Evaluate measures that could be pursued by individual firms and by the government to reduce a current account deficit (30)

The current account on the balance of payments measures the inflow and outflow of goods, services, investment incomes and net transfers. A deficit on the current account means that the value of imports is greater than the value of exports.

One measure the government could implement to help close this deficit is through supply side policies. If one of the major factors of a current account deficit is that the country is running a trade deficit, then in order to make consumers choose local goods over imports, there needs to be incentives for firms to compete with their global rivals. This can be done through the government creating subsidies/tax breaks for local firms in industries that the country may import a lot of. Subsidies and tax breaks would could the production costs for local firms, shifting LRAS out to the right - this increases the productive potential the country has. Furthermore if these subsidies were to be put forward for use in R&D to create better quality goods, then the likelihood would be that consumers would begin to start to choose local produced goods over imports. This would help to reduce the current account deficit, as the country would either have closed down on its trade deficit, or may even be running a trade surplus.

However the extent to how much this impacts the overall trade balance, and so the current account, depends on the elasticity of demand for imports for the citizens of that country. Many consumers may just prefer specific goods that are only produced abroad, I.e. exotic foods or electronic goods. Furthermore countries that have a large dependency on importing oil for power and production wouldn't be able to start up their own oilrigs without actual natural resources to extract. Therefore no matter how hard the government tries to encourage consumers to buy locally or for firms to increase production, they current account will always be burdened imports of commodities such as oil.

Another measure the government could take to improve its current account deficit is to devalue its currency. In countries where fixed exchange rates still exist such as China, devaluation of the currency can be done by the central bank printing more money and pumping it into the economy. The effect this has, is that it reduces the value of their currency against others. This means the price of importing goods increases and therefore the quantity demanded of imports falls. Also exports will be become cheaper and there will be an increase in the quantity of exports. Therefore a devaluation to lead to an improvement in X-M and will help close the current account deficit.

However in the short term, demand for imports and exports tends to be inelastic. This is due to contracts that between firms and importers/exporters lasting for several months/several years. So straight after devaluation, the current account may get worse before it gets better. Furthermore the extent to which devaluation will have an effect on the country’s current account will depend on the state of the global economy. If for example the global economy is in recession, then a devaluation of the currency will not be enough to boost exports. On the other hand if growth is strong, then there will be a greater increase in demand, which would help decrease the current account deficit.

A third measure the government could use to reduce a current account deficit is to raise interest rates. Higher interest rates firstly raise the cost of debt and mortgage repayments for consumers, which leaves them with less disposable income to spend. This reduces their consumption of imports and this improves the current account deficit. Furthermore high interest rates encourage saving and less spending into the economy, this causes a fall in AD as consumption falls. The deflationary affect cause by the fall in AD makes the country’s exports more competitive and therefore this also contributes to closing the current account deficit.

However in evaluation, there is a major downside to increasing interest rates as a means of trying to reduce a current account deficit. High interest rates encourage hot money flows into the country. This results in an appreciation of the exchange rate, which offsets the deflationary effect, it makes exports more expensive. Furthermore as the currency has appreciated, imports also become cheaper. This means the current account is more likely to worsen. The extent to whether the consequences of high interest rates are greater than the initial economic effects depends on factors such as what the marginal propensity to import in a country may be like.

A fourth measure that could be put in place to reduce the current account deficit is through protectionism. The government could put tariffs/increase tariffs on imports or even impose quotas on certain goods. This would decrease the amount consumers could import/foreigners want to export to the country. By reducing imports we reduce X-M and help to improve the current account deficit.

However many would see this as negative policy. Protectionism may lead to retaliation from other countries. They may put tariffs/quotas on our goods that would lead to a decrease in our exports. Furthermore if domestic industries are seen to be protected by tariffs imposed on foreign goods, they may become less competitive rather than more productive. This would have a negative impact on consumers.