What this lesson teaches
I can explain fiscal, monetary and supply-side policy and judge how well each works.
Syllabus 9570, 3.2.3(b). Macroeconomic Policies: Policy measures and their effectiveness in achieving macroeconomic objectives:; Fiscal policy - How discretionary fiscal policy can influence the level of economic activities and living standards through government spending and taxation; Monetary policy - How monetary policy can influence the level of economic activities and living standards through the management of exchange rates (case of Singapore) and interest rates; Supply-side policies - How supply-side policies can improve quantity, quality and mobility of factors of production to increase the productive capacity of an economy and hence affect living standards
Make a guess
A country's currency depreciates. In the first few months, what usually happens to its trade balance?
- It often worsens, before improving later.
- It never changes, because trade is fixed.
- It improves at once, because exports are cheaper.
Show the answer
It often worsens, before improving later.
Import bills rise at once, but buyers take time to switch. Once quantities respond, the balance can improve.
A depreciation improves the trade balance only if demand for exports and imports is price elastic enough.
A depreciation makes exports cheaper for foreigners and imports dearer at home. Whether this improves the trade balance depends on how much quantities respond.
The Marshall-Lerner condition says a depreciation improves the trade balance if the combined price elasticities of demand for exports and imports are greater than 1 (you only need to know the idea, not the formula).
In the short run, trade contracts are fixed and buyers take time to switch, so demand is inelastic. The trade balance may worsen at first, before improving later.
For Singapore, depreciation is less useful, because its exports contain many imported parts, which become dearer.
- Condition
- Combined PEDs of exports and imports > 1.
- Short run
- Trade balance may worsen first.
Worked example: Before orders can adjust
A currency depreciates. Exports become cheaper for foreigners and imports dearer at home, but existing orders are fixed for several months.
- At first, the country pays more for the same imports, so the trade balance worsens.
- Over time, foreign buyers order more of the cheaper exports, and domestic buyers switch away from dear imports.
- If demand is elastic enough, the trade balance then improves.
Watch out for this
A depreciation always improves the trade balance.
Only if export and import demand are price elastic enough. In the short run, it can make the balance worse.
Check your understanding
Why might the trade balance worsen right after a depreciation?
- Imports become cheaper, so households buy many more of them.
- Trade quantities take time to adjust, while import prices rise immediately.
- Exports become more expensive for foreign buyers, so export sales drop at once.
Show the answer
Trade quantities take time to adjust, while import prices rise immediately.
Right. Demand is inelastic in the short run.