difference between expenditure-switching and expenditure-reducing policies

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Policies to Correct Disequilibrium in the Balance of Payments (Syllabus 11.1)

Learning Objective (AO1)

Explain the difference between expenditure‑switching and expenditure‑reducing policies, identify the tools used, describe their impact on the current account and on other macro‑economic objectives, and evaluate their effectiveness.

1. Key Definitions and Direct Comparison

Aspect Expenditure‑Switching Expenditure‑Reducing
Primary aim Change the relative price of domestic vs. foreign goods so that spending shifts from imports to exports. Lower the overall level of domestic demand, thereby reducing import demand indirectly.
Mechanism Alters the terms of trade (price ratio Pimports/Pexports). Reduces aggregate demand (AD) through fiscal or monetary tightening.
Typical tools Exchange‑rate devaluation/depreciation, tariffs, import quotas, export subsidies, import licences. Contractionary fiscal policy, monetary tightening, credit controls.
Immediate effect on AD Little or no change – the shift is mainly between X and M. Direct fall in AD.
Time‑lag for impact on the current account Short‑run (price changes) – can be seen quickly. Medium‑ to long‑run (adjustment of consumption and investment).

2. Expenditure‑Switching Tools (AO1)

These policies change the relative price of imports and exports.

Tool Definition / Typical Form Effect on Exports (X) Effect on Imports (M) Key Limitation (Syllabus note)
Exchange‑rate policy Deliberate lowering of the domestic currency’s value.
– Managed‑float depreciation
– Fixed‑rate devaluation (requires IMF/peg‑holder approval)		 ↑ X (exports become cheaper abroad) ↑ Pimports → ↓ M Limited under a fixed‑rate regime; may trigger “currency wars”.
Tariffs Specific taxes on imported goods. Neutral (unless accompanied by export‑related measures) ↑ price of imports → ↓ M Subject to WTO rules; can provoke retaliation.
Import quotas Quantitative limits on the volume of selected imports. Neutral Directly caps M for the quota‑covered goods. Considered a non‑tariff barrier; WTO‑compatible only in limited cases.
Export subsidies Financial assistance that lowers producers’ cost of exporting. ↑ X (more competitive abroad) Neutral Generally prohibited by the WTO; may invite disputes.
Import licences (administrative controls) Permission required before importing certain goods; can be quantitative or value‑based. Neutral Restricts M by limiting entry of licensed goods. Often viewed as a non‑tariff barrier; can be challenged under WTO “sanitary‑phytosanitary” exceptions.

Effect on the Current Account

For each tool the change in the current account (CA) can be expressed as:

$$\Delta CA = (X-M)_{\text{new}}-(X-M)_{\text{old}}$$

  • Depreciation, export subsidies → ↑ X.
  • Tariffs, quotas, import licences → ↓ M.
  • The net effect is an improvement in the current‑account balance when the increase in X exceeds any offsetting rise in M (or vice‑versa).

3. Expenditure‑Reducing Tools (AO1)

These policies lower total domestic demand, which in turn reduces import demand.

Tool Definition / Typical Instruments Effect on Aggregate Demand (AD) Effect on Imports (M) Key Limitation
Contractionary fiscal policy Higher direct taxes (income, corporation), cuts in government spending, or reduced transfer payments. ↓ Disposable income & government‑sector demand → ↓ AD. ↓ M because M = m × AD (m = marginal propensity to import). Can deepen recession and raise unemployment.
Monetary tightening Higher policy interest rates, open‑market sale of government securities, higher reserve requirements. ↑ Cost of borrowing → ↓ Consumption & investment → ↓ AD. ↓ M via lower AD; however, higher rates may attract capital inflows that appreciate the currency, partially offsetting the import‑reduction effect. Risk of currency appreciation; may hurt export‑led growth.
Credit controls Loan‑to‑value ratios, credit ceilings, or direct limits on bank lending. Restricts financing for consumption and investment → ↓ AD. ↓ M through reduced AD. Enforcement can be difficult; may push activity into informal finance.

Quantitative Relationship

Import demand is directly proportional to aggregate demand:

$$M = m \times AD$$

where m is the marginal propensity to import. A fall in AD therefore reduces M and improves the BoP.

4. Linkages to Other Macro‑Economic Objectives (AO2)

Policy / Tool Growth Inflation Unemployment External Balance (Current Account)
Depreciation (exchange‑rate) Potentially growth‑friendly if export sector expands. Inflationary – higher import prices. Short‑run may raise cyclical unemployment if firms cannot adjust quickly. Improves CA (↑X, ↓M).
Tariffs / Quotas / Import licences Neutral to slightly positive (domestic substitution). Inflationary – domestic prices rise. May protect jobs in protected industries but can reduce employment in import‑dependent sectors. Improves CA by ↓M.
Export subsidies Positive if export sector is export‑elastic. Neutral to inflationary (depends on pass‑through). May create jobs in subsidised sectors but distort labour allocation. Improves CA by ↑X.
Contractionary fiscal policy Negative – reduces overall demand. Disinflationary – lower demand pressure. Raises cyclical unemployment. Improves CA by ↓M.
Monetary tightening Negative – higher borrowing costs. Disinflationary. Raises unemployment if credit contraction is strong. Improves CA by ↓M (but possible currency appreciation may offset).
Credit controls Negative – limits investment. Disinflationary. Potential rise in unemployment. Improves CA by ↓M.

5. Evaluation of the Two Policy Groups (AO2 / AO3)

Expenditure‑Switching

  • Effectiveness: Directly targets X‑M; a devaluation can improve the current account within a few months.
  • Time‑lag: Short‑run price adjustment; structural shifts (e.g., capacity to export) may take longer.
  • Trade‑offs: Often inflationary; may provoke retaliation (tariff wars) and can breach WTO rules (export subsidies, quotas).
  • Political feasibility: Devaluation may be unpopular if it raises living costs; tariffs enjoy domestic support but risk international disputes.

Expenditure‑Reducing

  • Effectiveness: Reduces import demand by shrinking AD; success depends on the size of the marginal propensity to import (m).
  • Time‑lag: Medium‑ to long‑run – households and firms adjust spending slowly.
  • Trade‑offs: Dampens growth, raises unemployment and can be socially painful (higher taxes, reduced public services).
  • Political feasibility: Generally low – tax hikes and spending cuts are unpopular; however, they are WTO‑compatible and do not provoke trade retaliation.

In practice, the most sustainable correction often combines a modest exchange‑rate adjustment (to improve competitiveness) with selective fiscal tightening (to avoid excessive inflation and to keep demand in check).

6. International Constraints (AO2)

  • WTO rules: Prohibit most export subsidies, limit the use of tariffs and quotas to “special circumstances”.
  • Exchange‑rate regimes: Fixed or pegged systems restrict devaluation; any adjustment usually requires IMF approval or a change of the peg.
  • Capital‑flow considerations: Monetary tightening can attract inflows that appreciate the currency, partially neutralising the intended import‑reduction effect.
  • Regional trade agreements: EU, NAFTA, etc., impose additional limits on tariff and quota use.

7. Illustrative Case Studies (AO3)

  • United Kingdom – 1992 ERM exit (devaluation)
    • Policy: The pound was allowed to float after leaving the European Exchange‑Rate Mechanism, resulting in a rapid depreciation.
    • Outcome: Export volumes rose and imports fell; the current‑account deficit narrowed from 5 % of GDP (1991) to 2 % (1993).
    • Evaluation: Quick improvement in the BoP, but import‑price inflation rose by ~3 % and the policy damaged the UK’s credibility in maintaining a fixed exchange rate.
  • United States – 2018‑2020 steel & aluminium tariffs
    • Policy: 25 % tariff on steel and 10 % on aluminium imports.
    • Outcome: Import volumes of the taxed goods fell by about 15 % in the first year; however, retaliatory tariffs on US agricultural exports reduced export earnings by roughly $3 bn.
    • Evaluation: Short‑run reduction in M was achieved, but the overall current‑account effect was muted by the loss of export revenue and the measures conflicted with WTO obligations, leading to legal challenges.
  • Japan – Abenomics fiscal tightening (2013‑2015)
    • Policy: Increase in the consumption tax from 5 % to 8 % (later to 10 %).
    • Outcome: Household consumption fell, import growth slowed, and the current‑account surplus widened from 3 % to 5 % of GDP.
    • Evaluation: The policy succeeded in curbing the deficit, but it also contributed to a prolonged period of weak GDP growth and higher unemployment, raising questions about long‑term sustainability.

8. Summary (AO1)

Expenditure‑switching policies alter the relative price of domestic and foreign goods, prompting a shift from imports to exports without necessarily lowering total demand. Expenditure‑reducing policies, by contrast, lower overall domestic demand, which indirectly cuts import demand. Both groups have distinct tools, timing, macro‑economic side‑effects, and international constraints. Effective balance‑of‑payments correction usually requires a judicious mix of the two, chosen on the basis of the underlying cause of the disequilibrium and the broader macro‑economic context.

Suggested diagram: Effect of a depreciation on the import‑demand curve (shift left from M₀ to M₁) and on the export‑supply curve (shift right from X₀ to X₁), illustrating the improvement in the current account.

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