Economics
Chapter 29: Policies to correct imbalances in the current
account of the balance of payments.
29.1 Government policy objective of stability of the current
account
- Most governments do seek to achieve balance of payment to
not getting into international debts and able to buy more
foreign products that it can afford.
- In the short run, the government may welcome a rise in
import from raw materials and capital goods, or allow the
consumption above output level to raise GDP.
- They usually encourage X revenue to larger than M to repay
external debt.
29.2 The effect of fiscal policy on the current account
Various fiscal policy tools to retaliate current account deficit:
- If they want to reduce the demand for imports,
contractionary fiscal policy like increases taxes and reduce
government spending can help the problem.
- If the government wants to reduce the current account
surplus and over saving, expansionary one can help it.
However, it is not a long-term solution:
- Because once it is stopped, households and firms are likely
to go back to their original spending.
- Raising too much tax causes economic stagnations and
increases unemployment; it may also reduce AS
29.3 The effect of monetary policy on the current
account
- Reducing the growth of the money supply may reduce the
growth in spending on imports, but the supply of money is
difficult to control (with exchange rates).
- This is a complex process
If the economy is on current account deficit + low inflation:
- Central banks may reduce interest rates to put downward
pressure on a floating exchange rate, resulting in a
depreciation. It leads to more competitive exports but may
lead to more inflation.
- Central banks may also increase interest rates to reduce
consumer expenditure on other things, including imports
and reduce inflationary pressures. However, it could be
reversed due to the floating exchange rate being
appreciated.
To reduce a current account surplus -> expansionary, low
interest rate (as shown above)
However, most monetary tools are not sustainable in the
long run:
- It does not tackle the structural weakness of an economy,
like the supply-side factors, including productivity, raw
materials, and innovation.
29.4 The effect of supply-side policy on the current
account
How it reduces deficit:
- Make domestic products more competitive and attractive
to invest in, like deregulation and privatisation (which
increases the competition and innovation)
- Increase spending on education and training. Increase
investment subsidies. Reducing its labour price and
increasing productivity.
It may attract multi-national companies
- Trade union reforms (deportment) may also enable
domestic firms to work with more flexibility, decreasing
industrial actions.
Drawbacks:
- Unable to reduce surplus
- Only effective in the long run
29.5 The effect of protectionist policy on the current
account
Target: encouraging domestic consumers and firms to buy
domestic products.
Reduce current account deficit through:
- Increasing import tariffs (like Donald Trump)
Disadvantages:
- Unable to apply in trade blocks or countries with FTAs
- Risk of retaliation
- Reduce competition in the domestic market, causing
inefficiency
- Rising price level, reducing purchasing power in consumer
for price inelastic imported products
- Corruption and monopolisation.
Exercise:
1. With the aid of a diagram, explain how a central bank
intervenes to maintain a fixed change rate when…