Try the CSQ on your own. But for the following 2 questions, please post your comments as a group (leader - please co-ordinate)
3(a) Evaluate the possible impact of rising oil prices on the Indonesian economy. (8)
- Since the question is asked with regards to the Indonesian economy at large, one way of structuring your answer is via the 4 macro goals.
- Review the case evidence to ascertain if Indonesia is a net exporter or net importer of oil. That will be important for your analysis.
- Try to support your points with evidence from the case as far as possible. For this question, Table 1 will be particularly helpful.
4. Assess how the measures taken by the Indonesian government will affect the rupiah. (8)
- Identify the measures from the case.
- An assessment would require you to explain how each measure impacts the currency as well as the extent of the impact.
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3(a)
ReplyDeleteOil is very price inelastic, thus a large increase in price will lead to a relatively small drop in quantity demanded.
when there is demand for oil from indonesia, indonesia will export oil to other countries. thus the demand for it's currency will rise, causing it to strengthen. when the currency strengthen, price of exports will rise and price of their imports will drop. assuming Marshall Lerner condition holds, i.e. Ex + Em >1, the country's BoT will decrease, resulting in a decrease in the country's BoP. when there is a decrease in the BoP of indonesia, money has to be taken out of their foreign reserves to fuel the deficit...
TO BE CONTINUED. (INCOMPLETE BRB)
3(a) Indonesia is slowly becoming a net oil importer as projects in Indonesia have failed to stem falling outputs of oil, and “without new investments, Indonesia will [in 2005] probably end up as a net importer of oil”. Hence, with rising oil prices worldwide, the import expenditure of goods such as oil will increase as oil is an inelastic good so increase in price will only lead to a less than proportionate fall in quantity demanded so expenditure will increase.
ReplyDeleteWith greater import expenditure, and falling export revenue, this will create a smaller or negative (X-M) value. Hence current account balance will fall, as can be seen from Table 1 where current account decreased by 80.7% from 2004 to 2005. Hence further increases in oil price will cause greater import expenditure and Indonesia might eventually face a current account deficit.
With the rising cost of production of firms, firms may move out of Indonesia and start production at countries with lower costs of production such as China. Together will the “recent rapid depreciation” of the Rupiah, there would be an outflow of FDIs out of Indonesia. This can be seen from a 150% decrease net FDI from 2004 to 2005. This would cause a capital account deficit. Overall there will be a balance of payment deficit.
Inflationary pressures will naturally increase due to imported inflation as prices of oil increased so cost of production of goods and services increased, causing the Aggregate Supply (AS) curve to shift left, leading to cost-push inflation. This can be seen from Table one where inflation rates increased 4% from 2004 to 2005.
With the fall in net exports (X-M), it will result in a fall in Aggregate Expenditure (AE), contributing to a fall in equilibrium national income. AD falls so there would not be actual growth. Firms that used to export oil would have to close down and workers would be out of job. Rising cost of production in many firms may lead to an inevitable situation where employers cut pay or even retrench workers to cut on costs Hence, output falls and unemployment increases. Due to the multiplier effect, other households in Indonesia would also be affected and face a falling national income and increase in unemployment. Hence overall, there will be a multiplied fall in equilibrium national income and unemployment increases. This can be seen from the higher unemployment rate of 10.3% in 2005.
However, the Indonesian economy has been growing at a positive Real GDP gowth rate for the past years from 2002 to 2005. And hence the economy is growing at a relatively healthy pace despite the problems of current account deficit and budget deficit. This could be due to the several policies such as wage subsidies implemented from the government.
4. From the case study, we have identified two measures which were taken by the Indonesian government. They are - reducing fuel subsidies, and the Central Bank raising its interest rates.
ReplyDeleteA reduction in fuel subsidies will minimise the drainage on Indonesian government's finances, and will therefore lower the budget deficit, because the govt cuts down on govt expenditure. As such, money supply will decrease, leading to an appreciation in the rupiah. Furthermore, the decrease in money supply will lead to an increase in interest rates, in the hopes of stimulating savings so that banks will be able to credit-create. As such, short-term capital flows may increase, as foreigners wish to deposit their money in Indonesian banks so as to make profits from their relatively higher interest rates. This will cause the Indonesian rupiah to appreciate further, since the demand for rupiah will increase.
In addition, a reduction in fuel subsidies will cause the price of fuel to increase, and may cause a "trim in fuel demand". If fuel consumption decreases significantly, imports of fuel will decrease as well. Hence money supply of rupiah decreases. This will lead to an appreciation of rupiah as well.
The extent of the impact of this measure may not be substantial enough to lead to a decrease in demand for fuel, as demand for fuel is relatively price inelastic due to a lack of close substitutes, unless people choose to take public transport or walk if their destination is fairly near.
Moreover, if the fall in demand for fuel is substantial enough, it will ease inflationary pressure on fuel prices, and lead to a fall in fuel prices. As such, this measure may backfire, as the demand for fuel may increase or revert back to its original level, since the price of fuel is relatively cheaper now.
The other measure taken by the Indonesian government would be the Central Bank raising its interest rates. This increase in interest rates would result in a decrease in investments made in Indonesia. Without new investments, and a domestic production of oil that has failed to keep pace with demand, Indonesia would “probably end up as a net importer of oil”. This would increase the supply of rupiah as trade is affected, and cause it to depreciate. Indonesians would have to buy oil from overseas as their domestic output of oil is not enough to meet their demand. However, the increase in interest rates in Indonesia will reduce short-term capital outflows from Indonesia to other countries, decreasing the supply of the rupiah, causing the rupiah to appreciate.
The extent of the impact of this measure is limited, and from extract 1 it says that the rupiah is still “rapid depreciating”. This means that the measure to raise interest rates has not proven successful to halt to reduce the depreciation of the rupiah. This could be because more investments are being pulled out of the country than the outflows going in. And the reduction in capital outflows from Indonesian due to the increase in interest rates is only a short-term effect and is not sustainable enough to counter the rapid depreciation of the rupiah
yikes. i forgot i had all the answers lying in the inbox. so i shall post them now.
ReplyDelete3(a) Evaluate the possible impact of rising oil prices on the Indonesian economy.
The soaring oil prices could potentially contract Indonesia’s economy thereby slowing down economic growth or even landing the economy into a recession.
This would occur when the cost of production (COP) due to higher oil prices increases significantly and causes the aggregate supply (AS) of the economy to decrease markedly. (shift to the left) Using the AD-AS model, real national income would correspondingly decrease. Likewise, there would also be rising unemployment as firms facing higher COP would be forced to downsize to lower their costs to stay viable.
A downward multiplier effect would then occur where the initial fall in national income leads to the national income falling multiple times as the rising unemployment induces the consumption component of the aggregate expenditure (AE) to fall as people start to feel poorer. For a country with such a large domestic market like Indonesia, the multiplier is likely to be large due to their high marginal propensity to consume domestic goods. (MPCd) The rise in oil prices will also affect the COP of many industries in Indonesia since it is a factor of production for many goods and the unemployment and fall in national income is thus likely to be very widespread and significant.
Table 1 shows that unemployment is at a high of 10.3% in 2005 which is in-line with the above analysis. However, the table illustrates that real GDP has grown 5.7% in 2005 which contradicts what is said above about big multiple falls in national income. This contradiction can perhaps be explained by the fact that the government had been heavily subsidising the price of oil till the last quarter or so of 2005. As a result, the rise in oil prices for the last quarter of the year might not have had significant impact of Indonesia’s overall economic growth for the whole of 2005. Furthermore, the government’s continued subsidising of other goods and services (making them more affordable even to the unemployed) may have contributed to the slowdown of the downward multiplier effect although this would further worsen (and is the original source of) its already significant budget deficit.
BOP
Rising oil prices would drain Indonesia’s finances because Indonesia provides oil subsidies to its people. With fewer finances, interest rate will rise, causing investments to fall. When investments fall, business confidence will decrease, causing AD to fall. Falling AD will lead to a fall in GDP, and household will experience a decrease in income. This will cause a fall in demand for imports and Indonesia will buy less from other exporting countries like Singapore, as stated in extract 1. Hence M falls.
Furthermore, rising oil prices caused the exchange rate to appreciate from 2002 to 2004. Hence, good in Indonesia will be more expensive relative to other importing countries. As such, demand for Indonesia’s exports will decrease. As such X also decrease. Hence, from 2002 to 2004, since X decrease and M also decreases, (X-M) will not be affected significantly.
However, from 2004 to 2005, the exchange rate depreciated and goods sold in Indonesia are now relatively cheaper compared to importing countries. Demand for exports will increase and X increase. Hence, BOP will encounter a surplus since (X-M) increases.
Inflation
Due to rising oil prices, cost of production will increase for firms that reply on oil for production. This will include most industries because oil is a source of energy. Hence, this will lead to cost push inflation.
(continued)
ReplyDelete4. Measures taken by the Indonesian government
- Reduce subsidies for fuel prices
Reducing the oil subsidies would mean raising the price of oil domestically. Cost of production for the firms in Indonesia is now increased, and this would reduce the profit margins of the firms. The expected rate of return of business investments will look more dismal. Foreign direct investment and other long term capital flows into the country may fall. The demand for rupiah would fall and depreciate further.
Since oil is a price inelastic good for many firms and households, this might also lead to firms finding alternative sources for oil as a FOP. They may turn to foreign oil exporting firms which may be cheaper. The increased imports of oil into the country will increase the demand for foreign currency and increase supply of rupiah, which would also cause the rupiah to depreciate.
The higher oil prices will help to curb demand in Indonesia as the “government hopes a reduction in subsidies will trim fuel demand”. If the domestic demand for oil decreases, since most of Indonesia’s population are low income and unemployed, this means that Indonesia can import less oil and gradually shift to relying just on domestic production. This will hopefully lead to decreased demand for foreign currency and hence reduce the supply of rupiah in the forex market. The rupiah would then appreciate.
However, this depends on the political will of the government to enforce such reductions. The government “know about the potential of social unrest if they move too aggressively”. Subsidies are hard to remove in reality once implemented as industries have become complacent and productively inefficient, removal of subsidies means increase in costs of production substantially and the need to find other cost cutting methods, which is politically unpopular, so this impact may not be substantial since the government needs to move in small steps.
- The central bank raised benchmark interest rate to 9.5 % (contractionary monetary policy)
An increase in the interest rate would raise the short term capital inflows of Indonesia. The rate of returns such investment / funding is now higher since more interest can be earned from the purchase of equities such as bonds and stocks from issuing firms.
This increase in capital inflows would then increase the demand for the rupiah as foreign investors purchase Indonesian equities in rupiah, and this would lead to an appreciation in the value of the rupiah / exchange rate.
However, the extent of this impact on the currency is debatable as there is concern over the “inability and unwillingness of the Indonesian authorities to address the underlying structural causes behind the rupiah’s rapid depreciation”. Indonesia may become a net oil importer if Indonesia does not “resolve contract disputes that have curbed spending by companies including Exxon Mobil Corp.” Without the investment of these companies, Indonesian oil firms may not have the funds to continue oil production at 1.425 million barrels a day, its quota from OPEC so as to remain a net exporter at 27,000 barrels a day. So if Indonesia imports oil (net) from the world oil market, there would be a decrease in the demand for the rupiah and increase in the demand for foreign currency. This would continue to weaken the rupiah further and offset any appreciation from the rise in interest rates.