Currently Sri Lankans are having a number of import restrictions, foreign currency restrictions due to the lack of foreign currency earnings during the pandemic hit years. Government has decided to stop importing non-essential items and also placed several measures to avoid speculation based foreign currency hoarding. Even though this external sector pressure is a result of long term economic mismanagement and inefficiencies rooted in their cultural values (Yes. Sri Lankans have the 2nd highest public holidays per year according to the world atlas), this article will not discuss the underlying facts but focuses on the economic theory.
IS-LM is the most famous or widely accepted macroeconomic concept on short run economic theory. Here I use the specific IS-LM approach called Mundel-Fleming model to show what will be the outcome of certain policies on,
- National Income
- Exchange Rate
- Trade Balance
|Adopted From: Macroeconomics 10th Ed. (Mankiw, 2019)|
- No change in National Income
- An Increase in the Exchange Rates
- No Change in Trade Balance
So what causes this? Initially, reduced imports will increase the trade balance and this will create an upward pressure on national income. Next, this increase of income will trigger an increase in money demand which will cause a rise in interest rates. (Since interest rates are equal to world interest rates in MF model) Foreign capital responds by flowing into the domestic economy, pushing the interest rate back to the world interest rate. This will increase the value of the domestic currency. This appreciation makes domestic goods more expensive relative to foreign goods which will decrease trade balance and returning income to its initial level.
Therefore, we can say that restrictive trade policies only make exchange rates higher and will not do any good to trade balance. But this is only applicable if Central Bank keeps exchange rates at floating. If they have a fixed exchange rate regime, this will be different as you can see in the table but unfortunately, Sri Lanka has a floating exchange rate regime (at least that's what they call it)
Interested in Chinese Influence on Sri Lanka? Read Chinese Debt Trap