What this lesson teaches
I can describe the policies that stabilise the balance of payments and judge how well they work.
Syllabus K343, 6.4.4. Policies to achieve balance of payments stability: the range of policies available to achieve balance of payments stability and their effectiveness
Make a guess
A country wants to cut its current account deficit for the long term without upsetting its trading partners. What fits best?
- Put high tariffs on imports so people buy local goods.
- Raise productivity so its exports compete better.
- Raise taxes to cut spending, including spending on imports.
Show the answer
Raise productivity so its exports compete better.
Supply-side policies make firms better and cheaper, so exports grow. They are slow but lasting, and do not invite retaliation.
A government can reduce a current account deficit by lowering the exchange rate, cutting spending on imports, raising competitiveness or using protection.
Exchange rate: a lower exchange rate makes exports cheaper and imports dearer. Exports rise and imports fall, so the deficit narrows. But dearer imports can push up prices.
Fiscal and monetary policy: higher taxes, less government spending or higher interest rates cut total spending, including spending on imports. But they also slow growth and can cost jobs.
Supply-side policy: training, new machines and better technology help firms make better goods at lower cost, so exports sell better. This lasts longest, but it takes years.
Protection: tariffs and quotas cut imports. But they raise prices, other countries may hit back, and local firms do not get any better. To reduce a surplus, the same tools can be used the other way round.
- Exchange rate
- Lower rate: exports cheaper, imports dearer; risks inflation.
- Fiscal / monetary
- Reduce spending on imports; slows growth.
- Supply-side
- Raise competitiveness; slow but lasting.
- Protection
- Cuts imports; higher prices and retaliation.
Worked example: Choosing a policy for a deficit
A country has a large, lasting current account deficit because its exports are uncompetitive.
- Quick fix: allow the currency to depreciate, making exports cheaper.
- Risk: imported food and fuel become dearer, raising inflation.
- Lasting fix: supply-side policies to raise productivity and quality.
- Avoid relying on tariffs: they may lead trading partners to retaliate.
Watch out for this
Cutting imports is the only way to reduce a current account deficit.
Raising exports, through a lower exchange rate or more competitive firms, can also reduce the deficit, and is usually less harmful.
Check your understanding
A country with a deficit chooses retraining and research grants to make its exports more competitive. What is the main drawback of this approach?
- It provokes partners into raising tariffs.
- It takes years before exports gain from it.
- It cuts spending and raises unemployment at once.
Show the answer
It takes years before exports gain from it.
Right. Skills and research raise productivity slowly, so the deficit shrinks only in the long run.
Check your understanding
Which policy aims to reduce a current account deficit by raising the competitiveness of exports?
- Subsidising training to raise workers' productivity
- Cutting income tax to raise household spending
- Raising interest rates to attract foreign savings
- Allowing the currency to appreciate
Show the answer
Subsidising training to raise workers' productivity
Right. Higher productivity lowers costs, so exports can be sold at lower prices.