Page 215 - DECO503_INTERNATIONAL_TRADE_AND_FINANCE_ENGLISH

Unit 19 : Expenditure Reducing and Expenditure Switching Policies

(a) The Expenditure Reducing or Changing Policies. Notes
(b) The Expenditure Switching Policy : Devaluation.
(c) Exchange Controls.
Each one of them merits a detailed discussion, which we will undertake in this unit.
19.1 The Expenditure Reducing or Changing Policies

The expenditure changing policies, also called ‘expenditure adjusting’ policies, refer to the policies that
are aimed at changing (reducing or increasing) the aggregate expenditure in the domestic economy.
Countries facing BOP deficit due to trade deficits adopt expenditure reducing policies. In a
macroeconomic framework, trade deficit (TD) can be measured as follows. We know that at
equilibrium,
Y ≡ C + I + G + X – M
If M > X, M – X ≡ TD
By substitution, Y at equilibrium can be expressed as
Y ≡ C + I + G – TD
Thus,
TD ≡ (C + I + G) – Y
This equation implies that there is trade deficit because (C + I + G) > Y, i.e., aggregate expenditure
exceeds aggregate income. It means that trade deficit can be reduced or eliminated by reducing the
aggregate expenditure that equals C + I + G. Let us now discuss the working and effectiveness of
these policy measures in eliminating the BOP imbalances. In this part of analysis, we will assume a
fixed exchange rate and free flow of capital.

The policies that are used to reduce the aggregate expenditure include : (i) monetary
policy, (ii) fiscal policy, and (iii) monetary-fiscal policy mix.

BOP Adjustment through Monetary Policy

Monetary policy refers to the measures adopted by the monetary authority to increase or decrease the
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money supply and availability of credit. A monetary policy aimed at increasing the money supply
and availability of credit to the public is called expansionary monetary policy or ‘easy money policy.’
And, a monetary policy aimed at decreasing the money supply and availability of credit to the public
is called contractionary monetary policy or ‘dear money policy.’ We will analyse here the working
of monetary policy in correcting the adverse BOP position and in restoring equilibrium in the BOP,
all other things remaining the same.
The working and effects of monetary policy are illustrated in Figure 19.1. Suppose that the internal
economy of a country is in equilibrium at point E , the point of intersection between the IS and LM
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schedules. The external balance (EB) at different combinations of income levels and interest rates is
given by the EB schedule which is the same as BOP schedule. Note that EB schedule does not pass
through the internal equilibrium point E . Therefore, the internal and external sectors are not
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1. The monetary measures that are used to change the money supply include (a) bank rate, the rate at which
central bank lends money to banks or discounts the bills of the commercial banks, (b) open market operation,
i.e. buying and selling the government bond and treasury bills in the open market, and (c) statutory cash
reserve ratio, the ratio of term deposits that commercial banks are, by statute, required to maintain in the
form of cash reserves.

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