- Introduction – Summarise the reasons for deteriorating Balance of Payment [primarily a worsening current account is due to worsening trade balance due to falling exports or worsening capital account due to fall in the inflow of FDI].
Body
- Explain how exchange rate policy helps to mitigate a deteriorating Balance of Payments of a country.
- An appropriate exchange-rate centred monetary policy would be devaluation. Devaluation makes the prices of exports cheaper in foreign currency and prices of imports more expensive in domestic currency. Assuming ML condition holds, the balance of trade will improve, leading to an improvement in the balance of payments, ceteris paribus.
- Devaluation would make investing in the country cheaper the country therefore encouraging inflows of foreign direct investments.
- Explain that the exchange rate policy may not help to mitigate a deteriorating Balance of Payments.
- May deteriorate the BOP further in the SR as the ML condition may not hold in the SR [J curve effect].
- May worsen imported inflation, which has a negative impact on export prices if the economy has a large proportion of imported factor inputs. The resultant imported inflation may cause exports to lose its competitiveness and hence if exports are not competitively priced due to high cost of production, the impact of the devaluation would be limited.
- Devaluation would not be effective if the cause of the deteriorating Balance of Payments is high import expenditure due to rising incomes in the domestic economy. So expenditure-reducing policy is more be more effective in this instance.
- Explain how supply-side policies may help mitigate a deteriorating Balance of Payments.
- A resource-constrained country, like Singapore, that is heavily reliant on imported factors of production would face a higher cost of production due to the devaluation of the exchange rate. Therefore supply-side policies would be more appropriate.
- Supply-side policies could increase the competitiveness of exports thereby improving the current account balance.
- Use examples of supply-side policies to explain how exports gain its’ competitiveness and thereby improving the trade balance and the Balance of Payments, ceteris paribus.
- Explain how supply-side improves the inflow of FDIs thereby improving the capital account and assuming ceteris paribus, improving the Balance of Payments.
- Explain the inflow of FDIs is dependent on the economic outlook so the impact of devaluation of the currency and supply-side policies would be limited. If there is a poor economic outlook or political instability, devaluation and supply-side policies would not encourage the inflow of FDIs. Hence the government has to implement measures to improve the investors’ confidence of the economy to encourage the inflow of FDIs.
- Explain that there could be other reasons for a deteriorating Balance of Payments and a devaluation may not be effective.
- Other reasons: Falling net Factor income [High outflow of factor income due to a significant number of foreign workers or FDIs], Outflow of hot money and portfolio investments.
- Devaluation may curb falling factor income but it may worsen the outflow of hot money, ceteris paribus it may worsen the capital account.
Conclusion
- Effectiveness of the policy would depend on the causes of the deteriorating Balance of Payments. Given that the primary cause is low exports, devaluation would assist in the mitigation of the Balance of Payments in the SR and a more sustainable LR approach would be to use supply-side policies to increase the export competitiveness.
- If the primary cause is high imports, devaluation may not be effective. Other policies such as expenditure reducing would be more appropriate.