Policies To Correct Imbalances on the Current Account (Cambridge International A-Level Economics)

Government policy objective of stability of the current account

Spec point — 6.5.1

• Current account stability refers to a government's objective of avoiding persistent and large imbalances - either deficits or surpluses - on the current account of the balance of payments

  • A persistent current account deficit is unsustainable in the long run as it requires continuous financing through the financial account - building up foreign liabilities and increasing future primary income outflows
  • A persistent current account surplus may attract international political pressure and reflect suppressed domestic consumption, reducing living standards below productive capacity

• Governments therefore aim for a broadly balanced current account over time rather than targeting an exact figure in any single period

Achieving current account stability may cause conflicts

• The objective of current account stability may conflict with other macroeconomic objectives

Potential macroeconomic conflicts which may arise in trying to achieve stability on the current account balance

• Policies to reduce a deficit (e.g. deflating domestic demand) may increase unemployment and reduce growth
• Policies to stimulate growth may worsen the current account by increasing import demand
• Achieving current account stability while maintaining low inflation, full employment and growth simultaneously is rarely possible - policy trade-offs are inevitable

Effect of fiscal policies on the current account

• Contractionary fiscal policy (higher taxes, lower government spending) reduces domestic aggregate demand, lowering household incomes and reducing expenditure on imports

  • The current account deficit narrows as import spending falls
  • However, lower growth and higher unemployment are likely side effects - a significant policy trade-off

• Expansionary fiscal policy worsens the current account as rising incomes pull in more imports

• Fiscal policy works through the demand channel - it affects the current account indirectly by changing the level of domestic income rather than directly targeting trade competitiveness

Effect of monetary policies on the current account

• Higher interest rates attract hot money inflows from foreign investors seeking better returns, increasing demand for the domestic currency and causing an appreciation

  • Appreciation makes exports more expensive and imports cheaper, tending to worsen the trade balance
  • However, higher interest rates also reduce domestic consumption and investment, lowering import demand - a partially offsetting effect

• Lower interest rates cause depreciation of the exchange rate, making exports cheaper and imports dearer, tending to improve the trade balance

• The effectiveness of monetary policy on the current account depends critically on price elasticities of demand for exports and imports

Effect of supply-side policies on the current account

• Supply-side policies improve the current account by raising the productive efficiency and international competitiveness of domestic firms

• Improved competitiveness lowers unit costs, making exports more price competitive in world markets and reducing dependence on imports

• Examples include:

  • Investment in education and training - raises labour productivity, lowering unit labour costs
  • Research and development subsidies - encourages innovation, improving export quality and non-price competitiveness
  • Deregulation - reduces costs of production, improving efficiency

• Supply-side policies address the structural causes of a current account deficit rather than merely suppressing demand - they are therefore regarded as the most sustainable long-run solution

• The main limitation is that supply-side policies operate slowly - improvements in productivity and competitiveness take years to feed through into export performance

Effect of protectionist policies on the current account

• Tariffs *raise the price of imports, reducing import volumes and narrowing the trade deficit directly

• Import quotas limit the volume of imports entering the country, directly reducing import expenditure

• Export subsidies lower the price of exports in foreign markets, boosting export demand and improving the trade balance

• Protectionist policies can improve the current account in the short run but carry significant risks:

  • Trading partners may retaliate with their own protectionist measures, reducing export demand and potentially worsening the current account
  • They reduce competitive pressure on domestic firms, allowing inefficiency to persist rather than addressing the underlying causes of the deficit
  • They may violate WTO rules, exposing the country to trade disputes and sanctions
  • Consumer welfare falls as import prices rise

Summary table of policy effects

Worked Example A government aims to reduce unemployment through expansionary fiscal policy and borrows more from commercial banks, increasing its borrowing requirement. What will be the result?

A. - a decrease in the budget deficit

B. - a decrease in the national debt

C. - an increase in the balance of payments deficit on the current account

D. - an increase in interest rates

Final answer: Answer: D

When the government borrows more from commercial banks, it increases the demand for loanable funds in the financial system - competition for available funds pushes up the price of borrowing, which is the rate of interest

This is the crowding out mechanism - government borrowing competes with private sector borrowing, driving up interest rates and potentially reducing private investment

Worked solution

• Option A is incorrect - borrowing more to fund expenditure increases the budget deficit, not decreases it
• Option B is incorrect - additional borrowing adds to the national debt, not reduces it
• Option C is the trap - students who know that expansionary fiscal policy increases incomes and therefore imports may select this; while this is a valid long-run consequence of expansionary fiscal policy, the direct and immediate result of increased government borrowing from commercial banks is upward pressure on interest rates, not a current account change

Exam Hint When evaluating policies to correct a current account deficit, always consider both the mechanism and the limitations - a policy that improves the current account may simultaneously worsen other macroeconomic objectives.

Supply-side policy is generally the strongest evaluation point as it addresses the root causes of uncompetitiveness rather than suppressing demand or distorting trade.