Question

Explain how deficit in balance of payments can be corrected by raising domestic rate of interest on savings.

Answer 1

Raising the domestic interest rate corrects a balance-of-payments deficit through two channels: a higher rate makes domestic saving more attractive and brings in foreign capital and portfolio inflows, which increases the supply of foreign exchange and helps finance the deficit; and it tightens domestic monetary conditions (higher bank/lending rates and reduced credit), which lowers investment and consumption and thereby reduces import demand, shrinking the current-account deficit. Monetary tightening therefore both raises capital inflows and lowers import outflows, improving the overall balance of payments; however, attracting capital this way is often a temporary fix and the contractionary effect on output and imports is an important trade-off.