Under a freely flexible exchange rate system and a stable foreign exchange market, the nation's currency will depreciate until the monetary deficit is entirely eliminated. Under a managed float, the nation's monetary authorities usually do not allow the full depreciation required to eliminate the deficit completely. Under a fixed exchange rate system, the exchange rate can depreciate only within the narrow limits allowed so that most of the balance of payments adjustment must come from elsewhere. A depreciation to the extent that it is allowed, stimulates production and income in the deficit nation and induces imports to rise. Thus reducing part of the original improvement in the trade balance resulting from the depreciation under a freely flexible exchange rate system. This simply means that the depreciation needed to eliminate a balanced-payment deficit is larger than if these automatic income changes were not present. Except under a freely flexible exchange rate system, a balance of-payment tends to reduce the nation's money supply, thus increasing its interest rates. This, in turn, reduces domestic investment and income in the deficit nation, which induces its imports to fall and thereby reduces the deficit. The increase in interest rates also attracts foreign capital. which helps the nation finance the deficit. The reduction in income and in the money supply also causes prices in the deficit nation to fall relative to prices in the surplus nation, thus Author improving the balance of trade of the deficit nation.
What is needed to completely eliminate the monetary deficit?
