Expenditure-switching and expenditure-reducing policies

Overview

Expenditure-reducing policy, expenditure-switching policy and key difference between expenditure-switching and expenditure-reducing policies.

What you need to know

Answer each one before you reveal it.

Questions from this subtopic

Each one with the model answer underneath.

1. 1

   What is an expenditure-reducing policy?

   Model answer

   An expenditure-reducing policy lowers the total level of spending in the economy so that, since a proportion of all spending falls on imports, import spending declines. Contractionary fiscal policy through higher taxes or lower government spending, and contractionary monetary policy through higher interest rates or tighter credit, are the main instruments. The policy operates on the aggregate volume of demand rather than on how that demand is divided between domestic and foreign goods.

2. 2

   What is an expenditure-switching policy?

   Model answer

   An expenditure-switching policy alters the relative attractiveness of domestic and foreign goods so that a given level of total spending is redirected towards domestic output. Depreciation or devaluation of the currency, tariffs, quotas and other import restrictions, and measures that improve the quality and non-price appeal of domestic products all fall into this category. It changes the composition of spending rather than its total.

3. 3

   Explain the key difference between expenditure-switching and expenditure-reducing policies.

   Model answer

   Expenditure-reducing policies cut the size of the spending cake, so imports fall because everything falls, and domestic output falls too. Expenditure-switching policies keep the cake the same size but change how it is divided between domestic and foreign producers, so imports fall while domestic output rises. This is why switching is generally preferred where the economy has spare capacity, since the extra demand for domestic output can then be met by producing more rather than by raising prices, and why the two are often combined when the economy is already at or near full employment.

4. 4

   Explain why expenditure-reducing and expenditure-switching policies are often used together.

   Model answer

   Expenditure switching redirects demand towards domestic producers, which raises the pressure on domestic capacity; if the economy is already close to full employment, this generates inflation that erodes the competitiveness gain the switch was meant to deliver. Expenditure reduction creates the spare capacity needed for the switch to be met with real output rather than higher prices. Conversely, expenditure reduction alone cures the deficit only by depressing the economy. Combining them can improve the external balance while keeping domestic demand consistent with the economy's capacity.

5. 5

   Explain why the share of spending that goes on imports determines how effective a reduction in demand is at correcting a current account deficit.

   Model answer

   The larger the share of each pound of spending that goes abroad, the more of any cut in demand falls on imports rather than on domestic output. A country where imports take a large share therefore corrects its deficit with a smaller loss of domestic output; one where the share is small must contract demand much further to achieve the same improvement, so the cost in output and employment is far higher.

6. 6

   A government reduces aggregate demand by £20 billion in an economy where a quarter of all spending goes on imports. Explain what happens to import spending and why the effect on the current account is larger than that first step suggests.

   Model answer

   Around a quarter of the £20 billion reduction falls directly on imports, so import spending falls by roughly £5 billion at once. The rest of the cut reduces domestic incomes, and those lower incomes are spent again at a lower level, part of which would also have gone abroad, so imports fall further in successive rounds. The improvement in the current account is therefore larger than the first £5 billion, at the cost of weaker domestic output.

Other ways to work this

The same content, four other ways.

What is inside Levo

Six ways to work the same material.