Question
Under a freely exchange rate system, a deficit in a Nation’s Balance of Payments Account is automatically corrected by
The correct answer is
a depreciation of its currency
BOP Deficit Correction Under Floating Exchange Rates
A deficit in the Balance of Payments (BOP) signifies that a country is demanding more foreign currency than it is supplying. In a freely exchange rate system, the value of the currency is determined by market forces.
Automatic Adjustment Process
A BOP deficit triggers an automatic correction mechanism:
- Increased Demand for Foreign Currency: A deficit means more domestic currency is being supplied to buy foreign currency than vice-versa.
- Currency Depreciation: This imbalance leads to downward pressure on the domestic currency's value, causing it to depreciate relative to foreign currencies.
- Trade Effects: Currency depreciation makes the nation's exports cheaper for foreign buyers and imports more expensive for domestic residents.
- Deficit Reduction: The increase in exports and decrease in imports improves the net trade balance, helping to eliminate the BOP deficit.
Thus, the automatic correction for a Balance of Payments deficit under a freely floating exchange rate is currency depreciation.
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Important Questions from External Sector and Currency Exchange rate
- At the Eighth Session of the International Solar Alliance (ISA) Assembly held at Bharat Mandapam in October 2025, which of the following initiatives was launched to address solar waste and promote circularity in the solar sector?
- Which theory is used to make long-term predictions about exchange rates in a flexible exchange rate system?
- The reduction in the external value of the domestic currency is called:
- MNCs can help the developing countries to:
(a) Obtain foreign technology and innovative methods of increasing productivity
(b) Employ rural unemployed labour
(c) Finance a savings gap or balance of payments deficit
(d) Generate appropriate technology by adapting existing processes
Choose the correct answer from the code given below : Exchange rates state the value of one currency in terms of other currencies. Which one of the following statements with respect to the exchange rate of a currency is correct?
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