(b) Explain 2 reasons why low and stable inflation is desirable.
· Investment Spending – As companies can predict future revenues and costs with less uncertainty/more confidence there are higher levels of investment spending.
· Export Competitiveness – as PL (price levels) doesn’t change export sells are more competitive so trade deficits do not widen creating BOP (balance of payment) problems/ export-driven growth is maintained.
· Income Inequality Stability – money wage earners and recipients of transfer payments do not suffer a decrease in their purchasing power as they usually cannot negotiate higher wages/payments (income inequality doesn’t widen).
· Price Mechanism Efficiency – efficiency of the price mechanism is maintained permitting efficient allocation of resources.
· Lenders Loss – so income is not redistributed from lenders to borrowers, so that lenders (banks) do not charge unnecessarily high interest rates/ so that borrowing is not excessively encouraged.
· Borrowers Loss – so income is not redistributed from consumers to other groups such as banks, shareholders or producers who would benefit from higher profits (or so income inequality does not widen)
· Currency Depreciation – which leads to higher import prices and production costs.
· Deflationary Spiral – prices and profits keep falling.
· Deflationary Gap – decrease in economic activity and higher unemployment or bankruptcies.
(c) State 2 functions of a country’s Central Bank.
· Regulator of commercial banks.
· Banker to the government/ managing government finances
· Conducting monetary policy/ control of interest rates/ control of money supply/ maintenance of price stability (control of inflation)
· Exchange rate policy.
· Holder of foreign exchange reserves
· Issuer of notes and coins
· Promoter of full employment
· Banker to the commercial banks
· Lender of last resort
(d) Using the data in table 1, identify 2 reasons many economists would consider Country A’s economy to be performing badly in 2012.
High Unemployment and Deflation.
The unemployment rate is 7% considered high and deflation is thought of as a negative.
Deflationary spirals may occur continually lowering price and profits.
(e) State 1 reason why monetary policy is considered to have limited effectiveness in increasing aggregate demand if an economy is in deep recession.
· Interest Rates are already close to zero (Monetary tool of lowering interest rates to stimulate the economy cannot be used)
· Spending depends on confidence/ indebtedness as well as interest rates (“You can lead a horse to water but you can’t make him drink” if citizens are afraid of the future they will be unwilling to take on additional debt no matter how low the interest rates are lowered)
· Money demand may be highly sensitive (flat) with respect to interest rates.
Investment/Consumption may not be sensitive to changes in interest rates.
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