Current Account Deficit- Expenditure Reducing and Expenditure Switching Policies Flashcards
(27 cards)
What are expenditure-reducing policies?
Policies that aim to reduce overall domestic spending, including on imports, to improve the current account balance.
Examples of expenditure-reducing policies?
Contractionary monetary policy (e.g. raising interest rates)
Contractionary fiscal policy (e.g. cutting government spending or raising taxes)
What are the drawbacks of expenditure-reducing policies?
Lower economic growth
Higher unemployment
Risk of recession
Inflation may fall below target
May reduce consumer and business confidence
Why might expenditure-reducing policies be ineffective?
If confidence remains high, AD might not fall
If the marginal propensity to import (MPM) is low, lower income might not reduce imports enough
If the economy is already at full employment, AD may just shift without reducing incomes
What are expenditure-switching policies?
Policies that aim to encourage consumers to buy domestic goods instead of imports, improving the trade balance.
Examples of expenditure-switching policies?
Currency depreciation (makes exports cheaper and imports more expensive)
Protectionist measures (tariffs, quotas, subsidies to domestic firms)
Trade deals that boost exports
What are the risks of protectionism as an expenditure-switching policy?
Risk of retaliation from other countries
May reduce consumer choice
Can lead to inefficiency and higher prices
When are expenditure-switching policies most effective?
When demand for imports and exports is price elastic
When domestic firms can scale up to meet increased demand
Over the long term (Marshall-Lerner condition & J-curve apply)
What is the Marshall-Lerner condition?
A depreciation will improve the current account only if the sum of the price elasticities of exports and imports is greater than 1.
What is a key risk of using tariffs and protectionism?
Retaliation – other countries may impose their own tariffs, reducing your exports and worsening global trade.
Why might tariffs breach international rules?
Protectionist policies often violate WTO rules, leading to legal disputes and possible trade sanctions.
How can protectionism cause inflation?
Tariffs and quotas raise the cost of imports, leading to cost-push inflation, especially if firms rely on imported raw materials.
What is the impact of protectionism on consumers?
Higher prices
Reduced choice
Possible decline in product quality
Risk of inefficient domestic producers being protected
How can a weaker exchange rate act as an expenditure-switching policy?
By making exports cheaper and imports more expensive, encouraging domestic consumption and improving the trade balance.
What does the Marshall-Lerner Condition state?
A depreciation improves the current account only if the sum of the price elasticities of demand for exports and imports is greater than 1.
What happens if the Marshall-Lerner Condition is not met?
A weaker exchange rate may worsen the current account deficit in the short run, especially if demand is price inelastic.
What is a risk of using exchange rates to fix trade deficits?
Currency wars – other countries may devalue their currencies in response, cancelling out any competitive advantage.
How can currency depreciation lead to inflation?
Cost-push inflation from higher import prices
Demand-pull inflation if export demand rises too fast
Shifts in SRAS to the left due to increased production costs
How can supply-side policies help reduce a current account deficit?
By improving international competitiveness, such as increasing productivity, reducing unit costs, and boosting export performance.
Examples of supply-side policies to improve trade balance?
Investment in education and skills
Infrastructure improvements
R&D subsidies
Labour market flexibility
Lower corporation tax to incentivise exports
What are the limitations of supply-side policies?
Take a long time to have an effect
Can be very expensive
No guarantee of success
Require precise targeting to specific competitiveness weaknesses
What is a major opportunity cost of supply-side policies?
Funds used for long-term structural reforms could be spent on immediate priorities (e.g. healthcare, education, or poverty reduction).
Why is the cause of the current account deficit important?
Policies must be matched to the cause:
If due to low competitiveness, use supply-side or switching
If due to high consumption, use expenditure-reducing policies
What trade-offs exist when reducing a CAD?
Improving trade may come at the cost of:
Lower growth
Higher unemployment
Potential recession
Risk of stagflation
