Question

4. How to use the three monetary policies and the three fiscal policies to reduce BOP deficit? Please explain how each policy works, i.e., how economic entities react to the policy changes so that the deficit will be reduced.

Answer 1

A BOP deficit arises when the value of the imports (of revenue from goods / services / inv.) exceeds the value of the exports. Current account deficit reduction policies involve: exchange rate devaluation (making exports cheaper – imports more expensive) Reducing domestic demand and import spending (e.g. tight fiscal policy / higher taxes) Supply side policies to boost domestic production and exports competitiveness.

Monetary policy The tight monetary policy means higher interest rates.

Higher interest rates would boost debt and mortgage servicing costs, and allow people to spend less money. This would also reduce their import intake, thereby boosting the current account.

In addition, higher interest rates would lead to a decrease in AD and thus a decline in economic growth. This would reduce inflation and lead to greater competitiveness exports.

Deflationary policies would also put pressure on producers to cut prices, leading to more competitive exports, and because of this impact, exports may increase over the long term.

Taking fiscal policy as an alternative to using monetary policy is.

The government could increase revenue tax, for example. That would reduce disposable income for consumers and reduce import expenditure.

Fiscal policy has the advantage that it does not negatively impact the exchange rate. Higher income tax will also boost public finances.

This strategy, however, would clash with other macroeconomic priorities – with lower aggregate demand (AD), growth is likely to decline causing higher unemployment. It is doubtful that a government will want to face higher unemployment only to reduce a current account deficit.