A balance of payments disequilibrium is a situation where the value of a country’s imports are greater than its exports, creating a deficit in the current account and leading to a net outflow from the country’s circular flow of income.
This current account deficit creates negative effects on the country’s economy because the outflow from the circular flow of income causes a net fall in aggregate demand. The fall in value of exports also means that exporting firms require less labour, while the rise in value of imports means that domestic businesses lose market share to imports, so they also require less labour. This leads to more unemployment, which will become long-term unemployment if these workers are not restrained, reducing the productive capacity of the economy. Because of the reduced foreign demand for exports, there will also be a fall in business confidence and capital investment by exporting firms whose profits have fallen.
To solve these problems, expenditure switching policies aim to improve the current balance by reducing aggregate demand to encourage less expenditure on imports and more on domestic goods and export production.
Devaluation or depreciation of a country’s currency is an expenditure switching policy which causes a fall in export prices in the foreign currency, hence extending its foreign demand so that the total value of exports in the domestic currency rises. On the other hand, it also causes a rise in import prices in the domestic currency, hence contracting its domestic demand so that the total value of imports in the foreign currency falls. This therefore creates an improvement in the current account.
However, the problem with currency devaluation/depreciation is that it may cause the current balance to worsen before it improves. This is because demand is usually inelastic in the short-term, so although exports are cheaper their quantity sold does not rise by as much, while imports as become more expensive their quantity sold does not fall by as much, causing a fall in the total value of exports and rise in the total value of imports. This can be demonstrated by the J-curve:
Protectionism is another expenditure switching policy that can help to improve the position of the current account, by reducing the supply of imports. This includes tariffs (taxes on imports), quotas (limits on the quantity of imports), voluntary export agreements (unofficial, self-imposed quotas), embargoes (total ban on all imports) and red tape (imposition of regulations on imports).
Tariffs and quotas, however, can lead to a loss of consumer welfare and a retaliation of trading partners imposing their own tariffs, resulting in more loss of consumer welfare. The WTO (World Trade Organisation) is therefore set up to reduce international trade barriers and encourage free trade, and trading blocs are agreed between different groups of countries to reduce or eliminate their internal trade barriers.
Inflation is another method which can be use to correct the balance of payment disequilibrium by either by controlling excess demand within the economy to prevent demand pull or to control costs and prevent cost push inflation. By doing this, domestic products will become cheaper as cost of making is lower, this will lead to increase in the country's competitiveness as the global market will demand more of the country’s domestic product as it is cheaper compared to other countries. In addition to that, the lower price for domestic product will reduce imports and will move the balance of payment from deficit to surplus.
To control a currency is to restrict the amount of money leaving the country. This will reduce the currency from leaving the country as well as having more control over the currency. This method can help to reduce the fluctuation of exchange rate as the currency transfer is fairly stable and this could encourage foreign investor to invest within the domestic economy and they are confident about the exchange rate. But there is a limit to this method as the amount of money flowing into and out of one country is massive and makes it nearly impossible for the government to keep track on the inflow and outflow of their currency. This is why most government abandoned this method.
The aim of supply side policy is to increase the competitiveness of the country's exports within the global market. This could be done by providing training and education for labour within the workforce to increase their efficiency which would increase the productivity of the country and increase the amount of goods produced and lower the price of that product which will make domestic product become more competitive. This method may take a long time to shift the balance of payment from deficit to surplus.
