Question 20N.2.SL.TZ0.b
| Date | November 2020 | Marks available | [Maximum mark: 4] | Reference code | 20N.2.SL.TZ0.b |
| Level | SL | Paper | 2 | Time zone | TZ0 |
| Command term | Explain | Question number | b | 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.]
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.
