A number of steps can be taken to solve the problem of deficits in the balance of payments.
The main methods of correcting the adverse balance of payments are:
(i) Depreciation: Under the flexible exchange rate system, changes in the rate of exchange will automatically adjust the balance of payments. Depreciation of the country’s currency will wipe out deficits in the balance of payments. Depreciation of currency means rise in the price of foreign currency or, which is the same thing, fall in the price of domestic currency.
(ii) Devaluation: A country can devalue its currency to wipe out deficit in the balance of payments. This makes imports expensive to domestic consumers and its exports cheaper in foreign countries. If demand and supply elasticities are fairly high, this will definitely lead to a fall in imports and a rise in exports and thereby an elimination or reduction of balance of payments deficit.
(iii) Import Control: I reports may be kept in check through the adoption of a wide variety of import control measures such as quotas and tariffs. Quotas limit the volume of imports by applying quantitative restrictions. The government may for example, decide that only 90 per cent of last year’s volume of imports can be imported this year. The government may also increase the import duties or tariffs. This will raise the prices of imported goods and reduce imports. As a consequence, balance of payments deficit is reduced.
(iv) Production of Import Substitutes: Steps may be taken to encourage the production of import substitutes. This will save foreign exchange in the short- run by replacing the use of imports by their import substitutes. If the industries producing import substitutes develop ultimately because of various incentives provided to these industries, they may turn out to be export earners as well.
