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Consider the economy, which is experiencing a deficit in the balance of payment. How can it be corrected if it follows a flexible exchange rate regime?
Let us consider an economy that is undergoing a deficit in the balance of payment, that means the imports surpasses its exports. The effective market mechanism will result in the trading of foreign currencies. An unstable BOP for an economy is seen as an unstable economic condition; hence investors will lose confidence, and the demand for domestic currency will be curtailed. Consequently, the currency will depreciate, and this depreciation will make the exports more affordable and imports pricey thereby, the imports will be compressed while the exports will be pushed up. Hence, the deficit is fixed.
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