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Difficulty: EasyBalance of Payments Disequilibrium and Adjustment Measures

Which of the following policy measures is an example of an expenditure-switching policy used to correct a balance of payments deficit?

  1. Currency devaluationAnswer
  2. B
    Raising the central bank rediscount rate
  3. C
    Increasing personal income tax rates
  4. D
    Reducing government spending on public works

Answer

Currency devaluation
Currency devaluation changes relative price ratios by making foreign imports relatively more expensive and domestic exports cheaper, causing both local and foreign consumers to switch their demand toward domestically produced goods.

Step-by-Step Solution

1
Understand the mechanism of expenditure-switching policy.
Expenditure-switching policies alter the relative prices of foreign and domestic goods, redirecting consumer spending away from imports and toward domestically produced alternatives.
Correcting a balance of payments deficit requires either lowering total domestic demand (expenditure-reducing) or redirecting demand toward local products (expenditure-switching).
2
Evaluate currency devaluation as a balance of payments adjustment tool.
Devaluation raises the price of foreign goods in terms of local currency while lowering the foreign-currency price of exports, effectively switching domestic and foreign expenditure toward local goods.
Changing foreign exchange rates directly alters price relative ratios between domestic goods and foreign imports.

Key Concept

Expenditure-Switching Policies in BOP Adjustment
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Topics

Balance of Payments Disequilibrium and Adjustment Measures

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