Methods of Correction of Disequilibrium

Method 1. Trade Policy Measures: Expanding Exports and Restraining Imports

Trade policy measures to improve the balance of payments refer to the measures adopted to promote exports and reduce imports.

Exports may be encouraged by reducing or abolishing export duties and lowering the interest rate on credit used for financing exports. Exports are also encour­aged by granting subsidies to manufacturers and exporters.

Besides, on export earnings lower in­come tax can be levied to provide incentives to the exporters to produce and export more goods and services. By imposing lower excise duties, prices of exports can be reduced to make them competi­tive in the world markets.

On the other hand, imports may be reduced by imposing or raising tariffs (i.e., import duties) on imports of goods. Imports may also be restricted through imposing import quotas, introducing li­censes for imports. Imports of some inessential items may be totally prohibited.

Before the economic reforms carried out since 1991. India had been following all the above policy measures to promote exports and restrict imports so as to improve its balance of payments position. But they had not achieved full success in their aim to correct balance of payments disequilibrium.

Therefore, India had to face great difficulties with regard to balance of payments. At several occasions it approached IMF to bail it out of the foreign exchange crisis that emerged as a result of huge deficits in the balance of payments. At long last, economic crisis caused by persistent deficits in balance of payments forced India to introduce structural reforms to achieve a long-lasting solution of balance of payments problem.

Method 2. Expenditure-Reducing Policies

The important way to reduce imports and thereby reduce deficit in balance of payments is to adopt monetary and fiscal policies that aim at reducing aggregate expenditure in the economy. The fall in aggregate expenditure or aggregate demand in the economy works to reduce imports and help in solving the balance of payments problem.

The two important tools of reducing aggregate expen­diture are the use of:

• Tight monetary policy and
• Concretionary fiscal policy

(i) Tight Monetary Policy

Tight monetary is often used to check aggregate expenditure or demand by raising the cost of bank credit and restricting the availability of credit. For this bank rate is raised by the Central Bank of the country which leads to higher lending rates charged by the commercial banks. This discourages businessmen to borrow for investment and consumers to borrow for buying durable consumers goods.

This therefore leads to the reduction in investment and consumption expenditure. Besides, availability of credit to lend for investment and consumption purposes is reduced by raising the cash reserve ratio (CRR) of the banks and also undertaking of open market operations (selling Government securities in the open market) by the Central Bank of the country.

This also tends to lower aggregate expenditure or demand which will helps in reducing imports. But there are limitations of the successful use of monetary policy to check imports, espe­cially in a developing country like India. This is because tight monetary policy adversely affects investment increase in which is necessary for accelerating economic growth.

If a developing country is experiencing inflation, tight monetary policy is quite effective in curbing inflation by reducing aggregate demand. This will help in reducing aggregate expenditure and, depending on the income propensity to import, will curtail imports. Besides, tight monetary policy helps to reduce prices or lower the rate of inflation. Lower price level or lower inflation rate will curb the tendency to import, both on the part of businessmen and consumers.

But when a developing country like India is experiencing recession or slowdown in-economic growth along with deficits in balance of payments, use of tight monetary policy that reduces aggre­gate expenditure or demand will not help much as it will adversely affect economic growth and deepen economic recession. Therefore, in a developing country, monetary policy has to be used along with other policies such as a appropriate fiscal policy and trade policy to tackle the problem of disequilibrium in the balance of payments.

(ii) Contractionary Fiscal Policy

Appropriate fiscal policy is also an important means of reduc­ing aggregate expenditure. An increase in direct taxes such as income tax will reduce aggregate expenditure. A part of reduction in expenditure may lead to decrease in imports. Increase in indirect taxes such as excise duties and sales tax will also cause reduction in expenditure.

The other fiscal policy measure is to reduce Government expenditure, especially unproductive or non-developmen­tal expenditure. The cut in Government expenditure will not only reduce expenditure directly but also indirectly through the operation of multiplier.

It may be noted that if tight monetary and contractionary fiscal policies succeed in lowing aggregate expenditure which causes reduction in prices or lowering the rate of inflation, they will work in two ways to improve the balance of payments. First, fall in domestic prices or lower rate of inflation will induce people to buy domestic products rather than imported goods. Second, lower domestic prices or lower rate of inflation will stimulate exports. Fall in imports and rise in exports will help in reducing deficit in balance of payments.

However, it may be emphasised again that the method of reducing expenditure through contractionary monetary and fiscal policies is not without limitations. If reduction in aggregate demand lowers investment, this will adversely affect economic growth. Thus, correction in balance of payments may be achieved at the expense of economic growth.

Further, it is not easy to reduce substantially government expenditure and impose heavy taxes as they are likely to affect incentives to work and invest and invite public protest and opposition. We thus see that correcting the balance of payments through contractionary fiscal policy is not an easy matter.

Method 3. Expenditure Switching Policies: Devaluation

A significant method which is quite often used to correct fundamental disequilibrium in balance of payments is the use of expenditure-switching policies. Expenditure switching policies work through changes in relative prices. Prices of imports are increased by making domestically produced goods relatively cheaper. Expenditure switching policies may lower the prices of exports which will encourage exports of a country. In this way by changing relative prices, expenditure-switching poli­cies help in correcting disequilibrium in balance of payments.

The important form of expenditure switching policy is the reduction in foreign exchange rate of the national currency, namely, devaluation. By devaluation we mean reducing the value or exchange rate of a national currency with respect to other foreign currencies. It should be remembered that devaluation is made when a country is under fixed exchange rate system and occasionally decides to lower the exchange rate of its currency to improve its balance of payments.

Under the Bretton Woods System adopted in 1946, fixed exchange rate system was adopted, but to correct fundamen­tal disequilibrium in the balance of payments, the countries were allowed to make devaluation of their currencies with the permission of IMF. Now, Bretton Woods System has been abandoned and most of the countries of the world have floated their currencies and have thus adopted the system of flexible exchange rates as determined by market forces of demand for and supply of them.

However, even in the present flexible exchange rate system, the value of a currency or its exchange rate as determined by demand for and supply of it can fall. Fall in the value of a currency with respect to foreign currencies as determined by demand and supply conditions is described as depreciation.

If a country permits its currency to depreciate without taking effective steps to check it, it will have the same effects as devaluation. Thus, in our analysis we will discuss the effects of fall in value of a currency whether it is brought about through devaluation or depreciation. In July 1991, when India was under Bretton-Woods fixed exchange rate system, it devalued its rupee to the extent of about 20%. (From Rs. 20 per dollar to Rs. 25 per dollar) to correct disequilibrium in the balance of payments.

Now, the question is how devaluation of a currency works to improve balance of payments. As a result of reduction in the exchange rate of a currency with respect to foreign currencies, the prices of goods to be exported fall, whereas prices of imports go up. This encourages exports and discour­ages imports. With exports so stimulated and imports discouraged, the deficit in the balance of payments will tend to be reduced.

Thus policy of devaluation is also referred to as expenditure switching policy since as a result of reduction of imports, people of a country switches their expenditure on imports to the domestically produced goods. It may be noted that as a result of the lowering of prices of exports, export earnings will increase if the demand for a country’s exports is price elastic (i.e., er > 1). And also with the rise in prices of imports the value of imports will fall if a country’s demand for imports is elastic. If demand of a country for imports is inelastic, its expenditure on imports will rise instead of falling due to higher prices of imports.

Devaluation: Marshall Lerner Condition. It is clear from above that whether devaluation or depreciation will lead to the rise in export earnings and reduction in import expenditure depends on the price elasticity of foreign demand for exports and domestic demand for imports.

Marshall and Lerner have developed a condition which states that devaluation will succeed in improving the balance of payments if sum of price elasticity of exports and price elasticity of imports is greater than one. Thus, according to Marshall-Lerner Condition, devaluation improves balance of payments if

ex + em > 1

Where,

ex stands for price elasticity of exports

em stands for price elasticity of imports

If in case of a country ex + em < 1, the devaluation will adversely affect balance of payments position instead of improving it. If ex + em = 1, devaluation will leave the disequilibrium in the balance of payments unchanged.

Income-Absorption Approach to Devaluation

Further, for devaluation to be successful in correcting disequilibrium in the balance of payments a country should have sufficient exportable surplus. If a country does not have adequate amount of goods and services to be exported, fall in their prices due to devaluation or depreciation will be of no avail.

This can be explained through income-absorption approach put forward by Sidney S Alexander. According to this approach, trade balance is the difference between the total output of goods and services produced in a country and its absorption by it.

By absorption of output of goods and services we mean how much of them is used up for consumption and investment in that country. That is, absorption means the sum of con­sumption and investment expenditure on domestically produced goods and services.

Expressing algebraically we have;

B = Y – A

Where:

B = trade balance or exportable surplus

Y = national income or value of output of goods and services produced

A = Absorption or sum of consumption and investment expenditure

It follows from above that if expenditure or absorption is less than national product, it will have positive trade balance or exportable surplus. To create this exportable surplus, expenditure on domestically produced consumer and investment goods should be reduced or national product must be raised sufficiently.

To sum up, it follows from above that for devaluation or depreciation to be successful in correcting disequilibrium in the balance of payments, the sum of price elasticities of demand for a country s exports and imports should be high (that is, greater than one) and secondly it should have sufficient exportable surplus. The devaluation will also not be successful in the achievement of its aim if other countries retaliate and make similar devaluation in their currencies and thus competitive devaluation of the exchange rate may start.

After Independence India devalued its currency three times, first in 1949, the second in June 1966 and third in July 1991 to correct the disequilibrium in the balance of payments. The devalua­tion of June 1966 was not successful for some time to reduce deficit in the balance of payments.

This is because the demand for bulk of our traditional exports was not very elastic and also we could not reduce our imports despite their higher prices. However devaluation of July 1991 proved quite successful as after it our exports grew at a rapid rate for some years and growth of imports remained within safe limits.

Method 4. Exchange Control

Finally, there is the method of exchange control. We know that deflation is dangerous; devalu­ation has a temporary effect and may provoke others also to devalue. Devaluation also hits the prestige of a country. These methods are, therefore, avoided and instead foreign exchange is controlled by the government.

Under it, all the exporters are ordered to surrender their foreign exchange to the central bank of a country and it is then rationed out among the licensed importers. None else is allowed to import goods without a licence. The balance of payments is thus rectified by keeping the imports within limits.

After the Second War World a new international institution’ International Monetary Fund (IMF)’ was set up for maintaining equilibrium in the balance of payments of member countries for a short term. Member countries borrow from it for a short period to maintain equilibrium in the balance of payments. IMF also advises member countries how to correct fundamental disequilibrium in the balance of Payments when it does arise. It may, however, be mentioned here that no country now needs to be forced into deflation (and so depression) to root out the causes underlying disequilib­rium as had to be done under the gold standard. On the contrary, the IMF provides a mechanism by which changes in the rates of foreign exchange can be made in an orderly fashion.

Conclusion

In short, correction of disequilibrium calls for a judicious combination of the following methods:

• Monetary and fiscal changes affecting income and prices in the country
• Exchange rate adjustment, i.e., devaluation or appreciation of the home currency;
• Trade restrictions, i.e., tariffs, quotas, etc.
• Capital movement, i. e., borrowing or lending aboard
• Exchange control

No reliance can be placed on any single tool. There is room for more than one approach and for more than one device. But the application of the tools depends on the nature of the disequilibrium.

There are, we have said, three types of disequilibrium:

• Cyclical disequilibrium,
• Secular disequilibrium,
• Structural disequilibrium (at the goods and the factor level)

It is more appropri­ate that fiscal measures should be used to correct cyclical disequilibrium in the balance of payments. To correct structural disequilibrium adjustment in exchange rate should be avoided. Capital movements are needed to offset deep-seated forces in secular disequilibrium.

The main methods of desirable adjustment are, therefore, monetary and fiscal policies which directly affect income, and exchange depreciation (that is, devaluation) which affects prices in the first instance. Devaluation or depreciation of exchange rate can also have income effect through price effects. Monetary and fiscal policies affect relative prices also.