5.4 Expenditure Reducing Policies to Rectify a Current Account Deficit

Question 1

1. What are examples of expenditure reducing policies to rectify a current account deficit?

Answer 1

Examples of expenditure reducing policies include contractionary fiscal policies such as an increase in income tax, an increase in corporation tax, and a cut in government spending. They also include contractionary monetary policies such as a rise in interest rates or a decrease in the money supply. These policies aim to reduce aggregate demand (AD) in the economy, which in turn reduces incomes and the marginal propensity to import. This leads to a reduction in imports and an improvement in the trade balance in the current account, rectifying a current account deficit.

Question 2

evaluation: What are the potential drawbacks of implementing expenditure reducing policies to rectify a current account deficit?

Answer 2

Expenditure reducing policies conflict with other macroeconomic objectives of the government. While these policies may improve the trade balance, they often have adverse side effects. One such effect is a fall in economic growth, potentially leading to a recession. Additionally, expenditure reducing policies can result in a rise in unemployment. These negative consequences are often considered more significant than the benefits of an improved trade position, leading to the infrequent use of these policies to reduce current account deficits

Question 3

Q: What is protectionism?

Answer 3

A: Protectionism refers to policies implemented by a country to restrict or limit international trade. It includes measures such as imposing or increasing tariffs, quotas, embargoes, domestic subsidies, and non-tariff barriers like red tape and standards. These policies aim to increase the price of imported goods or block imports, thereby reducing expenditure on imports and potentially improving the trade balance in the current account to rectify a current account deficit.

Question 4

evaluation: Q: What is one potential drawback of using protectionism to address a trade deficit?

Answer 4

A: One potential drawback of using protectionism to address a trade deficit is the likelihood of strong retaliation by trading partners. Trading partners may react negatively to the imposition of protectionist measures, as it affects their economy and exporters. This can lead to a tit-for-tat situation, where retaliation is enacted back on the initial country’s imports, resulting in a significant reduction in export revenue and potentially worsening their trade deficit over time. Protectionism can result in a zero-sum game for all involved.

Question 5

evaluation: Q: How can protectionism affect consumers?

Answer 5

A: Protectionism, such as tariffs, can increase prices for consumers and create a deadweight welfare loss of consumer surplus. Tariffs act as taxes on imports, thereby raising the price of imported goods. This particularly affects key imports like clothing, food, vehicles, and manufactured goods, which are often relied upon by low-income individuals who spend a greater proportion of their income on these goods. As a result, protectionism can be regressive and negatively impact consumer welfare.

Question 6

evaluation: Q: How does protectionism conflict with the principles of the World Trade Organization (WTO)?

Answer 6

A: Protectionism contradicts the aims and principles of the World Trade Organization (WTO), to which many countries are signatories. The WTO requires member countries to only impose protectionist measures that are fair and consistent, as approved by the organization. Breaking these rules by using tariffs to reduce current account deficits can result in heavy fines imposed by the WTO or allow trading partner countries to legally retaliate with stricter measures.

Question 7

evaluation: Q: How can protectionist measures lead to inflation and conflict with government macroeconomic objectives?

Answer 7

A: Protectionist measures, such as tariffs and quotas, can be inflationary and create a conflict with government macroeconomic objectives. Tariffs increase the price of imported goods, including raw materials and commodities, thereby increasing production costs for businesses reliant on these imports. These higher costs are passed on to consumers through higher prices, causing cost-push inflation. Even finished goods imported at higher prices can contribute to inflationary pressures throughout the economy.

Question 8

Q: How does protectionism affect the allocation of resources on a global scale?

Answer 8

A: Protectionism worsens the world allocation of resources. By promoting domestic production without considering comparative advantage, protectionism directs resources toward less efficient domestic producers rather than more efficient foreign producers. This distortion leads to a misallocation of resources, resulting in allocative inefficiency. Comparative advantage is compromised, and global resources are not optimally utilized.

Question 9

Q: How can the exchange rate be weakened to address a current account deficit?

Answer 9

A: The exchange rate can be weakened through various measures, such as reducing interest rates to increase hot money outflows, increasing the money supply, or selling domestic currency reserves. A weak exchange rate makes exports cheaper and imports more expensive. Economic theory suggests that this would lead to a decrease in the demand for imports and expenditure on imports, while increasing the demand for exports and revenue generated by exports. Both effects work towards improving the trade balance of the current account, reducing a current account deficit, or potentially moving it into a surplus.

Question 10

evaluation: Q: What condition must be satisfied for the exchange rate weakening strategy to be effective?

Answer 10

A: The effectiveness of the exchange rate weakening strategy depends on whether the Marshall-Lerner condition is satisfied. The condition states that the sum of the price elasticities of demand for exports (PEDx) and imports (PEM) must be greater than 1 (PEDx + PEM > 1). When export prices fall, demand for exports tends to rise, resulting in increased export revenue in domestic currency terms regardless of the price elasticity. However, if the demand for imports is price inelastic, as import prices rise, the expenditure on imports may increase, although to a lesser extent than the price rise. To offset the increase in import expenditure, greater export revenue is required, which can be achieved when the sum of the price elasticities of demand for exports and imports is greater than 1. If the Marshall-Lerner condition is not satisfied, there will be a net increase in import expenditure relative to export revenue, worsening the trade balance and current account deficit contrary to what economic theory suggests.

Question 11

evaluation: Q: Why may the Marshall-Lerner condition not be achieved in the short run?

Answer 11

A: The Marshall-Lerner condition is unlikely to be achieved in the short run due to the price inelasticity of demand for both imports and exports. Contracts and agreements make it difficult for countries to immediately switch their international buying and selling patterns. Consumers and businesses often take time to adjust and find substitutes in response to changes in exchange rates. As a result, a phenomenon known as the J-curve effect occurs, where the current account position for a country is more likely to deteriorate from an initial deficit to a worse deficit before eventually improving and recording a surplus after a noticeable time lag. This time lag allows for the adjustment of contracts and the search for substitutes in response to a permanently lower exchange rate. The achievement of the Marshall-Lerner condition, where the price elasticities of demand for both exports and imports sum to greater than 1, requires time and adjustments in economic agents’ behavior.

Question 12

evaluation: Q: How can the weakening of the exchange rate lead to inflation and conflict with macroeconomic objectives?

Answer 12

A: Weakening the exchange rate can lead to inflation, specifically demand-pull inflation. As aggregate demand (AD) increases in the economy, it puts pressure on existing factors of production, leading to an increase in their prices. Additionally, cost-push inflation can occur as firms must now pay more for imported raw materials, which have become more expensive due to the weakened exchange rate. Consequently, the costs of production for firms rise, and they pass on these extra costs through higher prices, causing cost-push inflation. Inflationary pressures can conflict with macroeconomic objectives, particularly if a nation heavily depends on imported commodities and raw materials. This situation can dampen economic growth and even lead to stagflation, characterized by high inflation and low economic growth.

Question 13

evaluation: Q: What potential issue can arise from purposefully weakening the exchange rate to improve the current account?

Answer 13

A: Purposefully weakening the exchange rate to improve the current account can lead to retaliation and currency wars. When countries manage and weaken their exchange rates to gain an advantage in their current account deficits, it can be seen as a protectionist action that causes outrage in trading partner countries. The increased cost of their exports due to a weaker currency reduces their export revenue and economic growth. In response, trading partner countries may weaken their own exchange rates, leading to a situation where no country has a cheaper export advantage, resulting in a zero-sum game. Currency wars and retaliatory actions can escalate tensions and disrupt international trade relationships.

Question 14

evaluation: Q: How does the severity of trade restrictions imposed by foreign governments impact the effectiveness of a weak exchange rate strategy?

Answer 14

A: The effectiveness of a weak exchange rate strategy depends on the severity of trade restrictions imposed by foreign governments. If foreign governments have strict controls that limit the quantity of domestic exports entering their country, a fall in the exchange rate may have limited impact on increasing the overall revenue brought in by exports. However, the work of the World Trade Organization (WTO) over the last two decades has led to a decrease in international trade barriers, allowing for more open and free trade. As a result, a weak exchange rate strategy may have a greater chance of success in the current global trade environment.

Question 15

evaluation: Q: How can the strength of demand overseas and at home affect the effectiveness of a weak exchange rate strategy?

Answer 15

A: The effectiveness of a weak exchange rate strategy in rectifying a current account deficit depends on the strength of demand overseas and at home. If demand overseas is weak due to a recession in major trading economies, the fall in export prices resulting from a weak exchange rate may not significantly increase demand for exports. Consequently, export revenues may not increase, leaving the current account deficit unaffected or even worsening it. Similarly, if demand at home is strong, such as during an economic boom, despite the rise in import prices caused by a weak exchange rate, demand for imports may remain high as consumers continue to “suck in” imports. This can result in import expenditure not decreasing and the current account deficit remaining unaffected or even worsening. The effectiveness of a weak exchange rate strategy is contingent on the prevailing demand conditions in both domestic and overseas markets.

Question 16

Q: How can government spending on education and training improve the price and non-price competitiveness of a country’s exports?

Answer 16

A: Government spending on education and training can improve the price and non-price competitiveness of a country’s exports by enhancing the skills and productivity of the labor force, which in turn reduces unit labor costs. This investment in human capital improves the quality and efficiency of goods and services produced, making them more competitive in terms of both price and non-price factors. For example, spending on apprenticeship schemes, adult retraining, and curriculum reforms in schools can lead to a better-educated and trained workforce. This, in turn, increases productivity, reduces costs, and allows for greater export revenue to be generated.

Question 17

Q: How does government spending on infrastructure contribute to improving a country’s export competitiveness?

Answer 17

A: Government spending on infrastructure, such as transport infrastructure, can reduce the costs of production for firms and increase the productive efficiency of the economy, boosting the price competitiveness of goods and services produced and generating greater export revenue. By investing in improving roads, building new transportation networks, airports, ports, and rail systems, the transportation of goods and services becomes quicker, easier, and more efficient. This improves the efficiency of business operations and lowers production costs. As a result, the price competitiveness of domestically produced goods and services increases, allowing for greater export revenue to be generated.

Question 18

Q: How does reducing corporation tax impact the price and non-price competitiveness of a country’s exports?

Answer 18

A: Reducing corporation tax creates incentives for firms to invest and improve their capital stock. With lower tax burdens, firms have more retained profits available to fund investments in new capital, upgrading machinery, technology, research and development, and innovation. This increased investment enhances both the quantity and quality of the capital stock in the economy, leading to improved productive efficiency. The improved productive efficiency, in turn, boosts the price and non-price competitiveness of goods and services produced, allowing for higher export revenue to be generated. Lower corporation tax encourages firms to allocate resources toward productive activities that enhance their competitiveness in the global market.

Question 19

Q: How does deregulation contribute to improving the price and non-price competitiveness of a country’s exports?

Answer 19

A: Deregulation, which involves reducing laws and government-imposed standards in the economy, has a positive impact on the price and non-price competitiveness of a country’s exports. By reducing the costs of production for firms, deregulation improves the efficiency of business operations. This results in lower production costs, making domestically produced goods and services more price competitive. Additionally, reducing barriers to entry into markets increases competition, driving firms to achieve maximum efficiency to remain competitive. These factors, combined, improve the productive efficiency of the economy and boost the price competitiveness of goods and services produced, allowing for greater export revenue to be generated. Deregulation promotes a more efficient allocation of resources and encourages competition-driven improvements in the quality and cost-effectiveness of products and services, enhancing non-price competitiveness in international markets.

Question 20

evaluation: Q: What is one potential drawback of implementing supply side policies?

Answer 20

A: One potential drawback of implementing supply-side policies is their high cost. For example, government spending on infrastructure projects, such as road improvements and bridge construction, can cost millions or even billions of pounds. Implementing such policies requires significant financial resources, resulting in an opportunity cost. If the money is borrowed, it may lead to increased taxes burdening future generations. Alternatively, funding for supply-side policies may require cuts in other areas of the economy, such as policing, healthcare, or education. This can have negative implications for those who rely on the proper functioning of these services in their daily lives. The cost and allocation of resources for supply-side policies need to be carefully considered and balanced with other societal needs.

Question 21

evaluation: Q: What is the time lag associated with the impact of supply-side policies on export competitiveness?

Answer 21

A: Supply-side policies, such as improvements in education and training, may take a considerable amount of time to have an effect on productivity and efficiency. It can take between 5 and 15 years before noticeable improvements in productivity are observed, which then contribute to enhancing the price competitiveness of a country’s exports. This long time lag reduces the short-term impact of supply-side policies on export competitiveness. Patience and sustained commitment to these policies are necessary to realize their full potential in improving both the price and non-price competitiveness of a country’s exports and increasing the revenue generated from exports.

Question 22

evaluation: Q: What is a potential risk associated with supply-side policies?

Answer 22

A: A potential risk associated with supply-side policies is their uncertainty in delivering the desired outcomes. There is no guarantee that providing subsidies to firms will effectively increase investment and technology. Firms may choose to use the subsidy to pay off debts, increase dividends to shareholders, or increase savings instead of making productive investments. Similarly, increased spending on education may not necessarily translate into higher productivity and a more skilled labor force. The effectiveness of supply-side policies relies on various factors, including the willingness of firms to invest, the ability of educational institutions to deliver high-quality training, and the overall effectiveness of policy implementation. Considering the risks of these policies not working and their high costs, there may be no benefit in improving export competitiveness, while future taxpayers bear the burden of the policies through higher taxes without reaping the expected benefits.

Question 23

Q: Why is it important for governments to identify the root cause of a current account deficit before implementing policies?

Answer 23

A: It is crucial for governments to identify the root cause of a current account deficit before implementing policies because they need to target policies that directly address the underlying problem. If the deficit is caused by excessive import expenditure due to high incomes, expenditure-reducing policies may be useful. However, if there are structural issues causing the deficit, supply-side policies are needed for a long-term solution. Implementing policies that do not target the cause of the deficit can lead to conflicts with other macroeconomic objectives, burden future taxpayers, or worsen international relations. It is essential to have a clear understanding of the root cause to implement effective and targeted policies that address the specific issues contributing to the current account deficit.

Question 24

Q: Is a current account deficit always a problem?

Answer 24

A: A small current account deficit is unlikely to be difficult to finance, especially if the country’s GDP growth rates are increasing faster than the current deficit. In such cases, the country can afford to borrow to finance the deficit without the risk of a panic-fueled currency crisis in the long term. Additionally, the negative impacts on aggregate demand (AD) are unlikely to be significant. However, if the deficit becomes larger and grows at a faster rate than increases in real GDP, it becomes unsustainable and indicative of debt dependency. This means that the negative consequences of running a current account deficit become more significant. Furthermore, if the deficit is caused by structural problems, it will persist in the long term. In these cases, targeted and well-considered interventions may be necessary to address the underlying issues and rectify the current account deficit.

Question 25

evaluation: Q: What is a potential drawback of using expenditure-reducing policies for a current account deficit?

Answer 25

A: One potential drawback of using expenditure-reducing policies for a current account deficit is that they may worsen growth and unemployment objectives unnecessarily. If the current account deficit is small and manageable, implementing expenditure-reducing policies can negatively impact economic growth and employment without significant benefits. It is important to assess the scale and sustainability of the deficit before implementing such policies. If the deficit is not severe and growing at a faster rate than real GDP, alternative policies that target the underlying causes, such as structural issues, may be more appropriate. It is crucial to carefully consider the potential negative consequences on other macroeconomic objectives and weigh the costs and benefits of implementing expenditure-reducing policies in the context of the specific current account deficit situation.

Question 26

evaluation: Q: Why might targeted and well-considered intervention be necessary for a persistent current account deficit caused by structural problems?

Answer 26

A: Targeted and well-considered intervention may be necessary for a persistent current account deficit caused by structural problems because such deficits are likely to be long term and require specific measures to address the underlying issues. If the deficit persists due to structural problems, it indicates that the usual cyclical adjustments may not be sufficient to rectify the imbalance. In these cases, targeted intervention can help address the root causes and promote sustainable improvement. By implementing policies that focus on structural reforms, the economy can address issues related to competitiveness, productivity, or imbalances in trade flows. This requires careful consideration and implementation of policies that are tailored to the specific structural challenges faced by the economy. Targeted interventions can help achieve long-term stability and reduce the dependency on external borrowing to finance the deficit, contributing to a more sustainable economic performance.