RVHS_H1_ECONS_EQ4

Governments typically use data on unemployment and inflation to assess the performance of an economy. (a) Explain how the above -mentioned indicators of economic performance determine the choice of policy to deal with a deficit on a country’s balance of payments. [10] (b) Discuss the view that supply -side policy is the best option available to any government to ensure a satisfactory balance of payments. [15] Suggested Answer: When a country is facing a deficit on her balance of payments (BOP), it would mean that there is more currency outflows tha n inflows as a country’s BOP is a record of the money value of all economic transactions between residents of one country and the rest of the world over a period of time. There are two main types of policies which can reduce a B OP deficit, namely the expenditure reducing policies and the expenditure switching policies. While both types of policies could potentially reduce the BOP deficit, there would be some conflicts with other macroeconomic aims under different economic conditions as indicated by the data on unemployment and in flation. Hence these indicators play an important role in determining which of the 2 policies would be more appropriate in correcting the BOP deficit. Data on unemployment is an important piece of information for the government to consider when they are i mplementing expenditure reducing policies. When the government adopts expenditure reducing policies, like contractionary monetary and fiscal policies, they aim at reducing aggregate demand which will then reduce the national income through the multiplier process. As import is a function of income, import expenditure will fall and t his will help to improve the BOP deficit. For example, in Singapore, t he government can cut its government expenditure by stopping the recruitment of more civil servants and stop the construction of national projects like lift upgrading and expressways etc. However, as a result of this, unemployment will rise if the country is on the Keynesian range of the long run aggregate supply curve. With reference to Figure 1 below, when A Do falls to AD1, national income falls from Yo to Y1 and unemployment rates will increase. On the other hand, if the country was experiencing high inflation at first, the fall in aggregat e demand from AD2 to AD3 might not cause unemployment if the extent of the fall in AD is manageable and within the classical range of LRAS. Therefore, the indicators of economic performance as seen from inflation and unemployment statistics will determine the suitability of impleme nting expenditure reducing policies. AD1 AD0 Y0 Yf Real GDP GPL Y1 AD2 AD3 Figure 1 Po P3 P2

In determining the relevance of implementing expenditure switching policies, which are policies which switch import expenditure to domestically produced goods, inflation data have to be considered as w