Economics – Government and the macroeconomy - Government macroeconomic intervention | e-Consult

Governments have several policy options to influence the balance of payments. Here are three examples:

1. Devaluation of the domestic currency: A devaluation makes exports cheaper and imports more expensive.

   • Current Account: A devaluation should improve the current account by increasing exports and decreasing imports. This leads to a current account surplus or reduces a deficit.
   • Capital Account: A devaluation can encourage foreign investment as domestic assets become cheaper relative to foreign assets. This can lead to an increase in capital inflows, improving the capital account. However, it can also lead to capital outflows if investors lose confidence.

2. Fiscal Policy (Government Spending and Taxation): Reducing government spending or increasing taxes can reduce aggregate demand, leading to lower imports and potentially improving the current account.

   • Current Account: Reduced aggregate demand leads to lower imports, improving the current account balance.
   • Capital Account: Fiscal policy can affect the capital account indirectly. Reduced government borrowing can decrease demand for loanable funds, potentially leading to lower interest rates and reduced capital outflows. However, if fiscal austerity signals economic weakness, it could deter foreign investment.

3. Monetary Policy (Interest Rates): Raising interest rates can attract foreign capital, increasing capital inflows and improving the capital account. Higher interest rates can also reduce domestic borrowing and spending, potentially improving the current account.

   • Current Account: Higher interest rates can reduce domestic borrowing and spending, leading to lower imports and improving the current account.
   • Capital Account: Higher interest rates attract foreign capital, increasing capital inflows and improving the capital account.