Cambridge International as and a level Economics Ebook

The eff ectiveness of fiscal policy
Fiscal policy measures may alter a country’s current 
account position in the short term but are unlikely 
to be a long-term solution. Th
is is because once 
the policy measures are stopped, households and 
fi rms are likely to go back to spending the same 
amount on imports relative to the amount of export 
revenue earned.
Raising taxes may also have adverse side eff ects. 
Th
ey lower demand, which may increase unemployment 
and slow economic growth. Higher taxation can 
also create disincentive eff ects and so may reduce 
aggregate supply.
Imposing tariff s against fellow members of a trade 
bloc is not an option. Imposing or increasing tariff s 
against other countries involves two risks. One is that 
it may provoke retaliation and the other is that it may 
reduce the pressure on domestic fi rms to become more 
effi
cient.
Equilibrium and eff iciency: 
In considering how 
domestic firms respond to being protected from foreign 
competition it is useful to make use of the key concept of 
eff iciency. Domestic firms may feel less pressure to seek 
to be productively, allocatively and dynamically eff icient 
if imports become more expensive due to the imposition 
of tariff s.
KEY CONCEPT LINK
Monetary policy
Reducing the growth of the money supply may be used as 
an expenditure dampening or an expenditure switching 
measure. Changing the rate of interest to infl uence the 
current account position is a more complex process. If an 
economy has a low rate of infl ation and a current account 
defi cit, its central bank may reduce the interest rate in 
a bid to put downward pressure on a fl oating exchange 
rate. A lower exchange rate may result in the country’s 
products becoming more internationally competitive but 
there is a risk it may generate infl ationary pressure. In 
contrast, a higher interest rate may act as a dampening 
policy measure, reducing demand for imports and 
reducing infl ationary pressure. It may, however, raise 
a fl oating exchange rate that could reverse the fall in 
demand for imports.
A government may decide to alter its exchange rate 
as an expenditure switching measure. If an economy 
is experiencing a current account surplus and has a 
fi xed exchange rate, the government may decide to 
revalue its currency. Raising the foreign exchange rate, 
as mentioned in
 Chapter 4
, will raise export prices and 
lower import prices. In the case of a current account 
defi cit, a government may consider devaluing the 
currency. In this case, export prices will fall and import 
prices will rise.