2017 Case Study Question 2

a) A fall in interest rates will lead to a fall in the costs of borrowing. When this happens, the number of profitable planned investments will rise which will lead to an increase in investment. Extract 4 (Paragraph 6) states that investment was expected to pick up during 2015 partly as a result of expansionary monetary policy which works through cutting interest rates.

b) According to Table 4, the rate of inflation in China was falling from 2011 to 2015. In that period, the general price level in China was rising at a slower rate.

c) When the US economy strengthens, national output and hence national income will rise which will lead to an increase in imports. As the US is an export market of China, China’s exports will rise which will lead to an increase in aggregate demand. When this happens, national output will rise which will lead to higher economic growth. Table 3 shows that exports account for over 20 per cent of aggregate demand in China which indicates that an increase in exports is likely to lead to a large increase in aggregate demand and hence national output. Draw a diagram showing AD shifting rightwards.

d) A fall in exports to China will lead to a decrease in aggregate demand which will lead to a fall in national output resulting in a rise in unemployment. Singapore has diverse trade links due to factors such as an extensive shipping network and hence is dependent on exports to China to a small extent. Therefore, a fall in exports in Singapore to China will only decrease its total exports to a small extent resulting in a small decrease in aggregate demand. Table 5 shows that a whopping 14.6 per cent decrease in China’s imports will only lead to an estimated US$2.16b decrease in Singapore’s exports which accounts for only a small proportion of its total exports of over S$700b. If the US and European economies are strengthening, their imports will increase which will lead to an increase in Singapore’s exports to the economies. As these economies are large export markets of Singapore, a fall in exports in Singapore to China is unlikely to decrease its total exports and hence aggregate demand.

e) To restructure the Chinese economy to one which is consumption-driven, the government can decrease income taxes or increase transfer payments to increase disposable income. When disposable income rises, households will increase consumption which will lead to an increase in aggregate demand resulting in higher economic growth. Extract 4 (Paragraph 6) states that consumption was expected to pick up during 2015 partly as a result of expansionary fiscal policy which typically involves a decrease in income taxes.

Limitations:

  1. China has a low MPC due to the culture of thrift and hence a rise in disposable income may not lead to a significant increase in consumption. Table 3 shows that consumption as a proportion of GDP in China decreased in the period from 2000 to 2014 which is a likely indication of a culture of thrift.
  2. Decreasing income taxes or increasing transfer payments may lead to a budget deficit and this will lead to an increase in the public debt-to-GDP ratio which has been rising in China.

The PBOC can decrease interest rates by increasing the money supply. A fall in interest rates will lower the incentive to save and the costs of borrowing resulting in an increase in consumption. When this happens, aggregate demand will rise which will lead to higher economic growth. Extract 4 (Paragraph 6) states that consumption was expected to pick up during 2015 partly as a result of expansionary monetary policy which works through cutting interest rates.

Limitations:

  1. China 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 3 shows that consumption as a proportion of GDP in China decreased in the period from 2000 to 2014 which is a likely indication of a culture of thrift.
  2. Expansionary monetary policy cannot be used to achieve long-term growth of consumption due to the problem of liquidity trap as interbank rates cannot be cut indefinitely.

The PBOC can revalue the yuan by buying domestic currency and selling foreign currency in the foreign exchange market. A rise in the exchange rate in China will lower the extent of the increase in the prices of imports in domestic currency resulting in lower imported inflation. As imported inflation is a major cause of inflation in China due to the high level of imports, the rate of inflation is likely to fall significantly. Table 3 shows that imports account for nearly 20 per cent of aggregate demand in China. This may increase the real value of the wealth of households which will lead to an increase in consumption and hence aggregate demand resulting in higher economic growth.

Limitations:

  1. A rise in the exchange rate will lead to a fall in export competitiveness resulting in a fall in exports. Table 3 shows that exports account for over 20 per cent of aggregate demand in China which indicates that a decrease in exports is likely to lead to a large decrease in aggregate demand and hence national output.
  2. Table 4 shows that inflation in China in 2015 was only 1.4 per cent which was well below the official target of 3 per cent stated in Extract 5 (Paragraph 3) and this means that a fall in inflation will make the big gap even bigger.

Evaluation: Whether the Chinese government will be successful in its attempt to restructure the economy to one which is consumption-driven will depend on the policies adopted. The Chinese government should adopt a policy mix rather than rely on any single policy as this will allow the strengths of some policies to compensate for the limitations of other policies. Furthermore, the policy mix adopted should include policies which will reduce the need to save for old age as it is a major factor that has contributed to the high savings in China. This could mean further relaxation of the one-child policy which will enable the elderly to be financially dependent on their children to a larger extent due to the increase in the number of children.

f) Expansionary monetary policy works through increasing the money supply. When the money supply in China increases, the amount of bank reserves will increase which will lead to a fall in interbank rates resulting in a fall in interest rates. A fall in interest rates will lower the incentive to save and the costs of borrowing resulting in an increase in consumption. A fall in the costs of borrowing will lead to an increase in the number of profitable planned investments. When this happens, aggregate demand will rise which will induce firms to increase production resulting in an increase in national output. Table 3 shows that consumption and investment are the two largest components of aggregate demand in China which indicates that an increase in consumption and investment is likely to lead to a large increase in aggregate demand and hence national output. When firms increase production they will employ more factor inputs from households and therefore will pay them more factor income which will lead to an increase in national income. When national income in China increases, households will increase consumption which will lead to an increase in imports of consumer goods. Extract 6 (Paragraph 2) states that China imports a large amount of luxury consumer goods from European countries. When firms in China increase production, they will import more capital goods and intermediate goods. Extract 6 (Paragraph 2) states that China imports intermediate goods which include gas, metals and other primary materials from regions which include Asia, Africa and South America. An increase in China’s imports will lead to an increase in the exports of the trading partners. When this happens, aggregate demand in the trading partners will rise which will lead to an increase in national output and hence national income resulting in a fall in unemployment.

Although an increase in aggregate demand in China’s trading partners will lead to an increase in national output, it will lead to a rise in the general price level resulting in higher inflation. This is undesirable particularly if the economies are overheating where aggregate demand is rising rapidly relative to aggregate supply resulting in high inflationary pressures.

China 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 3 shows that consumption as a proportion of GDP in China decreased in the period from 2000 to 2014 which is a likely indication of a culture of thrift. China may have a low interest elasticity of investment as a large proportion of investment is foreign direct investment which is made by foreign firms with foreign sources of funds and hence a fall in interest rates may not lead to a significant increase in investment. In addition, a fall in interest rates in China may not lead to a significant increase in investment due to the problem of over-capacity which is stated in Extract 5 (Paragraph 4). Due to these reasons, expansionary monetary policy in China may not lead to a significant increase in national and hence national income and hence may not affect the trading partners significantly.

When interest rates in China fall, hot money inflows and therefore the demand for yuan in the foreign exchange market will decrease. When this happens, the yuan will depreciate. A fall in the exchange rate in China will make the trading partners’ goods and services relatively more expensive than China’s goods and services. When this happens, exports in China’s trading partners to China will fall which will lead to a decrease in exports in the trading partners resulting in a fall national output and a rise in unemployment. Table 3 shows that imports account for nearly 20 per cent of aggregate demand in China, and coupled with the fact that China is the second largest economy in the world, China is a large export market of its trading partners. This indicates the fall in exports in China’s trading partners to China is likely to lead to a large decrease in aggregate demand and hence national output in the trading partners.

Evaluation: Although expansionary monetary policy in China may have a significant beneficial effect on the trading partners in the short term, it will not be the case in the long term due to the problem of the liquidity trap as interbank rates cannot be cut indefinitely. In the long term, what affects China’s trading partners to a larger extent is the success or failure of the government in its attempt to restructure the economy to one which is consumption-driven. This is because consumption is only 35 per cent of GDP largely due to the high savings which is far below the consumption/GDP ratio of 70 per cent in the US. Therefore, with the right policies, the Chinese government will be able to increase consumption at a fast rate for a long period of time which will benefit its trading partners to a large extent.

A more elaborate answer to 2017 Case Study Question 2 will be provided in economics tuition.

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