CHAPTER 5

Government Macro
Intervention

Policies to Correct BOP Disequilibrium,

Inflation and Deflation

Prepared by Ms Viky
Course: AL-ECO
Today`s Discussion
• Policies to correct balance of payment
disequilibrium
 assessment of the effectiveness of fiscal, monetary
and supply side policies to correct a balance of
payments disequilibrium

 expenditure-reducing and expenditure-switching

• Policies to correct inflation and deflation

 assessment of the effectiveness of fiscal, monetary
and supply side policies to correct inflation and
deflation
Policies to Correct BOP
Disequilibrium
• Expenditure switching policies: policy measures
designed to encourage people to switch from
buying foreign-produced products to buying
domestically produced products.
• Action taken by government to persuade purchaser
at home and abroad in spending away from foreign
produced goods and services and more towards that
country’s produced goods and services.
Policies to Correct BOP
Disequilibrium
• Rather than reducing the amount of spending, these
policies redirect or switch spending to a country’s
products.
• The impact:
▫ fall in import expenditure – fall in supply of
country’s currency on forex market
▫ rise in export earnings – rise in demand for
country’s currency in forex market.
Policies to Correct BOP
Disequilibrium
• Expenditure dampening policies: policy
measures designed to reduce imports and
increase exports by reducing demand.
• Action taken by government to reduce total level of
spending in an economy.
• This policy has 2 effects.
Policies to Correct BOP
Disequilibrium
• First, a reduction in spending will mean that there
will be fewer purchases on imported goods and
services.
• Secondly, domestic producers will find that their
domestic market is dampened. As a result they will
try to offset the decrease in domestic sales with
increase in sales abroad.
• Overall impact is fall in imports and rise in exports.
Policies to Correct BOP
Disequilibrium
• Government could use fiscal policy to correct
BOP disequilibrium.
• E.g. Government could raise tax and reduce
government spending.
▫ Rise in income tax reduce disposable income,
resulting less income for household to spend on both
imports domestically produced products.
▫ Lower government spending will directly reduce
demand for goods and services.
Effectiveness of Fiscal
Policy
• Fiscal policy measures may change a country’s
current position in the short term but are unlikely a
long term solution.
• There is also adverse effects on raising income tax.
▫ It reduce overall demand, discourage supply (lower AS),
increase unemployment and slow economic growth.

• Imposing trade restrictions on other countries may

provoke retaliation, limit innovativeness on domestic
firms to be more efficient.
Policies to Correct BOP
Disequilibrium
• Monetary policy
• If an economy has a low inflation rate and current
account deficit, its central bank may reduce the
interest rate to put downward pressure on a floating
exchange rate.
▫ A lower exchange rate may result in the country’s
produce becoming more price competitive
internationally (reducing current account deficit), but
there is a risk in generating inflationary pressure.
Policies to Correct BOP
Disequilibrium
• Monetary policy
• A higher interest rate may act as expenditure
dampening policy measures, reducing demand for
imports and reducing inflationary pressure.
▫ It may raise a floating exchange rate that could
reverse the fall in demand for imports.
Policies to Correct BOP
Disequilibrium
• Monetary policy
• Government may change its exchange rate as an
expenditure switching policy measures.
• If an economy is experiencing current account
surplus and has a fixed exchange rate, the
government may decide to revalue its currency.
Effectiveness of Monetary
Policy
• In recent decades, monetary policy has become more
popular because it is independent from any political
influences.
• However the last financial crisis shows that monetary
policy too can have many limitation.
• There is a time lag between changing interest rate and
full effect being transmitted to the macro economy.
▫ Some economists estimates it take as long as 18 months
for full impact, however still less time than fiscal policy.
Effectiveness of Monetary
Policy
• A rise in interest rates benefits the savers but
harms borrowers.
▫ High cost of borrowing could lead to unemployment
and slow down economic growth.
▫ High interest rates also discourage foreign direct
investments as this raise foreign firm’s costs.
▫ Also, if a country reduces its interest rates noticeably
lower than its rival countries, this could create hot
money.
Policies to Correct BOP
Disequilibrium
• Supply side policy
• Supply side policy measure may help to reduce
current account and financial account deficit.
▫ Making domestic products more competitive and more
attractive to invest in.
▫ E.g. increase spending on education and training help
to increase the quality of exports, deregulation increase
competition on domestic firms and react to consumer
demand.
Effectiveness of Supply Side
Policies
• What are the limitations on these supply side
policies?
Policies to Correct Demand-
Pull Inflation
• Government could employ deflationary fiscal and
deflationary monetary policy measures.
• Deflationary fiscal policy: increase income tax
rates, reduce government spending
• Consequences: reduce AD (shift inwards / left), real
output fall.
Policies to Correct Demand-
Pull Inflation
• Deflationary monetary policy: increase interest
rates.
▫ Cost of borrowing increase (investment level
reduced), leads to AD shift inwards
▫ This also attracts hot money.

• Many central banks now have a target rate for

inflation and will use interest rate changes to
achieve it.
Policies to Correct Demand-
Pull Inflation
• Monetarists argue that the only way to reduce
inflationary pressure is to lower the growth of
money supply.

• Supply side policy: include policies that increase

productivity, competition and innovation that can
increase overall AS.
Policies to Correct Demand-
Pull Inflation
• If increases in AS can keep pace with higher AD, a
country can enjoy higher real output without
experiencing inflation.

• This is called non-inflationary economic growth.

▫ AD, SRAS and LRAS all increase by the same
magnitude and so real GDP increases but the price
level remains constant.
Policies to Correct Demand-
Pull Inflation
Price level AS AS1 AS2

AD2
AD1
AD
Real GDP
Y Y1 Y2

Non-inflationary economic growth

Effectiveness of Policies to
Correct Demand-Pull Inflation
• Deflationary fiscal policy to correct demand-pull
inflation:
• High income tax rate will result workers demand
higher wage rates, which could lead to cost-push
inflation.
• Rising income tax may also create disincentive
effect as people by leave the labour force.
Effectiveness of Policies to
Correct Demand-Pull Inflation
• Deflationary monetary policy to correct demand-pull
inflation:
• Increase interest rates may creates hot money.
• If customer is confident about future, increase interest
rates will not discourage spending.
• Though increase interest rate may reduce investment,
company can choose to use profits and reinvest back to
company.
Effectiveness of Policies to
Correct Demand-Pull Inflation
• Some countries may face constraints on the fiscal
and monetary policy measures that they can use to
correct inflation.
• Higher income tax than those operating rival
countries may lead to migration of skilled workers to
rival countries.
• Countries that join economic union would have no
control over setting the interest rates.
Effectiveness of Policies to
Correct Demand-Pull Inflation
• Supply side policies may have the potential to
benefit all government’s policy objectives in the
long term.
• However in the short run may create inflation (e.g.
increase government spending on education
increase AD before they increase AS).
Policies to Correct Cost-Push
Inflation
• Similarly with demand-pull inflation, government
can use deflationary fiscal policy and deflationary
monetary policy to correct cost-push inflation.
• Government could also use supply side policy such
as increase spending on training to increase labour
productivity.
▫ Provide subsidies for firms that facing high cost of
production (e.g. high cost of raw materials).
Effectiveness of Policies to
Correct Cost-Push Inflation
• Though high interest rates can correct cost-push
inflation, it could lead to big fall in real output.
• Though training could help to increase labour
productivity, if workers demand higher wages
would lead to higher cost of production.
• There is also risk in government subsidies that it
could increase AD if firms do not respond positively
by using it to increase their efficiency.
Policies to Correct Deflation
and Their Effectiveness
• Bad deflation can be damaging to the economy.
• To reverse a fall in AD and price level,
governments employ reflationary fiscal and
monetary policy measures.
▫ This could be increase government spending,
reduce income tax, reduce interest rates, give credit
expansion, increase money supply etc.
Policies to Correct Deflation
and Their Effectiveness
• When interest rates are already low, any further
cuts will have little effect.
• E.g. if firms and household is not borrowing at
interest rates as low as 2%, lowering it to 1.5% is
unlikely to stimulate increased borrowing and
spending – this implies that people are concern
about future economic prospects.
Policies to Correct Deflation
and Their Effectiveness
• For monetarist, the way to create inflation is to
print more money.
• The challenging part is to know how much money
to print to get the right amount of inflation.
Policies to Correct Deflation
and Their Effectiveness
• Use of fiscal policy is seen as more effective in
correcting deflation.
▫ As firms and households may be reluctant to spend
during deflation even though their purchasing
power increase and it becomes cheaper to borrow,
hence government should start spending to
stimulate economic activity.
Policies to Correct Deflation
and Their Effectiveness
Demand side Supply side
policies policies

POLICIES

Price and income Exchange rate

policies policy
Policies to Correct Deflation
and Their Effectiveness
The cure depends on the causes, i.e the type of inflation. Policies
include:

• Demand side policies – reduce aggregate demand. E.g: reducing

public expenditure, raising taxes and increasing interest rates

• Supply side policies – to make the labour market more competitive

(e.g: reducing trade union power and unemployment benefits) or to
increase competition (E.g: privatization, encouraging small firms and
business start-ups)

• Price and income policies – attempts by the government to control

the increase in prices and/or incomes by legislation

• Exchange rate policy – E.g: increase value of the currency to reduce

imported factor input prices and reduce demand for exports
Key Terms
TERMS EXPLANATION
Fiscal policy The use of taxation and government spending to influence aggregate
demand
Discretionary fiscal Deliberate changes in government spending and taxation
policy
Automatic stabilizers Changes in government spending and taxation that occur to reduce
fluctuations in aggregate demand without any alteration in government
policy
Budget An annual statement in which the government outlines plans for its
spending and tax revenue
Cyclical budget deficit A budget deficit caused by changes in economy activity

Structural budget A budget deficit caused by an imbalance between government

deficit spending and taxation
Monetary policy The use of interest rates, direct control of the money supply and the
exchange rate to influence aggregate demand
Interest rate The price of borrowing money and the reward for saving

Money supply The total amount of money in a country

Supply side policy Measure designed to increase aggregate supply

Expenditure switching Policy measure designed to encourage people to switch from buying
policy foreign produced products to buying domestically produced products
Expenditure Policy measures designed to reduce imports and increase exports by
Question for Practice 9708/11/O/N/17
Question for Practice 9708/12/M/J/21
Question for Practice 9708/12/M/J/21
Question for Practice
Structured Questions:

(a) Describe the four components of the current

account of the balance of payments. Explain
what might cause a deficit in this account. [8]

(b)Discuss the ways in which expenditure-

reducing and expenditure-switching policies
attempt to remove a current account deficit.
Assess which approach is preferable. [12]

9708/22/O/N/17