Policies to Correct Disequilibrium in the Balance of Payments

Introduction

A disequilibrium in the balance of payments (BOP) occurs when a country's current account (which includes trade in goods, services, income, and current transfers) is not in equilibrium. This can manifest as a current account deficit (imports exceed exports) or a current account surplus (exports exceed imports). Governments and central banks employ various policies to address these imbalances and restore equilibrium.

These policies broadly fall into two categories: expenditure-switching policies and expenditure-reducing policies. The key difference lies in whether they aim to alter the composition of spending or the total amount of spending.

Expenditure-Switching Policies

Expenditure-switching policies aim to change the composition of a country's current account by influencing the demand for imports or the supply of exports. They do not necessarily change the overall level of spending.

Examples:

• Devaluation of the domestic currency: A devaluation makes exports cheaper for foreign buyers and imports more expensive for domestic consumers. This encourages exports and discourages imports, thus improving the current account.
• Exchange Rate Controls: These restrict the ability to exchange the domestic currency for foreign currencies. While less common now, they can limit the flow of imports and encourage domestic production.
• Tariffs and Quotas: Tariffs (taxes on imports) increase the price of imports, reducing demand. Quotas (limits on the quantity of imports) directly restrict the volume of imports.

Effectiveness: The effectiveness of expenditure-switching policies depends on the price elasticity of demand for exports and imports. If demand is relatively inelastic, the impact on the current account may be limited.

Expenditure-Reducing Policies

Expenditure-reducing policies aim to reduce the overall level of spending in the economy, thereby improving the current account balance. These policies directly impact the quantity of goods and services consumed.

Examples:

• Fiscal Policy: Reducing government spending or increasing taxes reduces aggregate demand, leading to lower imports and potentially higher exports (if the reduction in domestic demand is less than the increase in exports). This can improve the current account.
• Monetary Policy: Increasing interest rates reduces borrowing and investment, leading to lower aggregate demand and reduced imports. Higher interest rates can also attract foreign capital, increasing the demand for the domestic currency and potentially leading to a stronger exchange rate, which further reduces imports.
• Wage and Price Controls: These controls attempt to limit inflation and reduce demand, which can indirectly improve the current account. However, they are often difficult to implement and can lead to economic distortions.

Effectiveness: The effectiveness of expenditure-reducing policies depends on the responsiveness of consumers and businesses to changes in interest rates, taxes, and wages. There can be lags in the impact of these policies.

Table Summarizing Expenditure-Switching and Expenditure-Reducing Policies

Policy Type	Mechanism	Impact on Current Account	Examples	Advantages	Disadvantages
Expenditure-Switching	Changes the composition of spending (imports/exports)	Improves current account by altering the mix of trade.	Devaluation, Tariffs, Quotas	Can be relatively quick to implement.	May not significantly alter the overall level of spending. Can lead to retaliation (e.g., trade wars).
Expenditure-Reducing	Reduces the overall level of spending	Improves current account by reducing the quantity of goods and services demanded.	Fiscal Policy, Monetary Policy, Wage/Price Controls	Can address underlying inflationary pressures.	Can be politically unpopular. May lead to recession. Can have significant lags in impact.

Conclusion

Both expenditure-switching and expenditure-reducing policies can be used to correct disequilibria in the balance of payments. The choice of which policies to use depends on the specific circumstances of the economy and the desired outcomes. Often, a combination of both types of policies is employed to achieve the desired result. It's important to consider the potential trade-offs and unintended consequences of each policy option.