The following points highlight the top seven measures to correct deficit balance of payments. The measures are: 1. Adjustment through Exchange Depreciation 2. Devaluation or Expenditure-Switching Policy 3. Direct Controls 4. Adjustment through Capital Movements 5. Adjustment through Income Changes 6. Stimulation of Exports and Import Substitutes 7. Expenditure-Reducing Policies.
Measure # 1. Adjustment through Exchange Depreciation (Price Effect):
Under flexible exchange rates, the disequilibrium in the balance of payments is automatically solved by the forces of demand and supply for foreign exchange. An exchange rate is the price of a currency which is determined, like any other commodity, by demand and supply.
“The exchange rate varies with varying supply and demand conditions, but it is always possible to find an equilibrium exchange rate which clears the foreign exchange market and creates external equilibrium.” This is automatically achieved by depreciation of a country’s currency in case of deficit in its balance of payments. Depreciation of a currency means that its relative value decreases. Depreciation has the effect of encouraging exports and discouraging imports.
When exchange depreciation takes place, foreign prices are translated into domestic prices. Suppose the dollar depreciates in relation to the pound. It means, that the price of dollar falls in relation to the pound in the foreign exchange market.
This leads to the lowering of the prices of U.S. exports in Britain and raising of the prices of British imports in the U.S. When import prices are higher in the U.S., the Americans will purchase less goods from the Britishers. On the other hand, lower prices of U.S. exports will increase exports and diminish imports, thereby bringing equilibrium in the balance of payments.
Measure # 2. Devaluation or Expenditure-Switching Policy:
Devaluation raises the domestic price of imports and reduces the foreign price of exports of a country devaluing its currency in relation to the currency of another country. Devaluation is referred to as expenditure switching policy because it switches expenditure from imported to domestic goods and services.
When a country devalues its currency, the price of foreign currency increases which makes imports dearer and exports cheaper. This causes expenditures to be switched from foreign to domestic goods as the country’s exports rise and the country produces more to meet the domestic and foreign demand for goods with reduction in imports. Consequently, the balance of payments deficit is eliminated.
Measure # 3. Direct Controls:
To correct disequilibrium in the balance of payments, government also adopts direct controls which aim at limiting the volume of imports. The government restricts the import of undesirable or unimportant items by levying heavy import duties, fixation of quotas, etc.
At the same time, it may allow imports of essential goods duty free or at lower import duties, or fix liberal import quotas for them. For instance, the government may allow free entry of capital goods, but impose heavy import duties on luxuries. Import quotas are also fixed and the importers are required to take licenses from the authorities in order to import certain essential commodities in fixed quantities.
In these ways, imports are reduced in order to correct an adverse balance of payments. The government also imposes exchange controls. Exchange controls have a dual purpose. They restrict imports and also control and regulate the foreign exchange. With reduction in imports and control of foreign exchange, visible and invisible imports are reduced. Consequently, an adverse balance of payment is corrected.
Measure # 4. Adjustment through Capital Movements:
A country can use capital imports to correct a deficit in its balance of payments. A deficit can be financed by capital inflows. When capital is perfectly mobile within countries, a small rise in the domestic rate of interest brings a large inflow of capital.
The balance of payments is said to be in equilibrium when the domestic interest rate equals the world rate. If the domestic interest rate is higher than the world rate, there will be capital inflows and the balance of payments deficit is corrected.
Measure # 5. Adjustment through Income Changes:
Given the foreign exchange rate and prices in a country, an increase in the value of exports, causes an increase in the incomes of all persons associated with the export industries. These, in turn, create demand for other goods and services within the country. This will raise the incomes of persons engaged in the latter industries and services. This process will continue and the national income increases by the value of the multiplier.
Measure # 6. Stimulation of Exports and Import Substitutes:
A deficit in the balance of payments can also be corrected by encouraging exports. Exports can be encouraged by producing quality products, by increasing exports through increased production and productivity, and by better marketing. They can also be increased by a policy of import substitution.
It means that the country produces those goods which it imports. In the beginning imports are reduced but in the long run exports of such goods start. An increase in exports cause the national income to rise by many times through the operation of the foreign trade multiplier.
The foreign trade multiplier expresses the change in income caused by a change in exports. Ultimately, the deficit in the balance of payments is removed when exports rise faster than imports.
Measure # 7. Expenditure-Reducing Policies:
A deficit in the balance of payments implies an excess of expenditure over income. To correct it, expenditure and income should be brought into equality. For this expenditure reducing monetary and fiscal policies are used. A contractionary or tight monetary policy relates to increase in interest rates to reduce money supply and a contractionary fiscal policy relates to reduction in government expenditure and or increase in taxes.
Thus expenditure reducing policies reduce aggregate demand through higher taxes and interest rates, thereby reducing expenditure and output. The reduction in expenditure and output, in turn, reduces the domestic price level. This gives rise to switching of expenditure from foreign to domestic goods. Consequently, the country’s imports are reduced and the balance of payments deficit is corrected.