H2 Prelims Paper 2 Q6 Suggested Answers

Suggested Response for Essay Question 6 6. To ensure that international trade remains smooth, open and reliable, one must resist the temptation to turn inwards, protectionism is not viable, especially for small states. (a) Explain how a country’s balance of trade may worsen over time. [10] (b) Discuss the view that the pursuit of a healthy trade balance leaves no room for the use of protectionism. [15] (a) Explain how a country’s balance of trade may worsen over time. [10] Command word Explain – use economic reasoning Start point: factors affecting X and M End point: worsen BOT Concepts Macroeconomic concepts Context Open context Introduction: - Defining balance of trade: X-revenue minus M-spending on all goods and services (visible and invisible trade balances) - Worsen BOT: falling X-revenue and rising M-spending - Causes of the worsening can be internal or externally driven. Students are expected to give at least 2 factors, of which at least one factor must link to both X-revenue reduction and M-spending increasing. The factors can include either of the following: 1) Poorer foreign economic growth or national income The changes in relative economic growth rates across countries may lead to changes in demand for the country’s exports or its demand for imports. For example, a fall in national income of a trading partner’s economy, relative to domestic would lower the foreign residents’ purchasing power, hence reducing their demand for imports. This could reduce the X-revenue of the domestic country. The fall will be more significant if the trading volume is larger and the country is a close trading partner. Therefore, with the fall in X-revenue relative to the import-spending, this may worsen a country’s BOT. 2) Exchange rate Appreciation of the country’s exchange rate will make the country’s exports become more expensive in its trading partner’s currency. At the same time, its imports are relatively cheaper in its own domestic currency. If demand for both export and import are price elastic, the higher price of the country’s exports (in foreign currency) will lower the country’s export revenue while its cheaper imports (in its domestic currency) will increase its import expenditure, leading to worsening of BOT.

3) Relative inflation rates If domestic costs of a country rise faster than costs abroad, its exports will be relatively more expensive than before and imports relatively cheaper. Assuming that demand for exports and imports are both price elastic, the increase in domestic costs will lead to a more than proportionate fall in the quantity demanded for exports, hence, reducing X -revenue. At the same time, its domestic residents may turn towards cheaper imports, leading to higher demand for imports, increasing M-spending. The fall in X and rise in M will lead to a worsening of the BOT. 4) Loss of comparative advantage due to lack of technological progression Countries which do not invest in expanding its production capacity may face higher production costs, especially if domestic resources are tight (e.g. labour market). This could mean losing our relatively lower opportunity cost in the production of some goods. This will worsen when other countries invest in building their infrastructures and R&D capabilities ➔ allowing them to e njoy relatively lower opp cost (than us) in the production of the same good. Therefore, the domestic country loses its CA ➔ becomes an importer rather than exports. Foreign households buy less from the domestic country (due to more expensive prices) and local households also buy more from cheaper import sources ➔ X-revenue falls due to weaker DD and higher M-spending due to higher demand. (X -- M) drops and worsens. Conclusion Causes of BOT worsening can be due to many domestic or external factors or both. BOT worsening can lead to other macroeconomic implications such as economic growth and unemployment issues. Hence, it is important that government put in place policies to improve the BOT. Level Knowledge, Application, Understanding and Analysis Marks L3 • 2 factors are well -analysed to account for the worsening of BOT • Must explain the impact on both X-revenue and M -spending to qualify for 9m and 10m - Good use of economic concepts and tools of analysis (e.g. AD- AS) - No major inaccuracies - Content is relevant - Start and end point is clearly explained, no missing elaboration. 8-10 L2 • Developed but one-sided explanation on either X-revenue or M- spending can worsen the BOT Or • Under-developed analysis on both the X -revenue and M- spending factors: - Use of economic concepts but contains several inaccuracies 5-7

- start and end point not enti rely clear, some incoherence in the answers L1 • Descriptive answer without any conceptual framework • Answer contains many inaccuracies. 1-4

(b) Discuss the view that the pursuit of a healthy trade balance leaves no room for the use of protectionism. [15] Command word Discuss – balanced argument Req 1: how the use of protectionism can help to improve a country’s trade balance Req 2: How the use of protectionism may not help Start point: protectionistic tools End point: Balance of Trade Concepts Protectionism, BOT Context Open context – contextualise by considering different economies’ characteristics Introduction • Defining protectionism: use of tariffs, export subsidies, import quota • Aim: to switch spending on imports to domestic goods and increase competitiveness of domestic exports ➔ Improve balance of trade • Whether there is room for the use depends on 1) causes of worsening BOT and 2) country’s characteristics and 3) time. Requirement 1: How the use of protectionism can help to improve a country’s trade balance Protectionism such as a tariff may help to raise import prices and hence, reducing the spending on foreign imports and hence, improving balance of trade. Tariffs is a tax that is imposed on imported goods. The imported good will now face a higher selling price due to the imported tax, as seen from how the supply curve shifted upwards by the amount of the tax , from Sworld to Sworld + tariffs.

After the tariff is imposed, the imported good prices will therefore increase from Pworld to Ptariff. Importers will now pay a higher price of P tariff for imports. At this higher price, domestic quantity demanded for shoes falls from Q4 to Q3. At the same time, more domestic firms are willing and able to sell shoes, and domestic production increases from Q1 to Q2. As a result, the volume of imports will fall from Q1-Q4 to Q2-Q3. So, assuming that the PED for imports is more than 1, the higher price of imports lead to a more than proportionate fall in qty demanded for M ➔ M spending will fall. Ceteris paribus, BOT improved with the fall in M-spending. The use of import tariffs, coupled with exports subsidies can further improve a country’s BOT. The government collects the tax revenue from tariffs to use to subsidise the exports’ production. Export subsidies ➔ reduce the cost of production for the exported goods and services ➔ price of these exports fall ➔ assuming PEDx > 1, the rise in Qty demanded for these X is more than proportionate ➔ X-revenue increase Higher X and lower M improves BOT position. Requirement 2: How the use of protectionism may not be able to improve a country’s trade balance and/or bring about unintended consequences & hence no room for the use of protectionism (Note to markers: Should students interpret R2 to be the use of other policy tools such as Supply-side policies / FTAs to improve BOT, WITHOUT addressing why there is no room for use of protectionism ➔ this is counted as a Knowledge Answer (L1), max of L2 5m) Imposing protectionism such as import tariffs may bring about unintended consequences to the domestic economy: The tariffs have also