6 Macroeconomic problems

6 Macroeconomic problems
Core
Self-assessment task 6.1 (page 223)
A good newspaper or newspaper website contains a lot of information on the macroeconomy. In some cases this
information is for the home economy; in other cases features make comparisons with other economies. For your
own country, see what recent articles you can find on:
• inflation
• the balance of payments
• the foreign exchange rate.

From these articles, produce a short summary of:

• the perceived causes of the problem
• the consequences for your country’s economy in the short- and long-term.

Student’s own answer. Individual answers to this question will vary.

Self-assessment task 6.2 (page 225)

1 Zimbabwe is clearly experiencing severe hyperinflation. What effects is this having on the internal and external
operation of the macroeconomy?
Zimbabwe’s hyperinflation in 2006 was destroying the value of the currency, reducing the real income
of Zimbabwean citizens and encouraging people to resort to barter.

2 See what you can find out about how countries such as Argentina, Brazil and Nicaragua have dealt with
similar hyperinflation problems.
Countries such as Argentina, Brazil and Nicaragua have dealt with hyperinflation by replacing the
currency with a new currency and cutting back on the number of notes the central bank prints.

Self-assessment task 6.3 (page 229)

The rate of inflation in Pakistan was reported to have been 20.3% in 2008. Explain what this figure means and
how it might have been calculated.
An inflation rate of 20.3% in 2008 would mean that the price level was 20.3% higher than a year before.
It does not mean that all prices have risen or that all prices have risen by an equal amount. It is likely to
have been calculated by means of a weighted consumer price index. Such an index attaches weights to
different items of expenditure to reflect their importance.

Original material © Cambridge University Press 2010 1

 6 Macroeconomic problems

Self-assessment task 6.4 (page 231)

1 What is the difference between the trade balance and the current account balance of a country?
The trade balance is only part of the current account balance of a country. It covers the relationship
between export revenue and import expenditure. The current account balance includes, in addition to
the trade balance, income and current transfers.

2 Use the information in Table 6.3 to compare the current account positions of Hong Kong and Brazil. What
reasons might explain the differences?
Hong Kong has a current account surplus whereas Brazil has a current account deficit. As Hong Kong
has a trade deficit it must mean that it has a net surplus on the other items which is larger than its
trade deficit. As Brazil has a trade surplus, it must have a net deficit on the other items which is greater
than its trade surplus.

Trade balance Current

(US$bn) account balance
(US$bn)
China +250.6 +364.4
Hong Kong −22.2 +31.4
India −82.6 −26.6
Indonesia +14.8 +4.4
Malaysia +34.9 +36.7
Pakistan −14.4 −8.9
Singapore +18.6 +21.4
Thailand +13.9 +13.2
Argentina +16.4 +10.4
Brazil +26.4 −17.6
Mexico −14.6 −14.0
Egypt −25.2 −4.4
Saudi Arabia +212.0 +134.0
South Africa −3.7 −15.8

Table 6.3 Estimated current account contrasts for emerging

economies, October 2008–October 2009
Source: The Economist, 17 October 2009

Original material © Cambridge University Press 2010 2

 6 Macroeconomic problems

Self-assessment task 6.5 (page 232)

Give some possible reasons for the wide variation in the current account positions and external debt of the
countries shown in Table 6.4.

Trade Current External

balance account debt
(US$m) balance (% GNI)
(US$m)
Central −35 n/a 53
African
Republic
Congo, −350 n/a 119
Dem. Rep.
Ghana −3660 −1040 21
Kenya −5070 −526 26
Liberia −333 −138 1128
Nigeria +39 000 +24 202 9
Sierra −160 −101 10
Leone
Zambia +862 −505 9
Zimbabwe −370 n/a 110

Table 6.4 Current account positions and external debt for

selected African economies in 2007
Source: World Development Report, 2009

Nigeria has a large current account surplus largely because of its oil revenue. The other countries for
which there is data available all have current account deficits. This is partly because the terms of trade
operate against these countries – their imports are relatively expensive whereas their exports are relatively
cheap.
All the countries have positive external debt, with Liberia recording the highest percentage. Countries
with the highest debt are likely to have borrowed substantial sums to cover current account deficits and
promote development.

Self-assessment task 6.6 (page 233)

Using the data you have collected, decide whether the balance of payments of your country is in equilibrium or
disequilibrium. Can you explain why this is so?.

Student’s own answer. Individual answers to this question will vary.

Original material © Cambridge University Press 2010 3

 6 Macroeconomic problems

Self-assessment task 6.7 (page 236)

With reference to Figure 6.6, explain what would happen to the value of the pound if the rate was at P1.

D S

Price of £s (in $s)

P3

P2

P1

S D
0 Q1 Q2 Q3 Q4
Quantity of £s

Figure 6.6 Exchange rate determination in a free market

If the pound’s exchange rate was at P1, demand for pounds would exceed the supply of pounds. The
excess demand would drive up the value of the pound until demand and supply are again equal.

Self-assessment task 6.8 (page 237)

Consider the impact of the following changes upon the value of the dollar. Provide a sketch for each change.
a A rise in interest rates in the US.
A rise in interest rates in the US would attract ‘hot money’ into the country in search of a higher
return. This would increase demand for the dollar and result in a rise in its price.

D1

D S
Price of US dollars in £s

P1
P

D1

S D

0 Q Q1
Quantity of $s

Original material © Cambridge University Press 2010 4

 6 Macroeconomic problems

b A substantial current account deficit on the US balance of payments.

An increase in the current account deficit in the US balance of payments would mean that demand for
dollars would decrease as, for instance, fewer US products are exported. The supply of dollars would
increase as US citizens buy relatively more products from abroad. The changes in the demand for and
supply of the dollar would lower its price.

D S
D1 S1
Price of US dollars in £s

P1

S D
S1 D1
0 Q/Q 1
Quantity of $s

Self-assessment task 6.9 (page 239)

Study the information in Figure 6.9 and then answer the following questions.

£/€ £/$

€1.30 $1.75
Closing price €1.072 Closing price $1.585

€1.25
$1.65

€1.20

€1.15 $1.55

€1.10
$1.45

€1.05

€1.00 $1.35
O N D J F M A M J J A S O O N D J F M A M J J A S O

Figure 6.9 Sterling exchange rates, October 2008–October 2009

Source: Bloomberg

1 Has the pound depreciated or appreciated against the euro and the US dollar over the period shown? Justify
your answers with evidence from Figure 6.9.
The pound has depreciated against the euro and the US dollar over the period shown, with a pound
exchanging for a lower value of euros and dollars at the end of the period.

Original material © Cambridge University Press 2010 5

 6 Macroeconomic problems

2 Explain the likely effects of the exchange rate changes shown on (a) exporters (b) importers.
The price of exports, in terms of euros and dollars, fell, which would have been likely to have increased
demand for exports. As a result, exporters would have been able to sell more products abroad.
In contrast the price of imports, in terms of pounds, rose, which would have meant that importers
would have had to pay more to buy the same quantity of products.

Self-assessment task 6.10 (page 240)

Calculate the impact of the exchange rate changes below upon transaction prices in the following cases.
Assume that the nominal exchange rate of pound sterling to US dollars is £1 = $1.5. A cashmere sweater made in
the UK and which sold for £200 would cost a US importer $300. Similarly, a US car which sold for $12 000 would
cost a UK importer £8000.

1 Assume that the nominal exchange rate changes to £1 = $2.0.

a Calculate the cost of the cashmere sweater to the US importer.
$400 (an increase of $100).

b Calculate the cost of the US car to the UK importer.

£6000 (a decrease of £2000).

c What would you expect to happen to the volume of UK exports of cashmere sweaters and imports
of US cars as a result of the new exchange rate?
The appreciation in the value of the pound sterling against the US dollar, has made UK exports
relatively more expensive and imports relatively cheaper. The simple deduction is that the volume
of UK exports of cashmere sweaters would fall and the import of US cars would increase.

2 Assume that the nominal exchange rate now changes to £1 = $1.0.

a Recalculate the cost of the cashmere sweater to the US importer.
$200 – a fall in price.

b Recalculate the cost of the car to the UK importer.

£12 000 – an increase in price.

c What would you expect to happen to the volume of UK exports of cashmere sweaters and imports of US cars
as a result of the new exchange rate?
As cashmere sweaters would be cheaper it would be expected that their sales would increase. In
contrast, as imported US cars become more expensive, it would be anticipated that imports of US
cars would fall.

d As the exchange rate has changed it has changed the transaction prices of the trade in cashmere sweaters in
the UK and the US. As a result, we will expect the volumes of imports and exports to change. Explain what
further information would be required to assess the impact of these changes in sales upon total spending on
exports and imports.
It would be necessary to find out information about the price elasticity of demand of UK cashmere
sweaters and US cars to assess what will happen to export revenue and import expenditure. The
demand for cashmere sweaters in the UK is likely to be price inelastic – such sweaters are luxury
items and their demand is unlikely to be price sensitive. The price elasticity of demand for US cars
is likely to be more price elastic, as there are many manufacturers of cars in the EU and the rest of
the world and there is considerable price competition.

Original material © Cambridge University Press 2010 6

 6 Macroeconomic problems

Specimen exam questions (page 242)

1 a Inflation is a sustained rise in the price level and as a consequence a fall in the value of money.
Inflation may be caused by cost-push factors or demand-pull factors although once under way,
inflation is likely to be a combination of both factors.
Cost-push inflation is a rise in the price level caused by increases in the costs of production,
independent of increases in aggregate demand. For example, an increase in wages not matched by an
increase in productivity will raise firms’ costs. If they pass these on to their customers, the price level
will increase. A wage-price spiral can be set off with higher wages causing prices to rise and higher
prices stimulating workers to press for higher wages. Another cause of cost-push inflation is a rise in
raw material costs. If the exchange rate falls, for instance, imported raw material costs will increase. To
cover these higher costs, firms may raise their prices. Other causes of higher costs of production and so
cost-push inflation are increases in indirect taxes and increases in profit margins.
The diagram below illustrates cost-push inflation with the short run aggregate supply curve
shifting to the left from SRAS to SRAS1.

AD SRAS1
SRAS
Price level

P1
P

SRAS1 AD
SRAS
0 Y1 Y
Real GDP

In contrast to cost-push inflation, demand-pull inflation is caused by increases in aggregate

demand exceeding aggregate supply. If the economy is operating at or close to full employment,
an increase in aggregate demand cannot be matched by an increase in aggregate supply. The excess
demand will pull up the price level. The next diagram illustrates demand-pull inflation, with an
increase in aggregate demand from AD to AD1 causing the price level to increase from P to P1.

Original material © Cambridge University Press 2010 7

 6 Macroeconomic problems

AD1 SRAS

AD

Price level
P1
P

AD1
SRAS
AD

0 Q Q1

Real GDP

Demand-pull inflation can be caused by an increase in any of the components of aggregate

demand. For instance, an increase in consumer spending will lead to higher prices if firms cannot
easily respond to the higher demand with a higher output. The extra aggregate demand will bid up
prices and if aggregate demand continues to rise, for instance, during an economic boom, inflation
will occur.
Once inflation is underway, it can be difficult to identify the cause of inflation. This is because,
for instance, an increase in wage rates will increase costs of production and consumer spending and
higher aggregate demand may increase the power of trade unions to press for wage rises. Similarly,
higher raw material costs will increase costs of production and by raising foreigners’ income may
increase demand for exports.

b A country experiencing inflation may encounter a balance of payments problem but this is not
necessarily the case. Higher domestic prices could reduce export revenue and increase import
expenditure. This could result in an increase in a current account deficit.
Inflation may also reduce confidence in the economy. As a result it may discourage portfolio and
direct investment into the country and may encourage some financial investors to remove their funds
and some multinational companies to withdraw from the country. This would lead to a deficit on the
financial account.
Inflation, however, may be below that occurring in rival countries and may be of a more stable
nature. With lower relative inflation a country may enjoy higher export revenue and lower import
expenditure. A lower relative rate of inflation and greater stability in changes in the price level may
also increase confidence in the future performance of the economy and so may attract portfolio and
direct investment.
Even if a country is experiencing higher relative inflation and an accelerating rate, it does not
necessarily mean that it will experience a balance of payments problem. If demand for exports is price
inelastic, a rise in price will reduce demand but as demand will fall by a smaller percentage, export
revenue will increase. Similarly, if demand for imports is price inelastic, a fall in their price will result
in a fall in import expenditure.
A fall in the exchange rate can offset the effects of inflation by reducing the price of exports, in
terms of foreign currency, and raising the price of imports, in terms of the domestic currency.

Original material © Cambridge University Press 2010 8

 6 Macroeconomic problems

Demand for exports and imports is also influenced not only by changes in prices but also by a
range of other factors. For instance, rises in the quality of exports and rises in incomes in foreign
countries may increase demand for exports despite higher prices. Similarly, a fall in the quality of
imports and a fall in incomes at home will reduce demand for imports.
In addition, changes in other parts of the balance of payments can offset a trade deficit. If firms
and households have undertaken a considerable amount of direct and portfolio investment in the past,
there may be a large surplus on the income balance in the current account of the balance of payments.
There may also be a significant inflow of workers’ remittances in the current transfers section.
There is a chance that a country experiencing inflation may encounter a balance of payments
problem but this will not always be the case. The price elasticity of demand for exports and imports,
the external value of the currency, the quality of exports and imports, incomes at home and abroad
and other components of the balance of payments have to be considered.

Original material © Cambridge University Press 2010 9

 6 Macroeconomic problems

KEY TERMS

Definitions of key terms can be found in the glossary.

anticipated inflation managed float
appreciation (of exchange rates) menu costs
cost-push inflation monetary inflation
demand-pull inflation nominal value
depreciation (of exchange rates) pegged exchange rate system
fixed exchange rate Quantity Theory of Money
floating exchange rates real value
foreign exchange rate shoe leather costs
hyperinflation trade weighted exchange rate
inflation unanticipated inflation

Original material © Cambridge University Press 2010 10