Balance of Payments

Introduction to BOP
• BOP is a statement of the receipts and payments arising from all
economic transactions between the residents of a country and the
rest of the world over a period of time, usually a year
• All international transactions are recorded in the current account,
financial account and the capital account
4 Sub-accounts
• Current account (CA): records all flows of money into and out of the
economy for purchases in g/s, income flows across borders and for private
and government transfers between countries
• Financial account (FA): records all net flows of money for purposes of FDI,
portfolio investment and ST financial capital (hot money)
• Capital account (KA): records net inflows/outflows of capital between
countries eg purchase/sale of fixed assets, patent rights
• Official financing account (OFA): records changes in country’s foreign
reserves as a result of the net position of the first 3 accounts (if sum is in
deficit, corresponding decrease in foreign reserves must be recorded to
balance the overall BOP accounts, vice versa)
 BOP

CA KA FA OFA

Visible
Purchase/sale of
balance/BOT* FDI*
fixed assets*
(X-M)

Portfolio
Invisible balance
investment

ST capital
flow/hot
money*
BOP as a macroeconomic indicator
• Macroeconomic goal: favourable BOP position  so what does it mean to have an
unfavourable BOP position?
• An unfavourable BOP position means either a persistent* CA deficit or a persistent BOP
deficit (outflows of money>inflows of money), or both  why is it bad?
• A persistent BOP deficit has to be financed in one of 2 ways: by borrowing from overseas or
by drawing down on country’s foreign reserves
• If financed through borrowing from overseas, then this becomes a debt burden placed on
the future economy including interest payments on debt
• If continuously draw down on a country’s foreign reserves  erosion of confidence from
international community that the country’s government has the ability to keep the
exchange pegged at its current level/prevent e/r from continuously declining  speculative
attack on the currency, forcing a more rapid decline in reserves or a more rapid
depreciation of the currency, or both
Persistent (and large) CA deficit
• Occurs when receipts<payments in CA
• BOT and services account constitute a relatively larger proportion of
CA
• Key root causes of a deficit in these accounts can be broadly classified
into:
1. Persistently high prices of exports
2. Persistently high prices of imports
3. Fall in demand for exports/rise in demand for imports
Causes of persistent and large deficit on CA
1. Persistently high prices of exports which can be further caused by
(i) Persistently higher rate of domestic inflation compared to trading partners
• When inflation in domestic economy is relatively higher than trading partners,
the country’s X will be relatively more expensive and less competitive in the
world market
• Assuming PEDx>1, the rise in relative prices will lead to more than proportionate
decrease in qtydd of X  fall in X revenue
• At the same time, the country’s domestic goods will be more expensive
compared to M, causing local residents to switch to foreign M  rise in M
expenditure
• Taken together this will cause a fall in NX and hence, a persistently higher rate of
domestic inflation can result in a larger CA deficit
Causes of persistent and large deficit on CA
1. Persistently high prices of exports which can be further caused by
(ii) Persistently overvalued domestic currency
• X are more expensive in f.c. while M are cheaper in d.c.
• Assuming MLC is satisfied (|PEDx| + |PEDm| > 1), this will reduce NX and cause a
persistent and large BOP deficit on the CA
Causes of persistent and large deficit on CA
1. Persistently high prices of exports which can be further caused by
(iii) Loss in comparative advantage
• A country’s X may become more expensive if it loses comparative advantage in the
production of goods to other countries eg India, Vietnam  lower labour cost
• Assuming PEDx>1, the domestic country will likely see a loss of X-competitiveness 
fall in X revenue
• In addition, M for the domestic country might also increase if residents switch their
expenditure to the relatively cheaper imported goods
• Assuming PEDm>1, fall in price will lead to a more than proportionate increase in
qtydd for M  rise in M expenditure
• With fall in X revenue and increase in M expenditure arising from loss of comparative
advantage, the CA of the domestic country will worsen, leading to a deficit
Causes of persistent and large deficit on CA
2. Persistently high prices of imports which can be further caused by
(i) Persistently higher inflation overseas
• When inflation is relatively higher overseas, M into domestic economy will be
relatively more expensive than domestic goods
(ii) Persistently undervalued domestic currency
• An undervalued domestic currency will cause the price of M to be more expensive in
d.c.
For the 2 scenarios above, if PEDm<1 (eg if the country is reliant on imported r.m. and
other necessities), qtydd for M will fall less than proportionately  increase in M
expenditure  potentially lead to a persistent CA deficit
The more price inelastic the demand for M, the larger the CA deficit. The higher M
prices may further feed into higher X prices (due to higher COP), reducing X revenue
and worsening the CA deficit
Causes of persistent and large deficit on CA
3. Fall in demand for exports and rise in demand for imports
(i) Persistently higher domestic economic growth than trading partners
• A relatively higher rate of EG indicates that NY of the country has risen more
than its trading partners
• This means that residents have a greater increase in purchasing power than
residents in other countries
• Hence, demand for M tends to rise faster than demand for exports as import is a
function of income
• This results in fall in NX, potentially leading to a persistently large CA deficit
Policies to correct a persistent and large CA deficit
(i) Expenditure-reducing policies: CFP and CMP
• By reducing the expenditure components (aka reduce outflow of money) in the
economy, expenditure on imports would also decline. This will aid in reversing the
deficit on the CA
• CFP: reduce G and/or reduce C via higher taxes  reduce deficit on CA via multiplier
effect
• CMP: reduce C and I (both contain imports) via decrease in money supply and/or
increase in interest rates  reduce CA deficit
• Limitation: may be in conflict with internal macroeconomic aims. Contractionary
policies could lead to higher UNt in domestic economy and as such is often unpopular
with governments, particularly during/near elections. However, if the domestic
economy is faced with inflation, esp DD-pull inflation, expenditure-reducing policies
may be more congruent to the attainment of the country’s internal macroeconomic
goals
Policies to correct a persistent and large CA deficit
(ii) Expenditure-switching policies: Devaluation
• Aimed at influencing private spending away from imports towards locally
produced goods
• By directly/indirectly causing a depreciation of the local currency, the
government can cause X revenue to rise and M expenditure to fall, resulting in CA
position to improve
• Effectiveness of this policy depends on whether the MLC is satisfied
• Limitation: there is time lag before a weakening currency can reverse a worsening
BOP/CA position. (Fun fact: In fact, the BOP/CA deficit worsens further before it
improves  J-Curve effect). This lag is often caused by the inability of firms in the
M and X industries to respond immediately to changes in e/r due to previous
contractual agreements
Policies to correct a persistent and large CA deficit
(iii) Supply-side policies (SSP)
• A persistent CA deficit could signal weaknesses in the economic fundamentals of a country.
Whether it be too high an inflation rate, or too low a quality of goods or low productivity or
poor infrastructure, these can and should be tackled at the root rather than simply to manage
the symptoms using dd-mgmt policies
• SSP can increase efficiency by promoting an adequate level of competition in industries,
enhance the mobility of FOP through infrastructural development, and enhance the quality of
labour force through human capital development
• SSP can also be aimed at increasing the country’s attractiveness to investment (both domestic
and foreign)  increase the economy’s ability to produce and export g/s in the future
• Limitation: very long time lag. Attempts to adjust the level of competition in the economy,
particularly those that involve liberalization of markets tend to be slow and face tremendous
lobbying efforts from the incumbent monopolies in the industries affected. Infrastructural and
human capital development also tends to take many years, sometimes decades to accomplish
Policies to correct a persistent and large CA deficit
• Policy mix is required
• It is often prudent for the government to concurrently adopt SSP that are aimed
at addressing the underlying root cause of the deficit while at the same time,
employ short run demand side solutions in terms of expenditure switching or
expenditure reducing policies (depending on current economic conditions of the
other macroeconomic indicators) to address the symptom (CA deficit) of that
underlying problem
(b) Discuss the view that government policies
to deal with a CA deficit can be potentially
damaging and ineffective. [15]
(b) Discuss the view that government policies to deal with a large
and persistent CA deficit can be potentially damaging and
ineffective. [15]
Introduction:
• To deal with a persistent and large CA deficit, a government can implement expenditure-reducing and
expenditure-switching policies
• However, the use of these policies can be ineffective in achieving their intended objective of reducing the
CA deficit
• In addition, these policies may at times be potentially damaging in either worsening the CA deficit or
bringing about other negative consequences

Main:
• Expenditure-reducing policies: CFP and CMP
• Expenditure-switching policies: Devaluation
• SSP

Conclusion/Evaluation
(b) Discuss the view that government policies to deal with a large
and persistent CA deficit can be potentially damaging and
ineffective. [15]
Expenditure-reducing policies: CFP and CMP
• Expenditure-reducing policies aim to reduce AD through CFP and CMP
• CFP: reduce G and/or increase T
• CMP: reduce money supply or raise interest rate to increase cost of borrowing,
which discourages C and I
• Decrease in AD  multiplied fall in NY  lower M expenditure  reduce CA
deficit
(b) Discuss the view that government policies to deal with a large
and persistent CA deficit can be potentially damaging and
ineffective. [15]
Limitations of expenditure-reducing policies: CFP and CMP
• Long implementation lag: Cuts in G and hikes in T need to be debated and passed
in parliament before they can be implemented + Cuts in spending on social
infrastructure (eg education and healthcare) are likely to meet strong resistance.
Even after approval is given, it still takes a considerably long time for households
and firms to respond to higher tax and interest rates
• When economic outlook is good, the reduction in C and I could be minimal,
leading to negligible fall in NY and hence M expenditure
• For countries whose PEDm<1 (eg reliant on imported rm and finished goods), fall
in NY will only lead to less than proportionate fall in qtydd for M
• All these will make contractionary policies ineffective in reducing the country’s CA
deficit
(b) Discuss the view that government policies to deal with a large
and persistent CA deficit can be potentially damaging and
ineffective. [15]
Limitations of expenditure-reducing policies: CFP and CMP
• Expenditure-reducing policies could also be potentially damaging to the economy
• When i/r is raised relative to other countries’, hot money will flow into the
country to take advantage of the higher i/r  increase demand for d.c., pushing
up its external value
• Stronger currency  country’s X more expensive in f.c., M cheaper in d.c. 
assuming MLC is satisfied, NX will decrease  CA deficit is worsened
• However, this problem can be mitigated if the government temporarily limits the
hot money inflow or suppress the external value of the currency by selling
domestic currency in the forex market  the potentially damaging effect may not
arise
(b) Discuss the view that government policies to deal with a large
and persistent CA deficit can be potentially damaging and
ineffective. [15]
Limitations of expenditure-reducing policies: CFP and CMP
• Fall in AD lowers real output in the economy and causes economic contraction
• Could further lead to cyclical unemployment as less labour is needed when
production falls  lower SOL, loss of skills, greater fiscal costs (less income tax
collected, more unemployment benefits paid)
• However, if the economy was originally facing a DD-pull inflation, fall in AD may
not cause real o/p to fall. In fact, as GPL falls, the country’s X will become cheaper
in f.c. and more competitive
• Assuming PEDx>1, qtydd of X will increase more than proportionately  X
revenue increase  reduce CA deficit
(b) Discuss the view that government policies to deal with a large
and persistent CA deficit can be potentially damaging and
ineffective. [15]
Evaluation of expenditure-reducing policies
• Whether expenditure-reducing policies are ineffective and potentially damaging
depends on several considerations such as the state of the economy, timeframe
and the government’s ability to undertake remediation to mitigate the negative
consequences eg prevent the currency from appreciating/limit capital flow
• If the latter can be done, and if the large and persistent CA deficit is a result of
DD-pull inflation, then expenditure-reducing policies are beneficial
(b) Discuss the view that government policies to deal with a large
and persistent CA deficit can be potentially damaging and
ineffective. [15]
Expenditure-switching policies: Devaluation
• As the d.c. is devalued, X become cheaper in f.c. and M become more expensive
in d.c.
• Assuming MLC is satisfied, NX will increase, reducing the CA deficit
(b) Discuss the view that government policies to deal with a large
and persistent CA deficit can be potentially damaging and
ineffective. [15]
Limitations of expenditure-switching policies: Devaluation
• May be ineffective in reducing CA deficit as devaluation gives domestic producers an
unfair advantage over foreign producers and hence tend to invite retaliation from
trading partners. When trading partners retaliate by also devaluing their currencies to
prevent a fall in NX, the initial advantage gained from a devaluation will be negated
• Furthermore, if the economy has no spare capacity to accommodate the increase in
NX, DD-pull inflation would result
• If the economy is M-reliant, a weaker currency would lead to imported inflation as
costs of imported factor inputs increase in d.c.
• In the above 2 scenarios, prices of domestic goods/X will rise, offsetting the intended
effect of devaluation and making the policy ineffective. The resultant inflation also has
many damaging repercussions on the economy, such as misallocation of resources and
fall in I
(b) Discuss the view that government policies to deal with a large
and persistent CA deficit can be potentially damaging and
ineffective. [15]
Limitations of expenditure-switching policies: Devaluation
• Devaluation can be both ineffective and potentially damaging especially in the SR
since MLC may not hold
• Buyers take time to respond to changes in prices of exports and imports (eg due
to contractual agreements) so PEDx and PEDm both <1 just after devaluation, and
this will cause NX to fall, worsening the CA deficit
• However, over time as buyers make adjustments to their qtydd, CA will improve
and might even register a surplus eventually.
(b) Discuss the view that government policies to deal with a large
and persistent CA deficit can be potentially damaging and
ineffective. [15]
Evaluation for expenditure-switching policies: Devaluation
• The SR damage in terms of increase in CA deficit stems from the ineffectiveness
of devaluation
• Assuming trading partners do not retaliate, the benefit reaped in the LR could
possibly outweigh the damage done in the SR
(b) Discuss the view that government policies to deal with a large
and persistent CA deficit can be potentially damaging and
ineffective. [15]
Supply-side policies
• Where government encourages training, R&D, capital accumulation etc to
increase productivity in the economy  reduce COP and improve qly of g/s
• Helps country to regain comparative advantage and even develop new
comparative advantages  greater international competitiveness  X revenue
would rise and M expenditure would fall  reduce CA deficit in the LR
(b) Discuss the view that government policies to deal with a large
and persistent CA deficit can be potentially damaging and
ineffective. [15]
Limitations of supply-side policies
• Could be ineffective in the SR as it usually takes many years for training and R&D
to yield results
• Intended results are not guaranteed as effectiveness of training depends on many
factors such as aptitude and attitude of workers, and R&D efforts may not lead to
any technological breakthrough at all
(b) Discuss the view that government policies to deal with a large
and persistent CA deficit can be potentially damaging and
ineffective. [15]
Limitations of supply-side policies
• Drain on government resources/budget as huge sums are needed over a long
period of time to drive and sustain training, R&D etc
• Another problem is structural unemployment that could result as technology
advances and skills become obsolete at a faster pace or as the economy
restructures to move into new areas of comparative advantage
• However, this damage is likely to be short-lived, especially when proper training
programmes are in place to equip workers with new skills to take on new jobs
created
• [EV]: the long term gain in terms of improved CA position and a more competitive
economy where consumers enjoy cheaper and better products is likely to
outweigh the short term damage
Evaluation
• It is true that government policies to deal with CA deficit can be
potentially damaging and ineffective under specific circumstances
• However, certain damages could be remedied and effectiveness
enhanced with the help of other policies, and with the right
government intervention and monitoring, eg introducing the right
training programmes, the benefits could outweigh the costs in some
cases
2017 A Level CSQ2
(a) Explain briefly how any one component of aggregate demand
would be expected to change as interest rates are cut in China. [2]

• AD=C+I+G+X-M
• A cut in i/r in China implies a lower opportunity cost of consumption since the
rewards to savings has decreased
• A lower cost of borrowing also means that it is cheaper to finance a loan, so
households are encouraged to purchase big-ticket items such as cars, increasing
C, which is a component of AD
• I is also accepted
(b) With reference to Table 4, describe what has happened to the
rate of inflation and the price level in China between 2011 and 2015.
[2]
• Rate of inflation decreased between 2011 and 2015. However, the price level in
China increased (at a decreasing rate) during the same period
(c) Using an aggregate demand and aggregate supply diagram,
explain how the strengthening of the US economy might stimulate
growth in China. [4]
(c) Using an aggregate demand and aggregate supply diagram,
explain how the strengthening of the US economy might stimulate
growth in China. [4]
• When the US economy strengthens, that implies stronger economic growth and
an increase in real NY. Since M is a function of NY, a higher income leads to
increased demand for normal goods (eg textiles to make fashion apparels) in US
• China and US are trading partners. Hence, China’s X increases.
• AD = C+I+G+X-M, increase in X leads to an increase in AD and increase in NY by a
multiple
• Extract 5: China is facing “excess production capacity in many industries” 
economy is likely in the intermediate range
• Wrt Fig 1, when NX increases, AD increases from AD0 to AD1, real NY increases
from Y0 to Y1 and actual economic growth is achieved in China
(d) Explain two factors that would likely determine the impact of
the fall in export sales to China on any one economy shown in Table
5. [4]
• The particular economy in Table 5 chosen is the Singapore economy. The fall in
Singapore’s X will impact her NY. The extent of the impact is determined by the
degree of export orientation of the economy and the size of multiplier (k)
Degree of export-orientation:
• Table 5 shows a fall of 14.6% in China’s M will lead to a fall of US$2.16b of X sales
to Singapore. While not the largest fall in absolute terms, this is likely to be the
most impactful as a proportion of GDP compared to other economies
• This can be explained by Singapore’s high export-orientation (X/GDP) where
exports take up a significant portion of NY
• Hence, a 1% fall in Singapore’s X is likely to have a very large impact on its NY
compared to the same 1% fall in other sectors
(d) Explain two factors that would likely determine the impact of
the fall in export sales to China on any one economy shown in Table
5. [4]
Size of k:
• ΔNY = k X ΔAD, where k=1/MPW and MPW=MPS+MPT+MPM
• The larger the withdrawals, the smaller size of k, and the lower the multiplied
change in NY
• Singapore’s M-reliance and high savings mean a high level of leakage from the
circular flow of income and implied that k is likely to be small
• Thus when there is a fall in X and therefore fall in AD, the fall in NY is likely to a
smaller extent than a country with larger k
(e) Analyse how China’s policymakers might attempt to transform
the economy to one that is driven by consumer spending. Assess
whether they are likely to be successful. [8]
Introduction:
• From Extract 4, the Chinese economy is highly driven by I and X, which makes
them highly dependent on other countries for their EG and vulnerable to
economic fluctuations
• Relying on I as a driver of EG is also not sustainable in the LR compared to
depending on C
• Definition of successful: If policies are successful, C will overtake I to become the
key driver of EG in China’s AD (Table 3)
• Policy: EFP
(e) Analyse how China’s policymakers might attempt to transform
the economy to one that is driven by consumer spending. Assess
whether they are likely to be successful. [8]
Thesis: Policies will be successful in increasing C
• EFP: decrease T (PIT)  increase disposable income  increase purchasing power  spend
more on consumer g/s  increase C
• EFP: increase G  increase subsidies for essential services (healthcare, social security), which
will decrease the need for consumers to save for future expenses/retirement  encourage
spending  increase C
• Policies are targeted to increase C and G but not I and NX  increasing proportion of C of GDP
• Wrt Table 3, if C/GDP rises sufficiently from its current 35%, then C can overtake I as the main
driver of growth and thus successfully transform the Chinese economy
• EFP also needs to focus on ways to increase wage growth, which incentivises households to
consume since they earn a higher income. This can come in the form of government’s direct
hiring or skills training programme to increase labour productivity so that workers can
command higher paying jobs
(e) Analyse how China’s policymakers might attempt to transform
the economy to one that is driven by consumer spending. Assess
whether they are likely to be successful. [8]
Anti-thesis: Policies may not be successful in increasing C
• Table 3: China economy is highly unbalanced with 47% of GDP on I and 35% of GDP on C,
hence, increase in C needs to be substantial for China’s economy to be transformed  the
impact of any policy to transform the economy can only be seen in the long run
• If consumers have poor expectations of the economy/their jobs or income, increasing
subsidies may not lead to fundamental change in consumer behaviour since people may
view such a policy as temporary and they will not increase C to the desired extent
• Policies require substantial government expenditure and poses a strain on the government
budget position and incurs opportunity cost of government expenditure in other areas
• Successful results are also not guaranteed eg policies to encourage skills training and
upgrading depends on the attitude and aptitude of workers and results can only be seen in
the longer term
(e) Analyse how China’s policymakers might attempt to transform
the economy to one that is driven by consumer spending. Assess
whether they are likely to be successful. [8]
Conclusion
• [EV]: Government budget position  the stronger the position, the more the government is able to
influence C through rise in G
• [EV]: Depends on whether use the rise in disposable income to buy more imports or domestic goods.
If increase in disposable income leads to consumers buying more imports, C will not increase while M
increase instead
• [EV]: Overtime, urbanisation of China’s large population base especially in their 2 nd and 3rd tier cities
will continue to boost household income and provides greater accessibility to consumption
opportunities. This, alongside the gradual erosion of culture of thrift leading to changes in
consumption habits, could mean China’s efforts at rebalancing its economy to a consumption-led
growth would meet with more success. With consumption-led growth widely viewed as a more
sustained and stable growth model less prone to the fluctuations in business cycle, the determined
efforts by the Chinese government to reallocate resources from investment to domestic production of
consumption g/s will reduce the need for imports and reinforce the success of transforming the
economy
(f) Discuss whether an expansionary monetary policy adopted by
China is likely, on balance, to have a beneficial effect upon China’s
trading partners? [10]
Thesis: Positive impacts of EMP on trading partners
• Successful EMP increases China’s real NY  HH’s disposable income rises,
purchasing power rises  demand more M  trading partners’ X will increase
• Extract 6: a wide range of countries are dependent on China’s demand for both
final g/s and intermediate goods  Increase in NX  increase in AD of trading
partners from AD0 to AD1 and a multiplied increase in their NY from Y0 to Y1
(f) Discuss whether an expansionary monetary policy adopted by
China is likely, on balance, to have a beneficial effect upon China’s
trading partners? [10]
Thesis: Positive impacts of EMP on trading partners
• The increase in o/p also causes firms to hire more workers, thereby decreasing cyclical
UNt
• With an increase in Y, HH can consume more g/s  improve material SOL
• Strong EG and high Nt also improves government budget position due to the increase in
tax revenue collected and decrease the need for government spending on
unemployment benefits
• In addition, the increase in NX of the trading partners improve the CA position, allowing
for a more favourable BOP position
• Due to weaker Yuan, trading partners that import from China enjoy cheaper imports 
benefit due to lower risk of imported inflation. Lowered price of M also imply cheaper
imported final g/s and rm which can decrease GPL in trading partner
(f) Discuss whether an expansionary monetary policy adopted by
China is likely, on balance, to have a beneficial effect upon China’s
trading partners? [10]
Anti-thesis: Negative impacts of EMP on trading partners
• If the trading partner is approaching classical range, any further increase in AD
from AD1 to AD2 will cause a sharp increase in GPL to P2 as firms bid up prices of
scarce resources while o/p increases from Y1 to YF (as spare capacity is being
used up)
• If AD2 continues to increase in a sustained manner to AD3, prices will be ‘pulled
upwards’ to P3  producers are unable to respond to the excess demand by
expanding real o/p because all available resources are already fully employed
• DD-pull inflation result
(f) Discuss whether an expansionary monetary policy adopted by
China is likely, on balance, to have a beneficial effect upon China’s
trading partners? [10]
Anti-thesis: Negative impacts of EMP on trading partners
• Fall in i/r in China  hot money outflow from China to trading partners in search
of higher returns  BOP (financial account) position of trading partners improve
BUT if this leads to a situation where “too much money is chasing too few assets”
 increase in inflationary pressure in trading partners
• Overall, higher GPL  reduced export competitiveness and ability to attract FDI
for trading partners, esp for small and open economies dependent on X markets
and FDI for growth
(f) Discuss whether an expansionary monetary policy adopted by
China is likely, on balance, to have a beneficial effect upon China’s
trading partners? [10]
Anti-thesis: Negative impacts of EMP on trading partners
• A weaker Yuan also means that trading partners’ X to China is now more
expensive  reduce DD for g/s exported from trading partners to China as
Chinese consumers switch to domestically produced g/s
• The final outcome on NX will depend on the relative PED for X and M. If MLC
holds, NX of trading partners will fall, adversely affecting their BOT position,
causing them to have a trade deficit with China
• Extract 4: China is already having a “trade surplus that expanded 65.6%”. Hence,
trading partners’ BOP may go into deficit, causing a drain on their foreign
reserves
(f) Discuss whether an expansionary monetary policy adopted by
China is likely, on balance, to have a beneficial effect upon China’s
trading partners? [10]
Anti-thesis: Negative impacts of EMP on trading partners
• In addition, lower Chinese Yuan also increase the X competitiveness of Chinese X
in the world market. For trading partners whose X are close substitutes to china-
made g/s, their relatively higher price will cause a more than proportionate
decrease in qtydd since PED>1 given the abundance of close substitutes available
 X revenue in trading partners decrease further
• Trading partners’ AD will decrease  multiplied decrease in their real NY via
reverse multiplier effect in trading partners
(f) Discuss whether an expansionary monetary policy adopted by
China is likely, on balance, to have a beneficial effect upon China’s
trading partners? [10]
Evaluation
• On balance, whether EMP in China will have beneficial effects on trading partners will
depend on the initial state of economy of trading partners. In the SR, when China’s M
falls, if trading partners’ economy is already nearing Keynesian range, then the resultant
fall in NX, AD and NY will cause a recession. In the LR, when Chinese citizens demand
more trading partners’ Xs, if trading partners’ economy is already near classical range,
this may cause demand-pull inflation  Benefits and costs of EMP on trading partners
are amplified by their respective initial state of economy  different trading partners
will benefit to different extents
• While EMP undertaken by China is aggressive, the overall effect on China’s trading
partners will depend on the outlook of China’s economy. If there is bleak outlook, C and
I will likely only increase marginally. Hence, positive impact of increase in China’s HH
incomes to increase DD for trading partners’ X is likely achievable after a long time lag
 2012 A Level Q1
Most brands of car are available in different models. A large
rise in the cost of car manufacture and a rise in incomes are
likely to affect the sales of various models of car in different
ways.
(a) Explain how elasticities of demand can assist in
understanding the effect of each of these changes on the
sales volume of different models of car. [12]
(a) Explain how elasticities of demand can assist in understanding the effect of
each of these changes on the sales volume of different models of car. [12]

Introduction:
• Large rise in cost of car manufacture affects SS
• Rise in incomes affects DD
• Effect of the two events on sales volume will vary for diff models of car
depending on their PED and YED values
Main:
• Large rise in cost of car manufacture  PED
• Rise in incomes  YED
(a) Explain how elasticities of demand can assist in understanding the
effect of each of these changes on the sales volume of different
models of car. [12]
Large rise in cost of car manufacture
• Increase COP, reduce profitability of car manufacture, SS falls
• Eqm price rise, eqm qty fall
• Given a fall in SS and increase in eqm price, PED of diff models of car matter in
explaining the effect on the extent of fall in eqm qty
• PED measures the degree of responsiveness of qty dd of a good to a change in
its own price, c.p.
(a) Explain how elasticities of demand can assist in understanding the
effect of each of these changes on the sales volume of different
models of car. [12]
Large rise in cost of car manufacture
(a) Explain how elasticities of demand can assist in understanding the
effect of each of these changes on the sales volume of different
models of car. [12]
Large rise in cost of car manufacture

Hence, increase in cost of manufacture will reduce sales volume for cars with the fall in
eqm qty for luxurious models of car being to a larger extent than that for basic models of
car
(a) Explain how elasticities of demand can assist in understanding the
effect of each of these changes on the sales volume of different
models of car. [12]
Rise in incomes
• Given rise in income, YED matters in examining the effect on the sales vol of diff
models of car
• YED measures the degree of responsiveness of qty dd of a good at every price
level to a change in consumers' income, c.p.
• Effect on sales vol depends on whether the particular model of car is considered
a normal good (YED>0) or inferior good (YED<0)
(a) Explain how elasticities of demand can assist in understanding the
effect of each of these changes on the sales volume of different
models of car. [12]
Rise in incomes
(a) Explain how elasticities of demand can assist in understanding the
effect of each of these changes on the sales volume of different
models of car. [12]
Rise in incomes

• 
Conclusion: PED and YED is useful in examining the direction and extent of change in sales
vol given the occurrence of the above-mentioned events
 (b) Compare and contrast the likely combined impact
of both these changes on the revenue earned from the
sales of different models of car. [13]
(b) Compare and contrast the likely combined impact of both these
changes on the revenue earned from the sales of different models of
car. [13]
Intro:
• Sales rev/TR=P X Q
• Combined effect of the 2 events on sales rev will vary for diff models of car
depending on their PED and YED values

Main:
•Impact of large rise in cost of car manufacture on sales rev
•Impact of rise in incomes on sales rev
•Combined effect of both events on sales rev
(b) Compare and contrast the likely combined impact of both these
changes on the revenue earned from the sales of different models of
car. [13]
Impact of large rise in cost of car manufacture on sales rev
• Wrt Fig 1 in (a), for basic car models (|PED|<1), increase in price from P0 to Pi
will lead to < prop fall in qty dd from Q0 to Qi such that sales rev will still
increase from 0P0CQ0 to 0PiBQi
• For luxurious models (|PED|>1), increase in price from P0 to Pe will lead to >
prop fall in qty dd from Q0 to Qe such that sales rev will fall from 0P0CQ0 to
0PeAQe
(b) Compare and contrast the likely combined impact of both these
changes on the revenue earned from the sales of different models of
car. [13]
Impact of rise in incomes on sales rev
• Wrt Fig 2 in (a), for models regarded as luxury goods (YED>1), increase in income will lead to >
prop increase in DD from DD0 to DD2. Sales rev will increase by a large extent from 0P0BQ0 to
OP2EQ2
• For models regarded as necessity (0<YED<1), increase in income will lead to < prop increase in
DD from DD0 to DD1. Sales rev will increase by a smaller extent from 0P0BQ0 to 0P1CQ1
• For models regarded as inferior goods (YED<0), increase in income will lead to fall in DD from
DD0 to DD3. Sales rev will decrease from 0P0BQ0 to 0P3AQ3
(b) Compare and contrast the likely combined impact of both these
changes on the revenue earned from the sales of different models of
car. [13]
•[EV]: in reality, PED values of diff car models differ across countries depending on
factors such as state of road infrastructure development and public transport
•Eg countries with well connected and fairly reliable public transport system would
probably have higher PED value for cars given availability of close subs. In contrast,
countries with less developed public transport system and hence higher reliance on
cars as a means of private transport have lower PED value due to higher degree of
necessity.
(b) Compare and contrast the likely combined impact of both these
changes on the revenue earned from the sales of different models of
car. [13]
Combined effect of both events on sales rev:
•X-axis: large rise in cost of car manufacture
•Y-axis: rise in incomes
(b) Compare and contrast the likely combined impact of both these
changes on the revenue earned from the sales of different models of
car. [13]
Conclusion:
• Sales rev will vary for diff models of car depending on their PED and YED values
• It shld be noted that the classification of cars, whether they are
inferior/necessity/luxury is very subjective and influenced by many factors eg
tastes and preferences, income level and affluence in the country
• In reality, the extent to which the increase in income will increase the dd for
normal goods like certain models of cars depend on consumer perception of
how sustained the increase in income is.
• This is due to the nature of cars being a big ticket item involving substantial
financial commitment. Hence its dd may not be affected if the increase is income
is perceived to be temporary or too small