Economics paper 2 answer guidelines

9708/23/ON/13

4.In October 2011, the Chinese government said that they would not allow a further rise in the
international value of the Chinese currency, the Yuan, because the Chinese economy would be
damaged.

a) Explain how exchange rates are determined in the free market and now some governments
intervene to manage their exchange rate.

Definition: Exchange rate is determined by demand and supply on the FOREX. An exchange rate
consist of two currencies: A base currency and a quote currency; pricing one currency in terms of
another.

Diagram of fluctuations due to increase/decrease in demand and increase/decrease in supply +

explanation of each diagram.

Fixed/ Managed exchange rate definition : In fixed, the government sets the value of the currency
and that value maintained is maintained by the central bank. The central bank is committed
towards maintaining the value set by buying their own currency to increase demand when there is
prospect of depreciation/ selling their own currency to increase supply when there is prospect of
appreciation.(Another way would be to alter interest rates)

Diagram of managed/float exchange rate : Demand and supply diagram with fixed exchange rate
or floating within boundaries (managed float)+ explanation of the diagram

9708/21/MJ/11

3b) Discuss whether inflation can be both the cause and result of fluctuations in an economys
exchange rate

Definition of inflation : sustained rise in g.p.l

How inflation causes a rise in prices

Multipliers effect, increases in price because of inflation ultimately leads to increase in export
price. Increase in export price will cause large reduction in demand ( describe briefly Marshalls
Learner) + diagram of how this reduced demand effects exchange rate ( if PED elastic, export
demand reduces by a large margin. Demand for currency falls and currency depreciates)

How does inflation in home country compare to trading partner? If incidence of inflation falls on
countrys trading partner, and is relatively higher than home countrys inflation, demand for
exports from home country can increase( in this case, although both countries have inflation,
home countries inflation is less severe and exports are still competitive) .Imported inflation from
trading partners may also discourage consumption of imports. This can cause appreciation in
currency.

How inflation can be a result of fluctuations in exchange rate

When exchange rate depreciates, the demand for exports increases due to fall in the value of
exporting country currency (the exports have become cheaper for consumers in other countries).
 This causes an increase in net exports thus an increase in aggregate demand, leading to
demand-pull inflation. At the same time because the value of currency has fallen due to
depreciation, imports have become more expensive. If this imports are used in the production of
goods and services in the country, this causes cost-push inflation.

When exchange rate appreciates, demand-pull and cost-push inflation is reduced + explanation
(reverse of previous point)

Conclusion: Inflation causes fluctuations in exchange rate but when exchange rate fluctuates,
inflation may not always be a result.

9708/ON/21/2009

3a) Explain with the help of a diagram, how the price of a product moves to a new equilibrium
following a decrease in its supply

Supply definition: Quantity of a good that producers are willing to supply at a given price

Equilibrium definition : State of a market where quantity demanded and quantity supplied at the
same price are equal. There are no shortages and surpluses at this equilibrium price.

Factors that affect supply : (any 2 factors that cause a shift in supply to the left) Rise in cost of
production where producers find a good less attractive to produce because it is more expensive to
produce. Government policies like indirect taxes can increase cost of production, causing supply to
fall. Harsh weather conditions can cause a decrease in supply of agriculture goods for example, a
drought.

Diagram + Explanation (Example: The market is originally at equilibrium at point e. When supply
falls, the supply curve shifts to the left. This causes a rise in price and discourages consumer
consumption. Demand contracts and new equilibrium is restored, with a higher price equilibrium.

9708/22/MJ/2009

2a) Explain, with examples and diagrams, the effect of decrease in incomes on the markets for
normal and inferior goods.

Income elasticity of demand (YED) : definition + formula (Responsiveness of quantity demanded

to change in income)

Normal good definition : Quantity demanded increases when consumer income increases and it
has a positive YED (income elastic) + example. If an economy has a higher income level, there
would be larger provision and consumption of normal good.

Inferior good definition : Quantity demanded decreases when consumer income increases and it
has a negative YED (income inelastic) + example: public transport

2 diagrams - One for normal and one for inferior good when there is a decrease in income +
explanation for each diagram. For normal, when there is a decrease in income, demand curve
shifts inwards, and supply contracts to a new equilibrium.
9708/22/MJ/2010

4a) Explain, using a normal demand curve, how consumer surpluses occurs

Normal demand curve : Downward sloping representing an inverse relationship between quantity
demanded and price

Consumer surplus : Difference between what consumer is willing to pay for and the price the
consumer actually pays. It is represented as the area between maximum price and equilibrium
price (area between demand curve and price line). Surplus will continue to exist until maximum
price a consumer is willing to pay for an item equals to the equilibrium price of the item.

Example with diagram and numbers + definition consumer surplus

Effects of price change on consumer surplus.

Effects of PED on consumer surplus. The more elastic the PED is, the lower the level of
consumer surplus. At perfectly elastic, there is no consumer surplus.

9708/21/ON/2014

2b) Discuss whether it is both possible and beneficial for a business to change the price elasticity
of demand for its product.

Definition of PED : Responsiveness of quantity demanded to a change in price + formula

PED influencing total revenue : When product is inelastic, firms can increase price to increase total
revenue + vice versa and explanation of why this happens.

How to change PED : For example, successful advertising can make consumers more complacent
to price changes therefore, product becomes more price inelastic. Discuss merits and demerits of
advertising, and any other ways of influencing PED (reducing ease of substitution,etc).

Benefits of changing PED : Influence profits, forecast sales, control over pricing

Disadvantage of changing PED : Might not always work. For example, if the seasonal trend is to
wear furry clothing, then clothing companies are better off trying to alter production then changing
PED of existing goods that are not in trend.

9708/23/MJ/2013

2a) Explain how and why the price elasticity of supply of agricultural goods differ from that of
manufactured goods

Definition of PES : Responsiveness of quantity supplied to changes in price + formula

Factors that influence PES : i.e. Agricultural goods are more perishable than manufactured goods.
So when price increases, supply of agricultural goods does not increase by much in comparison
because it cannot be stored (supply cannot be manipulated easily). Other factors like length of
production period, etc.
Graphs : Relatively elastic supply curve for manufactured goods and relatively inelastic supply
curve for agricultural goods.

9708/22/MJ/2009

3b) With the help of a diagram, discuss how desirable it is for a government to pay subsidies to
producers

Diagram of a subsidy : Subsidy reduces cost of production for firms. This causes a shift in the
supply curve to the right. Equilibrium price lowers as the quantity traded increases, with an
expansion in demand. Producers sell at a higher price, and consumers purchase at a lower price.
Extent to which who benefits more depends on elasticities involved.

PED affecting subsidy : Diagram of inelastic demand and elastic demand during a subsidy. Note
the change in area indicating that during elastic demand, producers gain more whereas during
inelastic demand, consumers gain more.

Desirability of subsidy : Government finances subsidy (on graph, government bears the whole
area). To finance subsidy there may be taxation increases or reallocation of government budget
which involves an opportunity cost. Subsidies may contradict efficiency of market outcome (where
inefficient firms that should be driven out of business are financed by subsidies).

9708/21/MJ/2009

3 a) Explain,with the aid of a diagram, how consumer surpluses will be affected by the introduction
of an indirect tax

Consumer surplus : Definition + diagram (area between demand curve and price line)

Indirect tax : Definition + diagram. When tax is imposed, it causes a shift in the supply curve
inwards, causing quantity traded to fall and price equilibrium to increase accompanied by a
contraction in demand. This fall in demand and increase in price causes consumer surplus to
reduce, because the difference in the amount the consumer is willing to pay and the actual amount
paid has also reduced. Extent of the decrease in consumer surplus depends on PED.

PED influencing decrease in CS : Examples in the form of diagrams

9708/21/ON/15

4b) Distinguish between domestic and external consequences of inflation and discuss which is
more damaging.

Distinguishing:

Domestic effects : Lowered standard of living,lowered purchasing power,redistribution of

income,fiscal drag + in depth explanation

External effects : Depends on open or closed economy. i.e. affects as imported inflation etc.

Discuss:

Domestic is more damaging : Reduces confidence in the economy. Affects more lenders,borrowers
creditors,fixed incomer earners (explanation on negative consequences of inflation on these
groups).

External is more damaging : Affects larger amount of people (Multipliers, exporters, importers,
cause unemployment in the export market)

Conclusion : Draw your own conclusion + comment on why you think so.

9708/21/ON/15

With the help of diagrams explain how cost push inflation and demand pull inflation can be caused
by a falling exchange rate.

Cost push inflation : Definition + diagram ( AS curve shifts to the left causing an increase in general
price levels). When ER falls, price of imports increase, causing an increase in production costs if
thee imports are raw materials/machinery that are used heavily in production. The increase in cost
of production causes cost-push inflation.

Demand-pull inflation : Definition + formula of AD + diagram ( AD curve shifts to the right causing
an increase in general price levels). When ER falls, price of exports becomes relatively cheaper.
This causes demand for exports to increase, thus AD increases leading to demand-pull inflation.