Page 209 - DECO201_MACRO_ECONOMICS_ENGLISH

Macro Economics

Notes 6. Structural changes may change the demand for exports and imports adversely.
7. High rate of growth of population may necessitate more imports and a reduction in
exports.

8. Import restrictions and tariffs by developed countries is another reason for disequilibrium
in the balance of payments of LDCs.

Correction of Disequilibrium (Adverse Balance of Payments)

The following are the principal methods for adjusting the adverse balance of payments:
1. Adjustment under Gold Standard: In the classical gold standard system, disequilibrium
was corrected by price-specific flow mechanism. A deficit leads to outflow of gold and
thereby to a reduction in money supply which reduces the price level and promotes
exports and discourages imports. So, deficit is corrected.
2. Adjustment under Flexible Exchange Rate: Deficit is corrected automatically by a
depreciation of its currency.
3. Income Adjustment Mechanism: If exports go up, national income goes up, purchasing
power goes up and imports also go up.

Did u know? If MPS = 0, then increase in imports will be equal to increase in exports. MPS
means marginal propensity to save.
4. Adjustment under Gold Exchange Standard (Fixed Exchange Rate): The gold exchange
standard was set up after World War II and lasted until 1971. Under this, the exchange rate
was fixed in terms of dollar or gold. The exchange rates were then allowed to vary 1 per
cent up or down. The deficit could be settled in gold or in dollar. Automatic adjustment is
possible under this system.

Example: If exports increase, income increases. Therefore, prices in the surplus country
go up. This discourages exports and encourages imports.

The surplus nation’s exchange rate may appreciate and it can get an inflow of reserves
leading to greater money supply and lowering of rate of interest. All these may lead to
increased imports, capital outflow and reduced exports.

If permitted to operate, the above automatic adjustment mechanisms are likely to bring
about adjustment in BOP. But nations may not permit them to operate for fear of
unemployment and inflation. Therefore, some policies are necessary to complete the
adjustment.
5. Expenditure Changing Policy: Expenditure adjusting policies are monetary and fiscal tools.
A restrictive monetary policy leads to a reduction in investment and income, thus reducing
imports. Therefore, a restrictive monetary policy by reducing expenditure corrects an
external deficit.

However, under the policy of Operation Twist, short-term rate of interest is raised to
attract short-term capital from abroad which will cure the balance of payment deficit and
at the same time does not disturb economic growth and capital formation (long-term rate
is kept constant).
Fiscal policy may be very helpful for reducing expenditure. Taxes may be raised and
public expenditure may be reduced. Both, restrictive monetary and fiscal policies, will be
deflationary in character and will stimulate exports and discourage imports.

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