Policies To Correct Imbalances on the Current Account (Cambridge (CIE) A Level Economics): Revision Note

Government policy objective of stability of the current account

• Current account stability refers to a government's objective of avoiding persistent and large imbalances - either deficits or surpluses - on the current account of the balance of payments

  • A persistent current account deficit is unsustainable in the long run as it requires continuous financing through the financial account - building up foreign liabilities and increasing future primary income outflows

  • A persistent current account surplus may attract international political pressure and reflect suppressed domestic consumption, reducing living standards below productive capacity

• Governments therefore aim for a broadly balanced current account over time rather than targeting an exact figure in any single period

Achieving current account stability may cause conflicts

• The objective of current account stability may conflict with other macroeconomic objectives

• Policies to reduce a deficit (e.g. deflating domestic demand) may increase unemployment and reduce growth

• Policies to stimulate growth may worsen the current account by increasing import demand

• Achieving current account stability while maintaining low inflation, full employment and growth simultaneously is rarely possible - policy trade-offs are inevitable

Effect of fiscal policies on the current account

• Contractionary fiscal policy (higher taxes, lower government spending) reduces domestic aggregate demand, lowering household incomes and reducing expenditure on imports

  • The current account deficit narrows as import spending falls

  • However, lower growth and higher unemployment are likely side effects - a significant policy trade-off

• Expansionary fiscal policy worsens the current account as rising incomes pull in more imports

• Fiscal policy works through the demand channel - it affects the current account indirectly by changing the level of domestic income rather than directly targeting trade competitiveness

Effect of monetary policies on the current account

• Higher interest rates attract hot money inflows from foreign investors seeking better returns, increasing demand for the domestic currency and causing an appreciation

  • Appreciation makes exports more expensive and imports cheaper, tending to worsen the trade balance

  • However, higher interest rates also reduce domestic consumption and investment, lowering import demand - a partially offsetting effect

• Lower interest rates cause depreciation of the exchange rate, making exports cheaper and imports dearer, tending to improve the trade balance

• The effectiveness of monetary policy on the current account depends critically on price elasticities of demand for exports and imports

Effect of supply-side policies on the current account

• Supply-side policies improve the current account by raising the productive efficiency and international competitiveness of domestic firms

• Improved competitiveness lowers unit costs, making exports more price competitive in world markets and reducing dependence on imports

• Examples include:

  • Investment in education and training - raises labour productivity, lowering unit labour costs

  • Research and development subsidies - encourages innovation, improving export quality and non-price competitiveness

  • Deregulation - reduces costs of production, improving efficiency

• Supply-side policies address the structural causes of a current account deficit rather than merely suppressing demand - they are therefore regarded as the most sustainable long-run solution

• The main limitation is that supply-side policies operate slowly - improvements in productivity and competitiveness take years to feed through into export performance

Effect of protectionist policies on the current account

• Tariffs raise the price of imports, reducing import volumes and narrowing the trade deficit directly

• Import quotas limit the volume of imports entering the country, directly reducing import expenditure

• Export subsidies lower the price of exports in foreign markets, boosting export demand and improving the trade balance

• Protectionist policies can improve the current account in the short run but carry significant risks:

  • Trading partners may retaliate with their own protectionist measures, reducing export demand and potentially worsening the current account

  • They reduce competitive pressure on domestic firms, allowing inefficiency to persist rather than addressing the underlying causes of the deficit

  • They may violate WTO rules, exposing the country to trade disputes and sanctions

  • Consumer welfare falls as import prices rise

Summary table of policy effects