Policies to Correct Disequilibrium in the Balance of Payments (BOP)

Hello future economist! This chapter is all about how governments act as financial doctors, trying to cure their country's major international accounting problems, specifically when they have a persistent Current Account Deficit (CAD).

A disequilibrium in the balance of payments usually refers to a persistent Current Account Deficit (CAD), where a country spends consistently more on imports, services, and transfers than it earns from exports. This is unsustainable in the long run!

We will explore the toolbox governments use, categorized into two main strategies: stopping people from spending so much overall, or making them change *where* they spend. Let's dive in!


1. The Two Main Strategies: Reduction vs. Switching

When tackling a Current Account Deficit (CAD), economists categorize policies based on their primary mechanism:

A. Expenditure-Reducing Policies

Think of this as putting the entire economy on a tight budget or a financial diet. The goal is to reduce Aggregate Demand (AD) in the economy.

Why does this help the Current Account? When people have less money or find it expensive to borrow, they buy fewer goods overall—especially fewer imports (M). If M falls, the CAD should improve.

  • Tools: Contractionary Fiscal Policy and Contractionary Monetary Policy.
  • Core Trade-Off: Reducing AD usually leads to slower economic growth and potentially higher unemployment.
B. Expenditure-Switching Policies

This strategy aims to encourage domestic consumers to switch their spending away from imported goods and towards domestically produced goods. At the same time, it makes the country's exports more attractive to foreigners.

  • Tools: Exchange Rate Manipulation (Depreciation/Devaluation) and Protectionism.
  • Core Goal: Change the relative prices of imports versus domestic goods.
Quick Review: Expenditure Analogy

If your personal finances (BOP) have a deficit because you buy too many foreign sneakers (imports):

1. Expenditure-Reducing: Your parents cut your allowance (Fiscal Policy). You buy fewer sneakers overall.

2. Expenditure-Switching: Your country makes foreign sneakers expensive (Protectionism/Exchange Rate). You switch to buying cheaper domestic sneakers instead.

2. Policy Tools for Correcting BOP Disequilibrium

2.1. Fiscal Policy (Expenditure-Reducing)

The government uses its budget tools to decrease overall spending.

  • Increased Taxation (T): Higher income tax or indirect taxes reduce household disposable income. This decreases Consumption (C), which includes spending on imports (M).
  • Decreased Government Spending (G): Cutting public expenditure directly reduces AD.

Analysis:

  • Pros: Can be implemented relatively quickly (e.g., announcing tax changes).
  • Cons: It is a blunt instrument. It reduces demand for ALL goods (domestic and imported), leading to lower real GDP, potential recession, and higher cyclical unemployment. This conflicts with other macroeconomic objectives (growth, full employment).
2.2. Monetary Policy (Expenditure-Reducing)

The Central Bank uses interest rates to reduce borrowing and spending.

The policy involves raising the official interest rate.

  • Effect on Consumption (C): Higher interest rates increase the cost of mortgages and loans, discouraging spending (C). Higher rates also encourage saving.
  • Effect on Investment (I): Firms postpone or cancel investment projects because borrowing is now more expensive.
  • Effect on Current Account: Since C and I fall, AD falls. This reduces the demand for imports (M).

Analysis:

  • Pros: Can be changed quickly. If successful, it may also help reduce domestic inflationary pressures.
  • Cons: Similar to fiscal policy, it risks causing a recession. Additionally, higher interest rates may lead to a capital inflow, causing the exchange rate to appreciate, which works *against* the current account by making exports more expensive! This is a policy conflict.
2.3. Exchange Rate Policy (Expenditure-Switching)

This is one of the most powerful and direct ways to switch expenditure.

If the country operates a fixed exchange rate system, the currency is devalued. If it operates a floating exchange rate, the currency is allowed to depreciate.

How Depreciation/Devaluation Works:

1. Exports (X) become cheaper: If the local currency falls, foreigners need less of their currency to buy the country’s goods. Foreign demand for exports increases (assuming PED for exports > 1).

2. Imports (M) become more expensive: Local consumers need more local currency to buy foreign goods. Local demand for imports decreases (assuming PED for imports > 1).

This dual effect increases X and reduces M, directly improving the trade balance and the Current Account.

Crucial Conditions (Marshall-Lerner Condition):

For a depreciation/devaluation to successfully improve the Current Account, the sum of the Price Elasticities of Demand for exports (PEDx) and imports (PEDm) must be greater than one:
\[( |PED_x| + |PED_m| > 1 )\]

Don't worry if this seems tricky at first! In plain English: the quantities of exports and imports must be sensitive enough to the change in price. If trade is highly inelastic (e.g., a country imports essential oil), making it more expensive won't reduce the quantity imported much, and the total import bill (M) in local currency could actually rise!

The J-Curve Effect:

In the short run, trade volumes (quantities) often don't change immediately because firms have existing contracts and consumers take time to adjust habits. Since prices immediately change, the import bill rises initially, making the deficit worse. Over time, as consumers and firms adjust (volumes change), the CAD improves, drawing the graph into a "J" shape.

2.4. Protectionist Policies (Expenditure-Switching)

Protectionist measures restrict imports directly, forcing expenditure switching.

  • Tariffs: A tax on imports. Increases the price of foreign goods, making domestic goods relatively cheaper.
  • Quotas: A physical limit on the volume of imports allowed into the country.
  • Subsidies (for domestic producers): Lowers the cost of production for domestic firms, allowing them to lower prices and compete better against imports.

Analysis:

  • Pros: Guaranteed and immediate reduction of imports. Requires no reduction in AD, so it doesn't conflict with the objective of low unemployment directly.
  • Cons: Extremely risky due to retaliation. Other countries may impose tariffs on your exports, negating any initial improvement. Protectionism also leads to inefficiency (domestic firms don't have to compete) and reduces consumer choice.
2.5. Supply-Side Policies (Long-Term Solution)

These policies focus on improving the country's long-run productive capacity and efficiency, rather than just manipulating demand or prices.

  • Investment in Training and Education: Improves labour productivity.
  • Investment in Infrastructure: Lowers transport and communication costs for businesses.
  • Deregulation/Privatisation: Increases competition and efficiency.

How they help the Current Account:

By making domestic firms more efficient, their goods become more competitive on the global market (lower cost, higher quality). This leads to a long-run increase in export volume (X) and a replacement of imports (M) by higher-quality domestic substitutes.

Analysis:

  • Pros: They are the most sustainable solution. They improve the Current Account *without* needing to slow down economic growth (unlike expenditure-reducing policies).
  • Cons: They take a long time to work (years or even decades) and are often expensive to implement (e.g., building high-speed rail networks).

3. Synthesis and Policy Conflicts

In reality, governments often use a mix of these policies. The primary challenge is the trade-off inherent in the solutions.

Key Conflicts and Trade-offs

1. BOP vs. Growth/Employment:
The quickest ways to fix a CAD (Fiscal/Monetary contraction) involve expenditure reduction, which deliberately slows down the economy and increases unemployment.

2. BOP vs. Inflation:
Both exchange rate depreciation and protectionist measures (tariffs) can cause cost-push inflation.

  • Depreciation makes imported raw materials (like oil) more expensive.
  • Tariffs raise the cost of imported components.
  • This higher cost is passed onto the consumer, leading to higher inflation.

3. Policy Inconsistencies:
As mentioned earlier, expansionary Monetary Policy (raising interest rates to reduce spending) can attract financial flows, causing the currency to appreciate—this appreciation counteracts the goal of improving the Current Account.

The Ideal Policy Mix (For Sustainable Correction)

The most sustainable strategy is usually a combination of:

1. A small degree of Expenditure-Reducing policy (to manage AD and prevent inflation).

2. Aggressive Supply-Side Policies (to improve long-run competitiveness and efficiency).

3. Allowing the Exchange Rate to Adjust (Depreciation), provided the Marshall-Lerner condition is likely to hold in the medium run.


Memory Aid: Fixing the CAD in the Short vs. Long Run

When answering exam questions, remember the time dimension:

  • Short Run: Use Expenditure-Reducing (Fiscal/Monetary) or quick Expenditure-Switching (Protectionism/Depreciation).
  • Long Run: Focus on sustainable, non-deflationary measures like Supply-Side Policies to permanently increase competitiveness.

Did you know? Many developing economies that are heavily reliant on importing necessities (like basic fuel and machinery) often struggle severely with expenditure-switching policies, as the high price elasticities required by the Marshall-Lerner condition rarely hold true for critical imports.