Policies to reduce a current account deficit

Question 1

What are the policies to reduce a current account deficit?

Answer 1

Devaluation
Reducing expenditure
Protectionism
Supply side policies

Question 2

What is devaluation?

Answer 2

A deliberate policy of a government or central bank to decrease the exchange rate of the domestic currency

Question 3

What is devaluation different from and why?

Answer 3

Different from depreciation which means there is a fall in the value of a current due to free market forces and not due to government policy

Question 4

How could a government reduce the value of a currency?

Answer 4

By reducing interest rates
By selling domestic currency and buying foreign currency
By increasing the money supply

Question 5

How does reducing interest rates reduce the value of a currency?

Answer 5

Less hot money arriving in country (demand related)

More consumption/borrowing by consumers, more imports (supply related)

Question 6

What happens if a government devalues the domestic currency?

Answer 6

Price of exports will fall, Demand for exports will rise

Price of imports will rise, Demand for imports will fall

Question 7

What does the effectiveness of the policy of devaluation depend on?

Answer 7

PED for imports and exports

Marshall Lerner condition

Question 8

How could the government reduce growth of AD?

Answer 8

By using fiscal policy or monetary policy
e.g. Using fiscal policy - government could increase taxes or reduce government spending
Using monetary policy - government could raise interest rates

Question 9

What would happen if there is a slower growth of AD?

Answer 9

Inflation would be lower

Question 10

What would happen if domestic inflation is lower than inflation in the rest of the world?

Answer 10

Domestic goods become more competitive

Demand for exports will increase, demand for imports will fall

Question 11

What happens if there is a slower rate of AD growth?

Answer 11

This will slow the growth of imports

If imports rise at a slower rate than exports then the current account deficit will increase

Question 12

What are the costs of reducing growth of AD?

Answer 12

Greater levels of unemployment

Reduced living standards

Question 13

When is it a benefit to reduce AD growth?

Answer 13

When there is inflation because economy is at full capacity

Question 14

Why might raising interest rates to deflate economy be ineffective in reducing the current account deficit?

Answer 14

Attracts hot money, damages ability to export because currency rises in value

Question 15

What is protectionism?

Answer 15

Policies aim to protect domestic producers by restricting the level of imports
(this may be achieved by using tariffs, quotas, exchange controls)

Question 16

What are problems with using tariffs or quotes to restrict imports?

Answer 16

UK can’t do this as we are in EU customs union
Makes goods more expensive for consumers
Retaliation (trade war)

Question 17

What do supply side policies do?

Answer 17

Aim to influence AS in economy

Aim to make domestic producers more competitive and increase demand for UK goods reducing the current account deficit

Question 18

What are supply side free market policies?

Answer 18

Reduce income tax
Reduce corporation tax
Privatisation and deregulation
Reduce minimum wage
Reform benefits system
Reduce trade union power

Question 19

What are supply side interventionist policies?

Answer 19

Increase spending on education/training
Increase spending on infrastructure
Stricter government competition policy
Reduce geographical immobility of labour

Question 20

What is an evaluation of policies to reduce current account deficit?

Answer 20

Government can’t use protectionist policies because member of EU and WTO
Government would not want Bank of England to devalue the pound as it could cause higher inflation
Government don’t want to deflate economy if it causes lower growth and higher unemployment