There are a number of policy options available to reduce a balance of payments deficit.

Exchange Rate Adjustment

Devaluation results in expenditure switching.  Foreigners buy more of our exports and less of their own and other countries’ production, whilst domestic producers buy fewer imports and more domestically produced goods. 

The extent to which exchange rates affect exports and imports will depend upon the elasticity of demand for the products and the nature of the contracts that have been agreed. 

After a depreciation of the pound demand for exports will grow faster if the demand for UK goods overseas is elastic.

After a depreciation it may not be possible to switch away from imports as they maybe part of a long term contract, essential for production or cannot be made in the UK and have an inelastic demand.  Then we end up spending more when the exchange rate falls in value causing the balance of payments to worsen in the short run a process known as the J curve effect. 

Assuming that the economy begins at position A with a substantial current account deficit and there is then a fall in the value of the exchange rate. Initially the volume of imports will remain steady partly because contracts for imported goods will have been signed.

However, the depreciation raises the sterling price of imports causing total spending on imports to rise. Export demand will also be inelastic in response to the exchange rate change in the short term, therefore the earnings from exports may be insufficient to compensate for higher spending on imports. The current account deficit may worsen for some months. This is shown by the movement from A to B on the diagram.

Providing that the elasticities of demand for imports and exports are greater than one, in the longer term then the trade balance will improve over time. This is known as the Marshall-Lerner condition.  In the diagram, as demand for exports picks up and domestic consumers switch their spending away from imported goods and services, the overall balance of payments starts to improve. This is shown by the movement A to C on the diagram.

Demand Management

This is an expenditure reducing policy as aggregate demand falls causing fewer imports to be demanded.  This is very effective in the UK as we have a very high marginal propensity to import.  This can be carried out using either monetary or fiscal policies.

Monetary policy

Higher interest rates reduce aggregate demand in four ways;

·        Discouraging borrowing by both households and companies

·        Increasing the rate of saving (the opportunity cost of spending has increased)

·        The rise in mortgage interest payments will reduce homeowners' real 'effective' disposable income and their ability to spend. Increased mortgage costs will also reduce market demand in the housing market

·        Business investment may also fall, as the cost of borrowing funds will increase. Some planned investment projects will now become unprofitable and, as a result, aggregate demand will fall.

These policies will reduce the demand for imports by households and firms in the UK.

FISCAL POLICY

·        Higher direct taxes (causing a fall in disposable income)

·        Lower Government spending

·        A reduction in the amount the government sector borrows each year (PSNCR)

These fiscal policies increase the rate of leakages from the circular flow and reduce injections into the circular flow of income and will reduce demand for imports.

Supply Side Policies

These should lead to increased exports and reduced imports as the quality of UK goods improve whilst they decrease in cost.  Examples of supply side policies are:

·        changes in size & quality of the labour force available for production

·        changes in size & quality of capital stock through investment

·        technological progress and the impact of innovation

·        changes in factor productivity of both labour and capital

·        changes in unit wage costs (wage costs per unit of output)

·        changes in producer taxes and subsidies

·        changes in inflation expectations - a rise in inflation expectations is likely to boost wage levels and cause AS to shift inwards