NYJC H2 ECONS Q6

The United States has run a large deficit on the current account of its balance of payments for several years. Explain what might cause a persistent and large def icit on the current account of a country’s balance of payments. [10] Discuss the view that policies to deal with such a deficit can be ineffective and potentially damaging. [15] (a) Synopsis: The answer would look into the different causes of current account deficit which include both price and non-price factors . Introduction: • Define Current Account: Records receipts from the export of goods and services as well as payments for the import of goods and services during the current period. • Explain that Current Account consists of visible trade, invisible trade, unilateral transfers and income flows. • Explain that Current Account deficit implies export earnings of goods & services < import expenditure on goods & services Body: Explain 3 factors (at least 1 price and 1 non-price factor) that can cause a Current Account deficit : (i) Higher price of domestic goods relative to imports – could be due to: • Loss of price competitiveness of goods produced as a result of higher cost of production compared to other producers in countries like China or India (due to loss of comparative advantage leading to the shift of ma ny manufacturing industries to other countries/slower growth in productivity compared to trading partners). ⇒ Impact on the US’s exports and imports: -With a loss in export competitiveness, US might find that their trading partners who used to import from them would switch to buying relatively cheaper China or India made goods. Furthermore, Americans might also stop buying relat ively more expensive domestic goods and switch to buying the cheaper imports instead. W ith the drop in export revenue and increase in import expenditure, the visible balance in the current account will worsen. • Undervalued Yuan ⇒ Loss of price competitiveness of US exports and a fall in domestic price of imports from China. ⇒ US consumers may thus substitute domestic goods wi th cheaper China goods. If the demand for imports is price elastic, US’s import expenditure will rise significantly. ⇒ China consumers may also reduce their quantity dem anded of US’s goods as it seems relatively more expensive in Yuan. If the China’s c onsumers’ demand for exports is price elastic, US’s export revenue will fall significantly.

⇒ Thus, with the fall in export revenue and the rise in import expenditure, US may face a Current Account deficit, ceteris paribus. • Higher rate of inflation in the U.S. ⇒ US’s exports become more expensive. Hence, the qua ntity demanded of US’s exports will fall and export revenue fall significantly if the demand is price elastic. US consumers may then substitute domestic goods with cheaper imports. This will raise import expenditure and it will rise significantly a s well if demand is price elastic. Therefore, with a fall in export revenue and a rise in import expenditure, US may face a Current Account deficit, ceteris paribus. (ii) Changes in taste and preferences of Americans in favour of foreign goods – could be due to loss of non-price competitiveness. (iii) Increase in income due to continuous rate of growth in the country ⇒ Americans have higher disposable income higher purchasing power imports more OR ⇒ Americans have higher disposable income higher purchasing power Americans would travel more and adversely affect the invisible balance of the current account. (iv) Other logical reasons such as the presence of FTAs ( e.g. United States–Republic of Korea Free Trade Agreement, United States–Colombia Free Trade Agreement) signed between countries which in turn results in more imports (removal of tariffs – cheaper imports), fear of terrorism attacks that affects tourism (fall in exp orts earning from services), presence of unfair trade practices by other countries (e.g. China’s government giving subsidies to the solar manufacturers) etc. *A combination of both price and non-price factors for Current account deficit over an extended period will result in a persistent and large Current account deficit, ceteris paribus. Conclusion: • There are many causes of a persistent and large current account deficit. • Government intervention to solve the problem (should find out the root cause of the problem) is important as a persistent and large cur rent account deficit may have undesired effects on other macro goals. Level Knowledge, Understanding, Application, Analys is L3 (8 – 10) Clear explanation of price and non-price factors ca using large and persistent Current Account deficit using examples. L2 (5 – 7) Some attempt to explain the causes of Current Account deficit with some examples, but tends to be superficial. L1 (1 – 4) Smattering of points and weak in explanation.

(b) Discuss the view that government policies to de al with such a deficit can be potentially damaging and ineffective. [15] Synopsis: Students are required to have a two-sided argument in their answers in which the thesis will touch on how government policies to solve CA defici t can be damaging and ineffective while the anti-thesis will look at how government policie s that solves CA deficit may in fact be effective. Lastly, students should make a clear and sound judgment on whether they agree or disagree with the view or that their decision depends on certain factors. Introduction • Briefly explain why a government should be concerned with a CA deficit and state the policies that a government can implement to solve the problem. The ↑ in trade deficit will translate into a ↓ in AD, ceteris paribus. This will result in a fall in RNI through the multiplier effect; might cause othe r macro problems such as structural unemployment. Policies to solve CA deficit e.g. Expenditure-reducing measures (contractionary FP and MP), Expenditure-switching measures (Tariffs, Subsidies), SS-side policies However, not all the policies mentioned above are effective to a large extent. It may be potentially damaging and ineffective. Body: Thesis: Government policies to deal with CA deficit can be potentially damaging and ineffective 1) Expenditure-Reducing Measures • Explain how contractionary FP and MP work to reduce CA deficit. Illustrate with diagrams. • AD falls GPL falls (assuming the economy is operating at the intermediate range of AS) • This will result in reducing the domestic inflation rate relative to those in other countries hence increasing the price competitivenes s and quantity demanded for exports. Increase in export earnings assuming PED>1. • Demand for imports is also dampened as incomes are reduced. As demand for domestic goods also fall, producers are free to export more. • Hence, export revenue rise and import expenditure falls Improving the CA position. However , • The problem arises when the demand for exports and imports is price and income inelastic. The effect will be minimal and will not reduce import expenditure or raise export earnings. This will deem the policy to be ineffective.

• Furthermore, when AD falls (intermediate range of A S), RNI falls as well (conflicting macro goals). If CA deficit continues to rise, it will lead to a further fall in AD and hence RNI which is potentially damaging to the economic g rowth of the country. Unemployment may also rise in the country (labour being a derived demand). Evaluation: However, if the country is operating at the classic al range of the AS curve, contractionary policies may not necessary reduce RNI. Instead, it will only reduce GPL and hence lower the domestic inflation rate. This will increase the country’s price competitiveness without conflicting with the other macro goals of achieving sustainable economic growth and low