International Economics
By Robert J. Carbaugh
9th Edition
Chapter 13:
Balance-of-Payments
Adjustments
Copyright ©2004, South-Western College Publishing
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
2
Balance of payments adjustments
Automatic adjustment under fixed
exchange rates
 Key variables




Prices
Interest rates
Income
Money
Carbaugh, Chap. 14
3
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
4
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
5
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
6
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
7
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
8
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
9
Balance of payments adjustments
Interest rate adjustment
Carbaugh, Chap. 14
10
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
11
Balance of payments adjustments
Income adjustment applied
Carbaugh, Chap. 14
12
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
13
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
14
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
15
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
16
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
17