Balance-of-Payment Adjustments Chapter 13 Copyright © 2009 South-Western, a division of Cengage Learning. All rights reserved.

Price Adjustments o Hume: balance of payment moves towards equilibrium automatically as national price levels adjust o gold standard each nation’s money supply consisted of gold or paper money backed by gold each nation set price of gold in terms of its currency free import and export of gold o balance of payments surplus causes nation to acquire gold and increase its money supply

Quantity Theory of Money o equation of exchange: MV = PQ M = nation’s money supply V = velocity of money P = average price level Q = volume of final goods o classical economists assumed V and Q were constant o implication is that balance of payments is linked to money supply which is linked to domestic price level

Balance of Payments Adjustment o assuming balance of payments deficit gold outflow (under classical gold standard) decrease money supply reduce domestic price level increase international competitiveness increase exports and decrease imports return to balance of payment equilibrium o assuming balance of payments surplus opposite movements in each variable would lead to fewer exports again returns to equilibrium

Counterarguments o nation’s money supply no longer linked to its gold supply o central banks can offset a gold outflow through expansionary monetary policy or a gold inflow through restrictive monetary policy o if full employment does not exist prices may not rise in response to an increase in money supply o prices and wages may be inflexible in a downward direction

Interest Rate Adjustments o nation with a balance of payments surplus has increase in money supply leading to lower interest rates o nation with deficit sees decrease in money supply leading to higher interest rates o interest rate differential leads to flow of investment capital from surplus nation to deficit nation o facilitates balance of payments equilibrium exception – if central bankers reinforced interest rate adjustments

Financial Flows

Financial Flows (cont.) o higher U.S. interest rates leads to a net financial inflow represented by point B o lower interest rates would lead to a net outflow represented by point C o CFA 0 implies interest rate differentials are sole determinant of financial flows

Income Adjustments o Keynesian assertion o income determination nation with surplus will have increased income leading to increased imports nation with deficit will see income decline leading to fewer imports assumption of fixed exchange rates o foreign repercussion effect – increase in income stimulates imports causing an expansion abroad which in turn increases demand for home country’s exports

Monetary Adjustments o quantity of money demanded directly related to income and prices inversely related to interest rates o money supply as multiple of monetary base domestic component – credit created by monetary authority international component – result of foreign balance of payments disequilibrium results: o excess money supply => deficit o excess money demand => surplus