Question: Discuss policies that the government could use to cure a current account deficit.
One policy that the government could use is an exchange rate devaluation. An exchange rate devaluation makes the domestic currency cheaper, the domestic economy is more internationally price competitive, exports are cheaper and rise, imports are dearer and fall, so the current account moves towards a surplus.
But this depends on the Marshall-Lerner condition: A devaluation will only lead to an improvement in the current account if the sum of the elasticities of demand for exports and
imports is greater than one. Moreover, as shown by the J-curve: After an exchange rate devaluation, the current account moves into a deficit in the short-run because of fixed contracts for exports and imports. Exports are cheaper and imports are dearer yet their volumes remain the same, so the current account initially moves towards a deficit. After contracts are renegotiated in the long-run, exports rise, imports fall and the current account moves towards a surplus.
Another policy the government could use is AD management. A fall in AD means income falls, at a lower income the marginal propensity to import is lower, so imports fall and the current account moves towards a surplus. The initial decrease in AD could be caused by a rise in interest rates or a rise in taxation.
Although, in the short-run, a higher domestic interest rate attracts foreign savings, so the value of the domestic currency rises, exports become dearer and fall, imports become cheaper and rise, so the current account moves towards a deficit. The domestic economy could raise taxes to decrease AD instead, but taxes take time to come into effect.
Additionally, the government could cure a current account deficit by using supply-side polices. Supply-side polices could be used to increase LRAS and increase the productive capacity of the domestic economy so that it is able to meet its own consumption needs.
However, this costs money and a large investment so in the short-run AD will rise, inflation will rise, the domestic economy loses international price competitiveness, exports become dearer and fall, imports become cheaper and rise, so the current account moves towards a deficit. Moreover, supply-side policies only come into effect in the long-run.