Policies to correct imbalances in the current account of the balance of payments

Policies to Correct Imbalances in the Current Account (9708)

Hello future economists! This chapter is crucial because it moves beyond just identifying international trade problems (like a Current Account Deficit) and focuses on the practical tools governments use to fix them. Think of the government as a doctor diagnosing a patient (the economy) and prescribing medication (policies). Understanding these prescriptions—and their side effects—is essential for evaluation!

1. Understanding the Policy Objective: Current Account Stability

The main objective governments have regarding the Current Account (CA) is stability. An imbalance, especially a persistent large deficit, signals an unsustainable position where the country is spending more overseas than it is earning.

Quick Review: The Problem with a Large Current Account Deficit (CAD)

• Debt Risk: A persistent deficit must be financed by borrowing from abroad (a surplus in the Financial Account). This leads to rising national debt and future debt repayments.
• Currency Pressure: Continuously buying more imports than exporting means selling your currency to buy foreign currency. This puts downward pressure on the exchange rate.
• Loss of Confidence: International investors might lose confidence in the economy, leading to capital flight.

2. Policy Categories: Switching vs. Reducing

Economists typically divide policies aimed at correcting a Current Account Deficit into two main groups. This distinction is vital for evaluation.

A. Expenditure-Reducing Policies

These policies aim to reduce the total level of spending (Aggregate Demand or AD) in the economy. When people and firms spend less overall, they spend less on imports, thus reducing the deficit.

Analogy: This is like putting the whole economy on a strict diet to stop it from buying expensive foreign snacks.

B. Expenditure-Switching Policies

These policies aim to shift spending away from imports and towards domestically produced goods. They make local products relatively more attractive.

Analogy: This is like making the local snacks cheaper and the foreign snacks more expensive, so people switch their preference.

3. Expenditure-Reducing Policies (Demand-Side)

These are the standard contractionary (deflationary) macroeconomic policies you already know, used here to dampen import demand (M).

3.1 Fiscal Policy

The government uses contractionary fiscal policy:

• Tool: Increase income tax and/or decrease government spending (G).
• Mechanism:

  Higher taxes reduce disposable income. Lower G reduces overall AD.
  \( \text{AD} \downarrow \implies \text{National Income} \downarrow \implies \text{Import Demand (M)} \downarrow \)
  (We import less because we have less money to spend.)

• Evaluation (Trade-offs): While effective at reducing the CAD quickly, this policy also reduces GDP growth and increases unemployment. This creates a severe policy conflict with the goals of economic growth and full employment.

3.2 Monetary Policy

The Central Bank uses contractionary monetary policy:

• Tool: Increase the rate of interest.
• Mechanism:

  Higher interest rates increase the cost of borrowing, discouraging consumption (C) and investment (I). This causes Aggregate Demand to fall, leading to lower National Income and therefore less demand for imports (M).
  \( \text{C} \downarrow \text{ and } \text{I} \downarrow \implies \text{AD} \downarrow \implies \text{M} \downarrow \)

• Evaluation (Policy Conflict): The secondary effect of higher interest rates is attracting "hot money" (short-term foreign capital). This inflow of money increases demand for the local currency, causing it to appreciate. A stronger currency makes exports more expensive and imports cheaper, which actually worsens the Current Account balance.

4. Expenditure-Switching Policies (Trade and Exchange Rate Focus)

These policies aim to change the relative prices of domestic vs. foreign goods.

4.1 Exchange Rate Policy (Depreciation/Devaluation)

This is arguably the most direct expenditure-switching policy.

• Tool: If the country uses a floating exchange rate system, the central bank might sell domestic currency or lower interest rates (though this conflicts with expenditure reduction). If it uses a fixed/managed system, the government can officially devalue the currency.
• Mechanism:

  A depreciation means the currency is worth less internationally.
  
  

  For Foreign Buyers: Your exports become cheaper in foreign currency, leading to an increase in Export (X) volume.

  For Domestic Buyers: Imports become more expensive, leading to a fall in Import (M) volume.

• Evaluation:
  • Advantage: It corrects the underlying cause of the imbalance by changing relative prices and boosting competitiveness.
  • Disadvantage (Inflation): Cheaper imports cause the cost of imported raw materials and finished goods to rise, leading to cost-push inflation.
  • Disadvantage (Inelasticity): The policy only works if demand for exports and imports is sufficiently price elastic. If demand is inelastic, the value of exports earned may fall, and the value of imports purchased may not fall significantly, potentially worsening the CAD initially (the J-Curve effect, an advanced A Level concept).

4.2 Protectionist Policies

These policies directly restrict the volume or increase the cost of imports.

• Tools: Tariffs (taxes on imports), Quotas (limits on import volume), excessive administrative burdens ('red tape').
• Mechanism: By making foreign goods more expensive or harder to obtain, domestic consumers are forced to switch their expenditure to locally produced goods. This reduces M and improves the CA.
• Evaluation:
  • Advantage: Immediate impact on import volumes.
  • Disadvantage (Retaliation): Foreign countries are highly likely to impose their own tariffs on your exports, negating the original benefit and leading to a global fall in trade (trade war).
  • Disadvantage (Inefficiency): Domestic industries are shielded from international competition, reducing their incentive to become efficient or innovative.
  • Disadvantage (Consumer Harm): Consumers pay higher prices for both imports and domestic goods (as local firms hike prices when competition falls).

5. Supply-Side Policies (The Long-Term Solution)

Supply-side policies address the structural, long-term reasons for poor trading performance, such as low productivity or poor quality goods.

5.1 Core Supply-Side Policies

• Tools: Investment in training and education, infrastructure development, subsidies for Research & Development (R&D), deregulation, and tax cuts to encourage work/investment.
• Mechanism: These policies aim to increase the productive capacity (LRAS) of the economy, leading to lower costs of production and higher quality output.

  Lower costs and better quality means domestic goods are more internationally competitive.
  \( \text{Competitiveness} \uparrow \implies \text{Exports (X)} \uparrow \text{ and Imports (M)} \downarrow \)

• Evaluation:
  • Advantage: This is the only policy that solves the CA deficit without creating conflicts with growth or unemployment. It improves X and reduces M while increasing real output (GDP).
  • Disadvantage (Time): These policies have significant time lags. Training a skilled workforce or building new infrastructure takes years, so they are not suitable for an immediate crisis.

6. Evaluation and Policy Conflicts

When discussing policy effectiveness, high-level analysis requires evaluating limitations and trade-offs.

6.1 Policy Conflicts (The Trade-offs)

Governments rarely use just one policy, but policies often work against each other:

• CAD vs. Growth/Employment: Expenditure-reducing policies (Fiscal/Monetary tightening) are effective for the CA but worsen unemployment and slow growth.
• CAD vs. Inflation: Expenditure-switching policies, especially currency depreciation and protectionism, tend to increase domestic price levels.
• Monetary Policy Conflict: Using high interest rates to reduce AD and imports conflicts with the currency appreciation that high rates cause, which worsens X and M.

6.2 Choosing the Right Policy

The best policy depends heavily on the cause of the current account imbalance:

• If the deficit is caused by excessive domestic demand (e.g., a boom), expenditure-reducing policies are appropriate.
• If the deficit is caused by structural problems (e.g., poor quality domestic goods), only supply-side policies can offer a lasting fix.
• If the deficit is caused by overvaluation of the currency, exchange rate adjustment is the key.

Did you know? China has often been criticized for keeping its currency (the Yuan) artificially low (managed exchange rate) to ensure its exports remain highly competitive internationally, contributing to large Current Account surpluses.

6.3 Expenditure Switching vs. Expenditure Reduction: The Debate

Governments often use a mix of both. For example, they might use tight fiscal policy (reducing expenditure) while simultaneously weakening the currency (switching expenditure). This combined approach aims to reduce overall demand while making sure the limited demand that remains is directed domestically.