What is the net effect on the balance of trade from each of the THREE factors 1.

Question

What is the net effect on the balance of trade from each of the THREE factors

1.increased imports

2.decrease local interest rates relative to foreign interest rates.

3.remittance outflows

Select only three answers

(i) reduce net exports (trade deficit)

(i) increase net exports (trade surplus)

(ii) increase/cause current account deficit

(ii) reduce/eliminate current account deficit

(iii) increase capital inflows

(iii) reduce capital inflows

(iii) increase capital outflows

(iii) reduce capital outflows

(iii) net impact on capital flows uncertain

Explanation / Answer

Assuming we are to find effects on BoP, ie Balance of Payments (not Trade), which itself includes Balance of Trade and Financial flows; all the three factor's effects can be deduced by the Mundell Fleming Model, which incorporates the BP, the IS, and the LM curve, where IS curve shows equilibrium for goods market and LM represents equilibrium for money/asset market and BP represents the equilibrium in the Balance of Payments. We don't have to go through all that, but for reference and a better understanding, do consider the Mundell Fleming Model with fixed exchange rate and imperfect caital mobility.

1. Increased Imports: Increased imports means a negative in trade balance, ie the increase in consumption of domestic nation is provided (or financed) by foreign nation, for which the payment is made to foreigners. It is not related to capital account, which accounts for the financial flows, but is related to current account or trade balance. A negative in trade balance does implies a reduction in net exports (ie Export minus Import), and is recorded as a trade deficit (deficit in terms of gap to be filled by export, which itself is recorded as trade surplus). Thus, it causes reduce net exports (trade deficit).

2. Decrease local interest rates relative to foreign interest rates: If interest rates of a nation is reduced, relative to the world/foreign interest rate, then people in the nation will prefer to put their money in foreign nation, where interest rate is high; the vice versa being, when domestic interest rates are increased relatively to foreign rates, then foreigners will be willing to put their money in domestic nation, rather than in their nation. This process will end when interest rate stabilises - being equal to the foreign rate, as due to incoming or outgoing of money will affect the Money Supply of the nation. Thus, decrease in local/domestic interest rates relative to foreign interest rate will cause increase capital outflows, ie money will be out of the local nation, flowed out to foreign countries.

3. Remittance outflows: One of the part of current account is income account, meaning the records of income as payment made to foreign nation (made from foreigners working in domestic economy) and income as recept made from foreign nation by the domestic workers who are working in abroad nations. This income, the payment sent to home nation by abroad nation, is termed as remittance. Remittance outflows means the income sent to homes of foreign nation, by those foreigners, who are working in domestic nation. Remittance outflows is positively related to increase/cause current account deficit, ie, an increase in remittance outflow, as recoded as a negative in income account, causes increase in current account deficit.

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