Expenditure reducing policies

An expenditure dampening or reducing policy is any action taken by a government that is designed to reduce the total level of spending in an economy.



If a country is experiencing a deficit on the current account of its balance of payments, it may use a variety of deflationary fiscal policy measures.

A deflationary policy involves a reduction in the level of aggregate demand in the economy. To reduce aggregate demand ( i.e total expenditure), the government could

Increase income tax

A rise in income tax will reduce disposable income, leaving less income for households to spend on imports as well as domestically produced products.

Reduce government spending

Lower government spending will directly reduce demand for goods and services which, as noted above, may reduce imports and put pressure on domestic firms to increase their exports.

As aggregate demand falls, people's incomes fall and hence spending on imports is reduced. By reducing the rate of domestic price inflation relative to inflation rates in other countries, deflation improves the price competitiveness of exports and reduces that of imports.

Limitation

Fiscal policy measures may alter a country’s current account position in the short term but are unlikely to be a long-term solution.

This is because once the policy measures are stopped, households and firms are likely to go back to spending the same amount on imports relative to the amount of export revenue earned.

Adverse side effects.

Deflationary policies reduce national income. There is a possible conflict between external and internal objectives. The balance of payments may improve, but unemployment is likely to rise and the rate of growth to fall.