International Economics Mordecai E. Kreinin Copyright ©2002 South-Western/Thomson Learning. All rights reserved. Copyright ©2002 South-Western/Thomson Learning. All rights reserved. Part II International Financial Relations Part II International Financial Relations

C13-2 CHAPTER 13 Domestic Policies to Adjust the Balance of Payments

C13-3 OVERVIEW “Automatic” Processes Summary of the “Automatic” Balance-of- Payments Adjustment Government Policy Foreign Repercussions The Balance of Payments in the Context of General Policy Objectives Some Unanswered Questions “Automatic” Processes Summary of the “Automatic” Balance-of- Payments Adjustment Government Policy Foreign Repercussions The Balance of Payments in the Context of General Policy Objectives Some Unanswered Questions

C13-4 Important Concepts Marginal propensity to consume Marginal propensity to save Marginal propensity to import Multiplier Foreign trade multiplier Specie-flow mechanism Velocity (V) Demand elasticity Automatic adjustment mechanism Monetary policy Marginal propensity to consume Marginal propensity to save Marginal propensity to import Multiplier Foreign trade multiplier Specie-flow mechanism Velocity (V) Demand elasticity Automatic adjustment mechanism Monetary policy Fiscal policy IMF conditionality Expenditures-changing policies Portfolio capital Portfolio approach Locomotive country Foreign repercussions Consistent situation Inconsistent situation Degree of impact Time lags Incompatible trinity

C13-5 “Automatic” Processes The Monetary Mechanism Imbalance and Money Supply Add Direct Effect on Private Expenditures Income changes Price changes MPC, MPS, MPM The multiplier  X and  GDP Additional Insights: The specie-flow mechanism The equation of exchange Keynesian Position The Monetary Mechanism Imbalance and Money Supply Add Direct Effect on Private Expenditures Income changes Price changes MPC, MPS, MPM The multiplier  X and  GDP Additional Insights: The specie-flow mechanism The equation of exchange Keynesian Position

C13-6 Additional Insights: The Foreign Trade Multiplier Marginal propensity to consume Marginal propensity to save Marginal propensity to import Income and Price Mechanisms Trade and the national economy Marginal propensity to consume Marginal propensity to save Marginal propensity to import Income and Price Mechanisms Trade and the national economy

C13-7 Summary of the “Automatic” Balance-of-Payments Adjustment Automatic adjustment mechanism under fixed exchange rates, a function of aggregate expenditures, money supply—operating in same direction, affecting economy through income and price mechanism

The Four Linkages Involved in Automatic Adjustment Mechanism Under Fixed Exchange Rates C11-8

C13-9 Summary of the “Automatic” Balance-of-Payments Adjustment Deficit vs. surplus in balance of payments Marginal propensity to import Improved competitive position and price elasticity Money supply mechanism, sterilization Surplus, deficit contain seeds of reversal Under fixed exchange rate, income and price influence balance of payments in corrective direction Under floating exchange rate, above applies to current account Deficit vs. surplus in balance of payments Marginal propensity to import Improved competitive position and price elasticity Money supply mechanism, sterilization Surplus, deficit contain seeds of reversal Under fixed exchange rate, income and price influence balance of payments in corrective direction Under floating exchange rate, above applies to current account

Automatic Processes that Reverse External Imbalance under a Stable Exchange Rate FIGURE 13.1 C11-10

C13-11 Government Policy Domestic Policy Measures and the Current Account Expenditure-changing policies Effect on Direct Investment Capital Effect on Other Capital Movements Portfolio capital Portfolio approach Monetary and fiscal policies Monetary contraction Domestic Policy Measures and the Current Account Expenditure-changing policies Effect on Direct Investment Capital Effect on Other Capital Movements Portfolio capital Portfolio approach Monetary and fiscal policies Monetary contraction

C13-12 Foreign Repercussions Leading industrial nation has additional responsibility for fate of other countries To calculate foreign trade multiplier effect of any policy, foreign repercussions must complete circuit and affect policy-originating country No country completely free to pursue independent domestic policies Coordinated reduction of interest rates Giving up fixed exchange rates or independent monetary policy Leading industrial nation has additional responsibility for fate of other countries To calculate foreign trade multiplier effect of any policy, foreign repercussions must complete circuit and affect policy-originating country No country completely free to pursue independent domestic policies Coordinated reduction of interest rates Giving up fixed exchange rates or independent monetary policy

Foreign repercussions can be shown schematically for a two- country world, where country A experiences an autonomous increase in its exports to country B: C11-13 Country A Country B

C13-14 The Balance of Payments in the Context of General Policy Objectives Consistent situations Inconsistent situations Internal balance, external balance Relationship of balance of payments to other economic goals Consistent situations Inconsistent situations Internal balance, external balance Relationship of balance of payments to other economic goals

C13-15 Some Unanswered Questions Degree of Impact Economic estimation Time Lags Degree of Impact Economic estimation Time Lags

C13-16 Summary Domestic policies to restore balance of payments under fixed exchange regime Application to current account under flexible rate regime Multiplier effect Deficits, surpluses Automatic mechanisms provide partial remedies Fiscal and monetary measures, expansionary policies Consistent and inconsistent situations Domestic policies to restore balance of payments under fixed exchange regime Application to current account under flexible rate regime Multiplier effect Deficits, surpluses Automatic mechanisms provide partial remedies Fiscal and monetary measures, expansionary policies Consistent and inconsistent situations

A Hypothetical Import Function Based on Table A FIGURE A C1-17

A Hypothetical Export Function FIGURE A C1-18

Derivation of Total Injection and Total Leakage Functions FIGURE A C1-19

Equilibrium Output (Y E ) Occurs Where (S + M) = (I + X); Capital-Exporting Country (such as Japan) FIGURE A C1-20

A Capital-Importing Country (such as The United States): I >S and M > X; (I – S) = (M – X) FIGURE A C1-21

Effect on GDP of an Increase in (I + X) FIGURE A C1-22