Economics Assignment 2

Economics Assignment

Economics Assignment

Corrective Measures of Balance of Payment Deficits

Balance of Payment (BoP) is a system followed by countries to keep an account of their income and expenditures. There are mainly three accounts in this system, this is the current account, capital account, and balance of settlement. Du Plessis et al. (1998) mentioned that the disequilibrium in the Balance of Payment is a condition when there is surplus or deficits in the accounts. The three approaches have been identified in order to tackle the Balance of Payment Disequilibrium. This has been discussed in light of deficit situation of BoP.

Adjustment Approaches for BoP Disequilibrium , Du Plessis et al

Monetary Approach

The researches done by Chacholiades (1990) mentioned that the imbalances in the money markets affect the international reserves of the country. When the money supply increases due to fixed regime of exchange rates the expenditure on foreign goods and services increases, these results in the foreign reserves moving out of the country and creates the situation deficits in BoP. The step taken in such situation is to increase the interest rates, thereby controlling the expenditure and maintaining the foreign exchange reserves. China recorded the BoP deficit situation in the second quarter of 2012, first time after 1998 (The Economist, 2012). However the overall situation of current account was in surplus during that time, as China actively blocks the foreign outflow of funds by strict capital controls.

There has been studies conducted by Obioma (1998), this research was done for the period of 1960-1993 in Nigeria. This study was done under different exchange rate system. It was found that if the external credit is increased and there is the change in money stock that results in the changes in the foreign reserves and increases the outflow of funds to the foreign country. It is necessary at that time to reduce the credits by increasing the interest rates so that the outflow of funds can be curbed.

Elasticity Approach

The approach firstly propounded by Robinson (1937) argues that the exchange rate volatility and changes had a direct correlation with the exports and imports. The analysis of Marshallian Partial Equilibrium is used in the approach (Barbone & Rivera-Batiz, 1987). In case of the BoP deficit the approach is to devalue the currency. If foreign elasticity of exports ex + home elasticity for imports ei > 1 and currency is devalued it results in the increase in the balance of payments. It is assumed if the sum of elastic is greater than one than it will reduce the imports and increase the exports. The basic disadvantage of devaluation of currency is the rise of inflation as the domestic products become more affordable. Similar is the cases of currency pegged with others for the purpose of borrowing like the Thai Bhat linked with US Dollar (Norris, 2013). The research of Norris (2013) mentioned that the Thailand government had borrowed the debt in terms of the US Dollar. When the Dollar was devalued it resulted in aggravating the debt owned by the Thailand government thereby resulting in the financial crisis.

Absorption Approach

This approach is the critic of Elasticity approach. The BoP Deficits under this approach is corrected by increasing the production, which is the National Income, over and above the expenditure which is the Absorption. It can also be corrected if the level of Total Absorption is changed. Researches done by Machlup (1955) have found that when the income is devalued it affects the exports of the country, and it also synergizes the demand for domestic products. Absorption means that the people are consuming more and producing less. The absorption is measure which states that the people are consuming higher and the expenditure on the consumption is much more than the investments. If the absorption rate that can be denoted by a is greater than 1, this will bring undesirable affect of the devaluation on the BOP. In such situation it is ideal that the government follows a policy measure that is driven to reduce the expenditure and increase the investments so that the production of the country is increased. The increased production and decline in the absorption and buying capacity will improve the Balance of Payments of the country. The exports should be boosted and the imports should be brought to check so that the declines in the currency and the deficits in the Balance of Payments is brought to check.

Keynesian and Classic Causes of Inflation

Classical Cause

Classic case of Economics also called the case of Laissez Faire is based on the predictions that the economy automatically turns itself into full employment. The predictions of the classical economists are based on the principle developed by Say (1776-1832) and are known as Say’s Law. The Say’s Law mentions that the Supply has the potential of creating its own demand. The classical model also considered that when the demand is reduced it resulted in the reduction in the wages and the prices of the produce. This maintained the real GDP.

Meanwhile, higher demand resulted in inflation as the produce remained static. Classic economists were of the view that when the aggregate demand changed it only resulted in the changes in the prices of the product. Inflation and Money Supply are directly proportional in a given output level (EconomyWatch, 2010). The biggest demerit of the classical theory of inflation that basis itself onto the quantity theory of money is that it does not states how the increases in the supply of money cause the changes in the price levels.

The employment rates and the GDP remained unchanged. The supply curve in classical theories is vertically aggregate in nature. This is because of the assumption that the prices adjust themselves on the basis of the outputs. The classic theory states that the price levels shoots up and so is the demand for the goods and services (EconomyWatch, 2010). Wage rates and input prices are flexible in the cases of the classic theories. The demand increases are coupled with the increases in the inputs like wages of labour and the raw materials.

There has also been a different case in cases of Classical theories that is called the Neo Classical Theory of Inflation. Neo Classical theory views are changed from that of classical in the sense that the former specifies that when the money demand increases it simultaneously results in the increase in the prices resulting in Inflation (Wicksell, 1936).

Keynesian Inflation Theory

The extension of the Classical theory of inflation and its loopholes were catered by some extent by the Keynesian Theory on Inflation. Increase in money supply was the only factor that resulted in the changes in prices as per the Classical approach but the Keynesian Theory mentioned that the changes can also occur in demand if there is an underpinning of the real factors. Keynes (1940) stated that there is a inflation gap that exists when the planned expenses increases the output. Inflation gap is created due to the mismatch between the disposable income and changes in output. The prices and wages were also not fixed as per the Keynesian theorists.

Keynes was of the view that inflation should be controlled and if it not it can have ripple effects on the stakes. Increases in money supply might not directly relate to the increases in inflation as per Keynes. If Money in circulation is increased it results in the decline in the velocity with which this money is circulated. The speed with which the money is circulated is dependent on the money that is actually available. Keynes has also noted that the increase in the money supply also increases T, which is the transaction. Keynes theory of inflation is also linked with employment and the prospects thereof. According to the theory, the firms will increase the number of people to be employed that will result in the increasing of aggregate demand. The demand rise forces the firms to employ more and more people for raising the output. However, due to capacity constraints the increased output mismatches the actual demand. This mismatch between demand and supply ultimately results in the increase of the price of goods. Keynes was of the view that inflation stage began after the fill employment. Keynes theory of inflation is also based on assumption that the as the quantity of money changes there is also change in the employment.

The unemployment of human resource results in the increase in the quantity of money thereby creating inflation. As the employment reaches full stage it results in the change in the price level. The prices even rise before the full employment stage and the stage is known as bottleneck inflation.

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