Term 1 Week 6 P-cube answers

HCI 2010 C2 BT1

Q1. The US economy is currently faced with current account deficit and unemployment.
Evaluate the policies that the US government can adopt to tackle both problems.
[25]

Approach
Students must recognize the various possible causes of current account deficit and
unemployment in the USA. After identifying the main causes of the two problems, students are
required to explain at least 3 policies that the US government can adopt. Evaluating the
effectiveness of the policies and relative merits of policies in the context of USA are necessary to
get a good score.

Possible causes of current account deficit in the USA

 Emergence of competitors like China and India  more substitutes  fall in X revenue.
 Under-valuation of Yuan against USD  fall in export revenue and rise in import expenditure.
 Saving and spending habits of the Americans  rise in import expenditure.

Possible causes of unemployment in the USA

 Subprime mortgage crisis  fall in investors’ and consumers’ confidence in the US economy
 fall in AD due to fall in C and I  fall in national output  rise in cyclical unemployment.
 Changing comparative advantage  restructuring of the US economy  structural
unemployment.

Policy that tackles 1 problem - Expansionary demand management policies

Expansionary demand management policies will help to reduce cyclical unemployment. Policies
such as expansionary fiscal / monetary policies help to stimulate demand and hence
employment. However, such policies will worsen the current account deficit problem
(consumption of M increases with increased NI). Hence, these policies may not be a good option
unless unemployment is a more pressing issue than current account deficit.

Policies that can tackle both problems simultaneously

1. Expenditure-switching measures (protectionism and devaluation)
Protectionism – impose tariff / non-tariff barrier to reduce the consumption of imported goods
and switch to consumption of domestically produced goods
Eg. Tariff – tax on imports, makes consuming imports more expensive
 Fall in M expenditure if demand for imported goods is price elastic  improvement in current
account balance. (may use the tariff diagram to illustrate)
 Increase in (X-M)  increase in AD  increase in output  fall in cyclical unemployment.

Limitations:
 Retaliation which may worsen the current account deficit and unemployment problem.
 Short term measure

Devaluation – the weakening of external value of the currency.

Makes imports more expensive and exports cheaper
 Rise in (X-M) if ML condition is satisfied  improvement in current account balance and fall
in cyclical unemployment.
 In the case of US, the ML condition is likely to be satisfied as US manufactures and exports
goods with many substitutes available, PED of X is likely to be > 1. Since PEDx > 1 then ML
condition, PEDx + PEDm > 1, must be satisfied.
 Even if ML condition is satisfied, immediately after devaluation, BOT may worsen first
before improving (J-curve).

Limitations:
 J curve effect
 Trading partners retaliate by devaluating their currency

2. Supply side policies

 R&D and innovation  improve price and non-price competitiveness of exports
 Training and retraining of workers  improve productivity of labour force  lower cost of
production  improve price competitiveness of exports
 Improvement in current account balance and fall in cyclical and structural unemployment.

Limitations:
 long gestation period
 mindsets of older workers
 Greater inertia for the unemployed in US to go for retraining with the welfare system in
place in US.

Conclusion
The choice of policies is dependent on the priority of the government. In the case of US
economy, the government is faced with both internal and external problems. If unemployment
is considered to be of a more immediate concern (seems to be the case for the USA) than that of
current account deficit, policies should be targeted to address the unemployment while other
policies should be used to reduce the negative effect on current account balance. In the long
run, supply side policies would be most appropriate to make sure US stay competitive in the
world market.

Level Descriptors
A balanced answer on policies to address both current account deficit AND unemployment
L3 with application to the US economy.

For an answer that explains policies to address both BOP deficit AND unemployment.
L2 Answer may not be balanced.

L1 Explain causes and consequences of BOP deficit and unemployment without addressing
the question or explaining how policies will help each problem separately.

E2 A good conclusion that recognizes the conflicting aims of achieving a healthy BOP 3-4
and full employment.
E1 A generic conclusion that government needs a combination of policies to achieve 1-2
the aims of a healthy BOP and full employment.
HCI 2011 C2 BT1
Q5. In 2010, tension between the US and Chinese governments was high. This was due to the
negative effects of a weak Yuan on a huge US trade deficit.
(a) Explain the effects of a weak Yuan on the external balance and economic growth of US. [10]
(b) Discuss the measures, if any, the US government should adopt when confronted with such a
huge trade deficit. [15]

Suggested Answer:
(a) Explain the effects of a weak Yuan on the external balance and economic growth of US. [10]

Introduction

Key Word A weak Yuan means that the currency is undervalued.

China has been enjoying huge trade surpluses for many years and since
demand for exports is high, the derived demand for its Yuan should also be
high and yet Yuan only appreciated marginally over the years. This signals that
the Chinese government has artificially kept the value of Yuan low.

Issue & This essay aims to explain how a weak Yuan has adverse impact on US’
Approach external balance and economic growth.

Post Mortem
 Most candidates did not clarify what is a weak Yuan. Many took it as devaluation/depreciation.
Actually, the Chinese government has revalued the Yuan and did allow it to strengthen slowly
in a managed float regime. It is more of undervalued than devaluation.
 Some gave a list of definitions in the introduction such as exchange rate, BOP, current account,
financial account, economic growth, etc. That is inappropriate. You need to address the issue
and state the approach to the question. Some definitions are more meaningful to be included
in the body.

For interest:
The value of the renminbi was initally pegged to the U.S. dollar. As China pursued its gradual
transition from central planning to a free market economy, and increased its participation in foreign
trade, the renminbi was devalued to increase the competitiveness of Chinese industry.

Since 2005, the renminbi exchange rate has been allowed to float in a narrow margin around a fixed
base rate determined with reference to a basket of world currencies. The Chinese government has
announced that it will gradually increase the flexibility of the exchange rate.

Body
a) Effects of a weak Yuan on the external balance (Balance of payment) of US

Identify external balance to be balance of payment.

Define BOP and state that it mainly consists of the current and financial accounts.

Impact on Current Account

 A weak/undervalued Yuan will mean that the price of China’s exports will remain relatively
competitive compared to America’s.
 From US’s perspective, a relatively stronger USD will make its imports from China relatively
 cheaper in terms of USD and this increases their imports from China. At the same time, US’
exports will be relatively expensive in terms of Yuan and reduces their exports to China.
 Consider the PEDx and PEDm of USA to analyse the impact on X (export revenue) and M (import
spending). Use supporting examples.
 Consider the Marshall-Lerner condition if relevant for your analysis.
 Explain the net impact on X-M and hence the current account of the BOP

Impact on Financial Account

Since investing in China is now relatively cheaper due to lower exchange rates, investors might divert
their investments from US to China. This would mean that a fall in FDI into USA and an outflow of
investments from USA to China, worsening the financial account.

Post Mortem
External Balance
 Many think that external balance is only balance of trade and left out analysis on financial
account totally.
 Inaccuracy when it comes to explaining how a weak Yuan can make exports relatively cheaper in
terms of foreign currencies and imports relatively more expensive in terms of Yuan. Many merely
stated ‘cheaper’ and ‘more expensive’ which are incorrect.
 Some used devaluation and depreciation interchangeably.
 Very confusing at times when the words ‘imports’ and exports’ are used. As it is not clear
whether it is China’s or US’.
 No examples of export or imports were provided.
 Generally, candidates just merely made assumptions of how the weaker yuan led to US's trade
deficit (making Chinese exports cheaper relative to US's product, hence quantity demanded for
Chinese exports increases and vice versa for US's exports), without considering elasticity concepts
at all.
 Instead of focusing on the impact of weak Yuan, some brought in other factors such as change in
CA or stated that the weak Yuan resulted in China gaining CA!

b) Effects of weak Yuan on the economic growth (actual and potential) of US

 The worsening of US’s balance of trade and the fall in I would mean that AD would have
decrease since net exports and investment are components of AD.
 It will have a negative impact on both actual and potential growth.
 Define economic growth.
 Define actual growth.
 As a result, national income of US would have decrease via the reverse multiplier effects. Actual
growth would have been reduced. (Students need to relate back to AD-AS framework).
 Define potential growth.
 The fall in I would also mean that potential growth of US is also being slowed down.

Use AD-AS diagram to analyse.

Post Mortem

Economic growth
 Many of the candidates left out explanation on the effects of investment on potential growth
due to the weaker Yuan.
 Many did not define economic growth and that it consists of both actual and potential growth.
 The link between net exports to AD is not clear. Lack depth in the explanation.
  Quite a handful did not illustrate with an AWESOME diagram.
 Some used two models – both AE-Y and AD-AS diagrams to illustrate.
 A fall in Y does not necessarily mean negative growth or recession.
 A fall in I reduces potential growth, but not necessarily leads to a fall in (LR)AS!
 Some used AE and AD interchangeably.

Conclusion
A weak Yuan reduces the external balance of the US and also slows down both actual and potential
growth. Nonetheless, a weak Yuan is just one of the many factors of such negative impact. The root
of US’ problems is that it has lost its export competitiveness due to loss of comparative advantage
and overspending by the consumers. To solve these problems, the US government will have to use a
multi-pronged approach which shall be discussed in part (b) of the essay.

Mark Scheme:
Level Level Descriptor Mark
range
L3 Able to relate the answer to USA context with the use of AD-AS framework to 7-10
discuss the impact on actual and potential economic growth.

Analyzed the effects of a weak Yuan on both trade and investment.

Analyzed and substantiated the price elasticity of demand of USA exports and
imports with the use of relevant examples.

*Max 7 for students who give a detailed analysis on impact on actual growth and
trade balance only (i.e. not consider impact on financial account and potential
growth)

L2 Able to relate answer to the questions with sufficient economic theory and 5-6
framework.
Answer only one part of the question.

*Note that a heavier weighting is given on the explanation of a weak Yuan on the
trade balance and actual growth than the secondary effects on investments
(financial account) and potential growth.

L1 Little or no theory and relevance to question 1-4

(b) Discuss the measures, if any, the US government should adopt when confronted with such a huge
trade deficit. [15]

Introduction

Key Word Trade deficit arises when the import expenditures exceed the exports revenue.
Note: Refrain from defining it again if it is done in part (a).
Issue & This essay aims to discuss the policies the US government should adopt to
Approach improve the balance of trade.
Post Mortem
 The policies listed in the introduction were not the same as those in the body or different in
sequence.
 Some defined certain key concepts such as BOP even though they have done that in part (a).

A) Short Run Measures

Protectionism
Using protectionistic measure to narrow the deficit e.g. tariffs or quotas. This would have the effect
of restricting the level of imports into US by making imported goods more expensive.

Draw Tariff diagram to show reduction of qty of imports directly.

Note: Many candidates could not reproduce a well-explained AWEsome diagram and resulted in
losing of marks.

Policy limitations
 Incurs welfare loss (make reference to the diagram.)
 This is basically a ‘beggar-thy-neighbour’ policy and usually It will result in retaliation by trading
partners and resulted in a lose-lose situation.

Exchange rate policy

Devaluing the USD would mean that imports to US are now relatively more expensive in terms of
USD and US exports are cheaper in terms of foreign currency. As a result, quantity demanded for US
exports will increase while quantity demanded for US imports will fall. Assuming the Marshall-Lerner
condition holds, where the sum of price elasticity of demand for imports and exports is greater than
one, net exports will increase.

Note: Need not explain in much details since analysis is similar to part (a).

Policy limitations
 However the depreciation could actually harm the US household as they pay for more expensive
imports and may result in import-price push inflation.
 In addition, US uses floating exchange rate system which the governmentt may not be able to
manipulate easily.
 Might not benefit US exporters. This is because the trade deficit might be a result from the loss
of CA. If the government depreciates the currency, exporters will never learn to increase their
efficiency to reduce cost of production and gain back the CA.
 Could spark of competitive devaluation.
Expenditure Reducing Measures (Highlight the conflicting goals as an evaluation.)

US government should not be using expenditure reducing measures such as contractionary fiscal and
monetary policies. As these will further reduce national income of US which was in recession in
2010.

Post Mortem
Expenditure Switching Measures:

Tariff:
 Some candidates did not draw the tariff diagram when recommending the policy.
 Even when the diagram was drawn, the explanation was not clear or with many errors.
 Others failed to make good use of the diagram – could have used it to show the impact on M
and also consumer welfare. But many only considered either.
 Some chose subsidy rather than tariff as one of the expenditure switching measures. The latter
is highly recommended for elaboration as there are more in depth discussion.

Devaluation:
 After stating ML condition is satisfied, candidates went on to say if demand for X or M is not
price elastic, the policy is not effective! But it is about the sum of PEDx and PEDm >1 and not
individual price elasticity of demand.
 Some just mentioned ML condition and did not even bother to state it is the sum of PEDx and
PEDm >1 (write in full).
 Some had big misconception over exchange rate and monetary policy – Money supply vs supply
of currency are all in a mess.
 As similar details were elaborated in part (a), candidates should give a more succinct version
and focused on the limitations.

Overall comments on short-run policies:

The criticism of retaliation appeared for almost all the short-run policies. Should avoid repetition -
pick and choose the more appropriate ones for relevant policies. E.g. depreciation – elaborate why
ML condition is not satisfied – J-curve effect, tariff-retaliation that makes it ineffective and also the
implication on consumer’s welfare.

Expenditure Reducing Measures:

 Quite a number of candidates proposed contractionary fiscal/monetary policies to correct the
trade deficit, spending time writing more than a page and finally concluding that the policies
should not be used as there were conflicting goals!
 Many failed to realise that the current economic situation, in the context of the question, US is
facing recession.
 This part is only relevant if it is used as evaluation as in why US government should not use
these policies and not as analysis – explained in great details.
 Worse, some recommended expansionary FP and MP to solve BOT deficit!

B) Long Run Measures

Supply side policies

There is a need for US to build new CA. This is especially so as the root cause of the deficit might be
due to her loss of CA with the emergence of low cost countries. (Explain in details – note refrain
from giving generic elaboration. It should focus on how to improve export competitiveness in terms
of pricing and quality.)
Policy limitations
But it will take a long time before US sees any results and success.

Trade policies
Signing of free trade agreements to improve price competitiveness of American exports to other
countries

Policy limitations
May result in even larger imports from other countries, worsening net exports.

Post Mortem
For supply policies:
 Mostly generic and provided weak link to how they solve BOT problems. Quite a handful
digressed to elaborate on the impact on potential growth.
 Some tend to be descriptive.
 Failed to realize these help to solve the root of the problem regarding change in CA.
 As these are long-run policies, they should be elaborated after all the short-run policies and not
to be ‘inserted’ in between.
 Overall, weaker candidates' discussion lacked in elaboration (i.e. recommended appropriate
policies but the details/process/working of policies were not discussed).

Conclusion
Supply-side policies solve the root of the problem and it does not invite retaliation so it is a better
measure than expenditure switching methods such as tariffs and devaluation.

Tariff invites retaliation that may result in trade-war leading to a ‘lose-lose’ situation should be
avoided unless there is clear evidence of unfair trade practice such as dumping by China. (An
example of comparison.)

However, as the trade deficit is enormous, even though there are valid concerns for short-run
measures, there is a need to use them to alleviate the problem and give US more time to restructure
and develop new CA. US has to adopt both short and long term measures as no single policy can
resolve its trade deficit problem. (A need to justify the final stands)

Note: A good synthesis should have strong substantiated/elaborate judgment on the choice of
policies, i.e. why one is preferred to the other and final judgment the need for both SR and LR
measures.

General comments:
Most of the answers were generic and have little application.
Lack of exemplification; some tried to discuss instead of explain; used ‘firstly, secondly, etc’; used self-
invented acronyms; badly drawn or explained diagrams; included non-essential diagrams to show
how Yuan is ‘weak’.

Mark Scheme:
Level Level Descriptor Mark
range
L3 Able to relate the answer to the question and context with well-explained theory 9-11
and framework.
 Able to explore 3 policies that cover sensible short run and long run responses to
the US trade deficit problem, showing understanding of the trade problem and the
feasible measures that US can adopt.
1. Protectionism – tariffs (SR measure)
2. Depreciation (SR measure)
3. Supply-side policies (LR measure)
4. Trade policies (LR measure)

* Expenditure reducing policies are not appropriate in view of the conflicts to the
other macro goals and the recession US is facing now.
Limitations of the policies are considered carefully.
L2 Able to relate answer to the questions with sufficient economic theory and 6-8
framework. Limitations are briefly mentioned without elaborations. Answer is lop-
sided with small range in the number of policies.
L1 Little or no theory and relevance to question. Able to mentioned policies only. 1-5

Level Descriptors
E2 Judgment based on analysis 3-4

E1 Mainly unexplained judgment 1-2