TAYLOR’S BUSINESS SCHOOL

TAYLOR’S BUSINESS FOUNDATION

ASSIGNMENT

ECONOMICS 02
MARCH INTAKE/ SEMESTER 2

GROUP MEMBERS

NAME STUDENT ID Signature

NG KIM WOON 0703F61017
TAN YING YI 0703F62518
MELINDA CHONG LI PIN 0703F62256
PANG JA YE 0703F61833

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1. How would an increase in interest rate impact on the local economy? Your
discussion must include its impact on individuals and businesses. Diagram(s) can also
be shown in your answers. (10 marks)

Interest rate is the amount of money in percent that a borrower pays to borrow

money. For example, if a $100,000 loan has a 5% interest rate, the borrower will have to

pay $5,000 each year until the money is paid back. Besides that, interest rate is also the

fee charged by a lender to a borrower for the use of borrowed money, usually expressed

as an annual percentage of the principal; the rate is dependent upon the time value of

money, the credit risk of the borrower, and the inflation rate. Here, interest per year

divided by principal amount, expressed as a percentage. Besides that, the return earned on

an investment is also an interest rate which we get from our investment. Moreover, partial

or total ownership in an asset is also called as interest rate.

Gross Domestic product (GDP) of a country is defined as the market value (in

monetary term) of all final goods and services produced in the country during a particular

period of time normally one year. It is also known as the national income, (Y). From the

circular flow of income in a closed economy, total expenditure must be equal to total

income in equilibrium. Total expenditure or aggregate expenditure (AE) = Total income

(Y). In the closed economy or 2 sectors economy (household and firms), total

expenditure includes household spending i.e. consumption (C) and firm’s spending i.e.

gross investment (I).

Y= AE
AE = C+I
Y = C+I

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 Aggregate expenditure means the expenditure on final goods and services during

a specific period of time which is the quantity of real GDP demanded at a given price

level includes consumption and gross investment. Therefore when an increase in interest

rate will cause the aggregate expenditure decreases. This is because consumption and

gross investment fall when interest rate is high.

An increase in the rate of interest will cause impacts on individuals and

businesses. Firstly, an obvious impact on individuals which are households is it will

discourage the spending of an individual. This happens because individuals will be

discouraged to spend on buying assets as they will receive more at the end of the day on

their saving rates. Higher interest rates will make borrowers poorer, so they have to

consume less and save more. Besides that, high interest rates will have a negative effect

on consumer confidence. This is because only people are confident about their own

financial position will be willing and able to enter into large scale purchases. Durable

goods like houses and cars which are bought on credit will be decrease when there is a

high interest rate. Goods and services demanded will decrease, hence consumption for

goods and services will decrease.

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 AE

INCOME 45o line

EXPENDITURE
METHOD (C+I)
e (C’+I)

e’

Y
J,W Ye’ Ye

S’ S

INJECTION- e’
WITHDRAWAL e
METHOD
Y
Ye’ Ye

When interest rate increases, it will lead to a decrease in aggregate expenditure.

This is because when interest rate increases, people will consume less and save more in

the bank. When interest rate is high, we will save more in the bank, money which we

save in the bank will have a higher return. Therefore there will be a decrease in the

consumption function and increase in the saving function. From the diagram above,

aggregate expenditure will falls from (C+I) to (C’+I) and saving function will rise from

S to S’ when interest rate increases. When consumption fall, saving will rise therefore

there will be a decrease in the national income from Ye to Ye’.

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 On the other hand, as for one of the impact on businesses due to a rise in the rate

of interest is it will discourage businesses from investing. This happens because

businesses will have to pay a higher interest rate when they want to borrow money to

invest in a certain field causing them to gain less profit which will finally lead to a

decrease in investments. Another impact on the businesses would be causing domestic

bonds more attractive, so the demand for domestics bonds rises and the demand for

foreign bonds fall. Besides that, an increase in interest rates will decrease the business

confidence and decrease the level of planned fixed investment. Therefore the gross

investment will falls and national income will also decreases.

AE

Income expenditure 45o line

Method e (C+I)

(C+I’)

e’

Y
J,W Ye” Ye
S
e
Injection- withdrawal I
Method

e’ I’

Y
Ye’ Ye

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 When interest rate is high, the cost of borrowing and the return to saving are

greater. Fewer businesses choose to borrow to build new factories and buy new

equipment, so gross investments will fall. Therefore the diagram above shows that when

aggregate expenditure falls from (C+I) to (C+I’), national income also falls from Ye to

Ye’. Same go for injection-withdrawal method, gross investment falls from I to I’.

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2. Establish the likely type of inflation that Malaysia could possibly be facing.
Check out Malaysia’s inflation rate from 1996 to 2006 and comment on it. ( 5 marks)

Inflation is defined as an increase in general level of prices of goods and services

in the economy. When there is an increase in the costs of goods sold and services, the

value of a dollar will fall because consumers won’t be able to purchase as more as

previously as their income remain constant. Consumer’s purchasing power will reduce.

Well, not every price will increase in inflation, even during periods of rapid inflation,

some price maybe relatively constant and some may fall.

As there are many varying measures for the inflation due to the different prices

that affects different people, the most widely known incides are the consumer price index

(CPI) which measures the change in nominal consumer prices and the GDP deflator

which measures inflation in new product and services created.

CPI = Price of the most recent market basket in particular year

Price of same market basket in (year-year) x 100%

There are a couple types of inflation. Which are cost-push inflation, demand pull

inflation and built-inflation. Cost-Push inflation refers to the increasing in prices in terms

of factors that raise per-unit production coast at each level of spending. A per-unit

production means that the average cost of a level of output. An increase in the per-unit

production costs will reduce the amount of output that firms willing to produce. As a

result, the supply of goods and services will reduce and price level will increase. And it

shows that costs are pushing the price level upward. Demand Pull inflation is caused by a

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changed in price level which is an excess of total spending beyond economy’s capacity to

produce.

Malaysia could possibly be facing the Cost-push inflation. As the name

suggested, this is an inflation caused by the cost itself such as in this example the raise on

the oil prices and power tariffs to a higher rate causes the production cost to rise. This

forces the prices of the finished goods and services, contributing to the inflation. In the

article it is written that the government expects the further rise of the Consumer Price

Index as the government prepares to increase electricity rates and other controlled prices

amid higher oil prices. As the rising interest rates in the United States and Asia after

Malaysia removed the ringgit’s peg to the dollar in July 2005 is also taking into

consideration, it is stated that this are the causes that would most likely trigger a raise in

the Consumer Price Index.

The table below shows the inflation rate from year 1996 to year 2006.

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 As the table shows, the CPI inflation had a sharp raise from 1997-1998. This is

due to the Asia Economics Crisis 1997, however, the effects of the economic crisis

wasn’t immediately shown on the year but only on the year of 1998. The 1997 economic

crisis has caused a lot of job losses, business failure and pay cut. This led to a build in

inflation as most of the people are trying to keep their wages up. The inflation was also

contributed by the living cost that rose drastically due to so many business failure and

supply shortage.

However, the government has taken action to reduce the inflation rate.

Contractionary Fiscal Policy was taken to reduce the growth of the inflation rate.

Government has mostly reduced their spending to slower down the inflation rate.

However, as the economy was facing a recession, the government could not raise the

taxes as they were trying to encourage the community to spend. It could be seen that the

economy has improved ever since then as inflation rate grows again most probably the

demand pull or either cost push. This proves that the people are doing pretty well

financially overall and is more willing to spend more to improve their quality of life

instead of saving it to be sure that they would have enough to survive through the

economic crisis. However, there is a slight drop in year 2006. This is most probably due

to the actions taken by the government to control the inflation growth rate. As we were

not experiencing any economics recession, the government has most likely taken a

contractionary fiscal policy which is that they reduce their government spending and

increase taxes to ensure that people would slow down on their spending.

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3. How might savers and borrowers be affected if an economy faces a high
inflation rate? If you are the Economic Minister of a country that is facing a serious
inflation problem, what would you likely do to reduce the inflation? ( 10 marks)

What is inflation? Inflation is defined as an increase in general level of prices of

goods and services in the economy. When there is an increase in the costs of goods sold

and services, the value of a dollar will fall because consumers won’t be able to purchase

as more as previously as their income remain constant. Consumer’s purchasing power

will reduce. Well, not every price will increase in inflation, even during periods of rapid

inflation, some price maybe relatively constant and some may fall.

So, if economy faces a high inflation rate, not everyone’s nominal income will

increase at the same pace as price level. If the change of price level differs from the

change of person’s nominal income, consumer’s real income will be affected. For

example, for those consumers whose income is fixed, their real incomes will fall. Not

only that, inflation might greatly affect the savers and borrowers in the country. For the

savers, when prices increase, the real value of consumers will reduce as income remained

constant. Besides that, Consumer’s purchasing power of an accumulation of savings

deteriorates. Savings can earn interest. If the inflation rate exceeds rate of interests, the

value in the economy will decline.

When high inflation occurs, savers and borrowers will be affected. A high

inflation did harmed borrowers. Let say, the bank lend me $5000 which to need to be

repaid in 2 years time. So the price level doubles by that time, the $5000 that I repaid will

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have purchasing power of the $5000 I borrowed. The same amount will be repaid as what

I had borrowed when we ignored the interest charges. On the other hand, when inflations

occur, that amount will only buy half as much as it did when the loan negotiated. As a

result, when price increases, the value of the amount will decrease. So the banker will

suffer a great loss of real income when borrowers paid back the lesser amount than those

who received from the lender. Therefore, borrowers tend to benefit from inflation

because the real value of their repayments will fall over time.

If government policy is not able to achieve the objective of price stability in the

long run, the costs of inflation will be permanently damaging. The economic cost will

likely be a reduction in real savings and real investment. Not only that, there will be a

reduction in the purchasing power of consumers and producers as there’s a fall in real

income. There will be a higher debt in future due to the economy cycle Due to a serious

inflation problem, if I am the economics minister of a country, I would undertake

contractionary fiscal policy as one of the ways to reduce inflation in the country.

If inflation is due to demand- pull forces, then contractionary fiscal policy can be

used to reduce the inflation in the economy. The contractionary fiscal policy through an

increase in taxation or reduces government’s spending or a contribution of the two

measures. For instance, maintaining government spending and increasing taxes. When

government reduces its spending, total expenditure reduced and inflation reduced as well.

On the other hand, when government increase taxes, consumer’s personal disposable

income will fall, it causes the consumption to fall too. This result the total expenditure

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reduces as well as inflation. . Besides that, the government can also reduce transfer

payment to reduce the government spending so that the aggregate expenditure can be

decrease.

Besides that, price pegging method can be used to reduce serious inflation. In

price pegging method, government will fix price floor and price ceiling so that prices will

not increase rapidly. When the government imposed limit on how low a price can be

charged for a product, it is known as price floor. With price floor is imposed, producers

will not be able to increase prices with their own wills. Therefore, inflation can be

controlled when price floor is imposed. Furthermore, price ceiling is when government

imposed the maximum price of the product that can be charged. Under price ceiling,

government can intervene through a rationing system whereby consumers are given

coupons to purchase goods in certain quantities. For instance, each family is only allowed

to buy 5kg of rice per month. With this imposed the demand for the good is controlled

and consumption will decrease and saving will be encouraged. This result the total

expenditure reduces and inflation reduces.

If inflation is happens due to a rise in wages as a result of trade union demands,

then the government may wish to reduce the trade union power. Furthermore,

government can also reduce inflation by limiting the rise in wages or prices. Any raise in

wages or prices will have to stop until they reach a certain limit. . The fall of wages will

reduce the purchasing power of consumer. Therefore, consumption will be decrease and

saving is encouraged. This wills leads to a decrease in aggregate expenditure and

inflation are reduced.

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4. Assuming now Malaysia faces a recession. Discuss the likely effects of a
recession on the government’s budget. What type of fiscal policies would you suggest
the government to undertake in such times? (10
marks)

Recession means a period of decline in total output, income, employment, and

trade. This downturn, which lasts 6 months or more, is marked by the widespread

contraction of business activity in many sectors of the economy. But because many prices

are downwardly inflexible, the price level is likely to fall only if the recession is severe

and prolonged when depression occurs. Recession usually occurs because of less

consumption, decrease in supplies, increment in unemployment rate, decrement in

personal income and an unhealthy stock market.

The term business cycle refers to alternating rises and declines in the level of

economic activity, sometimes extending over several years. In other words is refers to the

fluctuations of economic activity about its long term growth trend. The cycle involves

shifts over time between periods of relatively rapid growth of output (recovery and

prosperity), and periods of relative stagnation or decline (contraction or recession). These

fluctuations are often measured using the real gross domestic product. The business cycle

will go through a process of economy expands, reaches peak, declines, reaches slump

then expansion again. The diagram of business cycle is shown as below.

Peak

Expansion Recession

Slump

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 Business Cycle
There are three types of government budget policy which is the budget deficit,

budget surplus and balance budget. Budget deficit means a budget is said to be in a

deficit when the government’s expenditure is more than its revenue (G > T). Budget

surplus occurs when the government’s revenue is greater than its expenditure (G < T).

Balance budget occurs when government expenditure is equal to its revenue (G = T).

During recession the national income declines, tax collection automatically fall and

budget deficits arise.

When recession occurs, it will bring effects on the government’s budget. When

economy goes into recession; costing many workers their jobs, and at the same time

causing corporate profits to decline. This causes less income tax revenue to flow to the

government, along with less corporate income tax revenue. Occasionally the flow of

income to the government will still grow, but at a slower rate than inflation, meaning that

flow of tax revenue has fallen in real terms. Besides that, this is because many workers

have lost their jobs; there is an increased use of government programs, such as

unemployment insurance. Government spending rises as more individuals are calling on

government services to help them out through tough times. Furthermore, to help push the

economy out of recession and to help those who have lost their jobs, governments often

create new social programs during times of recession and depression. Therefore

government spending rises, not just because of increased use of existing programs, but

through the creation of new programs. Because of factors one, the government receives

less money from taxpayers, while factors two and three, the government spends more

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money. Money starts flowing out of the government faster than it comes in, causing the

government's budget to go into deficit.

Fiscal policy refers to the government’s expenditure (government outlay) and

revenue (taxes and non taxes). In other words, it refers to the government’s budget

policy. It looks at how government manages the economy by changing the size and type

of taxes, government expenditure and public debt. The purpose is to achieve economic

stability. Fiscal policy has 2 important roles which are to remove any deflationary and

inflationary gaps and to smooth out any fluctuations (boom and slumps) in the economy

due to the business cycle.

There are two types of fiscal policy, discretionary fiscal policy and non-

discretionary fiscal policy (automatic stabilisers). Discretionary fiscal policy is the

deliberate changes in taxes and government spending in order to influence the level of

aggregate expenditure, employment, to control inflation and stimulate economic growth.

For instance, government raises the taxes on tobacco products to control the spending on

these items. Non discretionary fiscal policy exists when revenue and expenditure items

in the budget automatically change with the state of the economy in such a way to

stabilise the economy.

When recession occurs, discretionary fiscal policy can be taken by the

government. In here, government can undertake the expansionary fiscal policy in order to

raise aggregate expenditure (AE). Expansionary fiscal policy is a policy when the

government reduces taxes and/or increase its spending to stimulate the economic

activities. In order to raise aggregate expenditure, the government can increase its

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spending and maintaining taxes. The government can also maintain its spending and

reducing taxes to increase aggregate expenditure. Besides that, under expansionary fiscal

policy government can also encourage more private sectors investment and increase

transfer payments. An increase in transfer payments will increase the consumption

therefore aggregate expenditure will increase.

Multiplier means the magnitude (by how much) of changes in national incomes as

a result of a change in the components of the aggregate function. Formula of simple

multiplier or K :

= Change in equilibrium national income

Change in autonomous expenditure

K= Y
A

When AE increases, national income will also increase but by several times more

depending on the value of the multiplier. For example, if the simple multiplier is 5, a

RM20 billion increase in AE will cause a RM100 billion rise in national income. This

happens because when extra spending is injected into the economy, it will stimulate

further spending. The process will continue and goes on.

Y=Kx A
= 5 x RM 20 billion
= RM 100 billion

This means that when autonomous expenditure increases by RM 20 billion, national

income, Y, will increases by 5 times more or by RM 100 billion.

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5) It is mentioned in the article that the Malaysian ringgit has risen more than 2%
since the seven year peg to the US Dollar was scrapped on July 21, 2005. Discuss
whether a stronger ringgit is beneficial to the economy or otherwise. [5 marks]

Malaysia is a country that has a multitasking role when it comes to the nature of

the economy but more to exporting due to its rich sources. We have constantly been

dealing with exporting and importing goods from others and whether that if we have a

stronger ringgit would be beneficial to the economy, has had a very long debates as both

sides has very strong points to back them up.

Exchange rate is defined by the current market price for which one currency can

be exchanged for another. If Malaysia’s exchange rate for U.S is 3.52, this means that 1

US dollar can be exchanged for 1 Ringgit Malaysia. There has always been a saying for if

one’s country’s nature is importing goods, it is better off when they have a stronger

currency and if their nature is exporting goods, it would be otherwise.

The very classical way of how one would comment on whether a stronger

currency be beneficial. One of the many advantages of strengthening our Ringgit would

be that our country’s consumer will be able to see a lower price on foreign products or

services. This would eventually lead to Malaysian investors being able to purchase

foreign stocks or bonds at a lower cost. Malaysians can also benefit when they travel to

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foreign countries as they will not have to fork out as much money since our currency is

stronger and a stronger Ringgit will be able to help keep our inflation low.

However, there are disadvantages to a stronger currency. Our country’s firms will

have a much more difficult time to compete in foreign markets and that we will have to

compete with lower price foreign goods that have a weaker currency. Apart from that, our

tourism economy will be affected as foreign tourist finds it much more expensive to visit

Malaysia due to our strong currency.

Weakening our Ringgit on the other hand has also both advantages and

disadvantages. The advantages would be that Malaysia firms will be able to find it easier

to sell goods in foreign markets as we will be able to keep our prices low due to our

weaker currency. This will also boost our tourism economy as more people will be able

to afford to visit Malaysia. As the weaker currency will not require one to prepare as

much capital as one would have to in a stronger currency country, our markets will be

more attractive to foreign investors.

On the contrary, a weaker currency will have disadvantages such as the

consumers will have to face a higher price on foreign products and services. This will

burden our people more as we will have to pay a higher cost of living. Malaysians will

also find traveling abroad to be very costly as the weak currency will require them to

spend at least a few times more than what they are supposed to spend due to the exchange

rate. Firms in Malaysia and our investors will find it harder to expand into foreign

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markets as we will have to prepare a bigger capital to be able to start a business or invest

overseas.

Of course when an exporting country’s currency grows stronger, there will be a

tendency of importers to go to another country where the product is cheap. However,

analyst has sayings that a stronger Ringgit could be good for the Malaysian economic

scene in the long run, as Ringgit appreciation could help improve the productivity and

competitiveness of Malaysian industries. Though a cheaper Ringgit breeds

complacency, as we might be inclined to think our export competitiveness could never be

eroded. With the strengthening, it could push us further up the value-added chain and

compel us to improve our productivity as a whole, because export advantage for lower-

end manufacturing is not there anymore.

Also there a saying a weaker currency is good for local industries. This is

probably due to the thinking of exporters would assume that they will earn more as the

currency is weaker therefore getting a higher exchange rate payment. This however, is

not as how it seems. Exporters are actually at lost as exporting companies rely on making

easy money rather than increasing the quality and the efficiency at productivity. A

stronger currency will, as stated above triggers and motivates a person to improve to the

better. a stronger currency gives more flexibility and purchasing power. A business

would not need as much money when it comes to importing goods that leads to a lower

price of the final goods.

True that a stronger currency would require a stronger determination from the

exporters as they would have to strive for the better rather than getting a easier way out of

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earning money, but a stronger currency would actually push the country’s economy to

another whole new level. A stronger currency would definitely help on consumer

spending and to slow down inflation rate. There isn’t much sense when we stay at the

weak currency point and find the easy way out of everything when every other country is

striving for the best. Therefore it is important for our country to strive to make our

currency better and find a way to cover up the losses or the weakness in getting a stronger

currency to improve the economy and push Malaysia to be a stronger country.

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References

www.rieti.go.jp/en/events/07062901/pdf/2-3_E_Athukorala_RM_o.pdf

http://www.asiaweek.com/asiaweek/magazine/99/1210/investing.html

http://www.ardue.org.uk/world/currency.htm

http://thestar.com.my/news/story.asp?
file=/2007/7/28/bizweek/18406956&sec=bizweek

http://www.gocurrency.com/articles/stronger-dollar.htm

http://www.chicagofed.org/consumer_information/strong_dollar_weak_dollar.cfm

http://en.wikipedia.org/wiki/Cost_push_inflation

Book Title
Economics : principles, problems, and policies / Campbell R. McConnell, Stanley L.
Brue

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