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.
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.
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.
Higher interest rates reduce aggregate demand in four
Discouraging borrowing by both households and companies
Increasing the rate of saving (the opportunity cost of spending
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.
Higher direct taxes (causing a fall in disposable income)
Lower Government spending
A reduction in the amount the government sector borrows each
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
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