Current Account Deficits and Surpluses

Having examined the structure and causes of the balance of payments, this lesson focuses on the policies available to correct current account imbalances and the key theoretical frameworks — the Marshall-Lerner condition and the J-curve effect — that determine whether those policies will be successful.

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Policies to Correct a Current Account Deficit

Policies can be broadly divided into expenditure-reducing and expenditure-switching approaches.

Expenditure-Reducing Policies

Key Definition: Expenditure-reducing policies aim to reduce total spending in the economy (aggregate demand), thereby reducing spending on imports.

Policy	Mechanism	Evaluation
Contractionary fiscal policy (higher taxes, lower government spending)	Reduces disposable income → consumers buy fewer imports	Effective at reducing imports but causes unemployment and lower growth; politically unpopular
Contractionary monetary policy (higher interest rates)	Increases cost of borrowing → reduces consumer spending and investment → fewer imports; also attracts capital inflows, strengthening the currency	Reduces imports but may worsen the deficit through a stronger exchange rate; causes pain for mortgage holders and businesses
Wage restraint / austerity	If wages grow more slowly, consumers have less to spend on imports	Reduces domestic living standards; may face resistance from trade unions and voters

Key criticism of expenditure-reducing policies: They address the deficit by deliberately reducing economic activity and employment, which conflicts with other macroeconomic objectives. James Meade (1951) recognised this conflict in his analysis of the "internal-external balance" problem: a country may need expansionary policy for internal balance (full employment) but contractionary policy for external balance (trade equilibrium).

Expenditure-Switching Policies

Key Definition: Expenditure-switching policies aim to redirect spending away from imports and towards domestically produced goods and services, without necessarily reducing total spending.

Policy	Mechanism	Evaluation
Exchange rate depreciation	Makes exports cheaper in foreign currency and imports more expensive in domestic currency → consumers and firms switch to domestic alternatives	Only works if demand for exports and imports is sufficiently price-elastic (see Marshall-Lerner condition below); may increase inflation through higher import prices
Tariffs	Taxes on imports raise their price, encouraging consumers to switch to domestic substitutes	May provoke retaliation; violates WTO rules; reduces consumer choice; protects inefficient domestic firms
Quotas	Physical limits on the quantity of imports allowed	Highly restrictive; distorts markets; invites retaliation; now rare in developed countries
Subsidies to exporters	Reduce production costs for export industries, making them more competitive	Expensive for the government; may be challenged at the WTO as unfair trade practice

Supply-Side Policies

In the long run, the most effective way to improve the current account is to improve the economy's supply-side performance:

• Investment in education and training — improves human capital and productivity, making domestic firms more competitive
• R&D support and innovation policy — helps firms develop higher-quality products that can compete internationally
• Infrastructure investment — reduces costs for businesses and improves logistics
• Labour-market flexibility — helps resources move from declining to growing sectors

Exam Tip: In a 25-mark essay on correcting a current account deficit, always discuss both expenditure-reducing and expenditure-switching policies, and then argue that supply-side policies are the most sustainable long-term solution. This demonstrates strong evaluation.

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The Marshall-Lerner Condition

Key Definition: The Marshall-Lerner condition (named after Alfred Marshall and Abba Lerner) states that a depreciation of the exchange rate will improve the trade balance only if the sum of the price elasticities of demand for exports and imports is greater than one (in absolute terms).

|PED_X| + |PED_M| > 1 → depreciation improves trade balance

Intuition:

• When the currency depreciates, exports become cheaper abroad and imports become more expensive domestically.
• If demand for exports and imports is elastic, the volume changes will be large enough to outweigh the price effects, and the trade balance will improve.
• If demand is inelastic, the volume changes will be small. The country will earn less per unit of exports (because of the lower foreign-currency price) without exporting significantly more, and will import roughly the same volume at higher prices. The trade balance will worsen.

Empirical evidence:

• In the short run, demand for exports and imports tends to be price-inelastic because:
  • Contracts are fixed in advance
  • It takes time for consumers and firms to find alternative suppliers
  • Brand loyalty and switching costs limit responses
• In the long run, demand becomes more elastic as adjustments are made
• This gives rise to the J-curve effect

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The J-Curve Effect

Key Definition: The J-curve effect describes the tendency for a country's trade balance to worsen initially following a depreciation, before eventually improving — tracing out a J-shaped path over time.

Why does the trade balance worsen initially?

1. Import contracts are pre-agreed — the country pays more for the same volume of imports (since the currency is now weaker)
2. Export contracts are also fixed — export volumes do not increase immediately
3. Demand responses are inelastic in the short run

Why does it improve later?

4. Over time, foreign buyers respond to lower export prices and increase their purchases
5. Domestic consumers and firms switch away from more expensive imports to domestic alternatives
6. New trade contracts are negotiated at the new exchange rate
7. The Marshall-Lerner condition is met in the long run

The J-curve typically takes 12–24 months to complete, though this varies depending on the economy and the size of the depreciation.

Diagrammatic representation:

The J-curve is plotted with time on the horizontal axis and the trade balance (or current account balance) on the vertical axis. At the point of depreciation, the balance dips below its initial level (the "dip" of the J) before rising above it (the "recovery" of the J) as elasticities increase over time.