Policies to correct disequilibrium in the balance of payments — common mistakes

When discussing devaluation, always evaluate its effectiveness by referring to the Marshall-Lerner condition and the J-curve effect. High marks are awarded for explaining that the policy's success is not guaranteed and depends on price elasticities, which can change over time.

Not necessarily. Its success is conditional. Firstly, the Marshall-Lerner condition must be met (PEDx + PEDm > 1), otherwise the deficit could worsen. Secondly, devaluation can cause cost-push inflation by making imported raw materials more expensive. Thirdly, it may provoke retaliatory tariffs from trading partners, negating any competitive advantage gained. Finally, if the economy is at full capacity, it may not be able to meet the extra demand for its exports.

While they avoid deliberately causing a recession, they have their own significant drawbacks. Devaluation can lead to domestic inflation. Protectionist measures like tariffs often provoke retaliation (trade wars), reduce consumer choice, and protect inefficient domestic industries from competition. In contrast, expenditure-reducing policies, though painful in terms of growth and employment, can be very effective at quickly cutting import spending and can also help to tackle domestic demand-pull inflation.

The same policies can be applied in reverse to address a persistent current account surplus. To reduce a surplus, a country could use expenditure-switching policies like revaluing its currency (making exports more expensive and imports cheaper). Alternatively, it could use expenditure-increasing policies (the opposite of expenditure-reducing) such as expansionary fiscal policy (cutting taxes, increasing government spending) or expansionary monetary policy (lowering interest rates) to boost aggregate demand and, with it, demand for imports.