Policies and the current account
Definition
Expenditure-switching policy: a policy that switches demand away from imports and towards domestic goods, for example a depreciation, tariffs or quotas.
Expenditure-reducing policy: a policy that lowers total demand so that spending on imports falls, for example contractionary fiscal or monetary policy.
- Four types of policy can influence the current account: fiscal, monetary, supply-side and protectionist policies.
- Expenditure-reducing policies work by lowering total demand so that spending on imports falls.
- Expenditure-switching policies work by making domestic goods more competitive or by restricting imports directly.
- Each policy has side effects on other objectives and works with a time lag, so it depends on the circumstances.
Key Idea
- An expenditure-reducing policy improves the current account by cutting spending on imports.
- An expenditure-switching policy improves it by making domestic goods more competitive against imports and abroad.
Fiscal policy
- Contractionary fiscal policy means higher taxes and/or lower government spending, an expenditure-reducing tool.
- This lowers households' disposable income and reduces aggregate demand.
- Weaker demand cuts spending on imports, improving the current account.
- Expansionary fiscal policy has the opposite effect and tends to worsen the current account.
Example
- Suppose the UK government raises income tax to cut a current account deficit.
- Higher tax reduces households' disposable income.
- Consumers spend less, including less on imported cars and electronics.
- Total import spending falls, so the current account deficit narrows.
- But lower demand also slows growth and can raise unemployment.
Monetary policy
- Higher interest rates reduce borrowing and spending, cutting demand for imports.
- Higher rates can also attract inflows of foreign capital seeking better returns.
- These inflows raise demand for the currency, causing it to appreciate.
- A stronger currency makes exports dearer and imports cheaper, which can worsen the current account.
- So the overall effect of higher interest rates on the current account is uncertain; it depends on which effect dominates.
Note
- Higher rates cut import demand but can strengthen the currency, so the two effects pull in opposite directions.
Supply-side policy
- Supply-side policies raise productivity, quality and international competitiveness, an expenditure-switching approach.
- Examples include investment in education and training, infrastructure and incentives to invest.
- More competitive firms sell more exports and win back demand from imports.
- This improves the current account in the long run.
- The effects are gradual and take several years to appear.
Example
- Suppose a government funds vocational training and better transport links.
- Over several years workers become more productive and unit costs fall.
- Domestic firms can offer better-quality goods at competitive prices.
- Exports rise and consumers switch from imports to domestic goods.
- The current account improves, though only slowly.
Protectionist policy
- Tariffs, quotas and subsidies to domestic producers reduce imports and/or boost exports, switching spending to domestic goods.
- This can improve the current account in the short run.
- However, trading partners may retaliate with their own trade barriers, cancelling the gain.
- Protection also raises domestic prices and shelters inefficient firms, causing welfare loss.
Which policy is most effective at correcting the account?
- All of these policies work with time lags before the current account responds.
- Their success depends on the price elasticity of demand for exports and imports: expenditure-switching tools such as a depreciation or tariffs only improve the balance much if demand is fairly elastic, otherwise quantities barely move.
- Retaliation can cancel out the gains from protectionist measures.
- Contractionary fiscal and monetary policy improve the current account only by sacrificing growth and employment.
- Supply-side policies avoid these conflicts but are slow and costly, so the best choice depends on the time horizon.
- On balance, no single policy is best. Expenditure-reducing policy acts fastest but sacrifices growth and jobs; a depreciation or protection can switch spending quickly but depend on elasticities and risk retaliation; supply-side policy is the only lasting cure but is slow and expensive. The right choice depends on the size and cause of the imbalance, the elasticities of trade and the time horizon.
Exam technique
- Name the policy and state clearly whether it improves or worsens the current account.
- Trace the chain from the policy through import or export spending to the current account.
- Classify each policy as expenditure-reducing or expenditure-switching, then add an evaluation point such as time lags, elasticities or retaliation.
Common Mistake
- Do not assume protection always improves the current account, because retaliation can offset it.
- Do not forget that expansionary policy tends to worsen the current account by raising import spending.
Self review
- Explain how contractionary fiscal policy, an expenditure-reducing tool, improves the current account.
- How can higher interest rates both help and harm the current account?
- Why do supply-side policies improve the current account only in the long run?
- Give two risks of using protectionist policy to improve the current account.
- Why might improving the current account conflict with other macroeconomic objectives?
