Persistent disequilibrium in the balance of payments, particularly the deficit balance, is undesirable because it (a) weakens the country's economic position at the international level, and (b) affects the progress of the economy adversely.
It must be cured by taking appropriate measures. There are many methods to correct disequilibrium in the balance of payments. Important among them are discussed below:
Deflation is the classical medicine for correcting the deficit in the balance of payments. Deflation refers to the policy of reducing the quantity of money in order to reduce the prices and the money income of the people.
The central bank, by raising the bank rate, by selling the securities in the open market and by other methods can reduce the volume of credit in the economy which will lead to a fall in prices and money income of the people.
Fall in prices will stimulate exports and reduction in income checks imports. Thus, deflationary policy restores equilibrium to the balance (a) by encouraging exports through reduction in their prices and (b) by discouraging imports through the reduction in incomes at home.
Moreover, a higher interest rate in the domestic market will attract foreign funds which can be used for correcting disequilibrium.
However, deflation is not considered a suitable method to correct adverse balance of payments because of the following reasons: (a) Deflation means reduction in income or wages which is strongly opposed by the trade unions, (b) Deflation causes unemployment and suffering to the working class, (c) In a developing economy, expansionary monetary policy rather than contractionary (deflationary) monetary policy is required to meet the developmental needs.
Another method of correcting disequilibrium in the balance of payments is depreciation. Deprecation means a fall in the rate of exchange of one currency (home currency) in terms of another (foreign currency).
A currency will depreciate when its supply in the foreign exchange market is large in relation to its demand. In other words, a currency is said to depreciate if its value falls in terms of foreign currencies, i.e., if more domestic currency is required to buy a unit of foreign currency.
The effect of depreciation of a currency is to make imports dearer and exports cheaper. Thus, depreciation helps a country to achieve a favourable balance of payments by checking imports and stimulating exports.
Exchange depreciation is automatic:
It works in a flexible exchange rate system and can correct a mild adverse balance of payments if the country's demand for imports and the foreign demand for its exports are fairly elastic. But the method of exchange depreciation has the following defects:
(i) It is not suitable for a country which follows a fixed exchange rate system.
(ii) It makes international trade risky and thus reduces the volume of trade.
(iii) The terms of trade go against the country whose currency depreciates because the foreign goods have become costlier than the local goods and the country has to export more to pay for the same volume of imports.
(iv) Experience of certain countries has indicated that exchange depreciation may generate inflationary pressure by increasing the domestic price level and money income.
(v) The success of the method of exchange depreciation depends upon the cooperation of other countries. If other countries also start depreciating their exchange rates, then these methods will not benefit any country.
Devaluation refers to the official reduction of the external values of a currency. The difference between devaluation and depreciation is that while devaluation means the lowering of external value of a currency by the government, depreciation means an automatic fall in the external value of the currency by the market forces; the former is arbitrary and the latter is the result of market mechanism.
Thus, devaluation serves only as an alternative method to depreciation. Both the methods imply the same thing, i.e., decrease in the value of a currency in terms of foreign currencies.
Both the methods can be used to produce the same effects; they discourage imports, encourage exports and thus lead to a reduction in the balance of payments deficit.
The success of the method of devaluation depends upon the following conditions :
(i) The elasticity of demand for the country's exports should be greater than unity.
(ii) The elasticity of demand for the country's imports should be greater than unity.
(iii) The exports of the country should be non-traditional and the increasingly demanded from other countries.
(iv) The domestic price should not rise and should remain stable after devaluation.
(v) Other countries should not retaliate by resorting to corresponding devaluation. Such a retaliatory measure will offset each other's gain.
Devaluation also suffers from certain defects:
(i) Devaluation is a clear revelation on the country's economic weakness.
(ii) It reduces the confidence of the people in country's currency and this may lead to speculative outflow of capital.
(ii) It encourages inflationary tendencies in the home country.
(iv) It increases the burden of foreign debt.
(v) It involves large time lag to produce effects.
(vi) It is a temporary device and does not provide a permanent remedy to correct adverse balance of payments.
4. Exchange Control:
Exchange control is the most widely used method for correcting disequilibrium in the balance of payments. Exchange control refers to the control over the use of foreign exchange by the central bank.
Under this method, all the exporters are directed by the central bank to surrender their foreign exchange earnings. Foreign exchange is rationed among the licensed importers. Only essential imports are permitted.
Exchange control is the most direct method of restricting a country's imports. The major drawback of this method is that it deals with the deficit only, and not its causes. Rather it may aggravate these causes and thus may create a more basic disequilibrium. In short, exchange control does not provide a permanent solution for a chronic disequilibrium.