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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3a) With rising oil prices in Indonesia, there will be a Balance of Payment (BOP) disequilibrium. With higher oil prices, the demand for oil exports will decrease. The fall in fuel subsidies will further worsen this fall in demand. Hence, export revenue will decrease, leading to a fall in Current Account balance. Oil is an essential factor of production, inclusive of supply of electricity and transport. Investors may not be willing to invest in Indonesian firms anymore due to rising costs of production. With withdrawal of investments, there will be a decrease in short term capital flows. This results in a decrease in the capital account. Hence, BOP will decrease, indicating higher outflows than inflows in the Indonesian economy. Since Indonesia is a large exporter of oil and, the fall in demand for oil can be substantial, incurring a substantial drop in BOP.
ReplyDeleteThe rising oil prices is caused by demand-pull inflation, whereby the economy is near full employment but demand for fuel keeps increasing, especially from the booming China. In addition to this, this rising oil prices will further result in cost-push inflation. Rise in fuel prices will cause increases in electricity and transport costs, making it more expensive to operate machinery and vehicles, hiking up the costs of production. With higher costs of production, firms will increase the prices of goods and services as well as cut back on production. Hence, the General Price Level (GPL) will increase while real national income decreases. This may be very substantial as the country is already experiencing inflation. Further inflationary pressures will worsen the economic conditions of the country.
With high fuel prices, Indonesian oil exports will be more expensive and less competitive, causing a fall in exports. Since aggregate demand (AD)=C+I+G+(X-M), a decrease in exports (X) will cause a fall in AD, decreasing real output and GDP. This will drive down actual growth. Also, the government has cut oil prices. This reduction in government spending (G) will further decrease the AD . In addition, rising oil prices will result in decreased investment as costs of production increases, causing a reduction in expected return of investment. Hence, I decrease. This will only result in a fall in AD, but also a fall in potential growth. Increase in LRAS will slow down due to less I. If the increase in demand exceeds the increase in spare capacity, further inflation will result. Hence, due to rising oil prices, potential and actual growth decreases. Indonesia exports large amounts of oil. The government spending cut is as high as 138.6 trillion rupiah. Oil prices can greatly affect costs of production. Hence, the decrease in growth will be substantial and damaging to the economy.
Rising oil prices also have an impact on employment. With firms cutting down on production, there will be retrenchment of workers. There will also be a cut in wages of existing workers to cut back on the costs, inducing some workers to quit and be voluntarily unemployed or to find other jobs ie search unemployment. However, with the presence of unions, the threat of increasing unemployment may not be that substantial as unions fight against lowering of wages and unfair retrenchment.
4) To stem the rupiah’s decline, the Indonesian government has reduced its fuel subsidies and cut its budget. This signifies a cut in government spending (G) and hence AD will decrease. With lower AD, it will lower pressures on prices brought on by excessive demand. With lower inflation, Indonesia’s exports will be relatively less expensive in the global market, prompting an increase in Indonesia’s exports. Such increase in demand is accompanied by increase in demand for the rupiah, causing it to appreciate. With relatively lower inflation, imports will also seem relatively more expensive as compared to domestic goods. This will lead to fewer imports from foreign countries, decreasing the supply of rupiah in the exchange market, hence allowing it to appreciate.
ReplyDeleteHowever, the decrease in government spending also signifies more expensive fuel and other goods and services. This will cause the exports to remain expensive and uncompetitive. Indonesian’s exports may not rise as much expected. Correspondingly, the demand of rupiah may not rise as much as expected. Also, imports may not have decreased much and supply of the rupiah in foreign markets may still remain high. Whether or not rupiah appreciates will depend if the export revenue exceeds that of import revenue, a case possible if inflation is brought low enough to counter the rise in oil prices. Given that the cut in government spending is as high as 138.6 trillion rupiah and that Indonesia has high domestic demand and hence a strong multiplier, the policy may cause the strengthening of rupiah, although the extent is greatly limited.
In addition to cutting government spending, the Indonesia’s central bank has also increased the interest rate to 9.5%. By increasing the interest rate, Indonesia is able to attract short-term capital flow in the country. This will lead to a demand for rupiah as investors purchase bonds and financial assets in expectation of higher returns for their investments. Increase in interest rate will also decrease the short-term capital outflows from Indonesia to other countries with lower interest rate. Hence, the supply of rupiah in the foreign market will decrease. Hence, with the increase in demand and decrease in supply of rupiah, it will appreciate. This appreciation of rupiah may be significant due to the many areas of Indonesia lacking in spare capacity and investments. With the facts that Indonesia’s economy is fundamentally sound except for a few major flaws like fuel subsidies and budget deficit, it may remain as an area with positive business conditions and hence attractive to investors.
In conclusion, the policy of increasing the interest rate may be more effective than by decreasing the government spending in affecting the rupiah. By increasing the interest rate, it does not only strengthen the rupiah, but also put the country on track for potential growth, which will further stabilise and improve its economy for further investments and stronger currencies in the long run, though it may turn off long-term or domestic investors due to high cost of borrowing. In contrast, cuts in government spending does not solve the root of the problem, which is the lack of spare capacity which leads to demand-pull inflation and hence the depreciation of rupiah. Hence in conclusion, controlling interest rate is more effective in controlling the rupiah, though the government should take note not to allow the exchange rate to fluctuate too much, deterring investors.
Real GDP growth
ReplyDeleteRising oil prices would cause a decrease in the General Price Level (GPL) and hence GDP growth. From Extract 2, if Indonesia does not attract new investments, it will end up importing a net 61,000 barrels a day as compared to net exports of 27,000 barrels a day in the previous year (2004). Contract disputes, a lack of investment and a failure to meet output quotas set by OPEC would decrease Indonesia’s net exports. This is shown by Table 1, where the Goods Balance falls from US$24562m in 2004 to US$20152m in 2005. Being the only OPEC member in Southeast Asia (SEA), oil trade would take up a significant proportion of Indonesia’s exports. With negative net exports (X-M), Aggregate Demand (AD) would fall as (X-M) is a component of AD. As AD falls from AD1 to AD2, the GPL will fall from P1 to P2.
Unemployment
As AD falls, firms find that they are unable to sell their current level of output at the current price level of P1. For a time they may be prepared to build up stocks of unsold goods, but sooner or later they will start to cut back on production. Since labour is a derived demand, firms will also begin to cut back on the amount of labour they employ.
As shown by the graph, as AD falls from AD1 to AD2, real output will fall from Y1 to Y2. The equilibrium level of output is at Y1.The gap Y1 - Y2 is due to demand deficient unemployment. As seen in Table 1, the unemployment has increased over the four years, from 9.1% t 10.3%.
Inflation
A deflationary gap might be created due to the collapse in AD.
BOP
From Table 1, the goods balance has fallen as Indonesia imports more and exports less oil. A fall in (X-M) will result in a fall in Aggregate Expenditure (AE), according to Keynes. This contributes to falls in equilibrium national income, possibly output and employment, and may give rise to a deflationary gap.
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4)
ReplyDeleteInterest Rates
The central bank raised its benchmark interest rate to 9.5% to stem the rupiah’s decline. By increasing interest rates, the central bank is hoping that Indonesians will save more instead of consuming. Increasing the interest rate would provide a greater incentive to save. By saving, less is spent on consumption and possibly imports. This reduces the amount of Rupiah going into the Forex market and decreases supply of Rupiah. This would help to stabilize the exchange rate and if possible, allow the Rupiah to appreciate.
However, consumer sentiments still play a crucial part in determining consumption. Despite the higher interest rate, if people expect the price of oil to continue to rise, they would spend more on oil now as they speculate continued increase in prices of oil. Also, they might choose to spend their money on physical assets instead.
Reduction in Fuel Subsidies
By reducing fuel subsidies, the government is able to improve the government budget deficit as less of the budget is spent on subsidizing fuel for the locals. Also, by cutting fuel subsidies, the government hopes that fuel demand will decrease as a result of the people feeling the stronger impact of rising oil prices. If there was a fall in demand for fuel, oil imports would decrease, improving net exports. This would increase AD as (X-M) is a component of AD. As imports decrease, the Rupiah might appreciate as less people exchange Rupiah for foreign currency to pay for imports. The supply of Rupiah will fall from Ss1 to Ss2.There is less Rupiah available in the Forex market and the Rupiah will appreciate from P1 to P2 at the new equilibrium.
However, the demand for oil is relatively inelastic as oil is vital in many daily processes. An increase in the price of oil would lead to a less than proportionate fall in demand for oil. By cutting fuel subsidies, people might have to pay more for oil, but they might continue consuming due to their dependence on oil. The Indonesian central bank might then have to tap on foreign reserves to maintain the Rupiah at a certain exchange rate by buying up excess Rupiah from the Forex market. If the foreign reserves run out, Indonesia will not be able to stop the depreciation of the Rupiah.
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3a)
ReplyDeleteEconomic Growth
Real GDP would fall as COP (cost of production) would have increased as oil is an integral part of manufacturing and/or running the factory. Firms would tend to cut cost by producing less, resulting in decrease in production of G&S, hence C would fall as P of oil increases. In addition, there is poor business outlook, resulting in decrease in confidence of investors and firms alike, causing I and FDI to decrease. Thus, not only is actual growth stunted, potential growth is also not expanded, which would result in future less C.
Inflation: Cost push
Rise in price of oil means a rise in COP, which firms may try to counter by raising the price of G&S. This would result in cost-push inflation (10.5%), and when Indonesia buys its imports from other countries, it would cause imported inflation that would further escalate the problem of a decreased C as P increases.
Unemployment
With the decreases in C, it would cause demand-deficit unN (10.3%) as firms cut COP by laying off workers.
BOP
Current deficit (8106 to 1564): For Indonesia, its exports will decrease as increase in COP makes it less price competitive and thus demand for it decreases, especially when exports are price elastic, an increase in price would lead to more than proportionate decrease in quantity demanded. Unfortunately for Indonesia, imports are price inelastic, an increase in price would lead to a less than proportionate fall in quantity demanded, thus M expenditure would increase while X revenue decreases, causing a problem with current deficit account.
Capital: In the short term, there would be an outflow of hot money as investors’ confidence drops due to the increase in price of oil. Also, with business outlook looking poor, FDI (-1512) would also decrease, causing inability to have better potential growth.
3a)
ReplyDeleteEconomic Growth
Real GDP would fall as COP (cost of production) would have increased as oil is an integral part of manufacturing and/or running the factory. Firms would tend to cut cost by producing less, resulting in decrease in production of G&S, hence C would fall as P of oil increases. In addition, there is poor business outlook, resulting in decrease in confidence of investors and firms alike, causing I and FDI to decrease. Thus, not only is actual growth stunted, potential growth is also not expanded, which would result in future less C.
Inflation: Cost push
Rise in price of oil means a rise in COP, which firms may try to counter by raising the price of G&S. This would result in cost-push inflation (10.5%), and when Indonesia buys its imports from other countries, it would cause imported inflation that would further escalate the problem of a decreased C as P increases.
Unemployment
With the decreases in C, it would cause demand-deficit unN (10.3%) as firms cut COP by laying off workers.
BOP
Current deficit (8106 to 1564): For Indonesia, its exports will decrease as increase in COP makes it less price competitive and thus demand for it decreases, especially when exports are price elastic, an increase in price would lead to more than proportionate decrease in quantity demanded. Unfortunately for Indonesia, imports are price inelastic, an increase in price would lead to a less than proportionate fall in quantity demanded, thus M expenditure would increase while X revenue decreases, causing a problem with current deficit account.
Capital: In the short term, there would be an outflow of hot money as investors’ confidence drops due to the increase in price of oil. Also, with business outlook looking poor, FDI (-1512) would also decrease, causing inability to have better potential growth.
4) Singapore will buy less from Indonesia as she cuts the fuel subsidies, causing COP to rise even higher in lieu of rising oil prices. This would cause exports and oil sold to Singapore to be more expensive, hence Singapore would not buy as much and turn to other countries.
ReplyDeleteIndonesia will buy less from Singapore because of the impact that rising oil prices on Indonesia herself. Unemployment and reduction in GDP will cause them to lose purchasing power and the consumer demand as well. The two mentioned above will reduce income in general, causing them to be less able to afford goods from Singapore because Singapore is also facing the problem of rising prices of goods due to increase in oil prices.
4) Singapore will buy less from Indonesia as she cuts the fuel subsidies, causing COP to rise even higher in lieu of rising oil prices. This would cause exports and oil sold to Singapore to be more expensive, hence Singapore would not buy as much and turn to other countries.
ReplyDeleteIndonesia will buy less from Singapore because of the impact that rising oil prices on Indonesia herself. Unemployment and reduction in GDP will cause them to lose purchasing power and the consumer demand as well. The two mentioned above will reduce income in general, causing them to be less able to afford goods from Singapore because Singapore is also facing the problem of rising prices of goods due to increase in oil prices.