Transcript Balance of payments adjustments

International Economics
By Robert J. Carbaugh
8th Edition
Chapter 14:
Balance-of-Payments
Adjustments Under Fixed
Exchange Rates
Copyright ©2002, South-Western College Publishing
Balance of payments adjustments
Balance of payments adjustments
 If part of the balance of payments is in
deficit or surplus for a period of time,
mechanisms are needed to restore
equilibrium
 Adjustment mechanisms can be:
 Automatic - economic processes
 Discretionary - government policies
Carbaugh, Chap. 14
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Balance of payments adjustments
Automatic adjustment under fixed
exchange rates
 Key variables
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Prices
Interest rates
Income
Money
Carbaugh, Chap. 14
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Balance of payments adjustments
Schools of thought on adjustment
 Classical approach (1800s - early 1900s)
 Centered on gold standard
 Emphasized role of prices and interest rates
 Keynesian approach (1930s onward)
 Emphasized income changes affecting
adjustment
 Monetarist approach (1960s-, Chicago school)
 Focus on role of money in changes and
adjustment
Carbaugh, Chap. 14
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Balance of payments adjustments
Price adjustment - background
 Under the gold standard, each nation’s
currency was backed by gold and had a
fixed price in terms of gold
 Imports and exports were paid for in gold
 A nation’s money supply (total amount of
gold and gold-backed currency) was
directly tied to balance of payments whether gold was flowing in or out overall
Carbaugh, Chap. 14
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Balance of payments adjustments
Price adjustment - background (cont’d)
 Balance of payments surplus would expand
money supply; deficit would shrink money
supply
 By the classical quantity theory of money,
increases in the money supply led directly
to an increase in overall prices (and a
shrinking money supply caused overall
prices to fall)
Carbaugh, Chap. 14
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Balance of payments adjustments
Price adjustment of the BOP
 Deficit nations
 Would be losing gold, therefore shrinking their money
supply and causing prices to fall
 Lower prices would make their exports more
competitive and lessen demand for imports, restoring
equilibrium
 Surplus nations
 Would be gaining gold, increasing money supply and
price level
 Higher prices would cut exports and encourage imports
until the surplus was eliminated
Carbaugh, Chap. 14
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Balance of payments adjustments
Problems with price adjustment theory
 Gold flows are not directly linked to
domestic money supply
 Nations are often not at full employment
 If economy is not at capacity, less likely that
prices will rise as money supply does
 Prices and wages are often not able to fall
in the short run
 Falling money supply will cut output and
employment rather than prices
Carbaugh, Chap. 14
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Balance of payments adjustments
Interest rate adjustment
 Inflows of gold expand the money supply,
causing short-term interest rates to fall;
outflows cause rates to rise
 Investors in surplus nations would send
gold abroad in search of higher rates;
deficit nations would receive gold from
abroad for investment, restoring equilibrium
Carbaugh, Chap. 14
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Balance of payments adjustments
Interest rate adjustment
Carbaugh, Chap. 14
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Balance of payments adjustments
Income adjustment
 Surplus nations will experience rising national
income, leading to an increased demand for
imports - partially offsetting the surplus
 Deficit nations will experience falling income,
leading to a drop in demand for imports - partially
offsetting the deficit
 Foreign repercussions effect - one country’s
deficit is another’s surplus, so that while income
is declining in one country, its exports will
increase to the country with rising income
Carbaugh, Chap. 14
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Balance of payments adjustments
Income adjustment applied
Carbaugh, Chap. 14
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Balance of payments adjustments
Disadvantages of automatic mechanisms
 Require governments not to intervene
 Automatic systems seem desirable when
they are believed to lead to full
employment; when nations face
unemployment and shrinking output,
automatic mechanisms seem inadequate
Carbaugh, Chap. 14
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Balance of payments adjustments
Monetary adjustment - background
 BOP disequilibrium represents an imbalance
between the supply and demand for money
 Demand for money is:
 Directly related to income and prices
 Inversely related to interest rates
 Supply of money has two components:
 Domestic component - credit created by national
government
 International component - foreign exchange reserves
Carbaugh, Chap. 14
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Balance of payments adjustments
Monetary adjustment
 Payments deficits are the result of an
excess supply of money at home
 Excess supply of money encourages imports,
which results in foreign exchange reserves
flowing overseas and reducing the money
supply
Carbaugh, Chap. 14
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Balance of payments adjustments
Monetary adjustment
 Excess demand for money leads to a
payments surplus
 Excess demand is reflected in higher interest
rates and less spending on imports,
encouraging a flow of foreign exchange into
the country
Carbaugh, Chap. 14
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Balance of payments adjustments
Monetary adjustment - implications
 Theory focuses on domestic monetary
policy as key to balance of payments
 Other policies designed to affect the
balance of payments - tariffs, quotas,
devaluation of the currency - are ineffective
in the long run according to the theory
Carbaugh, Chap. 14
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