Question 20N.2.SL.TZ0.1
| Date | November 2020 | Marks available | [Maximum mark: 20] | Reference code | 20N.2.SL.TZ0.1 |
| Level | SL | Paper | 2 | Time zone | TZ0 |
| Command term | Define, Discuss, Explain | Question number | 1 | Adapted from | N/A |
Argentina’s currency keeps falling
- The year 2018 started badly for Argentina when the worst drought in 50 years negatively affected its export revenues from maize and soybeans, both important exports. The economy suffered several additional problems: a stronger United States dollar (US$), international investors selling Argentinian assets due to a lack of confidence in the economy, rising inflation from 25 % to nearly 50 % (Figure 1) and a significant depreciation of the peso, Argentina’s currency.
- When Argentina’s president was elected in 2015, inflation was at 25 %. He gave the central bank freedom to raise interest rates, which encouraged foreign investors to buy government bonds. The government had borrowed a lot of money from overseas to finance the persistent budget deficit, but by 2018, foreign investors were interested in other markets.
- As the peso was overvalued in 2015, it kept demand for imports high and made it hard for exports to compete. The current account deficit rose to more than 5 % of gross domestic product (GDP) but slowly narrowed in 2018, because the president allowed the peso to float freely.
- In May 2018, in an attempt to control the inflation rate and stop the fall in the peso’s value, the Argentinian central bank raised interest rates to 40 %. In addition, it started selling foreign currency reserves. However, there were concerns that if the selling of foreign currency reserves continued, they would be depleted quickly. To address this concern, the president negotiated a US$50 billion loan from the International Monetary Fund (IMF). Yet the peso continued to fall. The IMF loan means that most of Argentina’s debt-servicing requirements are covered until 2020. However, under IMF loan conditions, the budget deficit must be cut by postponing infrastructure projects, subsidies must be cut, and government jobs must be cut.
- A spokesperson from the IMF said “Argentina has a floating, market-determined exchange rate, and the IMF fully supports that. The exchange rate should continue to be determined by market forces.”
- The peso’s weakness causes imported oil prices to go up, further raising inflation. The falling real incomes of households combined with higher interest rates will affect the economy negatively, possibly leading to a recession. Interest rates will remain high for some time, discouraging investment. Economists expect Argentina to fall into recession, for the fifth time in a decade.
Figure 1: Argentina’s inflation rate
[Source: Adapted from Anon, n.d. Argentina Current Account, Trading Economics,
https://tradingeconomics.com/argentina/current-account.]
Define the term budget deficit indicated in bold in the text (paragraph [2]).
[2]
Most candidates scored level 2 on both definitions. A small minority confused budget deficit and current account deficit.
Define the term gross domestic product (GDP) indicated in bold in the text (paragraph [3]).
[2]
Note: This question has been amended from the original exam, to remove reference to a second figure that could not be cleared due to copyright restrictions.
Most candidates scored level 2 on both definitions. A small minority confused budget deficit and current account deficit.
Using an exchange rate diagram, explain how raising interest rates would “stop the fall in the peso’s value” (paragraph [4]).
[4]
Candidates who incorrectly label diagrams can be awarded a maximum of [3].
For an exchange rate diagram, the vertical axis may be exchange rate, price of pesos in USD, USD/peso, USD per peso. The horizontal axis should be quantity, or quantity of pesos.
A title is not necessary.
A diagram may show demand initially shifting left (and/or supply shifting right) causing the exchange rate to fall and then demand shifting right (or supply shifting left) to restore the value of the peso to its original level. If correctly drawn and explained, this can achieve full marks.
Almost all candidates reached level 2. The diagrams often depicted an increase in demand which was linked to an increase in foreign investment. However, fewer were clear about the type of investment. As higher interest rates typically deter investment in physical capital, it was thus necessary to specify that the higher interest rates would attract financial investment - in the form of savings in Argentinian banks/bonds/financial assets - or lead to increased inflows of "hot money". Some candidates also confused the 'external' supply of the currency with the 'internal' money supply.
Using an AD/AS diagram, explain how the peso’s weakness is “raising inflation” (paragraph [6]).
[4]
Candidates who incorrectly label diagrams can be awarded a maximum of [3].
For AD/AS the vertical axis may be average (general) price level, or price level. For the horizontal axis, real output, real national output, real income, real national income, real GDP or real Y. Any abbreviations are acceptable. A title is not necessary. “AS” is a valid label for the SRAS curve.
This question was also reasonably well attempted. Most candidates could link the weaker currency to a fall in SRAS or at least point to the more expensive imported oil. Some suggested that AD would rise as exports become cheaper and imports more expensive. While theoretically correct, this approach is not aligned to the context set in the referenced paragraph. Paragraph 6 did not suggest any alternative to imported (cost-push) inflation. For all part (b) and (c) questions, it is critical that candidates read carefully the passage of the text referenced.
Using information from the text/data and your knowledge of economics, discuss the view that Argentina should keep its floating exchange rate system.
[8]
Examiners should be aware that candidates may take a different approach which, if appropriate, should be rewarded.
Do not award beyond Level 2 if the answer does not contain reference to the information provided.
Command term
“Discuss” requires candidates to offer a considered and balanced review that includes a range of arguments, factors or hypotheses. Opinions or conclusions should be presented clearly and supported by appropriate evidence.
Responses may include:
- Definition of floating exchange rate.
Arguments for floating exchange rates may include:
- The peso is less likely to be overvalued, and therefore exports will be more price-competitive (paragraph 3).
- Allows current account to be self-correcting, which seems to be happening as the current account deficit is slowly narrowing (paragraph 3) now that the peso has significantly depreciated.
- More freedom to set interest rates and domestic monetary policy (paragraph 2), which has been necessary given the high inflation rate and need to finance the government deficit.
- The central bank needs not use foreign reserves to maintain a fixed exchange rate, which could otherwise be depleted (paragraph 4).
- Argentina needs to keep its floating exchange rate system to qualify for the US$50 billion loan from the IMF (paragraphs 4 and 5). The loan is necessary to meet Argentina’s debt requirements until 2020.
Arguments against floating exchange rates may include:
- Speculative activity can greatly influence the exchange rate, eg speculators selling pesos to buy US dollars (paragraph 1), further depreciating the peso.
- The rise in interest rates (to stop the peso falling) is reducing investment (paragraphs 4 and 6).
- Servicing foreign debt is difficult/costs more in terms of pesos when the value of the currency continues to fall in value (paragraph 4).
- Instability and lack of predictability for firms, consumers, importers and exporters – imported costs, including oil, have increased (paragraph 6).
- Governments not required to keep exchange rate fixed, hence there is less incentive for governments to keep inflation in check (paragraph 6).
- If the peso continues to fall, the IMF may need to continue to support the Argentinian economy. This could make Argentina over-reliant on (conditional) loans from the IMF.
- If demand for exports and/or imports is very inelastic, a depreciation will widen the trade deficit, causing further downward pressure on the peso.
- Further depreciation might lead to stagflation and/or a recession (paragraph 6).
Any reasonable discussion.
Almost all answers could offer some 'standard' benefits/drawbacks of floating exchange rates. The text was often referenced to support the analysis. In particular, most candidates could link the self-adjustment mechanism of floating exchange rates or the reduced need for foreign exchange reserves to relevant parts of the text. Fewer were able to elaborate on the independence of monetary policy and rare were references to figures 1 and 2. In some cases, the discussion was centred not on the floating exchange rate but just on the depreciation of the peso.
A level 3 answer is one where the candidate applies economic analysis to the text to reach conclusions which are not immediately obvious from the stimulus material. In this case, such response could be one which points out that Argentina's record of high inflation may make a floating exchange rate undesirable or that the current exchange rate is not really a free-floating one given the heavy intervention of the central bank in selling reserves.