Tuesday, November 11, 2008

Economics Higher Level Paper 3: May 2005: Q4(d)

A couple of days ago, I asked you to write in 25 minutes an answer to subquestion (d) of question 4 of the May 2005 Higher Level Economics Paper 3 exam. The goal was for you to realize that the time constraint you face in P3 (and in P2 for standard level candidates) is quite severe. To have a chance to move into the so called level 3 marks (6,7 or 8 of 8)for subquestion (d) you need to plan on spending about (but not more than) 25 minutes on it, which leaves you with around 15 minutes on subquestions a, b and c.

This specific question asks you to evaluate (using the text) the
"likely impact of the depreciation of the dollar on the domestic US economy."
Here are some ideas to organize your thoughts:

> explain what depreciation means
> effect on Px and Pm: exports become cheaper abroad and more competitive; imports pricier and less attractive
> effect on X (export revenues) and M (import bill) using price elasticities in your discussion and perhaps distinguishing between the short run and the long run; explanation of significance of M-L condition
> effect on export sector stakeholders: effect on labor (employment is expected to increase; could use text 'inside-out'); firm profits to rise and perhaps investment spending to pick up (could mention risk of excess capacity developing and associated long run dangers; could use text 'inside-out')
> expected effect on US import-competing firms: sales; employment
> could claim that a sharp depreciation may act as a subsidy on exports and a tax on imports (paraphrasing text)
> Assuming that NX (net exports) rise, AD will rise (as NX is a component); depending on how close to capacity the US is operating, there is a risk of inflationary pressures developing; but, by reading the first sentence of paragraph 1 where it states that the dolar decline 'will provide a much-needed stimulus to the US economy, it seems that this risk is rather low; on the other hand, since import prices will rise, the US cost of living automatically will go up and if US firms use a lot of imported inputs this too may prove inflationary; again, given the importance of services in the US, this risk is probably low
> whether the 'much needed' depreciation proves helpful for the US economy in succeeding to shrink its widening current account deficit (use info from text) also depends on whether the 'root cause' of this deficit is corrected; if, for example, the balloning deficit is a result of an excessive private and public deficits (eg interest rates maintained too low for too long leading to a household spending spree or tax cuts that have increased budget deficits) then the positive effect may be short lived.
> lastly, whether the 'much needed' depreciation proves helpful for US manufacturing also depends on whether it will focus and restructure in niches where it may still have a strong comparative (competitive) advantage (e.g.high tech areas), as it seems rather unlikely that in the long run it will be able to compete with very low wage countries such as China in washing machines or even (ordinary) steel products.

Rem: 25 minutes is tight so you need lots of practice.