Step four the nature of the adjustment

Whether a country will devalue its currency or let it float downward is ultimately a political decision. No matter how necessary a devaluation may be from an economic point of view, political factors have the final word before choosing between the implementation of corrective policies and a change in the par value of the currency.

Corrective policies In the case of a structural balance-of-payments deficit, policy-makers will first attempt to implement a number of corrective policies: deflate the economy and institute strict exchange controls, among others.

A government may adopt tight monetary and fiscal policies. To stem inflation, it should control budget deficits, reduce the growth in the money supply, and institute wage and price controls. These deflationary policies should reduce aggregate domestic demand for both domestic and foreign goods, so that the demand for imports falls and the supply of exports rises. In addition, external controls on capital account transactions should further reinforce improvement in the balance of payments.

Under foreign-exchange controls, a country would force its exporters and other recipients to sell their foreign exchange proceeds to the central bank. Then, the government would allocate this foreign exchange only to the various users of foreign exchange. In this way, the government restricts the country's imports to an amount of foreign exchange earned by the country's exports. Thus, imports under exchange controls are less than they would be under free market conditions.

Although deflationary policies appear to be a good way to fix balance-of-payments deficits, they are not without costs. Deflationary policies may slow the economy. Exchange controls may hurt foreign investment and tourism. In other words, the cost of such corrective policies for the balance-of-payments deficit is high unemployment, which is unlikely to arouse popular enthusiasm.

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