AQA Specification focus:
‘The effect policies used to correct a deficit or surplus may have upon other macroeconomic policy objectives.’
When governments use policies to address balance of payments imbalances, these actions rarely operate in isolation and often interact with broader macroeconomic policy objectives, creating both benefits and drawbacks.
Understanding Macroeconomic Policy Objectives
The main macroeconomic policy objectives are:
Economic growth: Sustained increases in real GDP.
Low unemployment: Achieving high levels of employment across the labour force.
Low and stable inflation: Maintaining price stability to protect purchasing power.
Balance of payments stability: Avoiding persistent deficits or surpluses that undermine external confidence.
Fiscal sustainability: Ensuring government finances remain manageable.
Policies to correct balance of payments deficits or surpluses often interact with these objectives, leading to policy conflicts or trade-offs.
Expenditure-Reducing Policies and Their Effects
Expenditure-reducing policies aim to reduce domestic spending, thereby cutting demand for imports. Examples include contractionary fiscal and monetary policy.
Impact on Growth
Contractionary measures reduce aggregate demand (AD), slowing economic growth.
If demand falls significantly, it may lead to negative output gaps.
Impact on Unemployment
Lower demand for goods and services can increase cyclical unemployment.
Industries reliant on consumer spending, such as retail and leisure, may be hit hardest.
Impact on Inflation
Reduced demand puts downward pressure on demand-pull inflation, potentially stabilising prices.
However, long-term disinflation may risk deflation if excessively restrictive.
Impact on Government Finances
Slower growth reduces tax revenues while increasing welfare payments, potentially worsening fiscal positions.
Expenditure-Switching Policies and Their Effects
Expenditure-switching policies aim to encourage consumers to buy domestic rather than imported goods. These typically include tariffs, quotas, and exchange rate devaluation.
Impact on Growth
Domestic industries may experience higher demand, supporting growth in the short term.
Export-led growth may expand GDP if competitiveness improves.
Impact on Unemployment
Higher demand for domestic products supports employment in protected or export industries.
However, retaliation from trading partners may reduce export opportunities, undermining job creation.
Impact on Inflation
Tariffs and devaluation raise the price of imports, increasing cost-push inflation.
Inflationary pressures may conflict with the goal of price stability.
Impact on International Relations
Widespread use of protectionism risks trade wars, damaging long-term growth prospects and creating global inefficiencies.
Exchange Rate Policies and Effects
Governments may intervene in currency markets to influence exchange rates. For example, depreciation can boost exports by making them cheaper abroad.
Growth: Depreciation can stimulate export demand, raising AD and growth.
Inflation: Import prices rise, worsening inflationary pressures.
Employment: Export sectors benefit, but domestic import-reliant industries may face higher costs, potentially offsetting gains.
External stability: If depreciation is sustained, it can improve the current account, but confidence in the currency may weaken.
Structural Policies and Long-Term Impacts
Rather than short-term demand measures, governments may use supply-side policies to boost competitiveness and reduce external imbalances sustainably.
Examples include:
Investment in education and training to improve productivity.
Infrastructure development to reduce costs for exporters.
Incentives for innovation to enhance global competitiveness.
Effects on Objectives
Growth: Stronger productivity drives sustainable long-term growth.
Employment: Structural improvements create jobs in higher-value sectors.
Inflation: Efficiency gains can reduce cost pressures.
Balance of payments: Exports become more competitive without inflationary side effects.
Supply-side policy: Measures aimed at increasing the productive capacity and efficiency of the economy, shifting long-run aggregate supply (LRAS) to the right.
Policy Conflicts and Trade-offs
Correcting external imbalances often forces governments to prioritise certain objectives over others.
Reducing a current account deficit through contractionary demand policies may conflict with goals for growth and employment.
Boosting exports through devaluation can conflict with the inflation target.
Trade restrictions may protect domestic jobs in the short run but harm long-term efficiency and growth.
The Role of Policy Mix
Given these trade-offs, policymakers often combine measures to balance outcomes:
Contractionary demand policies with supply-side reforms to improve competitiveness while controlling inflation.
Targeted exchange rate intervention supported by structural productivity improvements.
Temporary protectionist measures combined with innovation policies to prepare industries for global competition.
This integrated approach reduces the likelihood of undermining broader macroeconomic stability.
Wider Global Implications
A major economy correcting its imbalances may affect global demand.
For example, if the UK reduces its imports, exporting nations experience lower demand, impacting their growth.
Similarly, widespread adoption of protectionism risks slowing globalisation and reducing world output efficiency.
Overall, policies to correct balance of payments deficits or surpluses must be carefully assessed for their interaction with macroeconomic objectives, ensuring that solutions to external imbalances do not compromise internal stability.
FAQ
When contractionary fiscal or monetary policies slow economic growth, tax revenues from income and consumption may fall. At the same time, welfare spending on unemployment benefits often rises.
This combination can increase the budget deficit and government borrowing, even though the original goal was external balance rather than fiscal stability.
Devaluation makes imports more expensive, leading to immediate cost-push inflation.
If businesses rely on imported raw materials or energy, higher costs may feed into wage demands and inflationary expectations. This persistence can make it difficult for policymakers to maintain low and stable inflation over time.
If households are optimistic about future income, they may continue spending despite contractionary policies.
Strong consumer confidence can reduce the effectiveness of demand cuts.
Conversely, low confidence can amplify policy effects, leading to a sharper fall in growth and employment than intended.
Tighter policies reduce domestic demand, discouraging firms from expanding production capacity.
Reduced profitability can also deter foreign investors. This fall in investment may damage long-term competitiveness, making it harder for the economy to achieve sustainable external balance.
Supply-side policies boost productivity, reduce costs, and make exports more competitive without causing inflationary pressure.
Improved infrastructure reduces transport costs.
Better education and training increase efficiency.
Innovation drives higher-value exports.
Unlike short-term demand measures, these changes help maintain both external balance and internal macroeconomic objectives.
Practice Questions
Explain what is meant by an expenditure-reducing policy in the context of correcting a balance of payments deficit. (2 marks)
1 mark for identifying that it reduces overall domestic spending/aggregate demand.
1 mark for linking this to a reduction in demand for imports, helping improve the balance of payments.
Analyse how the use of expenditure-switching policies might conflict with other macroeconomic policy objectives. (6 marks)
1–2 marks for identifying expenditure-switching policies (e.g. tariffs, quotas, exchange rate devaluation).
1–2 marks for explaining how these policies aim to improve the current account by shifting demand to domestic goods.
1–2 marks for analysis of conflicts with other objectives, such as:
Cost-push inflation due to higher import prices.
Risk of retaliation reducing exports and employment.
Potential slowdown in global trade affecting long-term growth.
Maximum 6 marks for clear, relevant, and developed explanation with examples of conflicts.
