Balance of Payments and the Keynesian Model - Essay Example

Balance of Payments and the Keynesian Model The purpose of this essay is to critically evaluate the development of Keynesian based concepts and policy alternatives regarding the Balance of Payments. Firstly the paper discusses some of the Keynesian concepts related to the balance of payments. Then it moves onto discuss the current applicability of the concepts and the approach to economy of the United Kingdom. Keynesian concepts regarding the BOP The Keynesian concepts regarding the BOP are based on the equation or the identity of the national income. According to Keynesians the national income comprises of five components. The components are consumption, investment, government expenditure, and net exports. From the Keynesian identity it can be deduced that the current account deficit is caused by the reduction of the private spending and a large budget deficit. This model was applied to the international trade by Keynes. Keynes designed this model just to deal with the current account deficit that UK was suffering from in the 1960s. Since at that time the foreign capital investment was minimal and there was a fixed exchange rate system in the UK, most of the policies of the Keynesians work according to these two conditions. The Keynesian framework is divided into three sub categories, the expenditure changing policies, the expenditure switching policies and the direct controls. First the paper will discuss the expenditure changing policies and then move onto the other two. Expenditure Changing Policies The Keynesian model relies greatly on the expenditure changing policies. The expenditure changing policies are designed to change the level of spending in the domestic economy. This can be explained through the income and the adjustment model. According to the income model (the circular flow of income), the exports are considered as injections and the imports are considered as leakages to the circular flow of income. Since the expenditure that is spent on the imports results in a loss of the money and income to the foreign countries, it is considered an injection. The Keynesian model states that in order to maintain or improve the circular flow of income it is important that the expenditure on the imports is reduced. This can be done if the income in the country is reduced. The domestic income has a direct relation with the imports of a country. This is because as the income in the country increases, there is an increased amount spent on the imports. Also the increase in the income means that the production of the country has increased. The production process may also involve raw materials that are to be imported. As a result the expenditure on the imports would be further increased. In order to reduce the expenditure spent on the imports the Keynesian policies propose the reduction of the domestic production. Since the Keynesian identity is also applicable to the domestic economy (without the net imports), the governments can reduce the government expenditure and reduce the taxes etc to decrease the domestic activity and so the expenditure spent on imports. Another Keynesian approach, as Mankiw (2005) relates, can also be used to explain the expenditure switching policies. The rearrangement of the Keynesian identity (Y= X-M + (C+I+G)) implies that the net exports equal the domestic income (Y) less the domestic expenditure (C+I+G). As a result the current account deficit can be cured according to the Keynesians if the domestic income is increased and the domestic expenditure is reduced. In order to increase the domestic income the government needs to increase the government expenditure and reduce the taxes etc. This is called the Absorption model. It is interesting to note here that the absorption and the income model are complete opposites of each other. While one concentrates on the increase of the domestic income, the other focuses on the reduction of the domestic economic activity. Equally important is the fact, according to Mankiw (2005), that the domestic income can not be increased if the economy is already operating at the full employment level. As a result, the government according to the Keynesian model would spend more time on the reduction of the expenditures. Because it is difficult for the governments to reduce the expenditures related to the imports they would concentrate on other policies like the expenditure switching policies. Expenditure switching policies According to the Keynesian model the income switching policies are not aimed at the reduction of the expenditures in the economy. On the contrary, these policies maintain the expenditures of the economy. However, the switching policies ensure that the expenditure is switched from the exports to the imports. This can be achieved in a number of ways. The imposition of tariffs on certain imports can make the foreign goods expensive and so less competitive in the domestic market. With the domestic goods cheaper, the people would spend more on the domestic goods. As a result the expenditure spent would be switched from the imports to the domestic goods which would lead to the betterment of the balance of payments. Other approaches might include the providing of subsidies to the domestic producers in order to improve the quality of the domestic goods in relation to the imports. An important approach in the Keynesian model is the devaluation of the currency. The devaluation of the currency, as Mankiw (2005) discusses, can lead to the fall of the exchange rate according to the Keynesian Model. As a direct result of the devaluation of the currency, the imports become more expensive and so less competitive. The exports on the other hand become cheaper (in terms of the foreign currencies) and so the volumes of the exports may rise. This means that the expenditure is switched from the imports to the exports. Consequently, it means that the BOP can be improved. Apart from the expenditure switching and the expenditure changing policies the governments may also adopt the direct controls. Direct controls Direct controls can be made use of by the governments in order to reduce the amounts of the imports as a cure for the BOP problems. The direct controls are a method that can be used easily. This is because the expenditure switching and changing policies might help reduce the expenditure spent on the imports, they have many other implications. For instance the devaluation of the currency might help reduce the volume of imports yet they can also affect the economy badly. Recession and unemployment might result. The direct controls can affect the international trade and there may be fear of retaliation from the foreign countries. However the economy, as a whole, is not that badly affected. Direct controls can take two forms, the tariffs and the non tariff barriers. Tariff means that the cost of the imports is increased per unit. As a result they become more expensive and their demand is likely to fall. Tariff is also important because it may be a source of revenue for the governments. The non tariff barriers on the other hand do not increase the cost of the imports. Rather they impose physical limitations (quotas) or any other limitations on the volume of the imports and thus reduce the expenditure spent on the imports. From what has been discussed so far, the Keynesian concepts regarding the BOP concentrate on the expenditure switching, the expenditure changing and the direct controls to deal with the BOP problems. Now the paper analyses how successful these policies have been in shaping the Balance of Payments for UK. The applicability of Keynesian Concepts to the current UK economy UK, according to Lynn (2010), has been following the Keynesian model the most, with regard to the Balance of Payments problem, as compared to the other countries of the world. Since the Second World War, Britain has been concentrating on the application of the Keynesian concepts in the economy. That is why the governments have been giving attention to the reduction of the interest rates, the increase of the government expenditure, and the printing of money to deal with the credit crisis. However it seems that nothing has been working. Lynn (2010) argues that the government has been concentrating on the Keynesian concepts since 2008 but the economy is still not out of recession. The result of the Keynesian model is the reduction of the interest rates (to increase investment), but it has led to the loss of capital because the foreign firms are not attracted to invest with interest rates as low as 0.5% as Sen (1995) relates. The notion of the government spending its way out of the recession in order to improve the BOP also does not make sense in the present situation because the increase in the government expenditure (to increase the domestic income) would mean that the budget deficit is further worsened. This would have dire consequences on the BOP. In fact according to Lynn (2010), the BOP deficit has widened due to the Keynesian policies regarding the BOP. Conclusion To conclude, the Keynesian policies regarding the BOP problem include the expenditure switching policies, the expenditure changing policies and the direct controls. According to Keynes, these three can be used by the governments to reduce the import expenditure and hence improve the BOP. This method has previously worked for UK, but in the current situation the Keynesian Model does not seem appropriate because, as Lynn Holt and Pressman (2006) state, some of the Keynesian concepts are not practical. References Cherunilam. (2008). International Economics. India. Tata Mc GrawHill Holt,R and Pressman (2006) Empirical Post Keynesian Economics: Looking at the Real World. UK. M.E. Sharpe Lynn, M. (2010). Deathbed of Keynesian Economics Will Be in U.K. UK. Bloomberg Mankiw, G. (2005). Macroeconomics. UK. Worth Publishers. Sen, P. (1995). Foreign Direct Investment : A solution to BOP problems? UK. Jstor Read More