CIE A LEVEL SAMPLE ESSAYS

Expenditure reducing policies will reduce a balance of payments deficit but will also cause significant unemployment. Evaluate this statement [20]

Expenditure-reducing policies aim to decrease aggregate demand in an economy, thereby reducing the demand for imports and improving the balance of payments. The balance of payments records all economic transactions between a country and the rest of the world, with a deficit occurring when the value of imports exceeds exports.

Examples of expenditure-reducing policies include increases in interest rates and contractionary fiscal policy. Higher interest rates make borrowing more expensive and encourage savings, which decreases consumer and investment spending. This reduces domestic demand, leading to lower imports and, thus, a smaller balance of payments deficit. Contractionary fiscal policy, involving reduced government spending or higher taxes, directly lowers aggregate demand by reducing disposable income and consumer spending on both domestic and imported goods.

By decreasing the demand for imports, these policies can help improve the balance of payments. However, they often come with adverse effects on unemployment. Lower aggregate demand reduces overall economic activity, prompting firms to scale back production and lay off workers, leading to cyclical unemployment. This type of unemployment is particularly concerning during recessions or periods of low demand, as it can deepen economic downturns.

For example, when interest rates rise, businesses may reduce investments due to higher borrowing costs, leading to slower economic growth and job losses. Similarly, government spending cuts can reduce demand for public services, resulting in public sector job losses. In an economy already facing weak demand, these policies could further dampen consumer spending and business activity, exacerbating unemployment and potentially pushing the economy into a deeper recession.

The effectiveness of these policies depends greatly on the economic context. If an economy is experiencing high inflation and a positive output gap; where actual output exceeds potential output; reducing aggregate demand can help control prices without severely impacting employment levels. In such cases, increasing interest rates can curb inflation while having a moderate effect on unemployment. [A Keynesian graph could illustrate this by showing how shifting aggregate demand leftward helps reduce inflationary pressure.]

Moreover, the success of expenditure-reducing policies in tackling unemployment hinges on the underlying causes of joblessness. For structural unemployment; where a mismatch exists between workers’ skills and job requirements, these policies are less effective. Addressing such unemployment requires complementary supply-side measures, like skills training or incentives to industries that can absorb the unemployed workforce.

Expenditure-reducing policies may also encourage consumers to shift towards domestically produced goods, as imports become less attractive due to reduced demand. This could, in theory, create jobs in domestic industries, partially offsetting the rise in unemployment caused by lower aggregate demand. However, the extent of this substitution effect depends on the capacity of domestic industries to meet consumer preferences and needs, which is not always guaranteed.

In conclusion, expenditure-reducing policies can effectively reduce a balance of payments deficit by curbing import demand. However, they pose risks of increasing unemployment, particularly during economic downturns or in economies with already low demand. The overall effectiveness of these policies depends on the specific economic conditions and the nature of the unemployment. A balanced approach that combines demand management with supply-side measures may be necessary to avoid significant job losses while addressing trade imbalances.