When a country experiences a deficit on its current account, it can implement several fiscal policy tools to address the issue. To reduce demand for imports and goods and services, the government could use contractionary fiscal policy.

• This includes increasing income tax and decreasing government spending. A higher income tax would result in less disposable income, leaving households with less to spend on imports and domestic products.
• Lower government spending would directly decrease demand for goods and services, which could help reduce imports and encourage domestic firms to increase their exports.

On the other hand, if a government aims to decrease a current account surplus, it may choose to use expansionary fiscal policy.

• This could involve reducing income tax and increasing government spending, such as state pensions, which would increase consumer expenditure. This would lead to an increase in imports, and some products may be diverted from the export market to the domestic market.

However, these fiscal policies are unlikely to provide a long-term solution, as households and firms may revert to their previous spending habits once the policy measures are ceased.

Additionally, raising taxes may have adverse side effects, such as decreasing demand, increasing unemployment, and slowing economic growth. Higher taxation can also create disincentives and reduce aggregate supply.

Monetary policy can also be used to address current account imbalances.

• The growth of the money supply can be reduced to decrease spending on imports, but controlling the money supply can be difficult.
• A more complex approach is changing the interest rate to influence the current account position.
  • If an economy has a low rate of inflation and a current account deficit, its central bank may lower the interest rate to put downward pressure on the floating exchange rate. This may result in the country's products becoming more competitive internationally, but it also risks generating inflationary pressure.
  • Conversely, a higher interest rate may cut consumer expenditure, reduce demand for imports, and reduce inflationary pressure, but it may also raise the exchange rate and reverse the fall in demand for imports.

     

To decrease a current account surplus, a government may use expansionary monetary policy to increase consumer expenditure.

• This can be achieved by raising the money supply and cutting the interest rate, or by encouraging an appreciation of the exchange rate.

However, most monetary policy tools are unlikely to be effective in the long-term, as they may not address structural weaknesses or strengths in the economy that cause the current account deficit or surplus.

For example, a low rate of innovation and ownership of scarce raw materials may cause a current account surplus, while a lack of productivity may cause a current account deficit.

Supply-side policies aim to improve the competitiveness and productivity of the economy, which can help to address imbalances in the current account.

• By increasing the supply of goods and services and making them more competitive, supply-side policies can help to boost exports and reduce imports, ultimately reducing a current account deficit.
• One way supply-side policies can achieve this is by increasing investment in education and training. By increasing the skills and knowledge of the workforce, firms can become more productive, leading to more efficient production and lower costs. This can improve the competitiveness of domestic firms, making them more attractive to foreign buyers and helping to increase exports.
• Another supply-side policy is to invest in infrastructure, such as transportation networks, communication networks, and energy systems. This can reduce costs and improve efficiency, making it easier for firms to do business and reducing the time and cost of transporting goods to foreign markets. This can help to increase exports and reduce imports, ultimately improving the current account balance.
• Supply-side policies can also help to reduce costs and increase efficiency by reducing regulation and bureaucracy, promoting competition, and creating a business-friendly environment. This can encourage innovation, investment, and productivity, which can improve the competitiveness of domestic firms and increase exports.

Overall, while supply-side policies may not directly address the current account balance, they can indirectly contribute to improving it by making the economy more competitive and efficient, ultimately helping to reduce a current account deficit or increase a current account surplus in the long run.

Protectionist policies can potentially help to reduce a current account deficit by reducing imports and promoting domestic production, which can boost the export of domestic goods and services. This, in turn, can increase export revenue and help to reduce the trade deficit.

However, protectionist policies can also have negative effects on the domestic economy.

• They can lead to higher prices for consumers due to the reduced competition and increased costs for domestic producers due to the higher costs of imported inputs.
• Protectionism can lead to retaliation from other countries, such as the imposition of tariffs on exports, which can hurt the domestic economy.
• Protectionist policies can be seen as a violation of free trade principles and can create tensions between countries. Such tensions can lead to the escalation of trade wars, which can harm both countries involved.

Overall, while protectionist policies may help to reduce current account imbalances in the short term, they are unlikely to provide a long-term solution to the problem. Supply-side policies that address the underlying structural issues in the economy are more likely to be effective in reducing imbalances in the current account.