Balance-of-PaymentAdjustments

Chapter 13

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Price Adjustmentso 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 goldo balance of payments surplus causes nation

to acquire gold and increase its money supply

Quantity Theory of Moneyo equation of exchange:

MV = PQM = nation’s money supplyV = velocity of moneyP = average price levelQ = 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 Adjustmento 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

Counterargumentso 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 Adjustmentso 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 Bo lower interest rates would lead to a net outflow

represented by point C

o CFA0 implies interest rate differentials are sole determinant of financial flows

Income Adjustmentso Keynesian assertiono 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 rateso foreign repercussion effect – increase in

income stimulates imports causing an expansion abroad which in turn increases demand for home country’s exports

Monetary Adjustmentso 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 => deficito excess money demand => surplus