2011 April Q21

[Robert]

An economy with a floating exchange rate has a deficit on the current account of its
balance of payments. Which policy combination would be most likely to solve this
problem?
A Decrease interest rates and increase income tax rates.
B Increase interest rates and leave income tax rates unchanged.
C Decrease interest rates and decrease income tax rates.
D Increase interest rates and increase income tax rates.

May I know why the answer given is D as deficit here means withdrawals more than injection right ? Tq.

 

[Gresham Arnold]

Hi Pxliang

Injections and withdrawals; this terminology is normally used in the context of the circular flow of income model where I, G and X are injections and S, T and M are withdrawals. In contrast, a deficit on the current account of the balance of payments means that X-M is negative ie M>X

Potential rationale for D:

An increase in interest rates will reduce consumption and investment in the economy and dampen economic growth. This will tend to reduce M, and hence increase X – M. So B or D are potential answers.

An increase in income tax rates will reduce the amount of disposable income consumers have available to spend. Since they would tend to spend some of their disposable income on imports, the quantity of imported goods (M) would fall, hence increasing X – M. So D is more likely to solve the problem than B

Gresham