Balance of Payments Adjustment Policies

Policies to correct a BoP imbalance Most discussions focus on countries running a current account deficit But persistent surpluses can also be a problem! Both deficit and surplus can be described as a disequilibrium Evaluation might consider: Automatic partial correction of a deficit Demand-side policies Supply-side policies The consequences of policies for other macroeconomic objectives such as growth, inflation and jobs

Deficits and Surpluses as a share of GDP Why might the deficit as a share of GDP be a better guide to the size of a trade imbalance?

Are deficits self-correcting? Some partial self-correction Economic slowdown and recession Squeeze on real incomes and output Fall in import demand Releases capacity for exporting Deficit might lead to depreciation in the exchange rate Change in relative prices of exports and imports Expenditure-switching towards exports and away from imports Depends on price elasticity of demand for X and M and also elasticity of supply

The US trade deficit and their recession Note the steep fall in the trade deficit as the economy hit recession. Why is income elasticity of demand important in this chart? But what are the wider economic effects?

Expenditure switching Change in relative prices of X and M Changes incentives for consumers Changes profitability of exporting Can be caused by Movement in the exchange rate Introduction of import tariffs and other forms of protectionism Period of high or low relative inflation Key point is whether trade volumes respond to changing prices I.e. price elasticity of demand for X and M

Does a depreciation cut the trade deficit?

Any evidence for the UK?

The J Curve Effect of a depreciation on the trade deficit depends on price elasticity of demand. In the short term, demand is often inelastic – limits extra revenue from exports Demand for M is inelastic – higher prices cause a rise in total spending on imports The J Curve effect says a trade deficit can worsen after a depreciation, but get better in the long term provided that the elasticity of demand is high enough Marshall-Lerner condition: Trade balance will improve if Ped X + Ped M . 1 Elasticity of supply of domestic producers is also important (often forgotten)

The J Curve effect Trade surplus Ped X + Ped M > 1 for the trade balance to improve Time C A B Trade deficit

Expenditure Reduction Cutting aggregate demand Direct effect on consumption and therefore demand for imports: Possible routes: Higher direct taxes – lower disposable income Low taxes on saving Increased interest rates – to dampen consumption Cut in government spending Focus here is on income elasticity of demand for imports

Supply-side policies To rebalance trade over the medium term Focus on Improving competitiveness in global markets: Innovation Research and development Product quality / design Infrastructure to support trade sectors Attracting inward investment – producing output domestically and then exporting Raising productivity / lowering unit costs Developing areas of new competitive advantage Raising foreign income elasticity of demand for exports Reducing foreign price elasticity of demand for exports

Weaknesses on supply-side and UK trade Persistent productivity gap Low business investment as a share of GDP Low levels of research and development Loss of capacity in manufacturing industry Evidence that UK exports have lower income elasticity of demand than our income elasticity of demand for imports

The Productivity Gap Source: UK competitiveness indicators, Feb 2009

Investment Gap? Source: UK competitiveness indicators, Feb 2009

Research Gap? Source: UK competitiveness indicators, Feb 2009

UK Exports and Imports

Summary points Some trade deficits are partially self correcting But recession and a depreciation are not enough if the root causes lie on the supply-side of the economy Ultimately BoP adjustment requires: Period of below trend growth Improvement in investment in traded goods industries Control of price and cost inflation relative to that of our competitors Open trade to drive better export performance Protectionism is not the answer