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How do automatic adjustment mechanisms operate to correct a deficit in the balance of payments under...

How do automatic adjustment mechanisms operate to correct a deficit in the balance of payments under a fixed and flexible exchange rate system? Explain your answer separately for fixed exchange rate and flexible exchange rate system.

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Answer #1

The automatic adjustment mechanism is a market-driven mechanism in which there is no intervention of government. It is used to balance the deficit in the balance of payments. In this, the exchange rate is fixed but interest rates get change with time to time. In this, the balance of payment is in equilibrium.

Under the fixed exchange rate: In this, the gold standard is used and the exchange rate between the currencies is fixed. It results in the tremendous surplus because the price will encourage the sellers thus balancing the deficit in balance of payments.

Under the flexible exchange rate: Under the flexible exchange rate system, the deficit in the balance of payments will automatically get balanced with the forces of demand and supply of foreign exchange.

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