2022 JC2 H2 Prelim Essay Q6 (Suggested Answers)

6 (a) Explainoneinternalcauseandoneexternalcauseofabalanceoftradedeficit of a country. [10] (b) Discusswhetherprotectionismisthemostappropriatepolicytoimprovebalance of trade.[15] Suggested answer for (a) Introduction:Abalanceoftradedeficitcouldbearesultofafallintheexportrevenueofdomesticallyproducedgoodsand/oranincreaseinimportexpenditureonforeigngoods.Thiscouldoccur because of internal and/or external reasons. Explain an internal cause of BOT deficit: Higherdomesticinflationrelativeto the rest of the worldwill reduceexportcompetitiveness of a country and can cause a balance of trade deficit. Forexample,Indiahasbeenexperiencingrisingratesof inflationsincethestartof2022.Assumingpricesofothercountries’goodsandservicesriseataslowerratethanIndia,a higherincreasein domesticpricesin Indiarelativeto theforeignpriceswillcausedomestichouseholdsin Indiato increasedemandfor importedgoodsandservicesinsteadofdomesticallyproducedones,therebycausingimportexpendituretoincrease.At thesametime,moreexpensiveexportswillcauseforeignersto lowerquantitydemandedfortheexports.SincethedemandforIndia’sexportsislikelytobepriceelasticduetoavailabilityofsubstitutesfromothercountries,theincreaseinpricewillleadtoamorethanproportionatefallinquantitydemanded,causingexportrevenuetofall,ceterisparibus.ThefallingexportrevenueandrisingimportexpenditureworsenIndia’s trade balance and cause its balance of trade deficit to widen in 2022. Explain an external cause of BOT deficit: Withglobalisationandfreertradeflows,competitionfromemergingeconomiesmayleadtothelossofcomparativeadvantageofthemoredevelopedcountrieswhichcancause a balance of trade deficit. Ifthecountry’sdomesticallyproducedgoodsareseentobeofarelativelylowerqualityorrelativelyhigherpricedcomparedto foreigngoods,localconsumerswillswitchtobuyingtherelativelybetterqualityofcheaperimportedgoods.Thiswillresultinariseindemandforimportsandimportexpenditure.Ontheotherhand,foreignerswillalsobuy

lessofthedomesticallyproducedgoodsresultinginafallindemandforthecountry’sexportsandexportrevenue.Thefallinexportrevenueandriseinimportexpenditurewillleadtoa worseningofa country’s tradebalance.Forexample,theabundanceoflabour, landandotherrawmaterialsinChinahasresultedinaloweropportunitycostintheproductionof low-endmanufacturedgoodsthanthedevelopedcountriesliketheUS.ThiswouldmeanthattheChineselow-endmanufacturedgoodsaremorepricecompetitivethantheUSgoods.USwillexperienceafallinexportdemandandariseinimportdemand.AlossincomparativeadvantagewillthusleadtofallingexportrevenueandrisingimportexpenditurewhichworsenUS’s tradebalanceandresultedin abalance of trade deficit. Conclusion:Thus, both internal and external causes may cause a balance of trade deficit. L3 A well-developedanalyticalexplanationof bothinternalandexternalcausesof balanceof tradedeficit.Answershowsexcellent application with real world examples. 8-10 L2 Anundevelopedexplanationof thecausesof balanceof tradedeficit. Max5mfora well-developedanswerthatonlyexplainseitherinternal or external cause of balance of trade deficit. 5-7 L1 Adescriptiveanswerthatshowssomeknowledgeofthecausesofbalanceoftradedeficit.Largelylistingofcauseswhichareonlybriefly explained and/or answer contains errors. 1-4

(b)Discusswhetherprotectionismisthemostappropriatepolicytoimprovebalanceoftrade. [15] Suggested answer for (b) Introduction To improvebalanceof trade,a governmentcanadopteitherexpenditure-reducingorexpenditure-switchingpoliciesto increasetheexportrevenueof goodsandservicesand/ordecreasetheimportexpenditureongoodsandservices.Thisessaywilldiscusshowprotectionism,contractionaryfiscalpolicy, andsupply-sidepolicycanimprovebalanceoftrade.Theappropriatenessofthesemeasuresdependsontherootcausesof thebalanceof tradedeficit,economicconditions,natureof theeconomyandtheunintended consequences/ trade-offsin macroeconomicgoals. Policy 1: Explain how protectionism can improve balance of trade. Protectionismis a formof expenditure-switchingpolicywhichaimsto switchtheexpenditureofdomestichouseholdsfromforeigntodomesticgoodstoreduceimportsand/orswitchtheexpenditureofforeignhouseholdstogoodsproducedbythecountryto increase its exports. Forexample,theUSgovernmentimposed200%importtariffsonsolarpanelsimportedfromChina.Withtheimpositionofimporttariff,t,thepriceofimportedgoodincreasesfromPw toPw+t , asshownindiagrambelow. Asimportpricesincrease,consumerswillswitchtocheaperdomesticallyproducedsubstitutes,andthiswillreducethequantitydemandedofimportsfromQd -Qs toQ2 -Q1 . Assumingthedemandforimportsarepriceelastic(thereareclosesubstitutesproducedbydomesticfirms),theincreasein thepriceofimportswillreducethequantitydemandedbymorethanproportionatelyleadingto a fall in import expenditure. Ceteris paribus, balance of trade improves.

Limitations ● However, importtariffsmayreduceexportrevenueiftheexportindustryisrelianton importedrawmaterials.So,theoverallimpacton thetradebalanceisdependentonwhetherproducersin theexportindustrycanswitchtocheaperdomesticsupplies.If thefirmsin theexportindustryusetheimportedrawmaterialsthatexperienceanincreasein theprice,thecostof productionwillincreaseandthusleadtoanincreaseinthepriceofexports.Ifthedemandforexportsispriceelastic,thequantitydemandedforexportswoulddecreasemorethanproportionatelyandtherebyreducingexportrevenue.Theoverallimpactonthenetexportwouldmostprobablybeanimprovementofthetradebalanceastheimpactontheimportexpenditureis directwhiletheimpactontheexportrevenueismoreindirectwheretheimportedrawmaterialsmayonlytakeupasmall portion of the total cost of producing the exports.● Theimpositionoftariffsleadstothelossofconsumerwelfare.Consumersareworseoff asdomesticconsumptionofthegoodfallsfromOQd toOQ2 andtheyhavetopaya higherpriceofPw +t.Thelossinconsumersurplusismorethanthegainstobothproducerandthegovernment,leadingtoawelfarelosstothesociety shown by area (B+D).● Risein priceof importedrawmaterialswillalsoleadto a risein thecostofproduction SRASfalls RNYfallsandimportedcost-pushinflationoccurs(unintended consequences) Policy 2: Explain how contractionary fiscal policy can improve balance of trade. Agovernmentmayadoptcontractionaryfiscalpolicy(anexpenditurereducingpolicy)toimprovethebalanceoftradebyreducingitsimportexpenditure.Forexample,theUSgovernmentcanreducegovernmentexpenditureoneducation,healthcare,etc.and/orraisetaxestoreduceaggregatedemand.Ariseinincometaxwillreducethepersonaldisposableincomeandabilitytopurchasegoodsandservices.Ariseincorporatetaxwillreducetheexpectedafter-taxprofits,hencereducestheincentiveforfirmstoinvest.Fallin G,CandI fallinADfirmswillfaceanunplannedriseininventoriesandthereforereduceproductionandrequirelesserfactorsofproductionandthiswillresultin a fallin nationalincome.Withlowernationalincome,therewillbelowerinducedconsumptionfromhouseholdsandthiswillresultinadownwardmultiplierprocesswitha multipliedfallin thenationalincome.Aspurchaseof importsis dependentonthenationalincome,thefallin nationalincomewillresultin a fallin importexpenditurewhich will help to improve BOT, ceteris paribus. Limitations ● However, theremaybeconflictinmacroeconomicgoalsdependingonthestateoftheeconomy. If theeconomyisoperatingbelowfullemployment,thispolicy

mayresultinariseinunemployment.Moreover, thefallinADmayfuelbusinesspessimismandmayinducefirmstofurthercutdownoninvestment.Therefore,besidesreducingcurrentRNYandemployment,suchpoliciesalsoruntheriskofreducing potential growth.● Contractionaryfiscalpolicywillbemoreappropriateif theeconomyis initiallyexperiencinginflationarypressure,asa fallinADwillbeabletocooldowntheeconomyandlowerGPL.Thiswillimprovethepricecompetitivenessofexportsandwillalsoencourageconsumersto switchtowardsdomesticallyproducedgoods which are now relatively cheaper than imports.● Iftheconsumerconfidenceandbusinessoutlookareverystrong,thepolicymaynotbeabletoreducetheconsumpti