Question

Use the AD-AS model to explain and illustrate, from a theoretical perspective, that by choosing the right combination of measures (policies) it is possible for the economy to grow without it experiencing inflationary pressures. Which macroeconomic policies are critical in ensuring that the price level does not increase? (N.B: In your answer, discuss a minimum of 4 examples of macroeconomic policies that can be adopted)
[25 Marks]
3. Using a case study of a manufacturing company, describe the nature of business of the manufacturing company and explain the impact of fluctuations of the exchange rate on business performance. Identify and explain three factors that may have contributed to exchange rate volatility in your country during the last 12 months and three approaches that can be adopted by the business to minimise the negative impact of exchange rate volatility.
[25 Marks]

Answer 1

Part 1.-

The growth of an economy is measured by the growth of its GDP.

The Aggregate Demand-Aggregate Supply (AD-AS) model is very simple. It explains the relationship between Price (on Y axis) and output (GDP, on X-axis) and wherever the Demand and Supply curves meet, thats where the current level of prices and GDP (hence the economy) is. The graph below shows a typical AD-AS model.

It is clear from the graph that if demand moves faster to the right than the supply (because of economic growth etc.), prices would rise. Or if supply decreased even though demand was the same (supply curve moved to the left), prices would rise. In the long run, though, the supply curve is called Long Run Aggregate Supply (LRAS) and is vertcial, because it represents potential output of the economy. This is shown below

Its pretty clear that if Supply can keep up with the demand, there would be no rise if prices. So what policies can be used to do just that? Below are the possibilities-

• Use Fiscal Policies to control growth- If it is predicted that growth will be too much and might outstrip supply, the central bank can use measures such as higher interest rates to reduce the money supply in the market, which would result in slower growth as cost of borrowing will go up.
• Make sure no bottleneck in supply- This means create good infrastructure, transparent laws, no bottlenecks by bureaucracy etc. This would result in supply not being bottlenecked at any level.
• Stable exchange rate- A rapid decrease in the currency (devluation) may lead to inflation in the country. Keeping the exchange rate stable would remove such shocks.
• Efficiency improvements- encourage technological innovation, train people etc. so that whatever resources supply side needs, they are available and are performing better than before.

3. Lets take the example of Fiat, the car manufacturer. Fiat has a very big automobile manufacturing plant in Asangaon, India. The plant produces various cars like Punto, Linea etc but the most important car being produced there is the Jeep Compass. Fiat produces this for the Indian market as well as other markets such as Australia. Around 65% parts of the Compass are locally sourced or manufactured in India, rest come from different markets such as Germany, Mexico, US etc. This makes it a unique case study as far as exchange rates are concerned. Because when the rupee appreciates (become stronger as compared to the Dollar), the export to other countries become cheaper. Lets say the local parts of the car were costing 40000 dollars, which at 70 ruppes per dollar would come to around 2800000 rupees. If the rupee appreciated to 60, it would then come to 2400000 only. But Rupee appreciation has a reverse impact on the other 35% parts being imported. They are now more expensive! Inverse will happen if the Rupee depreciated. It would make exports more expensive and imports cheaper.

The final impact of the appreciation or depericiation, hence, depends on how much Fiat is importing and exporting.

Factors that affected the fluctuations-

• Lowering inflation- India's inflation rates have been consistently falling in past couple of years. This resulted in the Rupee appreciating against the dollar.
• Increased local manufacturing- India's manufacturing sector has shown substantial growth in past few years. This has resulted in lesser demand of foreign currencies and hence helped Rupee appreciating.
• High growth rate- India's economy has been growing at one of the fastest rates in the world. This leads to higher demand of imported goods, resulting in deperciation of the rupee.

Approaches that can be adopted by the business to minimise the negative impact of exchange rate volatility-

• Balance out the exporting and imporiting- As in our example of Fiat India, a company can operate in such a way that the amount its exporting and importing is roughly same. This would nullify any exchange rate fluctuation.
• Buy when prices are low, sell when high- A firm knows raw materials etc it would need in the future. If the prices are favourable, the firm can buy them in advance. Similarly, when the prices are high, it can resell them.
• Efficient operational pipeline- The manufacturing firm can make sure that it has more than one supplier available in different countrues. If the Euro is unfavorable, maybe the firm can import the same material from a firm in Australia?