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Current Account of the Balance of Payments » Policies for Balance of Payments Stability

What you'll learn this session

Study time: 30 minutes

Cambridge spec: 6.4.4

The range of policies a government can use to improve the balance of payments
How effective each policy is likely to be
The side effects each policy can have on other macroeconomic aims

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Why governments act on the balance of payments

One of the government's macroeconomic aims is balance of payments stability. In practice, this mostly means avoiding a large current account deficit that goes on year after year. A persistent deficit can pull down GDP and employment and put downward pressure on the exchange rate, as you saw in Current Account Deficits and Surpluses.

To cut a deficit, a government has to do one of two things: reduce spending on imports, or raise sales of exports. The policies below all try to do one or both. You already know how each measure works from earlier lessons, so here the key question is: how well does it work, and what else does it damage?

Fiscal and monetary policy

Contractionary fiscal policy (higher taxes or lower government spending) and contractionary monetary policy (higher interest rates, a smaller money supply) both reduce spending in the economy. Households have less to spend, and some of that lost spending would have gone on imports. So imports fall and the deficit shrinks.

✅ How effective?

Quite effective at cutting imports, although there is a time lag, especially if households buy many imported goods. But the policy does not make exports any higher. It only cuts spending.

⚠️ Side effects

Spending on home-made goods falls too. This slows economic growth and may raise unemployment. Higher taxes or interest rates are unpopular, and there is a time lag before the effect is felt.

There is one more problem with higher interest rates. They can make the country's currency more attractive to foreign savers, which may push the exchange rate up. A higher exchange rate makes exports dearer and imports cheaper, which works against the aim of cutting the deficit.

Exchange rate changes

A lower exchange rate makes exports cheaper for foreign buyers and imports dearer for home buyers. Governments and central banks can try to lower their currency's value, for example by cutting interest rates or by selling their own currency on the foreign exchange market.

💲 How effective?

It depends on price elasticity of demand. If demand for exports and imports is elastic, cheaper exports and dearer imports change the quantities bought a lot, and the deficit falls. If demand is inelastic, buyers hardly change what they buy, so the deficit may not improve.

⚠️ Side effects

Imported fuel, food and materials cost more, which can cause cost-push inflation. Households can afford fewer imports, so their living standards may fall.

Supply-side policies to raise competitiveness

Supply-side policies such as training, new infrastructure and support for research aim to raise productivity and quality. If goods are better and cheaper to make, more foreign buyers choose them, and home buyers choose them over imports. Exports rise and imports fall.

🏆 How effective?

Very effective in the long run, because it tackles the real cause of the deficit: poor competitiveness. It can also raise growth and cut unemployment, so it helps other aims at the same time.

⚠️ Side effects

It is slow. Training and building take years to pay off. It costs the government money, which may increase the budget deficit. If the money is wasted or badly aimed, nothing improves.

Trade restrictions

Tariffs, import quotas and other restrictions make imports dearer or limit how many can be bought. Home buyers switch to home-made goods, so imports fall and the deficit shrinks.

🛡️ How effective?

Quick, and it directly cuts imports. But other countries may retaliate with their own restrictions, which cuts exports and may cancel the gain.

⚠️ Side effects

Consumers pay higher prices and have less choice. Home firms facing less competition may become less efficient. Firms that use imported materials face higher costs, which can lead to inflation.

Comparing the policies

Policy	Speed	Main strength	Main weakness
Fiscal and monetary	Medium	Cuts import spending	Slows growth, may raise unemployment
Exchange rate change	Medium	Helps exports and imports together	Depends on elasticity, imported inflation
Supply-side	Slow	Fixes the cause, helps other aims	Slow and costly
Trade restrictions	Fast	Direct cut in imports	Retaliation, higher prices

No single policy is perfect. Governments often use a mix, and they must weigh the benefit to the balance of payments against the harm to growth, jobs and prices. This is why aims can conflict.

Worked example

Estravia imports $40bn of goods and exports $34bn, so its deficit is $6bn (assume the rest of its current account is zero). The government raises income tax. Households have less disposable income, and spending on imports falls by 5%.

5% of $40bn = $2bn. New imports = $40bn - $2bn = $38bn. New deficit = $38bn - $34bn = $4bn.

The deficit has fallen from $6bn to $4bn. But households also buy fewer Estravian goods, so total demand falls. This may slow growth and raise unemployment, so the policy has a side effect on other aims.

Common mistakes

Students often list the policies but never say how effective they are or what they harm. Another mistake is to say that trade restrictions always work: if other countries retaliate, exports fall and the deficit may not shrink. Also, do not say a lower exchange rate always cuts the deficit. It depends on elasticity.

Exam-style question

Quorland has had a current account deficit for five years. Its imports of cars and electronics have grown fast, and its exports are mostly low-value raw materials. The government is considering a 20% tariff on imported cars and electronics, or a large programme of training and new factories.

(a) Identify two policies Quorland's government could use to reduce its current account deficit. [2 marks]

(b) Explain how a tariff on imported cars and electronics could reduce the deficit, and one reason it might not work. [4 marks]

Model answer

(a) A tariff on imports, or another trade restriction (1). A supply-side policy such as training to raise competitiveness (1). Contractionary fiscal policy or a lower exchange rate would also be accepted.
(b) A tariff makes imported cars and electronics dearer (1). Home buyers switch to cheaper home-made goods, or buy fewer (1), so spending on imports falls and the deficit falls (1). It might not work because other countries may retaliate with their own tariffs, which would cut Quorland's exports (1).
(c) Supply-side policy such as training and new factories raises productivity and quality (1). Quorland's goods become more competitive, so exports of higher-value goods may rise and imports may fall (1). It also helps growth and jobs, so it supports other aims (1). However, it is slow because training and building take years (1), and it costs the government a lot of money, which may add to its budget deficit (1). Overall, it is likely to be effective in the long run because it tackles the cause, but it cannot fix the deficit quickly, so a quicker measure may also be needed (1).

Exam tip

In part (c), "Discuss" needs two sides. Give how supply-side policy helps, then at least one weakness such as time or cost, then a short conclusion that says how effective it is.

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