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 CFA0 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