Question

Assume the small open economy starts from a position of a balanced trade. Giving reasons, clearly explain what the effect of an expansionary fiscal policy abroad (by a large open economy) will be on the trade balance of a small open economy? You may need to draw diagrams to determine the effect. However, do not provide diagrams with the answer. (100 words maximum)

Answer 1

If there is an expansionary fiscal policy abroad it will lead to an increase in output of the large economy as a result there will be a rightward shift in the relative supply curve in the world market and the relative prices will go down. The trade balance of the small economy will be disturbed as the price of export fall relative to price of imports depending on the expansion impact on export or import industries.
There can be 3 situations:
The exports will go down and if imports remain same the small economy would face a trade deficit situation owing to the expansion in output of the large open economy and if the expansion happens in the import substitution industry.

The imports will become cheaper if the expansion happens in the export industry of the large open economy as a result the small open economy will be in trade surplus as its export earnings exceed its import costs.

The third situation can be if the fiscal policy expansion has an almost equal impact on export and import industry of the large open economy as a result the imports from the small economy will decrease but the price if exports will fall simultaneously thus nullifying the impact on the small open economy and the trade balance will remain intact.