| Date | November 2021 | Marks available | 8 | Reference code | 21N.2.SL.TZ0.2 |
| Level | Standard level | Paper | Paper 2 | Time zone | Time zone 0 |
| Command term | Evaluate | Question number | 2 | Adapted from | N/A |
Question
South Korea’s exchange rate and central bank intervention
- From mid-2017 until mid-2019, there was a downward trend in the exchange rate of the South Korean won (South Korea’s currency), and some commentators suggested that it was being deliberately undervalued. Despite the lower exchange rate, however, the value of South Korean exports declined by 10.3 % during 2019.
- The main reason for the decline in the value of exports was the weak market for semiconductors. Lower global prices of semiconductors, the largest single export item for South Korea, led to a drop of 25.9 % in the value of exports, despite an increase in their volume. Evidently, price competitiveness of exports from South Korea is not as significant as before, because its exports are now mainly luxury or high-technology items.
- In November 2019, South Korea’s current account surplus reached US$5.97 billion, more than 4 % of gross domestic product (GDP). The financial account in the balance of payments had a net outflow of US$5.34 billion, which was mainly due to a net outflow of US$4.01 billion in foreign direct investment (FDI). There was also a net outflow of US$1.07 billion in portfolio investment, because domestic residents increased their financial assets overseas while inward flows declined.
- The Bank of Korea (South Korea’s central bank, BoK) had reduced interest rates to record lows in October 2019, which partly accounted for the large portfolio investment outflows. Monetary policy is likely to continue to be expansionary through 2020, with the possibility of another interest rate reduction, because economic growth is forecast to be low, at less than 2.5 %. The forecast for inflation is that it will be below 1.5 %, while the unemployment rate is expected to continue to rise to over 4 %.
- While the BoK is not targeting a specific level for the exchange rate, it seems determined to intervene when the market is unstable. Its actions, however, have contributed to South Korea being accused by the United States (US) of changing the value of its currency to gain an export advantage. If the US concludes that South Korea has been manipulating its exchange rate unfairly, it could impose trade barriers on imports from South Korea.
- However, through the last six months of 2019, the South Korean won started to rise against the US dollar (US$). The appreciation was partly due to speculation and expectations of a rise in demand for semiconductors. Moreover, in August 2019, the BoK sold US dollars in order to prevent the South Korean won from depreciating again. Overall, the central bank’s foreign exchange intervention has been aimed at restraining the South Korean won’s depreciation or stabilizing the market rather than at trying to promote exports.
Figure 1: South Korea’s exchange rate with the US$
Table 1: South Korea’s balance of trade in goods and services, seasonally adjusted
Define the term foreign direct investment indicated in bold in the text (paragraph [3]).
List two responsibilities of a central bank (paragraph [4]).
Using an AD/AS diagram, explain how the change in the balance of trade in goods and services from 2018 to 2019 could have affected South Korea’s economy (Table 1 and paragraph [1]).
Using an exchange rate diagram, explain the effect on the South Korean won’s exchange rate of South Korea’s central bank selling US dollars (paragraph [6]).
Using information from the text/data and your knowledge of economics, evaluate the South Korean central bank’s decision to intervene in order to prevent the South Korean won from depreciating again.
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/general price level.
The horizontal axis may be real output, real national output, real income, real national income, real GDP or real Y. 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 won in another currency, other currency/won or other currency per won. The horizontal axis should be quantity, or quantity of won. A title is not necessary.
NB: an answer may alternatively draw an exchange rate diagram for the US dollar and show the supply curve shifting right with the US dollar depreciating, which is equivalent to the won appreciating. If the explanation is correct, this can be fully rewarded.
NB: the diagram may show the won initially depreciating due to declining demand and/or rising supply, with the demand curve then shifting right to reverse the depreciation. If the explanation is correct, this can be fully rewarded.
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
“Evaluate” requires candidates to make an appraisal by weighing up the strengths and limitations. Opinions and conclusions should be presented clearly and supported with appropriate evidence and sound argument.
Answers may include:
- definition of depreciation
- definition of exchange rate
- definition of a managed exchange rate.
Arguments for intervening to prevent depreciation may include:
- possibly the won is already undervalued due to the downward trend from mid-2017 to mid-2019. It will become more undervalued if it depreciates again (paragraph [1] and Figure 1)
- it needs to consider that demand for exports now seems to be price inelastic, therefore a depreciation would reduce export revenues, despite the fall in price (paragraph [2])
- it needs to take action because exchange rate movements are affected by speculative financial flows as well as trade flows (paragraph [3])
- it needs to take action because the financial account has a large deficit while the current account has a huge surplus (paragraph [3])
- it needs to stabilize the foreign exchange market (paragraph [6] and Figure 1)
- if the exchange rate depreciates again, South Korea risks being accused by the US of unfair currency manipulation (paragraph [5]).
- it needs to take action so that import prices do not rise / there is less inflationary pressure.
Arguments for not intervening to prevent depreciation may include:
- may be able to offset the decline in net exports by letting the exchange rate depreciate further (paragraph [1] and Table 1)
- macroeconomic indicators imply that a depreciation would benefit the economy and employment by promoting growth through cheaper exports (paragraph [4])
- although a depreciation might cause demand-pull (through a rise in (X-M)) and cost-push inflation (through a rise in import prices), present inflation rates are very low (paragraph [4])
- use of interest rates to stop outflows of portfolio investment affects both the financial account and domestic monetary policy (paragraph [4])
- market forces (rise in demand for semi-conductors, etc.) may naturally cause appreciation (paragraph [6]).
- may run out of reserves, if tries to prevent depreciation by selling its reserves (paragraph [6]).
Any reasonable evaluation.
Examiners report
Most candidates achieved L2 on both definitions. The candidates who were only awarded L1 on the definition of FDI were those who did not clearly differentiate between portfolio (financial) investment and FDI.
This question was also well attempted. Most candidates were able to identify a decreasing net export value as a component of aggregate demand and the direct reason for lower GDP and/or lower inflationary pressures. There were some cases in which the candidate took the approach of a decreasing but still positive net exports value. If the response was clearly explained full marks were awarded.
Many candidates recognised that the demand for the won increased in the foreign exchange market. In some cases, diagrams for the US$ were included and properly explained in terms of a decreasing value of the US$ which in turn represents an increasing value of the won. Often, those who were not awarded a mark on this question were those who shifted the supply of won.
Most candidates scored marks in the mid/top range of Level 2 for this question. Almost all could offer the ‘standard’ consequences of a depreciation but few specifically addressed the central bank’s decision to intervene to keep the won from depreciating further. Answers which merely focused on the advantages and disadvantages of a low exchange rate were often limited to L2. Those who evaluated the need for intervention and considered arguments such as retaliation or the depletion of foreign reserves were able to reach L3.
