Page 217 - DECO503_INTERNATIONAL_TRADE_AND_FINANCE_ENGLISH

Unit 19 : Expenditure Reducing and Expenditure Switching Policies

BOP Adjustment through Fiscal Policy Notes
Before we explain the working and effectiveness of fiscal policy in bringing about BOP adjustment,
let us recall that fiscal policy refers to the deliberate changes made by the government in its expenditure
and taxation policies or both. Fiscal policy can be used as an effective tool of changing the aggregate
demand and aggregate expenditure in the economy. Like monetary policy, a fiscal policy can be an
expansionary fiscal policy or a contractionary fiscal policy. An expansionary fiscal policy increases
the aggregate demand and a contractionary fiscal policy reduces the aggregate demand. A country
adopting an expansionary fiscal policy increases government spending or decreases the level of
taxation or adopts both the measures simultaneously. A country adopting a contractionary fiscal
policy cuts down government spending or raises the level of taxation, or uses both measures
simultaneously. What kind of fiscal policy is adopted depends on the causes and the nature of BOP
disequilibrium and the need for BOP adjustment.
Let us now examine the effect of fiscal policy on the BOP deficit and BOP surplus. We will analyze
first the effect of fiscal policy on BOP deficit—the major problem. With a view to avoiding complications
that might arise due to other policy measures, we assume that the government uses only fiscal policy
to influence country’s balance of payments, all other factors remaining the same.
The effect of fiscal policy on the BOP is illustrated in Figure 19.2. Let us assume that a country is faced
with BOP deficit and examine what kind of fiscal policy would be appropriate for restoring the BOP
to equilibrium. Suppose that internal equilibrium of the country is given at point E , the point of
2
intersection between the LM and IS schedules and that country’s external balance is given by schedule
2
EB. Note that the internal equilibrium point E falls below and to the right of the EB schedule. This
2
indicates that the country is faced with a BOP deficit indicated by point J.
LM
EB
EB

) 3 E 3
Interest Rate (r r r r 2 1 K J E E 2

1

IS 3
IS 2
IS
1
O
Y Y Y Income (Y)
0 1 2
Figure 19.2: BOP Adjustment through Fiscal Policy
It may be added here that there is some ambiguity in the effectiveness of both expansionary and
contractionary fiscal polices. To explain it further, let us examine the effect of contractionary and
expansionary fiscal policies alternatively on the country’s BOP position. Let us first look at the effect
of a contractionary fiscal policy on the BOP deficit and internal and external balance.
When the government adopts a contractionary fiscal policy, leaving other things undisturbed, the
schedule IS shifts downward to IS . A new internal equilibrium is reached at point E , the point where
2 1 1
schedule IS intersects with LM schedule. At this point of equilibrium, the BOP deficit increases further
1
as indicated by point K which is further away from equilibrium point E . That is, contractionary fiscal
1
policy causes BOP to deteriorate. What is worse, the level of income decreases, causing increase in
unemployment. The reason for the deterioration in the BOP is the decrease in interest rate from Or to
2
Or which causes outflow of capital. Although, a contractionary fiscal policy decreases simultaneously
1
the imports by decreasing national income, the outflow of capital overweighs the decrease in the imports
caused by the decrease in income. Therefore, country’s BOP position deteriorates.

LOVELY PROFESSIONAL UNIVERSITY 211