4.22 - Correcting a Current Account Deficit
Policies to correct current account deficits
Governments can address persistent current account imbalances using three main categories of policies: expenditure-reducing policies, expenditure-switching policies, and supply-side policies. The table below sets out what each category does, how it narrows the deficit, and what it costs; the sections that follow take each one in turn.
| Policy type | What it does | Effect on the current account | Main drawbacks |
|---|---|---|---|
| Expenditure-reducing policies | Lower the level of aggregate demand, through contractionary fiscal policy (cutting government spending or raising taxes) or tighter monetary policy (raising interest rates). | Lower national income means less spending on imports, and lower inflation makes exports more competitive, so imports shrink while exports may rise. | Growth slows and the economy may suffer a recession, with lower output, firms contracting and higher unemployment. |
| Expenditure-switching policies | Make imports more expensive so that spending switches to domestically produced goods, either by lowering the value of the currency or by imposing tariffs and other trade barriers. | Import spending falls as consumers buy local alternatives, and exports look cheaper to foreign buyers, so export revenue rises. | Rising import prices can trigger cost-push and demand-pull inflation, and protection invites retaliation, breaches WTO rules and misallocates resources. |
| Supply-side policies | Tackle the structural causes of uncompetitiveness: monopoly power in product markets, excessive business regulation, inflexible labour markets, high minimum wages and protective employment laws. | Domestic costs and prices fall, so domestic goods compete better at home and abroad, treating the fundamental cause of the imbalance rather than its symptoms. | Difficult to implement against resistance from affected groups, and the benefits appear only after a long time lag. |
Expenditure-reducing policies and their effects
Expenditure-reducing policies focus on lowering the overall level of aggregate demand in the economy to cut spending on imports.
Methods of implementing expenditure-reducing policies
- Contractionary fiscal policy - Involves cutting government spending or raising taxes.
- Tighter monetary policy - Achieved by increasing interest rates.
Positive effects on the current account
- Lower national income leads to reduced spending on imports.
- Potential decrease in inflation, which can make exports more competitive internationally.
- Overall, imports shrink while exports may rise, helping to narrow the deficit.
Drawbacks of expenditure-reducing policies
- Can slow economic growth or trigger a recession.
- May lead to reduced output and business contraction.
- Often results in higher unemployment as demand falls.
Expenditure-switching policies
Expenditure-switching policies encourage consumers and businesses to shift their spending from imported goods to those produced domestically. This is typically done by making imports less attractive through higher prices.
Currency devaluation and its impacts
How it works in different systems:
- In fixed exchange rate systems, the central bank authorises a deliberate reduction in the currency's value.
- In managed exchange rate systems, the central bank permits the currency to depreciate gradually or maintains it at a lower value.
Effects:
- Imports become more expensive in domestic terms, prompting consumers to buy local alternatives.
- Exports appear cheaper to foreign buyers, boosting overseas demand.
Risks:
- Can spark inflation as import prices rise, increasing production costs.
- May lead to higher wage demands and cost-push inflation.
- Potential for demand-pull inflation if spending surges without supply increases.
Protectionism through trade barriers
Protectionism involves imposing tariffs or other restrictions to raise the price of imports, making them less appealing. This encourages households and firms to opt for domestic products instead.
Drawbacks:
- Can provoke trade disputes and retaliatory measures from other countries.
- May breach World Trade Organization (WTO) regulations.
- Leads to inefficiency by distorting resource allocation in the economy.
Supply-side policies for competitiveness
Supply-side policies target the underlying structural issues causing a persistent current account deficit. These are long-term strategies designed to enhance the economy's efficiency and competitiveness.
Causes addressed by supply-side policies
These policies tackle problems such as:
- Uncompetitive product markets with excessive monopoly power influence.
- Overly strict business regulations that elevate production costs.
- Inflexible labour markets controlled by strong unions.
- Elevated minimum wages and protective employment laws.
Market-based supply-side approaches emphasise increasing competition in product markets to drive down costs and improve quality. They aim to resolve root causes of trade imbalances by making domestic goods more attractive globally.
Drawbacks of supply-side policies
- Implementation can be challenging due to resistance from affected groups.
- Benefits often emerge only after a significant delay, sometimes years.
Relationship between imports and income levels
Imports are closely linked to a country's income levels, influencing the current account balance.
How income affects imports:
- As national income rises, spending on imports typically increases.
- Conversely, when income falls, import spending decreases.
- This direct relationship means policies that reduce income can help curb imports, while growth in income may widen deficits unless exports keep pace.