Current Account Deficit & Policies (Revision Essay Plan)

Here is a revision essay plan on this question: 

"Assess policies that might be most effective in reducing the size of the UK current account deficit in the future." (25 Marks)

In 2018, the UK current account, saw a deficit of £82 billion, compared with £68 billion in 2017. The current account deficit was 3.9% of GDP in 2018 compared with 3.3% in 2017.

KAA Point 1

One demand-side policy is a rise in direct taxation – e.g. increase in income tax – reduces real disposable income – causing contraction in household spending – reduces demand for imports (expenditure-reducing effects) – assuming that the value of exports remains the same - this will lead to an improvement in net trade which is a component of the current account.

EVAL Point 1

Higher direct taxes are not always effective in reducing spending – people may view tax hikes as temporary – and choose to maintain spending by reducing their savings out of disposable income. Reduced consumer spending could also lead to a fall in planned investment which could then hinder the productive capacity of businesses that export.

KAA Point 2

A second approach might be for the Bank of England to try achieve a competitive depreciation of sterling e.g. by keeping interest rates lower, expanding QE or by direct intervention in currency markets. Weaker £ increases M prices and makes exports more competitive (in $s etc) – leading to expenditure-switching effects and an improvement in net trade providing that the Marshall-Lerner condition is met.

EVAL Point 2

The main causes of current account deficit are likely to be structural (e.g. linked to a persistent productivity gap) rather than due to an over-valued exchange rate. The majority of exports also require imports, so weaker £ increases costs of imported raw materials & components and also makes imported technology more expensive which can then hamper price competitiveness in the future.

FINAL CONCLUSION

Demand side policies carry risks (e.g. cuts in real living standards) and the option of a competitive devaluation is not available if the UK continues to operate a free-floating exchange rate system. Supply-side economic reforms can perhaps be more effective in the long run in helping to correct an external deficit. E.g. cuts in corporation tax designed to attract inward investment from overseas e.g. car manufacturing firms which then increases export volumes. Increased spending on STEM education and tax relief for research & development in emerging sectors such as life sciences can raise a country’s export potential in industries where global demand is likely to be strong in the years ahead.