Question

how will the BOP imbalances impact the local currency if your country uses a fixed exchange rate regime as opposed to a floating exchange rate regime? How can governments use the expenditure-switching policy to resolve their BOP issues?

Answer 1

BOP imbalances imply a country imports more goods and services than it exports, or vice versa. In floating exchange rate regime a currency will automatically depreciate( lose its value ) if there is a trade deficit as demand for the foreign currency is higher because of higher imports.

Now in a fixed exchange rate regime, the local currency is fixed to another currency. For example $1 = 1 local currency which is fixed. Now when BOP imbalances occur, for example when there is a trade surplus, the central bank will buy the foreign currency as there is excess supply of foreign currency in the market because of higher exports. from the local country. So when the domestic country exports more, it will get paid in dollars and the excess supply will have to be taken in by the central bank. It will be vice versa in the case of BOP deficit wherein the central bank will sell the foreign currency as there are more imports and people will have to pay in dollars to pay for the imports. Thus the local currency won't be impacted in a fixed exchange rate regime.

Expenditure switiching policies are taken to reduce deficit in BOP. It involves imposing higher import tariffs so that domestic consumers will buy domestic goods and less of imported goods. Thus this will reduce the deficit as less goods are imported. In a floating exchange rate system, devaluation of the currency also leads to less imports and this reduces the BOP deficit.