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Reducing a Trade Deficit (Revision Essay Plan)

A-Level, IB

Last updated 1 May 2018

Here is a revision video on structuring an answer to this question on trade. "Evaluate the micro and macroeconomic policies that might be effective in reducing the UK’s current account deficit" (25)

Reducing a Trade Deficit (Synoptic Essay Plan)

Essay Plan Reminder

  • Define current account deficit
  • Distinguish between a cyclical and a structural external deficit
  • Policies to reduce a deficit should focus on the underlying causes
  • Build 3 key points – analyse using chains of reasoning
  • Support with contextual knowledge where you can
  • Evaluate the point made in turn (evaluation follows analysis)
  • Reach a brief final reasoned conclusion – again supporting with context if possible.

Point 1: Macro policy to correct an external deficit

One macroeconomic policy would be for the government to use deflationary policies such as a rise in direct taxation or for the Central bank to increase monetary policy interest rates.

Deflationary policies aim to slow down the growth of consumption which is the biggest component of aggregate demand. A rise in direct taxes leads to less disposable income and ought to lead to a reduction in consumer demand for imported goods and services. The UK has a high income elasticity of demand for imports so a rise in tax can be effective in causing imports to contract and therefore reducing the size of the current account deficit. It will also help to lower inflation which will then help to improve the price competitiveness of export industries.

One significant risk of using deflationary policies is that real disposable incomes for households will decline. The trade balance may improve but at a cost and people may not be willing to accept the trade-off shown in a drop in living standards. Deflationary policies can also cause a contraction in planned capital investment which – in the long term – damages productive potential, hits productivity and therefore can lead to a worsening of a structural trade deficit.  

Point 2: Macro policy to correct an external deficit

A second macroeconomic policy might be for the central bank to change monetary policy and intervene in the currency markets to bring about a depreciation of the exchange rate against the UK’s major trade partners.

This policy would involve a switch to a managed floating currency. The Bank of England might sell sterling to bring about a depreciation of the exchange rate. A fall in the external value of sterling makes exports more competitive when priced in foreign currencies. It also makes imports more expensive when priced in sterling. This should lead to expenditure-switching effects as consumers in the UK change their demand to domestic suppliers and overseas buyers increase their demand for UK exports. A depreciation also increases the £ value of inflows of primary income.

An attempt to manage the currency and cause a depreciation might not be effective in improving the current account. The trade balance will only improve (over time) if the Marshall-Lerner condition is satisfied (i.e. PedX + PedM >1). And there is also a risk that a weaker pound will cause a rise in cost—push inflation. Many exports require imported components, so the gain in price competitiveness for domestic producers from depreciation can be eroded by a higher rate of inflation.

Point 3: Micro policy to correct an external deficit

Microeconomic supply-side policies  might be used to increase the productivity and competitiveness of the economy – making UK exports more competitive and reducing dependency on imported products.

Microeconomic policies might include tax incentives to encourage investment in human capital and business innovation. Stronger higher-level skills and knowledge will drive an expansion of sunrise industries with strong export potential such as digital industries, life sciences and renewable energy.  Innovation is crucial in improving non-price competition in global markets – for example, the next generation of renewable technologies and low carbon products can increase exports as a country develops new comparative advantage in higher-value added sectors.

Supply-side policies in theory offer the best prospect of achieving a durable improvement in the current account. Foreign investment for example helps to increase LRAS and export capacity. But in practice there might be trade-offs with other objectives such as a possible widening of inequality and risks of structural unemployment as government policies prioritize expansion in emerging industries. The decline of oil, gas and coal replaced by a range of capital-intensive renewable industries is an example of this.

Final reasoned comments

To what extent is a current account deficit partially-self correcting if the UK runs a free-floating currency. Some of a deficit will be cyclical
Many factors affect the scale of a current a/c deficit independent of policy decisions:

  • Fluctuations in global commodity prices (UK is a net importer of most commodities)
  • The strength of income / demand in key export markets
  • Changes in regional and bi-lateral trade agreements
  • Impact of protectionist policies affecting trade partners
  • Dynamic nature of world economy (fast-changing comparative advantage)

Problems in measuring trade balances when there is so much intra-industry trade, components cross borders many times
The possible impact on UK trade and primary/secondary income flows arising from post-Brexit trade and investment agreements. 
Macro-performance has micro-foundations, businesses trade rather than countries

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