Mauritius' policy dilemma

The Mauritius Finance Minister and Central Bank Governor are considering what to do with the rupee (the Mauritian currency): appreciate it to fight inflation, or depreciate it to increase export competitiveness. In fact, export competitiveness appears to be dominating in their minds. They appear to be thinking that rupee depreciation will work to increase exports and lower imports, whereas appreciation will do the opposite. Recent high inflation is due mainly to increases in prices of imported food and oil. The central bank recently lowered interest rates to prevent large inflows of financial capital, and to prevent an appreciation of the rupee. In earlier years, a rupee depreciation did not work to improve Mauritius' current account on its balance of payments. Between 2003 and 2006, the rupee went from 1 pound sterling = Rs 47.30 to Rs 66.95. Yet the current account went from surplus in 2003 to deficit over the following years. One possible explanation relates to price elasticity of demand for imports and exports. The demand for imports in Mauritius may be highly price-inelastic. The reason is that exports have a large import content. It is estimated that imports of raw materials and intermediate goods required for production of exports represent about 60% of the value of exports produced by export-oriented enterprises. Strong dependence of production of export goods on imports makes demand for these very price inelastic. Therefore, import expenditures may not fall much as a result of a rupee depreciation. In addition, depreciation may not lead to an increase in the volume of exports. Since depreciation increases the prices of imported inputs, the effect of higher costs of production may be so strong as to lead to a drop in export volumes. By the same logic, exports need not fall as a result of currency appreciation, which might even cause export volumes to increase. Whereas the rupee appreciated strongly after 2007, exports were not negatively affected. Export competitiveness can also be achieved through productivity increases, which can be pursued through improvements in human capital and physical capital including new technology development.

(b) Using an international trade diagram, illustrate the effect a protectionist subsidy would have on

foreign producer revenue. [4 marks]

(c) Using an exchange rate diagram, illustrate the effect that an increase in U.S. tariffs on Mexican

exports would have on the U.S. dollar. [4 marks]

(d) Using information in the text and your knowledge of economics, discuss the possible consequences

of a U.S. policy of increased trade protection measures, as suggested by the author. [8 marks]