Consequences of a Balance-of-Trade Deterioration and the Policy Response

Answer

Part (a) — Consequences of a deterioration in the balance of trade and capital outflow [10]

A deterioration in the balance of trade and a capital outflow both bear on a country’s macroeconomic goals, with effects that may be positive or negative.

Deterioration in the balance of trade. A worsening trade balance — a fall in net exports $(X-M)$ — is a net withdrawal from the circular flow with a contractionary effect on the economy.

Assuming the deterioration stems from a fall in $(X-M)$, aggregate demand falls from AD₀ to AD₁, and through the multiplier real national output falls from Yf to Y₁, slowing actual growth. As output falls, the derived demand for labour falls and demand-deficient (cyclical) unemployment rises. The one offsetting benefit: if the economy is overheating, the fall in aggregate demand eases demand-pull inflation as the general price level falls from P₀ to P₁. The effect on future living standards depends on the composition of the imports — a deficit driven by consumer imports raises current standard of living at the expense of future standard of living, while one driven by capital imports raises productive capacity and so need not worsen future welfare.

Capital outflow. An outflow of direct investment lowers aggregate demand and, through the reverse multiplier, output and employment, as above; in addition, the fall in investment slows the growth of productive capacity, dampening potential growth. An outflow of short-term “hot money” — typically chasing higher foreign interest rates — raises the supply of and lowers the demand for domestic currency in the foreign-exchange market, tending to depreciate the currency. A depreciation can improve export price competitiveness and so raise net exports, growth and employment; but a sudden, large depreciation imports inflation, severely so for an import-dependent economy such as Singapore.

Part (b) — Which policy is appropriate? [15]

The preamble identifies two responses to a trade deficit: contractionary fiscal policy (an expenditure-reducing measure) and currency devaluation (an expenditure-switching measure). The thesis is that neither is appropriate in general — the right choice depends on the cause of the deficit, the state of the economy, and the structure of the country’s trade.

Contractionary fiscal policy. Cutting government spending and/or raising direct taxes lowers G, C and I, reducing aggregate demand from AD₀ to AD₁ and, through the multiplier, real output and income. With lower income, import expenditure falls (imports being normal goods), improving the trade balance. The trade-off is direct: output falls from Yf to Y₁, opening an output gap and raising demand-deficient unemployment. The policy therefore buys an external improvement at an internal cost.

Currency devaluation. A deliberate lowering of the exchange rate makes exports cheaper in foreign currency, raising export revenue in domestic currency, and makes imports dearer in domestic currency. Whether import expenditure falls depends on the price elasticity of demand for imports; the trade balance improves only if the Marshall-Lerner condition holds — the combined price elasticities of demand for exports and imports exceed one. Limitations are several: devaluation is more effective where domestic goods are strong substitutes for imports (so import demand is elastic); it may invite retaliatory “tit-for-tat” devaluations and a currency war; and the rise in net exports raises aggregate demand, so an economy at or near full employment risks demand-pull inflation.

Judgement. The appropriate policy depends on context. If the deficit reflects over-spending on consumer imports while the economy is overheating, contractionary fiscal policy is preferable: the growth-and-employment trade-off is minimal because some cooling is desired. If the economy is in downturn, devaluation — which boosts rather than depresses aggregate demand — is preferable, since contraction would deepen the recession. Country structure matters too: large, diversified, resource-rich economies such as China and the USA face stronger import substitution than small open economies, so devaluation tends to be more effective for them. Two further qualifications complete the verdict. First, intervention is not automatic — a small deficit is generally left alone, since correcting it incurs trade-offs against other goals; only a large and severe deficit warrants action. Second, where the root cause is a long-term loss of competitiveness, neither expenditure-reducing nor expenditure-switching measures suffice; the appropriate long-run remedy is supply-side policy to raise competitiveness directly. The reasoned conclusion is therefore conditional: contractionary fiscal policy suits an overheating, consumer-import-driven deficit; devaluation suits a downturn in a country with strong import substitutes; and a structural deficit requires supply-side measures rather than either.