Balance of Payments 2
Economics: IB Diploma, topic 3.3.2
Policies to Reduce a Current Account Deficit
Policies to solve a current account deficit can be broadly split into two types of policies: expenditure-switching and expenditure-reducing.
Expenditure-switching
- Expenditure switching policies aim to influence the relative prices of exports and imports - to switch expenditure away from imports and towards domestic consumption / exports.
- Expenditure-switching policies could include tariffs, supply side policies and exchange rate manipulation.
- Supply side policies could be used to boost international competitiveness of exports and so improve the current account deficit - either by improving the quality or the price of exports.
Expenditure-reducing
- Expenditure reducing policies aim to control aggregate demand (AD) and limit spending on imports.
- Expenditure reducing policies would be contractionary monetary and fiscal policies, which would serve to reduce AD, and so real GDP and incomes.
- This means the marginal propensity to import and current account deficit will fall.
Expenditure-reducing cont.
- The consequences for the wider economy are that the economy’s real GDP will fall. Fiscal policy, like increasing income taxes, would reduce disposable income and cause unemployment.
Foreign Direct Investment
To balance a current account deficit, we need a financial account surplus. This is primarily achieved by attracting FDI. The consequences of FDI flows can be positive or negative.
Benefits of FDI
- Shifting the LRAS of an economy outwards.
- Creates employment.
- A rise in the stock of capital.
- Contributes to aggregate demand (AD) and so real GDP (multiplier effects).
- Regional economic impact, especially in areas of lower employment.
- Positive effects on productivity.
- Funds to contribute to growth (especially if domestic credit is lacking).
- Competition for domestic businesses.
- Inward investment by foreign manufacturing firms can cause a rise in exports.
Dangers of FDI
- Research and development (high-value added) activities remaining in the “home” country.
- Long-term repatriation of profits.
- Strategic assets owned by foreign companies.
- The economy becoming increasingly dependent on external firms.
- Race to the bottom by governments to attract FDI (e.g. tax and regulations compromised).
Test yourself on Balance of Payments 2
Which of the following is an expenditure-switching policy?
Which of the following is an expenditure-reducing policy?
Which of the following are expenditure reducing policies?
Which of the following are benefits of FDI?