PRICE ADJUSTMENT UNDER FIXED EXCHANGE RATE

PRICE ADJUSTMENT UNDER FIXED EXCHANGE RATE

In a flexible exchange rate regime, whenever there will be surplus or deficit in BOP account, there will be an adjustment in exchange rate and the currency’s appreciation or depreciation will automatically correct the disequilibrium. But in case of fixed exchange rate regime, the process of price adjustment is similar to that of the price adjustment under the gold standard system. When under fixed exchange rate regime there is disequilibrium, it is corrected by changes in domestic prices. When there is a deficit, it reduces money supply in the country which in turn reduces the domestic prices. It will encourage exports and discourage imports. It will correct deficit in current account. At the same time, it will also lead to higher rate of interest. It will induce more capital inflows which will correct deficit in capital account. Both these will eliminate deficit in BOP account. On the other hand, when there is a surplus, it increases money supply in the country which in turn increases the domestic prices. It will encourage imports and discourage exports. It will correct surplus in current account. At the same time, it will also lead to lower rate of interest. It will induce more capital outflows which will correct surplus in capital account. But practically speaking, we need not to correct surplus in BOP account as it is desirable for the economy. 

Now let us explain how price adjustment under the gold standard system takes place. The gold content in one unit of currency and hence exchange rate is also fixed. Suppose, $1 contains 23.22 grains of gold and Rupee 1 contains 0.774 grains of pure gold then exchange rate ($/Re) will be 0.87/23.22 which is equal to Rs. 30/$. This exchange rate will be stable as long as there is no change in the gold reserves of the country. It is so because gold worth Re. 1 can be purchased in India and can be exchanged for 3.33 cents in USA. When there will be deficit, gold reserves will outflow. It will lead to fall in money supply. This fall in money supply will lead to rise in the level of domestic prices. Consequently, exports will get discouraged and imports will get encouraged. BOP equilibrium will be regained.