit and high level of
foreign debt. Australia has recently had a very sound economy with low
unemployment, low inflation and good growth. Yet at the same time Australia has
consistently hade a reasonably high current account deficit and high foreign debt.