AQA Specification focus:
‘Expenditure-switching and expenditure-reducing policies.’
Expenditure-switching and expenditure-reducing policies are essential tools governments use to correct balance of payments deficits, helping realign demand between domestic and foreign goods while addressing macroeconomic stability.
Understanding the Balance of Payments Context
The balance of payments records all economic transactions between residents of a country and the rest of the world. A current account deficit occurs when a nation imports more goods and services than it exports. Persistent deficits can undermine confidence in the economy, weaken the currency, and reduce growth prospects. To correct imbalances, policymakers may apply two broad strategies: expenditure-switching policies and expenditure-reducing policies.
Expenditure-Switching Policies
Expenditure-switching policies aim to encourage consumers and firms to shift spending from imports towards domestically produced goods and services. Rather than cutting overall spending, they alter the direction of demand.
Key Tools of Expenditure-Switching Policies
Exchange rate adjustments: A deliberate devaluation or depreciation of the currency makes exports cheaper and imports more expensive, encouraging substitution towards domestic goods.
Protectionist measures: Tariffs, quotas, and subsidies raise the relative cost of imports or support local producers, thereby incentivising domestic consumption.
Non-tariff barriers: Regulations, product standards, and administrative procedures can limit imports indirectly, switching expenditure back to home production.
Expenditure-switching policy: A policy designed to shift demand away from imports and towards domestically produced goods without necessarily reducing total spending levels.
Advantages of Expenditure-Switching Policies
Improve trade balance by raising demand for domestic goods.
Protect domestic employment in key industries.
Support long-term industrial growth by strengthening local firms.
Disadvantages of Expenditure-Switching Policies
Risk of retaliation from trading partners through counter-protectionist measures.
May reduce consumer choice and raise prices.
Devaluation can worsen inflation if imports are vital (e.g., energy or raw materials).
Expenditure-Reducing Policies
Expenditure-reducing policies lower overall domestic demand, thereby cutting demand for both imports and domestically produced goods. By reducing the aggregate level of spending, import expenditure naturally falls.
Key Tools of Expenditure-Reducing Policies
Contractionary fiscal policy: Increasing taxes or reducing government expenditure to reduce disposable incomes and consumption.
Contractionary monetary policy: Raising interest rates to dampen borrowing, investment, and consumer spending.
Direct controls: Wage and price controls, though less common today, may restrict growth in demand.
Expenditure-reducing policy: A policy aimed at cutting total national spending levels to lower demand for imports and restore balance of payments equilibrium.
Advantages of Expenditure-Reducing Policies
Address underlying excess demand pressures in the economy.
Help reduce inflationary pressures if the economy is overheating.
Provide a sustainable adjustment when the deficit reflects excessive domestic consumption.
Disadvantages of Expenditure-Reducing Policies
Reduce living standards by restricting consumption opportunities.
Increase unemployment due to lower aggregate demand.
Politically unpopular, especially during times of low growth.
Combining Expenditure-Switching and -Reducing Policies
Policymakers often use a combination of switching and reducing measures to correct imbalances while limiting negative side effects. For example, a government may devalue the currency (switching) but also tighten fiscal policy (reducing) to prevent inflation from worsening.
Key Considerations for Policy Choice
Elasticity of demand for imports and exports: If demand is price inelastic, switching policies may be ineffective, requiring reducing policies.
State of the economy: In a recession, expenditure-reducing policies may worsen unemployment, so switching policies might be preferable.
Political feasibility: Protectionist policies may conflict with international trade agreements, while contractionary fiscal policy may face resistance domestically.
Case Linkages within the Specification
Expenditure-switching and reducing policies have broader macroeconomic implications. They can affect inflation, growth, and employment, and they interact with exchange rate policies and trade regulations. For example, a devaluation (switching) may improve the current account but can worsen inflation. Similarly, raising interest rates (reducing) may stabilise external deficits but at the cost of investment and growth.
Evaluation Points for AQA Students
When evaluating expenditure-switching and -reducing policies, consider:
Time lags: Exchange rate changes or fiscal measures take time to influence trade balances.
Global interdependence: In a globalised economy, policies in one nation can spill over to others, sometimes offsetting intended effects.
Long-term vs short-term outcomes: Switching may provide short-term relief, but structural competitiveness improvements are needed for long-term sustainability.
Policy conflicts: Measures to correct a deficit may conflict with other macroeconomic objectives, such as achieving low inflation or high growth.
FAQ
Expenditure-switching policies change what consumers buy, encouraging them to purchase domestic goods instead of imports. They do not reduce overall spending levels.
Expenditure-reducing policies, however, cut consumers’ total spending power. As aggregate demand falls, consumers buy fewer goods overall, including both imports and domestic products.
These policies often involve tax increases, cuts in government spending, or higher interest rates. Each of these reduces disposable incomes or raises borrowing costs.
As a result, households face lower living standards, and unemployment may rise. Politicians may avoid such measures because of their negative social and electoral consequences.
If imports and exports are price elastic, a change in relative prices leads to large changes in demand, making switching policies effective.
If demand is price inelastic, even large changes in relative prices have little effect, limiting the success of these policies in reducing a current account deficit.
Risk of inflation if imports are essential (e.g., oil or food).
Trade retaliation from other countries through tariffs or quotas.
Possible decline in international competitiveness if domestic industries become reliant on protectionist measures rather than improving efficiency.
Using both can balance out weaknesses. For example, devaluation (switching) may cause inflationary pressure, but contractionary fiscal policy (reducing) can dampen that inflation.
This combined approach provides a more stable adjustment process, tackling the deficit without causing excessive economic instability.
Practice Questions
Define an expenditure-switching policy and give one example. (2 marks)
1 mark for an accurate definition: e.g., a policy designed to shift demand from imports towards domestically produced goods.
1 mark for a valid example: e.g., devaluation, tariffs, quotas, or subsidies.
Explain how expenditure-reducing policies might be used to correct a current account deficit. (6 marks)
Up to 2 marks for identifying relevant policies: e.g., contractionary fiscal policy (raising taxes, cutting spending) or contractionary monetary policy (increasing interest rates).
Up to 2 marks for explaining how these reduce aggregate demand and, therefore, import demand.
Up to 2 marks for further development or elaboration: e.g., reduction in disposable incomes leading to lower consumption, higher borrowing costs discouraging investment, and overall lowering import expenditure.
