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 well. When countries implement a depreciation of the exchange rate to enhance export competitiveness to correct a BOP deficit , demand-pull inflation might occur as a trade-off, especially if the economy was already experiencing high inflation. For import reliant countries, they become more vulnerable to imported inflation too, which might cause the cost of production to rise and fuel cost -push inflation. When a country depreciates the external value of their currencies, prices of exports in f oreign currency becomes relatively lower while prices of imports in local currency becomes relatively higher. Assuming Marshall Lerner condition is satisfied, net exports will increase and this reduces the BOP deficit. At the same time, this results in an increase in aggregat e demand too and national income will then increase via the multiplier process, depending on the state of the economy it is in. If the country had already been experiencing high inflation , the devaluation of the currency would cause AD to increase from ADo to AD1 and result in demand -pull inflation if there is no corresponding increase in prod uctive capacity of the country. From Figure 2, prices will increase significantly from P1 to P2. On the other hand, if inflation rates or the risk of inflation has been low, then the country would have fewer concerns to implement expenditure switching policies to correct the BOP deficit . With reference to Figure 2, if AD2 increases to AD3, there will be an increase in national income from Y2 to Y3 with no increase in prices because of the spare capacity. Therefore , it is clear that both unemployment and inflation statistics are important factors to consider so that p olicy conflicts can be avoided as they help determine the suitability and relevance of policies to fight BOP deficit. Level 3 For a developed explanation of how economic performance (given by indicators of inflation and unemployment ) determines how BOP deficit can be reduced without tradeoff in policy objectives. 8-10 Level 2 For a developed explanation of how expenditure reducing OR expenditure switching policies can cause policy conflict with unemployment and inflation. For an undeveloped explanation of how policies to reduce BOP deficit can affect unemployment or inflation. 4-7 Level 1 Smattering of valid points 1-3 Y2 AD2 AD0 AD0 Y3 Yf Real GDP GPL AD1 AD AD0 Po P1 P2

Suggest answer for “b”, Most governments would implement supply-side policies to ensure a satisfactory balance of payments. A satisfactory balance of payments would mean a healthy BOP and it is in a surplus. This would mean that the main accounts of BOP, namely current and financial account, would be mainly in a surplus position as well. In comparison with a surplus, i f BOP had been in a deficit, that would mean that the country might be importing mor e than it is exporting or even facing a dearth of investments from overseas, implying an uncompetitive investment market and this would usually require intervention to correct the BOP deficit. If it is a persistent deficit, the country would lose foreign r eserves or be pushed to take up international loans to pay off their external debts, which would cause the future generations of the country to be in debt. Therefore, most countries would adopt an array of economic policies to reduce a BOP deficit and which policy is the best would depend on several factors like economic conditions and the root cause of the deficit etc. One of the policies that government would adopt can be supply -side policy. The aim of the policy is to increase the quantity and quality of the resources in the economy so that costs of production can be reduced in the long run, which will then enhance export competitiveness . For example, governments can roll out training subsidies and research incentives which can help offload the producers financially when they send their employees for training and incentivise automation. Upon completion of training and a successful research and development, the employees and the production line become more productive. This will allow the prices of exports to be more competitive and if demand for exports is price elastic, quantity demanded of exports will increase more than proportionately, increasing export revenue and reduces the BOT deficit at the same time. With a more productive workforce and consistent attempts by the government to improve the infrastructure for investments, foreign investors would be attracted to the country to invest and the influx of FDI would improve the financial account, helping to reduce the overall BOP deficit. For example, in Singapore, corporate income tax rates have remained competitive and favourable tax exemptions and incentives are given to pioneering investors, so that FDI can continue to stream into Singapore to boost our financial account. However, supply