Question

Assume that a small open economy is at full-employent but suffers from a large government budget deficit. The country wants to increase its net exports. Using the Classical Model, explain what would be the best policy to acheive this objective. a) Imposing import tariffs, or, b) increasing income taxes, or, c) reducing government expenditure. Explain why you have chosen a) or b) or c).

Draw a graph to support your answer

Answer 1

The best policy to acheive this objective is Imposing import tariffs.

Explanation:

As the govt is willing to increase the Net export which could be only possible if either Export increases or Import decreases. So the best policy is imposing import tariff, it will reduce the imports while export remain uneffected which leads to increase net export ( Export - Import) .

- Other policy are not so helpful because :

Increasing income tax - will reduce the income of the consumers which further reduce aggregate demand leads to reduction in the price of the product and produce will then reduce supply as law of supply which leas to reducing real GDP of economy so while the price falls export demand rises but the growth of the economy is effected so this is not the best alternative.

Reducing govt expenditure - This again leads to reduce the employment which reduce demand and reduce price again the export demand rises but the growth of the economy hinders so this is also not a good alternative.

Diagram of import tariff:

Price Demand Supply Consumer Supus Producer Surplus Tax Revenue Size of Tart Societal I LOSS Qs O Q Q Quantity Quantity of met -------- Quantity of ---- -