Policy Measures To Counter Current Account Deficit

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Following policy measures should be taken by governments to reduce current account deficit

Devaluation

This entails lowering the currency’s value relative to other currencies. (Selling Rupee, for instance, would lower the value of the Rupee.)

  • There will be a decrease in the price of exports and an increase in export volume.
  • We would therefore anticipate a devaluation to result in an improvement in (X-M) and, consequently, the current account on the balance of payments, assuming demand is somewhat price elastic.
  • It does, however, rely on how elastic the demand is for imports and exports.

Deflationary policies

These are measures intended to slow the expansion of the overall demand and lower inflation. They may involve tightening monetary or fiscal policies, which will lower aggregate demand.

Monetary policy

In a tight monetary policy, interest rates rise.

  • Higher interest rates will make debt and mortgage repayments more expensive and reduce people’s disposable income. As a result, their consumption of imports will decline, helping the current account.
  • Additionally, rising interest rates will lower AD, which will slow off economic growth. This will lower inflation and improve the competitiveness of Pakistan exports.
  • Deflationary policies will also put pressure on manufacturers to cut costs, which will result in more competitive exports. Because of this effect, exports may eventually rise.

Analysis of monetary policy for current account reduction

As a result, monetary policy has two opposing outcomes.

  • Lower expenditure on imports results from higher interest rates, which helps the current account.
  • However, higher interest rates also lead to an increase in the value of the dollar, which worsens the current account.
  • Depending on whether effect is more significant, the overall effect is unknown.
  • It depends on a variety of other things. For instance, if the economy is booming, a hike in interest rates might not actually have an impact on consumer purchasing because income growth and consumer confidence are both high.

Deflationary fiscal policy

  • Fiscal policy can be used as a substitute for monetary policy. The government could, for instance, raise income taxes. As a result, spending on imports and consumer discretionary income would decline.
  • Fiscal policy has the advantage of not negatively affecting the exchange rate. Increased income tax revenue would also help the state’s budget.
  • However, this strategy will be at odds with other macroeconomic goals because decreased aggregate demand (AD) will probably cause GDP to slow down and higher unemployment. It is improbable that a government would risk increased unemployment in order to close a current account deficit.

Supply-side strategies

  • Supply-side strategies can boost the economy’s competitiveness and increase the allure of exports. This can strengthen the current account position, although results might not be seen for some time.
  • For instance, the profit motive in the private sector could contribute to boost the economy’s efficiency if the government adopted a policy of privatisation and deregulation. This improved effectiveness would result in cheaper manufacturing costs and higher exports.

Lower Pay

Many economies in the Eurozone who are running big current account deficits (but are unable to devalue under the single currency) employ the policy of wage reduction. Lower salaries will lower production costs and increase competitiveness.

  • Lower salaries, however, will also result in a decrease in overall demand, which could cause deflation and slow economic growth.
  • Government pay reductions may not have much of an impact on raising export competitiveness.
  • Internal devaluation is another name for wage reduction.

Protectionist policies

The government may set quotas or even raise import duties. Both of these actions would result in lower imports, which would enhance the current account.

However:

  • Protectionism might result in retaliation, when other nations impose tariffs on our goods, which would cause exports to decline.
  • Domestic industries that are protected by tariffs may lose their competitiveness because there are less incentives to reduce costs.

Additionally, policies to minimise a current account could be divided into two categories:

1. Policies for transferring expenses

  • This entails altering the products that customers purchase. For instance, devaluation raises the price of imports while making domestic goods relatively cheaper. As a result, customers will start purchasing native items instead of imports.
  • British goods are relatively more attractive as a result of supply-side policy.

2. Policies that reduce spending

  • Policies to lower import spending overall.
  • Tight monetary or fiscal policies may be necessary for this.

Originally published at https://www.shoaibkhan.com.pk.