Question 23M.3.HL.TZ0.2
| Date | May 2023 | Marks available | [Maximum mark: 30] | Reference code | 23M.3.HL.TZ0.2 |
| Level | HL | Paper | 3 | Time zone | TZ0 |
| Command term | Calculate, Define, Explain, Recommend | Question number | 2 | Adapted from | N/A |
Experts have predicted that the naira (Nigeria’s currency), which operates under a fixed exchange rate system, will be devalued in the coming months.
Many Nigerians convert their savings into foreign currencies as protection against the falling value of the naira and surging inflation, according to a recent research paper published by the Central Bank of Nigeria.
Africa’s largest economy devalued the naira twice last year after a crash in the price of oil. While oil contributes less than 10 % to Nigeria’s gross domestic product (GDP), it accounts for nearly all foreign exchange earnings.
The naira has lost 66 % of its official value since 2009 when it exchanged at ₦149 per US dollar (US$).
An economics professor predicts that the naira will be further devalued due to foreign investors selling their currency and choosing to invest elsewhere.
Another economist says that the naira has fallen in value due to the balance of trade deficit. Most of the rice consumed in Nigeria is imported because domestic production is not sufficient to satisfy the needs of the population. Consumer goods such as cooking oil, cars, fuel and clothes are mostly imported.
The economist recommends, “If you have naira, you should go and exchange into dollars or pounds or any foreign exchange.”
Table 1: Selected economic data for Nigeria
Nigeria’s fixed exchange rate
Nigeria maintains a fixed exchange rate for its currency, despite demands for reform from the International Monetary Fund and The World Bank. These institutions say a floating naira would help the economy withstand future shocks. But Nigerian authorities fear inflation stemming from a sharp depreciation could throw millions into poverty. Inflation has risen steadily since mid-2019, reaching nearly 18 % in May 2021. Although inflationary pressure is partly due to cost-push factors, it is also caused by the government’s expansionary fiscal policy.
The global recession and oil price crash damaged Africa’s largest economy, 90 % of whose foreign exchange earnings come from oil exports, pushing it into its second recession in four years. The recession ended by the fourth quarter, but the drop in oil revenues led to a current account deficit of US$16 billion last year and has depleted its foreign reserves.
Table 2
[Source: National Bureau of Statistics, 2021. CPI and Inflation Report December 2021 [online] Available at: https://nigerianstat.gov.ng/elibrary/read/1241113 [Accessed 12 July 2023] Source adapted.
Using the information provided in Table 1, calculate the inflation rate for Nigeria between 2020 and 2021.
[2]
Any valid working is sufficient for [1]
= 16.44% or 16.44
An answer of 16.44 without any valid working is sufficient for [1].
A response that uses the percentage change in the GDP deflator to provide an answer may be fully rewarded.
= 13.53% or 13.53
An answer of 13.53 without any valid working is sufficient for [1].
This question was generally well-answered. The minority of candidates who used the GDP deflator accurately were fully rewarded.
[2]
Any valid working is sufficient for [1] (e.g. if x100 has been neglected).
= 70 354.76 billion or 70 355 billion [1]
An answer of 70 354.76 billion or 70 355 billion without any valid working is sufficient for [1].
The vast majority of responses demonstrated an ability to use the GDP deflator. However, many neglected to multiply by 100. Once again unit errors were common.
[2]
Any valid working is sufficient for [1].
= 341 528 or 341 529
Where a response provides an answer correct to 2 decimal places, assume correct rounding to the nearest naira and award as appropriate.
An answer of 341 528 or 341 529 without any valid working is sufficient for [1].
OFR applies from part (ii).
A response that uses 2021 figures accurately may be awarded [2].
Any valid working is sufficient for [1].
= 328 124 or 328 123
An answer of 328 124 or 328 123 without any valid working is sufficient for [1].
Where a response provides an answer correct to 2 decimal places, assume correct rounding to the nearest naira and award as appropriate.
The majority of candidates were able to use their answer to part (a)(ii) and divide by the population. However, many found it difficult to divide billions by millions.
A Nigerian business pays US$14 000 every year to a consultant in the United States. Using the information in Table 2, calculate the increase in the cost of this payment, in naira, between 2018 and 2020.
[2]
2020: 14 000 × 379.5 = 5 313 000
Increase = 5 313 000 – 4 291 000
Any valid working (either 2018 or 2020 is correct) is sufficient for [1].
Generally answered accurately.
Define the term overvalued currency.
[2]
Stronger responses were able to explain clearly that an overvalued currency is one which is maintained (via a fixed/managed system) above its value in a freely floating system. Many responses, however, were not so precise, stating that the currency was "stronger than it should be" or "has a value which is too high".
Using an exchange rate diagram, explain how the Central Bank of Nigeria might attempt to maintain a fixed exchange rate.
[4]
An alternative approach which suggests that the central bank may increase the interest rate, which may increase the demand for naira, may be fully rewarded.
Alternatively, the increase in interest rates may decrease the supply of naira, as investors may be discouraged from selling naira in the foreign exchange market in order to invest overseas, OR the central bank reduces its sales of naira, which shifts supply to the left. Therefore, a diagram which shows a shift of supply of naira to the left should be rewarded.
Another valid approach would be to show that, at the fixed exchange rate, a surplus of naira would need to be offset by the central bank purchasing naira, thus increasing demand for the naira.
For an exchange rate diagram, the vertical axis may be exchange rate, price/value of the naira in US$, US$/Naira or US$ per naira. The horizontal axis should be quantity, or quantity of naira. A title is not necessary.
Candidates who incorrectly label diagrams can be awarded a maximum of [3].
Well-prepared candidates explained clearly that a central bank may buy or sell its currency (or use interest rate policy) on the foreign exchange market in order to maintain a fixed exchange rate. However, a significant number of scripts revealed confusion between intervention in the domestic money market and in the foreign exchange market. "Reducing the supply of money" was often equated to action taken to decrease the supply of naira in the foreign exchange market. Furthermore, a significant number of candidates drew a static diagram with no shift in supply of or demand for naira. Labelling the vertical axis was also an issue for many candidates. ₦/$ is not accepted but $/₦ is accurate.
Calculate the cost of this shipment in US$ at the official exchange rate (Table 2).
[2]
Generally well-answered, although with several rounding errors.
Using an AD/AS diagram and information from Table 2, explain how the change in the official value of the naira between 2018 and 2020 might have influenced the rate of inflation for Nigeria.
[4]
Candidates might explain that the depreciating naira results in an increase in the cost of imported inputs and therefore, a fall in (short-run) aggregate supply, resulting in (cost-push) inflation. This alternative approach should be fully rewarded.
If the student assumes that the naira has appreciated (revalued), an accurate diagram (with AD shifting left or SRAS shifting right) and explanation may be stamped ECF and awarded a maximum of [2].
Candidates who incorrectly label diagrams can be awarded with a maximum of [3].
For AD/AS, the vertical axis may be Average (General) Price Level, APL or Price level. The horizontal axis may be real output, real national output, real income, real national income, real GDP or real Y. A title is not necessary. LRAS may be shown in any appropriate position. Aggregate supply may be labelled SRAS or AS.
If AD shifts and SRAS is omitted, but LRAS is present, then the diagram may be rewarded.
The majority of responses were able to explain that a weaker currency would make exports more competitive and imports more expensive, leading to an increase in net exports and thus an increase in AD OR would increase the cost of imported inputs and thus decrease SRAS. Some candidates inferred from Table 2 that the naira had become stronger, leading to a decrease in net exports. In such cases no marks were awarded for the diagram but error carried forward (ECF) was applied and candidates could earn up to 2 marks for an accurate explanation based on the incorrect inference.
Using the text/data provided and your knowledge of economics, recommend a policy which could be introduced in Nigeria to stabilize the value of the naira.
[10]
Refer to Paper 3 markbands for May 2022 forward, available under the "My tests" tab > supplemental materials.
Possible policies may include (but are not restricted to):
- Policies to increase the export of manufactured goods (supply-side policies)
- Interest rate increase
- Exchange controls – limiting access to foreign currency
- Adopting a floating exchange rate
- Demand-management policies to limit imports (expenditure reducing)
- Trade barriers to reduce import spending (expenditure switching)
- Borrowing from overseas
- Attempt to persuade fellow OPEC members to increase the world price of oil
- Tax and other incentives to encourage inward foreign direct investment and portfolio investment
- Since most rice is imported, incentives to agricultural sector to grow rice
- Any other valid policy.
A wide range of policies was suggested for this question.
Weaker responses treated the prompt as similar to part (vi) rather than using the information provided. As a result, they suggested a fixed/pegged exchange rate, similar to the existing system.
Common recommendations were:
- Supply-side policies to increase export of manufactured goods — but often without specifying what type of supply-side policies.
- Import substitution — often without explaining how this might be achieved.
- Interest rate policy — although there was significant confusion between the foreign exchange and the domestic money market. Also, it was common to see the incorrect argument that higher interest rates would attract FDI.
- Contractionary fiscal/monetary policies — expenditure-reducing policies were often quoted although the link to decreased demand for imports and the impact on the foreign exchange market were often overlooked.
- Adopting a floating exchange rate system — but only a small number of candidates were able to explain accurately why a floating system might result in a more stable currency — many just quoted the IMF advice without support.
- Trade protection was often recommended. Stronger responses established a clear link to the value of the currency while weaker responses focused more on a generic explanation of a tariff, with the standard tariff diagram and description.
A common approach was to focus almost completely on policies to address inflation and then write "and thus stabilise the naira" without showing the link between the two concepts. Thus the policy might be appropriate but the explanation/use of theory would be somewhat weak.
