2016 Case Study Question 2

a) According to Table 2, between 2011 and 2012, consumer prices in Brazil were rising as inflation was positive. In the same period, consumer prices in Japan were falling as inflation was negative.

b) An increase sales tax will lead to a rise in the cost of production. When this happens, the supply will fall which will lead to a rise in the price and a fall in the quantity demanded. The extent of the rise in the price of a good will depend on the price elasticity of demand. For example, the demand for agricultural products is price inelastic due to the high degree of necessity and hence the price is likely to rise by a large extent. Extract 5 (Paragraph 1) states that the prices of fresh food are volatile which is a likely indication of a low price elasticity of demand. Draw a diagram with a relatively steep demand curve and the supply curve shifting leftwards. In contrast, the demand for private cars is price elastic due to the large proportion of income spent on the good and hence the price is likely to rise by a small extent.

ci) An increase in consumption expenditure and government expenditure on goods and services will lead to an increase in aggregate demand resulting in a rise in the general price level and hence higher inflation. According to Extract 4 (Paragraph 2), consumption expenditure in Brazil increased due to an increase in the consumer market as millions moved out of poverty, and according to Extract 4 (Paragraph 3), consumption expenditure in Brazil increased due to an increase in the cash welfare benefits given by the government that increased disposable income. It is also stated in the same paragraph that the Brazilian government was increasing spending. According to Extract 4 (Paragraph 3), measures to maintain high employment were increasing labour costs. A rise in labour costs will lead to a rise in the cost of production in the economy which will lead to a decrease in aggregate supply resulting in a rise in the general price level and hence higher inflation. Draw a diagram showing AD shifting rightwards and AS shifting leftwards.

cii) When the US and the EU economies strengthen, national output and hence national income will rise which will lead to an increase in imports. According to Extract 4 (Paragraph 5), when the US and the EU economies get stronger, they will import more. As the US and the EU are exports markets of Brazil, Brazil’s exports will rise which will lead to an increase in aggregate demand. When this happens, the general price level will rise which will lead to higher inflation.

d) According to Extract 5 (Paragraph 1), excluding the effect of the increase in the sales tax, core inflation in Japan in July 2014 would be only 1.3% which was below the official target of 2% which the central bank pledged to meet in the following year. According to Extract 5 (Paragraph 4), firms continued to cut back on production which would lead to a fall in national output. A fall in national output will decrease the demand for labour in the economy which will lead to a rise in unemployment and this is stated in Extract 5 (Paragraph 5).

In order to solve the problems in Japan, the central bank can use expansionary monetary policy. An increase in the money supply through an open market operation will lead to an increase in bank reserves which will reduce interbank rates and hence the level of interest rates in the economy. When this happens, the incentive to save and the costs of borrowing will fall which will induce households to increase consumption. A decrease in the costs of borrowing will also lead to an increase in the number of profitable planned investment which will induce firms to increase investment. When consumption expenditure and investment expenditure increase, aggregate demand will rise which will lead to a rise in inflation and national output and a fall in unemployment. According to Extract 5 (Paragraph 2), consumption expenditure fell more than expected which indicates that cutting interest rates to increase consumption expenditure may be effective for increasing solving the problems in Japan. A fall in interest rates will lead to a decrease in hot money inflows and an increase in hot money outflows. This will lead to a decrease in the demand for domestic currency and an increase in the supply resulting in a fall in the exchange rate. When the Japanese yen depreciates, Japan’s goods and services will become relatively cheaper than foreign goods and services which will lead to an increase in net exports resulting in an increase in aggregate demand. According to Extract 5 (Paragraph 2), exports were disappointing which indicates that cutting interest rates to increase exports may be effective for solving the problems in Japan. A fall in the exchange rate in Japan will also lead to a rise in the prices of imports in domestic currency resulting in higher imported inflation. This is particularly true in view of the high level of imports.

Japan has a low interest elasticity of consumption due to the culture of thrift and hence a fall in interest rates may not lead to a significant increase in consumption. Table 2 shows that inflation in Japan was either negative or low between 2009 and 2014 which is a possible indication of a culture of thrift. This is particularly true in view of the fact that consumption is the largest component of aggregate demand in Japan. Japan may have a low interest elasticity of investment due to the problem of over-capacity and hence a fall in interest rates may not lead to a significant increase in investment. Extract 5 (Paragraph 4) states that firms continued to cut back on production which may lead to over-capacity. Due to these reasons, expansionary monetary policy may not lead to a significant increase in aggregate demand and hence may not solve the problems in Japan. The overnight call rate, which is the overnight interbank rate in Japan, is near zero. In other words, Japan is in a liquidity trap. Therefore, an increase in the money supply will not lead to a significant fall in the overnight call rate and hence will have limited effect on aggregate demand and hence inflation, national output and unemployment.

Evaluation: Cutting interest rates is not an effective policy for solving the problems in Japan due to the problem of liquidity trap. Nevertheless, the central bank of Japan should continue to keep interest rates low to maintain a low incentive to save and low costs of borrowing. In addition, as Japan has a public debt-to-GDP ratio of about 200% which is the highest in the world, the scope for the use of expansionary fiscal policy is limited. Instead, the Japanese government should focus its effort on innovations such as in the area of artificial intelligence. This will help increase exports which will lead to an increase in aggregate demand resulting in a rise in inflation and national output and a fall in unemployment. Such a measure is feasible in Japan due to its high level of research capability.

e) The Brazilian government may have a more damaging and persistent inflationary problem. According to Extract 4 (Paragraph 1), the inflation rate in Brazil in June 2014 was 6.52% which exceeded the target range of 2.50%-6.50%. When inflation is high, nominal interest rates on savings will not fully compensate for the substantial rise in the general price level. When this happens, the same amount of savings will allow individuals to buy only a smaller amount of goods and services which will reduce the real value of savings. When inflation is high, domestic goods and services may become relatively more expensive than foreign goods and services. If this happens, net exports will fall which will. A decrease in net exports will lead to a decrease in aggregate demand which will lead to a decrease in national output and hence national income resulting in a rise in unemployment. This is particularly undesirable in Brazil in view of the fact that the Brazilian economy is a developing economy which is highly dependent on exports.

The problem of high inflation in Brazil may be difficult to solve. In order to decrease inflation, the central bank of Brazil can decrease the money supply to raise interbank rates and hence the level of interest rates in the economy to decrease the growth of consumption and investment which will lead to a decrease in the growth of aggregate demand and hence lower inflation. However, according to Extract 4 (Paragraph 2), although the central bank of Brazil raised the interest rate from 7.25% in April to 11% in April 2014, the inflation rate exceeded the target range of 2.50%-6.50% in June 2014. According to Extract 4 (Paragraph 3), rising government expenditure on goods and services and transfer payments which will increase aggregate demand and hence inflation in Brazil are contributing to inflation which means that the government can reduce expenditure to reduce inflation. However, according to Extract 4 (Paragraph 4), the manufacturing sector in Brazil is in a slump. Therefore, reducing government expenditure to reduce the growth of aggregate demand and hence inflation will worsen the manufacturing slump which may result in a fall in national output. This is also true if contractionary monetary policy is used to reduce inflation which is stated in Extract 4 (Paragraph 5).

The Japanese government may have a more damaging and persistent inflationary problem. According to Extract 5 (Paragraph 1), excluding the effect of the increase in the sales tax, core inflation in Japan in July 2014 would be only 1.3% which was below the official target of 2% which the central bank pledged to meet in the following year. Due to several reasons such as falling sales, firms may need to cut real wages to avoid closure. In the absence of inflation, they will need to cut nominal wages in order to cut real wages. However, as cutting nominal wages is difficult due to factors such as the existence of employment contracts and trade unions protecting the standards of living of their members, this means that the absence of inflation will make it harder for firms to cut real wages which will lead to more firm closures and hence more job losses resulting in higher unemployment. In contrast, if there is some inflation, say 2 per cent, firms will be able to cut real wages without cutting nominal wages. This is because when firms keep nominal wages constant at a time when the prices of goods and services are rising, they are effectively cutting real wages. This means that the presence of some inflation will make it easier for firms to cut real wages which will lead to fewer firm closures and hence fewer job losses resulting in lower unemployment. With an inflation rate of only 1.3% which limits downward flexibility in real wages in Japan, unemployment will be higher.

In order to increase inflation, the central bank of Japan can increase the money supply to lower interbank rates and hence the level of interest rates in the economy to increase consumption and investment which will lead to an increase in aggregate demand and hence higher inflation. However, as discussed earlier, Japan has a low interest elasticity of consumption and possibly a low interest elasticity of investment. Coupled with the problem of liquidity trap, an increase in the money supply may not lead to a significant increase in aggregate demand and hence may not increase inflation significantly. In order to increase inflation, the Japanese government may increase expenditure or reduce direct taxes to increase aggregate demand to increase inflation. However, Japan has a public debt-to-GDP ratio of about 200% which is the highest in the world. Therefore, the scope for the use of expansionary fiscal policy to increase inflation is limited.

Evaluation: The Brazilian government is likely to have a more damaging inflationary problem. The costs of high inflation are generally higher than the costs of unhealthily low inflation as the former include a decrease in export competitiveness and a fall in the real value of savings which are very detrimental. This is particularly true in Brazil due to the high dependence of the economy on exports. In contrast, the Japanese government is likely to have a more persistent inflationary problem. The Japanese government has for decades been trying to increase inflation to achieve the official target. However, despite much effort, little success has been achieved. This is largely due to the culture of thrift which the Japanese government is unable to change, at least not significantly.

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