Question

Consider an open economy with flexible exchange rates. Suppose that policy makers are happy with the level of output (unemployment is at the natural rate) but that a large trade surplus has been provoking complaints from other countries.
What kind of fiscal and/or monetary policy would you recommend in order to reduce the trade surplus while keeping output unchanged?

Answer 1

A flexible exchange rate system allows the exchange rate to be determined on the basis of demand and supply in the economy. Trade surplus is such a situation when the value of exports are greater than the value of imports. This means that there is a net inflow from foreign market in to the domestic market and it represents a positive balance of trade. A trade surplus could be reduced either by decreasing the exports or by increasing the imports. The following actions could be taken through monetary and fiscal mechanisms so as to reduce the trade surplus of the nation

· Increased taxes on imports and reduced taxation on exports which would result in reducing the exports and increasing the imports thereby causing a reduction in the trade surplus of the economy.

· Sale of government bonds in an economy would result in absorbing excess monetary flow in the economy which could result in lesser availability to induce export cost and thus could reduce exports and attract imports.

· Decrease the rate of interest which would increase the monetary flow in the economy and thus results in devaluation of the domestic money and thus would make exports costlier, which would result in reduction of exports and increase of imports

· Introduction of more stringent EXIM policies could result in more rejection of export of commodities and hence would result in fall of trade surplus.

· Introducing regulations in export of certain commodities could result in reduction of such exports which could reduce the trade surplus.

All the above policies would have no influence on the production rates in the economy, but only influences the exchange mechanism in the foreign market and thus would have effects on international trading patterns which could be varied so as to reduce the trade surplus of a nation as discussed above