Answers for Econ protected(aka waste) time (W4)

b) Effective use of interest rate to curb inflation?

• Define inflation: a situation in which there is a sustained inordinate and persistent increase in general price level
• Explain the link between a rise in interest rates and inflation rate.
o Contractionary money policy (a deliberate attempt by the central bank to reduce AE by changing money supply or interest rates

• Effects on internal economy
o Consumption will fall as:
• Cost of borrowing will increase
• Savings will become more attractive
o Investment will fall as more projects would become unfeasible assuming MEC is constant.
o AE will be lowered, this will contract the economy by the multiplier and acclerator effect. (Demand-pull) Inflation is eased.

• Effects on the external economy
o Increase in interest rates relative to other countries lead to the inflow of hot money. This raises the demand for local currency, leading to the appreciation of local currency, ceteris paribus.
o Reduce thailand’s international competitivness as prices of exports would rise in terns of foreign currency. Imports will be cheaper in terms of thai baht. Resulting in fall in net exports (X-M) leading to a fall in AD.
o This helps to reduce import-cost-push inflation as appreciation of thai baht will reduce import prices of raw materials and finished goods.
o This may force domestic producers to stay competitive by lowering their prices and accepting profit margins, thereby easing inflationary pressure
o However, this has implications on the BOP assuming elastic exports and imports (Marshal learner’s condition)

• Evaluate
o Responsiveness of consumption and investment to a change in i/r
o Consumption may not fall with higher interest rates as it is a function of past and expected income
o Keynes postulated that investment may be i/r inelastic as it is influenced by animal spirits. Borrowing is usually marginal as investment are planned and financed through retained profits.
o But given inflation, investment in Thailand is likely to fall.
• FDI which borrow may not be much affected by domestic i/r as they usually borrow from their home country.
o A rise in i/r may not be able to attract infow of hot money as speculators are dettered with inflation in Thailand
o A rise in i/r will have a more effective dampening effect on the economy if the exchange rate is floating. Less effective if it is a managed float. (Thai is a managed float)
o Demand for X&M may be price inelastic as it takes time to negiotiate new contrats (J-curve), PED for fuel is also inelastic (high dependency) therefore a fall in AD may not be achieved.
• If fall in AD occurs at the horizontal portion of the AS curve, prices may not even fall at all.

• The cause of inflation in Thailand according to the question is cost push in nature.
o A rise in i/r will contract AD, raise unemployment and restrict growth.
o Note: a rise in i/r will increase cost of production further thus fueling cost push inflation.
• Supply side measures could be implemented. (Price controls, XR policy)
• Inflation tends to be multicausal in nature
• Side effects of policies can be minimized if appropriate policy mix of short term and long term measures to raise productivity.