How BoP is adjusted?
There is not much bothering if there is a surplus in the balance of payments, however, every country strives to remove or at least reduce a balance of payments deficit. There are a number of adjustments, which are done to correct the balance of payments disequilibrium. Two of them are important, and they are automatic measures and deliberate measures.
The Automatic measures were useful and relevant when there was Gold Standard. Since, now the Gold Standard is not there, the whole mechanism is irrelevant, yet it works in Paper currency environment on the basis of the fact that if the market forces of demand and supply are allowed to have free play, in course of time, equilibrium will be automatically restored. This can be understood by a simple example that whenever there is a deficit, demand for foreign exchange exceeds its supply and this result in an increase in the exchange rate and a fall in the external value of the domestic currency. This would result in the exports of the country go cheaper and imports dearer than before. Consequently, the increase in exports and fall in imports restore the balance of payments equilibrium.
Deliberate Measures refer to the correction of disequilibrium by means of measures taken
deliberately with this end in view. There are various deliberate measures such as
Monetary measures such as Monetary Contraction, Devaluation, Exchange Control
Trade measures : Export Promotion, Import Control
These various measures have been shown in the following graphics:
The contraction or expansion of money supply affect the level of aggregate domestic demand, domestic price level and the demand for imports and exports, and this intervention can be used to correct the disequilibrium of the BoP.
We take an example:
We assume there is a situation of balance of payments deficit. The BoP deficit means that there is an increased level of aggregate demand that have led to the increased imports.
When the money supply is contracted, it would leave less money in the system and finally would reduce the purchasing power.
The reduced purchasing power would reduce the aggregate demand.
The reduced aggregate demand also reduced the domestic prices.
The reduced domestic prices also reduced the demand for the imports. The fall in the domestic prices’ would encourage more exports, to earn better money.
Thus, the overall result in case of monetary contraction is that Imports decrease and Exports Increase. This results in the correction of a BoP deficit situation.
Devaluation is defined as a reduction of the official rate at which the currency is exchanged for another currency. The idea behind devaluate the currency is to stimulate its exports and discourage imports to correct the disequilibrium. The direct impact of devaluation is that it makes the export goods cheaper and imports dearer. How? lets understand:
We assume that Current Rate of Dollar is Rs. 45.
In this situation, an exporter in India would realize Rs. 4500 for an export worth 100 Dollars.
We assume that the Rupee is devalued and now a Dollar becomes of Rs. 55
In this situation, the same exporter would realize Rs. 5500. The result is that Export earnings would increase and export of good would become cheaper.
We again assume that there is an importer who needs to make a payment of $ 100 to a party sitting abroad.
At Rs. 45, this importer would need Rs. 4500 to make payment.
At Rs. 55, this importer would need Rs. 5500 to make payment. The result is the import becomes dearer. So, most commonly, the Currency devaluation takes place to correct the BoP deficit.
This is yet another popular measure of correcting the BoP deficit. Under the exchange control, the government via the central bank assumes complete control over the foreign exchange reserves and earnings of the country. The recipients of foreign exchange, like exporters, are required to surrender foreign exchange to the government/central bank in exchange for domestic currency. By virtue of its control over the use of foreign exchange, the government can control imports and also increase its foreign currency reserves.
This may include the reduction and abolition of the export duties, providing export subsidy, encouraging export production and export marketing by giving monetary, fiscal, physical and institutional incentives and facilities.
‘This may be done by improving or enhancing import duties, restricting imports through import quotas, licensing and even prohibiting altogether the import of certain inessential items.
Some example are obtaining foreign tourists and providing incentives to enhance inward remittances.