A depreciation in the value of currency exchange of a country should help boost oversees’ demand for U.S. exports because American firms will be able to supply more cheaply internationally (Keeler, 2007). A country can devalue its currency by a large margin in one or two installments in quick successions so that foreigners can find goods and services of a country cheaper to buy and boost exports rapidly.
Another method that a government can use to improve balance of trade over the short term is to reduce demand in the economy thereby reducing consumer spending in the economy. The government can use fiscal policy to increase taxes or reduce public spending. On the monetary side, increasing interest rates can help improve the balance of trade over the short period. Higher interest rates can help inhibit the consumer demand and therefore lead to cutbacks in the demand for imports. This will reduce the current account deficit.
Explain the advantages and disadvantages of the measures used in part (a) above
The main problem with using expenditure reducing policies is that the deflation in the economy is likely to cause, at the very least, an economic slowdown and possibly a recession. However, devaluation is always the first resort in cases where there is serious adverse balance of payment. Devaluation is a successful means only when the other country does not retaliate using the same policy. Devaluation is successful only when the demand for exports and imports is elastic. In case of inelastic demand for imports and exports, it may turn the situation worse. Even though considered suitable for correcting the disequilibrium, devaluation is considered a weakness for the country.
Devaluation may bring inflation in the following conditions: devolution reduces imports, and when the imports are reduced, the domestic supply of such goods must be increased the same level. A failure to do so brings scarcity of such goods initiating inflationary trends (Keeler, 2007). Developing economies such as India require more capital investment. Due to lack of availability of capital goods in India, there is no option but to continue importing at higher costs. This will eventually force the industries depending on capital goods to increase their prices. Devaluation may also bring inflation when demand for demands for exports rises when more of goods and services produced in a country go for exports thus creating shortage of such goods at the domestic level. In addition, devaluation may not be effective if the deficit arises due to structural or cyclical changes.
As mentioned earlier, a government can use fiscal policy to increase taxes or reduce public spending. Increasing tariffs may increase the prices of imported goods. The resulting increased prices will eventually reduce the demand for imported goods and services and at the same time induce domestic producers to produce more of import substitute. However, there are drawbacks associated with imposing higher rate of tariff. Tariffs carry the risk on bringing the equilibrium by reducing the volume of trade. Some scholars have argued that tariffs obstructed the expansion of world trade and prosperity. Introducing higher tariffs may not necessarily reduce imports. This makes the effects of tariff on the balance of payment uncertain. Additionally, imposing tariffs only seeks to establish the equilibrium without removing the root cause of the problem. It is also important to note that new or higher tariffs may aggravate the disequilibrium in the balance of payments of a country already having a surplus. Lastly, success of tariffs depends on an efficient and honest administration, which unfortunately is difficult to find in many countries. Rampant corruption among the administrative staff of many governments may render tariffs ineffective.
Increasing interest rates may have various economic implications. Increasing interest rate will increase the cost of borrowing resulting to increased interest payment on loans and credit cards. This therefore discourages people from borrowing and saving. People who already loans will have less disposable income because they spend more on interest payment (Lee and Miller, 2006). This will eventually lead to failure in areas of consumption. Higher interest rate increases the value of exchange rate. For example, if the U.S. increases its interest rates relative to other countries, investors are more likely to save in U.S. banks because they get better return. A stronger domestic currency makes exports less competitive and imports cheaper. This reduces exports and increases demand for imports. Rising interest rates has significant impacts on both firms and consumers. This can likely make a country experience a fall in consumption and investment.
Discuss the range of measures that are available to a government to improve the balance of trade in the long-term
The key to reducing balance of trade deficit in the long term is for a country to achieve relatively low inflation with sufficient productive capacity to meet the domestic demand from consumers. This requires the ability of economy of a country to deliver sustained growth of exports and meet the balance of trade deficit. A government may introduce quotas to fix and permit the maximum quantity or value of a commodity to be imported during a given period. Restricting imports into a country through quota system reduces the deficit and improves the balance of payments. Governments can also adopt export promotion measures in their bid to correct the disequilibrium in balance of payments. This includes tax concessions, substitutes, marketing facilities, credit and incentives, among others. The government may also promote export through trade fairs, exhibition, conducting market research and development, and providing the required administrative and diplomatic help to tap the potential markets.
A country may also resort to import substitution to reduce the volume of imports and make the country self-reliant. Monetary and fiscal measures may be adopted to encourage industries to producing substitutes. Industries producing import substitutes require special attention in the form of various concessions, which include technical assistance, tax concession, subsidies, and proving scarce resource among others. Non-monetary methods are more effective compared to monetary methods and are more applicable in correcting adverse balance of payment in the long-term.
Lee, S. and Miller, S. 2006. Balance of trade. New York: Ace Books.
Keeler, D. 2007, "The Balance of Trade", Global Finance, vol. 21, no. 2, pp. 2.