Q. No. 7. Examine the causes of Balance of Payments problem under Fixed Exchange Rate in short-run keeping in view the New Classical and Keynesian Analyses. (2017-I)

New Classical Analysis:

In the New Classical analysis, the causes of balance of payments problems under a fixed exchange rate regime are primarily attributed to short-run disturbances resulting from imperfect information, rational expectations, and market inefficiencies. Here’s an explanation in 300 words:

New Classical economists argue that under a fixed exchange rate system, market participants have rational expectations and adjust their behavior based on all available information, including anticipated government policies and future economic conditions. In the short run, however, imperfect information and adjustment lags may lead to temporary imbalances in the balance of payments.

One key factor in the New Classical analysis is the phenomenon of speculative attacks. Rational investors, expecting future changes in exchange rate policies or economic fundamentals, may anticipate currency devaluation or revaluation and adjust their portfolios accordingly. Speculative pressures can lead to capital outflows or inflows, causing abrupt changes in the balance of payments.

Moreover, New Classical economists emphasize the role of government credibility and commitment to maintaining the fixed exchange rate. If policymakers deviate from their announced exchange rate targets or pursue inconsistent monetary or fiscal policies, market participants may lose confidence in the sustainability of the fixed exchange rate regime. This loss of credibility can trigger speculative attacks and exacerbate balance of payments problems.

Additionally, supply-side shocks, such as changes in productivity, terms of trade, or international competitiveness, can affect the balance of payments in the short run. New Classical theorists argue that flexible labor markets and price adjustments should facilitate the reallocation of resources to restore equilibrium in the long run. However, in the short run, rigidities in wages and prices may impede the adjustment process, leading to temporary imbalances in trade and capital flows.

Overall, New Classical analysis emphasizes the importance of market expectations, government credibility, and supply-side factors in understanding the causes of balance of payments problems under fixed exchange rates. While market forces tend to restore equilibrium over time, short-run disturbances can create challenges for policymakers in maintaining exchange rate stability and external balance.

Keynesian Analysis:

In the Keynesian analysis, balance of payments problems under a fixed exchange rate regime are viewed through the lens of aggregate demand, income determination, and the role of government intervention. Keynesians highlight the potential for demand-driven imbalances, exchange rate misalignments, and the limitations of market mechanisms in restoring equilibrium. Here’s an explanation in 300 words:

Keynesian economists argue that under a fixed exchange rate system, balance of payments imbalances can arise due to fluctuations in aggregate demand and income levels. In the short run, changes in domestic and foreign spending patterns can lead to trade deficits or surpluses, contributing to external imbalances.

One key factor in the Keynesian analysis is the propensity for domestic demand to exceed or fall short of output capacity, leading to demand-pull or recessionary pressures. If domestic spending exceeds the economy’s productive capacity, imports may rise, leading to a trade deficit and pressure on foreign reserves. Conversely, if domestic demand weakens relative to output capacity, exports may decline, exacerbating balance of payments deficits.

Keynesians also emphasize the role of exchange rate misalignments in exacerbating external imbalances. Fixed exchange rates may not always reflect underlying economic fundamentals, leading to overvalued or undervalued currencies. An overvalued currency can undermine export competitiveness and worsen trade deficits, while an undervalued currency may exacerbate inflationary pressures and import dependency.

Moreover, Keynesian economists highlight the limitations of market mechanisms in restoring equilibrium in the short run. Price and wage rigidities, imperfect information, and market failures can impede the adjustment process, prolonging balance of payments imbalances. In such circumstances, government intervention through fiscal and monetary policies may be necessary to stabilize the economy and address external imbalances.


Overall, Keynesian analysis underscores the importance of managing aggregate demand, correcting exchange rate misalignments, and employing proactive government policies to mitigate balance of payments problems under fixed exchange rates. By addressing demand-side factors and implementing appropriate policy interventions, policymakers can promote external balance and macroeconomic stability in the short run.

Short-Run Factors:

  1. Demand Fluctuations: Short-term fluctuations in domestic and foreign demand can impact trade and capital flows, leading to temporary imbalances in the balance of payments. Changes in consumer preferences, business investment, or government spending can affect import and export levels, influencing the current account balance.
  2. Exchange Rate Movements: Rapid changes in exchange rates can have immediate effects on trade competitiveness and capital flows. In the short run, exchange rate volatility or misalignments can distort trade patterns, affecting export competitiveness and import demand.
  3. Speculative Activity: Short-term speculative behavior in currency markets can exacerbate balance of payments pressures. Speculators may anticipate future exchange rate movements or government policy changes, leading to abrupt capital inflows or outflows and affecting the balance of payments position.
  4. Macroeconomic Shocks: Sudden macroeconomic shocks, such as changes in interest rates, inflation, or income levels, can disrupt trade and financial flows in the short run. These shocks may arise from domestic policy changes, external economic developments, or unforeseen events, impacting the balance of payments.
  5. Policy Responses: Short-term policy responses by governments and central banks can influence the balance of payments dynamics. Monetary policy actions, such as changes in interest rates or reserve requirements, can affect capital flows and exchange rates, while fiscal policy measures, such as changes in tariffs or subsidies, can impact trade balances.

Understanding these short-run factors is essential for policymakers to effectively manage balance of payments challenges and mitigate their adverse effects on economic stability and growth. By addressing short-term fluctuations and implementing appropriate policy responses, countries can promote external balance and maintain macroeconomic stability in the face of external shocks.

Fixed Exchange Rate Dynamics:

  1. Pegging to a Reference Currency: Under a fixed exchange rate regime, countries peg their currency to a stable and widely accepted foreign currency, such as the US dollar or the euro. The exchange rate is set at a fixed value relative to the reference currency, and the central bank intervenes in the foreign exchange market to maintain this parity.
  2. Role of Central Bank Intervention: The central bank plays a crucial role in stabilizing the exchange rate by buying or selling foreign exchange reserves to counteract imbalances in supply and demand. If the domestic currency depreciates or appreciates beyond the agreed-upon exchange rate, the central bank intervenes to restore stability.
  3. Limited Exchange Rate Flexibility: Unlike floating exchange rate systems, where currencies fluctuate freely based on market forces, fixed exchange rate regimes offer limited flexibility in exchange rate adjustments. Central banks are committed to maintaining the pegged exchange rate within narrow bands, which may require significant intervention efforts.
  4. Speculative Pressures: Fixed exchange rate regimes are susceptible to speculative pressures from investors and traders who anticipate deviations from the pegged exchange rate. Speculative attacks, where investors sell the domestic currency in anticipation of devaluation or revaluation, can undermine the credibility of the fixed exchange rate and create volatility in financial markets.
  5. Adjustment Mechanisms: In the absence of exchange rate flexibility, countries under fixed exchange rate regimes rely on alternative adjustment mechanisms to restore external balance. These may include fiscal policy adjustments, changes in interest rates, wage and price controls, or structural reforms aimed at improving competitiveness and reducing imbalances in the balance of payments.

Understanding the dynamics of fixed exchange rate regimes is essential for policymakers to effectively manage external imbalances and maintain macroeconomic stability. While fixed exchange rates offer benefits such as price stability and reduced exchange rate uncertainty, they also pose challenges in terms of maintaining credibility, managing speculative pressures, and adjusting to changing economic conditions.

Balance of Payments Imbalances:

  1. Current Account Deficits: Persistent deficits in the current account, which includes trade in goods and services, income flows, and transfers, indicate that a country is spending more on imports and foreign investments than it is earning from exports and investments abroad. This can lead to a depletion of foreign exchange reserves and external debt accumulation.
  2. Capital Account Surpluses/Deficits: Imbalances in the capital account, which records financial transactions such as foreign direct investment, portfolio investment, and borrowing, reflect variations in capital flows into and out of a country. Capital account deficits may indicate a reliance on foreign borrowing to finance domestic investment or consumption, while surpluses may result from capital flight or inflows of speculative capital.
  3. Foreign Exchange Reserves Depletion/Build-up: Significant declines in foreign exchange reserves suggest that a country is experiencing sustained outflows of capital or struggling to finance its external obligations. Conversely, large build-ups of reserves may indicate an accumulation of surplus funds or efforts to defend a fixed exchange rate regime.
  4. Exchange Rate Volatility: Excessive volatility in the exchange rate can signal underlying imbalances in the balance of payments. Sharp depreciations may reflect deteriorating competitiveness, capital flight, or speculative attacks, while rapid appreciations may indicate excessive inflows of foreign capital or currency manipulation.
  5. External Debt Accumulation: Rising levels of external debt relative to GDP and export earnings can indicate unsustainable borrowing patterns and potential debt servicing difficulties. High debt ratios may signal a vulnerability to external shocks, such as changes in interest rates or commodity prices, and pose risks to macroeconomic stability.

Addressing balance of payments imbalances requires a combination of policy measures aimed at promoting export competitiveness, reducing import dependence, attracting sustainable capital inflows, and managing external debt levels. By addressing underlying structural weaknesses, improving macroeconomic fundamentals, and implementing prudent policy reforms, countries can mitigate the risks associated with balance of payments imbalances and promote long-term economic stability and growth.

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