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2 queries

T

tirmizi

Member
1. In the book economics for business on page 669, one reason for why do booms come to an end is "echo effects" saying that the replacement of goods and capital purchased in a previous boom may help bring recession to an end.

Firstly, how is this an echo effect and secondly how does this help bring the recession to an end?

2. April 2011 q 22

An economy with a floating exchange rate has a deficit on the current account of its balance of payments. Which policy combination would be most likely to solve this problem?

A Decrease interest rates and increase income tax rates.
B Increase interest rates and leave income tax rates unchanged.
C Decrease interest rates and decrease income tax rates.
D Increase interest rates and increase income tax rates.

The answer is given as D, but doesn't rise in i translate to appreciation and thus a current account deficit? Shouldn't the answer be A?

Thanks alot!
 
1. I think it means that there's an echo effect from a previous period. If some equipment needs to be replaced, this will increase investment and hence aggregate demand and help to pull the economy out of recession.

2. I think this question should have said under a fixed exchanged rate system, rather than a floating exchange rate system. Then the answer would clearly have been D. An increase in interest rates and an increase in income tax are both deflationary policies intented to decrease aggregate demand and hence decrease pressure on prices (to make exports more competitive) and decrease the demand for imports.

However, the fact that it's a floating exchange rate confuses the issue because the increase in interest rates will increase the currency and reduce net exports. (Also, if it's a floating rate, the government shouldn't need to do anything to correct a current account deficit - it should sort itself out automatically!) I suppose the examiners think the deflationary effects will outweigh the exchange rate effect.

The answer A is a mixture of deflationary and reflationary policies: the decrease in interest rates would encourage spending and therefore increase the demand for imports and possibly increase prices (and hence reduce the demand for exports); whereas the increase in income tax would decrease consumption and decrease demand for imports. (However, if you bring in the effect on the currency, the decrease in interest rates would decrease the currency and hence increase net exports!) Not a brilliant question!
 
thnx alot for the reply!

I still dont understand how the deflationary effect will outweigh the exchange rate effect, we just can't tell that with the information provided...
 
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I guess that's what Freddie means when he says it's not a brilliant question!

I don't think we can tell either, but it's probably just one that we have to accept and hope the questions are better in future! :)
 
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