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Question

(a) What causes disequilibrium in BOP? 

(b) Why is flexible exchange rate better than fixed exchange rate system? 


Solution

(A) Causes of disequilibrium are: 

(a) Cyclic Fluctuations: Cyclic fluctuations in the business activity lead to BOP disequilibrium. When there is a depression in a country, the volume of both exports and imports fall. But the fall in exports may be greater than fall in imports due to the decline in domestic production. Therefore, there is adverse BOP situation or disequilibrium. 

(b) Price Changes: If there is inflation in the country, the prices of the exports increases. As a result, the export falls. At the same time, the demand for the imports increases. This results in adverse balance of payment. 

(c) Scope of Economic Development: The country's balance of payment also depends upon the stage of economic development. If a country is developing, it will have a deficit in the balance of payment because it imports raw material, capital equipment, machinery and services associated with the development process and export primary products. The country has to pay more for the imports and receive less leading to disequilibrium. 

(B) Flexible exchange rate is preferred over fixed exchange rate due to the following reasons: 

(1) No Need to maintain Reserves: 
There is automatic adjustment in the balance of payment under this system, so there is no need to maintain the reserves. If there is any shortage of foreign currency, it is maintained through the forces of demand and supply. Thus, it reduces the responsibility of government to maintain reserves. 

(2) Automatic Adjustment in BOP: 
When a country is not able to make the foreign payment, this raises the demand for foreign currencies which in turn leads to fall in foreign exchange rate. This makes exports cheaper and imports dearer. As a result, inflows of foreign exchange rises and outflows fall and BOP problem is solved. 

(3) No Dependence on External Sources: 
Since BOP problem of foreign payment can be solved through the automatic adjustment in the flexible exchange rate system, it reduces the dependence of government on external sources. 

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