May 2001 Q2 :
Examine the impact of a decision to raise interest rates in an economy where there is both a high rate of inflation and a large current account deficit. Specific reference should be made to the exchange rate in your answer.
A rise in interest rates will reduce (candidates may use either the level, or the rate of growth of) aggregate demand. Consideration of likely transmission mechanisms: candidates should consider the impact on at least two elements of C+I+G+X-M.
- An appropriate AD/AS diagram is also required.
- Identifying income effects on inflation/current a/c
- Identifying exchange rate effects on inflation/current a/c
Evaluation points might include:
- More extended analysis of the impact of the changes already
- The relative strengths of the various income and price effects identified
- Other things may not be equal,
- The shape of the AS curve (elasticities).