Policies to correct imbalances in the current account of the balance of payments

Economics AS · International economic issues. The idea in plain words, the rules to remember, the mistake to avoid and a worked example, written and checked by Mega Lecture.

Test this topic free All Economics AS topics

The idea

Governments want a stable current account: no large and persistent deficit or surplus. A lasting deficit must be paid for by borrowing from abroad or selling assets. A lasting surplus may mean living standards are lower than they could be and may bring trade disputes.

To reduce a deficit, contractionary fiscal or monetary policy cuts total spending, so people buy fewer imports. This is expenditure-reducing, and its cost is lower output and higher unemployment. Protectionist measures such as tariffs make imports dearer so buyers move to home goods. This is expenditure-switching, and its risk is retaliation.

Supply-side policy raises productivity and quality, so exports become more competitive. It deals with the cause but works slowly.

Rules to remember

Stability of the current account = avoiding large, persistent deficits or surpluses.
Contractionary fiscal policy (higher taxes, lower spending): incomes fall, spending on imports falls, deficit narrows.
Contractionary monetary policy (higher interest rates): spending on imports falls, but the currency may appreciate and make exports less competitive.
Protectionist policy (tariffs, quotas): switches spending from imports to home goods; risk of retaliation and higher prices.
Supply-side policy: lower costs and better quality raise exports and replace imports in the long run.
To reduce a surplus, use the opposite: expansionary fiscal or monetary policy or lower trade barriers.

Common mistake

Students forget the side effects. Higher interest rates reduce import spending but can also raise the exchange rate, which hurts exports, and cutting demand to fix a deficit raises unemployment.

Worked example

A country has a current account deficit. To win support, its government cuts income tax sharply. What is the most likely effect on the current account?

A cut in income tax is expansionary fiscal policy: households keep more disposable income.
Consumer spending rises, and part of the extra spending goes on imported goods and services.
Imports rise while exports are not directly changed.
Debits on the current account grow faster than credits.

Answer: The current account deficit is likely to widen.

Ask about this

Type what you are stuck on. The helper finds the explanation, worked examples and the notes to read, free and instant.

Read the full notes

Keep going

← Exchange rates Take a Economics AS test