Revise Policies to correct disequilibrium in the balance of payments for Cambridge 9708 (11.1)

When a country faces a persistent deficit on its current account, it signifies a fundamental disequilibrium in its balance of payments. To correct this, governments can employ two main categories of macroeconomic policy. The first, expenditure-switching policies, aim to alter the relative prices of domestic and foreign goods to encourage consumers, both at home and abroad, to switch their spending towards the country's own products. The second, expenditure-reducing policies, seek to lower overall spending (aggregate demand) in the economy, which in turn decreases the demand for imported goods and services. The choice of policy, or combination of policies, depends on the underlying cause of the deficit, the current state of the economy (e.g., level of employment), and potential conflicts with other macroeconomic objectives.

Expenditure-switching policies directly target the trade balance by changing the appeal of domestic versus foreign goods. The primary methods are devaluation/depreciation of the currency and protectionism. A devaluation makes a country's exports cheaper in foreign currency terms and its imports more expensive in domestic currency terms. This should, in theory, boost export volumes and reduce import volumes. Protectionist measures, such as tariffs (taxes on imports) and quotas (limits on import quantities), also directly increase the price or limit the availability of foreign goods. The success of these policies, particularly devaluation, is heavily dependent on the price elasticity of demand for both exports and imports, as summarised by the Marshall-Lerner condition. A major risk is retaliatory action from trading partners.

Expenditure-reducing policies aim to correct a current account deficit by dampening aggregate demand (AD). This is a deflationary strategy. The two main tools are contractionary fiscal policy and contractionary monetary policy. Contractionary fiscal policy involves increasing direct/indirect taxes or reducing government spending. This reduces disposable income for consumers and overall demand in the economy. Contractionary monetary policy involves the central bank raising interest rates, which makes borrowing more expensive and saving more attractive, thereby discouraging consumption and investment. As overall expenditure in the economy falls, the demand for all goods, including imports, decreases. The effectiveness of this approach depends on the marginal propensity to import (MPM) – the higher the MPM, the more effective the policy will be at cutting the deficit.

In practice, governments rarely use either expenditure-switching or expenditure-reducing policies in isolation. A combination of the two is often required for a sustainable solution. For instance, if a country devalues its currency (expenditure-switching), the resulting increase in net exports will boost aggregate demand, which could be inflationary if the economy is already near full employment. To counteract this, the government could simultaneously implement a mildly expenditure-reducing policy, such as a small increase in interest rates. This helps to absorb the excess demand, preventing inflation while still allowing the relative price changes to improve the trade balance. This combined approach addresses both the external imbalance and the potential internal consequences, such as inflation or deep recession.