Simulator test 2 doubts

A similar kind of question came in Prelims 2011. I am sharing pictures of the question and the solution. 

Coming to the question asked in today’s test, the question had  closed options. It was in my mind that devaluation of currency helps in boosting exports which will further help in reducing CAD but  I was sure that the third statement that is, Incresed consumption expenditure has nothing to do with the CAD reduction and with elimination method i marked B option which is 2&4 only. 

India imports much more than exports. 

Devaluation would make exports more competitive but would lead to imports getting costlier too. And since we import higher amount of goods these costs would overweight the benefits. 

Read the Marshall Lerner condition

• It states that, for a currency devaluation to lead to an reduction in CAD, the sum of price elasticity of exports and imports (in absolute value)must begreater than 1.

https://www.economicshelp.org/blog/2089/economics/exchange-rate-and-current-account/

I did the question wrong as well :/ 

i think its about choosing the best of 4 option...devaluation does increase exports and ideally should reduce deficit.. but  it is subjective and varies country wise(India deficit is increasing despite a fall in the exchange rate.whereas china devalues to reduce deficit)...however an increase in consumption spending is bound to increase import.. so 3rd option is eliminated

however, acc to UPSC devaluation reduces deficit.. can't argue with them

How did you all score in the test ? I found the test on a bit tougher side and scored poorly !! 

Q4. Which of the following is a likely outcome of a widening fiscal deficit in a country

1. Slowdown in economic growth rate.

hardaha_rajan8389214said

How did you all score in the test ? I found the test on a bit tougher side and scored poorly !! 

It was tougher than last Test. Please see this for Cut off discussion and how to improve marks

https://forumias.com/post/detail/LIVE130-PM-Simulator-Test-12-Cut-off-Marks-Ways-to-Improve-Score-1586589616

ishitatrisaid

Q4. Which of the following is a likely outcome of a widening fiscal deficit in a country

1. Slowdown in economic growth rate.

2. Decrease in capital expenditure.

While the discussion video also says that the pain point in this Q is the 2nd statement, whether we will see a decrease in capital expenditure or not– I don't believe a high fiscal deficit necessarily leads to slowdown in economy (Statement 1), because both crowding in (high expenditure leading to FD) and crowding out effects (huge borrowing from market) will balance each other out.

Why is it assumed that there will be a slowdown in growth? Is it because the Q nudges us to consider long term effects ("widening" fiscal deficit)? 

@ishitatri When govt have 50 rupees in revenue and 100 rupees in expenses, and it borrows 50 rupees or more from market, what happens is that

1. money left for borrowing by private sector is less
2. money borrowing rate increases due to demand

Therefore a widening fiscal deficit is likely to cause a slowdown.

In second point, you are expecting that govt will use this 50 rupees for capex, like building roads, bridges etc, thus stimulating the economy. However, this is not necessary. For example, govt of India is already using this moneynot for capex, but for revenue expenditure. It may give away the money in salaries and pensions!

Hope this clears.

ishitatrisaid

@Neyawn thanks so much for clarifying. My doubt was around the 1st statement only. 

In fact if you observe the govt policy since past 20 years, you will see that govt went for a lot of Public Private model initially for infrastructure development. 

Why? Because it's super costly and government doesn't have the money! So it thought that private player will bring in some money.

Private players thought that government will "allow" it to recover money by way if service charges like tolls etc.

The private sector had a poor experience with the government to some extent.  Lot of companies saw that once the investment was made by private company, when the recovery / earning time came, govt ( including judiciary ) ruled that you can't make so much money. Or you are hurting the environment.

Now unless companies have money they can't take risks or make investment commitments. 

Now if you see PPP models, no private player is willing to get into it.

Right now, the govt says we don't have money and private sector also says we dont have money!