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(Suggested Answer)


(a) Explain the potential causes of a balance of payments deficit on current account.
[10]

(b) Discuss which measures, if any, a government should adopt when confronted with a
current account deficit. [15]

Part (a)

The best approaches to this question chose to limit their answers to two or three potential causes and to group
alternatives within them. These candidates gave excellent analytic explanations based on elasticities of demand
and marginal propensities to explain the reasons for their choice.

The most common cause related to an increase in export price. A second choice tended to be increases in import
prices caused specifically through increased price of oil imports. The third group consisted of a change in DD for
exports and imports.

Too many candidates attempted to list every possible cause with, in consequence, limited explanation of
each. This lack of development resulted in the majority being limited to Level 2 marks.

Some weaker candidates wasted a good deal of time explaining the whole of the Balance of Payments account
structure rather than focusing on the current account as flagged up by the question.


S1: causes: ? / effect: current a/c deficit in BOP

S2: select some reasons, without expanding details.

S3: Current a/c in deficit largely due to invisibles, not invisibles. So for BOT to be in deficit,
either i) export price is too high, ii) DD for exports is too low, iii) import price is too low OR iv) DD
for imports is too high.


S4:

a. Explain why export price is too high local currency appreciation/revaluation ( do use
Marshall-Lerner condition), relatively higher domestic inflation rates

b. Explain why DD for exports is too low loss of quality or comparative advantage, lack of
investment of new tech or new production methods

c. Explain why import price is too low - protectionism such as export subsidies, dumping,
foreign currency depreciation, relatively lower foreign inflation rates

d. Explain why DD for imports is too high gain of new CA. huge change in taste &
preferences in favour of imported goods.

Can combine points b and d. So largely 3 groups of answers, fitting a 10-mark question.




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Part (b)

Most of the better candidates distinguished between expenditure-switching and expenditure-dampening policies,
then went on to consider a supply-side approach as a much better long term policy to adopt.

The best answers were those that offered clear supporting analysis of each approach combined with an evaluation
of the relative potential success of each measure particularly in mind of the original cause of the balance of
payments deficit, as highlighted in part (a).

This latter approach offered a very clear bridge between the two parts of the question and consequently allowed the
candidate to draw a rather more holistic conclusion to the essay. Analytical tools drawn on included the Marshall-
Lerner condition, elasticities and marginal propensities. (Level 3)

A possible criticism is that candidates attempted to use every possible approach to this part of the question and too
many alternative policies were considered rather than being selective and focused on more relevant policies.
(Level 2)

Weak responses were descriptive and the policies chosen were not linked to the potential causes highlighted in the
candidates part (a) of the answer. (Level 1)

S1: causes: policies / effect: reduce current a/c deficit

S2: select some policies, largely 3 types.

S3: already done in part (a)


S4: How contractionary FP reduces import demand

How currency depreciation/devaluation export prices and raises import prices.

How supply side policies raise export demand.
ss-side---restructuring policies to gain new growth industries (theory of CA)--- dd for x
ss-side----productivity---- lower export prices----quantity demanded for x


Samples of writing:

In order to address the cause of high import demand leading to a current a/c deficit, a
government can adopt an expenditure reducing policy,

Instead of the 1
st
policy is to adopt fiscal policy. By having a contractionary fiscal policy,
demand for imports for decrease.

(the former is highly recommended, as writing in this manner allows you to give signal to the
examiner that you do aim to link the policy to the root of the problem)

(REMEMBER: the most appropriate choice of policy depends on the ROOT of the problem)

(Continuing)


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In order to address the cause of high import demand leading to a current a/c deficit, a
government can adopt an expenditure reducing/dampening policy, for instance a contractionary
fiscal policy.

Specifically, the government can raise direct taxes such as personal income and corporate
income taxes. A higher personal income tax rate reduces households purchasing power, so
consumption (C) level will fall. Hence demand for all goods and services, including imports will
fall.

(Note that I gave examples of a contractionary FP.)

Likewise, firms will have less profits for further investment activities, hence investment (I) will
fall, again leading to fall in import demand, such as raw materials and machinery from abroad.

(Carry on evaluating for expenditure-reducing policy, as examined in our lessons)

In order to reduce export price and raise import price, a government can adopt an exchange
rate policy to boost export competitiveness.


In order to raise export demand, a government has to adopt supply side policies


A government can also adopt supply side policies, such as those that emphasis on productivity
to reduce export prices.

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