BPEA | 1987 No. 1

External Balance Correction: Depreciation or Protection?

1987, No. 1

OVER THE NEXT DECADE the U.S. noninterest current account will have to shift from a deficit of 3.9 percent of GNP in 1986 to balance or even a surplus. Is there a need for policy intervention to bring about the adjustment? If so, which method will maximize welfare: exchange depreciation, tariffs, quotas, voluntary export restraints, or a mix? The first section of this paper sets out a conceptual framework for analyzing the trade deficit and explains why it must be improved. A number of arguments suggest that the deficit is no problem. One such argument is that deficits can be financed indefinitely; another is that while surpluses may ultimately be necessary, there is no need for policy intervention. My own view is that adjustment is in fact required and that, at the real exchange rate levels of early 1987, even allowing for lags, the adjustment will be insufficient unless there are major changes in the relative growth rates of demand here and abroad. Subsequent sections review the policy options for encouraging adjustment, starting with a tariff. In reviewing the macroeconomic effects of tariffs I highlight the revenue effects and note that in general the effects on interest rates, prices, and exchange rates are dependent on the monetary rule. I explore the effects under a nominal income rule and offer simulation results to show the contractionary effects of tariffs on output. After some discussion of selective tariffs, quotas, and voluntary export restraints, I conclude that further dollar depreciation and competitive interest rate reductions are the preferable policy choices.