AQA Specification focus:
‘The policies that might be used to correct a balance of payments deficit or surplus.’
Introduction
Correcting imbalances on the balance of payments is a key macroeconomic objective. Governments deploy a range of policies to restore external stability, often balancing trade-offs with growth, inflation, and employment.
Understanding Balance of Payments Imbalances
An imbalance occurs when a country runs a persistent current account deficit (spending more on imports and income outflows than it earns) or a persistent surplus (exporting significantly more than importing). These situations can threaten economic stability, exchange rates, and international competitiveness.
Balance of Payments: A record of all economic transactions between residents of a country and the rest of the world over a period of time.
While short-term fluctuations are common, long-term imbalances often require corrective action through policy intervention.
Policy Approaches to Correct Imbalances
1. Expenditure-Switching Policies
These policies aim to shift demand away from imports and towards domestically produced goods, or to encourage exports.
Devaluation or depreciation of the exchange rate:
Makes exports cheaper and imports more expensive.
More effective under a floating exchange rate system.
Depends on price elasticity of demand for exports and imports (Marshall-Lerner condition).
Protectionist measures (tariffs, quotas, subsidies):
Restrict imports and boost domestic production.
Risk of retaliation from trade partners and conflict with WTO rules.
2. Expenditure-Reducing Policies
These policies focus on reducing overall demand in the economy to lower import spending.
Deflationary fiscal policy:
Higher taxes or reduced government spending decrease aggregate demand.
Reduces demand for imports but may also slow economic growth.
Contractionary monetary policy:
Higher interest rates discourage borrowing and consumption.
Lower demand for imports but may increase unemployment.
3. Supply-Side Policies
Supply-side reforms aim to improve long-term competitiveness, boosting exports and reducing reliance on imports.
Investment in education and training to enhance productivity.
Infrastructure development to reduce costs for exporters.
Innovation and technology policies to expand export capacity.
These policies take longer to implement but address structural causes of deficits.
4. Exchange Rate Policies
Governments may intervene directly in currency markets to influence trade flows.
Fixed exchange rate support: Using foreign reserves to maintain currency value.
Managed float interventions: Buying or selling domestic currency to adjust competitiveness.
Risks include depletion of reserves and speculative attacks.
5. Incomes Policies
If domestic inflation is high, exports become less competitive.
Wage restraint or agreements between government, businesses, and unions can help maintain competitiveness.
Politically challenging to implement and enforce.
6. Encouraging Foreign Direct Investment (FDI)
Attracting inward FDI can help finance current account deficits.
Provides capital inflows in the financial account.
Brings technology transfer and job creation.
However, profits repatriated abroad may worsen future income outflows.
7. Surplus-Correcting Policies
Countries with persistent current account surpluses may adopt expansionary policies to boost imports and global demand.
Fiscal expansion can stimulate domestic demand for foreign goods.
Exchange rate appreciation can reduce competitiveness of exports.
Encouraged by international bodies such as the IMF to maintain global stability.
Key Trade-Offs in Policy Choice
Inflation vs Competitiveness
Deflationary policies reduce demand but risk higher unemployment.
Devaluation boosts exports but raises import prices, worsening inflation.
Growth vs External Stability
Policies reducing demand may conflict with growth objectives.
Supply-side reforms align better with long-term growth but take time to impact.
Equity Considerations
Tariffs and taxes can disproportionately affect lower-income households.
Wage restraint may limit living standards while stabilising the external balance.
Important Theoretical Frameworks
Marshall-Lerner Condition: A depreciation will improve the current account if the combined price elasticity of demand for exports and imports is greater than one.
J-Curve Effect: After a depreciation, a country’s current account may worsen in the short run before improving in the long run as demand adjusts.
These frameworks highlight why policy effectiveness often depends on time lags, elasticities, and the structure of trade.
Coordinated International Action
Balance of payments imbalances often require global cooperation. For example:
IMF support programmes may provide temporary financing.
Policy coordination among major economies can prevent competitive devaluations.
Surplus nations may be pressured to expand domestic demand to support deficit nations.
Policy Mix Approach
In practice, governments often combine policies to correct imbalances:
Short-term expenditure-reducing measures to stabilise demand.
Exchange rate adjustment to influence competitiveness.
Long-term supply-side reforms to improve productivity and export strength.
This layered approach balances immediate correction with sustainable improvements.
FAQ
Short-term policies, such as raising interest rates or imposing tariffs, work quickly to reduce import demand or improve export competitiveness. However, they often come with trade-offs, like higher unemployment or inflationary pressure.
Long-term policies, such as investment in infrastructure or education, address structural weaknesses that cause deficits. These take years to show results but help achieve sustainable external balance without harming growth.
Supply-side policies improve productivity and competitiveness without reducing living standards in the way that higher taxes or reduced spending can.
They enhance export potential.
They reduce reliance on imports through domestic efficiency.
They support growth alongside balance of payments correction.
However, they are slower to implement and may require significant government investment.
Devaluation only improves the current account if demand for exports and imports is price elastic.
If exports are inelastic, lower prices do not significantly increase demand.
If imports are inelastic, higher prices do not greatly reduce demand.
According to the Marshall-Lerner condition, the sum of these elasticities must be greater than one for devaluation to improve the balance.
Protectionism can reduce imports temporarily, but long-term issues remain. Other countries may retaliate with their own tariffs, reducing export opportunities.
Protectionism can also:
Increase domestic prices and reduce consumer choice.
Conflict with international trade rules (e.g., WTO).
Fail to address underlying competitiveness problems.
Although a surplus may appear beneficial, it can signal under-consumption and weak domestic demand. This can slow living standard improvements.
Internationally, persistent surpluses can create tensions. Trading partners may accuse surplus nations of currency manipulation or unfair trade practices, leading to pressure from bodies like the IMF to stimulate demand.
A surplus can also make an economy over-reliant on external demand, leaving it vulnerable to global downturns.
Practice Questions
Define what is meant by an expenditure-switching policy and give one example. (3 marks)
1 mark for identifying that expenditure-switching policies aim to shift demand away from imports towards domestic goods and/or encourage exports.
1 mark for providing an accurate definition using appropriate economic terminology.
1 mark for giving a valid example such as devaluation, tariffs, or quotas.
Explain two policies a government might use to correct a persistent current account deficit on the balance of payments. (6 marks)
Up to 3 marks for each policy explained (maximum 6 marks overall).
1 mark for identification of a relevant policy (e.g., contractionary fiscal policy, devaluation of the currency, supply-side measures).
1–2 marks for clear explanation of how the policy works in correcting a deficit (e.g., fiscal tightening reduces aggregate demand and therefore import expenditure; devaluation makes exports more competitive and imports more expensive).
Award maximum marks if both policies are clearly explained with accurate economic reasoning.
