Questions

(a) Define the following terms from the passage:

i. ‘Central bank’. (line 1) [2 marks]

The institution that manages the currency, money supply, and interest rates of a state or
formal monetary union plus oversees the commercial banking system.

ii. 'Devaluation'. (line 3) [2 marks]

This is when a government intentionally reduces the value of a currency in order to make
their domestic products more competitive on world markets. In the passage, the Chinese
government has been accused of trying to improve the competitiveness of their goods and
services by devaluing the Yuan.

(b) i. Define the term 'market orientated'. (line 12) [2 marks]

An approach to exchange rate policy that puts the needs of the market (i.e supply and demand
for the currency) as the primary determinate of value, rather than political directives.

ii. Calculate the % fall in the value of the Yuan, following the central bank’s ‘one-time
correction’. (line 25) [3 marks]

6.401 - 6.336 / 6.336 x 100 = 1.03% (difference / original number) x 100

(c) Explain two methods that China might employ to ‘keep a tight grip on the yuan,
allowing it to fluctuate up or down just 2% on either side of the reference rate’. [4
marks]

Managing the supply and demand for its own currency using its own foreign currency
reserves. A central bank/government will purchase its own currency to support the value
when needed and purchase foreign currency when it wishes to devalue its own currency.

Control of interest rates. A central bank/government can set interest rates at an appropriate
level to support the exchange rate that it chooses e.g. raising interest rates to attract 'hot
money flows' when it wishes to support the currency value.

Purchase / sell foreign currency using bonds when required.

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(d) Using an appropriate diagram illustrate the impact on the Chinese Yuan of the
Chinese government's decision to employ 'direct intervention in the foreign exchange
market'. [4 marks]

2 marks for a correctly labeled diagram

showing a fall in the value of the Yuan,
illustrated by a right shift in supply,
resulting from the Chinese government’s
measures to intervene in the foreign
exchange market by purchasing overseas
assets. This will result in a new
equilibrium price for the Yuan (a
devaluation). Alternatively, the response
could show an AD / AS diagram with a
rise in AD (right shift), representing that
following the devaluation China's net
exports would increase.

2 marks for a description of why a fall in

the value of the Yuan may cause a rise in
export levels and a fall in imports,
providing that Chinese traded goods and services are PED elastic. As a component of AD, a
rise in net exports (X and M) will increase AD.

(e) Explain why China may be attempting to ‘wage a currency war’ in its bid to raise
economic growth? [4 marks]

China may be attempting a currency war in an attempt to devalue its currency, forcing down
the value of its exported goods and services and improve further its net trade balance. Such a
move may or may not be successful depending on the relative price elasticities of its traded
goods and services. Nations may adopt this policy in circumstances where their own domestic
consumption is weak.

(f) Outline one advantage and one disadvantage of the government’s decision to adopt a
'more market-oriented method of calculating the currency rate' (line 10). [4 marks]

Responses should include one fully explained advantage of a fixed exchange rate system and
one advantage of a floating exchange rate system. Suitable responses are:

The advantages of a fixed exchange rate system include:

A fixed exchange rate provides certainty for importing and exporting businesses, as well as
potential investors. If a business knows exactly the rate at which they can exchange their
own currency for another, then this reduces one of the uncertainties facing any business when
planning future decisions.

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A second advantage is that with governments unable to use a competitive devaluation, in
order to remove a current account deficit, policies aimed at fiscal discipline are forced upon
them.

The advantages of a floating exchange rate system include:

A floating rate exchange system is self-regulating meaning that it automatically adjusts to

changes in supply and demand without the need for government intervention in the currency
markets. This applies in theory at least.

Floating exchange rate systems do not require central banks to hold very large foreign
currency reserves in order to intervene in buying and selling their own currency.

Central banks will not be required to use interest rates as an exchange rate tool and can
instead use rates as a monetary policy tool to control inflation.

(g) Using information from the passage and your knowledge of economics evaluate the
impact on the Chinese macroeconomic indicators of the Chinese government’s decision
to devalue its currency. [15 marks]

Responses should identify the four macroeconomic indicators as unemployment, inflation,

economic growth and net trade.

Impact on inflation

A fall in currency values will push up import prices which will have an immediate impact,
pushing up cost-push inflation. This can be illustrated by a left shift in the AS curve.

China is also likely to see a temporary rise in demand-pull inflation through a rise in AD,
caused by a short-term rise in exports - this presumes that China is exporting PED elastic
goods and services.

Impact on unemployment / economic growth

There is likely to be a short-term fall in cyclical unemployment and a rise in economic

growth as a result of a rise in exports. The impact of this, however, is likely to be short-lived
as the initial advantage caused by the competitive advantage will be gradually eroded by cost-
push inflation. Students should refer to the J curve here.

China's competitive devaluation is also likely to encourage other nations to devalue their
currency, starting a currency war or race to the bottom as highlighted in line 12 of the
article. China has been using export revenues as an engine for growth over a couple of
decades but the impact of this is running out as sluggish world growth has made other nations
reluctant to run up significant current account deficits just to finance China's growth. At
some point, China will need to focus its growth strategy towards domestic consumption
rather than exports. Such a policy would be helped by a stronger yuan as this will increase
domestic purchasing power.

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Impact on the current account

Initially, this will depend on the combined elasticity of both exports and imports. According
to the Marshall-Lerner condition, if the combined elasticity of exports + imports is greater
than 1 then the devaluation will have a short-term positive impact on China's current account.
Their already significant surplus will grow further. However, if the combined elasticity of
both exports and imports is less than 1 then China will see the opposite impact on their
current account.

Long term, according to the J curve theory any initial advantage caused by the competitive
devaluation will be eroded by higher import inflation. Candidates may illustrate this with a
correctly labeled J curve.

Responses for question G should be graded according to the following mark bands:

There is no clear answer to the question but some limited: 1-3

• Use of economic terms
• Application of economic theory
• Evaluation
• Use of information from the case example to support the answer
There is a vague answer to the question with limited: 4-6
• Use of economic terms
• Application of economic theory
• Evaluation
• Use of information from the case example to support the answer

There is an answer to the question with satisfactory: 7-9

• Use of economic terms
• Application of economic theory
• Evaluation
• Use of information from the case example to support the answer
There is a clear answer to the question with good: 10-12
• Use of economic terms
• Application of economic theory
• Evaluation
• Use of information from the case example to support the answer

There is a clear answer to the question with excellent: 13-15

• Use of economic terms
• Application of economic theory
• Evaluation
• Use of information from the case example to support the answer

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InThinking www.thinkib.net/Economics 4