Question 1

Does a currency devaluation always fix a current account deficit?

Accepted Answer

No. Its success is not guaranteed. Firstly, the Marshall-Lerner condition must hold (PEDx + PEDm > 1). Secondly, the J-curve effect means the deficit will likely worsen in the short term before it improves. Thirdly, devaluation raises the price of imported raw materials, which can cause cost-push inflation, eroding the competitive advantage gained.

Question 2

Are expenditure-reducing policies the best way to cut a deficit?

Accepted Answer

Not necessarily. While they can be effective in reducing import spending, they do so by slowing down the entire economy. This can lead to a recession, rising unemployment, and falling living standards. It is often described as 'curing the disease by killing the patient', highlighting a severe conflict with other major macroeconomic objectives.

Question 3

Why isn't protectionism used more often if it reduces imports?

Accepted Answer

Protectionism is generally viewed as a poor long-term policy. It often leads to immediate retaliation from trading partners, who impose their own tariffs, potentially leading to a trade war where all countries lose. It also harms domestic consumers through higher prices and less choice, and it protects inefficient domestic firms from international competition, leading to a misallocation of resources.

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

What you need to know

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