| Date | November 2019 | Marks available | 8 | Reference code | 19N.2.SL.TZ0.2 |
| Level | Standard level | Paper | Paper 2 | Time zone | Time zone 0 |
| Command term | Discuss | Question number | 2 | Adapted from | N/A |
Question
Bank of Canada raises interest rates for the first time in seven years
- For seven years Canada’s central bank, the Bank of Canada, kept its official interest rate at 0.5 %. This period of easy monetary policy may be coming to an end. The Bank of Canada has just raised its official interest rate from 0.5 % to 0.75 %, claiming that there is new confidence in the Canadian economy. Figures show that the 3.5 % growth in gross domestic product (GDP) in the first quarter of 2017 is above its potential. In addition, the Bank of Canada expects growth in consumer spending, exports and business investment to stimulate economic growth in the months ahead. Such factors might contribute to inflationary pressure in the future.
- One of the issues that might have delayed the interest rate increase in Canada is that the inflation rate is still low and falling. Central banks typically raise interest rates when inflation is rising. That is not the problem in Canada, where the consumer price index (CPI) has been rising at well below the Bank of Canada’s 2 % inflation target. However, the governor of the Bank of Canada says that he is looking at forecasts of future inflation rates, noting that the data suggest the interest rate increase is necessary. An official statement from the Bank of Canada notes that growth is increasing across all industries and regions and that the economy has started to improve. There is no longer a need for the low interest rate.
- Positive economic growth figures, the optimism shown by the Bank of Canada, and the recent interest rate increase have caused a rapid appreciation of the Canadian dollar against the United States (US) dollar over recent months. There are now expectations that the Bank of Canada will raise the interest rate once or possibly twice more before the end of the year, as signs continue to point to a healthy economy. This would likely cause further strengthening of the Canadian dollar against the US dollar.
- An economist has said that the gain in the Canadian dollar against the US dollar may have a large effect on importers and exporters, although it will likely be months before consumers see the effects. She further noted that the effects would vary across different industries. There is some concern about the consequences for the Canadian current account. Currently the current account deficit is at 3.6 % of GDP.
- A stronger currency is also likely to encourage more Canadians to travel south to the US.
[Source: adapted from Bank of Canada raises interest rates for first time in seven years,
The Globe and Mail, July 12, 2017, https://beta.theglobeandmail.com]
Table 1: Canada’s main exports
[Source: adapted from https://tradingeconomics.com, accessed 4 September 2017]
Table 2: Canada’s main export destinations
[Source: adapted from https://tradingeconomics.com, accessed 5 October 2017]
Outline two roles of a country’s central bank (paragraph [1]).
Define the term current account deficit indicated in bold in the text (paragraph [4]).
Using an AD/AS diagram, explain the likely impact on the Canadian economy of the increase in the official interest rate (paragraph [1]).
Using an exchange rate diagram, explain one reason for the appreciation of the Canadian dollar (paragraph [3]).
Using information from the text/data and your knowledge of economics, discuss the possible effects on the Canadian economy of the strengthening of the Canadian dollar against the US dollar.
Markscheme
Candidates who incorrectly label diagrams can be awarded a maximum of [3].
For AD/AS, the vertical axis may be “price level” or any similar terms such as “average (general) price level”. For the horizontal axis, “real (national) output/income” or “real GDP”. Any relevant abbreviations are acceptable.
A title is not necessary.
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 CA$ in US$, or US$ per CA$, or US$/CA$ (US$ may be replaced by “other currencies”). The horizontal axis may be quantity or quantity of CA$.
Examiners should be aware that candidates may take a different approach which,if appropriate, should be rewarded.
Do not award beyond level 2 if the answer does not contain reference to the information provided.
Command term
“Discuss” requires candidates to offer a considered and balanced review that includes a range of arguments, factors or hypotheses. Opinions or conclusions should be presented clearly and supported by appropriate evidence.
To discuss the effects on the economy, candidates might consider the advantages and disadvantages related to macroeconomic goals.
Responses may include:
A definition/explanation of a “stronger currency”.
Economic growth:
- The strong Canadian dollar may cause a decrease in demand for exports and an increase in demand for imports, resulting in a fall in net exports and a decrease in AD. This may hinder economic growth, which has been increasing (paragraph [2]).
Low unemployment:
- The stronger Canadian dollar may result in a decrease in demand for exports and an increase in demand for imports, thus raising unemployment in export industries and industries that compete with imports.
- The need to cut costs may result in structural unemployment.
- If demand for exports is relatively inelastic, as in the case for commodities (with reference to Table 1), there may be little effect on unemployment.
- If demand for exports is relatively elastic, as in the case for manufactured goods (with reference to Table 1), there could be an increase in unemployment in this sector.
- A stronger Canadian dollar makes it more attractive for Canadians to travel to the US, rather than travel in Canada, which may damage the Canadian tourism sector (paragraph [5]) and may lead to unemployment.
Low and stable inflation:
- The stronger Canadian dollar will make imported factors of production less expensive, resulting in an increase in SRAS and a fall in possible inflationary pressure.
- The stronger Canadian dollar may also present a risk of increased deflationary pressure from lower priced imports and reduction in net exports (paragraph [2]).
- The strong Canadian dollar may cause a decrease in demand for exports and an increase in demand for imports, resulting in a fall in net exports and a decrease in AD, thus a reduction in demand-pull inflationary pressure (paragraph [1]).
- The effects depend on the PED for exports and imports.
Current account:
- The current account deficit is a concern at 3.6 % of GDP (paragraph [4]), and a stronger Canadian dollar could lead to an increase in the deficit on the current account balance.
- The effect depends on the PED for exports and imports.
- The vast majority of Canada’s exports go to the US (Table 2), so the effect of the appreciation of the Canadian dollar against the US dollar is likely to be significant.
Standard of living
- Consumers will gain from lower prices of imports, including effectively cheaper holidays in the US (paragraph [5]).
To reach Level 3, candidates must refer to the particular situation in the Canadian economy, not just present the advantages and disadvantages of a stronger currency in general.
Any reasonable discussion.
