Question

Explain which policies should be used under the following conditions to achieve both internal and external balance.

1. A trade deficit combined with output above potential;
2. A trade deficit combined with output below potential;
3. A trade surplus combined with output above potential;
4. A trade surplus combined with output below potential.

Answer 1

Trade deficit = Imports are greater than exports

Trade Surplus = Imports are lesser than exports

Output above potential = Economy is producing more than expected at full capacity

Output above potential = Economy is producing less than expected at full capacity

Case 1: The country should focus more on exports and try to reduce the imports as the country is producing more than expected and the domestic demand can be satisfied with the domestic production. This can be done by putting restriction on imports, buying the foreign exchange from the market causing the exchange rate to rise leading to increase in the cost of imports.

Case 2: In such a case where the country is not producing to its full potential, imports cannot be discouraged as the demand will not be satisfied without imports. Country should focus on increase in employment thus increasing the output and helping in more exports and less imports. The foreign exchange rate should be increased by buying the foreign currency in order to encourage the producers to produce more and export the products

Case 3: In such case, export must further be increased as trade surplus is always a good thing. The output above potential can be curbed by increasing taxes and reducing the government expenditure.

Case 4: In this case, country's domestic demand will not be met as the products which are already below the potential are being exported and imports are lesser than the exports. In this case, country should focus on the imports or use the domestic products to first meet the domestic demand and then export the surplus.