Deflation is a policy of reducing expenditure with the intention of curing a deficit by reducing the demand for imports. This reduction of expenditure may be achieved by the use of either fiscal or monetary policy. In addition to reducing demand for imports however, deflationary measures may also have expenditure switching effect upon the balance of payments. The depression of demand may cause the domestic inflation rate to fall relative to that of competitor countries and thus increase the price competitiveness of exports. Consumers in other countries may then switch their demand towards the country's exports, whilst its own residents switch away from imports, preferring instead to buy home produced substitutes. The difficulty posed by deflation is that it not only reduces demand for imports but also reduces demand for domestically produced goods. This in turn can have a knock on effect in the form of lower output and higher unemployment.
Import controls have immediate effect on the balance of payments. Quotas and embargos directly prevent or reduce expenditure on imports, while import duties or tariffs discourage expenditure by raising the price of imports, while import duties or tariffs discourage expenditure by raising the price of imports. Import controls also have their limitations and problems. They do not tackle the underlying cause of this disequilibrium i.e. the lack of competitiveness of a country's industry and what is more they are likely to invite retaliation to the long-term detriment of themselves as well as their trading partners. It is also the case that trade agreements such as GATT limit the opportunities for member countries to make use of import controls and the use of subsidies to encourage exports.
A third option is that of devaluation. Devaluation of a fixed exchange rate or the downward float of a managed exchange rate is mainly expenditure switching in its effect. The cure works in a similar manner to the freely floating adjustment mechanism under a floating exchange rate system. In the case of a fixed exchange rate system devaluation consists of an administered reduction in the value of the currency against other currencies. In a managed system the authorities can engineer a downward float by temporarily reducing their support. In both cases the effect is to increase the price of imports relative to the price of exports and so switch domestic demand away from imports and towards home produced goods.
Certain conditions have to be met for devaluation to have this effect on boosting exports/curbing imports. They are:
a. Competing countries must not devalue at the same time, otherwise there would be no competitive advantage gained (exports would not become any cheaper in comparison with products of those countries).
b. The demand for exports (or for imports) must be price elastic, i.e. the sales must be affected by the change in price. Thus, when the domestic currency falls in value, the demand for exports should rise by a larger proportion in order to earn more foreign exchange.
c. There must be appropriate domestic policy.
i. The extra exports must be available. If there were full employment in the economy, the home demand would have to be curbed to make room for the extra export production.
ii. Inflation must not be allowed to erode the competitive advantage secured by devaluation.
A devaluation of the currency is not a soft option. There are a number of problems that will be involved, and these must be outlined:
a. To the extent that home demand has to be cured to make room for the extra exports, the domestic standard of living is reduced. This is only because, before it took place, the country was "living beyond its means", but it does come as a shock to find the domestic "squeeze" accompanying devaluation. Yet if it does not take place, then the strategy will not have worked; the exports may not rise to meet the higher demand from abroad.
b. The larger cost of importing goods raises the domestic cost of living. This is not just inflationary in itself, but can trigger off pay claims which if settled will further worsen inflation.
c. It does not boost exports immediately. There is a period during which the balance of payments gets worse as the country faces a higher import bill. It is only when exports start rising (and there is a considerable time lag involved) that the situation improves.
d. It does not tackle the long-run problem of why exports were not doing well. The problem may be more in inefficiency and other non-price factors than in the price of the exports themselves. In which case devaluation would make little difference to the basic problem.
A fourth option is to use Exchange control. When this is used to deny foreign exchange to would be importers, its effects are identical to those of the various import restricdtions already discussed. There are various forms of exchange control that can be imposed by a government and enforced by legislation. They all involve restrictions on the actions of holders of its currencies and residents of the country who may hold foreign currency.