Government Microeconomic Intervention

Maximum and Minimum Prices

MAXIMUM PRICES MINIMUM PRICES

Max. price control: is where a price ceiling Min. price control: is where a price floor is
is established below equilibrium price, established above equilibrium price, creating a
creating a shortage. surplus.
Cheap essentials Demerit goods
Rent control Proper wages
Restriction of fares Import reduction
More affordable to the poor \text{PED}PED dependent
Queueing Unemployment
Corruption Smuggling
Black market Inefficiencies
Taxes, Subsidies and Transfer Payment
Fiscal measure Levied on/ Given to Shif Burden/Benefit
t
Direct tax Income D← Consumer
Indirect tax Expenditure S← Elastic demand – producer & converse
Subsidy Consumer D→ Consumer
Subsidy Producer S→ Inelastic demand – consumer & converse

Note: Specific measures cause parallel shift, ad valorem ones non-

parallel

Direct tax
Advantages Disadvantages
Economic stability May discourage:
Progressive Saving
Certain & convenient Effort

Indirect tax
Redistribute income Risk-taking
Economic stability Regressive
May not discourage effort Inflationary
Difficult to evade Reduce consumer surplus
Can be adjusted quickly Move demand abroad
Discourage imports Distort choice
Discourage demerit goods Effect depends of \
text{PED}PED
Aims of taxes Canons of taxes
Advantage Disadvantage
Demerit goods Cost
Income distribution Efficiency
Release resources Equity
Discourage imports Transparency
Demand/supply Convenience
management

Impact of tax: refers to unit on which a tax is levied.

Incidence of tax: refers to burden of taxation.

Specific tax: is paid in fixed amount.

Average rate of tax: is the average percentage of total income that is paid in taxes.

Marginal rate: is the proportion of additional income that is taken in income tax.

Marginal rate of taxation: is the addition to tax paid out of change in income.

Transfer payment: is a govt. provided benefit to poor units, without protective effort; so funds shift
from taxpayers to recipients.

Means-tested benefit: is paid to units whose income is below a level.

Universal benefit: is paid to units without income reference.

Poverty-trap: is a situation in which an individual has work-disincentive, as additional income will be

taken away as taxes & lost benefits.

Negative income-tax: is a system which brings together payment of tax and receipt of benefits thus,
making markets more flexible by removing poverty-traps.

Direct Provision of Goods & Services

Certain goods and services that ought to benefit the public are under-provided, or under-consumed
in the economy.

Direct provision of goods and services in the form of merit and public goods are a solution to this
issue.

Nationalisation & Privatisation

Nationalisation: is a process whereby private sector firms become part of the public sector of
economy, with state involved in direct provision of goods and services.

The converse is: Privatization: which is achieved by sale of assets, deregulation, outsourcing &

franchising.

Nationalisation
Advantages Disadvantages
Economies of scale Inefficient
Reduce income inequality Non-competitive
Private monopoly prevented Political-mileage
Avoids wasteful duplication SOE monopoly
CBA involved Limited scope for increase in long term investment

Privatisation
Advantages Disadvantages
Economic efficiency Private monopoly
Government revenue One off income generated
Growth by investment Regulations needed
Lower price Unemployment
Enterprise encouraged Wasteful duplication
 
Government failure: occurs when government intervention reduces economic performance rather
than increasing, thus failing to correct market failure, due to:

 Imperfect information
 Policy conflicts
 Political mileage
 Corruption

NOTE:
Aggregate Demand & Aggregate Supply Analysis

Macroeconomy: is the economy as a whole.

Aggregate demand  {(AD)}: is the total spending on an economy’s goods and services, at a given price
level in a given time period.

Total spending in an economy in a certain time period

In consists of Consumption, Investment, Government spending and Net Exports (C+I+G+(X-M))

Consumption – spending by households and other consumers. Depends on income levels, interest
rates, tax rates, etc. A major part of AD.

Investment – expenditure made by firms in terms of capital equipment. Depends mostly on profits
and interest rate, corporation tax rates, etc

Government spending – total spending by the government on both consumer and capital goods.
Depends on tax revenue collected.

Net exports – exports minus imports. Depends on inflation rates domestically and abroad, exchange
rates, etc

Aggregate supply (AS) is the total output produced in an economy within a given time period.

Shifts in the LRAS curve

AS, in the long run may increase due to:

Increase in quantity of resources:

Net immigration

Increase in retirement age

More women entering the labour force

Net investment

Discovery of new resources

Land reclamation

Increase in quality of resources:

Improved education and training

Advances in technology

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Inflation

Inflation: is a sustained increase in general price levels in an economy over a given time period,
causing a fall in purchasing power of a currency.

Creeping inflation: has a low rate.

Hyper-inflation: has an exceptionally high rate of inflation, which may result in people losing
confidence in currency.

Inflation rate can be measured by (CPI)(CPI) or (RPI)(RPI):

Selecting a stable base year for comparison.

Carrying out surveys to find spending patterns.

Attaching weights to products to indicate relative importance.

Finding out price changes.

Multiplying weights by price changes.

Deflation: is a sustained decrease in general price levels in an economy over a given time period,
causing a rise in purchasing power of a currency.

Disinflation: is a fall in the inflation rate.

Cause Inflation Deflation

s
Good AD \up-arrow AD↑ AS \up-arrow AS↑
Bad AS \down-arrow AS↓ AD \downarrowAD↓
Money values: are of prices operating at the time.

Real values: are adjusted for inflation.

Real values = nominal values * price index of base year (100)/price index of current year

Menu costs: are incurred by firms for having to change prices.

Shoe-leather costs: are incurred by firms moving money for high-interest.

Fiscal drag: is pushing of income into higher tax brackets by inflation.

Inflationary noise: is confusion over relative prices.

Causes of inflation:

Cost-push inflation: is caused by increases in costs of production decreasing aggregate supply, e.g.

Wages rising by more than productivity.

Raw material costs rising (especially imported ones).

Increase in indirect/corporate taxes.

Rise in profit margins.

Demand-pull inflation: is caused by increase in aggregate demand unmatched by equivalent rise in
aggregate supply, e.g.

Consumer boom.

Money supply growing faster than output (monetarist)

Growing budget deficit.

Increase in net exports.

 Consequences of disequilibrium
Domestic
Change in money supply
Confidence & FDI levels change, leading to
changes in ADAD, employment, growth etc
Changes in standard of living owing to
different access of imports.
Change in government policies
External
Change in exchange rate both appreciation &
depreciation naturally and artificial devaluation &
evaluation.
Government pressured to change protectionist
measures.

Disadvantages Advantages
Reduction in net exports. Stimulate output
Unplanned redistribution of income Reduce burden of debt
Fiscal-drag Prevent some unemployment
Inflationary noise Factors effecting extent of consequences
Investment discouragement Cause of inflation
Unemployment Rate of inflation
Cost-wage spiral Stability
Menu costs Expectancy
Shoe leather costs Comparability
Balance of Payments

Balance of payments: is a record of a country’s economic transactions with the rest of the world over
a year. It consists of:

Current account: Financial account:

Visible trade in goods Direct investment
Invisible trade in services Portfolio investment
Income, e.g. profits, interest Reserve assets
Current transfers (no exchange involved) Other investment
Capital account: Balancing item:
Capital transfers Net errors and omissions
Nonfinancial assets
Note: Money into country, credit (+) items, e.g. export.
Money out of country, debit (−) items, e.g. import.
* Financial account: * Hot money flows * Lack of business confidence * Balancing item: * Imperfect
information * Smuggling, black market

Exchange Rates

Factors determining exchange rate:

Balance of payments disequilibrium – Deficit causes reduction.

Inflation rate – High rate reduces confidence, hence demand.

Foreign direct investment – Inflows increase rate.

Speculation – Acts in a way to aggravate problem.

Purchasing power parity: is a way of comparing international living standards by using an exchange
rate based on amount of each currency needed to purchase some basket of products.

Nominal exchange rate: is price of one currency in terms of another.

Trade-weighted exchange rate: is price of one currency against a basket of weighted currency.

Real effective exchange rate: is a currency’s value in terms of its real purchasing power.

\therefore Real\ effective\ exchange\ rate = \frac{Nominal\ exchange\ rate \times Domestic\ price\
rise}{\text{Foreign\ exchange\
rate}}∴Real effective exchange rate=Foreign exchange rateNominal exchange rate×Domestic price ris
e

Effect of changing exchange

rates – Domestic
Aspect Effect
Inflation Depreciation will make imports more expensive. (Imported cost
push inflation)
Unemployment Appreciation will make exports more expensive reducing AD.
Economic growth Depreciation will reduce terms of trade, leading to economic
growth if Marshall-Lerner condition holds.
(+) |

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Principles of Absolute and Comparative Advantage

Absolute advantage: is the ability to produce more of a product than another country using same
amount of resources.

Comparative advantage: is ability to produce at lower opportunity cost.

Trading possibilities curve: is the consumption possibilities of rations post specialization and trade at
any term of trade.
Protectionism

Protectionism: is an action designed to help domestic products from foreign competition by reducing
international trade.

Measures include:

Tariffs (tax) Embargoes (bans)

Quotas (limits) Voluntary export restraint (agreed limit)
Foreign currency exchange control Red tape (administrative delays)
Export subsidies Dirty float exchange rate

Free trade Protectionism

Foreign products within reach
Greater variety
Importing raw materials
Better quality
More sales
Economies of scale
Larger market
Greater competition
Lower price
Spread of ideas & technology
Avoids over specialization
Improve terms of trade
Strategic industries
Declining/sunset industries
Infant/sunrise industries
Prevent dumping
Reduce current account deficit
Raise revenue
Protect employment
Retaliation
 Macroeconomic Policies
Macroeconomic aims
 Full employment
 Low and stable inflation
 Balance of payments equilibrium
 Sustained and steady economic growth
 Stable exchange rate
 Sustainable economic development
 Advertisement

Types of policies
Fiscal policy

 It involves the use of taxation and government spending to influence AD

 Expansionary/reflationary fiscal policy – lower taxes, higher government spending
 Deflationary/contractionary fiscal policy – higher taxes, lower government spending
 A budget is a government’s estimates for its revenue and spending
 Budget deficit – expenditure exceeds revenue
 Budget surplus – revenue exceeds expenditure
 Balanced budget – revenue equals expenditure
 Only a short-term measure, households and firms will go back to older spending patterns
once implementation of these policies is stopped.
 Raising taxes can create disincentive to work, lowering labour force and productive capacity,
increasing unemployment, lower GDP lowering economic growth
 Tariffs may not be possible in a trade bloc. May even provoke retaliation. Domestic firms
may become dependent
 Workers press for higher wages, wage-price spiral, cost push inflation
 Skilled workers may emigrate
 May increase AD, demand-pull inflation
 Firms may become dependent, complacent

Monetary policy

 It involves the use of interest rates, money supply and exchange rates to influence AD
  Expansionary monetary policy – lower interest rate, increase money supply, currency
depreciation
 Contractionary monetary policy – increase interest rate, lower money supply, currency
appreciation
 Money supply can be controlled through the changes in the cash reserve ratio (CRR)
 Difficult to control money supply
 Interest rates have a time lag of 12-18 months
 Interest rates are uncertain
 Higher interest rate can have negative effect on unemployment, economic growth
 Lower interest rates will lower hot money flows into the country
 Higher interest rate will discourage FDI
 Higher ROI will not guarantee fall in consumer spending as commercial banks may not pass
on the higher interest rate
 Fixed exchange rate, interest rate rises will cause currency appreciation leading the
government to sell its currency to go back to the fixed level

Supply-side policy

 They are designed to increase AS

 Increased spending on education and training
 Deregulation & Privatisation
 Direct tax cuts
 Subsidies
 Spending on infrastructure
 Trade union/labour market reforms
 Reduction in welfare payments
 Only effective in the long run, have a time lag
 Uncertain outcomes
 Privatisation & deregulation – may develop monopolies
 Subsidies – may not be passed to consumers
 Education & training – only works if quality improved
 Spending on training will reduce costs only if productivity rises greater than wage rates
 Corporate tax – depends on confidence levels

Expenditure switching policies

 Measures designed to encourage consumer to switch to domestic products rather than
foreign produced ones
 Ex. protectionism measures like tariffs
 Expenditure reducing/dampening policies
 Measures designed to lower domestic demand.
Ex. higher income tax, interest rate Expenditure reducing/dampening policies
 Measures designed to lower domestic demand
Ex. higher income tax, interest rate
The Price System & the Micro Economy
Price mechanism
It is the means through which scarce resources (factors of production) are allocated in a market
economy.

Signalling – prices act as a signal to both producers and consumers. Ex. if there is excess demand for
a product due to a fall in quantity, this indicates to the producer that they must supply more of the
product in the market. In turn, if consumers withhold their demand, it signals to the producers that
they must lower price and in turn produce less.

Rationing – if a producer wants to retain exclusivity for their product, they may limit the supply of
the product in the market, thereby driving its price up and in turn restricting its demand.

Transmission of preferences – this means that if consumers do not buy a particular product because
they don’t like it, or it is not priced to their liking, then this message is transmitted back to the
producer.

Demand and supply

Demand/supply: is the quantity of a product that consumers/producers are willing and able
to buy/sell at various prices per period time, ceteris paribus.

Note that demand & supply are also referred as market forces or the invisible hand.

Laws of demand: Rise in price, fall in demand and vice versa

Laws of supply: Rise in price, rise in supply and vice versa

Schedules: lists these relations while curves: graphically represent them.

Notional demand/supply: isn’t backed up by ability to pay/sell but effective demand/supply is.

Individual: refers to a certain producer/consumer in the market: which is an arrangement for buyers

and sellers to trade.

Products in joint demand/supply: are produced/consumed together.

Products in alternative demand/supply: are those whose consumption/production reduces

need/availability of the other.

Multi-purpose products have composite demand.

Products which help in producing other product have a demand derived from the product produced.

Note: As income rises, demand of normal goods rises, inferior good falls.

Contractions/Extensions of demand/supply: are movement along curves due to changes in price,
while:

Shifts of demand/supply: are movements of the whole curve due to changes in conditions.

Their effects on equilibrium price, quantity and revenue will depend on degree of shifting and price
elasticity of other curve.

Demand conditions Supply conditions

Disposable income Costs of production
Price of related products Price of related products.
Taste and fashion Climate & technology
Population structure Government regulations
Price speculation Availability of resources
Income distribution Taxes and subsidies
Taxes and subsidies Competitor actions
Price Elasticity, Income Elasticity & Cross-Elasticities of Demand, and Price Elasticity of Supply

Elasticity: is responsiveness of quantity demanded/supplied to a change in price, income or prices of

related products.

Note: It is a numerical measure of the inverse of the gradient, so lower elasticity gives steeper curve.

Limitations of elasticities:

Irrelevant and unreliable data

Unrealistic assumptions

Omission of Total Cost

Omission of Production Capacity

Elastic >1 Perfectly elastic ∞ Horizontal

line
Inelastic <1 Perfectly inelastic 0 Vertical line
Unitary =1; Such PED gives rectangular hyperbola, i.e. change in
demand/supply doesn’t affect revenue.

PED = % change in QD / % (−)ve; used to inspect revenue and tax

change in P effects.
PES = % change in QS / % change (+)ve; indicates allocative efficiency and
in P need to expand.
YED = % change in QD / % (+)ve – normal good (−)ve – inferior
change in income good
XED = % change in QD / % (+)ve – substitutes (–)ve
change in P (another) – complements
 PED conditions PES conditions
Time period Time period
No. Of substitutes Availability of resources
Degree of necessity Spare capacity/stocks
Durability No. of firms in market
Proportion of income Allocative efficiency of factors

Interaction of Demand & Supply, Market Equilibrium & Disequilibrium, and Consumer & Producer
Surplus

Prices:

Signal surpluses/shortages.

Ration resources to uses.

Transmit preferences by encouraging producers to produce according to consumer demand.

 Basic Economic Ideas and Resource Allocation

Scarcity, Choice & Opportunity Cost

 The fundamental economic problem: of scarcity arises due to unlimited human wants of

consumption exceeding finite economic resources for production.

 Consumption: is process by which consumers satisfy their wants.

 Production: is process of creating goods and services in an economy

 Economic goods – these are goods which require resources to be produced and obtained

and therefore have an opportunity cost. Allocative mechanism will be used to allocate such

goods. Ex. cars.

 Free goods – these are goods which do not require any resources to be produced and

obtained and therefore are abundant and have no opportunity cost. Ex. sunlight.

 Ceteris paribus is a Latin word meaning ‘all other things being equal’

 Needs are necessary, wants are not.

 Thus, choices have to be made at all levels

 Consumers – maximum satisfaction.

 Producers – maximum profit.

 Governments – maximum benefits.

 Choice: is the need to make decision about the possible alternative uses of scarce

resources due to scarcity. It gives rise to the concept of opportunity cost and the 3 basic

economic problems.

 Opportunity cost: is the cost of choosing something in terms of the benefit derived from the

best alternative forgone.

 Economic resources/factors of production: are inputs available for production of goods

and services.

 Positive and Normative Statements

Statement Basis Type

Positive Facts Objective
Normative Value judgments Subjective
Value judgments: reflect particular beliefs, while facts: are evident to all.
 Factors of Production

Factor Definition Reward

Land Natural resources Rent
Labour Physical and mental human effort Wage
Capital Man-made resources Interest
Enterprise Production organization, risk-bearing Profit
Resource Allocation in Different Economic Systems & Issues of Transition

 Different economic systems answer the 3 basic economic questions differently.

 Note, that mixed economics try to gain advantages and avoid disadvantages of both market

and planned economies.

Question Market economy Planned economy

What to produce Price mechanism Cost-benefit analysis
How to produce Least cost combination Directives to SOEs
For whom to produce Purchasing power Vulnerable groups
Comparison between market & planned economies:

Feature Market economy Planned economy

Ownership Private State
Decision Consumers Governments
Mechanism Price mechanism Directives to SOEs
Key sector Private Public
Public Absent Present
goods
Profit motive Present Absent
Other names Free enterprise, private Central, collectivist, state-
enterprise, laissez faire owned.
Examples USA North Korea
 Note that in reality, all economic systems are mixed.

 SOE: State-owned enterprise.

Market economy
Advantages Disadvantages
Efficiency Information failure
Public goods not provided
Consumer sovereignty Merit goods under-consumed
Demerit goods over-consumed
Quick response Negative externalities
Unemployment of resources
Profit incentive Factor immobility
Market power abuse
Maximizes producer and consumer Advertising distortion
surplus
Too much consumer goods
Government freedom Poor lack purchasing power
Inflation
Planned economy
Advantages Disadvantages
 Provision of public goods No incentives
Merit goods encouraged Low production
Demerit goods discouraged Low competition, low efficiency
Full cost-benefit analysis Bureaucracy
Full employment Unresponsive
Wasteful duplication Too much of capital goods
avoided
Vulnerable groups protected Lack of consumer sovereignty
 Transitional economy: is one which is in process of changing from a planned economy to a

mixed economy where market forces have greater importance.

 Issues of transition:

 Inflation.

 Industrial unrest.

 Fall in output.

 Unemployment.

 Balance of payments’ deficit.

 Reduction in welfare services.

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Production Possibility Curves

Production possibility curve: is one which joins together the different combinations of

products that can be produced in an economy, over a period of time, given existing

resources and technology.

 It is also known as production transformation frontier, boundary or a production

transformation curve. It demonstrates the ideas of choice, trade-offs and opportunity cost.
 Point inside curve indicates unemployment and point on curve shows full employment. This

is productive efficiency.

 Point shifting occurs owing to allocative efficiency.

 Production point shifting from C to F requires a reallocation of resources to capital goods

and factor mobility determines the speed of this. This would act as an investment, shifting

the PPC to the right. This indicates economic growth.

 Factor mobility: is extent of reallocation of resources or ease of moving factors of

production.

 Investment: is expenditure of capital goods, both fixed and working.

 Economic growth: is an expansion in the productive capacity in an economy.

(Lowering of long-run average cost, i.e., LRAC ensures this.)

 Other causes of PPC shifting right:

 New resources.

 Increased labour supply.

 Improvements in human capital.

 Improved resource management.

 Privatisation.

 Straight PP line indicates constant opportunity cost which is next to impossible.

 Curved PP line indicates increasing opportunity cost which occurs when the extra

production of one good involves ever-increasing sacrifices of another as less suitable

economic measures have to be diverted into the production of the former, increasing

marginal cost and decreasing productivity.

Money

 Money: is anything which is universally acceptable as a means of payment for goods and

services. Most money, except coins is ‘legal tender’ for settlement of debt.

 Functions:

 Medium of exchange.
 Measure of value.

 Standard for deferred payment.

 Store of value.

 Characteristics:

Acceptability. Scarcity.
Divisibility. Stability of supply and value.
Portability. Recognizable.
Durability. Uniformity.
 Advantages over barter:

 Avoids double coincidence of wants.

 Permits evaluation.

 Enables giving change.

 Eases saving.

 Barter: is the direct exchange of one product for another. It was used before money.

Cash + Bank deposits = Money

 Cash: includes the notes and coins in an economy. It is the most liquid form of asset.

 Bank deposits: are money held in accounts with a financial institution, e.g. bank, building,

society, etc.

 Liquidity: refers to the extent and ease of converting a non-cash asset into cash.

 Near money: or ‘quasi-money’ are non-cash assets that can be quickly and easily converted

into cash.

 Cheques: are written instruction to a financial institution to pay an amount of money from an

account. So, they are means of payment through bank deposits, not money.

Classification of Goods & Services

Good Opportunity cost & scarcity Rivalry Excludabilit Free-rider Reject ability
y
Free ✗ ✗ ✗ ✓ ✗
Economic/ ✓ ✓ ✓ ✗ ✓
Private
Public ✓ ✗ ✗ ✓ ✗
9708/23/M/J/19

Section A

1a) Between 2015 and 2016, oil production in Nigeria fell by 0.9 barrels per day from 2.3 barrels to
1.6 barrels each day

\n b) In order to successfully compete against the US, in 2014, the OPEC decided to increase its
supply by 12% (S-S1) which caused the price to fell by 60% to $30 per barrel (P-P1) and quantity

demanded to expend (Q-Q1) \nBut, in 2016, as all economies in the OPEC were suffering due to
falling oil revenue. OPEC decided to reduce its supply by 3% (S-S1) which caused price to rise by 10%
(P-P1) and quantity demanded to contract (Q-Q1)
c) Inelastic demand is when percentage change in price is greater than percentage change in
demand, ceteris paribus. A fall in world price of oil by 60% only caused a 45% fall in OPEC’s revenue
which shows that increase in demand was lesser than the fall in price was lesser than change in
price, indicating inelastic demand.

d) Since quarter 3 of 2015, there has been a decline in the growth rate of oil production for Nigeria.
Even after such a drastic decline in oil production, the Nigerian economy only contracted by 2%
indicating that oil is not a significant part of the country’s GDP. It shows that contraction in other,
non-oil sectors which are of greater significance in the economy’s GDP didn’t have such a drastic
decline.

e) The 2 major decisions of OPEC that has a large impact on the Nigerian economy included OPEC’s
policy of reducing its oil supply and increasing price in 2016 and increasing supply and reducing
prices in 2014.

In order to remain competitive with the US, OPEC decided to increase its oil supplies and lower the
world price of oil. This caused a rise in the total GDP of Nigeria, indicating short-term economic
growth, high employment and living standards. But, as the world price of oil fell, Nigeria’s export
revenue fell drastically as 80% of its exports were oil which worsened its current a/c balance. Later,
in 2016, due to revenue issues, OPEC decided to reduce its supply in order to raise prices. This
causes a rise in export revenue for Nigeria as OPEC’s oil demand is inelastic, improving its balance of
payments disequilibrium. But, this led to oil producers lowering their supply and making workers
redundant. That, in turn, increased unemployment and worsened living standards and economic
growth prospects.
f) OPEC may be able to control the world price of oil as they supply half of the global demand of oil.
They are a monopoly with approximately 50% of the market share. As even slight changes in their
supply of oil, the entire world oil supply will be disrupted OPEC may be considered as a price marker.
Also, when OPEC increased in supply by 12% in 2014, prices fell by more than 60% showcasing the
effect of OPEC’s supply decisions on the world, thus on price. But, in the future OPEC may not be as
successful in altering and influencing world oil prices through changes in their supply, due to the
development of a new method of oil extraction - fracking by the US. This is increasingly growing in
demand as it is cheaper than OPEC’s market share will reduce and their ability to influence prices will
also decrease. Overall, whether or not OPEC is able to influence prices depends on how effectively
they are able to implement their policies to keep oil prices high. It even depends on how efficient
OPEC is in maintaining its market share while the US develops their oil industry through the method
of fracking.

Section B
2a. Merit goods are goods which have positive side effects when consumed. Merit goods include
education, health care, etc. They generate greater social benefits when compared to social costs. As
information failure exists, consumers are not fully aware about the benefits of consuming them,
which is why they are under consumed and hence, under produced in an economy. As they are not
produced and consumed at the socially optimal level, it causes market failure in an economy. Due to
the existence of information failure, the government is encouraged to produce merit goods and
provider awareness campaigns to help solve the problem of information failure, in turn helping
increase their demand and supply. Demerit goods are goods which have negative side effects when
consumed. Demerit goods include alcohol and cigarettes. They generate greater negative
externalities in the economy. Due to information failure, consumers do not fully realise the negative
effects of consumption of such goods due to which they are over consumed. This encourages
producers to increase supply leading to overproduction. Furthermore, demerit goods are considered
to be addictive in nature, making it difficult for consumers to lower its demand.  As they are not
produced at a socially optimal level, market failure exists and it encourages the government to
intervene in the market by taxing demerit goods and providing awareness campaigns about their
negative effects.
3a. Inflation is the sustained rise in the general price level of an economy. Inflation can be cost-push
or demand-pull. Cost push inflation occurs when there is a rise in a firm’s costs of production which
encourages producers to increase prices leading to inflation.

For example, depreciation of a country’s currency increases the price of imported raw materials,
leading to a rise in total costs of production and encouraging producers to raise prices in order to
maintain profit levels. Another reason for cost-push inflation to occur may be due to increased wage
rates, greater than the rise in workers productivity. This leads to a rise in a firm’s labour costs,
increasing total costs, and leading to cost push inflation. Demand pull inflation occurs when there is
a rise in any of the 4 components of AD - consumption, investment, government spending, net
exports. This increased AD leads to an increase in the price level of an economy.

For example, a cut in income tax may increase consumers' disposable incomes and their purchasing
power, encouraging them to increase spending, leading to a rise in the ‘C’ component of AD and
causing demand pull inflation. Also, a fall in corporation tax and interest rates will make it easier for
firms to borrow more and invest in expansion and purchase of capital equipment like machinery and
advanced technology. This increases the ‘I' component of AD, leading  to demand pull inflation. Also,
depreciation of a country’s currency will make exports more internationally competitive as they will
become cheaper. This will increase demand for exports, increasing the (X-M) component of AD,
causing demand pull inflation.

3b. Inflation is the sustained rise in the general price level of an economy. It leads to a fall in the real
value of money. A high rate of inflation can cause many internal and external problems for an
economy. A high rate of inflation will cause an unplanned redistribution of income. During inflation,
people on fixed incomes like pensions and unemployment benefits suffer as there is a fall in
purchasing power of money. This leads to a fall in their living standards which may lead to a rise in
poverty levels in the economy. Also, during inflation, borrowers gain as they have to pay back less in
terms of real money. Furthermore, if tax brackets are not adjusted for inflation, it can cause fiscal
drag when individuals are forced to pay higher taxes due to increases in their nominal income which
may not represent an increase in their real income. This will lead to a fall in purchasing power of
such individuals, leading to a fall in average living standards. Also, high inflation rates lead to
increased costs for producers in terms of menu and shoe leather costs. Menu costs occur due to the
need to continuously change prices on menu cards, catalogues, etc. Shoe leather costs occur as firms
keep moving in search of financial institutions which have an interest rate higher than the current
inflation rate. This increases total costs of production for firms, which may act as a disincentive for
producers to lower their supply, negatively affecting the country’s GDP and employment rate as
producers may make workers redundant in order to lower output. It will even lead to increased cost
push inflation for the economy.  Other than the internal problems an economy faces due to
increased inflation, the economy will even have to suffer a fall in their export revenue. As prices rise,
exports become expensive in foreign markets, leading to a fall in their international competitiveness,
encouraging consumers to switch to other, low-cost countries. This will lead to a fall in export
revenue, worsening the current account deficit. Also, as domestic goods are expensive, domestic
consumers may start demanding cheaper imports, increasing import expenditure. This will further
worsen the currency account deficit and increase the country’s dependence on international trade.
Moreover, a high inflation rate will lead to a depreciation of the country’s currency as its demand
will fall due to decreased demand for exports and supply will rise due to increased demand for
imports. Overall, a high and increasing rate of inflation is harmful for an economy and the
government must control it. The most serious problems faced by an economy as a result of inflation
may be external problems like fall in international competitiveness and depreciation of the currency
as internal problems may be resolved easily by the implementation of fiscal and monetary policies.
But a country does not have full control over external aspects making it difficult to control and
resolve.

4a. The theory of comparative advantage suggests that an economy must specialise in a product for
which it has a lower opportunity cost when compared to other countries. Free trade occurs when
movement of goods and services face no trade barriers like tariffs and quotas. Trading on the basis
of free trade will allow a country to specialise and produce products they are most efficient at
producing. This allows maximization of limited resources - land, labour, capital & enterprise. This
further helps increase global output and employment in turn improving living standards and
lowering poverty. Trading on the basis of comparative advantage allows a country to consume
outside their PPC curve by trading with other countries for products they are not efficient at
producing. This further helps improve living standards across the globe. Also, specialising in a single
product will allow the industry to grow and increase output to benefit from economies of scale like
purchasing economies. This helps them lower costs and improve the quality of products produced.
Also, trading on the basis of free trade will allow a country to be able to import high quality raw
materials more cheaply, helping lower costs and leading to a fall in prices. This will lead to
consumers enjoying cheaper and high quality products. But, the theory of comparative advantage
ignores the exchange rate fluctuations which can cause a change in comparative advantage. This will
make it difficult for a country to specialise in the production of one good/service.
9708/23/M/J/20

Section A

1a) Plastic bottles are considered private goods as they are both excludable and rival. This occurs as
plastic bottles have a charge on them, making it excludable and also are limited making them rival in
nature. Plastic bottles are even considered as demerit goods as they are over-consumed and over
produced due to information failure. Also, the consumption of plastic bottles leads to negative
externalities like death of marine animals

b)i) A  specific tax is an indirect tax that is fixed per unit purchases. For example, $1 per bottle of
alcohol purchases. An ad valorem tax is a type of tax where a fixed percentage of tax is charged on
the total price for the product. For example, GST, VAT.

ii) The bottle tax the government is planning to impose is a mix of both specific and ad valorem tax
as there is a fixed amount on each bottle, $0.10, however it even depends on the size of bottle
purchased (1l, 2l)

c)i Imposition of a bottled tax on plastic bottles caused the supply curve to shift to the left (S-S1) as
costs of production rose. This caused a price rise (P1-P2) leading to a contraction in quantity
demanded (Q-Q1)

c)ii) The incidence of the bottled tax will depend on the price elasticity of demand of plastic bottles.
When the PED of plastic bottles is inelastic, that is percentage change in price is greater than change
in demand, an imposition of tax (S-S1) will lead to consumers bearing most of the tax (P1XYP) when
compared to producers bearing just a small proportion of it (PYZQ).

Whereas, if demand is elastic, that is percentage change in price, producers will bear most of the tax
(PYQZ) whereas consumers will bear a small proportion of it (P1XYP).
d) A tax is a charge imposed by the government. If the government taxes plastic bottles, it may be
successful in reducing the consumption of plastic bottles as it will become expensive to buy it. It will
be effective in reducing its production as it will become expensive. This will reduce the over-
production and consumption of the demerit goods - plastic bottles. It will further help reduce the
negative externalities caused by it like the threat to marine life. Also, imposing this charge will raise
government revenue allowing them to spend this in reducing the negative externalities created by
the production and consumption of plastic bottles.

But, the effectiveness of imposing the bottle tax will depend on the PED of plastic bottles. If plastic
bottles have inelastic demand, an imposition of tax will be less likely in lowering its usage and
negative externalities it causes. Also, it depends on the size of tax. A small tax may not be passed on
to consumers, having no effect on consumption of plastic bottles. Instead, the government should
aim to raise awareness regarding the negative effects of plastic bottles as this is likely to be more
effective in reducing its consumption and production in the long run.

Section B
2)a) Price elasticity of supply (PES) is a numerical measure of responsiveness of supply to a change in
price. 

PES = % change in quantity supplied/ % change in price 

In the short run, producers expect the PES of the new smartphone to be 0.8, which means it is
inelastic. This means that change in price is greater than change in quantity supplied. The PES may
be inelastic in the short run because producers may not be flexible. This may occur as suppliers may
not have access to advanced technology and productive labour. This makes it difficult for producers
to quickly respond to change in demand and price, making PES inelastic. Also, in the short run, it will
be difficult to alter the productive capacity of the firm as only the quantity of labor can be changed.
Supply may be more inelastic if there is little/no spare capacity for the producer to increase
production of smartphones in the short run as it is difficult to increase the productive capacity of the
firm. But, in the long run, producers expect the PES for this smartphone to be, 1.5, elastic in nature.
This means that a change in price is lesser than change in quantity supplied. The PES may be elastic
in the long run due to technological advancements. Access to advanced technology may make the
production process more efficient and flexible, allowing producers to quickly respond to changes in
demand and price. Also, in the long run, more producers may enter the market, increasing
competitive pressure and encouraging them to be more responsive to change in demand and price,
making PES elastic. Furthermore, supply may have become elastic as factors of production may have
become more geographically and occupationally mobile, making it easier for producers to quickly
alter production by employing more resources. 

  

2b) price elasticity of demand (PED) is a numerical measure of responsiveness of demand to a

change in price. Cross elasticity of demand (XED) is a numerical measure of responsiveness of the
quantity demanded of A to a change in price of product B. Knowledge about PED may be very
beneficial to a manufacturer. It will allow the producer to set prices and change them in order to
raise revenue. For example, if demand is elastic, a firm will want to maintain low prices or further
lower prices from existing levels as it will increase revenue. This is because change in demand will be
higher than change in price. Information about PED will even help a firm implement a price
discrimmination policy to different consumers based on differences in their PED. So, this will allow
the smartphone producer to maximise revenue from every consumer group. For example,
children/elderly are likely to have elastic demand, charging them lower for smartphones and
business people may have inelastic demand, encouraging producers to charge them
higher. Knowledge about XED will help a business identify its competitors. It will help the
smartphone producer understand the effect of a change in competitors strategies, to that of sales of
their smartphone marketing and promotional strategies and help understand how effective they will
be when compared to that of competitors. XED will even help producers understand complements
of their smartphones like earphones, chargers, encouraging them to expand their production and
profits. But, both PED and XED calculations are based on the ceteris paribus assumptions which may
not stand true in real life. Also, they are based on past calculations, which may not be accurate
representations of future market conditions, given the dynamic structure of the markets. Overall, for
a smartphone manufacturer, I believe knowledge of XED will be of greater importance as it is
something that the smartphone producer doesn’t have control over. However, PED is something the
producer has direct control over, in terms of how they devise their pricing strategies. They do not
have control over their competitors actions.       

3a) Inflation is the sustained rise in the general price level of an economy. A high rate of inflation
means domestic goods are less internationally competitive as their price is high. This means that
demand for exports is low, leading to fall in demand and sales for producers from foreign markets.
Also, a high rate of inflation will increase a producer’s menu costs as they will have to keep altering
prices on menu cards and catalogues. This will lead to a fall in profits for the business. Also, inflation
will encourage workers to press for higher real wages, leading to higher costs of production. This will
cause a wage-price spiral where inflation will lead to further inflation. Also,  a very high rate of
inflation creates uncertainty in the economy making it difficult for producers to plan ahead in terms
of investment in capital goods like machinery and advanced technology. Inflation leads to a fall in
purchasing power, making it difficult for people on fixed incomes like pensions, savings to fulfil their
daily requirements causing a fall in their living standards and rise in poverty. Also, it increases shoe
leather costs as savings keep moving their money in search of banks with interest rates higher than
the inflation rate. Also, if tax brackets are not adjusted for inflation, it leads to fiscal drag. This means
that workers are forced into higher tax brackets due to a rise in their nominal income which leads to
a fall in their real incomes, lowering purchasing power and standards of living. 

  

3b) Inflation is the sustained rise in the general price level of an economy. Interest rates are a reward
for saving and a cost for borrowing. These are implemented as a part of the government’s monetary
policy. Increasing interest rates is a part of the country’s contractionary monetary policy which may
be implemented to overcome inflation. When interest rates rise, incentives on savings and costs of
borrowing increase. This encourages consumers to save more, lowering spending. This inturn,
reduces the ‘C’ component of AD, contributing in lowering demand-pull inclination. Plus, as the cost
of borrowing rises, consumers borrow less leading to a fall in their purchasing power. This, further,
reduces AD and lowers demand-pull inflation. Also, when interest rates rise, businesses reduce their
investment as cost of borrowing increases, leading to a fall in the ‘I’ component of AD, lowering
demand-pull inflation. Furthermore, with increased interest rates, the amount of hot money flowing
into the country rises as return on investment is high. This leads to a rise in demand for the country’s
currency, leading to its appreciation. This will, intrun, make exports more expensive, leading to a fall
in their demand. It will help lower the (X-M) component of AD, reducing demand pull inflation. But,
using interest rates as a method to correct inflation may not always be effective. When interest rates
rise, businesses face higher production costs as costs of existing loans increase. This encourages
producers to raise prices in order to maintain profit margins, causing a rise in cost-push inflation.
Also, increased interest rates encourage businesses to postpone investment plans as borrowing
becomes expensive. This leads to reduction in the productive capacity of the economy, leading to fall
in GDP. Also, rising interest rates is an expenditure reducing measure, aiming to lower AD, which
means it slows down the growth of the economy. This encourages producers to restrict supply and
make workers redundant, leading to increased unemployment and the risk of recession. Overall,
interest rates may be effective in reducing inflation in the short run, given that it was high and
unexpected inflation, when compared to supply side policies as they have a very long time lag of 12-
18 months, they are a quicker measure than supply side policies. Although, the effectiveness of 
interest rates depends on the type of inflation. Higher interest rates will help overcome demand pull
inflation but will exacerbate the problem of cost push inflation. In order to tackle cost push inflation,
supply side policies should be used. 

   

4a) Comparative advantage is a situation where a country can produce at a lower opportunity cost
than another country. Free trade is when international trade is not restricted by tariffs and other
protectionist measures. The theory of comparative advantage only looks at two goods/services,
which may not be realistic as an economy may produce a wide range of products and trade them
internationally. Also, this makes it impossible for a country to identify its comparative advantage in
just one product. Furthermore, to identify the one product, the economy will have to calculate its
opportunity cost for every good and service it provides which is impossible and not cost effective.
Plus when identifying the comparative advantage of a country, transportation costs of exporting it to
another country is ignored. Whereas, for free trade to occur, transportation cost is one of the most
important factors. Also, the theory of comparative advantage doesn’t include exchange rate
fluctuations. Appreciation or depreciation of a currency may alter the comparative advantage as
appreciation may make it internationally more expensive. Plus, depreciation will make imports
expensive, altering the costs of production as imported raw materials become expensive, increasing
the opportunity cost. Also, if a country trades and specialises in a product with its comparative
advantage, the industry may face diseconomies of scale which will raise a firm’s production costs
and increase its opportunity cost. This is ignored while identifying the comparative advantage.** 

  

4b) Tariff is a tax imposed on imports. Through the imposition of tariffs, sun-rise industries in the US
like technological products and declining industries in China like soya beans will benefit as they will
not have  to face intense, international competition. It will allow the infant industries in the US like
technological products to grow and eventually develop a comparative advantage. This will help
improve GDP, employment and current account balance in the long run. Also, imposition of tariffs on
soya beans will help slowdown decline of sun-set industries in China, helping avoid a rapid fall in
GDP and rise in unemployment. Also, through imposition of tariffs, the US and China will be able to
avoid dumping and other unfair trade practices, allowing domestic producers to grow and benefit
from economies of scale in the future. Also, imposing tariffs will allow the US to protect its strategic
industries like steel from foreign competition, which is a necessary good for the economy.
Furthermore, it will help both China and the US to reduce their current a/c deficits as imposing tariffs
will make imports expensive, lowering their demand. Plus, doing so will generate revenue for the
government allowing them to spend it on education, healthcare and infrastructure, further helping
expand the country’s productive potential. But, as both the countries are utilizing the free trade
mechanism, their consumption will be limited to their domestic production capacity. As they are not
trading on the basis of comparative advantage, both the countries lose out the opportunity to trade
outside their PPC boundaries and improve the average living standards of the country. Plus,
exporters of both the countries will lose out as they will have access to limited markets. This will
encourage them to lower their output, reducing GDP. Furthermore, they will make workers
redundant, increasing unemployment. This will lead to a fall in incomes, increasing poverty and
worsening the standard of living. Also, as both countries are not focusing on their best capabilities,
they will not be able to fully utilize the scarce resources, indicating inefficiencies. Due to the
existence of inefficiencies there is likely to be a shortage or surplus leading to market failure. Overall,
from the imposition of tariffs, some people in China and the US will benefit, whereas some people in
both countries will lose out. But, the level of benefits incurred depends on the involvement of both
countries in international trade and their level of dependence on each other.
9708/23/O/N/19

Section A

1)a)i) Between 2012 and 2015, India’s inflation rate grew by a greater percentage (24.8%) whereas
China’s was relatively stable and had only a slight increase (6%) in its inflation rate.

ii) For BRICS economies like India, CPI  may not be a very accurate measure of inflation as it only
includes transactions in the formal economy. For a country like India, the informal economy will
have a major proportion of the GDP, which CPI calculations do not include, leading to inaccurate
results. Also, CPI doesn’t include illegal transactions and the subsistence economy which will lead to
undervalued GDP in developing countries like India as they will be major contributors to the total
demand of the country, as well as the country’s GDP.

b) Inflation is the sustained rise in the general price level of an economy. Inflation rates among the
BRICS economies may differ due to differences in exchange rates. If one of the country’s currency
depreciates, the price of their imported raw materials will rise, where a fall in AS is greater than a fall
in AD, increasing total costs of production and causing cost push inflation. Therefore, the country
with a depreciated currency will have a higher inflation rate than other BRICS economies. Also,
differences may occur due to differences in interest rates. One of the BRICS economies may have
lower interest rates than others, increasing their AD as consumption and investment will rise. This
will lead to demand-pull inflation in that country as AD will be greater than AS. in this case, the
country with low interest will have a higher inflation rate than other economies.

c)i) China’s terms of trade between 2015 and 2016 has worsened. The index fell from 117 to 93 by
24 points.

ii) The terms of trade may have worsened due to a depreciation of the Chinese currency. This might
have caused export prices to fall relative to import prices, worsening the terms of trade.

d) There are various factors that determine how successfully India will be able to compete with
China. One main factor is the inflation rates in both countries. If India’s inflation rates are higher
than China’s, their goods are likely to be more expensive in international markets than China,
lowering India’s international competitiveness. The ability to compete even depends on the relative
changes in exchange rates. If India’s currency depreciates, its exports will become cheaper in
international markets than that of China, increasing India’s ability to compete and its international
competitiveness. Also, the productivity of factors of production in both countries also influences
their ability to compete as it will determine the quality of products and relative costs incurred in
production. If India’s factors of production productivity is greater than China’s, the quality of their
products will be higher, improving their international competitiveness. Overall, the most important
factor is the elasticity of goods from China compared to the elasticity of goods from India.

Section B
2a. Demand is the willingness and ability of a consumer to buy a product. Supply is the willingness
and ability of a producer to sell a product. An increase in demand for chocolate caused a right shift in
the demand curve from D-D1. This led to a rise in price (P-P1) and an extension in quantity supplied
(Q-Q1) as producers found it more profitable to supply chocolates encouraging them to raise their
supply.  But, as supply of cocoa beans fell, which is an ingredient required in production of
chocolate, suppliers were forced to lower their supply, causing a left shift in the supply curve from S-
S1. As supply fell and demand rose, there was a shortage in the market. This led to a further increase
in price, in order to establish an equilibrium point. But, its effect on quantity traded depends on the
extent of change of both demand and supply following the changes. This led to a further rise in price
to P2 and fall in quantity traded to Q2.

2b. Demerit goods are goods which have negative side effects when consumed. Chocolate may be an
example of a demerit good. In order to reduce consumption of chocolate the government can use a
variety of different policies. The government can impose an indirect sales tax on the production of
chocolate. This will lead to an increase in total costs of production for chocolate producers, causing a
left shift in the supply curve. This will in turn encourage producers to lower supply, further leading to
an increase in price of chocolate for consumers. As it becomes expensive for both producers and
consumers, consumption and production of chocolate may fall, reducing the negative externalities
which are caused by it, like obesity and diabetes. But, chocolates are likely to be very addictive in
nature, due to which their demand may be inelastic. This means that imposing a tax on chocolate
may not help reduce its consumption as the percentage change in price will be greater than the
percentage change in demand. This means that very few consumers will stop purchasing chocolates
after an increase in its price, making the tax ineffective. The government can even choose to run
awareness campaigns on the internet and social media platforms to inform young children about the
health problems with the over consumption of chocolate. Using social media may be highly effective
as it will make it easier for the government to target the younger population and it will be much
cheaper. Also, as the main reason for over consumption of chocolate is the information failure, it
may encourage children to reduce its demand and switch to healthier substitutes. But, these
campaigns may not always be effective. Their effectiveness depends on the government's ability to
fund them and implement it in convincing and persuading ways. Overall, awareness campaigns may
be a better method to help reduce the over consumption of chocolate as it will help tackle the direct
problem leading to the overconsumption which is information failure.

3a. Aggregate demand is the total spending on an economy’s goods and services over a given time
period. AD = C+I+G+(X-M). Aggregate supply is the total output that producers are willing and able to
sell in a given time period in an economy. An increase in investment in the country’s railways system
will help increase AD as the ‘Investment’ and the ‘Government spending’ component rises. This
leads to a rise in price, further leading to an increase in the real GDP of the economy. In order to
increase GDP, producers will have to employ more people, leading to an increase in the employment
rates.

An increase in investment on Indian railways will even cause a rise in the AS in the long run, as
infrastructure in the economy improves. This will help lower the cost of production for businesses,
encouraging them to increase output. As AS increases, employment in the economy will rise and
there may be an increase in the price level. But, the extent to which the price rises in the economy
depends on how close it is to full employment.

In the short run, increased investment will cause a shift of the AD curve (AD-AD1) leading to increase
in price (P-P1) and output (Y-Y1). In the long run, AS will increase (AS-AS1) causing a fall in price level
(P1-P2) and a further rise in GDP (Y2-Y3). Overall, with an increase in investment, both AD and AS
will rise in an economy, which will lead to increased employment and GDP.

b. Privatisation is the sale of a state-owned public sector business to the private sector. Using
privatisation for rail travel will help reduce government intervention in the economy. It helps reduce
the bureaucratic system of the economy and is a process towards a market economy. A privatised
business is likely to be more efficient as their main aim is profits. Due to the competitive pressure,
businesses will aim to minimize costs and increase productivity. This will further encourage them to
lower prices, leading to higher consumer surplus. Also, it will increase the choice available to
consumers as when privatised, it will face high competitive pressure. Plus, due to the competitive
pressure, businesses will be encouraged to be more innovative and creative, enhancing the quality
of service provided. Furthermore, selling of the railways will generate greater revenue for the
government, helping reduce its opportunity cost. It will increase funds available to the government
for spending on education, health care, etc. But, the privatised industry may be a monopoly, which
may encourage it to exploit customers, employees and suppliers due to the lack of competitive
pressure. This may lead to higher prices and fall in efficiency as the business may be a price maker.
Also, the privatised industry may but consider the negative externalities and may not operate in
public benefit. They may only consider the private costs and benefits, which will lead to higher social
costs, causing market failure in the economy.  Nationalisation occurs when governments take over a
private sector business and transfer it to the public sector. A nationalised industry is likely to be a
monopoly so it may enjoy economies of scale. This means that average costs for each rail trip will
fall, leading to lower prices for consumers. Furthermore, it will consider all externalities in its
decision making process. Before making any decision, the government is likely to conduct a cost
benefit analysis and only make decisions which are in public benefit. But, due to lack of competitive
pressure, it may be managed efficiently. Also, innovation will be discouraged due to which the
quality of the railway service may be poor. Moreover, it will be funded through government
revenue, due to which there will be an opportunity cost. The government could’ve used this money
elsewhere, which could be of greater public benefit, like education and healthcare. Overall, it may be
in the public benefit for the economy if railways are operated by the government as it is a strategic
industry and be controlled by the government. Furthermore, it will avoid duplication of scarce
resources like rail tracks, trains, etc. But, it depends on whether the privatised industry will be a
monopoly or not.

4a. The current account is a record of the trade in goods, trade in services, investment income and
current transfers within the balance of payments of an economy. A current account deficit occurs
when the expenditure on imports exceeds the revenue earned from exports. A current account
deficit may occur due to high inflation rates in the country when compared to other, competing
countries. If this occurs, demand for the country’s agricultural goods will fall as they will become
more expensive due to a loss of international competitiveness. This will further lead to a fall in the
total export revenue earned by the economy, leading to a worsened current account deficit. Also, as
inflation rate is high, domestic consumers may find it easier and cheaper to import goods from other
countries rather than purchase them in the home country, leading to a rise in import expenditure,
further increasing the deficit. Another reason for a current account deficit to develop may be a fall in
productivity of factors of production. A fall in productivity will lead to an increase in the total costs of
producing agricultural products, leading to an increase in the price and a fall in its quality. This will
lead to lost international competitiveness, encouraging international customers to switch to
competitors, leading to a fall in export revenue and worsened current account
balance. Furthermore, if developed countries impose trade barriers like tariffs and quotas on the
country’s agricultural products, it will further increase their prices, causing a fall in demand. This will
cause a fall in export revenue and therefore the current account balance.

4b. Current account deficit occurs when import expenditure exceeds export revenue. In order to
reduce the current account deficit, the US government can implement fiscal, monetary or supply-
side policies. In order to reduce the currency account deficit, the US government can adopt
contractionary fiscal policy measures which includes increased taxation and reduction in government
spending. Increase in tariffs will make imports into the US economy more expensive, encouraging
consumers to lower spending on imports and switch to exports. As import expenditure falls, current
account balance will improve. Also, increase in taxation will reduce consumers' disposable incomes
helping lower their purchasing power. This will in turn lead to reduced spending on imports,
lowering import expenditure and improving the balance of payments position. Furthermore,
reduction in purchasing power will reduce domestic demand, allowing producers to increase
exports. As export revenue increases and import expenditure falls, the current account will be
improved. But, this is an expenditure-reducing method, which aims to lower AD, which will increase
the risk of recession and bad deflation. If the fall in domestic demand is not offset by exports, there
will be a fall in economic growth and rise in unemployment in the US economy. The government can
even use contractionary monetary policies, which involves increased interest rates, reduction in
money supply and depreciation of the currency. Depreciation of the currency will make imports
more expensive in the domestic market and exports cheaper in international markets. As imports
become more expensive, people will switch to domestic producers, lowering total import
expenditure. Also, as exports are cheaper in international markets, international competitiveness
will increase, leading to a rise in demand for the country’s exports, increasing total export revenue.
Increased export revenue and a fall in import expenditure will lead to a fall in the current account
deficit, improving the balance of payments. But, it will increase the risk of inflation. As demand for
exports rises, (X-M) component of AD will increase, leading to price rises and causing demand pull
inflation. Increasing interest rates may also help reduce the current account deficit as it will make
borrowing more expensive and increase the return on savings, encouraging people to save. As
people’s purchasing power falls, the C component of AD reduces, leading to a fall in import
expenditure. But, this is an expenditure-reducing method which may lead to recession and
unemployment in the long run. The government can even use supply-side policy measures to reduce
current account deficit.  Supply side policy measures are designed to increase aggregate supply (AS).
Supply side policy measures may include increased education and training, privatisation,
deregulation, labour market reforms, tax incentives, etc. Increase in education and training helps
improve labour productivity, improving the quality of output produced, leading to increase in
international competitiveness. This will even lead to an increase in exports from the US, , improving
their current account balance. But, this will only be effective if the quality of education and training
provided rises. Also, such policies are expensive and their effectiveness depends on the
government’s ability to fund them. Overall, the type of policy used by the US government depends
on the cause of the current account deficit. A cyclical deficit is not likely to be a problem for the
government, but a structural deficit will require government intervention to be corrected. Therefore,
for a structural deficit, the government should adopt supply side policies because it will directly help
tackle problems which are causing a fall in the country’s international competitiveness.