Reducing Balance of Payments Surplus via Exchange Rate and Monetary Policy

Steps:

• Balance of payments surplus occurs when inflows exceed outflows in current and capital accounts.
• To eliminate surplus, policies must worsen the current account (reduce exports or increase imports) or reduce capital inflows.
• Currency appreciation makes exports costlier and imports cheaper, reducing net exports.
• Cutting interest rates lowers returns on investments, discouraging foreign capital inflows.

Why B is correct:

• Appreciation reduces export competitiveness per the Marshall-Lerner condition, worsening current account; lower interest rates reduce capital inflows via the interest rate parity theory.

Why the others are wrong:

• A: Depreciation boosts net exports, increasing surplus; higher government spending may raise imports but net effect likely worsens the goal.
• C: Money supply increase lowers rates to cut capital inflows but pay freeze controls wages without directly addressing BOP surplus.
• D: Tax increases reduce domestic spending and imports, improving current account and enlarging surplus.

Final answer: B