Question

Explain why a country operating under a fixed exchange rate regime and with a current account deficit is a candidate for currency devaluation.

Answer 1

When a country suffers from current account deficit , it implies the import of the country is larger than export. So to reduce this deficit either import has to or export has to increase or both. Now to reduce the import or increase the export a country take policy of devaluation under fixed exchange rate regime. Devaluation means the reduce the valuation of own currency. If the price or valuation of own currency falls then import will be more costly because the domestic buyer has to pay more price for same product and at the same foreign buyers will be able to purchase at less price than before. As a result import will fall and export will rise. This fall in import and rise in export will mitigate the deficit.