Policies to correct imbalances in the current account of the balance of payments — practice questions

Here is a breakdown and evaluation of each policy:

(i) Raising interest rates

• Classification: This is an expenditure-reducing policy. It is a form of contractionary monetary policy.
• Mechanism: Higher interest rates make borrowing more expensive for consumers and firms, which discourages consumption (C) and investment (I). This leads to a fall in aggregate demand (AD), reducing overall spending in the economy, including spending on imports.
• Evaluation: While it can be effective in cutting import spending, its main drawback is that it can trigger a recession and increase unemployment. It does not address the underlying competitiveness of the country's exports. This policy is most appropriate if the deficit is caused by an overheating economy with high inflation.

(ii) Devaluing the currency

• Classification: This is an expenditure-switching policy.
• Mechanism: A devaluation makes a country's exports cheaper for foreign buyers (in their currency) and makes imports more expensive for domestic buyers. This should increase the quantity of exports sold and decrease the quantity of imports bought, improving the net exports (X-M) balance.
• Evaluation: Its success depends on the Marshall-Lerner condition (PEDx + PEDm > 1). It can also cause cost-push inflation due to higher import prices. In the short term, the deficit might worsen before it improves, an effect known as the J-curve.

(iii) Investing in vocational training

• Classification: This is a supply-side policy.
• Mechanism: Investing in training improves the skills and productivity of the workforce. This can lead to lower unit labour costs and higher quality goods and services, making the country's exports more competitive on the international market over the long term.
• Evaluation: This policy addresses the root cause of a structural deficit and has no negative side effects like inflation or unemployment. However, its major limitation is the significant time lag; it can take many years for the benefits to be realised. It is not a solution for an immediate crisis.

Step 1: Calculate the initial current account deficit. The current account balance is the value of exports minus the value of imports. $ext{Current Account Balance} = ext{Export Revenue} - ext{Import Expenditure}$ $ext{Balance} = \text{\textdollar}400 ext{ billion} - \text{\textdollar}480 ext{ billion} = -\text{\textdollar}80 ext{ billion}$ Atlantis has an initial current account deficit of $80 billion.

Step 2: Check the Marshall-Lerner condition. The Marshall-Lerner condition states that a devaluation will improve the current account balance if the sum of the price elasticities of demand for exports and imports is greater than 1. $ext{Condition: } PED_x + PED_m > 1$ $0.9 + 0.7 = 1.6$ Since 1.6 > 1, the Marshall-Lerner condition is satisfied. The devaluation is expected to improve the current account balance.

Step 3: Calculate the new export revenue and import expenditure. A 20% devaluation means export prices in foreign currency fall by 20%, and import prices in domestic currency rise by 20%.

New Export Revenue: The quantity of exports will increase by: $\% Delta Q_x = PED_x \times \% Delta P = 0.9 \times 20\% = 18\%$ Assuming domestic prices for exporters remain constant, the revenue in 'Shells' increases with the quantity sold. $ext{New Export Revenue} = ext{Old Revenue} \times (1 + \% Delta Q_x)$ $ext{New Export Revenue} = \text{\textdollar}400 ext{ billion} \times (1 + 0.18) = \text{\textdollar}472 ext{ billion}$

New Import Expenditure: The quantity of imports will decrease by: $\% Delta Q_m = PED_m \times \% Delta P = 0.7 \times 20\% = 14\%$ The price of imports in the domestic currency rises by 20%. The total expenditure change depends on both the price increase and the quantity decrease. $ext{New Import Expenditure} = ext{Old Expenditure} \times (1 + \% Delta P) \times (1 - \% Delta Q_m)$ $ext{New Import Expenditure} = \text{\textdollar}480 ext{ billion} \times (1 + 0.20) \times (1 - 0.14)$ $ext{New Import Expenditure} = \text{\textdollar}480 ext{ billion} \times 1.20 \times 0.86 = \text{\textdollar}495.36 ext{ billion}$

Step 4: Determine the new current account balance and evaluate. $ext{New Current Account Balance} = ext{New Export Revenue} - ext{New Import Expenditure}$ $ext{New Balance} = \text{\textdollar}472 ext{ billion} - \text{\textdollar}495.36 ext{ billion} = -\text{\textdollar}23.36 ext{ billion}$

Conclusion: The current account deficit has decreased from $80 billion to $23.36 billion. The devaluation policy was successful in significantly improving the current account balance, as predicted by the Marshall-Lerner condition.