Economics – Policies to correct disequilibrium in the balance of payments | e-Consult

A current account deficit occurs when a country imports more goods and services than it exports, leading to a net outflow of capital. Several policy tools can be employed to address this, each with its own strengths and weaknesses. The effectiveness of each depends on the specific causes of the deficit and the broader economic context.

Fiscal Policy

Fiscal policy involves the government’s use of taxation and spending to influence the economy. To address a current account deficit, the government could:

• Reduce Government Spending: This would decrease aggregate demand, potentially reducing imports. However, it could also lead to a recession and reduced economic activity.
• Increase Taxes: Higher taxes would reduce disposable income, leading to lower consumer spending and potentially reduced imports. However, this could also dampen economic growth.

Strengths: Fiscal policy can directly influence aggregate demand and potentially reduce import demand. It can also be targeted at specific sectors.

Weaknesses: Fiscal policy often has a time lag (recognition lag, decision lag, implementation lag, and impact lag). It can also be politically unpopular and difficult to implement effectively. Furthermore, increased government borrowing to finance deficits can lead to higher interest rates and crowding out of private investment.

Monetary Policy

Monetary policy involves the central bank controlling the money supply and interest rates. To address a current account deficit, the central bank could:

• Increase Interest Rates: Higher interest rates would attract foreign capital, increasing demand for the domestic currency and appreciating the exchange rate. A stronger currency makes exports more expensive and imports cheaper, potentially improving the current account.
• Reduce the Money Supply: This would also lead to higher interest rates, with the same effects as above.

Strengths: Monetary policy can be implemented relatively quickly. It is often independent from political pressures.

Weaknesses: The effects of monetary policy can be lagged and uncertain. Higher interest rates can also slow down economic growth and potentially lead to a recession. Furthermore, if other countries are also raising interest rates, the impact on the exchange rate may be limited.

Exchange Rate Policy

The government can intervene in the foreign exchange market to influence the value of its currency. To address a current account deficit, the government could:

• Devalue the Currency: This would make exports cheaper and imports more expensive, potentially improving the current account.

Strengths: A devaluation can quickly improve the trade balance.

Weaknesses: Devaluation can lead to inflation (as imports become more expensive) and potentially trigger a currency war (other countries devaluing their currencies in response). It can also reduce the purchasing power of consumers.

Trade-offs: Each policy has trade-offs. Fiscal policy can be slow and politically difficult. Monetary policy can slow economic growth. Exchange rate policy can lead to inflation and currency wars. The optimal policy mix depends on the specific circumstances of the UK economy and the nature of the current account deficit.