Mechanisms of International Adjustments
10 important questions on Mechanisms of International Adjustments
Balance of Payments (BoP) occurs when:
A current account deficit refers to an excess of outpayments over
inpayments whereas a current account surplus (vice versa)
Current account deficit is a result of excess of imports > exports
of goods, services, income flows, and unilateral services.
A nation finances it current account deficit:
· By attracting investment (factories purchased by foreign businesses or by borrowing from other nations).
The current account takes two different forms:
2. Should the above automatic conditions be unable to restore equilibrium, then government intervention (discretionary policies) enacted to achieve the equilibrium.
3. How is the initial equilibrium restored.
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Automatic adjustments in the Balance of Payments (BoP):
· Foreign prices
· Domestic prices.
Price adjustment mechanism or the Price-specie-flow-doctrine:
· Surplus nation: chain of events promoting a BoP equilibrium:
é Money supply è é Domestic prices è é Imports è ê Exports.
· Deficit nation: chain of events promoting a BoP equilibrium:
ê Money supply è ê Domestic prices è ê Imports è é Exports.
Thus Hume’s theory stresses the role of prices playing a vital role
in promoting current account equilibrium.
Gold standard, late 1800s to early 1900s:
· Money supply = gold or paper money backed by gold
· The official price of gold – defined in terms of national currency
· Buy and sell gold at that price
· Free import and export of gold
· Money supply - directly tied to current –account
Rules of the Game: Classical Gold Standard:
Three conditions:
· Official price of gold was defined in terms of its national currency and the buying and selling of gold at that price.
· Example:
1 ounce of gold was worth: GBP 22, USD 44, D.M. 88, FF 264.
The exchange rate thus: GBP1 = USD2 = 4 D.M. = 12 F.F. or
USD1 = GBP 0.5 = 2 D.M. = 6 F.F.
· Free import and export of gold was permitted by member nations.
Rules of the game suggested:
Surplus nations should increase their money supplies.
Income Adjustment Mechanism:
weakness of the classical economists by formulating the income
adjustment mechanism. Focus: automatic changes in income to bring about an adjustment in a nation’s current account.
Foreign repercussion effect:
exports and income level.
Faced with a higher income level, Germany imports more goods
from India. Thus a change in imports in India results in a
feedback effect on its exports called the repercussion effect.
Consider the case of a large versus a small country.
Example of a closed economy (No exports and imports):
spending of $100 million.
Marginal propensity to save = 0.2
Marginal propensity to consume = 0.8
What does this multiplier mean?
A $100 million increase in government spending will lead to a five-fold increase in income (i.e. K times G è 5.0 times $100 mln = $500 Million). Thus consumption will ultimately increase to $400 million. Savings will increase to $100 million.
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