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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

Current Account Balances - Deficits and Surpluses


Current account deficit as a percentage of GDP
10.0 10.0

7.5 7.5

5.0 5.0 Why might the deficit


2.5 2.5
as a share of GDP
be a better guide to
PERCENT

0.0 0.0
the size of a trade
-2.5 -2.5 imbalance?
-5.0 -5.0

-7.5 -7.5

-10.0 -10.0

-12.5 -12.5
98 99 00 01 02 03 04 05 06 07 08

Germany Spain West Germany


Ireland United Kingdom
Japan United States
Source: OECD
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

United States Balance of Trade in Goods


$ billion per month
8 8

6 6 Note the steep fall in


4 4 the trade deficit as the
Percent

2 2 economy hit recession.


0 0
Why is income
-2 -2
elasticity of demand
-4 -4

-25 -25
important in this chart?
-30 -30
-35 -35
But what are the wider
economic effects?
USD (billions)

-40 -40

billions
-45 -45
-50 -50
-55 -55
-60 -60
-65 -65
-70 -70
01 02 03 04 05 06 07 08

Annual growth of real GDP Trade balance in goods and services $bn
Source: Reuters EcoWin
Expenditure switching

• 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?

US Trade Deficit and the US Dollar


trade balance $ billion per month, dollar exchange rate index
130 130
125 125
120 120
115 Dollar depreciating 115
Index

110 110
105 105
100 100
95 95

-25 -25
-30 -30
-35 -35
USD (billions)

-40 -40

billions
-45 -45
-50 -50
-55 -55
-60 -60
-65 -65
-70 -70
00 01 02 03 04 05 06 07 08 09

Federal Reserve, Nominal Trade Weighted Exchange Index Broad


Trade Balance, Total, Goods and services, SA
Source: Reuters EcoWin
Any evidence for the UK?

UK Trade & the Sterling Exchange Rate


Quarterly trade balance, £ billion (bottom pane) and exchange rate index
105 105

100 100

95 95
Sterling index

90 90

85 85

80 80

75 75

70 70
Quarterly balance £ (billions)

0.0 0.0
-2.5 -2.5
-5.0 -5.0

billions
-7.5 -7.5
-10.0 -10.0
-12.5 -12.5
-15.0 -15.0
90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08

Effective Exchange Rate Index Balance of Trade in Goods and Services


Source: Reuters EcoWin
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
Ped X + Ped M > 1 for
surplus
the trade balance to
improve

Time
C
A

Trade B
deficit
Expenditure Reduction

• 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

GDP per hour worked


Comparison, 1996-2007
Index, UK = 100
140

135

130 France
125
Germany
120
UK
115
US
110

105

100

95
1992 1994 1996 1998 2000 2002 2004 2006

Source: ONS

Source: UK competitiveness indicators, Feb 2009


Investment Gap?

Business investment
Comparison, 1992-2007
Per cent of GDP in current prices

14

12
Germany

France

10
UK

US

8
1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007
Source: OECD

Source: UK competitiveness indicators, Feb 2009


Research Gap?

Gross domestic expenditure on R&D


Comparison, 1992-2006
Per cent of GDP
3.0

France

Germany
2.5
UK

US
2.0

1.5
92

93

94

95

96

97

98

99

00

01

02

03

04

05

06

07
19

19

19

19

19

19

19

19

20

20

20

20

20

20

20

20

Source: OECD

Source: UK competitiveness indicators, Feb 2009


UK Exports and Imports

UK Exports and Imports of Goods and Services


Annual value of trade - £billion at current prices
450 Balance of Payments: Exports: Total Trade in Goods & Services 368.337G 450
Balance of Payments: Imports: Total Trade in Goods & Services 415.817G

400 400

350 350

Imports
GBP (billions)

300 300

billions
250 Exports 250

200 200

150 150

100 100
90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07

Source: Reuters EcoWin


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

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