Question

(a)What international transactions make up the current account and basic account of a country’s BOP? (b)What measures can a country take to deal with its balance of trade deficit? (c) Briefly discuss how devaluation is supposed to work to reduce a country’s trade deficit? What are the limitations of this strategy?

Answer 1

Answer(a): Balance of Payment- It is the statement of transactions of goods from one country to other countries. BOP tells all the transactions that a country have with other countries.

Current account shows the balance of export and import of goods and services. Current account calculates the country's trade balance plus net income and the direct payments.

Answer (b) Trade deficit- It happens when a country imports more goods than exports.

Measures to deal with trade deficit: Are as following:

1. By reducing value of exchange rate, trade deficit can be reduced. If company devaluates its currency then imports will be costlier and customers will consume less so demand less, in this way, trade deficit can be reduced.
2. Country should reduce the consumption and demand for goods from abroad. Government should have tight fiscal policies to do that so that trade deficit can be reduced.
3. Companies and Government should try to make the products in the home country itself so that there will be no need for importing the same goods.

Answer(c): By devaluating value of exchange rate, trade deficit can be reduced. If company devaluates its currency then imports will be costlier and customers will consume less so demand less, in this way, imports will be less and trade deficit can be reduced.

Limitation of this strategy- Devaluation gives birth to inflation, when country's currency loses its purchasing power, prices of commodities increase and inflation increases in the country. It also increases the external debt.