Critically Evaluate How a Country Could Restore Balance of Payments Equilibria If Devaluation Is Ineffectual

1.0 - Introduction

The current account deficit between 2007 and 2009 reflected the UK's poor competitiveness internationally, irrespective of the attempt of devaluation that involves reducing the value of the UK’s currency against foreign currencies. Carrying forward this method as a policy solution would simply lead to higher inflation. We will instead evaluate alternative policy options from the Keynesian, Monetarist and Structuralist perspective in their methodology of solutions to restoring the UK’s BOP equilibrium while taking into consideration of potential policy constraints.

2.0 – Traditional Approach and Policies To BOP Disequilibrium

The traditional policies were based upon a synthesis of BOP theory in the 1950s and 1960s within the IS-LM framework extended to include international trade (Bordo and Schwartz 1984). For the UK this was intended to satisfy purposely for an economy with a persistent current account deficit. This approach relies around two assumptions that concerned at the time the traditional approach evolved; fixed exchange rates
and insignificant movements in international capital. Using Meade’s (1951) general equilibrium framework we can show where a government desires simultaneously to attain internal balance (IB) and external balance (EB) which likely comprises a trade-off between the two. Table 1 shows some possibilities.

Table 1: Policy options - The conflict between internal and external balance

Source: Baimbridge,M (2015) Lecture 3 …: International Monetary Economics

Fig 1 shows how a mixture of expenditure changing and expenditure switching policies could move an economy towards its internal and external goals.

Figure 1

Source: Baimbridge,M (2015) Lecture 3 …: International Monetary Economics

But with devaluation were ruled out, Mundell (1968) suggested that if we introduce international capital mobility into the model, it might be possible to reach point E by using monetary policy to achieve EB and fiscal policy for IB. Table 2 shows how this could be done for our cases A to D.

Table 2:

Source: Baimbridge,M (2015) Lecture 3 …: International Monetary Economics

In case A, for example, to improve the BOP, the authorities can implement a firm monetary policy, to raise interest rates and attract foreign capital. However, since high interest rates can diminish domestic activity making the

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