Answers to ACJC 2010 H2 Case Study Question 2

a. Explain meaning of the ‘balance of payment’ of an economy. [2]

The balance of payments is a record of all economic transactions between residents of an economy and the rest of the world.

It comprises transactions in goods and services, income flows, transfers, as well as capital and financial flows.

It is very useful for assessing the external performance of an economy and for formulating policies connected with it.

b. (i)With reference to the data, analyse the relationship between private consumption expenditure and the balance on current account in the United States from 1999 to 2009.

[3]

1999 – 2006: When pte consumption rises, the deficit in current account balance also rises.

Reason: The rise in pte C between 1999 and 2006 is fuelled by availability of credit and debt. Cheaper imports from China and other emerging economies widened the deficit further.

Post 2006: When pte consumption slows down (shown by the slower increase and then a fall in 2009), the current account deficit showed an improvement.

(ii) Why is the trend of widening trade deficit “worrisome”? [3]

Deficit has a contractionary effect on the economy Fall in AD, rising unemployment

Deficit may reflect a shortfall in export unemployment inefficiency in production and uncompetitive exports low incomes and wages

Losing out in global competition for trade and labour low growth rates

Debt problem: The country incurs a debt or has to draw down her reserves to finance the trade deficit

Outflow of currency and capital will lead to depreciation of exchange rates, and increasing import prices inflationary pressure from imports

future rises in interest rates possible.

c. Examine the effects of China’s rising current account balance on her economy. [4]

Increasing trade surplus from 2005-2007 Pressure for Chinese currency to appreciate loss of competitiveness Optimism may lead to over-investment by firms, as has been shown to happen. Over-capacity

results. (AS shifts right Unemployment may result if Chinese economy has to cut back on production)

Rising income and affluence may lead to over-heating. However, Chinese lack of consumption may reduce inflationary pressure

d. Consider the impact of the reduction in consumption in the United States on the Singapore economy.

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Examine the extent of dependency of the Singapore economy on the US (Table 2)o 7% of Singapore’s exports are to the United States. This share has probably been

relatively reduced by the -15.3% change over 2007.o 11.7% of imports were from the United States. There is a growth of 8.6% over 2007.

Direct impact of a fall in consumption in the US:o Demand for Singapore’s exports by the US continues to fall further

Evaluation: Despite the fall in % growth in exports to the US, the overall exports growth shows a positive sign. This could mean that demand from the other regions and countries remain stable and strong, and the fall in growth of exports to the US has been offset.

Indirect Impact:o Effect of US fall in consumption on demand for Chinese goods.

How Chinese exports could be affected, and thus Chinese demand for Singapore exports could be affected too (domino effect, contagion effect, etc) – and China represents more than 10% of share of Singapore’s exports.

Evaluation: Extent of indirect impact depends on the extent that the many countries affected by the

fall in US’ consumption would demand less of Singapore’s exports. Highlight the share of exports to specific countries in Table 2.

e. Assess whether, on balance, the net capital outflows from other regions of the world into the United States has benefited her economy.

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Approach:Students would need to provide a balanced analysis of the impact of capital inflows into the US economy. There will be benefits to the economy, but there will also be problems that the economy would face when there is too much capital flowing into it. How the situation pans out could depend on the nature of the capital flow, the presence or absence of structures that could channel the capital to good use, or the conditions that support or hinder stable economic progress. An unbalanced global situation (the probable source of funds) could also negatively affect the US economy.

Why capital flows in to the US? Better economic prospects in the long-term, offering higher returns to investment Offer of higher interest rates in US banks and on US Govt bonds. Students should identify whether the capital flows are short-tern or long-term.

Analysis of capital inflows into US:

1. Types of capital flows:

Short-term flows (hot money) can be de-stabilizing to the overall monetary policy objectives of the economy due to the fickleness of deposits.

Long-term flows are more stable, since funds are meant for investment and production. Sovereign funds (foreign government reserves) often are placed in long term

instruments like government bonds Institutional funds (privately and collectively owned) are generally short-term in nature,

and are more likely to be volatile.2. Discussion of impact on US economy:

Effects of capital inflow on interest rates in the US Pressure for banks to lower rate of interest Effect on borrowing and credit Spurring borrowing and consumption Evaluation: Rising growth but with pressure on inflation rate to rise

Funds available for I may improve innovations, productivity and technology Firms are able to borrow and expand production at lower rates Evaluation: Current mood in the economy may not inspire widespread borrowing, but instead

firms may continue to cut production and employment. Capital flows may be in the form of purchases of long-term government bonds that was

introduced to ease liquidity fears Accumulation of debt. Problem will worsen at the point of maturity of bonds, where bond-holders demand their

money back. Future incomes will have to be used to finance debt-repayment high opportunity cost

Shortage of funds arises in other regions of the world increased cost of borrowing, and curtailed growth

Demand for US exports would also be dampened.

Assessment of Situation:

Funds flowing into USA have to be managed and channelled into productive uses. Govt should employ policies that encourages growth in consumption and domestic demand

firms would be more willing to borrow to expand Interest rates can be managed through careful channeling of funds to improve

productivity, and not to finance consumption and asset hoarding.