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` To achieve adjustment in BOP

following policy instruments areneeded:

1. Expenditure Changing or Demand

Policies;

2. Expenditure Switching Policies;

3. Direct Controls; (Exchange Controls)

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` Expenditure Changing Polices refers to both the

Fiscal and Monetary Polices.

` Fiscal Policy

` It refers to change in

Government Expenditure;

Taxes;Both;

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Monetary Policy

` It controls the nations money supply by

affecting domestic interest rate.

Expansionary Monetary Policy

` If interest rate falls, which induces an

increase in the level of investment andincome in the nation through the multiplierprocess and increase money supply thatleads imports to rise.

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` Contractionary Monetary Policy

` On the other hand, contractionary monetary

policy refers to a reduction in the nationsmoney supply and rise in interest rate.

`

Rise in interest rate discourages investment,income, and imports.

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` This policy mainly works by changingrelative prices of imports and exports for

which

` A change in exchange rates is required.

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` Devaluation refers to the lowering of the

value of a home currency in respect of theprice of gold/respective foreign currency.

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` The immediate effect of devaluation is a change

in relative price.

If a country devalues its currency, say, 25%

Ceteris paribus its import price will rise by25% in terms of home currency. Resultantly,import bill will tend to fall.

A rise in import prices often provides protectionto home industries and thus import substitutiontakes place.

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` There are two approaches for effectiveness of

devaluation:

1. The Elastic Approach :` The extent by which devaluation can make

improvement in the Balance of Payment deficit of a

country depends upon:

` The countrys Price elasticity of demand for imports

` The Price elasticity of foreign demand for its

exports.

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If price elasticity for exports of devaluing country is

EpX > 1 (more Elastic)

BOP deficit will reduce and vice-a-versa.

On the other hand, if price elasticity for imports of

devaluing country is-

EpM > 1 (more elastic)

It has positive impact, BOP deficit will reduce.

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` This theory states that-

` Devaluation leads to increase in the price of

imports which will affect the volume of imports.

` But to what extend it will decrease as a result of

devaluation it will very much depend upon

countrys elasticity of demand for imports.

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` The elasticity of demand for imports of necessitieslike, capital equipment and petroleum is low in the

country, country would find it difficult to reduce itsimports in response of devaluation.

` On the other hand when elasticity of demand for exports is high, it has positive impact on BOP.

` Developed countries are fall in this category. Theless developed countries exporting agriculture,minerals and selected consumer goods generallycannot take advantage of devaluation as the

elasticity of demand for these exports is often low.

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Limitation` Elastic approach and Marshall-Lerner condition

for external balance has some limitations, suchas,

Partial Equilibrium Approach

` Elastic and Marshall-Lerner is based onunrealistic assumption as stability of domesticprice.

Neglect ofIncome distribution ` Devaluation results in reallocation of productive

resources from other sector to export sector andthe import substitution sector, which leads

redistribution of income.

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Off-setting effect of Inflation-

` Devaluation causes an expansion in exports andreduction in imports due to decline in the relativeprice in the devaluing country compare with foreigncountry.

` On the other hand the higher import price may pushthe domestic cost structure in devaluing country.

` The expansion of exports-incomes in devaluing

country. Consequently, increase demand for productdue to the higher income may push up theinflationary pressure.

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` Because of above mentioned Limitation, Sidney

S. Alexander has developed an another approach for effectiveness of devaluation.

` As per

Alexander, devaluation can only besuccessful in correcting disequilibrium of BOP

when a country has sufficient exportable

surplus, because fall in price of exportable

commodities due to devaluation leadsincreasing demand.

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2. Absorption Approach

` As per this approach trade balance is the

difference between goods and services

produced in a country and its absorption.

` Absorption means the sum of

consumption and investment expenditure

on domestically produced goods andservices.

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` Algebraically

B = Y-A

B = Trade Balance , Y = National income or value

of output of goods and services

A = Absorption or sum of consumption and

investment expenditure.

` As perAbsorption approach, if expenditure

or absorption is less than national product, it willhave positive trade balance or exportable surplus.

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` Precisely, as per absorption Approach-

` e = b+a (marginal propensity to absorb)

` b marginal propensity to consume,

` a - marginal propensity to invest,

1. e < 1 = Trade deficit reduce

2. e > 1 = Trade deficit increase

3. e = 1 Neither trade deficit or

surplus.