Balance of Payments Adjustment Policies Policies to correct a BoP imbalance Most discussions focus on countries running a current account

ount 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?

Current Account Balances - Deficits and Surpluses

Current account deficit as a percentage of GDP
10.0 7.5 5.0 2.5 10.0 7.5 5.0 2.5 0.0 -2.5 -5.0 -7.5 -10.0 -12.5 98 99 Germany Ireland Japan 00 01 02 03 04 05 06 07 08

PERCENT

0.0 -2.5 -5.0 -7.5 -10.0 -12.5

Spain United Kingdom United States

West Germany

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

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 Expenditure switching: Change in relative prices of X and M Changes incentives for consumers Changes profitability of exporting Can be caused by The J Curve aEffect 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) 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?