Thursday, March 26, 2009

Data Response Exam Preparation: HL P3Q Q2 May 2006

IB Economics - Higher Level - Data Response Question - May 2006, Paper 3, Question 2
(What follows can be soon found as a file -including the diagrams- at our wikispace here)

This one is a macro data with questions (a), (b) and (c) very easy and with (d) somewhat demanding but manageable.

Question (a)(i) asks you to define the unemployment rate. It’s the number of unemployed individuals in an economy expressed as a proportion of the labor force (the number of unemployed divided by the labor force). That’s it! No need to explain who is considered unemployed (BTW, it’s the individual actively searching for a job and unable to find one) or to define the labor force (the sum of those employed and unemployed).
Question (a)(ii) asks you to define the business (or, trade) cycle. A precise and concise definition is that the business cycle refers to the short run fluctuations of real GDP around its long run trend. Again, there is no need to define real GDP or trend output here. Mind you that you could sketch a diagram with real GDP on the vertical and time on the horizontal illustrating these ups and downs which could help you earn the 2 points if the definition you gave was vague.

Question (b) asks you to explain using an appropriate diagram how a government may attempt to close a deflationary gap. Well, the diagram here could be an AD / AS diagram with average price level (P) on the vertical and real output/income (Yr) on the horizontal. A vertical long run aggregate supply curve at the full employment level of output (Yfe) is necessary, an upward sloping short run aggregate supply and an aggregate demand that intersects the SRAS at some level of real output to the left of the full employment level of real output Yfe (below that is full employment; left of the vertical LRAS)). The distance on the vertical axis between the equilibrium level of real output and the full employment level of output is the deflationary gap (also referred to as the recessionary gap). You should also draw a second AD (call it AD’) such that it intersects the SRAS and the point the SRAS intersects the LRAS (so that the equilibrium level of output coincides with the full employment level of output). Remember the (correctly drawn and labeled) diagram earns you 2 points automatically. Now, for the remaining 2 points you could explain that a deflationary gap results when the economy is at equilibrium at a level of output/income below the full employment level (refer to the diagram at this point) and that it is a result of insufficient aggregate demand. It follows that if somehow aggregate demand increased to AD’ the gap would close. The government could thus use either expansionary fiscal policy (increasing government spending and/or lowering taxes) and/or easy monetary policy (lowering interest rates)

Question (c) asks you to explain why deflation creates conditions that make it ‘unfavorable’ for businesses to invest. Here you are not asked to illustrate using a diagram. Well defining deflation will not only set you up but help you organize your thoughts. Deflation refers to a sustained decrease in the average level of prices (negative inflation rates). Deflation is typically the result of AD decreasing. As such, periods of deflation are accompanied by falling output (recession). You could draw an AD/AS diagram with AD shifting left but there is no need to do so. Deflation is serious and is difficult to get rid off. (see Krugman, slide 7, here ). If AD (i.e. total spending) is falling then it will not be necessary for businesses to expand their capacity (to invest). If households and firms come to expect prices to continue falling then consumers will cut down on their purchases and firms will witness a fall in their revenues, hardly a time to invest. In addition, falling prices imply that the real debt of businesses (their debt expressed in terms of goods) increases thus making it unlikely to borrow more to make investments.

Question (d) asks you to evaluate (using the extract, as always) the extent to which unemployment would still be a problem if inflation were allowed to increase. One must read the question very carefully. It really asks whether rising inflation in Singapore would imply lower unemployment. It thus seems to ask you to evaluate whether and to what extent a (short run, at least) Phillips curve trade-off is present. I think that looking at the data of the table gives is quite some information (remember, always squeeze every bit of info out of whatever data is given). Looking at the 2000-02 3 year period seems to illustrate that the increase in unemployment from 3.1% to 3.3% and then to 4.4% was accompanied by a decrease in inflation from 1.3% to 1.0% and to -0.4% (deflation). This fits the original Phillips curve trade off (which you could describe). You could also draw a Phillips curve diagram with inflation on the vertical and unemployment on the horizontal making sure you use on the axes the figures above. The fact that in 2003 (expected) inflation picks up to 0.5% and unemployment further rises 4.7% can be explained by noting that the increase in the inflation rate is not accompanied by higher growth (growth drops from 2.8% in 2002 to 2.3% in 2003) so there is a chance that prices rose a bit because of cost-push factors. As a matter of fact something like that is hinted in paragraph 1 when it mentions that ‘increases in the cost of food, clothing and housing had resulted in the price index rising’. On the other hand one could note that when in 2000 Singapore registered a 10.1% growth rate unemployment was at 3.1% suggesting that 3% unemployment may be the natural rate for the country. You must explain the natural rate of unemployment concept here and perhaps draw a vertical Phillips curve (LRPC) at the 3% unemployment rate in your diagram. In paragraph 2 it mentions that ‘the increase in inflation is welcome’ and that the rise in unemployment is a result of low economic growth. You could also note that in paragraph 3 it becomes clear that there is a deflationary gap in Singapore as there is ‘excess productive capacity in Singapore’s economy, which is dependent on trade’. Singapore is in the ‘slump phase of the business cycle’ as ‘trade (read, exports) have fallen by 30% from the previous year’. One may thus argue that if trade (export demand from the US) picks up, then Singapore’s AD will increase (shift to the right) increasing prices and lowering unemployment, as to produce more exports they will need to hire more people.

One could of course conclude that you need more disaggregated labor force and industry related data to make a better evaluation of the labor market effect of higher inflation. On the other hand, both the extract and the table seem to suggest the existence of a clear short run trade off between the two variables so that it is reasonable to expect that unemployment will decrease if inflation picks up but not below the 3% rate which probably is Singapore’s NRU.

Hope this makes sense and helps you prepare! Remember, you should practice writing short and long essays as well as data questions at home. The more you write, the better your chances. Also, remember to practice under a time constarint. That's the real problem with the HP3 and SP2 paper.

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