What is a balance of payments how automatic deficit removed in BOP by the price mechanism, flexible exchange rate?
The balance of payments of a country is a systematic record of all its economic transactions with the outside world in a given year.
According to Bosodersten, “the balance of payments is merely a way of listing receipt and payments in international transactions for a country”. A deficit is an excess of debits over creditors in the current account.
Automatic Price Adjustment Mechanism
An automatic adjustment mechanism is one that is activated by the balance of payments disequilibrium itself without any govt. action and operates until the disequilibrium is eliminated.
On the other hand, adjustment policies are specific measures adopted by the govt. with the primary aim of correcting a balance of payments disequilibrium.
Adjustment with Flexible Exchange Rate
A deficit in a nation’s balance of payments is corrected by depreciation or devaluation of the nation’s currency.
This is shown in the figure it is assumed that U.S and U.K are the only two countries in the world, and there are no international capital flows.
In this figure at R=$2/£1. The demand of £ by the USA is 12 million per year while the supply is 8 million, so the USA has a deficit of 4 million in the balance of payments.
With D£ and S£ a 20% depreciation or devaluation of the $ would completely dominate the deficit and S£* and D£* curves with 100% depreciation will eliminate the deficit.
The Derivation of Demand Curve for Foreign Exchange
Derivation Demand CurveIn this diagram, the US demand curve is derived from the demand and supply curves of US imports in terms of Pounds.
At R=$2/£1 demand for pounds by the US is 12£. A depreciation of 20% Dm shifts down to Dm’. Then Dm=.9 and QM=11. Then a new equilibrium at point E’ reached. DM’ is not parallel to DM because the shift is of a constant percentage.
Furthermore, given SM the less elastic is DM. The smaller is the reduction in the US quantity demanded of £ and the less elastic is the US demand curve for £’s.
Derivation of Supply Curve for Foreign Exchange
In this figure, Dx is the UK demand for US exports in terms of pounds, and Sx is the supply of exports of US to the UK at R=$2/£1 with Dx and Sx and Sx the pound price of US exports is Px=£2 and the quantity of US exports is Qx=4.
So US quantity of pounds supplied is 8. This corresponds to the point at A is the figure. When the dollar is devalued by 20% to R=$2.40/£1. Dx remains unchanged, but Sx shifts down by 20% to Sx’.
After depreciation of the dollar, each pound is now worth 20% more in terms of the dollar. Now UK will demand greater quantities of US exports, while the US will supply a greater quantity of exports at pound prices above Px=£1.6 until the new equilibrium E’ is reached.
Sx is not parallel to Sx because the shift is of a constant percentage. The less elastic is Dx, the less elastic is the derived US supply curve for pounds.
The Marshall Lerner Condition
The condition that tells us whether the foreign exchange market is stable or unstable is the Marshall Lerner Condition.
Then the Marshall Lerner condition indicates a stable foreign exchange market if the sum of the price elasticity’s of the demand for imports (DM) and the demand for exports (Dx), is absolute term is greater than 1.
If the sum of the price elasticity of DM and Dx is less than 1, the foreign exchange market is unstable, and if the sum of these two demand elasticity is equal to 1, a change in the exchange rate will leave the balance of payments unchanged.
For example, in the second diagram, we can visualize that given a horizontal Sx that shifts down by the percentage depreciation or devaluation of the dollar.
The quantity of pounds supplied to the US rises remains unchanged. The US balance of payments improves if the elasticity of Dx is greater than 1.
Now we can explain it by diagram if Sx is horizontal.
SX HorizontalIf DM vertical and if SM horizontal
In this diagram, if DM were vertical and SM is horizontal, a depreciation or devaluation of the dollar would leave the US demand for imports and thus the number of pounds demanded by the US completely unchanged.
If DM is negatively sloped.
If DM is negatively sloped so that it falls or shifts down by the amount of the depreciation of the dollar, the quantity of pounds demanded by the US falls, and thus, by itself, improves the US balance of payments.
The greater the amount by which the sum of these two elasticities exceeds 1, the greater is the improvement in the US balance of payments for a given depreciation of devaluation of the dollar.