Question

What are the automatic adjustment mechanisms in the balance of payments that returns it to equilibrium under a fixed exchange rate system? Are any of these applicable to the US, even though we have a floating exchange rate system? Why or why not?

Answer 1

Under the international gold standard which operated between 1880-1914, the currency in use was made of gold or was convertible into gold at a fixed rate. The central bank of the country was always ready to buy and sell gold at the specified price. The rate at which the standard money of the country was convertible into gold was called the mint price of gold.

This rate was called the mint parity or mint par of exchange because it was based on the mint price of gold. But the actual rate of exchange could vary above and below the mint parity by the cost of shipping gold between the two countries. To illustrate this, suppose the US had a deficit in its balance of payments with Britain.

The difference between the value of imports and exports would have to be paid in gold by US importers because the demand for pounds exceeded the supply of pounds. But the transshipment of gold involved transportation cost and other handling charges, insurance, etc.

The main objective was to keep BOP in equilibrium. A deficit or surplus in BOP under the gold standard was automatically adjusted by the price-specie-flow mechanism. For instance, a BOP deficit of a country meant a fall in its foreign exchange reserves due to an outflow of its gold to a surplus country. This reduced the country’s money supply thereby bringing a fall in the general price level.

This, in turn, would increase its exports and reduce its imports. This adjustment process in BOP was supplemented by a rise in interest rates as a result of reduction in money supply. This led to the inflow of short-term capital from the surplus country. Thus the inflow of short-term capital from the surplus to the deficit country helped in restoring BOP equilibrium.

The practical use of flexible exchange rates is severely limited. Depreciation and appreciation lead to fall and rise in prices in the countries adopting them. They lead to severe depressions and inflations respectively.

Further, they create insecurity and uncertainty. This is more due to speculation in foreign exchange which destabilizes the economies of countries adopting flexible exchange rates. Governments, therefore, favour fixed exchange rates which require adjustments in the balance of payments by adopting policy measures.

Economic theory has furnished us with two different approaches to adjustment process-the classical approach which explains the adjustment as operating through changes in the price levels of countries as the force which restores equilibrium and the modern approach which explains the adjustment as operating through the changes in the levels of national income to restore the balance. These approaches are not alternative theories, mutually exclusive through the correctness and modernity of one and the obsolescence of the other. They are rather complementary ways of regarding the adjustment process.

Each approach springs from the general body of economic theory current at the time of its inception. The classical approach reflecting the Ricardian system with its emphasis on price changes, the quantity theory of money and flexibility of costs and prices. The income approach reflecting the Keynesian theory of income determination with its emphasis on income changes through multiplier effects.

Each approach dictates a different emphasis for policy—the classical approach implying price adjustment through monetary policy and income approach reflecting the use of fiscal policy for income adjustment. In the adjustment process price and income changes work in the same direction. The income approach has supplemented rather than supplanted the classical approach to BOP adjustment process.

The price mechanism can operate in two ways to produce BOP adjustment. The first and most obvious way is for prices to act directly, through changes in the price levels of countries; the second is indirect and occurs where changes in relative prices are brought about by changes in exchange rate between two currencies. The classical economists explained the BOP adjustment under two currency standards—the gold standard and the inconvertible autonomous paper currency standard.