Reasons for trade restrictions: reduce a deficit on the current account of the balance of payments

International Trade and Globalisation – Globalisation and Trade Restrictions

Objective

Understand why governments may impose trade restrictions in order to reduce a deficit on the current account of the balance of payments.

1. The Current Account and Its Deficit

The current account records a country’s trade in goods and services, net income from abroad and net current transfers. The key component for trade restrictions is the trade balance:

\$\text{Current Account (CA)} = \text{Exports (X)} - \text{Imports (M)} + \text{Net Income} + \text{Net Transfers}\$

A deficit occurs when imports exceed exports, i.e. \$M > X\$, leading to a negative balance that must be financed by capital inflows or borrowing.

2. Why Reduce a Current‑Account Deficit?

• Prevent excessive foreign debt and vulnerability to external shocks.
• Maintain the value of the domestic currency.
• Protect domestic employment in import‑competing sectors.
• Preserve foreign exchange reserves needed for essential imports.

3. Trade Restrictions as a Policy Tool

Governments can influence the volume and price of imports (and sometimes exports) through various trade restrictions. By making imports more expensive or limiting their quantity, the aim is to reduce \$M\$ and improve the trade balance.

4. Main Types of Trade Restrictions

5. Mechanism: How Restrictions Reduce the Deficit

1. Price Effect: Tariffs increase the domestic price of imported goods. According to the law of demand, higher prices lead to lower quantity demanded.
2. Quantity Effect: Quotas and licensing set a hard ceiling on import volumes, directly limiting \$M\$.
3. Currency Effect: Exchange controls restrict the outflow of foreign exchange, making it harder for importers to purchase foreign goods.
4. Revenue Effect: Tariff revenue can be used to bolster foreign‑exchange reserves, providing a buffer for essential imports.

6. Example Calculation

Assume a country imports \$200 bn\$ and exports \$150 bn\$ of goods. The current‑account trade balance is \$-50 bn\$.

If a 10 % tariff is imposed on imports, the price of imports rises, reducing import demand by 5 % (price elasticity of -0.5). New imports:

\$M_{\text{new}} = 200 \times (1 - 0.05) = 190 \text{ bn}\$

New trade balance:

\$\text{CA}_{\text{new}} = 150 - 190 = -40 \text{ bn}\$

The deficit narrows from \$50 bn\$ to \$40 bn\$, a 20 % improvement.

7. Advantages and Disadvantages

• Advantages

  • Quick reduction in import volume.
  • Potential protection for domestic industries.
  • Increased government revenue from tariffs.

• Disadvantages

  • Higher prices for consumers and possible inflation.
  • Retaliation from trading partners (trade wars).
  • Reduced competition can lead to inefficiency.
  • May hurt export‑dependent sectors if other countries impose counter‑measures.

8. Suggested Diagram

9. Summary Points

• A current‑account deficit means \$M > X\$ and must be financed.
• Trade restrictions aim to reduce \$M\$ (or increase \$X\$) to improve the trade balance.
• Tariffs, quotas, licensing and exchange controls are the main tools.
• While effective in the short term, restrictions can have negative side‑effects such as higher consumer prices and possible retaliation.