Question

It is argued that import substitution is a misguided trade policy if the intent is to promote long-term economic growth. Explain the reasons underlying this argument and discuss this assertion using the following framework: Y↑ = C + I + G + (EXPORTS - ↓IMPORTS)

Answer 1

I’ll keep this simple. A free market will almost always seek and find the cheapest solution to providing consumers with goods. If the cost of producing and shipping is less elsewhere than the cost and shipping of producing them locally, then they will be produced elsewhere, and shipped to consumers. Barriers to that will necessarily increase their cost to consumers.

Consumers have limited amounts of money to spend. The more “things” they can buy, the more prosperous they feel, and the greater the economic growth. When that given amount of money buys fewer things, consumers feel the pinch, spend less, in effect, saving for the rainy day they anticipate will soon come, consumption slows, and economic growth slows. It’s not the amount of disposable income that drives economies near as much as it is the number of “things” that disposable income will buy, and how prosperous it makes consumers feel. It’s psychological, and behavioral.

GDP can be measured using the expenditure approach: Y = C + I + G + (X – M).

• if M decreases, Y increases
• if M increases, Y decreases
• if X increases, Y increases
• if X decreases, Y decreases