2 Policies to correct a BoP imbalance Most discussions focus on countries running a current account deficitBut persistent surpluses can also be a problem!Both deficit and surplus can be described as a disequilibriumEvaluation might consider:Automatic partial correction of a deficitDemand-side policiesSupply-side policiesThe consequences of policies for other macroeconomic objectives such as growth, inflation and jobs
3 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?
4 Are deficits self-correcting? Some partial self-correctionEconomic slowdown and recessionSqueeze on real incomes and outputFall in import demandReleases capacity for exportingDeficit might lead to depreciation in the exchange rateChange in relative prices of exports and importsExpenditure-switching towards exports and away from importsDepends on price elasticity of demand for X and M and also elasticity of supply
5 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?
6 Expenditure switching Change in relative prices of X and MChanges incentives for consumersChanges profitability of exportingCan be caused byMovement in the exchange rateIntroduction of import tariffs and other forms of protectionismPeriod of high or low relative inflationKey point is whether trade volumes respond to changing pricesI.e. price elasticity of demand for X and M
9 The J CurveEffect 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 exportsDemand for M is inelastic – higher prices cause a rise in total spending on importsThe 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 enoughMarshall-Lerner condition: Trade balance will improve if Ped X + Ped M . 1Elasticity of supply of domestic producers is also important (often forgotten)
10 The J Curve effect Trade surplus Ped X + Ped M > 1 for the trade balance to improveTimeCABTrade deficit
11 Expenditure Reduction Cutting aggregate demandDirect effect on consumption and therefore demand for imports:Possible routes:Higher direct taxes – lower disposable incomeLow taxes on savingIncreased interest rates – to dampen consumptionCut in government spendingFocus here is on income elasticity of demand for imports
12 Supply-side policies To rebalance trade over the medium term Focus on Improving competitiveness in global markets:InnovationResearch and developmentProduct quality / designInfrastructure to support trade sectorsAttracting inward investment – producing output domestically and then exportingRaising productivity / lowering unit costsDeveloping areas of new competitive advantageRaising foreign income elasticity of demand for exportsReducing foreign price elasticity of demand for exports
13 Weaknesses on supply-side and UK trade Persistent productivity gapLow business investment as a share of GDPLow levels of research and developmentLoss of capacity in manufacturing industryEvidence that UK exports have lower income elasticity of demand than our income elasticity of demand for imports
14 The Productivity GapSource: UK competitiveness indicators, Feb 2009
15 Investment Gap?Source: UK competitiveness indicators, Feb 2009
16 Research Gap?Source: UK competitiveness indicators, Feb 2009
18 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 economyUltimately BoP adjustment requires:Period of below trend growthImprovement in investment in traded goods industriesControl of price and cost inflation relative to that of our competitorsOpen trade to drive better export performanceProtectionism is not the answer