Balance of Payments Test - 10

Automatic adjustment of balance of payments

Devaluation would lead to increase in net exports. 

BOP is a broader concept than BOT. 

When foreigners arrive other country they want to recreate in,they supply foreign currency to be exchanged for that country's currency.

Subject to higher foreign interest rate, domestic currency needs to be exchanged in forex market to invest in foreign banks. So, demand for foreign exchange increases. 

A stable currency does not involve uncertainties about capital loss on account of changes in exchange rate. 

Fluctuations of foreign interest rates have direct effect on foreign exchange rate and are included in market forces.But, under fixed exchange regime, foreign interest rate fluctuations have neutral effect on foreign exchange rate. So, speculation becomes impossible. 

When foreign exchange rate is constant, the domestic investors cannot invest in foreign banks under speculative motive. So, capital would not move out of the domestic country. 

Fixed exchange rate system is that it prevents the Government of the countries from adopting inflationary policies. Generally, Governments have often been tempted to pursue undue expansionary fiscal and monetary policies to lower unemployment and create boom conditions. However, inflation has several bad effects for the economies.

It increases inequalities of income and wealth and hurts the poor most. Further, inflation hampers economic growth in the long run. Fixed exchange rate system forces the Governments to achieve price stability by taking effective anti-inflationary measures.

This is be­cause in the case of fixed exchange rate, inflation will cause balance of payments deficits and result in loss of international reserves. Therefore, this forces the Government to adopt measures to check inflationary pressures in the economy.

 Under the flexible exchange rate system, exchange rate between different currencies, like the prices of commodities are freely determined by market forces, that is, by demand and supply forces. With the change in economic conditions underlying demand and supply, the exchange rate will automatically change without any intervention by the Government.They can concentrate on solving their domestic problems of economic stability, inflation and unemployment. “Flexible exchange rates should therefore give an increased freedom both to individuals and countries to pursue whatever aims they have for their economic policies.”