Question

Fully explain how the balance in the BOP is related to the equilibrium exchange. In addition, explain how an appreciation of the domestic currency will correct a balance of payments deficit stemming from both a FA and CA deficit.

Answer 1

Answer-

With the result demand for local currency increases till exchange rate falls. On the other hand if demand for foriegn exchange is greater than supply, exchange rate will tend to rise. The demand for imports will rise and the demand for exports will tend to fall. This will happen till equilibrium exchange rate is reached.Bop is related to equilibrium im exchange rate. If the demand for local currency is greater than supply the exchange rate will tend to fall. At this exchange rate the demand for imports will be less and demand for exports will be high.

Appreciation will reduce demand for exports as foriegners will not import much due to higher price of country's goods. On the other hand investment in country will fall as it becomes costly in local currency of foriegners and returns are less in terms of domestic currency. The demand r for Foreign goods will increase as they are cheap. Also investment in foreign countries will rise as it is cheap and returns will be greater in terms of local currency. Thus bop surplus will be corrected.