EJC H2 ECONS Essay5 Suggested ans and mark scheme

1 5 (a) Explain how a country’s circular flow of income could be affected by its trading partners’ pro-trade policy. [10] (b) Discuss whether an increasing balance of payments surplus is necessarily desirable for a country. [15] Part (a): Explain how a country’s circular flow of income could be affected by its trading partners’ pro-trade policy. [10 Question Dissection Command Word Explain Question Type Explanation Concept(s) • Circular flow of Income • Workings of the Multiplier Process End Point To explain how increase in injection via an increase in export expenditure (due to pro-trade policy adopted by a country’s trading partner) into the circular flow of Income can lead to a multiplied increase in the country’s national income OR Students can alternatively interpret as a rise in X and M but M rising more than X and hence a rise in W  reverse k process. Context Any country Suggested Answers (I) Introduction When a country’s trading partner adopts a pro-trade policy, this suggests that free trade is promoted where b uyers and sellers from different economies may voluntarily trade without a government applying tariffs, quotas, subsidies or prohibitions on goods and services. This may facilitate the increase in the demand for the country’s exports, hence increasing its export revenue. Assuming that import expenditure remains unchanged, the increase in the country’s export revenue will lead to an injection into a country’s circular flow of income, which will then lead to a multiplied increase in the country’s national income. [Note: students can also explain that pro-trade policy of trading partners can encourage an increase in import expenditure of the country. Assuming that increase in export revenue is greater than import expenditure, this will lead to an increase in injection into the country’s circular flow of income) (II) Body (1) Describe the circular flow of income model The circular flow of Income shows the flow of goods & services and their payment around the economy. It illustrates the relationship between various economic units and how the economy arrives at an equilibrium level of output, income and expenditure

2 Figure 1: The Circular Flow of Income Model To produce a country’s final goods and services, firms pay income to households for the use of factors services i.e. labour services, land , capital and entrepreneurship-ability owned by households. Households will then use their factor income to buy domestically produced consumer goods and services from firms. However, in a 4-sector economy, not all income earned by households is spent on domestically produced goods and services and passed back to firms. Some of the income may leak out of the circular flow of income in the form of savings, taxes paid to the government and expenditure on imported goods. These make up the withdrawal from the circular follow of income. Withdrawals (W) or leakages from the circular flow refer to household income that is not spent on domestically produced goods and services. Additionally, only part of the demand for firms’ output arises from household expenditure. Expenditure on domestically produced goods and services is also made up by firms, government an d the foreign sector in the form of injections. Injections (J) or additions into the circular flow of income refer to the income received by domestic firms that do not arise from domestic household consumption. These include the investment expenditure (I), government expenditure (G) and export expenditure (X). In an 4-sector economy, equilibrium national income is achieved when total withdrawals equals total injections i.e. W (i.e. S+T+M ) = J (i.e. I+G+X). At the equilibrium level of national income, current spending also equals current national output. Hence, there is no depletion of inventories or accumulation of inventories and firms have no incentive to increase or reduce production. (2) Explain how rise in export expenditure (X) as an injection leads to a multiplied increase in national income through the workings of the multiplier process. With the pro-trade policy adopted by a country’s trading partner, this can lead to an increase in the country’s export expenditure. This in turn represents an increase in injection such that total injections now exceed total withdrawals and the economy is now in disequilibrium. As J > W , there will be a depletion of the inventories. Hence firm will step up production in the next period which translate into hiring more labour which is a derived demand for producing the goods and services. Firms will pay out more factor income which increases the national income and induce more consumption. Assuming a 4-sector economy with excess capa city, an injection or autonomous increase in exports expenditure of $100 million will generate an initial increase in income of $100 million for

3 households employed by firms. These households will spend a proportion of the additional income on consumption of $50 million, depending on the size of their marginal propensity to consume (assume MPC 0.5), while the rest (i.e. $50 million) is leaked away as additional savings, taxes or particularly imports spending given that there is free-trade promoted between the trading countries and hence the country will be more incentivized to increase its expenditure in imports. Since one person’s spending creates another person’s income and income stimulates further spending, this rise in consumption on domestically produced goods of $50m creates income for another group of people who supply the consumer goods. They will in turn increase induced consumption based on their MPC (which equals $25 million in this example) while the rest constitutes further leakages (of another $25 million here). • This cycle of spending and re-spending will continue until the total increase in leakages (i.e. 100 million here) equals to the initial injection (i.e. $100 million here) into the circular flow of income. The multiplier process eventually stops because of the presence of leakages. The increase in induced consumption is smaller with each successive round as part of increase in income is leaked out in the form of S+ T + M. The eventual increase in national income is several times the initial increase in injections. In this numerical example, it will rise by $200 million. The multiplier, k, represents how many times the national income increase with respect to the initial injection. In this numerical example, multiplier = 1/MPW or (1-MPC) = 2. (III) Conclusion Hence, with a pro-trade policy adopted by a country’s trading partner, it can enable the country to enjoy a multiplied increase in its national income. The extent of the increase in its national income is dependent on the size of the multiplier which is in turn dependent on the proportion of leakages (MPW) or the proportion of induc ed consumption (MPC). Therefore, the smaller the value of MPW or higher the value of MPC, the greater the size of the multiplier, and that would mean a greater multiple increase in a country’s real national income. In this case, since the marginal propensity to import may increase due to the pro-trade policy advocated by the country’s trading partners, the size of the multiplier is expected to be smaller and hence the leading to a smaller increase in real national income. Note: Candidates could alternatively provide the explanation for which the rise in M exceeds the rise in X for the domestic country due to the partner’s pro-trade position. Level Knowledge, Application / Understanding and Analysis Marks L 3 For a well-analysed and reasoned answer on how an increase in export expenditure due to trading partner’s pro-trade policy can lead to a multiplied increase in nat