To achieve adjustment in BOP following policy instruments are needed: 1.

Expenditure Changing or Demand Policies;

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2. Expenditure Switching Policies; 3. Direct Controls; (Exchange Controls)

Expenditure Changing Polices refers to both the Fiscal and Monetary Polices.

` Fiscal

Policy ` It refers to change in Government Expenditure; Taxes; Both;

Expansionary Fiscal Policy

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If Govt. expenditures are increased and tax reduced which leads to an expansion of domestic production and income through a multiplier process and induce a rise in imports.

Contractionary Fiscal Policy

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If Govt. expenditures are reduced and tax increased, which reduce domestic production and income and induce a fall in imports.

Monetary Policy
` It controls the nations money supply by affecting domestic interest rate.

Expansionary Monetary Policy

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If interest rate falls, which induces an increase in the level of investment and income in the nation through the multiplier process and increase money supply that leads imports to rise.

` Contractionary

Monetary Policy

On the other hand, contractionary monetary policy refers to a reduction in the nations money supply and rise in interest rate. Rise in interest rate discourages investment, income, and imports.

This policy mainly works by changing relative prices of imports and exports for which A change in exchange rates is required.

Devaluation refers to the lowering of the value of a home currency in respect of the price of gold/respective foreign currency.

The immediate effect of devaluation is a change in relative price.

If a country devalues its currency, say, 25% Ceteris paribus its import price will rise by 25% in terms of home currency. Resultantly, import bill will tend to fall. A rise in import prices often provides protection to home industries and thus import substitution takes place.

There are two approaches devaluation:

for effectiveness

of

1. The Elastic Approach : ` The extent by which devaluation can make improvement in the Balance of Payment deficit of a country depends upon:
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The countrys Price elasticity of demand for imports

The Price elasticity of foreign demand for its exports.

If price elasticity for exports of devaluing country is EpX > 1 (more Elastic) BOP deficit will reduce and vice-a-versa. On the other hand, if price elasticity for imports of devaluing country isEpM > 1 (more elastic) It has positive impact, BOP deficit will reduce.

This theory states thatDevaluation leads to increase in the price of imports which will affect the volume of imports. But to what extend it will decrease as a result of devaluation it will very much depend upon countrys elasticity of demand for imports.

The elasticity of demand for imports of necessities like, capital equipment and petroleum is low in the country, country would find it difficult to reduce its imports in response of devaluation. On the other hand when elasticity of demand for exports is high, it has positive impact on BOP. Developed countries are fall in this category. The less developed countries exporting agriculture, minerals and selected consumer goods generally cannot take advantage of devaluation as the elasticity of demand for these exports is often low.

Limitation
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Elastic approach and Marshall-Lerner condition for external balance has some limitations, such as,

Partial Equilibrium Approach ` Elastic and Marshall-Lerner is based on unrealistic assumption as stability of domestic price. Neglect of Income distribution ` Devaluation results in reallocation of productive resources from other sector to export sector and the import substitution sector, which leads redistribution of income.

Off-setting effect of Inflation`

Devaluation causes an expansion in exports and reduction in imports due to decline in the relative price in the devaluing country compare with foreign country. On the other hand the higher import price may push the domestic cost structure in devaluing country. The expansion of exports-incomes in devaluing country. Consequently, increase demand for product due to the higher income may push up the inflationary pressure.

Because of above mentioned Limitation, Sidney S. Alexander has developed an another approach for effectiveness of devaluation. As per Alexander, devaluation can only be successful in correcting disequilibrium of BOP when a country has sufficient exportable surplus, because fall in price of exportable commodities due to devaluation leads increasing demand.

2.
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Absorption Approach

As per this approach trade balance is the difference between goods and services produced in a country and its absorption. Absorption means the sum of consumption and investment expenditure on domestically produced goods and services.

Algebraically

B = Y-A
B = Trade Balance , Y = National income or value of output of goods and services A = Absorption or sum of consumption and investment expenditure.
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As per Absorption approach, if expenditure or absorption is less than national product, it will have positive trade balance or exportable surplus.

Precisely, as per absorption Approache = b+a (marginal propensity to absorb) b marginal propensity to consume, a - marginal propensity to invest, e < 1 = Trade deficit reduce e > 1 = Trade deficit increase e = 1 Neither trade deficit or surplus.

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1. 2. 3.