Question

How can fixed exchange rates lead to balance of Payment Deficits?

Answer 1

Fixed exchange rate system is the system in which government decide the value of its currency in terms of some other currency. In this system, the government need to maintain the foreign exchange reserve to keep exchange rate at a particular level.

Balance of payment is an accounting statement in which all the transactions between resident of a country and rest of the world take place. The balance of payment is deficit when debit side(negative item) is more than the credit side(positive items).

Suppose there is a situation when imports of goods and services are more than the exports. It implies that demand for foreign exchange is higher than the supply which cause a downward pressure on value of domestic currency so to control that and to keep foreign exchange rate fixed, the government starts to sell foreign exchange in the market to offset the higher demand for foreign exchange. This means that the reserve of foreign currency with government or central bank decreases which is considered to be the negative or debit side item in balance of payment which cause balance of payment deficit.