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12 Methods to Correct Disequilibrium in Balance of Payments (BOP) – Step-by-Step

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The main problem is to check the adverse Balance of payments. There are many measures to correct disequilibrium in the Balance of payments.

Methods to Correct Disequilibrium in Balance of Payments
Methods to Correct Disequilibrium in Balance of Payments

Methods to Correct Disequilibrium in Balance of Payments

Following are the main methods of Correct Disequilibrium in Balance of Payments:

1. Monetary Policy (Deflection)

Monetary policy may be devised to correct a deficit in the balance of payments of a country. The deficit occurs because of high import and exports. This is to be reversed.

In this regard, the country may adopt deflationary or dear money policy by raising the bank rate and restricting credit.

Under deflation, prices fall which makes exports attractive and imports relatively costlier.

This eventually leads to a rise in exports and a fall in imports.

The policy of money contraction or deflection keeps exchange rates unaffected and tries to correct the deficit in the Balance of payments through domestic changes.

However, deflation being in inexpedient, its Side Effects are dangerous to a poor Nation. It creates more unemployment and poverty.

Again a developing economy has to adopt an expansionary rather than a contraceptive monetary policy to cater to developmental needs.

Related: Format and Components of Balance of Payment Account (With Examples).

2. Exchange Depreciation

Exchange depreciation means the decline in the rate of exchange of one country in terms of another.

For example – Assume- the Indian rupee exchanges for 65 Roubles of the Russian currency. If India experiences an adverse Balance of payments with regard to Russia, the Indian demand for Rouble will be rise.

Consequently, the price of Rouble in terms of Rupee will be appreciated in its external value.

Thus, the rate of exchange of Indian rupee in terms of rouble may change to 1 Rupee = 45 Roubles from 1 equal 45 balls this is known as 1 Rupee = 64 Roubles. This is known as Exchange Depreciation.

It is automatic and it helps in correcting a mild adverse Balance of payments.

This stimulates exports by making the domestic goods cheaper to the foreigners and thereby leading to favorable balance.

However, this method is not feasible under the present system of IMF which prescribes the fixed exchange rate system.

3. Devaluation

Devaluation of currency is another way that makes exports attractive.

The term Devaluation means a reduction in the official rate at which one currency is exchanged for another.

It is an alternative to exchange depreciation.

Devaluation is undertaken when the currency is found to be unduly overvalued.

Related: 13 Causes of Disequilibrium in Balance of Payments (Step-by-Step).

Devaluation makes the Goods cheaper for foreigners. Exports will rise and imports decline.

The Success of Devaluation, however, depends on certain following factors:

  • The demand elasticity for the exports must be greater than Unity.
  • The elasticity of supply for the imports should be greater than Unity.
  • Devaluation should not be exceedingly adverse because it will not do anything.
  • There should not be retaliative action from other Nations, that is, other nations should not have the corresponding Devaluation that nullifies each other’s gain.
  • Devaluation of the country’s “terms of trade” should not be exceedingly adverse otherwise it will not gain anything from trade.

Moreover, these are the following ‘Drawbacks of Devaluation’:

  1. It may lead to ‘Inflationary’ tendencies in the internal economy.
  2. It is nothing but the acknowledgment of a country’s economic weakness.
  3. It puffs up the burden of Debt servicing.
  4. It takes considerable time to yield expected results.
  5. Its effect is strongly purgative I.e. violent.

4. Exchange Control

Restriction on the use of foreign exchange by the central banks called Exchange Control.

When exchange control is adopted, all the exporters have to surrender their foreign exchange earnings to Central Bank.

Under exchange control, the central bank releases foreign exchanges only for essential imports and conserves the rest of the balance.

This is the most direct method of curbing imports.

Exchange control, in General, deals with the balance of payments disequilibrium by suppressing the deficit that is only a symptom and not the Basic Trouble.

Exchange control deals with only the deficit, not its causes, and it may irritate those causes tending to create a more basic disequilibrium.

In other words, exchange control can prevent a complete breakdown, but it cannot eliminate a condition of disequilibrium.

Thus, exchange control offers no permanent solution to the problem of persistent disequilibrium.

It can, at best be justified only as a temporary measure, to gain time while other more fundamental adjustments made to restore equilibrium in the Balance of payments.

Related: 5 Main Types of Disequilibrium in Balance of Payments (BOP).

5. Fiscal Policy- Import Duties

Under this policy, import traffic tariff duties are imposed so as to make the import dearer with an overall aim of checking imports.

Imports get reduced and Balance of payments becomes favorable.

6. Import Policy (Import Quotes)

Under this mechanism, the government fixes a maximum quantity or value of a commodity to be imported.

This in turn reduces and the deficit is reduced and thereby the Balance of payments, the position is improved.

This measure has the immediate effect of checking imports as the marginal propensity to import becomes zero once the quota limit is reached.

To correct disequilibrium in Balance of payments import quotes are assumed to be better than import duties.

The quota has the immediate effect of restricting imports as the marginal prosperity to import become zero, once the quota-limited is reached.

Thus, the effect of quotas on quantitative restriction (QR) of imports is explicit. But the Balance of payments effects of import duties and not to certain.

Related: 10 Important Objectives of Demand Forecasting (With Examples).

7. Stimulating/Improving Export

To correct disequilibrium in the Balance of payments, it is necessary that exports should be increased, the government may adopt export programs for this purpose.

Export promotion programs include subsidies, tax concession to exporters, marketing facilities, incentives for exporters, reducing export duties, etc.

Further, to encourage exports the level of costs in the country may have to be brought down.

Thus, may involve cutting down on wages and interest rates and other incomes and also a contraction of currency to bring the prices down.

8. Foreign Loans

The government can also secure loans from foreign banks or foreign governments to reduce the deficit in the balance of payments.

Since the repayment of these loans is spread over a long period, This helps the government to remove the deficit in the Balance of payments.

During the currency of the loans, the government takes steps to improve its foreign exchange position.

Related: 18 Key Success Factors in Retail Business (With Examples).

9. Encouragement to Foreign Investment

The government induces the foreigners to make an investment in the country offering them all sorts of investors incentives and concessions.

This provides the government with extra foreign exchanges which are utilized to reduce the deficit in the Balance of payments.

But while inviting the foreign capitalist to invest their capital within the country, the government sees to it that this does not produce any adverse repercussions on the economy.

10. Incentives to Foreign Tourist

The government may also encourage foreign tourists to visit the country in increasing numbers of offering them various facilities and constitutional travel.

This increases the foreign exchange earnings of the country with the help of which the deficit in the Balance of payments can be reduced.

11. Automatic Measures

The disequilibrium in the balance of payments may automatically disappear after sometime when certain forces came into operation in the country.

For example – The disequilibrium in the Balance of payments of a country under the gold standard was automatically corrected through the inflow and outflow of gold.

If the balance of payments was unfavorable there was an outflow of gold from the country causing a contraction in the volume of currency and credit, and ultimately a fall in the domestic price level.

This encouraged exports, while it discouraged imports. The equilibrium in the BOP was automatically restored after some time.

Similarly, the equilibrium in the Balance of payments of a country on the paper standard was automatically corrected through fluctuations in its rate of exchange.

For example – If the country’s BOP was unfavorable, the demand for foreign exchange exceeded its supply, and consequently, the exchange value of its currency went down. The fall in its exchange value encouraged exports while it discouraged imports.

The Equilibrium in the BOP was automatically restored after the lapse of some time. The opposite process worked when the Balance of payments of the nation turned favorable.

The automatic measures discussed above did not produce the desired results in a short period.

Nor were they effective in dealing with a serious and fundamental disequilibrium in the BOP.

12. Miscellaneous Measures

These include- developing import-substituting Industries, postponing debt payments, check on inflation, check on smuggling, etc. All these may help in correcting disequilibrium in the Balance of payments.

To Sum up, some of the deficit in the balance of payments is not a desirable phenomenon for a nation.

The methods mentioned above aim at reducing imports and stimulating exports.

Of these, The trade measures are better and effective. It produces immediate results.

The Government of a nation may use this method in combination with other methods to eliminate or reduce a chronic deficit in the Balance of payments.

Thus, Now you know all the Methods to Correct Disequilibrium in Balance of Payments.

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