is 0.4 percent, the inflation-rate differential remaining constant. The positive relationship suggests that relatively high income growth in the United States leads to an appreciation in the franc against the dollar, and vice versa. Once the regression coefficients have been estimated, and any potential statistical problems have been corrected, the coefficients can be tested to determine if they are statistically significant. If so, there exists a predictable relationship between a given exchange-rate determinant and the franc's exchange rate.

Our regression model can now be used for exchange-rate forecasting. Suppose that in the most recent year the U.S. inflation rate exceeded the Swiss inflation rate by 3 percentage points and that the U.S. income-growth rate exceeded the Swiss income-growth rate by 1 percentage point. Combining these data with the estimated regression coefficients, the forecast for the franc's exchange value is

Yt == bo + b7X1 t_n + b2X2 t_n + U7

==.01 + .6(3%) + .4(1 %)

==1% + 1.8% + .4%

==3.2%

Our forecast is that the franc will appreciate by about 3.2 percent against the dollar in the next quarter.

In practice, using regression analysis to forecast exchange rates is more difficult than our simplified model suggests. Recall that our model was based on the impact of inflation differentials and income-growth differentials on trade flows and their effects on foreignexchange market trading. In reality, much foreign-exchange market trading is related to investment flows and speculation, which requires that other variables be included in our model, such as relative interest rates and future expectations. Finally, other exchangerate determinants, such as labor strikes, are difficult to measure and cannot be included in our model. As a result of these limitations, even the most sophisticated regression models cannot produce consistently accurate exchange-rate forecasts. Forecasters typically modify the results of regression models with their own commonsense judgments.

Although the various automatic adjustment approaches have their contemporary advocates, each was formulated during a particular period and reflects a different philosophical climate. That the balance of payments could be adjusted by prices and interest rates stemmed from the classical economic thinking of the 1800s and early 1900s. The classical approach was geared toward the existing gold standard associated with fixed exchange rates. That income changes could promote balance-of-payments adjustments reflected the Keynesian theory of income determination, which grew out of the Great Depression of the 1930s. That money plays a crucial role in the long run as a disturbance and adjustment in the nation's balance of payments is an extension of domestic monetarism. This approach originated during the late 1960s and is associated with the Chicago school of economic thought.

currency and was prepared to buy and sell gold at that price. (3) Free import and export of gold was permitted by member nations. Under these conditions, a nation's money supply was directly tied to its balance of payments. A nation with a balance- of-payments surplus would acquire gold, directly expanding its money supply. Conversely, the money supply of a deficit nation would decline as the result of a gold outflow.

The balance of payments can also be tied directly to a nation's money supply under a modified gold standard, requiring that the nation's stock of money be fractionally backed by gold at a constant ratio. It would also apply to a fixed exchange-rate system in which payments disequilibria are financed by some acceptable international reserve asset, assuming that a constant ratio between the nation's international reserves and its money supply is maintained.

IPrice Adjustments

The original theory of balance-of-payments adjustment is credited to David Hume (1711-1776), the English philosopher and economist.' Hume's theory arose from his concern with the prevailing mercantilist view that advocated government controls to ensure a continuous favorable balance of payments. According to Hume, this strategy was self-defeating over the long run because a nation's balance of payments tends to move toward equilibrium automatically. Hume's theory stresses the role that adjustments in national pricelevels play in promoting balance- of-payments equilibrium.

Gold Standard

The classical gold standard that existed from the late 1800s to the early 1900s was characterized by three conditions. (1) Each member nation's money supply consisted of gold or paper money backed by gold. (2) Each member nation defined the official price of gold in terms of its national

'David Hume, "Of the Balance of Trade." Reprinted in Richard N. Cooper, ed., InternationalFinance: Selected Readings (Harmondsworth. England: Penguin Books, 1969). Chapter l.

Quantity Theory of Money

The essence of the classical price-adjustment mechanism is embodied in the quantity theory of money. Consider the equation of exchange:

MV=PQ

M refers to a nation's money supply. V refers to the velocity of money-that is, the number of times per year the average currency unit is spent on final goods. The expression MV corresponds to the aggregate demand, or total monetary expenditures on final goods. Alternatively, the monetary expenditures on any year's output can be interpreted as the physical volume of all final goods produced (Q) multiplied by the average price at which each of the final goods is sold (P). As a result, MV = PQ.

This equation is an identity. It says that total monetary expenditures on final goods equals the monetary value of the final goods sold; the amount spent on final goods equals the amount received from selling them.

The classical economists made two additional assumptions. First, they took the volume of final output (Q) to be fixed at the full employment level in the long run. Second, they assumed that the velocity of money (V) was constant, depending

402 Balance-af-Payments Adjustments

on institutional, structural, and physical factors that rarely changed. With V and Q relatively stable, a change in M must induce a direct and proportionate change in P. The model linking changes in M to changes in P became known as the quantity theory of money.

Balance-of-Payments

Adjustment

The preceding analysis showed how, under the classical gold standard, the balance of payments is linked to a nation's money supply, which is linked to its domestic price level. Let us consider how the price level is linked to the balance of payments.

Suppose that, under the classical gold standard, a nation realized a balance-of-payments deficit. The deficit nation would experience a gold outflow, which would reduce its money supply and thus its price level. The nation's international competitiveness would be enhanced, so that its exports would rise and imports fall. This process would continue until its price level had fallen to the point where balance-of-payments equilibrium was restored. Conversely, a nation with a balance- of-payments surplus would realize gold inflows and an increase in its money supply. This process would continue until its price level had risen to the point where balance-of-payments equilibrium was restored. Thus, the opposite price-adjustment process would occur at the same time in each trading partner.

The price-adjustment mechanism as devised by Hume illustrated the impossibility of the mercantilist notion of maintaining a continuous favorable balance of payments. The linkages (balance of payments-money supply-price level-balance of payments) demonstrated to Hume that, over time, balance-of-payments equilibrium tends to be achieved automatically.

With the advent of Hume's price-adjustment mechanism, classical economists had a very powerful and influential theory. It was not until the Keynesian revolution in economic thinking during the 1930s that this theory was effectively challenged. Even today, the price-adjustment mechanism is a hotly debated issue. A brief discussion of some of the major criticisms against the priceadjustment mechanism is in order.

The classical linkage between changes in a nation's gold supply and changes in its money supply no longer holds. Central bankers can easily offset a gold outflow (or inflow) by adopting an expansionary (or contractionary) monetary policy. The experience of the gold standard of the late 1800s and early 1900s indicates that these offsetting monetary policies often occurred. The classical view that full employment always exists has also been challenged. When an economy is far below its full employment level,there is a smaller chance that prices in general will rise in response to an increase in the money supply than if the economy is at full employment. It has also been pointed out that, in a modern industrial world, prices and wages are inflexible in a downward direction. If prices are inflexible downward, then changes in M will affect not P but rather Q. A deficit nation's falling money supply will bring about a fall in output and employment. Furthermore, the stability and predictability of V have been questioned. Should a gold inflow that results in an increase in M be offset by a decline in V, total spending (MY) and PQ would remain unchanged.

These issues are part of the current debate over the price-adjustment mechanism's relevance. They have caused sufficient doubts among economists to warrant a search for additional balance- of-payments adjustment explanations. The most notable include the effect of interest-rate changes on capital movements and the effect of changing incomes on trade flows.

I Interest-Rate Adjustments

Under the classical gold standard, the priceadjustment mechanism was not the only vehicle that served to restore equilibrium in the balance of payments. Another monetary effect of a payments surplus or deficit lay in its impact on short-term interest rates and hence on shortterm private capital flows.

Consider a world of two countries: nation A, enjoying a surplus, and nation B, facing a deficit. The inflow of gold from the deficit to the surplus nation automatically results in an increase in nation Ns money supply and a decline in the money supply of nation B. Given a constant

demand for money, the increase in nation A's money supply would lower domestic interest rates. At the same time, nation B's gold outflow and declining money supply would bid up interest rates. In response to falling domestic interest rates and rising foreign interest rates, the investors of nation A would find it attractive to send additional investment funds abroad. Conversely, nation-B investors would not only be discouraged from sending money overseas, but they might also find it beneficial to liquidate foreign investment holdings and put the funds into domestic assets.

This process facilitates the automatic restoration of payments equilibrium in both nations. Because of the induced changes in interest rates, stabilizing capital movements automatically flow from the surplus to the deficit nation, thereby reducing the payment imbalances of both nations. Although this induced short-term capital movement is temporary rather than continuous, it nevertheless facilitates the automatic balance- of-payments adjustment process.

During the actual operation of the gold standard, however, central bankers were not totally passive in response to these automatic adjustments. They instead agreed to reinforce and speed up the interest-rate adjustment mechanism by adhering to the so-called rules of the game. This required central bankers in a surplus nation to expand credit, leading to lower interest rates; central bankers in deficit nations would tighten credit, bidding interest rates upward. Private short-term capital presumably would flow from the surplus nation to the deficit nation. Not only would the deficit nation's ability to finance its payments imbalance be strengthened, but also the surplus nation's gold inflows would be checked.

Financial Flows and

Interest-Rate Differentials

The classical economists were aware of the impact of changes in interest rates on international financial movements, even though this factor was not the central focus of their balance-of-payments adjustment theory. With national financial systems closely integrated today, it is recognized that interest-rate

United States and the rest of the world are assumed to respond to interest-rate differentials between the two areas (Ll.S, interest rate minus foreign interest rate) for a particular set of economic conditions in the United States and abroad.

Referring to schedule CFAo, the U.S. capital and financial account is in balance at point A, where the U.S, interest rate is equal to that abroad. Should the United States reduce its monetary growth, the scarcity of money would tend to raise interest rates in the United States compared with the rest of the world. Suppose U.S. interest rates rise 1 percent above those overseas. Investors, seeing higher U.S. interest rates, will tend to sell foreign securities to purchase U.S. securities that offer a higher yield. The 1 percent interest-rate differential leads to net financial inflows of $5 billion for the United States, which thus moves to point B on schedule CFAo. Conversely, should foreign interest rates rise above those in the United States, the United States will face net [iancial outflows as investors sell U.S. securities to purchase foreign securities offering a higher yield.

Figure 13.1 assumes that interest-rate differentials are the basic determinant of financial flows for the United States. That is, movements along schedule CFAo are caused by changes in the interest rate

in the United States relative to that in the rest of the world. However, there are certain determinants other than interest-rate differentials that might cause the United States to import (or export) more or less assets at each possible inter- est-rate differential and thereby change the location of schedule CFAo.

To illustrate, assume the United States is located along schedule CFAo at point A. Suppose that rising U.S. income leads to higher sales and increased profits. Direct investment (in an autoassembly plant, for example) becomes more profitable in the United States. Nations such as Japan will invest more in their Ll.S, subsidiaries, whereas General Motors will invest less overseas. The higher profitability of direct investment leads to a greater flow of funds into the United States at

each possible interest-rate differential and an upward shift in the schedule to CFA,.

Suppose the U.S. government levies an interest equalization tax, as it did from 1964 to 1974. This tax was intended to help reverse the large financial outflows that the United States faced when European interest rates exceeded those in the United States. By taxing U.S. investors on dividend and interest income from foreign securities, the tax reduced the net profitability (that is, the after-tax yield) of foreign securities. At the same time, the U.S. government enacted a foreign-credit-restraint program, which placed direct restrictions on foreign lending by U.S. banks and financial institutions and later on foreign lending of nonfinancial corporations. By discouraging flows of funds from the United States to Europe, these policies resulted

in an upward shift in the u.s. capital and financial account schedule in Figure 13.1, suggesting that less funds would flow out of the United States in response to higher interest rates overseas.

I Incon1e Adjustments

The classical balance-of-payments adjustment theory relied primarily on the price-adjustment mechanism, while delegating a secondary role to the effects of interest rates on private short-term capital movements. A main criticism of the classical theory was that it almost completely neglected the effect of income adjustments. The classical economists were aware that the income, or purchasing power, of a surplus nation rose relative to that of the deficit nation. This would have an impact on the level of imports in each nation. But the income effect was viewed as an accompaniment of price changes. Largely because the gold movements of the nineteenth century exerted only minor impacts on price and interest-rate levels, economic theorists began to look for alternate balance-of-payments adjustment explanations under a fixed exchangerate system. The theory of income determination, developed by John Maynard Keynes in the 1930s, provided such an explanation.'

Keynes asserted that under a system of fixed exchange rates, the influence of income changes in surplus and deficit nations would help restore payments equilibrium automatically. Given a persistent payments imbalance, a surplus nation will experience rising income, and its imports will increase. Conversely, a deficit nation will experience a fall in income, resulting in a decline in imports. These effects of income changes on import levels will reverse the disequilibrium in the balance of payments. The income adjustment mechanism is more fully discussed in "Exploring Further 13.1" at the end of this chapter.

The preceding income-adjustment analysis needs to be modified to include the impact that changes in domestic expenditures and income levels have on foreign economies. This process IS referred to as the foreign repercussion effect.

'John Maynard Keynes, The General Theory of Employment, Interest, and Money (London: Macmillan, 1936).

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 effect is likely to be significant and must be taken into account when the incomeadjustment mechanism is being considered.

Disadvantages of

Automatic Adjustment

Mechanisms

The preceding sections have considered automatic balance-of-payments adjustment mechanisms under a system of fixed exchange rates. According to the classical school of thought, adjustments occur as prices and interest rates respond to international

406 Balance-af-Payments Adjustments

gold movements. Keynesian theory emphasized another adjustment process, the effect of changes in national income on a nation's balance of payments.

Although elements of price, interest rate, and income adjustments may operate in the real world, these adjustment mechanisms have a major shortcoming. The problem is that an efficient adjustment mechanism requires central bankers to forgo their use of monetary policy to promote the goal of full employment without inflation; each nation must be willing to accept inflation or recession when balance-of-payments adjustment requires it. Take the case of a nation that faces a deficit caused by an autonomous increase in imports or decrease in exports. For income adjustments to reverse the deficit, monetary authorities must permit domestic income to decrease and not undertake policies to offset its decline. The opposite applies equally to a nation with a balance-of-payments surplus.

To the classical economists, abandoning an independent monetary policy would not be considered a disadvantage. This is because classical thought envisioned a system that would automatically move toward full employment over time and placed a high priority on balance-of-payments adjustment. In today's world, unemployment is often the norm, and its elimination is generally given priority over balance-of-payments equilibrium. Modern nations are thus reluctant to make significant internal sacrifices for the sake of external equilibrium. The result is that reliance on an automatic payments-adjustment process is politically unacceptable.

I Monetary Adjustments

The previous sections have examined how changes in national price, interest rate, and income levels automatically lead to balance-of- payments adjustment. During the 1960s and 1970s, a new theory emerged, called the monetary approach to the balance of payments." The

'The monetary approach to the balance of payments had its intellectual background at the University of Chicago. It originated with Robert Mundell. lnternational Economics (New York: Macmillan. 1968) and Harry Johnson, "The Monetary Approach to Balance-of-Payments Theory." Iournal of Financial and Ouantitative Analysis, March 1972.

monetary approach views disequilibrium in the balance of payments primarily as a monetary phenomenon. Money acts as both a disturbance and an adjustment to the balance of payments. As in the classical and Keynesian approaches, adjustment in the balance of payments is viewed as an automatic process.

Payments Imbalances Under

Fixed Exchange Rates

The monetary approach emphasizes that disequilibrium in the balance of payments reflects an imbalance between the demand and the supply of money. A first assumption is that, over the long run, the nation's demand for money is a stable function of real income, prices, and the interest rate.

The quantity of nominal money balances demanded is directly related to income and prices. Increases in income or prices trigger increases in the value of transactions and an increased need for money to finance the transactions, and vice versa. The quantity of money demanded is inversely related to the interest rate. Whenever money is held rather than used to make an investment, the money holder sacrifices interest that could have been earned. If interest rates are high, people will try to keep as little money on hand as possible, putting the rest into interest-earning investments. Conversely, a decline in interest rates increases the quantity of money demanded.

The nation's money supply is a multiple of the monetary base that includes two components. The domestic component refers to credit created by the nation's monetary authorities (such as Federal Reserve liabilities for the United States). The international component refers to the foreignexchange reserves of a nation, which can be increased or decreased as the result of balance-of- payments disequilibrium.

The monetary approach maintains that all payments deficits are the result of an excess supply of money in the home country. Under a fixed exchange-rate system, the excess supply of money results in a flow overseas of foreign-exchange reserves, and thus a reduction in the domestic money supply. Conversely, an excess demand for money in the home country leads to a payments

surplus, resulting in the inflow of foreign-exchange reserves from overseas and an increase in the domestic money supply. Balance in the nation's payments position is restored when the excess supply of money, or the excess demand for money, has fallen enough to restore the equilibrium condition:

Money supply equals money demand. Table 13.1 summarizes the conclusions of the monetary approach, given a system of fixed exchange rates.

Assume that to finance a budget deficit, the Canadian government creates additional money. Considering this money to be in excess of desired levels (excess money supply), Canadian residents choose to increase their spending on goods and services instead of holding extra cash balances. Given a fixed exchange-rate system, the rise in home spending will push up the prices of Canadian goods and services relative to those abroad. Canadian buyers will be induced to decrease purchases of Canadianproduced goods and services, as will foreign buyers. Conversely, Canadian sellers will offer more goods at home and fewer abroad, whereas foreign sellers will try to increase sales to Canada. By encouraging a rise in imports and a fall in exports, these forces tend to worsen the Canadian payments position. As Canada finances its deficit by transferring international reserves to foreign nations, the Canadian money supply will fall back toward desired levels. This, in turn, will reduce Canadian spending and demand for imports, restoring payments balance.

Changes in the Supply of Money and Demand for Money Under Fixed Exchange Rates:

Impact on the Balance of Payments According to the Monetary Approach

Change' Impact

*Starting from a position at which the nation's money demand equals the money supply and its balance 01 payments is in equilibrium.

The monetary approach views balance-of- payments adjustment as an automatic process. Any payments imbalance reflects a disparity between actual and desired money balances that tends to be eliminated by inflows or outflows of foreign-exchange reserves, which lead to increases or decreases in the domestic money supply. This self-correcting process requires time. Except for implying that the adjustment process takes place over the long run, the monetary approach does not consider the time period needed to achieve equilibrium. The monetary approach thus emphasizes the economy's final, long-run equilibrium position.

The monetary approach assumes that flows in foreign-exchange reserves associated with payments imbalances do exert an influence on the domestic money supply. This is true as long as central banks do not use monetary policies to neutralize the impact of flows in foreign-exchange reserves on the domestic money supply. If they do neutralize such flows, payments imbalances will continue, according to the monetary approach.

Policy Implications

What implications does the monetary approach have for domestic economic policies? The approach suggests that economic policy affects the balance of payments through its impact on the domestic demand for and supply of money. Policies that increase the supply of money relative to the demand for money will lead to a payments deficit, an outflow of foreign-exchange reserves, and a reduction in the domestic money supply. Policies that increase the demand for money relative to the supply of money will trigger a payments surplus, an inflow of foreign-exchange reserves, and an increase in the domestic money supply.

The monetary approach also suggests that nonmonetary policies that attempt to influence a nation's balance of payments (such as tariffs, quotas, or currency devaluation) are unnecessary because payments disequilibria are self-correcting over time. However, in the short run, such policies may speed up the adjustment process by reducing excesses in the supply of money or the demand for money.

For example, given an initial equilibrium, suppose the Canadian government creates money in excess of that demanded by the economy, leading to a payments deficit. The monetary approach maintains that, in the long run, foreign-exchange reserves will flow out of Canada and the Canadian money supply will decrease. This automatic adjustment process will continue until the money supply decreases enough to restore the equilibrium condition: Money supply equals money demand. Suppose Canada, to speed the return to equilibrium, imposes a tariff on imports. The tariff increases the price of imports as well as the prices of nontraded goods (goods produced exclusively for the domestic market, which face no competition from imports), owing to interproduct substitution. Higher Canadian prices trigger an increase in the quantity of money demanded, because Canadians now require additional funds to finance higher-priced purchases. The increase in the quantity of money demanded absorbs part of the excess money supply. The tariff therefore results in a speedier elimination of the excess money supply and payments

deficit than would occur under an automatic adjustment mechanism.'

The monetary approach also has policy implications for the growth of the economy. Starting from the point of equilibrium, as the nation's output and real income expand, so do the number of transactions and the quantity of money demanded. If the government does not increase the domestic component of the money supply commensurate with the increase in the quantity of money demanded, the excess demand will induce an inflow of funds from abroad and a payments surplus. This explanation is often advanced for the German payments surpluses that occurred during the late 1960s and early 1970s, a period when the growth in German national output and money demand surpassed the growth in the domestic component of the German money supply.

'An import quota would also promote payments equilibrium by restricting the supply of Canadian imports and increasing their price. The quantity of money demanded by Canadians would rise. reduc-

ing the excess money supply and the payments deficit. As discussed in the next chapter, a currency devaJ nation also leads to higher-

priced imports. This generales a higher demand lor money and a shrinking payments deficit, according to the moneta ry approach.

1.Because persistent balance-of-payments dis- equilibrium-whether surplus or deficittends to have adverse economic consequences, there exists a need for adjustment.

2.Balance-of-payments adjustment can be classified as automatic or discretionary. Under a system of fixed exchange rates, automatic adjustments can occur through variations in prices, interest rates, and incomes. The demand for and supply of money can also influence the adjustment process.

3.David Hume's theory provided an explanation of the automatic adjustment process that occurred under the gold standard. Starting from a condition of payments balance, any surplus or deficit would automatically be eliminated by changes in domestic price levels. Hume's theory relied heavily on the quantity theory of money.

4.Another important consequence of international gold movements under the classical theory was their impact on short-term interest rates. A deficit nation suffering gold losses would face a shrinking money supply, which would force up interest rates, promoting financial inflows and payments equilibrium. The opposite held true for a surplus nation. Rather than relying on automatic adjustments in interest rates to restore payments balance, central bankers often resorted to monetary policies designed to reinforce the adjustment mechanism during the gold-standard era.

5.With the advent of Keynesian economics during the 1930s, greater emphasis was put on the income effects of trade in explaining adjustment.

6.The foreign repercussion effect refers to a situation in which a change in one nation's