Economics Model Essay 8

This question will be discussed in the second week of term 3 (JC2) in economics tuition.

“A fall in the terms of trade is undesirable for the economy.” Discuss the statement. [25]

Answer

Introduction

The terms of trade (TOT) refer to the number of units of imports that can be obtained with one unit of exports. It is expressed as the ratio of the price of exports to the price of imports. The effects of a fall in the TOT on the economy can be discussed in terms of the effects on the balance of payments, national output and hence national income, unemployment and inflation.

Deterioration in the Balance of Payments: Demand Factors

A fall in the TOT due to demand factors will lead to a deterioration in the balance of payments. The balance of payments is a record of all the transactions between the residents of the economy and the rest of the world over a period of time and is made up of the current account and the capital and financial account. The TOT may fall due to a decrease in the demand for exports. When the demand for exports falls, the price will fall which will lead to a fall in the TOT. For example, the fall in the demand for exports in Singapore in the 2008-2009 Global Financial Crisis caused by the Subprime Mortgage Crisis in the United States led to a fall in the TOT in Singapore. A decrease in the demand for exports will also lead to a decrease in the quantity. When the price and the quantity of exports fall, export revenue will decrease which will lead to a deterioration in the current account and hence the balance of payments. The TOT may also fall due to an increase in the demand for imports. When the demand for imports rises, the price will rise which will lead to a fall in the TOT. An increase in the demand for imports will also lead to an increase in the quantity. When the price and the quantity of imports rise, import expenditure will increase which will lead to a deterioration in the current account and hence the balance of payments.

Fall in National Output/National Income: Demand Factors

When the TOT fall due to demand factors, aggregate demand will fall which will lead to a decrease in national output and hence national income. Aggregate demand is the total demand for the goods and services produced in the economy over a period of time and is comprised of consumption expenditure, investment expenditure, government expenditure on goods and services and net exports. The decrease in the quantity of exports due to the decrease in the demand and the increase in the quantity of imports due to the increase in the demand will lead to a decrease in net exports and hence aggregate demand which will induce firms to decrease production resulting in a decrease in national output. When firms decrease production, they will employ less factor inputs from households and hence will pay them less factor income which will lead to a decrease in national income.

In the above diagram, a decrease in aggregate demand (AD) from AD0 to AD1 leads to a decrease in national output and hence national income (Y) from Y0 to Y1. When firms decrease production in response to a decrease in aggregate demand due to a decrease in net exports, they will employ less factor inputs from households and hence will pay them less factor income. When households’ income falls, they will decrease consumption expenditure which will lead to a further decrease in aggregate demand and this will induce firms to further decrease production. When this happens, firms will employ even less factor inputs from households and hence will pay them even less factor income. The further decrease in households’ income will induce them to further decrease consumption expenditure resulting in a further decrease in aggregate demand. Therefore, the initial decrease in aggregate demand due to the decrease in net exports will lead to decreases in consumption expenditure and hence further decreases in aggregate demand resulting in a larger decrease in national output and hence national income. This is commonly known as the reverse multiplier effect.

Rise in Unemployment: Demand Factors

The decrease in national output due to the decrease in aggregate demand will lead to a fall in the demand for labour in the economy resulting in a rise in unemployment.

Deflation: Demand Factors

The decrease in aggregate demand will lead to a fall in the general price level resulting in deflation. A decrease in aggregate demand will lead to a surplus of goods and services resulting in a fall in the general price level. Furthermore, when aggregate demand falls which will induce firms to decrease production, the decrease in the demand for factor inputs in the economy will lead to a fall in the prices. When this happens, the cost of production in the economy will fall which will induce firms to decrease prices to maintain competitiveness resulting in a fall in the general price level. When the general price level falls, households may expect it to fall further. If this happens, consumption expenditure will fall which will lead to a further decrease in aggregate demand.

Although a fall in the TOT due to demand factors is undesirable for the economy, a fall in the TOT due to supply factors or the exchange rate factor may be desirable for the economy.

Improvement in the Balance of Payments: Supply Factors

A fall in the TOT due to supply factors may lead to an improvement in the balance of payments. The TOT may fall due to an increase in the supply of exports. When the supply of exports rises, the price will fall which will lead to a fall in the TOT. For example, the increase in production and hence export of oil in Saudi Arabia in late 2014 and early 2015 led to a fall in the TOT. An increase in the supply of exports will also lead to an increase in the quantity. When the price of exports falls and the quantity rises, if the demand is price elastic, which means that the decrease in the price will lead to a larger proportionate increase in the quantity demanded, export revenue will increase which will lead to an improvement in the current account and hence the balance of payments. The TOT may also fall due to a decrease in the supply of imports. When the supply of imports falls, the price will rise which will lead to a fall in the TOT. A decrease in the supply of imports will also lead to a decrease in the quantity. When the price of imports rises and the quantity falls, if the demand is price elastic, import expenditure will decrease which will lead to an improvement in the current account and hence the balance of payments.

Rise in National Output/National Income: Supply Factors

When the TOT fall due to supply factors, aggregate demand will rise which will lead to an increase in national output and hence national income. The increase in the quantity of exports due to the increase in the supply and the decrease in the quantity of imports due to the decrease in the supply will lead to an increase in net exports and hence aggregate demand resulting in an increase in national output and hence national income.

In the above diagram, an increase in aggregate demand (AD) from AD0 to AD1 leads to an increase in national output and hence national income (Y) from Y0 to Y1. Furthermore, due to the multiplier effect, the initial increase in aggregate demand due to the increase in net exports will lead to a larger increase in national output and hence national income.

Fall in Unemployment: Supply factors

The increase in national output due to the increase in aggregate demand will lead to a rise in the demand for labour in the economy resulting in a fall in unemployment.

Improvement in the Balance of Payments: Exchange Rate Factor

A fall in the TOT due to the exchange rate factor may lead to an improvement in the balance of payments. The TOT may fall due to a fall in the exchange rate. When the exchange rate falls, the price of imports in domestic currency will rise which will lead to a fall in the TOT. For example, the substantial fall in the exchange rate in Russia in late 2014 led to a substantial fall in the TOT. When the price of imports rises, the quantity demanded will fall. If the demand for imports is price elastic, import expenditure will decrease which will lead to an improvement in the current account and hence the balance of payments. Furthermore, a fall in the exchange rate will decrease the price of exports in foreign currency which will lead to an increase in the quantity demanded. As the price of exports in domestic currency will not be affected by a fall in the exchange rate, an increase in the quantity demanded will lead to an increase in export revenue. Therefore, even if the demand for imports is price inelastic, which means that the increase in the price will lead to a smaller proportionate decrease in the quantity demanded resulting in an increase in import expenditure, if the sum of the price elasticities of demand for exports and imports is greater than one, the increase in export revenue will be greater than the increase in import expenditure which will lead to an improvement in the current account and hence the balance of payments, assuming export revenue is equal to import expenditure initially.

Increase in National Output/National Income and Fall in Unemployment: Exchange Rate Factor

When the TOT fall due to the exchange rate factor, the increase in the quantity of exports and the decrease in the quantity of imports due to a fall in the exchange rate will lead to an increase in net exports and hence aggregate demand which will lead to an increase in national output and hence national income resulting in a fall in unemployment.

Evaluation

In the final analysis, whether a fall in the TOT is undesirable for the economy depends on several factors. If the fall in the TOT occurs due to demand factors, aggregate demand will fall which will lead to a decrease in national output and hence national income resulting in a rise in unemployment. However, if the fall in the TOT occurs due to supply factors, aggregate demand will rise which will lead to an increase in national output and hence national income resulting in a fall in unemployment. If the fall in the TOT occurs due to a fall in the exchange rate as a result of a devaluation of domestic currency, aggregate demand will rise. However, if the fall in the TOT occurs due to a fall in the exchange rate as a result of a decrease in exports, aggregate demand will not rise. Apart from the cause of the fall, whether a fall in the TOT is undesirable for the economy also depends on the state of the economy. For example, although an increase in aggregate demand is generally desirable for the economy as it will lead to higher economic growth and hence lower unemployment, a substantial increase may cause the economy to overheat where aggregate demand rises rapidly relative to aggregate supply resulting in high inflationary pressures. This is particularly undesirable for an economy with a high savings rate. An example is Singapore where the savings rate is close to 50 per cent due to the culture of thrift, the compulsory savings scheme and the absence of a generous welfare system.

The question will be discussed in economics tuition by the Principal Economics Tutor in greater detail.

Author’s comments

Students simply need to explain the effects of a fall in the TOT on the economy in terms of the effects on the balance of payments, national income, unemployment and inflation.

Students should understand that the BOP is affected by both the change in the price and the change in the quantity. Aggregate demand, however, is only affected by the change in the quantity as it is measured in real terms (i.e. base-year prices).

Students should explain the reverse multiplier effect as it is an important concept in the Singapore-Cambridge GCE ‘A’ Level Economics. Students need not explain the multiplier effect as it is the exact opposite of the reverse multiplier effect and therefore is repetitive.

Students should understand that a fall in the price of exports or a rise in the price of imports may not necessarily lead to a fall in the TOT. For example, a rise in the price of imports may not lead to a fall in the TOT as the price of exports may rise by a larger proportion.

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