International Economics
国际经济学
Lectured by Yuanfen Tu
School of International Trade and Economics
Email:[email protected]
1
International Economics
By Robert J. Carbaugh
9th Edition
Chapter 14:
Balance-of-Payments Adjustments
Under Fixed Exchange Rates
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 mechanism returns the BOP to its
equilibrium after its initial equilibrium is
disrupted.
Balance of payments adjustments
Balance of payments adjustments

Adjustment mechanisms can be:


Automatic - economic processes
Discretionary - government policies
Balance of payments adjustments
Automatic adjustment under fixed exchange rates

Key variables




Prices
Interest rates
Income
Money
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
Balance of payments adjustments
Price adjustment

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.
Balance of payments adjustments
Gold Standard
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.
Balance of payments adjustments
Quantity Theory of Money

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 adjustments
Balance-of-Payments Adjustment

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 adjustments
Balance-of-Payments Adjustment
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
Balance of payments adjustments
Interest rate adjustment


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.
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
Balance of payments adjustments
Interest rate adjustment

In the classical world, both the price
and the interest rate adjustment
mechanisms require the central bank to
remain passive through this adjustment
process.
Balance of payments adjustments
Interest rate adjustment

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.
Balance of payments adjustments
Capital flows and the balance of payments


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.
Balance of payments adjustments
Capital flows and the balance of payments
Balance of payments adjustments
Capital flows and the balance of payments

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.
Balance of payments adjustments
Income adjustment

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.
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
Balance of payments adjustments
Income determination in a closed economy


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
Balance of payments adjustments
Income determination in a closed economy
Balance of payments adjustments
Income determination in a closed economy
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
Balance of payments adjustments
Income determination in a closed economy

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
Balance of payments adjustments
Income determination in a closed economy
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
Balance of payments adjustments
Income determination in a open economy

The condition for equilibrium income:
S+M=I+X S-I=X-M

△M=m △Y
where m represents the marginal propensity
to import
Balance of payments adjustments
Income determination in a open economy

Foreign-trade multiplier(对外贸易乘数）
△S+ △M= △I + △X
△S=s △Y
△M=m△Y
(s+m) △Y= △I + △X
1
Y  (
)  I
sm
Balance of payments adjustments
Income adjustment applied
Balance of payments adjustments
Implications of the foreign-trade multiplier

Under a system of fixed exchange rates, the
impact of domestic policies on the balance of
payments cannot be overlooked.
Balance of payments adjustments
Income determination in a open economy
Example:
Given: I=1350 X=1500 S=-400+0.35Y,
M=250+0.25Y, determine the equilibrium
level of national income.
Balance of payments adjustments
Income determination in a open economy
Balance of payments adjustments
Income determination in a open economy
Suppose an autonomous exports increase by 300,
What is the effect on income, and BOP?
Balance of payments adjustments
Foreign Repercussions

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.
Balance of payments adjustments
Foreign Repercussions

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.
Balance of payments adjustments
Foreign Repercussions
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
Balance of payments adjustments
Monetary adjustment

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.
Balance of payments adjustments
Payments Imbalances Under Fixed Exchange Rates

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
Balance of payments adjustments
Payments Imbalances Under Fixed Exchange Rates

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
Balance of payments adjustments
Payments Imbalances Under Fixed Exchange Rates
Change
Impact
Increase in money supply
Deficit
Decrease in money supply
Surplus
Increase in money demand
Surplus
Decrease in money demand
Deficit
Balance of payments adjustments
Payments Imbalances Under Fixed Exchange Rates

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.
Balance of payments adjustments
Payments Imbalances Under Fixed Exchange Rates

Supply increases (decreases)
Bop deficit
(surplus)
international reserve outflow
(inflow)
money market equilibrium
Bop equilibrium
Balance of payments adjustments
Payments Imbalances Under Fixed Exchange Rates

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
Balance of payments adjustments
Policy Implications

Nonmonetary policies:

Unnecessary: Disequilibria are selfcorrecting


Continued
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