Term 1 Week 10 Tut 1

1.How did the Colombian economy in the second half of 1990s compare with that in the first part? (2 marks)

The performance worsened [1 mark]
Economic growth rates fell from 4.7 percent on the average a year in the earlier half of 1990s to that of 1.8 percent in the later half. Unemploymnt was 19.5 percent in the later half compared to the earlier. [1 mark for elaboration with example from date]

2.A “sharp decline in economic growth has caused a rise in the government’s budget deficit.” Explain why this may be so. (2 marks)

A fall in economic growth rates imply that national income falls [1 mark]. The government’s tax revenue from direct taxes would have fallen. Assuming government expenditure remains unchanged, budget deficit worsens. [1 mark]

3.What may be the impacts of the change in government investment on the Colombian economy? (4 marks)

Government investment is a form of injection into the circular flow of income. It is also a component of the aggregated demand (AD). In the short run, a fall in government investments would mean a fall in injections and AD. This kicks off a multiplier process that brings about a fall in the real output of the economy (fig. 1), resulting in a fall in national income. [2 marks]

In the long run, the aggregate supply (AS) curve would shift left due to a fall in capital formation as government reduces its expenditure on capital goods. The production capacity of the economy would fall, ceteris paribus. The result of the leftward shift in AS is a fall in real output. Negative change in real output in the long and short runs reinforce each other to result in a large fall in real output. [2 marks]














































4.Explain how a devaluation of the peso may cause a change in the macroeconomic performance of the Colombian economy. (4 marks).

The devaluation of a currency is a reduction of the currency’s value by the discretion of the government or central bank. The devaluation of the peso suggests that Colombia adopts a fixed exchange rate regime. [1 mark]

As the peso devalues, price of Colombia’s exports in terms of foreign currency falls. The quantity demanded of Colombian exports increases in the international markets. Conversely, the price of foreign goods in Colombian markets is lower. Quantity demanded of imported goods by Colombians fall. [1 mark]

As Colombia is a relatively small market on the international scale, demands for exports and imports tend to be price elastic. This leads to the fulfillment of the Marshall-Lerner condition such that with devaluation of the currency, net exports increase. [1 mark]

This improves the AD of the Colombian economy. As seen from fig. 2, the real output increases. [1 mark]









































5.Analyze whether the Colombian government can pursue an expansionary monetary policy using interest rates if it wishes to maintain control on the peso. (6 marks).


An expansionary monetary policy aims to promote increment in real output via an increase in money supply or a reduction of interest rates. It is a demand-side policy that causes AD to shift rightwards.

The decrease in interest rates would cause an outflow of short term capital (hot money) from Colombia. In figure 3, we see that such a capital outflow increases the supply of the peso in the currency market, exerting a downward pressure on the exchange rate of peso. To maintain the exchange rate of peso at ef, the central bank of Colombia has to sell foreign exchange and buy peso, such that the demand for peso increases from D0 to D1.


Selling foreign exchange continually to protect the value of the currency is unsustainable as the central bank may soon find itself drained of foreign reserves in its effort to sustain the fixed exchange rate. It would therefore raise the interest rate back to the original level in order to restore the market equilibrium exchange rate of the peso. Raising the interest rates back can be seen as a contractionary monetary policy. This move neutralizes the initial expansionary policy.




[It is also argued that interest rates may rise back automatically. As hot money flows out of the economy, the availability of loanable funds for firms and households is being reduced. Interest rates will hence rise, offsetting the initial fall dictated by the central bank. Hence the initial expansionary policy is neutralized]




It can thus be seen that to maintain a fixed exchange rate, a government actually forsakes the control over interest rate as a tool for monetary policies.
However, the above analysis is based on the assumption that Colombia has an open capital and financial account. However, this may not necessarily be the case. If Colombia has a closed capital account (imposition of capital control[1]), the reduction of interest rate




[1] Capital control refers to the restriction of the amount of a country’s currency that can be sold at any one time. For example in the aftermath of the 1997 financial crisis, Malaysia imposed capital control to restrict the outflow of short term capital from Malaysia. Despite heavy criticisms from organizations such as International Monetary Fund, it has been argued (by renowned Western academics inclusive) that Malaysia became one of the faster countries to recover from the crisis due to the imposition of capital control.