Policies to correct current account imbalances

Overview

How contractionary fiscal policy can reduce a current account deficit, use of supply-side policies to correct a current account deficit and competitiveness about more than price.

What you need to know

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Questions from this subtopic

Each one with the model answer underneath.

1. 1

   What are the broad categories of policy available to a government seeking to reduce a current account deficit?

   Model answer

   There are three. Expenditure-reducing policies cut total domestic spending so that less is spent on imports. Expenditure-switching policies change relative prices or the availability of foreign goods so that spending moves from imports to domestic output. Supply-side policies raise the productivity, quality and cost competitiveness of domestic producers so that exports rise and imports are displaced without the need to suppress demand or distort prices.

2. 2

   Explain how a depreciation of the currency is intended to reduce a current account deficit.

   Model answer

   A lower external value of the currency raises the domestic price of imports and lowers the foreign currency price of exports, so foreign buyers find the country's goods cheaper and domestic buyers find imports dearer. Export volumes therefore rise and import volumes fall, and the trade balance improves provided the volume responses are large enough to outweigh the fact that each unit of imports now costs more. The mechanism works on relative prices rather than on the level of domestic demand, so it is a form of expenditure switching.

3. 3

   Evaluate the use of currency depreciation as a means of correcting a current account deficit.

   Model answer

   It has the advantage of acting on the whole traded sector at once, without needing to identify particular industries, and it does not require the government to suppress domestic demand and employment. Against this, its success depends on the sum of the price elasticities of demand for exports and imports exceeding one, which may not hold in the short run, so the deficit can widen before it improves. The higher price of imported inputs and finished goods raises domestic inflation, which erodes the competitiveness gain over time, and it can prompt higher wage demands. Under a floating rate the government cannot simply choose the exchange rate anyway, and any attempt to engineer a fall may provoke retaliation. Depreciation is best regarded as buying time for underlying competitiveness to improve rather than as a cure.

4. 4

   Explain how contractionary fiscal policy can reduce a current account deficit, and identify the cost.

   Model answer

   Raising taxes or cutting government spending reduces disposable income and total demand, and since a proportion of every pound of spending goes on imports, import spending falls. The reduction goes further than the initial cut, because lower income leads to lower consumption, which lowers imports further. The cost is that the improvement in the external position is bought with lower domestic output and higher unemployment, so the policy sacrifices one macroeconomic objective to achieve another. It also does nothing to address the underlying competitiveness of the country's producers.

5. 5

   A government reduces its spending to cut a current account deficit. Explain why the fall in imports is larger than the share of the spending cut that would have gone abroad.

   Model answer

   The cut reduces incomes directly, and those who lose income spend less in turn, so total demand falls by more than the initial cut. Because a share of all spending goes on imports, each successive round of lower spending lowers import demand again. The current account therefore improves by more than the import content of the original cut alone, though the cost is lower output and higher unemployment at home.

6. 6

   Explain why tighter monetary policy has an ambiguous effect on the current account.

   Model answer

   Higher interest rates reduce consumption and investment, lowering income and therefore import spending, which improves the current account. But higher rates also attract capital inflows seeking the better return, raising demand for the currency and causing it to appreciate, which makes exports dearer and imports cheaper and worsens the current account. The two effects work in opposite directions, and which dominates depends on how sensitive spending is to interest rates and how mobile international capital is. In an economy with open capital markets the exchange rate effect is often the stronger.

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