| Date | May 2021 | Marks available | 2 | Reference code | 21M.2.SL.TZ0.2 |
| Level | Standard level | Paper | Paper 2 | Time zone | Time zone 0 |
| Command term | Define | Question number | 2 | Adapted from | N/A |
Question
The fall of the Indian rupee
- Over the past year, India’s current account deficit widened as the 14 % increase in export revenue could not offset the rise in import expenditure. Over the same period, the value of the rupee (India’s currency) has fallen by 13 %.
- The rise in import expenditure was in part caused by higher oil prices following production cuts by the Organization of the Petroleum Exporting Countries (OPEC). Another reason for the increase in import expenditure was the higher spending on machinery and capital goods needed to achieve economic growth.
- Exports of services, especially software services, have helped to boost export revenue. However, one critical weakness in India’s exports of services is the lack of diversification. Exports of software services account for more than 41 % of India’s total service exports and more than 90 % of its software service exports are restricted to the United States and the European Union.
- The depreciation of the rupee, one of the steepest seen in recent years, has resulted in fears of high inflation. An economist at the Reserve Bank of India (India’s central bank) has warned that the increase in oil prices and consumers’ expectations of rising inflation could worsen inflationary pressures.
- Despite calls for an increase in interest rates in order to protect the rupee from further depreciation, the Reserve Bank of India has chosen to keep interest rates unchanged. The combined effect of a fall in confidence and higher interest rates would dampen economic growth.
Table 1: Selected economic indicators for India
Tulsi Jayakumar, Forbes India, 2018. Reining in Current Account Deficit: Options for India. Available at: http://www.forbesindia.com/article/spjimr/reining-in-current-account-deficit-options-for-india/51455/1 [accessed 19 January 2019]. Source adapted. Reproduced by permission of the author.
Define the term current account indicated in bold in the text (paragraph [1]).
Define the term depreciation indicated in bold in the text (paragraph [4]).
Using an AD/AS diagram, explain how an increase in oil prices “could worsen inflationary pressures” (paragraph [4]).
Using an exchange rate diagram, explain how higher interest rates could “protect the rupee from further depreciation” (paragraph [5]).
Using information from the text/data and your knowledge of economics, discuss the possible economic consequences on the Indian economy of a depreciating rupee.
Markscheme
Candidates who incorrectly label diagrams can be awarded a maximum of [3].
For AD/AS, the vertical axis may be price level or average price level or general price level. The horizontal axis may be real output, real national output, real national income, or real GDP. Any abbreviation is 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 the (Indian) rupee in another currency, other currency/(Indian) rupee or other currency per (Indian) rupee. The horizontal axis should be quantity, or quantity of (Indian) rupee. A title is not necessary.
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.
Benefits of the depreciation may include:
- The depreciation would help close the current account deficit (paragraph [1]) by making imports more expensive and exports cheaper
- Exported services would become cheaper in foreign currency terms which may lead to higher demand (but will not encourage diversification of exports (paragraph [3]))
- The cheaper export services might help capture other markets (in addition to US and Europe) (paragraph [3])
- Other currencies have also depreciated and hence the depreciation keeps Indian exports competitive (paragraph [5]).
Limitations/disadvantages of the depreciation may include:
- The depreciation would make imported oil even more expensive. Given that demand is likely to be inelastic and since rising oil prices are already a contributor to the current account deficit (paragraph [2]), that would worsen the deficit
- Higher prices for imported capital goods and oil would worsen cost-push inflation (paragraphs [2] and [4])
- Higher prices for imported capital goods may reduce imports of such goods and slow down potential growth (paragraph [2])
- The inflation rate has risen between 2017 and 2018 (Table 1) and hence the depreciation would only lead to further increase in prices
- With the current high growth rate (Table 1), an increase in exports could lead to further demand-pull inflation.
Any reasonable discussion.
Examiners report
Most candidates scored at least Level 1 on both definitions.
Many limited their definition of the current account to the balance of trade in goods and services.
Most candidates scored at least Level 1 on both definitions.
Those who were awarded Level 1 for this question often had not specified that the decrease in exchange rate was the result of changes in market forces (or that it was occurring under a floating exchange rate system). That omission meant that the simple mention of a 'decrease in the value of a currency' could refer to both a depreciation and a devaluation. In general, if if a definition can apply to two concepts, then it is a vague definition. This has also been an issue in past examination sessions.
This question was reasonably well attempted. Most candidates could link the higher oil prices to a fall in SRAS. Some suggested that AD increased as a result of the currency depreciation which made exports cheaper and imports more expensive. While theoretically correct and using information from paragraph 4, such a response did not answer the question and hence could not be rewarded.
Many candidates recognised that the demand for rupees increased in the foreign exchange market. However, some students only referred to the actions of foreign 'investors' without any link to inwards flows of financial/portfolio investment or savings. A minority of candidates had difficulties distinguishing between the internal money supply and the supply of currency on the foreign exchange market.
Most candidates scored marks in the mid/top range of Level 2. Almost all could offer the 'standard' consequences of a depreciation, but effective use of the text was less prevalent. There was also a heavy emphasis on the impact on economic growth and inflation, few even considered the impact on the current account deficit. Some students got fixated on the issue of inflation and often neglected the data provided in the table which suggested that inflation was still not very high. The lack of effective use of the text kept many answers with a good show of theoretical analysis in Level 2. For example, candidates often stated that the depreciation would make exports cheaper but seldom referred to the fact that since other Asian currencies also depreciated, the impact on export prices might not be so significant.
