With the help of Salter-Swan diagram, define the zones of disequilibrium and assign policy prescriptions for the situations pertaining to unemployment and inflation vis-à-vis BOP deficit.

Understanding the Salter-Swan Diagram

The Salter-Swan diagram consists of two main curves: the BB curve (Balance of Payments curve) and the AA curve (Aggregate Expenditure/Internal Balance curve). The intersection of these curves represents a point of simultaneous internal and external balance.

• AA Curve: Represents the equilibrium in the domestic goods market. It slopes upward, indicating a positive relationship between domestic output (Y) and the exchange rate (E). A depreciation of the exchange rate (E increases) stimulates domestic demand, leading to higher output.
• BB Curve: Represents the equilibrium in the balance of payments. It slopes downward, indicating an inverse relationship between domestic output (Y) and the exchange rate (E). Higher output leads to increased imports and a worsening trade balance, requiring a depreciation of the exchange rate to restore equilibrium.

Zones of Disequilibrium

1. Inflationary Gap (Region A)

This occurs when domestic output (Y) is above the full employment level, leading to inflationary pressures. The economy is experiencing a BoP surplus. This is represented by the area above the AA curve and to the left of the BB curve.

• Characteristics: High output, rising prices, BoP surplus, appreciated exchange rate.
• Policy Prescriptions:
  • Fiscal Contraction: Reduce government spending and/or increase taxes to curb aggregate demand.
  • Monetary Tightening: Increase interest rates to reduce borrowing and investment, thereby cooling down the economy.
  • Exchange Rate Appreciation: Allow or encourage the exchange rate to appreciate to reduce net exports and dampen inflationary pressures.

2. Deflationary Gap with Unemployment (Region B)

This occurs when domestic output (Y) is below the full employment level, leading to unemployment. The economy is experiencing a BoP deficit. This is represented by the area below the AA curve and to the right of the BB curve.

• Characteristics: Low output, rising unemployment, BoP deficit, depreciated exchange rate.
• Policy Prescriptions:
  • Fiscal Expansion: Increase government spending and/or reduce taxes to boost aggregate demand.
  • Monetary Easing: Reduce interest rates to encourage borrowing and investment, stimulating economic activity.
  • Exchange Rate Depreciation: Allow or encourage the exchange rate to depreciate to increase net exports and reduce the BoP deficit.

3. Stagflationary Gap (Region C)

This is a more complex situation characterized by both high inflation and high unemployment, often accompanied by a BoP deficit. This is represented by the area above the AA curve and to the right of the BB curve.

• Characteristics: High inflation, high unemployment, BoP deficit.
• Policy Prescriptions: This situation is difficult to address as policies to combat inflation tend to worsen unemployment, and vice versa.
  • Supply-Side Policies: Focus on improving productivity and reducing costs of production to address both inflation and unemployment. Examples include deregulation, investment in education and training, and infrastructure development.
  • Selective Demand Management: Carefully calibrated fiscal and monetary policies to avoid exacerbating either problem.
  • Exchange Rate Adjustment: A moderate depreciation might help improve the BoP without significantly fueling inflation.

4. BoP Disequilibrium with Full Employment (Region D)

This occurs when the economy is at full employment, but still experiences a BoP deficit or surplus. This is represented by points on the AA curve but off the BB curve.

• Characteristics: Full employment, BoP deficit/surplus.
• Policy Prescriptions:
  • BoP Deficit: Exchange rate depreciation, import controls, export promotion.
  • BoP Surplus: Exchange rate appreciation, export controls, import liberalization.