Economics International Baccalaureate (IB) Practice Question: Current account deficit poses a challenge to Pakistan’s economy Pakistan’s president has raised concerns about the incre...

• Correct supply and demand diagram. 1 mark
• World price / supply below domestic equilibrium price, imported quantity shown. 1 mark
• Axes and curves correctly labeled. 1 mark

• The exchange rate is the value of one currency in terms of another.
• By increasing the supply of rupees (S1 to S2), with a constant demand for rupees (D), the central bank can achieve a fall in the exchange rate (e1 to e2).
• This depreciation means the rupee loses value relative to other currencies.
• A weaker rupee makes Pakistani exports cheaper for foreign buyers, increasing demand for Pakistani goods abroad.
• Additionally, depreciation makes imports more expensive, reducing demand for foreign goods in Pakistan.
• If exports increase and imports decrease, the trade deficit may shrink, improving Pakistan’s current account.

2 marks for correct diagram OR explanation

4 marks for correct diagram AND explanation

• A rise in government debt compromises Pakistan's government future spending, since a greater part of their government budget must be allocated towards repaying the debt.
• Since government spending is one of the components of aggregate demand, lower government spending reduces aggregate demand at all possible price levels, shifting the AD curve leftwards (AD1 to AD2).
• This establishes a new macroeconomic equilibrium where lower real output is produced (Yp to Y2).
• Hence, the increase in government debt could slow down or decrease economic growth.

2 marks for correct diagram OR explanation

4 marks for correct diagram AND explanation

• A quota is a limit on the quantity of imports allowed into a country.
• Under free trade, Pakistan imports Q4 - Q1, but has now decided to limit imports to Q3-O2.
• Therefore, a new supply curve is created by the addition of the amount of the quota units to the domestic supply (Sd1 to Sd2).
• Hence, now only Q3 - Q2 is imported, meaning that domestic producers now cover a greater part of the market.
• In turn, the imposition of the quota increases domestic production (Q1 to Q2).

Answers may include:

Definition

• Economic growth: An increase in a country's real output (real GDP) over a period time.

• Economic development: The process of increasing real per capita income while improving living standards and reducing poverty within an economy as whole.

• Economic growth refers to increases in real output over time, whereas economic development refers to a process that leads to improved living standards for a population as a whole.

• Increasing levels of output and incomes resulting from economic growth do not, by itself, guarantee economic development.

Import Restrictions on Luxury Goods

Short-Term Reduction in Import Expenditure

• The government has proposed quotas on luxury, non-essential imports to address the growing current account deficit, which increased from USD 4.86B (2015/16) to USD 12.12B (2016/17) (Table 1).
• Quotas reduce the quantity of imports, particularly non-essential items, limiting outflows of foreign exchange and potentially improving the trade balance.
• By discouraging imports of luxury goods, the policy reduces consumption of imported items, allowing resources to be redirected to domestic production, improving short-term aggregate demand (AD).

Diagram: Quota on Imports

• A quota restricts supply, shifting the supply curve of imports leftward, reducing import volume and increasing domestic production.
• This could protect local industries, particularly SMEs and agriculture, from foreign competition, supporting employment and income generation.

Limitations

• Only partial effectiveness, as 32% of imports are capital goods, essential for SME, construction, and agricultural growth. Restricting too broadly could disrupt supply chains, reduce productivity, and hurt long-term growth.
• Risk of retaliation by trade partners and inefficiency if domestic industries are not competitive.

Currency Depreciation and Export Competitiveness

Addressing Overvaluation

• The rupee is estimated to be overvalued by 20% in 2016 and 18% in 2017 (Table 2), making exports more expensive in global markets and contributing to the decline in export revenues (from USD 22B to USD 21.5B).
• Depreciating the rupee would lower export prices in foreign currencies, potentially boosting exports and correcting the current account imbalance.
• It also makes imports more expensive, reducing import demand, helping narrow the deficit.

Diagram: Exchange Rate Depreciation

• A depreciation leads to a movement along the AD curve, as net exports (X-M) rise, shifting AD rightward, potentially increasing output and employment.

Limitations

• Depreciation may lead to cost-push inflation, especially as Pakistan is a net importer of oil, machinery, and intermediate goods.
• Inflation undermines real incomes, especially for low-income households, and can reduce development outcomes like affordability of basic goods.

Support for SMEs Through Credit Access

Promoting Long-Term Growth and Employment

• Government aims to raise SME loans from 7.5% to 15–17% of total business loans. SMEs are labor-intensive, and expansion in this sector supports job creation and inclusive growth.
• Increased access to credit enables capital investment, technology adoption, and productivity growth, especially in agriculture and construction.

Development Link

• SMEs operate in rural and semi-urban areas, promoting regional development, reducing inequality, and improving income distribution.
• Supporting SMEs also helps diversify the economy away from a reliance on low-value exports or public investment.

Limitations

• Requires financial literacy, institutional support, and credit risk management to be effective. Without strong governance, loans may not reach productive sectors, limiting the multiplier effect.
• Structural barriers such as informal sector dominance and lack of collateral may restrict the impact of SME credit initiatives.

Macroeconomic Constraints and Fiscal Policy

Rising Public Debt and Budget Deficit

• Public debt increased to 62% of GDP in 2016 and 65% in 2017, above the central bank’s 60% threshold, reflecting unsustainable fiscal expansion.
• High debt servicing limits fiscal space for public investment in infrastructure, health, and education, weakening long-term development capacity.

Policy Trade-offs

• Balancing external account management with internal demand stimulation is challenging. Excessive borrowing to finance the twin deficits may result in sovereign risk, deterring FDI and reducing investment confidence.
• The government must ensure that any borrowing is directed toward productive uses (e.g., SME development, infrastructure) rather than consumption.

Overall Evaluation

Strengths

• Targeted import restrictions may reduce unnecessary import expenditure and improve the trade balance.
• SME loan expansion has the potential to generate inclusive, employment-driven growth, especially in underserved sectors.
• Currency depreciation could restore external competitiveness, supporting exports and narrowing the current account deficit.

Weaknesses

• Import controls risk hurting capital goods imports, undermining long-term investment.
• Currency depreciation may worsen inflation, reduce real income, and undermine development objectives.
• Rising debt and fiscal mismanagement limit capacity for long-term investment in human capital and infrastructure.

Conclusion

Pakistan’s current measures offer short-term relief from its external imbalances and promote growth through SME credit and rupee correction. However, these policies carry inflationary, fiscal, and institutional risks. To achieve sustained economic growth and development, Pakistan must complement these measures with structural reforms, investment in productivity, and sound fiscal management.