International Economics 国际经济学 Lectured by Yuanfen Tu School of International Trade and Economics Email:jxnctyf@126.com

International Economics By Robert J. Carbaugh 9th Edition Chapter 14: Balance-of-Payments Adjustments Under Fixed Exchange Rates

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 mechanism returns the BOP to its equilibrium after its initial equilibrium is disrupted.

Balance of payments adjustments Adjustment mechanisms can be: Automatic - economic processes Discretionary - government policies

Automatic adjustment under fixed exchange rates Balance of payments adjustments Automatic adjustment under fixed exchange rates Key variables Prices Interest rates Income Money

Schools of thought on adjustment Balance of payments adjustments 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

Price adjustment Balance of payments adjustments The original theory of BOP adjusted is credited to David Hume. Concern with the prevailing mercantilist view A nations’ BOP tends to move toward equilibrium automatically. Price levels is the main factors.

Gold Standard Three conditions: Balance of payments adjustments Three conditions: Each nation’s money supply consisted of gold or paper money backed by gold. Each member nation defined the official price of gold in terms of its national currency and was prepared to buy and sell gold at that price. Free import and export of gold was permitted by member nations.

Quantity Theory of Money Balance of payments adjustments MV=PQ M refers to a nation’s money supply V refers to the velocity of money P refers to the price of final goods Q refers to the physical volume of all final goods produced in a year 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)

Balance-of-Payments Adjustment Balance of payments adjustments 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

Balance-of-Payments Adjustment Balance of payments adjustments

Problems with price adjustment theory 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

Interest rate adjustment Balance of payments adjustments In the classical approach, another channel through which a BOP disequilibrium is corrected is through adjustments in the short-term interest rates. This factor, was not the central focus of the classical approach to BOP adjustment because financial markets were not advanced during this time.

Interest rate adjustment Balance of payments adjustments 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

Interest rate adjustment Balance of payments adjustments In the classical world, both the price and the interest rate adjustment mechanisms require the central bank to remain passive through this adjustment process.

Interest rate adjustment Balance of payments adjustments The central bankers will reinforce and speed up the interest-rate adjustment mechanism by adhering to the so-called rules of the game. Central bankers in a surplus nation to expand credit, leading to lower interest rates. Central bankers in a deficit nation would tighten credit, bidding interest rates upward. In practice, they were not closely adhered to during the gold standard era.

Capital flows and the balance of payments Balance of payments adjustments Interest-rate fluctuations can induce significant changes in nation’s capital account and balance of payment. However, other factors are important too, such as investment profitability, national tax policies, and political stability.

Capital flows and the balance of payments Balance of payments adjustments Capital flows and the balance of payments

Capital flows and the balance of payments Balance of payments adjustments The U.S. government levied an interest equalization tax（利息均衡税）, which was intended to help reverse the large capital outflows that the United States faced when European interest rates exceeded those in the United States.

Income adjustment Balance of payments adjustments The theory of income determination was developed by Keynes in the 1930s, which is known as Keynesian approach. Under a system of fixed exchange rate and an economy that is under full-employment, a BOP disequilibrium triggers automatic changes in national income that help restore balance of payment equilibrium.

Income adjustment Balance of payments adjustments 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

Income determination in a closed economy Balance of payments adjustments In the Keynesian Model： national income: Y=C+S total expenditure: Y=C+I Y=C+S=C+I The basic equilibrium condition can thus be stated as S=I or S-I =0

Income determination in a closed economy Balance of payments adjustments

Income determination in a closed economy Balance of payments adjustments Examples: Given C=100+0.8Y and autonomous investment I=100,determine the equilibrium level of national income. Y=C+S S=Y-C I=S Y-100-0.8Y=100 Y=1000

Income determination in a closed economy Balance of payments adjustments Multiplier process(乘数过程): △Y=k △ I where k represents multiplier △I= △S=s △Y where s represents the marginal propensity to save △Y=(1/s) △I

Income determination in a closed economy Balance of payments adjustments Examples: Given C=100+0.8Y and autonomous investment increases from I=100 to I=200,determine the new equilibrium level of national income. △Y=(1/s) △I=(1/0.2)*100=500 Y=1000+500=1500

Income determination in a open economy Balance of payments adjustments The condition for equilibrium income: S+M=I+X S-I=X-M △M=m △Y where m represents the marginal propensity to import

Income determination in a open economy Balance of payments adjustments Foreign-trade multiplier(对外贸易乘数） △S+ △M= △I + △X △S=s △Y △M=m△Y (s+m) △Y= △I + △X

Income adjustment applied Balance of payments adjustments Income adjustment applied

Implications of the foreign-trade multiplier Balance of payments adjustments Under a system of fixed exchange rates, the impact of domestic policies on the balance of payments cannot be overlooked.

Income determination in a open economy Balance of payments adjustments Example: Given: I=1350 X=1500 S=-400+0.35Y, M=250+0.25Y, determine the equilibrium level of national income.

Income determination in a open economy Balance of payments adjustments

Income determination in a open economy Balance of payments adjustments Suppose an autonomous exports increase by 300, What is the effect on income, and BOP?

Foreign Repercussions Balance of payments adjustments Foreign repercussions effect (国外反应效应）-increase in income stimulates imports, causing an expansion abroad, which in turn increase demand for the home country’s exports.

Foreign Repercussions Balance of payments adjustments The importance of the foreign repercussion effect depends in part on the economic size of a country as far as international trade is concerned. A small nation that increases its imports from a large nation will have little impact on the large nation’s income level. But for major trading nations, the foreign repercussion effects is likely to be significant.

Foreign Repercussions Balance of payments adjustments

Disadvantages of automatic mechanisms 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

Monetary adjustment Balance of payments adjustments Monetary adjustment emerged during the 1960s and 1970s. BOP disequilibrium represents an imbalance between the supply and demand for money Money acts as both a disturbance and adjustment to the BOP. Adjustment in the BOP is an automatic process.

Payments Imbalances Under Fixed Exchange Rates Balance of payments adjustments Demand for money is: Md=PL (Y, i) Directly related to income and prices Inversely related to interest rates Supply of money has two components: Domestic component - credit created by national government (D) International component - foreign exchange reserves (F) Ms=m (D+F) m: money multiplier When m=1, Ms=D+F

Payments Imbalances Under Fixed Exchange Rates Balance of payments adjustments When in a equilibrium Md=Ms=D+F F=Md-D 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

Payments Imbalances Under Fixed Exchange Rates Balance of payments adjustments Change Impact Increase in money supply Deficit Decrease in money supply Surplus Increase in money demand Decrease in money demand

Payments Imbalances Under Fixed Exchange Rates Balance of payments adjustments Note: the BOP surplus or deficit is temporary and self-correcting automatically in the long-run. That is after the excess demand for money or the excess supply of money is eliminated through an inflow of funds or out flow of funds, the BOP surplus or deficit is corrected.

Payments Imbalances Under Fixed Exchange Rates Balance of payments adjustments Supply increases (decreases) Bop deficit (surplus) international reserve outflow (inflow) money market equilibrium Bop equilibrium

Payments Imbalances Under Fixed Exchange Rates Balance of payments adjustments Any payments imbalance reflects a disparity between actual and desired money balances. Inflows or outflows of foreign-exchange reserves will lead to increases or decreases in the domestic money supply. It emphasizes the economy’s final, long-run equilibrium position.

Balance of payments adjustments Policy Implications Theory focuses on domestic monetary policy as key to balance of payments Policies that increase the supply of money relative to the demand will lead to: A payments deficit An outflow of foreign-exchange reserves A reduction in the domestic money supply Policies that increase the demand for money relative to the supply will trigger: A payments surplus An inflow of foreign-exchange reserves An increase in the domestic money supply

Policy Implications Nonmonetary policies: Implications for growth Balance of payments adjustments Policy Implications Continued Nonmonetary policies: Unnecessary: Disequilibria are self-correcting In the short run, such policies may speed up adjustment process Implications for growth If domestic component of the money supply is not raised commensurate with demand: Excess demand will induce an inflow of funds from abroad and a payments surplus