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Changes in Inflation Rate and Domestic Interest Rate Cause a Deterioration of a Country's Balance of Payments Position

  • Date Submitted: 09/01/2010 08:49 AM
  • Flesch-Kincaid Score: 48.7 
  • Words: 319
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Inflation is the general,inordinate and sustain increase in price level. When there is an increase in inflation rate in a country, prices of exports will rise. Hence there will be a fall in the quantity demanded for its exports as it is too expensive for foreign countries to purchase these goods. Assuming price elasticity less than one, this will result in a fall in export earnings, hence leading to current account deficit. Since current account is a component of balance of payment, current account deficit will may lead to balance of payment deficit.

Futhermore a rise in the general price level in a countr, ceteris paribus alos means that imports are now relatively cheaper. Hence the demand fo imports will increase and producers will now supply or sell more of their local currency to import. Hence the supply of the local currnecy in the foreign exhcnage market rises. An increase in supply of local currency will lead to a depreciation of its own local currencyrelative to foreign countries thus resulting in trade balance deficit and therfore balance of payment deficit.

When domestic interest rates relative to other countries falls. Foreign investors will not invest in that particular country as the rate of returns from their investments would be relatively low. With lesser investments in the country it will lead to short term capital outflow, causing a deficit in capital and financial account. Since capital and financial account is a component of balance of payments a deficit it this component may cause detorioration in the country's balance of payments position.  
Changes in relative interest rates will also affect the exchange rate of the country currency. For example, if interest rates in the country rises relative to foreign country it will lead to hot money flowing from the local country to the foreign country. Thus the demand of the local country in the foreign exchange market will increase.

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