Consider the Consequences of Reducing a Balance of Payments Deficit Essay

Consider the Consequences of Reducing a Balance of Payments Deficit - Essay Example So as the consequences are the results of relative actions/measures, it makes sense to review the measures of reducing the BOP deficit and consider the impact of each measure on economics. Definition of balance of payments and balance of payments deficit Pippenger (1973, p.6) defines balance of payments as a record of the value of all transactions between foreign and domestic residents over a certain period of time, usually one year; the balance of payments is based on the principle of double entry bookkeeping where the dollar value of every transaction is recorded as both a debit and a credit (Pippenger, 1973). Debit or minus entry in the balance of payments reflects the purchase or import of anything from a foreign partner, while a credit or plus item in the balance of payments reflects the sale or export of anything to a foreign partner (Pippenger, 1973). Applying double entry bookkeeping, the payments received for exports are recorded as debit and the payments made on imports are recorded as a credit (Pippenger, 1973). Balance of payments deficit is an imbalance in a nation’s balance of payments in which payments received by the country are less than the payments made by the country (Economic Glossary, n.d.). This term is also known as unfavorable balance of payments because less currency is flowing in to the country than is flowing out (Economic Glossary, n.d.). Thus, balance of payments deficit causes unequal flow of currency and results in reducing the supply of money in nation, imposing negative implications for unemployment, inflation, production, and other aspects of import-prevailing economy (Economic Glossary, n.d.). In order to minimize these implications it is necessary to understand better how balance of payments deficit can be reduced and what are the consequences of possible measures of reducing BOP? Measures of reducing BOP deficit and its consequences There exist different measures aimed at reducing balance of payments deficits; these measures are divided into two groups: automatic correction and deliberate correction of BOP disequilibrium. In this paper, we will review only deliberate measures as tools for reducing the deficit in BOP. Deliberate measures, broadly applied in different economics of the world, are differentiated by three main categories, including monetary measures, trade measures, and miscellaneous measures. Monetary measures – monetary contraction Monetary contraction or money supply allows a country to influence its level of aggregate domestic demand, demand for exports and imports, and price level of domestic production (Cherunilam, 2008). Contraction of money supply results is applied in order to reduce the purchasing power and consequently, aggregate demand of nation (Cherunilam, 2008). By adopting monetary contraction in the country, domestic output decreases, while domestic real interest increases. Increase of the rate of interest is caused in result of decrease in money supply (Dwiv edi, 2010). Increase in interest rate leads to reduction of domestic investment, and fall of investment leads to reduction of income levels of population (Dwivedi, 2010). Additionally, increase in the interest rate leads to the inflow of foreign capital, which reduces deficits in capital account of BOP (Dwivedi, 2010). In result, demand for imports is reduced because of the fall in domestic prices and domestic aggregate demand, while demand for