Question

Elaborate on the policies the government should implement to improve a secular current account deficit

Answer 1

A current account deficit occurs when the value of imports of good & services is greater than the value of exports.

Policies government should implement to improve are:

These policies are common that every government should implement,

1. Devaluation of exchange rate ( make exports cheaper and imports more expensive)

2. Reduce domestic consumption and spending on imports

3. Supply side policies to improve the competitiveness of domestic industry and exports.

Explanation :

1. Devaluation:  

This involves reducing the value of the currency against others. (e.g. selling pounds would cause the value of the Pound to fall)

• If there is a devaluation of the currency, the price of imported goods increases and therefore the quantity demanded of imports falls.
• Exports will become cheaper, and there will be an increase in the quantity of exports.
• Therefore, assuming demand is relatively price elastic, we would expect a devaluation to lead to an improvement in (X-M) and therefore the current account on the balance of payments.
• However, it does depend upon the elasticity of demand for exports and imports.

The Marshall Learner Condition:

This states that a devaluation will improve the balance on the current account, on the condition that the combined elasticity’s of demand for imports and exports is greater than one.

• If (PED x + PED m > 1) then a devaluation will improve the current account.
• If (PED x + PED m > 1) then an appreciation will worsen the current account.

• In the short term, demand for imports and exports tends to be inelastic. Therefore, after a devaluation, the current account tends to get worse before it gets better. However, over time, demand becomes more price elastic and the current account improves.
• Another problem with devaluation is that it can lead to imported inflation. Basically, imports will be more expensive. Higher inflation can reduce the countries competitiveness. Therefore the improvement in the current account might only be temporary.

2. Deflationary policy :

Monetary policy :

• Higher interest rates will increase the cost of debt and mortgage repayments and leave people with less money to spend. Therefore, this will reduce their consumption of imports, improving the current account.
• Deflationary policies will also put pressure on manufacturers to reduce costs, and this will lead to more competitive exports, and so exports may increase in the long run because of this effect.

3. Supply side policy :

• Supply side policies can improve the competitiveness of the economy and help make exports more attractive. This can improve the current account position, but it may take considerable time to have an effect.
• For example, if the government pursued a policy of privatization and deregulation it may help to increase the efficiency of the economy because of the profit motive in the private sector. This increased efficiency would translate into lower costs of production and more exports