Switching versus reducing
Definition
Expenditure-switching policy: a policy that redirects spending from imports towards domestically produced goods, for example a devaluation or a tariff.
Expenditure-reducing policy: a policy that lowers total demand in the economy, cutting spending on imports along with everything else.
- A government can act to correct a current account deficit or surplus.
- Expenditure-switching policies shift demand from foreign goods towards domestic goods.
- Expenditure-reducing policies cut total demand and so cut spending on imports.
- Supply-side measures improve competitiveness over the longer term.
Key Idea
- Expenditure-switching moves spending towards home-produced goods.
- Expenditure-reducing lowers total demand, cutting spending on imports.
- Each carries costs for other macroeconomic objectives.
Expenditure-switching policies
- A devaluation or depreciation makes exports cheaper abroad and imports dearer, so buyers switch towards domestic goods.
- Tariffs, quotas and other trade barriers raise the price or limit the volume of imports, switching demand to domestic goods.
- Both routes aim to raise net exports and improve the current account.
- But dearer imports can raise inflation, and trade barriers can invite retaliation.
- How well a devaluation switches spending depends on price elasticities: it improves the current account only if the Marshall-Lerner condition holds, so the combined price elasticity of demand for exports and imports exceeds 1, and even then the J-curve delays the gain for several months while volumes adjust.
Example
- A weaker currency can switch spending towards domestically made goods.
- But dearer imported raw materials and goods can add to inflation.
- Trade partners may retaliate against tariffs, which can cancel out the gain.
Expenditure-reducing policies
- Tighter fiscal or monetary policy cuts aggregate demand.
- Lower demand pulls in fewer imports, so the deficit narrows.
- The size of the fall in imports depends on the marginal propensity to import.
- But output and employment fall too, so the correction has a real cost.
Note
- Higher interest rates cut demand and so imports.
- But they also slow growth and raise unemployment.
- So deflating demand to fix a deficit has a real cost.
Example
- A contractionary policy cuts aggregate demand by £50bn and the marginal propensity to import is 0.2.
- Fall in imports = £50bn × 0.2 = £10bn
- Imports fall by £10bn, narrowing the deficit, but the £50bn drop in demand also lowers output and jobs.
Do the policies work
- In favour, these policies can narrow a deficit and support competitiveness.
- Against, deflation costs output and jobs, while switching can raise inflation and provoke retaliation.
- Supply-side gains are the least damaging but take time to appear.
- On balance, correcting an imbalance trades off against growth, jobs and inflation, so the best mix depends on the cause of the deficit and the state of the economy.
Exam technique
- Distinguish expenditure-switching from expenditure-reducing policies clearly.
- Note the effect on growth, employment and inflation, not just the current account.
- Reach a supported judgement that fits the cause of the imbalance.
Common Mistake
- Do not confuse switching (moves spending towards domestic goods) with reducing (cuts total demand).
- Do not recommend deflation without noting its cost in lost output and jobs.
Self review
- What is an expenditure-switching policy?
- What is an expenditure-reducing policy?
- How does a depreciation help the current account, and on what condition?
- What is the cost of deflating demand, and how does the marginal propensity to import matter?
- How do supply-side measures help correct a deficit?
