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

2. 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

3. Automatic adjustment under fixed exchange rates
Balance of payments adjustments
Automatic adjustment under fixed exchange rates
Key variables
Prices
Interest rates
Income
Money
Carbaugh, Chap. 14

4. Schools of thought on adjustment
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

5. Price adjustment - background
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

6. Price adjustment - background (cont’d)
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

7. Price adjustment of the BOP
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

8. 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
Carbaugh, Chap. 14

9. Interest rate adjustment
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

10. Interest rate adjustment
Balance of payments adjustments
Interest rate adjustment
Carbaugh, Chap. 14

11. 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

12. Income adjustment applied
Balance of payments adjustments
Income adjustment applied
Carbaugh, Chap. 14

13. 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
Carbaugh, Chap. 14

14. Monetary adjustment - background
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

15. 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

16. 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

17. Monetary adjustment - implications
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