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.
Important Questions from Balance of payments (BOP)
- Devaluation, will improve the balance of payment deficit, if sum of elasticity of exports and imports of the devaluing country is :
Match the following :
List – I List – II a. Sum of price elasticity of demand for exports and imports greater than unity. 1. J-curve effect b. Balance of Payments is the difference between National Income and expenditure 2. Import quota systems c. Empirical evidence showing lower short run price elasticities of exports and imports. 3. Marshall-Lerner condition d. Method to cut down imports 4. Absorption approach
Select correct code :
Codes :
- Which amongst the following is included in the Capital account of the Balance of payments ?
I. Foreign loans
II. Foreign Direct Investment
III. Private Remittances
Choose the correct answer from the codes below :
Codes : - A deficit or surplus in the India’s balance of payments is measured by the net balance of
Match the items of List I with the items of List II and choose the correct answer from the code given below.
List I
List II
(a)
Balance of trade
(i)
Imports and exports of goods and services
and unilateral transfer of goods and services(b)
Current account
(ii)
Transactions leading to changes in the
financial assets and liabilities of a country(c)
Balance of payments
(iii)
All economic transactions between a country's
residents and residents of other countries(d)
Capital account
(iv)
Value of exports and imports of country
