An economy is said to be experiencing a
balance of payment deficit if the imports of goods, services, investment income
and transfers exceed the imports of the same items. Factors which could have
led to a balance of payments deficit include economic factors such as high
level of inflation and cyclical fluctuations, political factors such as
political instability and other disturbances and finally social factors which
include changes in taste, fashion and trends – since an unfavourable change
towards domestic goods leads to a balance of payments deficit.

            As
depicted by diagram 4.1, point A is a point depicting a balance of payments
deficit (given it is below the BP Curve). 
Under a fixed exchange rate, the money supply falls, thus shifting the
LM Curve inwards.  At point B, output is
lower and hence unemployment will be higher than at point A.  On the other hand, in a situation having a
flexible rate system, given point A (in diagram 4.2) represents a balance of
payments deficit, a depreciation will take place, shifting the IS and BP curves
outwards.  At the new equilibrium point
B, output is higher than potential output (Yp), so inflation is
likely to take place.

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