An economy with a floating exchange rate has a large deficit on the current account of its balance of payments. Which policy combination would be most likely to reduce this deficit? The answer is: Increase interest rates and increase income tax rates. I thought we needed to decrease interest and T so there would be more exports than imports, since the Current account = X-M then decreasing the rate would reduce the deficit, but the answer is the opposite, can anyone urgently answer me, please?
Hi Ben This was a tricky exam question, and it is possible to approach it from a few different angles. I think where your thinking isn’t quite right is the statement that: “I thought we needed to decrease interest and T so there would be more exports than imports,…” If interest rates decreased and tax rates decreased, both of those things would be likely to stimulate an increase in aggregate demand in the domestic economy (individuals would have more disposable income and companies would likely invest more). If you consider the impact of aggregate demand and aggregate supply curves, the aggregate demand curve is likely to shift to the right, which would likely increase both (domestic) national income and also domestic prices. If domestically produced goods increase in price, this will mean that imports become relatively cheaper to people in this country, while exports become relative more expensive to people in other countries. Also, the increase in national income may mean people spend more money on imports. Hence imports may rise and exports fall (which is the opposite to what you said). And therefore the balance of payment falls even more into deficit. If instead, as per the solution, interest rates increase and tax rates increase, this would reduce aggregate demand. Prices of domestically produced goods are likely to fall (or would rise less rapidly than would otherwise be the case). Hence exports become more attractive to those overseas, while imports become relatively more expensive. In addition, the higher tax rates in particular mean people have less net income, so may reduce spending on imports. Exports may therefore rise, while imports fall, and so the current account deficit reduces (or maybe even moves into surplus). All of this would have an impact on the exchange rate, which would then have an impact on the financial account, but that’s probably outside of the scope of this question. I trust that helps? There’s more details in modules 13, 16, 18 and 21. Best of luck. Greg
