Economics 9708/22 — May/June 2019

Background Concept

The canons of taxation are principles that a good tax system should follow. Adam Smith proposed four: equity (fairness), certainty (clear rules), convenience (easy payment), and economy (low collection cost). Other economists have added simplicity, productivity, elasticity, etc.

Understanding the Question

The question asks to identify two canons satisfied by Egypt's new VAT. The text states: 'The VAT does not apply to basic goods and services to protect the poor.' This suggests equity. Also, VAT is collected at each stage of production and distribution, which is convenient for taxpayers. Other canons like certainty or economy could also be argued.

Approach

Read the description of the VAT in the extract and match it to the canons. Provide a brief justification for each.

Step-by-Step Reasoning

• Equity: The VAT exempts basic goods, so it is fairer to the poor. This satisfies the canon of equity.
• Convenience: VAT is collected at multiple stages, making it easier for taxpayers to pay in installments rather than a lump sum. This satisfies convenience.
• Alternatively, one could argue certainty (clear rules) or economy (low collection cost if well-designed).

Key Takeaways

The canons are criteria for evaluating tax systems. Be able to recall Smith's canons and others, and apply them to real-world examples.

Common Mistakes

• Using 'equality' instead of 'equity' (equality is not a canon).
• Listing canons that are not clearly supported by the text.
• Not providing justification.

Things to Be Careful About

• Only canons that are explicitly or implicitly satisfied should be chosen.
• The mark scheme accepts a range of canons, so choose the most obvious ones.

Background Concept

Exchange rate depreciation means the domestic currency loses value relative to foreign currencies. This affects the economy through two main channels: the cost of imports and the competitiveness of exports. Cost-push inflation occurs when the costs of production rise, shifting the short-run aggregate supply (SRAS) curve leftwards. Demand-pull inflation occurs when aggregate demand (AD) increases, shifting the AD curve rightwards, especially when the economy is at or near full capacity.

Understanding the Question

The question asks to explain how the decline in the value of the Egyptian pound (depreciation) could cause both demand-pull and cost-push inflation. The extract mentions that the pound depreciated by 50% against the US dollar. This is the starting point.

Approach

Separate the explanation into two parts: one for cost-push and one for demand-pull. For each, build a clear chain of reasoning from depreciation to the type of inflation.

Step-by-Step Reasoning

Cost-push:

• Depreciation → imports become more expensive in domestic currency.
• Many Egyptian firms rely on imported raw materials and intermediate goods.
• Higher import costs increase firms' production costs.
• Firms pass on these higher costs to consumers by raising prices.
• This leads to a leftward shift of SRAS, causing a rise in the price level (cost-push inflation).

Demand-pull:

• Depreciation → Egyptian exports become cheaper for foreign buyers.
• Quantity of exports demanded increases.
• Imports become more expensive, so domestic consumers switch to locally produced goods.
• Net exports (X - M) rise, increasing aggregate demand (AD).
• If the economy is near full capacity, the increase in AD leads to a rise in the price level (demand-pull inflation).

Key Takeaways

Depreciation is inflationary through both supply and demand channels. The relative strength depends on factors like the proportion of imported inputs, the price elasticity of demand for exports and imports, and the state of the economy (spare capacity).

Common Mistakes

• Confusing cost-push and demand-pull mechanisms.
• Not explaining the full chain of reasoning (e.g., stopping at 'imports more expensive' without linking to costs and prices).
• Ignoring the role of aggregate supply and demand.

Things to Be Careful About

• Distinguish between a movement along the AD curve and a shift.
• The demand-pull effect requires that the economy is not in a deep recession with large spare capacity; otherwise, the increase in AD may not cause inflation.
• The cost-push effect is more certain in the short run.

Background Concept

The current account balance is affected by changes in imports and exports. Imports depend on domestic income (positive relationship) and the exchange rate. Exports depend on foreign income and the exchange rate. Falling unemployment typically raises national income and output. The effect on the current account depends on whether the income effect (rising imports) or the production effect (rising output leading to more exports and import substitution) dominates.

Understanding the Question

The question asks how the estimated changes in unemployment (falling from 12.7% in 2016 to 10.7% in 2019) might be expected to affect the current account balance after 2016. The extract does not provide current account data after 2016, so the answer must be theoretical, based on economic reasoning.

Approach

Present two possible channels: the income effect (demand side) and the production effect (supply side). Then evaluate which is likely to dominate, considering factors like time lags, elasticities, and other policies.

Step-by-Step Reasoning

Income effect:

• Falling unemployment → more people employed → total household income rises.
• Higher income → increased consumption, including imports (imports are a normal good).
• Also, some goods that were exported may now be consumed domestically, reducing exports.
• Net effect: imports rise, exports may fall → current account deficit worsens.

Production effect:

• Falling unemployment → more workers employed → national output (GDP) rises.
• Higher output → more goods available for export → exports can increase.
• Also, domestic production can substitute for imports → imports fall.
• Net effect: exports rise, imports fall → current account deficit improves.

Evaluation:

• The income effect tends to be immediate because consumption responds quickly to income changes.
• The production effect takes time because firms need to hire, train, and increase production capacity.
• The net effect depends on the marginal propensity to import (MPM) and the export orientation of the new output.
• Other factors: if the economy is operating below full capacity, the production effect may be stronger; if there are supply constraints, the income effect may dominate.
• In the short run, the current account likely worsens; in the long run, it may improve as production adjusts.

Key Takeaways

Falling unemployment has an ambiguous effect on the current account. A thorough answer considers both demand and supply sides and evaluates the conditions under which each dominates.

Common Mistakes

• Only discussing one effect (e.g., only income effect).
• Not providing evaluation or conclusion.
• Ignoring the time dimension.
• Not using economic terminology (e.g., marginal propensity to import).

Things to Be Careful About

• The question says 'might be expected', so it is acceptable to say the outcome is uncertain.
• Use the data from the table to support the trend in unemployment.
• Distinguish between short run and long run.

Background Concept

Fiscal policy involves changes in government spending and taxation to influence aggregate demand. Monetary policy involves changes in interest rates and money supply. Both can be used to control inflation. However, some policies can be inflationary (e.g., depreciation, tax increases that raise costs). The question requires a discussion of whether the specific policies mentioned in the article are likely to cure inflation.

Understanding the Question

The question asks to discuss whether the Egyptian government's fiscal and monetary policies are likely to succeed in curing the inflation problem. The extract mentions: reducing the budget deficit, introducing VAT, cutting energy subsidies (fiscal), and raising interest rates and floating the pound (monetary). Each has both anti-inflationary and pro-inflationary aspects.

Approach

Separate the discussion into fiscal and monetary policies. For each, identify the measures and explain how they might help or hinder curing inflation. Then evaluate overall, considering time lags, magnitudes, and possible conflicts.

Step-by-Step Reasoning

Fiscal policy:

• Anti-inflationary: Reducing the budget deficit (contractionary fiscal policy) reduces AD, which helps reduce demand-pull inflation.
• Pro-inflationary: VAT and cutting energy subsidies increase costs for firms and consumers, shifting SRAS left, causing cost-push inflation.
• Net effect: The cost-push effects are immediate, while the contractionary effect takes time. So in the short run, inflation may rise.

Monetary policy:

• Anti-inflationary: Raising interest rates (contractionary monetary policy) reduces AD, helping reduce demand-pull inflation.
• Pro-inflationary: Floating the pound led to depreciation, which raises import costs and causes cost-push inflation.
• Net effect: Again, the depreciation effect is immediate, while the interest rate effect takes time.

Evaluation:

• The cost-push shocks (depreciation, VAT, subsidy cuts) are large and immediate, so inflation is likely to remain high in the short run.
• The contractionary policies may eventually reduce AD, but they also risk causing a recession if too aggressive.
• The success also depends on expectations: if the public expects high inflation, it may become entrenched.
• Overall, the policies are unlikely to succeed in the short run; in the long run, if the government maintains credibility and the exchange rate stabilises, inflation may fall, but the cost-push factors may persist.

Key Takeaways

When evaluating policy effectiveness, consider that different measures can work in opposite directions. A thorough evaluation weighs the magnitude and timing of each effect.

Common Mistakes

• Only discussing one side (e.g., only the anti-inflationary effects).
• Not distinguishing between fiscal and monetary policies.
• Not using the specific policies from the article.
• Failing to reach a justified conclusion.

Things to Be Careful About

• Use AD/AS analysis implicitly or explicitly.
• Consider both demand-pull and cost-push inflation.
• The conclusion should be specific to the question: 'likely to succeed?'
• Avoid fence-sitting without justification; state the conditions under which success is more or less likely.