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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
Consequences
By loans and
By selling domestic assets
But what are the consequences?
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