Methods of Correcting Disequilibrium ill Balance of Payments
When serious disequilibrium arises in a country’s balance of payments, steps must be taken to correct it. if the country’s economy is to be kept in a sound condition.
Obviously, the causes which are responsible for such a slate of affairs must be removed. The ‘classical’ view of the adjustment mechanism is: “An active or passive balance, accompanied by an inflow or outflow of gold, was normally supposed not result in an expansion or contraction of the domestic money supply; and this expansion or contraction was expected to bring about· a rise or fall in the level of domestic costs and prices tending, in the former case, to stimulate imports and discourage exports or, in the latter, to discourage imports and stimulate exports. Gold flows, changes in relative price levels thus appeared as the principal factors in the mechanism of adjustments:
Recent currency experience has, however, led to certain modifications in the classical theory. It i~now thought that changes in the flow of income induced by balance of payments serve as an calibrating factor. “The main point is that any active or passive balance of current transaction tends directly to expand or contract the total now of money income within a given country The change induced by the balance of payments in the flow of income and outlay affect, in turn, the demand for imported us well as home-produced goods and 1>0 react on the balance in an equilibrium manner .
There are five well-known methods of correcting an adverse balance of payments:
Iii Stimulating exports and or checking important If the exports have fallen off. step should be taken to encourage them. To encourage exports the level of costs in the country may have to be brought down. This may involve Lulling down of wages and interest rates and other incomes and also contraction of currency to bring the prices down. Exports arc also encouraged by granting bounties to manufacture res and exporters. Imports may be discouraged either by total prohibition or by imposition of import duties or by adopting the quota system. Another method is to depreciate the value of the home currency. thus cheapening domestic goods for the foreigner. This latter course, however. has serious limitations. because other countries may start doing likewise and ‘competitive’ depreciation of exchange rates may start. as
4. League of Nations Currency Experience, 1944, p. 9.
5. ‘htrl. p 6010it happened during the depression years in the thirties. It may be not cd that the rate of exchange serves as an calibrating factor between ‘he balance of payments. If, for instance, the demand for American goods increases, the demand for the dollars will increase, and, in the absence of exchange control the price of dollar in terms of foreign currencies will go up. This by itself will discourage the foreign buy from buying j;l America and encourage Americans to ~uy from abroad. In this way the balance may be restored, Normally, it will be such But if a further rise in the price of the dollar is feared. the foreigners will increase’ their purchases f American goods now lest they should become dearer still; it will also hold back the Americans from buying more from abroad. In this way, the disequilibrium may be accentuated. instead of being cured.
(ii,) The think method is to Toltec the reverence. Is currency contracts, prices will fall. which will ‘stimulate exports and check imports. But the . method of deflation is also full of dangers. If prices arc forced down while I.. IS. which are proverbially rigid (especially as regards wages in countries where trade unions arc well organised), L10 not follow suit, the country may face a serious depression and unemployment. Correcting the balance of payments, therefore, once a disequilibrium has arisen is nut an easy matter.
(iv) The fourth method is devaluation.devaluation. its effect is the same as that of depreciation. When a currency is devalued (i.e., its metallic content is reduced), its value ill terms of foreign currency decreases. The result i~ that foreigners arc able to buy in our country more goods than before with the same amount of their currency. This would stimulate exports. But when we want to buy foreign goods, our currency, ‘having become cheaper. we have to pay more for them. Imports arc thus discouraged, and, in course of time, the balance of trade turns in our favor and corrects the balance of payments .