BIS Abu Dhabi Economic Society Journal

Economics Society

IBDP ECONOMICS JOURNAL

VOLUME 1: ISSUE #1

HEADLINES

Bank of England Rate Rises

Page 1

Uncle Sam's Debt Ceiling Problem

Page 3

When Suplly Can's Meet Demand Page 5

TEACHER TIPS

Contextualising Diagrams Developing Chains of Reasoning Paper 3 Policy Questions

JUNE 2023

Aleena Asad Jasmine Pitman Owen Rice Mr. J McLean

What is happening?

The Bank of England has raised interest rates for the 10th time in a row, causing the base rate, the rate that all other UK banks must follow, to reach its highest level in 14 years. This is intended to combat the rising inflation rate, which reached 10.1% in January, over five times the Bank’s target of2%.Inflation,whichreferstoariseinthegeneral price level, has led to the current cost-of-living crisis due to the rising price of necessities, with housing and bills alongside food and drinks being thelargestcontributorstotheinflationrate.Prices have risen worldwide after governments eased Covid restrictions, causing a surge in consumer demand. Another factor is the war in Ukraine, whichhaspushedoilandgaspricesup,leadingto the soaring cost of energy, and reduced the amountofgrainavailable,drivingfoodpricesup.

InflationRate(ConsumerPricesIndex)

More rate rises are likely to come, with some analystsspeculatingthatitwillpeakat4.5%inthe summer. The MPC meets eight times a year to decideinterest-ratepolicy.

BaseInterestRate

Source:BBC

Latest Changes

Following the latest meeting of the Bank’s monetary policy committee (MPC), the benchmarkratehasrisenfrom3.5%to4%.

Source:BBC

Why?

The intended impact of the policy is to lower inflation by making it more expensive to borrow money.Peoplewillbeencouragedtoborrowand spend less and save more. This will help reduce inflation caused by the surge in consumer demand. Since wages rose by 6.7% from SeptembertoDecember2022,whichwouldraise demand for consumer goods, the Bank maintained that further interest rate changes wereneededtoeffectivelyreduceinflation.

However,thisisatrickybalancingactashigherinterest rates can lead to a decline in economic growth,astheyreduceconsumerdemand.This

About the Author: Aleena Asad is a Year 12 student at the British International School Abu Dhabi, studying IB Economics at Higher Level.

could worsen the recession the UK is expected to enter this year. The Resolution Foundation thinktank said that statistics show that the UK is in the midst of the weakest 20-year period of growth since before the second world war and the Bank’s policies will only worsen this. None theless, Chancellor Jeremy Hunt, whose recent tax rises are also expected to reduce economic growth, “supportstheBank’sactions”inprioritisinginflation levels as they are “the biggest threat to living standardstoday”.

Who does this affect?

Therateincreasewillhavesignificantimplications for borrowing costs. Many homeowners on variableortrackermortgageswillbeforcedtopay more expensive monthly repayments. According to the Bank of England, up to four million households face a higher monthly mortgage bill this year. Around three-quarters of mortgage customers have a fixed-rate mortgage and will not be affected by the interest rate rise. Howeverer, those seeking to buy or remortgage a house, estimated to be around 1.8 million this year, will havetopaymuchmorethaniftheyhadtakenout the same mortgage a year ago. The Bank’s interest rates also influence the rate charged on credit cards, bank loans and car loans. Ahead of this decision, the average interest rate on bank overdrafts was 19.77% and 19.55% on credit cards. Lenders may decide to drive up their interest rates further, in anticipation of higher base rates inthefuture.

Ontheotherhand,dealsbeingofferedforsavings in banks are better than anything seen in years. Some banks now offer up to 7% inter est on savings accounts. As some widely held accounts, such as Barclays and Santander easy access accounts, are lagging behind with just 0.5-0.6% interest,analystsrecommendpeopleshoparound for a better savings rate. Although savers are receiving

Source:BBC

a higher return on their money, the rates are not keeping up with the inflation rate, meaning the purchasingpowerofsavingsisfalling.

Looking Ahead

With the current policies, the Bank of England expects the inflation rate to fall rapidly this year to 3.5% by the end of the year, and then 1% in 2024. However, this may come at a cost as the soaring interest rate could have harmful consequences for ordinary people facing mortgage and credit paymentsandexacerbatethecoming recession.

Key Terms:

•Inflation-ariseinthegeneralpricelevelinan economy.

•Interest-thepriceofborrowingmoney.

•Baserate-theinterestratesetbytheBankof Englandforlendingtootherbanks.

•Costofliving-thelevelofpricesrelatingtoarange ineverydayitems.

•Mortgage-atypeofloanusedtopurchaseor maintainahome.

Further Reading:

•InterestRates:DifferentTypesandWhatThey MeantoBorrowers-Investopedia

•Whatdoesthelatestriseininterestratestellus abouttheUKeconomy?-EconomicsObservatory

•Whatdointerestraterisesmeanforyou?

-TheTimes

The Imminent Threat Of Uncle Sam’s Debt Ceiling Problem

Jasmine

Pitman

is a Year 12 student at the British International School Abu Dhabi who is studying Higher Level IB Economics

is the U.S. debt ceiling? What happens in a default?

The U.S. debt ceiling was put in place by the Second Liberty Bond Act in 1917, it is explicated as the total amount of money that the United States government is authorized to borrow, essentially a cap on issuance of bonds. This debt limit allows the government to finance existing legal obligations that have been made but does not permit new spending commitments. Notionally, the debt ceiling isameanstokeepthegovernmentfromexpanding unchecked and prompts it to act financially responsible.

The U.S. is considered a ‘safety haven’ for investors across the world as government bonds are deemed risk-free.Inthepast,thedebtceilinghasbeenraised whenever the United States has impended the limit. Failure to raise the limit would decrease its credit rating from S&P (and other rating companies), causingdetrimentaleffects(expandedonbelow).

Thecurrentdebtlimitis$31.4trillion,andtheU.S.hit this limit on the 18th of January 2023 - in order to keep the economy functioning after this limit was reached, the treasury has taken ‘extraordinary measures’ by shifting around funds. However, this canonlylastforsolong.

A default would simply be defined as the inability to repay the country’s debt. Raising or defaulting on the debt is a political issue which is ultimately decidedbyCongress.Raisingthislimitwouldallow the government to increase its borrowing to cover spending already approved by Congress. Contrastingly, failure to raise the ceiling would causethegovernmenttodefaultinpayingbackits debts. The U.S has never defaulted on its debt ceiling; Congress has always acted when called upontoraisethelimit.Hittingthedebtceilingisn’t the predominant problem, it’s only the beginning before the principal disaster strikes – a default. It is estimatedthatthisdefaultwilloccurbetweenJuly and December 2023 (dependent on forthcoming tax revenues). Simply put, once the debt limit is reached, the Treasury cannot sell any more bonds orothersecuritiestopayoffthedebt.

Defaulting on the debt limit could be said to have catastrophic effects; the treasury would be unable to pay federal money towards expenditures such as, Medicare, social security, defense salaries and coupons for bond holders. Subsequently, the U.S. credit rating would most certainly be degraded, causing interest rates to rise, and making loans more expensive. These higher interest rates would cause businesses to decrease their borrowing, leading to less opportunity for expansion and less hiringofworkers,reducingdemand.

As consumers spend less money, businesses may lowerpriceswhichmeanstheyconsequentlymake less profit. When that happens, there’s a risk of layoffs, which could lead to a recession. This would send shock waves through global financial markets, ensuing a fall in confidence amongst U.S. borrowers. The consequent effect on the stock market would cause plummets across the globe, volatility spikes and would unnerve the financial markets.

What

Jasmine Jane Pitman

How does this affect YOU?

When the debt ceiling is reached, your standard of livingcouldbeaffected;interestratesmayincrease, hindering economic growth. The increasingly falling investor confidence could mean lower returns on investments, making a recession possible. It also places pressure on the country’s currencybecauseitsvalueistiedtothevalueofthe country’s bonds. As the value of the currency declines, foreign bond holders› repayments are worth less and goods and services may become more expensive, which contributes to inflation. This will increase prices, which leads to a decrease in purchasingpoweramongstconsumers.Inthelikely case that salaries don’t increase proportionally with inflation levels, this will cause all consumers to be worseoff.

How can the debt limit be reduced?

In the case of a default, contractionary fiscal policy may occur which involves raising taxes and reducing government expenditure. These effects however can impede on living standards and slow economic growth. Furthermore, this process could be viewed as rather cyclical as if the government reduces expenditure, the revenue in turn is also likelytodecrease,whichcanleadtoalargerdeficit.

How likely is a debt default?

Regardless of the ongoing political brinkmanship over the debt ceiling measures, it is said to remain unlikely that the U.S. will default on its debts; the ceiling has been revised 78 separate times since 1960. Furthermore, President Biden has already made deals back in 2021 with Republicans to pass critical legislation, most notably the $ 1.2 trillion infrastructure package. Therefore, it’s likely that he will be able to negotiate spending reduction measuresinexchangeforraisingthedebtceiling.

Further Reading: https://www.washingtonpost.com/business/2023/ 05/01/con-gress-debt-limit-deadline-bidenmccarthy/

https://www.cfr.org/backgrounder/what-happenswhen-us-hits-its-debt-ceiling

https://www.whitehouse.gov/cea/writtenmaterials/2023/05/03/debt-ceiling-scenarios/

KeyWords:

Debt limit / ceiling - the total amount of money that the United States government is authorized to borrow

Default –thefailuretomakerequiredinterestor principalrepaymentsondebt.

Interest rates – defined as the cost of borrowing moneyandtherewardforsaving.

Contractionary fiscal policy – targets a reduction in demand (increased taxation and reduction in governmentexpenditure).

What happens when Supply can’t meet Demand?

Owen Rice is an IB Higher Level Economics student at the British International School Abu Dhabi

Impact

Oneofthefirstlessonsofeconomicsisthatdemand is the quantity of a good or service consumers are willingandabletopurchaseatagivenprice.

The definition of supply can seem a little bit more complicated. According to your textbook, supply is the amount of a good or service “that producers are willing to offer for sale at different prices in a given period of time”. This makes sense; if supplying a productmeantthatafirmwaslosingmoney,they would (in a theoretical sense) be both unable and un- willing to supply it. But what about cases where firmsarewillingtosupplybutareunableto?

Whilst supply chain disruptions may appear to be only a minor inconvenience, they can have massive, negative economic impacts – hurting consumers,businessesandeconomiesasawhole.

When Supply cannot meet demand, markets stop operating efficiently and firms are given outsized pricingpoweroverconsumers.Ashortage–inthis case caused by a geographic divide between production facilities and consumers – results in firms being able to charge more in the market as consumers have no choice but to pay a higher priceiftheywishtobuytheproductinquestion.

Supplychaindisruptionsalsomeanthatproducers struggle to get to inputs needed to produce finished goods. This means that even firms who can easily supply their goods to consumers have also had to raise prices and waiting times for consumersduetotheslowmovementofinputs.

Finally,oureconomiesonthewholehaveseenthe negative impacts of higher prices, lower supply and longer waiting times. Inflation has been rampant throughout all developed economies in thepastyearandahalf.

Why?Becauseoffailuresinglobalsupplychains.

Real Life Examples

Inthepastthreeyearssomeoftheworld’sbiggest firms (think Apple, Tesla, Amazon) have been willing but unable to supply goods to their markets.

In the US, car shortages have been especially bad, with stock levels down by 64% since pre-Covid levels caused by semi-conductor shortages due to manufacturingslow-downsinChinaandTaiwan.

and is originally from Australia.

A supply chain is effectively everything between you and the factories and mines where the goods you want come from. Consider an iPhone. IPhone components are largely produced in Mainland China, India and the US, with metals from Mongolia,theCongo,Australiaandelsewhere.Inall an iPhone could contain parts and raw materials from as many as 43 countries. This allows companies like Apple to keep their production costs low to make as big a profit as possible – and (sometimes)toprovideaslowapriceaspossibleto consumers.

Apple’sglobalsupplychainsworkgreat–solongas everythingrunstoplan.Solongasthereisn’ta global event which forces factories to close, shipping to grind to a halt and workers to be confinedtotheirhomes.

Current Outlook

Looking forward in to 2023 and beyond, many of the supply chain issues we have faced in the past 2 years appear to be subsiding – freight capacity throughports,especiallyinChinaandtheUShave increased to pre-Covid levels, Covid lockdowns, a major cause for the disruptions, appear to be a thing of the past and ocean freight prices have fallentopre-Covidlevels.

CPI Inflation (a measure of price increases of consum-ergoods)currentlysitsat6.4%annuallyin theUSand8.8%intheUK.

Lower supply on the whole means that even consum- ers who have enough money to afford to buy a prod- uct aren’t always able to – and are forced either on to second hand markets (this is especially clear in the market for second hand cars, in the UAE prices in- creased by 20% in 2022) or are leftunabletopurchasethegoodsthattheywant.

Finally, longer waiting times for both consumers and firms have significantly reduced economic efficiency – be it firms’ inability to efficiently use

Although lagging shortages and long-term inflation appear to be pervasive in our modern economies we appear to have emerged from the past two years with a very important economic lesson–sometimessupplycannotmeetdemand.

Keywords:

CPI-ConsumerPriceIndex,weightedaverage pricechangesofabasketofconsumergoods

SupplyChain-productionandlogisticalsystem forgoodsandcommodities

FurtherReading:

https://www.imf.org/en/Publications/fandd/issues/2022/06/the-stretch-of-supply-chainsB2B

IBDP TEACHER TIPS

EFFECTIVE CHAINS OF REASONING/ANALYSIS OF DIAGRAMS

The new economics specification places a heavy emphasis on a student’s application skills (AO2 Application and Analysis). For example, Paper 1 now explicitly requires students to use real world examples when answering the fifteen-mark question.Fortopmarkstobeawarded,therubric (below) states that “relevant real-world examples” must be “fully developed to support the argument”. Amongst other things, this means that explanations of diagrams should be in contextifyouwanttoscorewell.

Below are two model answers that highlight the differencebetweenacontextualised explanation of a diagram, and one that simply describes the diagram. Unfortunately, a lot of students provide simple textbook answers like example one below and, whilst it is technically correct, it doesn’t show any application of the

Example 1 – no context or examples (level 2 response)

The diagram above is a representation of a deflationary gap. A deflationary gap exists when actual outputintheeconomyislessthanpotentialoutput.IfADfallsduetoareductioninconsumerspending ADwillshifttoAD1and,asaresult,outputwillfallfromY(f)toY1.

Prices will also fall from Po to P1. The gap between Y(f) and Y1 represents the deflationary gap and the economywillnowbeexperiencingalessthanfullemployment,shortterm equilibrium.

Example 2 – in context with an example (level 4 response)

The diagram above is a representation of a deflationary gap inSpain in 2007/8. A deflationary gap exists when actual output in the economy is less than potential output. During that time of financial crisis consumption spending fell dramatically in Spain as consumers cut back in the face of high levels of unemployment (approximately 25%) and uncertainty. As consumption spending fell in Spain, AD would decreasesignificantlyfromADtoAD1.WhenADfallslikethisthelevelofoutputalsofallsfromY(f)toY1. The gap between Y(f) and Y1 represents a deflationary gap where approximately seven million people were unemployed at the height of the crisis. At this point, Spain was experiencing a less than full employment,shorttermequilibrium.

Paper 3 - Policy Question Advice

Anothernewfeatureofthesyllabusisthepolicyquestionattheendofpaper3.Thepolicypaperpresents a problem (set out in the paper’s previous questions) and requires you to provide a recommended solution.

Of course, you must fully understand the problem presented in the question before you can begin to suggestaviablesolution.Asaresult,itisnecessarytostructureyouressayasfollows:

Step 1: Outline the Problem and signpost the solution,

Step 2: Explain your Solution (Point, Explain, Apply, Evaluate x2)

Step 3: Synthesis/Conclusion.

Example problem:

Using the data provided and your knowledge of economics, recommend a policy that could be introduced by the government of China in response

Possible solution:

1. Outline the problem and how it relates to the solution

China is experiencing cost-push inflationary pressures due to internal supply side issues (higher labor costs) and external factors such as rising energy costs. There are also demand side pressures due to strong export demand. As any suitable solution to inflation is always determined by the causes of the problem, it is necessary for China to adopt a complementary strategy that involves a policy mix of contractionary monetary policy and supply-side growth. This will ensure that inflation is brought under control while limiting the inevitable cut in economic growth.

2. Solution ( Point. Explain. Apply. Evaluate) balanced paragraphs X 2

In the trade off between inflation and growth, price stability takes precedence as it can impact future growth As a result, it will be necessary for China’s central bank to increase interest rates from the current 4.5%. The increase in rates will make borrowing more expensive, which will reduce domestic demand. It will also appreciate the value of the Yuan and make exports more expensive. The combined reduction in domestic and international demand willower prices and reduce real output. We can see this as a movement along the Phillips curve from “a” to “b” in the diagram below.

The increase in interest rates will also send a signal to the market that the issue is being taken seriously, which will manage consumer and producer “expectations” of future increases in price levels. However, as we can see from the diagram above, their will be a trade off between inflation and unemployment in China. As spending declines in response to the cost of borrowing, firms will cut back on labour costs and the level of employment. The extent of this downturn in growth will depend on the magnitude of the interest rate rise necessary to curb inflation. Given that inflation is not particularly high at 4%, and that the inflationary pressures are “temporary” due to external influences, this would suggest that any interest rate rise could be reversed fairly quickly thereby limiting the impact on employment in the longer term.

If inflation becomes persistent despite interest rate rises, then the supply side becomes more important to minimise the impact on employment and growth. Specifically, it is necessary to address the long-term structural issues in the Chinese labour market that are causing costs for firms to rise. Labour market reforms that increase productivity will reduce costs and increase output. Tax reforms that remove “rigidities” in the labour market and incentivise work will be beneficial here. For example, China might lower personal and corporate taxes to incentivise investment in more efficient technology and training which would increase the output per worker and the productive potential of the Chinese economy. This can be seen in the diagram above as a shift inward of the Phillips curve and a reduction of unemployment and inflation at point “c”. The problem with such policies is, of course, that these take time to implement and feed through to the economy. This means that a shorter-term supply-side strategy to reduce costs - such as eliminating trade barriers – could be a more effective policy to relieve the upward pressure on prices in China. However, such trade liberalisation could negatively effect demand in the longer term as demand for imported goods increase and more money leaks from the Chinese economy. This will increase unemployment in the Chinese export sector as consumers go for cheaper imported goods and services. Again, the trade off between controlling inflation and maintaining employment levels and the economic welfare of its citizens depends on the correct mix of policies being adopted.

3. Conclusion (The most important consideration is …)

The most important consideration is the wider economic context faced by China. As inflation is not yet very high, and a lot of the pressures are external in nature, then prudent and timely forward guidance on interest rates should allow the economy to expand whilst maintaining a degree of price stability.

Note:

The marking rubric makes no specific reference to diagrams in the level descriptors (see below), but a well-placed diagram that helps explain how your suggested policy will work is an obvious thing to include in your answer. The examiner also suggests that students should focus on ONE policy in their answer - and this makes a lot of sense in the time and for most situations - but a policy mix may be required (as is the case above) for some contexts.