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Balance of Payments and exchange rates

Under free float:

BOP surplus - upward pressure on the exhange rate

BOP deficit - downwards on the exchange rate

Deficit M>X

Surplus X<M

Deficit needs to be financed

as the country keeps paying out

How do countries finance persistent current account deficits?

Consequences

By loans and

By selling domestic assets

But what are the consequences?

  • Need for higher interest rates to attract foreign financial investments, leading to recession.
  • High indebtness.
  • Depreciating exchange rate.
  • Poor international credit ratings
  • Painful demand management policies
  • Cost of paying interest on loans
  • Possibility of lower economic growth
  • Lower standard of living in the future

Consequences

Other methods to correct persistent current account deficits

Expenditure reducing policies:

May create recession in the economy

High interest rates may result in appreciation

Trade protection: Higher domestic price for consumers, inefficiency, global misallocation.

Depreciation: may crete cost-push inflation (in case of imported resources)

Undervalue: Dirty float

  • Expenditure reducing policies: Influence the levels of exports by reducing AD through contractionary fiscal policy.
  • Expenditure switching policies: Replaces imports by domestic consumption by
  • Trade protection: It aims to restrict imports by trade protection.
  • Depreciation: Deficit leads to depreciation, which may be beneficial for exports.
  • Undervaluing the currency

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