(b) Evaluate the policies by which a deficit in the current account of the balance of payments might be corrected. [15 marks]

Deficits in current accounts might be resolved either by expenditure switching, expenditure reducing or supply side policies.

Expenditure switching: Protectionism, devaluation

This policy works by switching consumption from imported goods to domestic items. That is, it switches spendings from M to C.

A policy like protectionism could be used to set up import tariffs and quotas that limit imports and raise prices of them. This raises the prices of imported items and consumers make the switch to cheaper domestic items, thereby reducing the current account deficit, since M goes down.

The problem with protectionism is that it raises price of imports and domestic items in some cases, resulting in inflation and inefficiencies. Local producers get unfair advantage over foreign ones, and countries might face retaliation. The protectionism policies are also bad due to the significant welfare losses arising to local economies due to rising prices and lower consumption. If the country was a net importer of raw material, it might lead to cost push inflation and reduce their overall productivity.

Devaluation can be employed where governments intervene in the foreign exchange market to push down the value of their own currency, usually by increasing supply in the market (selling local dollars to buy foreign dollars).

It works because with a devalued currency, foreign parties find it cheaper to buy the country’s exports. This will increase export competitiveness and lead to a rise in export if MLC is fulfilled.

At the same time, due to a weak currency, imports become more expensive for local consumers. They start to switch to domestic items instead, hence reducing import expenditure.

Assuming MLC holds, devaluation leads to increase in net exports (X-M).

Such policy might suffer from the J curve effect, effectively suggesting that the CA deficit might worsen first before finally improving. This is because in the short run, demand for imports and exports and generally price inelastic, hence devaluation would lead to a rise in import expenditure and not much increase in export revenue. Only in the long run when people manage to find substitutes for instance, that the demand for imports and exports are price elastic, resulting in a drop in import and rise in exports, hence improving the CA deficit.

The J curve is illustrated as follows.

j curve economics qeducation.sg

Expenditure reducing: Contractionary Fiscal, Contractionary monetary

Reduce income of consumers, and they buy less imported goods and local goods

Overall drop in GDP

Expenditure reducing consists of contractionary fiscal (rise in tax and drop in government spendings): this leads to a drop in disposable income forcing consumers to drop consumption of both imports and local items. There is a simultaneous drop in both C and M. The drop in M will result in improvement in the CA.

Contractionary monetary (rise in interest rates) works by increasing the costs of borrowing. Consumers start to save more and borrow less. Consumption will decrease for both local and foreign imports. Similarly there is a drop in M and C, and improvement in CA deficit.

These policies generally reduce CA deficit, but tend to lead to recession and unemployment because of the drop in AD. It is generally seen to be deflationary in impact and is not desirable in the long run.

Supply side policies works by increasing governments spendings on education and training. This increases productivity and efficiency of the local economy, hence increasing output and export competitiveness. For instance, the economy starts to make higher value added goods and services which are in high demand from foreign countries. This leads to improvements in X. Governments could also give subsidies to local producers to reduce their cost of production, hence making their items more competitive. Local consumers might then start purchasing such items and buy less imports, ultimately reducing CA deficit.

To solve a CA deficit, it is important to address the cause of the problem. Expenditure switching generally works in short run to protect certain key industries. Supply side policies might be better if the economy is suffering from inefficient local producers, while expenditure reducing can be used when the economy is suffering from simultaneous inflation and CA deficits.

Join our Economics tuition classes or view more resources.

Contact us now and join us for a free trial!