Balance of Payments Deficit under Floating Exchange Rate

A balance of payments deficit signifies that a country is spending more on foreign transactions than it is earning. In a floating exchange rate system, the currency's value is determined by market forces (supply and demand) without central bank intervention.

Mechanism in a Floating System

When a country runs a balance of payments deficit:

• There is an excess supply of the domestic currency in the foreign exchange market (as residents need more foreign currency than foreigners need the domestic currency).
• This increased supply, relative to demand, puts downward pressure on the currency's price.
• Consequently, the external value of the currency falls (depreciates).

This depreciation makes exports cheaper for foreigners and imports more expensive for residents, helping to automatically correct the deficit over time.

Evaluating Options

• Option 1: Correct. A deficit leads to currency depreciation.
• Option 2: Incorrect. A surplus would cause the value to rise.
• Option 3: Incorrect. This describes a surplus (injections > withdrawals). A deficit means withdrawals > injections.
• Option 4: Incorrect. Aggregate demand changes are a separate macroeconomic issue, not the direct result of a BoP deficit mechanism in a floating rate system.

Therefore, in a floating exchange rate system, a balance of payments deficit causes the external value of the currency to tend to fall.