Evaluate 3 policies to correct a current account deficit (25)
Current account deficit is when the value of exports of goods and services exceed the value
of imports of goods and services. There are many reasons to it, it can be due to demand side
problems such as lack of comparative advantage of the country, or supply side problems like
lack of investment in capital goods which leads to lower rate of productivity compared to
rate of increase in aggregate demand. In order to correct the current account deficit, there
are many different approaches.
Firstly, government can switch domestic consumers’ expenditure from imports to local
goods by internal devaluation, which is a policy used by a country to gain competitiveness
through decreasing wages thus cost of production and prices of goods, without altering the
exchange rate. This is proven to be useful by Latvia in 2007, where its GDP growth was
resulted. However, it may only work because there are plenty of domestic goods that can
replace imports, if the PEDs of imports are inelastic, then this policy wouldn’t have worked.
Some argue that external devaluation may be a better policy as it directly improves the
country’s competitiveness by making price of imports more expensive and exports cheaper,
but it is difficult for the government to affect exchange rate, and increase price of imports
may lead to cost-push inflation of domestic goods if raw materials and capital goods are
being imported.
The country can also improve its non-price competitiveness by improving its productivity,
quality of goods and services. Especially in lower income countries, where lack of capital
machinery and skills are the main reasons for their low export revenue. By attracting FDI,
transfer of skills, higher employment, better training and education may be brought about
by MNCs, therefore without the need of increasing government spending, productivity and
quality of goods and services can be improved, thus improving the countries’ export
revenue and reduces its need to import, correcting the current account deficit. However, to
have these positive results, the FDI must be an investment that create new capacity in local
economy such as Nike in Vietnam. If it simply buys up existing assets like the privatization of
copper mine in Zambia, then it would only have a short-term benefit, and a long-term
opportunity cost will be resulted.
Lastly, some countries may also introduce protectionism to reduce imports and increase
demand of domestic goods. For example, the EU was accused of giving $22bn in state aid to
Airbus to help launch its A380 and A350 jets, causing losses to US rival Boeing. This is a form
of subsidy given by the government to boost supply and demand by lowering the firm’s cost
of production and thus the price of goods and services. This can be shown by the graph
below, both consumer and producer surplus, output of the firm and employment can be
increased. However, this would result in higher government spending and a net welfare loss
as the price of goods are sold at a price lower than it should be in a free market. More
importantly, firms will become more reliant on subsidies, and subsidies are banned by WTO,
therefore it’s illegal to be used.
There are many different approaches to correct current account deficit, in order to apply the
most effective one, the country should first find out the reason for the deficit, then choose
Current account deficit is when the value of exports of goods and services exceed the value
of imports of goods and services. There are many reasons to it, it can be due to demand side
problems such as lack of comparative advantage of the country, or supply side problems like
lack of investment in capital goods which leads to lower rate of productivity compared to
rate of increase in aggregate demand. In order to correct the current account deficit, there
are many different approaches.
Firstly, government can switch domestic consumers’ expenditure from imports to local
goods by internal devaluation, which is a policy used by a country to gain competitiveness
through decreasing wages thus cost of production and prices of goods, without altering the
exchange rate. This is proven to be useful by Latvia in 2007, where its GDP growth was
resulted. However, it may only work because there are plenty of domestic goods that can
replace imports, if the PEDs of imports are inelastic, then this policy wouldn’t have worked.
Some argue that external devaluation may be a better policy as it directly improves the
country’s competitiveness by making price of imports more expensive and exports cheaper,
but it is difficult for the government to affect exchange rate, and increase price of imports
may lead to cost-push inflation of domestic goods if raw materials and capital goods are
being imported.
The country can also improve its non-price competitiveness by improving its productivity,
quality of goods and services. Especially in lower income countries, where lack of capital
machinery and skills are the main reasons for their low export revenue. By attracting FDI,
transfer of skills, higher employment, better training and education may be brought about
by MNCs, therefore without the need of increasing government spending, productivity and
quality of goods and services can be improved, thus improving the countries’ export
revenue and reduces its need to import, correcting the current account deficit. However, to
have these positive results, the FDI must be an investment that create new capacity in local
economy such as Nike in Vietnam. If it simply buys up existing assets like the privatization of
copper mine in Zambia, then it would only have a short-term benefit, and a long-term
opportunity cost will be resulted.
Lastly, some countries may also introduce protectionism to reduce imports and increase
demand of domestic goods. For example, the EU was accused of giving $22bn in state aid to
Airbus to help launch its A380 and A350 jets, causing losses to US rival Boeing. This is a form
of subsidy given by the government to boost supply and demand by lowering the firm’s cost
of production and thus the price of goods and services. This can be shown by the graph
below, both consumer and producer surplus, output of the firm and employment can be
increased. However, this would result in higher government spending and a net welfare loss
as the price of goods are sold at a price lower than it should be in a free market. More
importantly, firms will become more reliant on subsidies, and subsidies are banned by WTO,
therefore it’s illegal to be used.
There are many different approaches to correct current account deficit, in order to apply the
most effective one, the country should first find out the reason for the deficit, then choose
