Question

10. What are the differences between expenditure switching policies and expenditure reducing policies?

Answer 1

In every economy, policymakers aim to achieve two types of macroeconomic stability. One is the internal balance and the other external balance.

Internal balance means the economy is at its potential level of output, where there is a full employment of the country's resources and the economy's internal, domestic price levels are stable. External balance is the state when the economy has neither an excessive current account deficit nor surplus.

Achieving both these balances require two sets of macroeconomic policy tools - Expenditure Switching Policies and Expenditure Reducing Policies.

Expenditure Switching Policies - These are policies undertaken by a government to reduce the economy's demand for foreign goods and services, in order to reduce current account deficit. One way is to increase trade barriers - tariffs, quotas etc - to induce domestic consumers to switch their expenditure from imported goods and services to domestically produced goods and services. An increase in trade barriers will increase the price of imported goods, making them costlier than domestic goods and services. Thereby, inducing consumers to shift their spending on domestic goods and services.

The other measure the government can take for expenditure switching is devaluation of the exchange rate. By artificially reducing the value of the currency vis-a-vis other currencies, the government ensures that the price of exports is higher than domestic goods and services.

Expenditure Reducing Policies - Unlike Expenditure Switching Policies, Expenditure Reducing Policies are used by the government to reduce the domestic consumers' demand for goods and services in general.This is done to reduce consumer spending. The government could raise taxes or lower public spending or raise interest rates. The problem is this could trigger a recession in the economy.

Governments need to use a combination of Expenditure Switching Policies and Expenditure Reducing Policies by raising taxes (slightly though!) to reduce domestic spending in general along with slight devaluation to reduce the demand for imports, thereby correcting the economy's current account deficit.