1. Balance of Payments Adjustment Policies

2. Policies to correct a BoP imbalance
Most discussions focus on countries running a current account 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

3. 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?

4. 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

5. 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?

6. Expenditure switching
Change in relative prices of X and M
Changes incentives for consumers
Changes profitability of exporting
Can be caused by
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

7. Does a depreciation cut the trade deficit?

8. Any evidence for the UK?

9. The J Curve
Effect 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)

10. The J Curve effect Trade surplus
Ped X + Ped M > 1 for the trade balance to improve
Time C A B
Trade deficit

11. Expenditure Reduction
Cutting aggregate demand
Direct effect on consumption and therefore demand for imports:
Possible routes:
Higher direct taxes – lower disposable income
Low taxes on saving
Increased interest rates – to dampen consumption
Cut in government spending
Focus here is on income elasticity of demand for imports

12. Supply-side policies To rebalance trade over the medium term Focus on
Improving competitiveness in global markets:
Innovation
Research and development
Product quality / design
Infrastructure to support trade sectors
Attracting inward investment – producing output domestically and then exporting
Raising productivity / lowering unit costs
Developing areas of new competitive advantage
Raising foreign income elasticity of demand for exports
Reducing foreign price elasticity of demand for exports

13. Weaknesses on supply-side and UK trade
Persistent productivity gap
Low business investment as a share of GDP
Low levels of research and development
Loss of capacity in manufacturing industry
Evidence that UK exports have lower income elasticity of demand than our income elasticity of demand for imports

14. The Productivity Gap
Source: UK competitiveness indicators, Feb 2009

15. Investment Gap?
Source: UK competitiveness indicators, Feb 2009

16. Research Gap?
Source: UK competitiveness indicators, Feb 2009

17. UK Exports and Imports

18. Summary points Some trade deficits are partially self correcting
But recession and a depreciation are not enough if the root causes lie on the supply-side of the economy
Ultimately BoP adjustment requires:
Period of below trend growth
Improvement in investment in traded goods industries
Control of price and cost inflation relative to that of our competitors
Open trade to drive better export performance
Protectionism is not the answer