Paper 2 Practice 2

1. Thai finance minister happy with exchange rate

❶ The Thai finance minister said the current level of the Thai baht (Thailand’s currency) was appropriate and that the Bank of
Thailand was broadly allowing the ​exchange rate ​to be set by the market. The central bank’s responsibility is only to prevent the
value of the Thai baht from disrupting the economy. The minister also said that he was certain official interest rates would go
even lower. The Bank of Thailand has cut its benchmark rate by 2.25 % since December 2008, taking it to a four-and-a-half-year
low of 1.5 %.
❷ Asked if the Thai baht needed to weaken further, he said “it has been weakening, but relative to other currencies, I think its
current value is fair. Exporters always want to see their currencies weaker, but I think the relative exchange rate for Thailand is
appropriate. I also believe the central bank has left it to market forces, which I think is correct,” he added. The Thai baht hit its
lowest value against the US dollar in over a year recently, and some dealers believed the central bank was pushing it down to
help exporters.
❸ The minister was asked if he thought ​interest rates ​had reached the lowest possible level. “Given the struggling export sector,
which contributes to a lack of aggregate demand and a danger of increased unemployment, I am quite certain there is more to
come. I would expect to see interest rates fall further unless there is a very rapid change in economic conditions.”
❹ Thailand’s state planning agency reported last week that GDP fell a record 6.1% in the fourth quarter of 2008. It expects zero
GDP growth at best in 2009 and says the economy could shrink by as much as 1%. According to this agency, unemployment is
expected to rise to 2.5 %, up from 1.4 % in 2008, while the Commerce Ministry announced that exports had fallen 26.1 %
compared with the previous year.
(a) Define the following terms indicated in bold in the text:
(i) exchange rate ​(paragraph​❶​) [2 marks]
In finance, an exchange rate is the rate at which one currency will be exchanged for another. It is also
regarded as the value of one country's currency in relation to another currency.
(ii) interest rates ​(paragraph​❸​)​. [2 marks]
An interest rate is the amount of interest due per period, as a proportion of the amount lent, deposited or
borrowed. The total interest on an amount lent or borrowed depends on the principal sum, the interest rate,
the compounding frequency, and the length of time over which it is lent, deposited or borrowed.
(b) Using an appropriate diagram, explain how Thailand’s central bank might
intervene to lower the value of the Thai baht.
[4 marks]
If the Thailand central bank wants to lower the value of the thai baht, then they
can do so by lowering the demand for the Thai baht in the foreign exchange
market. If the Thai central bank decreases the demand for the Thai baht, perhaps
by lowering the interest rate, then foreigners will not want to save their savings in
the Thailand banks, so the demand for the Thai baht will decrease. This will
result in less Thai baht being demanded in the FOREX market, which lowers the
Thai bhat’s value relative to other currencies.

(c) With the aid of an AD/AS diagram, explain the likely effect on the Thai economy of a further cut in interest rates
(paragraph❸​ ​)​. [4 marks]
If the interest rates in Thailand were to become relatively cheaper, then
aggregate demand would increase. This would increase the price level
from PL1 to PL2 and real GDP from Q1 to Q2. The determinants of AO
are consumer spending, investment government spending, and net
exports. As IT decreases, consumer spending increases, as there is less
incentive to save and borrowing is relatively cheaper, so AD increases. Additionally, investments will rise,as lower interest
rates make it cheaper for businesses to invest in capital, along with less risk, so AD increases. As the interest rate falls,
Thai people seek to invest , so the supply in the FOREX increases. This then lowers the exchange rate, so now it is
relatively cheaper for foreign cou buy Thai exports and relatively more expensive for Thai people to import foreign
goods. As a result, net exports increases, which causes AO to increase.

(d) Using information from the text/data and your knowledge of economics, evaluate the view that Thailand’s central bank
should intervene in the foreign exchange market in order to weaken the Thai baht.
[8 marks]
A country whose currency is falling should see its terms of trade - the cost of its exports relative
to its imports - fall encouraging foreigners to buy its goods and keep its economy healthy.