Model Answer
0 min readIntroduction
A persistent balance of payments deficit indicates a nation is importing more capital and goods than it is exporting, leading to a depletion of foreign exchange reserves. Under a fixed exchange rate system, maintaining the peg requires intervention by the central bank. Both monetary contraction and devaluation are potential responses, but their suitability differs significantly, especially for developing economies. While devaluation directly impacts the exchange rate, monetary contraction focuses on managing domestic demand. This answer will argue that, given the structural vulnerabilities of developing economies, monetary contraction is a more prudent approach than devaluation to improve the BoP position under a fixed exchange rate system.
Understanding the Tools
Monetary Contraction: This involves reducing the money supply in the economy, typically through measures like increasing the cash reserve ratio (CRR), statutory liquidity ratio (SLR), raising repo rates, or open market operations (selling government securities). This leads to higher interest rates, reduced credit availability, and dampened aggregate demand.
Devaluation: This is a deliberate downward adjustment of a country’s currency relative to another currency or a basket of currencies, under a fixed exchange rate regime. It’s usually undertaken by the government or central bank. While officially a fixed exchange rate shouldn’t allow for devaluation, in practice, a ‘managed float’ or realignment can occur.
Mechanisms and Effects
Monetary Contraction
- Reduced Imports: Higher interest rates discourage borrowing for import financing, leading to a fall in import demand.
- Increased Capital Inflow: Higher interest rates attract foreign capital inflows, bolstering foreign exchange reserves.
- Demand Compression: Reduced credit availability and higher borrowing costs curb domestic demand, lessening the pressure on imports.
Devaluation
- Increased Exports: A weaker currency makes exports cheaper for foreign buyers, potentially increasing export volume.
- Reduced Imports: Imports become more expensive, discouraging their consumption.
- Inflationary Pressure: Increased import prices can lead to cost-push inflation, especially if the economy is heavily reliant on imported inputs.
Comparative Analysis: Developing Economy Context
Developing economies often possess specific characteristics that make devaluation a less desirable option than monetary contraction. These include:
- High Import Dependence: Many developing countries rely heavily on imports for essential goods like food, fuel, and capital machinery. Devaluation significantly increases the cost of these imports, leading to inflation and potentially social unrest.
- Debt Burden: A substantial portion of developing countries’ debt is denominated in foreign currencies. Devaluation increases the domestic currency value of this debt, exacerbating the debt burden.
- Limited Export Diversification: Developing economies often have a narrow export base, concentrated in a few primary commodities. The price elasticity of demand for these commodities may be low, meaning that devaluation may not lead to a significant increase in export revenue.
- Weak Institutional Capacity: Effective implementation of monetary policy requires strong institutional capacity. While this can be a challenge, it is generally more manageable than controlling the inflationary consequences of devaluation.
- Vulnerability to Imported Inflation: Developing economies are more susceptible to imported inflation due to weaker domestic supply chains and limited capacity to absorb price shocks.
Monetary contraction, while not without its drawbacks (slower economic growth), offers a more controlled approach. It addresses the BoP deficit by curbing domestic demand, which is often a significant driver of import demand in developing economies. The inflationary risks are generally lower and more manageable than those associated with devaluation. Furthermore, it can attract foreign capital, strengthening the currency and reserves.
Illustrative Example: India in the 1991 Crisis
In 1991, India faced a severe BoP crisis. While some devaluation was undertaken, the primary response involved monetary contraction and fiscal consolidation. The RBI increased interest rates and implemented other measures to curb domestic demand. This, coupled with structural reforms, helped stabilize the economy and avert a complete collapse. A purely devaluation-based approach would have likely exacerbated inflation and debt distress.
| Feature | Monetary Contraction | Devaluation |
|---|---|---|
| Inflation Risk | Lower, manageable | Higher, significant |
| Debt Burden | Neutral/Slightly Positive | Increased |
| Impact on Imports | Reduced through demand compression | Reduced through price effect |
| Impact on Exports | Indirect, through improved competitiveness | Direct, through price effect |
| Social Impact | Slower growth, potential unemployment | Increased cost of living, potential unrest |
Conclusion
In conclusion, while both monetary contraction and devaluation can address a BoP deficit under a fixed exchange rate, monetary contraction is the more suitable option for developing economies. Their structural vulnerabilities – high import dependence, substantial foreign debt, limited export diversification, and susceptibility to inflation – make devaluation a risky proposition. Monetary contraction, though potentially slowing growth, offers a more controlled and sustainable path to BoP correction by addressing the root cause of the deficit: excessive domestic demand. A nuanced approach combining monetary contraction with supply-side reforms is often the most effective strategy.
Answer Length
This is a comprehensive model answer for learning purposes and may exceed the word limit. In the exam, always adhere to the prescribed word count.