International Economics By Robert J. Carbaugh 7th Edition

1. International EconomicsBy Robert J. Carbaugh7th Edition Chapter 14: Balance-of-payments adjustments under fixed exchange rates

2. 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

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

4. 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. 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. 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. 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. 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. 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. Balance of payments adjustments Interest rate adjustment US capital account ($ bill.) Surplus (net capital inflow) CA1 CA0 B US interest rate minus rest of world interest rate A C Deficit (net capital outflow) 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. Balance of payments adjustments Income adjustment applied S - I Saving, investment S-I, X-M (dollars) F G S - I’ E Income (dollars) X - M’ I H X - M Carbaugh, Chap. 14

13. 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. 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. 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