Economics (9708) | Policies to correct imbalances in the current account of the balance of payments

👋 Welcome to the Current Account Policy Toolkit!

The current account (CA) of the balance of payments acts like a country's trade scorecard. When this score is unbalanced (a large deficit or surplus), governments need to step in.

In this chapter, we explore the powerful tools governments use to fix these imbalances. Don't worry if international economics seems complicated—we’ll break down these policies into simple actions and see their real-world trade-offs!

🧐 Quick Review: What is a Current Account Imbalance?

An imbalance occurs when the total value of money flowing into a country from trade (exports, primary income, secondary income) does not equal the money flowing out (imports, etc.).

• Current Account Deficit: Outflows > Inflows. The country is buying more than it is selling internationally. This must be funded by borrowing or selling off financial assets (Financial/Capital Account surplus).
• Current Account Surplus: Inflows > Outflows. The country is exporting more than it is importing. While seemingly good, a sustained large surplus can cause inflationary pressure and lead to political tensions with trading partners.

The primary government objective here (6.5.1) is often stability of the current account, meaning keeping it near balance, or correcting chronic deficits.

Section 1: The Two Key Policy Approaches (11.1.3)

When tackling a current account deficit, governments use two main strategic types of policy. It is vital to distinguish between these two groups, as they aim to solve the problem in fundamentally different ways.

1. Expenditure-Reducing Policies

These policies aim to reduce overall Aggregate Demand (AD) in the economy. Why? Because when people have less income or find it more expensive to borrow, they spend less, and specifically, they buy fewer imported goods.
(Analogy: If your bank account balance goes down, you stop shopping online and buying things from abroad.)

Tools used: Contractionary Fiscal Policy and Contractionary Monetary Policy.

2. Expenditure-Switching Policies

These policies aim to change the pattern of spending. They encourage consumers (domestic and foreign) to buy domestically produced goods instead of imported goods. Total AD might stay the same, but the mix changes.
(Analogy: You still want a new phone, but you decide to buy the local brand instead of the foreign import.)

Tools used: Exchange Rate Manipulation (Devaluation/Depreciation) and Protectionist Measures.

Section 2: Policy Effects in Detail (6.5.2)

A. Fiscal Policy (Expenditure-Reducing)

Mechanism: The government uses Contractionary Fiscal Policy.

• Raise Direct Taxes (e.g., Income Tax): Reduces disposable income (\(Y_d\)).
• Cut Government Spending (G): Directly reduces a component of AD.

Impact on Current Account:
A fall in AD leads to a fall in national income (\(Y\)). Since imports (M) are a function of income (when people earn less, they buy fewer imports), M falls. This reduction in M improves the Current Account Balance (CAB).

Evaluation and Trade-offs

• Pro: Can be highly effective in reducing import consumption rapidly.
• Con: Creates policy conflicts! The main goal of CA improvement conflicts directly with other key macroeconomic objectives: economic growth and low unemployment. Cutting AD means slower growth and higher unemployment (cyclical).
• Analytic Point: If the marginal propensity to import (MPM) is very low, the government may have to cut AD drastically (causing a recession) just to achieve a small CA improvement.

B. Monetary Policy (Expenditure-Reducing)

Mechanism: The Central Bank uses Contractionary Monetary Policy by increasing the rate of interest.

• Higher interest rates increase the cost of borrowing and the reward for saving.
• This reduces Consumption (C) and Investment (I), causing AD to fall.

Impact on Current Account:
Similar to Fiscal Policy, the fall in AD and national income leads to reduced import spending (M), thus improving the CAB.

Evaluation and Trade-offs

• Pro: Can be implemented relatively quickly (Central Banks can announce rate changes instantly).
• Con (Conflict 1): Just like Fiscal Policy, it conflicts with growth and unemployment objectives.
• Con (Conflict 2 - Exchange Rate Risk): Higher interest rates attract hot money (short-term financial inflows). This increased demand for the domestic currency leads to an appreciation of the exchange rate. An appreciation makes exports more expensive and imports cheaper, potentially worsening the CAB in the long run!

C. Exchange Rate Policy (Expenditure-Switching)

Mechanism: Allowing the currency to depreciate (floating rate) or actively implementing a devaluation (fixed/managed rate).

Impact on Current Account:
The weaker currency makes foreign goods more expensive (M falls) and domestic goods cheaper to foreigners (X rises). This switches consumption towards domestically produced goods.

Evaluation: The Marshall-Lerner Condition and the J-Curve

Don't worry, this concept just tells us when depreciation actually works!

For depreciation/devaluation to improve the CAB, the demand for exports and imports must be elastic enough.

Marshall-Lerner Condition (MLC): The sum of the price elasticity of demand for exports (\(PED_X\)) and the price elasticity of demand for imports (\(PED_M\)) must be greater than one.
$$PED_X + PED_M > 1$$

• If the condition is met, the improvement in the quantity of X and reduction in the quantity of M will outweigh the adverse initial price change.
• Why the time lag? The J-Curve: In the short run, demands for X and M are often inelastic because contracts are already signed, and consumers take time to change habits. Therefore, the CA initially worsens (the cost of imports goes up immediately) before finally improving as consumers react to the price changes. This lag is called the J-Curve effect.
• Risk: Depreciation makes imports (like raw materials) more expensive, which can lead to cost-push inflation domestically.

D. Protectionist Policies (Expenditure-Switching)

Mechanism: Government uses measures like tariffs (taxes on imports), quotas (limits on import volume), or subsidies (to lower the price of domestic goods).

Impact on Current Account:
Tariffs and quotas directly restrict the quantity or raise the price of imports (M), improving the CAB. Subsidies lower domestic prices, making local goods more competitive internationally (X rises) and locally (M falls).

Evaluation and Trade-offs

• Pro: Very rapid and targeted way to reduce import spending.
• Con (Retaliation Risk): Trading partners may respond with their own tariffs on your exports, cancelling out any gains (a trade war).
• Con (Efficiency): Protectionism shields domestic industries from competition, reducing their incentive to become efficient, leading to misallocation of resources.
• Con (WTO Rules): Using aggressive protectionism violates World Trade Organization (WTO) rules and can lead to international fines or sanctions.

E. Supply-Side Policies (Long-Term Solution)

Mechanism: These policies focus on increasing the economy's productive capacity (shifting LRAS right) and improving the quality and competitiveness of goods and services. Examples include investment in infrastructure, education/training, and supporting R&D.

Impact on Current Account:
As domestic goods become higher quality, more innovative, and cheaper (due to higher productivity and lower costs), the demand for exports (X) increases and domestic demand switches away from imports (M). This leads to a sustainable, long-term improvement in the CAB.

Evaluation and Trade-offs

• Pro: This is the only policy that can improve the CA without conflicting with economic growth or employment. It improves the underlying fundamentals of the economy.
• Con (Time Lag): Infrastructure projects and education reforms take years or even decades to produce meaningful results. They are not suitable for fixing an urgent crisis.
• Con (Cost): Supply-side policies are often extremely expensive for the government.

Section 3: Policy Conflicts and Limitations

1. The Income-CA Conflict

The most common conflict is between using expenditure-reducing policies to fix the CA and maintaining domestic economic stability.

• If you raise interest rates (Monetary) or taxes (Fiscal) to cut imports, you risk plunging the economy into a recession (high unemployment, negative growth).

2. Exchange Rate Policy Conflicts

If a country uses Monetary Policy (high interest rates) to fight domestic inflation, the resulting currency appreciation will worsen the current account balance, showing a conflict between price stability and external balance.

3. The Trade-off between Short-run and Long-run Solutions

Short-run fixes (Fiscal/Monetary/Protectionism) are fast but often carry heavy domestic costs (recession, retaliation). Long-run fixes (Supply-Side) are ideal but offer no immediate relief. Governments must balance these trade-offs.