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WORLD TRADE
AND PAYMENTS
AN INTRODUCTION

TENTH EDITION

RICHARD E. CAVES
HARVARD UNIVERSITY

JEFFREY A. FRANKEL
HARVARD UNIVERSITY

RONALD W. JONES
UNIVERSITY OF ROCHESTER
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Contents ix

13.4 Special Protection in Action 236

13.5 Prospects for Special Protection 241
13.6 Summary 242
CHAPTER PROBLEMS 243
SUGGESTIONS FOR FURTHER READING 244

CHAPTER 14 Preferential Arrangements

and Regional Issues in Trade Policy 245
14.1 Regional Preferences and Regional Trade 245
14.2 Welfare Effects of Trade Preferences 247
14.3 Preferential Arrangements in Practice 251
14.4 Trade Problems of the Economies in Transition 257
14.5 Trade and Growth: China and the Asian NICs 260
14.6 Preferential Arrangements: New Policy Issues 264
14.7 Summary 267
CHAPTER PROBLEMS 269
SUGGESTIONS FOR FURTHER READING 269

PART IV MONEY, INCOME, AND THE BALANCE OF PAYMENTS 271

CHAPTER 15 The Balance of Payments Accounts 273

15.1 Breakdown of the Accounts 275
15.2 How Individual Transactions Are Recorded 278
15.3 Double-Entry Bookkeeping 280
15.4 The Balances 282
15.5 Statistical Errors in the Payments Accounts 286
15.6 Summary 288
CHAPTER PROBLEMS 288

CHAPTER 16 The Foreign Exchange Market and Trade Elasticities 291

16.1 The Flow of Supply and Demand for Foreign Exchange 291
16.2 Empirical Effects of Devaluation on the Trade Balance 297
16.3 Summary 300
CHAPTER PROBLEMS 301
SUGGESTIONS FOR FURTHER READING 303
APPENDIX: Stability of the Foreign Exchange Market 303
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x Contents

CHAPTER 17 National Income and the Trade Balance 307

17.1 The Small-Country Keynesian Model 307
17.2 The National Saving-Investment Identity 309
17.3 Multipliers 310
17.4 The Transfer Problem 314
17.5 For a Large Country: The Two-Country Keynesian Model 316
17.6 Summary 321
CHAPTER PROBLEMS 322
SUGGESTIONS FOR FURTHER READING 324
APPENDIX: The Two-Country Model in Graphical Form 324

CHAPTER 18 Spending and the Exchange

Rate in the Keynesian Model 327
18.1 Transmission of Disturbances 327
18.2 Expenditure-Switching and Expenditure-Reducing Policies 330
18.3 Monetary Factors 337
18.4 Summary 343
CHAPTER PROBLEMS 344
SUGGESTIONS FOR FURTHER READING 346
APPENDIX A: The Laursen-Metzler-Harberger Effect 346
APPENDIX B: The Assignment Problem 350

CHAPTER 19 The Money Supply, the Price Level,

and the Balance of Payments 353
19.1 The Nonsterilization Assumption 353
19.2 The Purchasing Power Parity Assumption 358
19.3 Purchasing Power Parity in a Hyperinflation 369
19.4 PPP in the Model of the Balance of Payments 372
19.5 Summary 374
CHAPTER PROBLEMS 375
SUGGESTIONS FOR FURTHER READING 377
APPENDIX A: The Gold Standard 378
APPENDIX B: Reserve Flows After Spending Increase and Devaluation 382
APPENDIX C: The Determination of the Balance of
Payments in the Monetarist Model 384
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Contents xi

CHAPTER 20 Developing Countries and Other Small

Open Economies with Nontraded Goods 391
20.1 Nontraded Goods 392
20.2 Expenditure and the Relative Price of Nontraded Goods 395
20.3 The Monetary Approach with Nontraded Goods 401
20.4 Summary 407
CHAPTER PROBLEMS 407
SUGGESTIONS FOR FURTHER READING 408

PART V INTERNATIONAL FINANCIAL MARKETS

AND THEIR MACROECONOMIC IMPLICATIONS 409

CHAPTER 21 The Globalization of Financial Markets 411

21.1 The Postwar Financial System (1944–1973) 412
21.2 The Foreign Exchange Market 414
21.3 Liberalization 419
21.4 Innovation 426
21.5 Advantages of Financial Integration 435
21.6 Summary 439
CHAPTER PROBLEMS 439
SUGGESTIONS FOR FURTHER READING 440
APPENDIX: The Effect of a Budget Deficit
Under Intertemporal Optimization 441

CHAPTER 22 The Mundell-Fleming Model with

Partial International Capital Mobility 445
22.1 The Model 447
22.2 Fiscal Policy and the Degree of
Capital Mobility Under Fixed Rates 450
22.3 Monetary Policy and the Degree of
Capital Mobility Under Fixed Rates 452
22.4 When Money Flows Are Not Sterilized 454
22.5 Other Automatic Mechanisms of Adjustment 456
22.6 The Pursuit of Internal and External Balance 457
22.7 Summary 460
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PART IV

Money, Income, and the

Balance of Payments

Chapter 15 ■ The Balance of Payments Accounts

PAGE 273

Chapter 16 ■ The Foreign Exchange Market

and Trade Elasticities
PAGE 291

Chapter 17 ■ National Income and the Trade Balance

PAGE 307

Chapter 18 ■ Spending and the Exchange Rate

in the Keynesian Model
PAGE 327

Chapter 19 ■ The Money Supply, the Price Level,

and the Balance of Payments
PAGE 353

Chapter 20 ■ Developing Countries and Other Small

Open Economies with Nontraded Goods
PAGE 391
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CHAPTER 15

The Balance of
Payments Accounts

P
arts I through III of this book concentrated on the behavior of “real” variables in
the international economy—on the quantities of goods produced, consumed, and
traded. Prices were crucial in securing equilibrium, but only as the relative prices
of goods (the terms of trade) or of factors of production. The focus now turns to the
macroeconomic side of international economics.1 This requires an examination of the
behavior of monetary magnitudes—the quantity of money itself and various prices that
are measured in currency units. These include overall price levels, wage rates, and the
foreign exchange rate, which is the price at which currencies exchange for one another.
The subject of international monetary economics has grown rapidly in interest and
importance over the last 40 years. Much has happened over this period in the world
economy. In 1973 the major industrialized countries moved from a system under which
exchange rates were fixed by governments—a system that had held sway since World
War II—to a new system in which exchange rates are determined in the marketplace.
Meanwhile, both goods markets and financial markets have become highly inte-
grated, forcing even previously insular American macroeconomists to recognize the
importance of the foreign sector; oil price changes have induced economists to build
back into their view of the macroeconomy some of the real factors that had been left
behind; developing countries have become integrated into the global economy;
European countries have achieved monetary integration with each other; and large
new macroeconomic policy disturbances, unprecedented trade imbalances, and cur-
rency crises in some countries have tested the limits of the modern financial system.
Exchange rate flexibility has continued to spread, including to major developing coun-
tries. At the same time, thinking on the subject has been stimulated by new develop-
ments in the macroeconomic theory of closed economies: Intellectual revolutions that
introduced such concepts as rational expectations in financial markets, credible com-
mitment in monetary policy, and intertemporal optimization in saving behavior.
This half of the book will introduce eight or ten factors, or variables, that received
little or no attention in the first half of the book.The variables include the exchange rate,
output and employment (emphasizing the cyclical components of each), the interest

1
The term international finance applies as well, particularly to the material covered in Parts V and VI.

273
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274 Chapter 15 ■ The Balance of Payments Accounts

rate, stocks of money and reserves, the aggregate price level, the relative price of non-
traded goods, international flows of portfolio capital, and expectations. Understanding
how the macroeconomic system works can be quite difficult if one tries to consider all
ten variables simultaneously. These variables will be introduced one at a time, so that
each can be assimilated—understood in terms of its interaction with the other vari-
ables—before the next is introduced. Thus we need not discard what we have used at
each stage as we move on to the next stage and the next variable. Rather, we can con-
sider what came before to be the right answer when the variable in question is held con-
stant; we will then examine the corresponding change in the results when the new
variable is allowed to change.
Before proceeding, however, we briefly explain the sequence of the different vari-
ables. Chapter 16 will introduce the exchange rate and show how it helps determine a
country’s balance of trade. The effect of the exchange rate on the trade balance will be
examined first in the most controlled environment, in which price levels, income levels,
and all other variables are held constant. Then Chapter 17 will allow for cyclical fluctu-
ations in income. Unlike changes in output considered previously, these fluctuations
will represent changes relative to potential output, changes associated with unemploy-
ment of labor and unutilized capacity. They are the consequence of wages and prices
that are rigid, or at least “sticky”—that resist moving to equilibrate the labor and goods
markets. This represents a sharp departure from the first half of the book, in which all
prices were assumed to be flexible enough that they adjusted to ensure that supply
always equaled demand. Some of the results, such as the existence of unemployment
and excess capacity, are familiar from standard macroeconomics textbooks. However,
much will be new and different in the open economy. For example, when prices are not
free to adjust, the exchange rate can sometimes be used to restore equilibrium.
In the last part of Chapter 18 the money supply and the interest rate will make
their appearance. At this point we will address how five variables—trade balance,
exchange rate, level of income, money supply, and interest rate—all interrelate. Here,
and throughout the last half of the book, a key question concerns the effects of mone-
tary and fiscal policy on the open economy. In Chapter 19 two more factors are added.
The first half of the chapter introduces the stock of international reserves (e.g., gold)
that is held by the central bank. The second half of the chapter examines, for the first
time, the overall price level. Chapter 20 distinguishes between traded and nontraded
goods, providing a particularly useful model for developing countries and other coun-
tries that are small in world trade.
The core of Part V concerns the international flow of capital, the most powerful
new factor in the modern world macroeconomy. To simplify: Parts I through III con-
centrated on the international flow of goods, with the net trade balance generally con-
strained to zero; Part IV introduces the international flow of money, allowing nonzero
payments balances; and Part V introduces the international flow of portfolio capital—
assets such as stocks and bonds. Because an asset is a claim to future consumption,
international trade in assets is what allows countries to spend more than they earn in
some periods, then make up for it by spending less than they earn in other periods.
Finally, Part VI examines the determination of exchange rates in international asset
markets, where expectations also arise as a key variable.
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15.1 ■ Breakdown of the Accounts 275

We will see that two particular aspects of the structure of the world economy as it
evolved since the 1970s—the great ease of international capital movements and the
system of market-determined exchange rates—have completely altered how policy
changes and other macroeconomic disturbances operate. These aspects of the modern
economy have important implications for the resolution of international payments
imbalances and other policy problems that the world faces.
Before we begin exploring the operation of the international macroeconomy, it is
necessary to go through the mechanics of balance-of-payments accounting in the pres-
ent chapter. This tool would be necessary even if the subject were as tedious as mat-
ters of accounting sometimes appear. Balance-of-payments accounts, however, have
attained a new fascination. Some measures of the balance of payments are closely
watched by the press and policy makers.
Considerable insight into present international payments imbalances can be
gained simply from the accounting identities, even before the discussion turns to the
more interesting questions of economic causality. An accounting identity is an equation
that must hold precisely, as a matter of definition or arithmetic, as opposed to behav-
ioral equations, which represent theories of economic behavior that are not expected
to hold precisely.

15.1 Breakdown of the Accounts

A nation’s balance-of-payments accounts is the statistical record of all economic trans-
actions taking place between its residents and the rest of the world. These are most
conveniently broken up into three accounts, as shown in Table 15.1. First, the current
account (CA) is the record of trade in goods and services and other current transac-
tions, as opposed to trade in assets, which are obligations regarding the future. Trade in
assets appears in the capital accounts. If the asset is traded among private citizens of
the countries, then it appears on the private capital account (KA). If the buyer or seller
of the asset is a central bank—that is, the monetary authority of either the domestic or
foreign government—then the transaction appears on the official reserve transactions
account (ORT).

Breakdown of the Current Account

Each of these three accounts is in turn divided into subaccounts. Within the current
account the first subaccount is merchandise trade, consisting of exports and imports of
goods, which includes all movable goods either sold, bought, or otherwise transferred
between domestic and foreign owners.
The second subaccount within the current account is services (also known in the
United Kingdom as “invisibles,” as opposed to “visibles,” which refer to merchandise).
Some of the important international service transactions are as follows:
1. Transportation services include freight and insurance charges for the international
movement of goods and also the expenditures on international travel of tourists
and other passengers.
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276 Chapter 15 ■ The Balance of Payments Accounts

TABLE 15.1
Schematic Representation of the Balance of Payments
Accounts and Subaccounts Cumulative Balances
CURRENT ACCOUNT (CA)
Merchandise . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Merchandise balance
Services
• Transportation
• Tourism
• Business and professional services . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Balance of goods and services
Investment income. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Balance of goods, services,
and income
Unilateral transfers
• Government grants
• Private remittances . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Current account balance
PRIVATE CAPITAL ACCOUNT (KA)
Direct investment
Portfolio investments (securities and banking flows)
• Long term. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Basic balance
• Short term . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Overall balance of payments
OFFICIAL RESERVE TRANSACTIONS (ORT)
Changes in foreign central banks’ holding of domestic assets
Changes in the domestic central bank’s holding of foreign assets
• Gold
• IMF credits and SDRs
• Foreign exchange reserves

Note: Each balance at the right is the sum of the previous balance and the additional items listed before the dotted line.

2. Tourist services include all expenditures by a country’s citizens in foreign countries

(on food, lodging, local transportation, etc.).
3. Business and professional services make up a diverse class of international trans-
actions, which has come to public prominence under the name “overseas out-
sourcing.” International trade in the services of engineer firms, management
consultants, computer programmers, telephone receptionists, and so forth, is a
rapidly growing component of trade. Royalties and license fees paid for the use of
a work or invention, when the copyright or patent is held by a resident citizen of
another country, are also counted as payments for a service.
A third subaccount within the current account is investment income. Interest payments
or dividends appear here because they are considered payments for the services of
capital that is “working” abroad. The profits earned by a factory owned by a foreign
resident, for example, are payments for the services of the capital embodied in that fac-
tory. It is important to distinguish these yearly payments for the services of capital,
which appear in the current account, from the original investment itself, which appears
in the capital account.
Unilateral transfers are a fourth subaccount. This subaccount consists of govern-
ment grants (foreign aid) and private remittances (from emigrant workers to their
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15.1 ■ Breakdown of the Accounts 277

families, from pensions to retired people living abroad, etc.). Transfers appear in the
current account rather than in the capital account because they do not create any
obligation for repayment in the future, as a loan does.

Breakdown of the Capital Account

Within the capital account,2 the key distinction is between direct investment and port-
folio capital. Portfolio investment in turn can be divided into long term and short term.
1. Foreign direct investment occurs when the residents of one country acquire con-
trol over a business enterprise in another country. The acquisition may involve buying
enough stock in an existing enterprise to become a controlling shareholder (defined
for this purpose as 10 percent ownership), taking over the enterprise outright, or build-
ing a new factory or enterprise from scratch (including, as well, the purchase of real
estate). When an investor buys only a small fraction of the shares of a foreign company,
however, it is an example of long-term portfolio investment.
2. Long-term portfolio investment involves international transactions in financial
assets with an original term to maturity greater than one year. Such investment consists
of purchases of securities (stocks, also called shares or equities, and bonds) and long-
term bank loans. Often the distinction between long-term and short-term capital flows is
arbitrary, as when an investor buys a 10-year government bond, intending to resell it in a
short time, or buys a bond that has already been held for 91⁄2 years and is about to mature.
3. Short-term capital flows involve assets with original terms to maturity of less
than one year. Examples are Treasury bills, commercial paper, and certificates of
deposit (short-term claims on the government, corporations, and banks, respectively).
Also included as short-term capital flows are any international shifts in the ownership
of liquid funds, such as an interest-earning deposit or even a check or cash that does
not pay interest. For example, British pound notes, or deposits in a British bank, are
assets giving a claim on future British goods and services, just as surely as British trea-
sury bills. The distinction between short term and long term is still reported in Japan,
Germany, and some other countries, but not in the U.S. accounts, mainly because it is
difficult to disentangle the two types of portfolio investment in the data.
Finally, the ORT account consists of central bank transactions in international reserve
assets: gold, foreign exchange reserves, credits issued by the International Monetary
Fund (IMF), and Special Drawing Rights (SDRs).3 Central banks hold these reserve
assets to back up the liabilities they issue (domestic currency and other assets that add
up to the monetary base), much as commercial banks hold reserves to back up the lia-
bilities that they issue (checking account deposits and other assets that add up to the
total money supply).

2
“Capital account” is generally used here to refer to the private capital account, as distinct from the transac-
tions of central banks. (It does include, however, any international transactions undertaken by government
agencies other than the central bank—for example, credits to U.S. armed forces stationed abroad.)
3
Special Drawing Rights, sometimes described as “paper gold,” are an asset created by the IMF. Their value is
defined in terms of four currencies: the dollar, yen, pound, and euro.
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278 Chapter 15 ■ The Balance of Payments Accounts

15.2 How Individual Transactions Are Recorded

The key rule for recording transactions is as follows: Whatever enters the country, such
as an import, is recorded as a debit; whatever leaves the country, such as an export, is
recorded as a credit. The examples that first come to mind concern trade in merchan-
dise (goods).An import of an automobile appears as a debit in the merchandise account
because something is entering the country; the export of jet engines appears as a credit
because something is leaving the country. Of course, the country that exports the auto-
mobile earns a credit on its merchandise account; and the country that imports the jet
engines receives a debit.
There are many other examples for exports and imports of various services, and
for each of the other subaccounts as well. When an American importer arranges trans-
portation with a Greek shipping company or American tourists cross the Atlantic on a
foreign airline, the import of the service is recorded as a debit in the U.S. transportation
service account. When foreign firms hire American ships to carry goods or when for-
eign tourists come to the United States, the export of the service is recorded as a credit.
The spending of American tourists in Europe is recorded as a debit, again on the ser-
vice account, and the spending of Japanese tourists in the United States as a credit.
When an American firm contracts out to a call center in India, a service import of the
United States again appears. When a foreign student comes to an American university
to study or a foreign medical patient comes to an American hospital for surgery, it
appears as a U.S. service export.
The convention is that gifts and other transfers are recorded under unilateral
transfers. Even though a transfer from another country does not create any obligation
for future monetary repayment, as does a loan, a device for remembering that it
appears as a credit might be to think of the transfer as the export of a political or moral
IOU. In 1991 the United States received large payments from Japan and other allies to
finance Operation Desert Storm in Kuwait. These credits did not appear on the ser-
vices account because they were not literally exports of military services but appeared
instead as transfers. Emigrants’ remittances are an important source of credits for
Mexico, the Philippines, and countries around the Mediterranean; the corresponding
debits are incurred in the United States, northern European countries, and Persian
Gulf states that host the immigrant workers.

Credits and Debits on the Capital Account

The acquisition of a foreign asset counts as a debit on the capital account because the
asset, or at least the claim to the asset, is entering the home country. As a device for
remembering that an investment abroad counts as a debit, think of it as the “import” of
an asset. (The equivalent term—“capital outflow”—may be less helpful here, in that it
may not sound like an import, even though it is one.) When General Electric builds a
factory in China, an outflow of direct investment, a debit equal to the value of the
equity that GE acquires in the factory, is recorded in the U.S. balance of payments. In
this sense the purchase of machine tools bolted down to a factory floor in Scotland is
similar to the purchase of Scottish machine tools imported into the United States, but
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15.2 ■ How Individual Transactions Are Recorded 279

in the former case the debit appears on the capital account and in the latter case it
appears on the merchandise trade account. An American purchase of the bonds of a
Canadian provincial government is recorded as a portfolio capital outflow, a debit on
the long-term portfolio capital account. The American acquisition of a short-term asset
in another country—whether it is a Treasury bill, corporate IOU, certificate of deposit,
check, or currency—counts as a debit on the short-term portfolio capital account. This
point should be emphasized because it will be important for understanding the
accounting to follow. Remember that the reason this acquisition counts as a debit is
that an American has increased individual holdings of a foreign asset, even if the asset
is only foreign currency.
Ever since 1982, the U.S. capital account has shown many more credits than debits.
Foreign citizens have been acquiring assets of every sort in the United States: currency,
Treasury bills, bank loans, bonds, stocks, and direct investment. The term credit makes it
sound like a good thing for the receiving country. In one sense this is true: It can be
viewed as a vote of confidence when foreigners decide to invest in the United States.
The downside, of course, is that U.S. citizens will have to service the debt (i.e., pay inter-
est, and eventually repay the principal) in the future; or, in the cases of sales of stocks
and inward direct investment, dividends and profits will have to be repatriated abroad
in the future.
If American citizens resell to a foreign resident a bond originally issued by a for-
eign corporation, or any other foreign asset they acquired in the past, that too counts as
a credit. There is no economic difference between an increase in your obligations to a
foreigner or a decrease in a foreigner’s obligations to you. Both contribute to a
decrease in the net foreign investment position of the United States, which is simply
one more way of saying “capital inflow” or “credit on the capital account.” Similarly, if
an American buys back a U.S. Treasury bill from a foreign resident who acquired it in
the past, it counts as a debit in the U.S. capital account in the same way as when the
asset the American purchases from the foreign resident is one that was originally
issued by some foreign government or institution.4
The final place where credits and debits can appear is the Official Reserve
Transactions account. When the domestic central bank buys foreign currency or gold,
its purchase counts as a debit, just as it does when a private investor makes the pur-
chase, but here it appears on the ORT account rather than the private capital account.
As a device for remembering that it counts as a debit, the purchase can be thought of
as an import of gold or foreign currency by the central bank. In this sense it is like the
import of gold jewelry or shares in a foreign gold mine, except that in the jewelry case
the debit appears in the merchandise trade account and in the gold mine case in the
capital account. Only when the central bank makes the purchase does it appear on the
ORT account.

4
As a matter of fact, increases in U.S.-held assets issued abroad and decreases in foreign-held assets in the
United States are reported separately in the detailed balance-of-payments accounts published every quarter
by the Department of Commerce. Economic discussions of the balance of payments usually focus only on the
net capital flows, however. (Incidentally, since 1999, U.S. capital flows appear on what is now technically called
the “financial account.”)
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280 Chapter 15 ■ The Balance of Payments Accounts

Another example arises if the country in question is one whose currency is used by
other central banks as a reserve asset (as are the dollar, euro, and several other curren-
cies5). When a foreign central bank buys some of the domestic currency, its purchase
counts as a credit in the domestic balance-of-payments accounts, just as it does when a
private foreigner buys some.

15.3 Double-Entry Bookkeeping

Note a critical point: As a matter of accounting, every complete economic transaction
is recorded twice, once as a debit and once as a credit. The reason is that in every com-
plete transaction there is something leaving the country in exchange for something
entering the country. If there were not, then one party or the other would be giving up
something for nothing.6 One case where this is easy to see is barter. If, for example,
Argentina exports wheat to Russia in exchange for tractors, then both the credit for the
wheat export and the debit for the tractors import appear on the merchandise trade
account. Similarly, if Russia accepted the claim to some Argentine farmland in pay-
ment for the tractors, the Argentine balance-of-payments statistics would show a debit
to the trade account and a corresponding credit under foreign direct investment.

Paying for Imports

Usually, however, transactions are paid for in an immediate sense through the banking
system.7 Argentina pays for the tractors by writing a check on a bank. The credit that
corresponds to the debit on the trade account appears on the short-term capital
account. Recall that any time a foreign resident acquires an asset or a claim on the
domestic country, even if it is a bank deposit rather than a more tangible investment, it
counts as a credit on the domestic capital account. It is quite likely that the Russian
tractor manufacturer will quickly cash in its check, which is a claim on an Argentine
bank, to buy something more directly useful to it than Argentine pesos (perhaps that
Argentine wheat), but this would count as an entirely separate transaction and would
appear in the accounts as a new credit-debit pair.

5
Only convertible foreign currencies are held as foreign exchange reserves. Central banks do not hold
Tajikistani rubles as reserves because neither the government nor private banks will freely convert them into
gold, dollars, or other international reserve assets.
6
The unique case where one party does in fact give up something for nothing is the unilateral transfer. When
the United States donates grain to an African country, for example, a debit is assigned to the trade account of
the African country (or to its capital account if the donation consists of money) because something is entering
the country. A credit is assigned to the United States because something is leaving the country. As already
noted, the unilateral transfers account is where accountants, by convention, also assign a corresponding credit
to the recipient country and a debit to the donor country.
7
In a type of international transaction called countertrade, the exporter of goods to a country promises to
import a corresponding value of goods from that country. However, most countertrade transactions are still
paid for through the banking system. Relatively little of it is outright barter for goods, as this is awkward. Dalia
Martin, “Tying in International Trade: Evidence on Countertrade,” The World Economy, 13, no. 3 (1990):
445–462.
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15.3 ■ Double-Entry Bookkeeping 281

Other than paying for transactions by cash or check, the only other common
method is trade credit: The tractor manufacturer extends to the Argentine importer the
credit needed to buy the tractors (i.e., the importer does not have to pay until a later
date) or else a bank extends the credit to the importer. In this case the credit item
again appears in the short-term capital account: A foreign resident has acquired a
short-term claim against an Argentine resident. In this sense paying for an import on
short-term credit looks just like paying cash; both appear as credits in the same line of
the balance of payments.

Paying for Asset Purchases

As a final set of examples, consider how the purchase of an asset is paid for. If a
Japanese company buys an office building in Los Angeles and pays by check, the U.S.
balance of payments registers a credit under direct investment (a foreign company has
increased its holdings of U.S. real estate) and a debit under banking flows (an American
company has increased its holdings of short-term claims on foreigners—it has the
Japanese check). If an American firm buys a Mexican bond and pays by check, the U.S.
balance of payments shows a debit to portfolio capital (the firm has increased its hold-
ings of foreign securities) and a credit under banking flows (a foreign firm has increased
its holdings of short-term claims on Americans). If an American buys a 90-day
Certificate of Deposit in the United Kingdom and pays by check, both the credit and
the debit appear under banking flows (two short-term assets have been exchanged). In
some cases it is difficult to say which side of the transaction is paying for the other.
There is nothing wrong with this; both parties have to get something out of it.
It may be clearer now why it makes accounting sense to enter a payment abroad as
a credit to the capital account at the same time that a debit is entered for the other half
of the transaction (e.g., on the trade account in the case of an import of merchandise).
Take the case of an American company paying for an import in dollars, either cash or a
check on its bank account. If the foreign company were to hold on to the dollars rather
than cashing them in, in exchange for its own currency—that is, if there were no second
transaction undoing the capital flow— this would have to mean that the foreign com-
pany had made a deliberate decision to increase its holdings of dollars. This should
count as a capital-account credit; it constitutes foreign investment in U.S. assets, just as
if the foreign company had increased its holdings of U.S. stocks or bonds. Again, nor-
mally the foreign company would be expected to cash in the dollars for something
more useful, but doing so would count as a separate transaction. If the foreign com-
pany sells the dollars to the central bank, the second transaction consists of a debit to
the U.S. short-term capital account (a foreign private company has now reduced its
holdings of short-term U.S. assets) and a credit to the ORT account (the Federal
Reserve has exported some foreign currency reserves).

What If the Importer Pays in Foreign Currency?

It has been assumed so far that the U.S. importer can make payment in dollars. The
story is similar, however, if it pays in foreign currency. Assume first that the U.S.
importer has on hand a stock of foreign currency just for such purposes. Initially the
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282 Chapter 15 ■ The Balance of Payments Accounts

current account debit is paid for by a short-term capital-account credit: A U.S. com-
pany has reduced its holdings of foreign assets, which represents a capital inflow just as
if it had sold off a security. (Recall that when the U.S. company decreases its credit
position vis-à-vis foreign companies, it is as if foreign companies had increased their
credit position vis-à-vis U.S. companies.) However, if the importer obtained the foreign
currency by drawing down some transactions balances that were kept on hand for the
purpose, subsequently it will probably want to replenish its stock of foreign currency
by buying some in the foreign exchange market. If the importer does not have a stock
of foreign currency to begin with, then again it has to go into the foreign exchange mar-
ket to obtain some. Either way, the importer needs foreign currency, and there will be a
second transaction in which it is obtained. If the importer obtains the foreign currency
from its central bank, the second transaction consists of a debit to the short-term capi-
tal account and a credit to the ORT account, exactly as in the first example.
Conversely, if the importer allows its stock of foreign currency to remain lower at
the end of the period than it was at the beginning (or goes into debt in foreign cur-
rency), then it must have decided deliberately to decrease its (net) holdings of foreign
assets. The net credit then remains on the capital account—as when foreign companies
increase their claims on domestic companies—rather than being transferred to the
ORT account.

15.4 The Balances

Every year, the country adds up the debits and credits arising from the international
transactions that have taken place. For most purposes in macroeconomics, the only
concern is net flows, or total credits minus total debits. Within any given line of the bal-
ance of payments, there will be many credits and debits that cancel each other out. For
example, short-term banking flows are typically very high in gross terms as banks buy
and sell short-term positions in foreign currency and send checks back and forth for
collection. But the net flow is much smaller.
The country then adds together the net flows, or subtotals, from different lines
in the accounts to determine various balances, such as the trade balance. If credits
outweigh debits, then the balance in question is positive. A positive balance is com-
monly referred to as “favorable.” If debits outweigh credits, the balance is negative, or
“unfavorable.”
Note the subtle implication of the semantics. The export side owns all the positive
words—and has done so ever since the eighteenth-century mercantilists made a
national virtue of selling abroad more than one bought to “store up treasure.” Although
economists from Adam Smith on have proclaimed that economic welfare ultimately
depends on the goods available for the nation’s use and not on the money earned from
exporting, they have never conquered this linguistic remnant of mercantilism. When
the term unfavorable is used in reference to a negative trade balance, remember that it
may be perfectly appropriate for a country to run a trade deficit, depending on the cir-
cumstances. For example, developing countries sometimes run large trade deficits. This
practice can be perfectly appropriate if they are growing rapidly and need, typically, to
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15.4 ■ The Balances 283

import capital goods to invest in plants and equipment. Such countries are necessarily
borrowing from abroad to finance their current-account deficits. If they are spending
the funds well, they will in the future have the capital stock, particularly export capac-
ity, necessary to generate export earnings with which to repay that debt.

The Adding-Up Constraint

Because every debit has an offsetting credit somewhere, CA 1 KA 1 ORT ; 0.
(Three bars are used in the equality sign to indicate this is an accounting identity.)
Because it is always zero, the three-account sum is not a very interesting statistic! Two
interesting statistics are (1) the current-account balance and (2) the sum of the current
and capital accounts, which is what is generally meant by the overall balance of pay-
ments (BP): BP ; CA 1 KA. These statistics reveal whether the country is spending
beyond its means, and whether there is a net supply of, or demand for, its currency. A
country that is running a current-account deficit—for example, the United States since
1982—is borrowing from abroad to do so, running down its net foreign asset position.
Ever since 1917, the United States had been accumulating claims on the rest of the
world, but in a few years the enormous deficits of the 1980s wiped out that accumu-
lated investment position. The official statistics show that the country passed from net
credit status to net debtor status in 1989.8
A country running a current-account surplus—Japan, for example—is accumulat-
ing claims on foreigners and building up a positive net foreign asset position. If the for-
eign assets are acquired by the private residents of the domestic country, then the
capital-account deficit can offset the current-account surplus and the overall balance of
payments can be zero. In this case, KA 5 2CA, so ORT 5 0.
If a country is running a current-account surplus and its private residents are not
acquiring foreign assets, however, then it must be the central bank that is acquiring for-
eign assets. In this case, KA 5 0, so ORT 5 2CA. Such a country is running a surplus,
not just on its current account, but also on its overall BP, which is sometimes called the
official settlements balance. Note that it is the negative of the sum of the items on the
ORT account: ORT ; 2BP. The overall balance of payments is the net supply of for-
eign currency (or the net demand for domestic currency, which is the same thing), after
the private sector has made all its desired current-account and capital-account transac-
tions. If it is a positive number, the ORT is negative, which means that the central bank
is adding to its foreign exchange reserves (or is supplying the domestic currency that
private agents in the foreign exchange market want, which is the same thing). If BP is a

8
This may be the appropriate place to introduce the distinction between stocks and flows. Flows have a “per
unit of time” dimension, whereas stocks are absolute and dimensionless. Examples of stocks are the level of
reserves held by a central bank and the level of assets held by private investors, whether money, bonds, equi-
ties, or physical capital. Examples of flows are the balance of payments, the current account, income, spending,
and saving. A flow is the rate of change of a stock. The current account is the rate of change of the net interna-
tional investment position, with the proviso that the latter also changes discretely when there is a change in
the price of the assets (e.g., because of a change in the value of the currency). Such valuation effects have been
important in recent years for the United States.
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284 Chapter 15 ■ The Balance of Payments Accounts

negative number, then ORT is positive, which means the central bank is selling foreign
exchange reserves (or is buying the domestic currency that private agents in the mar-
ket want to sell).

Where to Draw the Line?

There used to be a presumption of causality running from items reported higher in the
accounts shown in Table 15.1 to items reported lower. Trade, for example, logically
came first. Suppose a line is drawn under the entries for trade in goods and services.
Then, if the balance is in deficit, it could be financed by transfers, by borrowing (KA), or
by reserve loss (ORT). All items “above the line” would be considered autonomous—
they cause the items below the line, which are financing or accommodating. There was
much debate as to where to draw the line. Obvious places are the CA balance, with KA
and ORT as accommodating, or at BP, with ORT alone as accommodating. However,
there are other places to draw the line, as shown in the right-hand column in Table 15.1.
Monthly merchandise trade balance numbers historically received more attention
than any other measure of the balance of payments. They become available more
quickly than financial components of the U.S. balance of payments because they are
reported directly to the Commerce Department by the Customs Service. They are sub-
ject to short-term fluctuations and sometimes have to be substantially revised at a later
date, related in part to lags before imports arrive in port to be counted. This means
that the merchandise trade balance for any one month is not a very good indicator of
future trends.
There is no reason, conceptually, to focus on exports and imports of merchandise
while ignoring services. Thus a better measure than the merchandise trade balance is
the balance on goods and services. The Commerce Department began to report ser-
vice exports and imports on a monthly basis in 1994, in recognition of their growing
importance.
The balance on goods and services is a point of juncture between the international
payments statistics and national-income accounts. Gross domestic product, the chief
measure of a nation’s economic output in one year, consists of goods and services pro-
duced at home for consumption, investment, government use, and export. The national
accountants measure these flows of goods, however, not as they are produced but as
they are purchased. Some purchases (whether by households, firms, governments, or
foreign residents) consist of imports—goods that are produced abroad. Therefore, after
all purchases are added up, the statisticians must then subtract out imports to arrive at
the desired measure of domestic production. The import total is often shown as a sub-
traction from exports. Thus
GDP ; C 1 I 1 G 1 (X 2 M)
The term in parentheses is the balance of goods and services. In the national-income
accounts it is called “net exports of goods and services.”9

9
The U.S. trade balance numbers differ from “net exports” in the national income and product accounts in a
number of minor technical ways, such as the treatment of gold.
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15.4 ■ The Balances 285

Another place to draw the line is to include interest payments and other invest-
ment income. This total is referred to as the balance of goods, services, and income.10
Next comes the current-account balance, the measure of the balance of payments
that adds transfers in with goods, services, and investment income. We have already
explained that the current account is important because it represents the net acquisi-
tion of foreign assets, whether by private citizens of the home country or by the central
bank. Also discussed was the overall balance of payments (also called the official set-
tlements balance), which adds to the current account all private capital-account trans-
actions and is important because it represents the net acquisition of foreign reserve
assets by the central bank. Some economists have argued that the line should be drawn
between these two, that “exports” of claims to factories, along with other forms of for-
eign direct investment and sales of long-term assets, should count above the line—as
do exports of goods. Thus the basic balance adds these long-term capital inflows to the
current account. The accounting shows that this balance must be financed, or accom-
modated, either by short-term private capital flows or by official reserve transactions.
The basic balance is no longer reported for the United States. Indeed, it cannot even be
computed because the statistics collected no longer distinguish between long-term and
short-term portfolio investment. The balance is still reported for Japan and some other
countries.

Are There Really Accommodating Transactions?

Originally, the reason for drawing the line—whether at the merchandise trade balance;
goods and services; goods, services, and income; current account; basic balance; or over-
all balance of payments—was so that transactions below the line could be thought of as
financing or accommodating (being caused by) transactions above the line. This rea-
soning is now somewhat out of date.
A more modern view of causality in the balance-of-payments accounts evolved
out of the transition to floating exchange rates. The definition of (pure) floating is
ORT 5 0: The central bank does not buy or sell foreign exchange, so there are no offi-
cial reserve transactions to record. Obviously, in this case BP is not an interesting sta-
tistic because it is now always equal to zero.
Currently, most central banks at times do participate in foreign exchange markets
to try to influence the exchange rate. This is managed floating, rather than pure float-
ing.11 Yet there is no clear sense in which central bank sales or purchases of interna-
tional reserves necessarily accommodate (i.e., are caused by) private trade and capital
flows, rather than the other way around. For example, in the late 1960s, under fixed

10
The distinction among (1) the balance of goods and services; (2) the balance on goods, services, and income;
and (3) the current-account balance is roughly similar to the distinction between (1) gross domestic product,
which includes only income from domestic production; (2) gross national product, which also includes profits
from abroad (net factor income); and (3) total national income, which also includes income from transfers. The
U.S. government began to emphasize GDP over GNP in 1991.
11
The United States is one of the few countries that seldom intervenes in the foreign exchange market. Mexico,
Brazil, and Chile are three middle-income countries that joined the ranks of the floaters in the 1990s.
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286 Chapter 15 ■ The Balance of Payments Accounts

exchange rates, it made some sense to say that large U.S. balance-of-payments deficits
caused foreign central banks to buy up unwanted dollars. In the case of the deficits run
by the United States in recent years, however, it was as correct to say that the voluntary
decision by foreign central bankers to buy dollars allowed, or even “caused,” the U.S.
deficits.
This point is even more applicable when assets are sold to foreign private residents
rather than to foreign central banks. A surplus in the private capital account is what
allows, or even causes, a country to run a deficit on the current account, as much so as
the deficit in the current account giving rise to the surplus in the capital account. The
most prominent example is the large U.S. current-account deficit. To say that the
decision by private foreigners to increase their holdings of U.S. assets caused the U.S.
current-account deficits is as correct as saying that the decision by Americans to
import more goods and services caused the current-account deficits, which then had to
be financed by borrowing from abroad. The important point is that no clear presump-
tion exists as to the direction of causality. In reality, the various accounts are generally
determined simultaneously.
In fact, even the figures for the overall balance of payments are no longer explic-
itly reported for the United States, as can be seen from the actual balance of payments
statistics reproduced in Table 15.2. The net capital-account balance has to be com-
puted. In 1983 it turned sharply from deficit into surplus as foreigners began to acquire
U.S. assets in record amounts. We must add the capital-account number to the balance
on current account (a large deficit since 1983) to find the overall balance of payments.
At first, the private capital inflow was sufficient to finance the U.S. current-account
deficit. In 1986–2000, however, the private capital inflow has usually fallen short of the
current-account deficit. Foreign central banks make up the difference, as evidenced in
Table 15.2 under “foreign official assets.” The United States runs a deficit, not just on
its current account, but also on its overall balance of payments.
Making these calculations can be instructive even though we have abandoned the
presumption that the U.S. balance-of-payments deficit was necessarily causing central
banks to buy up unwanted dollars, rather than the other way around.

15.5 Statistical Errors in the Payments Accounts

When government statisticians assemble the record of a nation’s international transac-
tions, they do not observe directly the two sides of every transaction. Errors creep in
for two reasons: Some transactions are valued incorrectly, so the quantity recorded for
one side of the transaction fails to equal that for its compensating transaction, or one
side of a transaction is omitted entirely. Although the authorities measure each class of
transaction as accurately as possible, because of these and other errors the sums of
credit and debit items do not come out equal. Therefore, the accounts include an item
called “statistical discrepancy,” or “errors and omissions,” equal to this difference.
These measurement errors are no small problem. The errors in the U.S. statistics began
to run wild in the 1980s, indicating an unmeasured net inflow of money, as can be seen
in Table 15.2. This inflow was due in part to turmoil in some foreign countries that
 TABLE 15.2
U.S. Balance of Payments Statistics in Summary Form (Billions of Dollars)
Merchandisea

Foreign Statistical
Balance on Net foreign-owned U.S. Official Official Discrepancy
Balance on Goods and Unilateral Balance on Assets in U.S. Reserve Assets Reserve Assets (sum of the
Net Goods Net Goods and Investment Services and Transfers Current Excluding Official c Abroad d in the U.S. items with
Year Exports Imports Balance Services Services Income (Net) Income (Net)b Account (increase) (decrease) (increase) sign reversed)

1981 237.0 2265.1 228.0 11.9 216.2 32.9 16.7 211.7 5.0 227.7 24.1 5.0 21.8
1982 211.2 2247.6 236.5 12.3 224.2 35.2 11.0 216.5 25.5 229.9 25.0 3.6 36.6
1983 201.8 2268.9 267.1 9.3 257.8 36.4 221.4 217.3 238.7 17.7 21.2 5.8 16.2
1984 219.9 2332.4 2112.5 3.4 2109.1 35.1 274.0 220.3 294.3 77.4 23.1 3.1 16.7
1985 215.9 2338.1 2122.2 0.3 2121.9 25.7 296.2 222.0 2118.2 106.3 23.9 21.1 16.5
1986 223.3 2368.4 2145.1 6.5 2138.5 15.5 2123.0 224.1 2147.2 82.3 0.3 35.6 28.6
CAVE.6607.cp15.p271-290 6/6/06 5:01 PM Page 287

1987 250.2 2409.8 2159.6 7.9 2151.7 14.3 2137.4 223.3 2160.7 114.8 9.1 45.4 29.0
1988 320.2 2447.2 2127.0 12.4 2114.6 18.7 295.9 225.3 2121.2 104.1 23.9 39.8 219.3
1989 359.9 2477.7 2117.7 24.6 293.1 19.8 273.3 226.2 299.5 66.3 225.3 8.5 49.6
1990 387.4 2498.4 2111.0 30.2 280.9 28.6 252.3 226.7 279.0 28.6 22.2 33.9 25.2
1991 414.1 2491.0 276.9 45.8 231.1 24.1 27.0 9.9 2.9 23.3 5.8 17.4 244.8
1992 439.6 2536.5 296.9 57.7 239.2 24.2 215.0 235.1 250.1 51.9 3.9 40.5 245.6
1993 456.9 2589.4 2132.5 62.1 270.3 25.3 245.0 239.8 284.8 11.1 21.4 71.8 4.6
1994 502.9 2668.7 2165.8 67.3 298.5 17.1 281.3 240.3 2121.6 82.1 5.3 39.6 23.7
1995 575.2 2749.4 2174.2 77.8 296.4 20.9 275.5 238.2 2113.7 213.8 29.7 109.9 28.3
1996 612.1 2803.1 2191.0 86.9 2104.1 22.3 281.7 243.1 2124.9 4.3 6.7 126.7 212.2
1997 678.4 2876.5 2198.1 89.8 2108.3 12.6 295.7 245.2 2140.9 203.3 21.0 19.0 279.4
1998 670.4 2917.1 2246.7 81.7 2165.0 4.3 2160.7 253.3 2214.1 96.4 26.8 219.9 145.0
1999 684.0 21030.0 2346.0 82.6 2263.4 13.9 2249.5 250.6 2300.1 183.9 8.7 43.5 68.8
2000 772.0 21224.4 2452.4 74.1 2378.3 21.1 2357.2 258.8 2416.0 443.9 20.3 42.8 269.4
2001 718.7 21145.9 2427.2 64.5 2362.7 25.2 2337.5 251.9 2389.5 377.1 24.9 28.1 29.6
2002 682.4 21164.7 2482.3 61.1 2421.2 10.0 2411.2 264.0 2475.2 388.1 23.7 115.9 223.7
2003 713.4 21260.7 2547.3 52.5 2494.8 46.3 2448.5 271.2 2519.7 280.9 1.5 278.3 237.8
2004 807.5 21472.9 2665.4 47.8 2617.6 30.4 2587.1 280.9 2668.1 187.1 2.8 394.7 85.1
2005* 657.9 21224.2 2566.3 41.4 2524.8 20.5 2525.3 262.3 2587.6 416.4 9.3 146.3 20.6

*2005 figure is between Quarter I and IV.

a
Excludes military.
b
Includes transfers of goods and services under U.S. military grant programs.
c
The number reported here shows net private capital account. It is computed as nonofficial financial inflows (the increase in private foreign assets in the United States,
minus the increases in U.S. private assets abroad and U.S. government assets abroad, other than official) plus a new category of miscellaneous capital account transactions.
d
Consists of gold, Special Drawing Rights (SDRs), convertible currencies, and U.S. reserve position in the IMF.
Source: Department of Commerce (Bureau of Economic Analysis).

287
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288 Chapter 15 ■ The Balance of Payments Accounts

impelled funds to seek a safe haven in the United States. The acquisition of such claims
by foreigners, called “capital flight,” often is clandestine and goes unrecorded. Sub-
sequently this net flow reversed, suggesting that this flight capital was returning home.
The absolute magnitude of the discrepancy is still large.
Another major discrepancy appears when the net current-account positions of all
countries are added together. Because every export is some country’s import, these
accounts would sum to zero if all countries got their measurements right. The discrep-
ancy has run as large as $100 billion in recent years. It appears as though the world
were running a deficit with other planets.

15.6 Summary
The study of international monetary economics begins with the balance-of-payments
accounts. The current account adds up all credits and debits arising from trade in goods
and services and from transfers, the private capital account covers the purchase and
sale of assets, and the official reserve transactions account consists of changes in inter-
national reserve holdings by central banks.
We will now turn from rules of accounting to models of economic behavior.
Throughout most of the book, the subaccounts will usually be ignored and the focus
will be on the CA/KA/ORT level of aggregation. For example, the discussion will often
abstract from transfers to speak interchangeably of the trade balance (TB) and current
account (CA).

CHAPTER PROBLEMS

1. In this question you must play balance-of-payments accountant.

The Rules
• On the current account, exports are credits; imports are debits.
• On the capital account, capital inflows are credits (exports of stocks, bonds, etc.);
capital outflows are debits (imports of stocks, bonds, etc.).
• On the official reserve transactions account, reserve losses are credits (exports of
gold, foreign currencies, etc.); reserve gains are debits (imports of gold, foreign
currencies, etc.).
• Every autonomous debit (e.g., a merchandise import) must have an accommo-
dating credit (e.g., an inflow of short-term capital to pay for the import), and
vice versa.
For each of the following transactions indicate (a) on which account the debit occurs,
and (b) on which account the credit occurs. Your choices are merchandise, services,
income, transfers, direct investment, long-term capital, short-term capital, and official
reserve transactions. Also, in each case indicate (c) the effect on the current-account
balance (1, 0, or 2), and (d) the effect on the overall balance of payments (1, 0, or 2).
CAVE.6607.cp15.p271-290 6/6/06 5:01 PM Page 289

Chapter Problems 289

Answer only the implications of the transaction specified for the U.S. balance of pay-
ments. Do not assume that the recipients of payments from abroad necessarily
exchange foreign currency with the central bank as would be the case if capital flows
were assumed to be zero.
1. U.S. imports BMWs from Germany; pays by check in euros.
2. U.S. exports grain to Japan; paid by check in dollars.
3. U.S. imports coffee from Brazil; agrees to pay in dollars 3 months later.
4. U.S. tourists spend Swiss francs in Geneva.
5. Mexico buys locomotives from U.S. firm, which agrees to let the Mexicans pay in
dollars 18 months later.
6. French firms and banks, because they are accumulating more dollars than they
want or than U.S. banks will accept, turn them in to the Federal Reserve, which
agrees to give them euros.
7. A U.S. investor buys a 2-year Canadian treasury note; pays by check.
8. U.S. firm builds a factory in Mexico; pays for land, local labor, and so on,
in pesos.
9. U.S. government sends foreign aid to Pakistan, which Pakistanis hold in the form
of dollars.
10. China buys nuclear reactors from the U.S. government; pays in gold. (No central
bank is involved.)
11. Portuguese immigrant sends money back to family in Lisbon in the form of
a 10-year U.S. savings bond.
12. U.S. firm receives profits in the form of pesos from the factory it previously built
in Mexico.
13. Dutch holding company buys a controlling interest in an American firm;
pays in dollars.
14. U.S. ship is leased to carry beef from Australia to Britain. Payment for freight
charges is in dollars.
15. Federal Reserve sells gold to support the value of the dollar.
2. We hear of financial transfers to “launder” illegally acquired funds. For example, a
South American smuggler might deposit income from illegal exports in a Miami bank,
and arrange for the bank to re-lend it to the smuggler to invest in a legitimate activity.
a. How would this transaction appear in the U.S. balance-of-payments accounts if
it were recorded correctly? How would it appear in the accounts of the South
American country?
b. What error will it create in the accounts if the exporter’s earnings and claim on
the Miami bank are not recorded in the exporter’s home country but the transac-
tions are recorded in the United States? (This could be the case if the commodity
exported is legal, but the exporter leaves the dollar proceeds in the Miami bank
to evade taxes.) What will this do to the worldwide current-account discrepancy?
c. What error will be created in the two countries’ accounts if the exporter’s claim
on the bank is not recorded in either country, but the export is reported in both?
(To minimize the chances of getting caught, the exporter simply fails to inform the
Miami bank that he or she is not a U.S. citizen.) What would this error do to the
worldwide current-account discrepancy?
CAVE.6607.cp16.p291-306 6/6/06 12:00 PM Page 291

CHAPTER 16

The Foreign Exchange Market

and Trade Elasticities

T
he foreign exchange market is where domestic money (for example, dollars) is
traded for foreign money (for example, pounds sterling). The exchange rate is
usually defined as the price of the foreign currency in terms of the domestic cur-
rency, although it could as easily have been the reverse.1 This convention will be fol-
lowed here. Note that a depreciation, a decrease in the value of the domestic currency,
is an increase in the exchange rate because it is an increase in the price of foreign cur-
rency. Some find it counterintuitive that a decrease in the value of the currency is
called an increase in the exchange rate. Yet just as economists often talk about an
increase in the prices of commodities rather than the equivalent depreciation of
money’s purchasing power over commodities, so it is often intuitive to talk about an
increase in the price of foreign currency rather than the equivalent decrease in the
value of the domestic currency.
We are simplifying when we speak of the exchange rate for a country. In reality,
each country has many exchange rates, one for every other currency in the world. The
United States, for example, has the dollar/yen rate, the dollar/pound rate, and so on.
Although these exchange rates tend to be correlated, the measure of the movements in
the home country’s currency depends on which exchange rate is used.To get a good idea
of the value of the currency overall, it is necessary to use an exchange rate index, known
as the effective exchange rate, which computes a weighted average of the exchange rates
against each of the individual countries. Typically the weights used are the countries’
shares in trade.

16.1 The Flow of Supply and Demand for Foreign Exchange

In the foreign exchange market, as in other markets, supply and demand are central.
The proceeds from exports, and other credit items in the balance of payments, generate
the supply of foreign exchange or foreign currency. Import spending and other debit
items generate the demand for foreign exchange. In Figure 16.1 we measure the quan-
tities of foreign exchange supplied and demanded on the horizontal axis, and the price

1
In the United Kingdom, for example, the practice is to speak in terms of the dollar/pound rate, an exception
to the general rule because the pound is the domestic currency.

291
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292 Chapter 16 ■ The Foreign Exchange Market and Trade Elasticities

FIGURE 16.1
Increase in Demand for Foreign Currency
When the demand for foreign currency shifts out from D to D9, the result depends on the
exchange rate regime. Panel (a) illustrates a floating exchange rate: An increase in the price
of foreign currency is necessary to equilibrate the private market. Panel (b) illustrates a fixed
exchange rate: The central bank intervenes by supplying the excess amount demanded, out of
its foreign exchange reserves.

(a) Floating Exchange Rate (b) Fixed Exchange Rate

Price of Price of
foreign foreign
exchange exchange
(E in $/£) D′ S (E in $/£) D′ S

D D

BP deficit
0 Quantity of foreign exchange (£) 0 Quantity of foreign exchange (£)

of foreign exchange—the exchange rate E—on the vertical axis. We can think of the
supply and demand for foreign exchange as functions of the currency’s price—the
exchange rate—just as the supply and demand for any commodity are functions of its
price. Unless otherwise specified, supply and demand refer to private sources (i.e.,
transactions on the current account and private capital account, not official reserve
transactions by the central bank). In Figure 16.1 the supply curve and demand curve
are (for the moment) simply assumed to slope the conventional ways: upward and
downward, respectively.
The behavior of the exchange rate varies considerably depending on which regime
is in effect: floating exchange rates or fixed exchange rates. Under pure floating, the
exchange rate is whatever it must be to equilibrate supply and demand in the private
market. Consider an increase in the demand for foreign exchange, an outward shift of
the curve in Figure 16.1(a) from D to D9. Such an outward shift in the demand for for-
eign currency could result, for example, from an increase in demand for imports or
from an increase in investors’ demand for foreign assets. Under floating, the increased
demand for foreign currency causes an increase in its price, the exchange rate, just as
an increase in demand for a commodity causes an increase in the price of the commod-
ity. E goes up.
With a completely fixed or “pegged” exchange rate, conversely, the central bank
stands ready to buy or sell foreign currency whenever private supply and demand are
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16.1 ■ The Flow of Supply and Demand for Foreign Exchange 293

not equal at the fixed rate. The official exchange rate would only by coincidence be the
rate that precisely equates private supply and demand. Under this regime, an increase
in demand, illustrated in Figure 16.1(b), would result in an excess demand for for-
eign currency that must be met by sales of foreign currency by the central bank. From
our discussion of the balance-of-payments accounts, we know that the country runs a
balance-of-payments deficit. The central bank keeps the domestic currency from
depreciating by buying up the excess supply of the domestic currency. Obviously, the
central bank can continue this only as long as it has foreign exchange reserves. (The
other country’s central bank also could use its own currency to buy up the unwanted
domestic currency, if it were willing to do so.) There are policy changes, which will be
examined later, that the domestic government can make to reduce the deficit instead
of financing it, but such policies generally take time to have an effect. If the deficit con-
tinues, eventually the central bank will run out of foreign exchange reserves and will be
forced to withdraw support from the domestic currency. The central bank must then
either (1) set a new, higher exchange rate at which it will stand ready to sell foreign
exchange from then on, or (2) cease foreign exchange operations and allow the market
to determine the rate. The first option constitutes a devaluation of the currency, the
second the floating of the currency.2

Deriving Supply and Demand for Foreign

Exchange from Exports and Imports
What determines the supply and demand for foreign exchange? Three assumptions
together will provide a preliminary answer to this question. We are, in effect, going to
derive the shapes of the curves in Figure 16.1.
Assumption 1. Assume (until Part V of this book) that there are no net capital
flows (KA 5 0). Thus the private supply and demand for foreign exchange are deter-
mined entirely by the trade account. Most of the results in this part of the book would
be unaffected if it were assumed that capital flows were constant or exogenous, without
necessarily being zero. In the 1950s capital flows indeed consisted largely of govern-
ment loans (e.g., lending to Europe under the Marshall Plan after World War II) and
foreign direct investments that were not very responsive to short-term factors such as
the interest rate.
Furthermore, assume now that two goods are traded: an importable good and an
exportable good. Thus the first assumption is that the balance of payments is simply
sales of the export minus spending on the import.
Assumption 2. Assume (through the remainder of this chapter) that domestic res-
idents look only at prices expressed in domestic currency. Thus, in the case of domestic
consumers, the demand for imports depends only on the price of the import expressed
in domestic currency. In the case of domestic firms, the supply of exports depends only

2
The appendix to this chapter shows how stability in the foreign exchange market depends on the slopes of the
supply and demand curves in Figure 16.1(a). This analysis holds whether or not the curves are derived from
exports and imports, as in the next subsection. Chapter 21 will discuss the mechanics of how foreign exchange
is actually bought and sold, most of it by banks.
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294 Chapter 16 ■ The Foreign Exchange Market and Trade Elasticities

on the price of the export expressed in domestic currency. Similarly, assume that foreign
residents look only at prices expressed in foreign currency when choosing the demand
for the home country’s exports (in the case of foreign consumers) or the supply of
imports to the home country (in the case of foreign firms). Changes in demand arising
from changes in income are ignored. This assumption, representing the defining charac-
teristic of the “elasticity approach” to devaluation, will be relaxed in Chapter 17.
Assumption 3. Finally, assume for now that firms set a price for their product and
then meet any forthcoming demand. In other words, assume that supply is infinitely
elastic. This assumption can be regarded as a special case that is only a realistic descrip-
tion of the short run. In light of Assumption 2, the price at which domestic firms supply
exportables with infinite elasticity must be set in domestic currency—call it P—and the
price at which foreign firms supply the home country with importables must be set in
foreign currency—call it P*. Assumption 3 will be relaxed later as well.
By Assumption 3, output levels are determined by demand. The demand for
imports, MD, is a decreasing function of the import’s price expressed in domestic cur-
rency, which is the fixed price in foreign currency times the exchange rate.
M 5 MD(EP *)
If a Range Rover costs £20,000 and the exchange rate is $2.00 / £, then the price to
an American is ($2.00 / £)(£20,000) 5 $40,000. Americans will buy fewer Range Rovers
when the dollar price goes up, without distinguishing whether it is the exchange rate or
the pound price that has changed. Figure 16.2 graphs prices in terms of foreign cur-
rency to facilitate calculation of export revenue and import spending. Thus the import
demand curve is drawn for a given exchange rate, E. A change in E would shift the
entire MD curve. The demand for exports, XD, is a decreasing function of their price
expressed in foreign currency, which is the fixed price in domestic currency divided by
the exchange rate.
X 5 XD(P/ E)
If a Ford costs $20,000 and the exchange rate is $2.00 / £, then the price in Britain
is $20,000 / ($2.00 / £) 5 £10,000. British buyers will buy fewer Fords when the pound
price goes up, regardless of whether it is the dollar price that rose or the exchange rate
that fell.
A devaluation, an increase in E, lowers the price of exports to foreigners. This is
a movement down the curve, increasing the quantity of exports demanded, XD, in
Figure 16.2(b). The devaluation also raises the price of imports to domestic residents,
reducing their demand, MD. This is represented in Figure 16.2(a) as a proportionate
downward shift of the entire import demand curve because the curve was drawn con-
tingent on the exchange rate.3

3
If the vertical axes had been expressed in domestic currency instead of foreign currency, the devaluation
would have been an upward movement along the import demand curve and an upward shift of the export
demand curve, instead of the other way around. (The effect on the quantities would have been the same as in
Figure 16.2.) The general rule is that a devaluation is a movement along the curve that describes the behavior
of the people (domestic or foreign residents) whose currency is on the vertical axis; it shifts the curve that
describes the behavior of the people whose currency is not on the axis.
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16.1 ■ The Flow of Supply and Demand for Foreign Exchange 295

FIGURE 16.2
Effect of a Devaluation on Trade
Panel (a) shows how a devaluation lowers the quantity of imports. Panel (b) shows how the
devaluation raises the quantity of exports. The effects on import spending and export revenue,
respectively, are shown by the areas of the shaded rectangles.

(a) Imports (b) Exports

Price in Price in
foreign foreign
currency, currency,
P* P/E

MD (EP* ) XD (P/E )

MD (E ′P* )

P* P/E

P/E ′

0 M 0 X

Now consider the market for foreign exchange. Assumption 1 means that the
demand for foreign exchange is identical to import spending: In the absence of borrow-
ing, foreign exchange must be obtained on the market to pay for imports. Import
spending is quantity times the foreign currency price. The supply of foreign exchange is
identical to export revenue: All foreign exchange earned through exports is cashed in
on the foreign exchange market. Export revenue is export quantity times foreign cur-
rency price. So the demand for foreign currency prior to the devaluation is P*M, the
shaded rectangular area in Figure 16.2(a), and the supply is (P / E)X, the shaded area in
Figure 16.2(b). The net supply of foreign exchange is
(P/E )X 2 P *M
which is also the trade balance measured in foreign currency, TB*.
The appendix to this chapter considers the question of stability in the foreign
exchange market: Does an increase in the exchange rate increase the net supply of for-
eign exchange? This question is identical to this one: Does a devaluation improve the
trade balance? The two questions are the same because no capital flows have been
assumed. Domestic consumers cannot borrow abroad to get the foreign exchange
they need for imports, so the trade balance is the same as the net supply of foreign
exchange. We will now derive the condition under which the answer to the two ques-
tions is yes.
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296 Chapter 16 ■ The Foreign Exchange Market and Trade Elasticities

The Marshall-Lerner Condition

The effect of a devaluation on the trade balance can be decomposed into three factors.
(1) A devaluation reduces the real quantity of imports (the number of Range Rovers
imported, in the example) and, because their nominal price is fixed in foreign currency,
clearly reduces the amount of foreign exchange spent on imports. The rectangular area
in Figure 16.2(a) shrinks. This factor helps improve the trade balance. (2) The devalua-
tion also increases the real quantity of exports. This factor also helps the trade balance.
(3) Any given quantity of exports earns less foreign exchange than before because
their nominal price is set in domestic currency. This factor hurts the trade balance.
The net effect on foreign currency export revenue is unclear. The size of the rec-
tangular area in Figure 16.2(b) may either increase or decrease, depending on the elas-
ticity of export demand. If the demand response (factor 2) is small enough, export
revenue may actually fall. This will be the case if the elasticity of export demand is less
than 1. Export revenue could fall, and yet be outweighed by a reduction in imports, so
that the total trade balance would still improve. However, if the demand response on
the import side (factor 1) is also small enough, the trade balance will actually worsen:
The net supply of foreign exchange will fall. (The various cases are explored further in
the appendix.)
At this point a fourth assumption is added to those required by the elasticities
approach.
Assumption 4. Assume that the economy is initially in a position of balanced
trade (TB 5 0). Given this, the necessary and sufficient condition for the devaluation to
improve the trade balance, or for the foreign exchange market to be stable, is the
Marshall-Lerner condition. The supplement to Chapter 3 includes a derivation of the
Marshall-Lerner condition. Here, with price levels fixed in each country, the exchange
rate plays the role of the price of foreign goods in terms of domestic. The condition is
eX 1 eM . 1
where eX and eM are the elasticities of demand for exports and imports, respectively. For
example, if exports have an elasticity of exactly one, a devaluation leaves export rev-
enue unchanged in foreign currency (the second and third factors just described cancel
out); then, if import demand has any elasticity, the devaluation reduces imports, thereby
improving the trade balance. Alternatively, if imports are more-than-unit elastic and
exports have any elasticity, or if both elasticities are greater than half, then the third fac-
tor will be outweighed by the first two and the trade balance again will improve.4
We have discussed the supply and demand for foreign exchange, but we could as
easily have discussed the demand and supply of domestic exchange. Assuming again
that the starting point is a position of balanced trade, the Marshall-Lerner condition
applies unchanged to the question of the trade balance expressed in domestic currency.5

4
The proof of the Marshall-Lerner condition in the present context (i.e., where the exchange rate takes the
role of the relative price) is given in the supplement to this chapter.
5
The proof of the Marshall-Lerner condition in terms of domestic currency is left to the student in Problem 5a
at the end of the chapter.
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16.2 ■ Empirical Effects of Devaluation on the Trade Balance 297

The model can be generalized in two directions. First, Assumption 4 can be

relaxed. In particular, note that in practice a country seldom devalues unless it starts
from a position of deficit, rather than balanced trade: TB , 0, or EP*M . PX. Now, it
makes a difference whether the trade balance is measured in terms of domestic cur-
rency or foreign currency. If trade is measured in terms of domestic currency, the nec-
essary condition for a devaluation to improve the trade balance is more stringent: The
elasticities must be higher than those given by the Marshall-Lerner condition.6 The
economic reason is that, given the relatively large initial value for imports, M, the valu-
ation effect on import spending is more negative. For example, the import elasticity
could be almost as high as one, and yet if the export elasticity—even though positive—
is not high enough, the trade balance could worsen. A 10 percent devaluation may raise
exports, yet this accomplishes little if exports initially were a small number; meanwhile,
the already large import bill falls.
Another generalization involves relaxing Assumption 3—that firms exhibit infi-
nitely elastic supply. The supplement to this chapter (second half) considers this gen-
eral case.
According to general equilibrium theory, consumer demand should be a function
not of nominal prices but of relative prices and real income. The elasticities approach
is frequently criticized for the partial equilibrium nature of Assumption 1. (Partial
equilibrium means that some important variables are held constant.) For example, an
increase in demand for a country’s exports should raise its real income and thus raise
its demand for imports, but in the elasticities model there are no such effects. Chap-
ter 17 begins to remedy this deficiency by introducing income as a variable in the
import demand function.

16.2 Empirical Effects of Devaluation on the Trade Balance

Clearly, much depends on the magnitude of the import and export elasticities. Are they
large enough in practice for a devaluation to improve the trade balance? It is now time
to turn to the empirical evidence.

Elasticity Pessimism
A view known as elasticity pessimism suggests that actual trade elasticities are too low
to satisfy the Marshall-Lerner condition. Several factors have contributed to this view
historically. First, floating exchange rates in the 1930s were unstable, in that they were
highly variable. The appendix to this chapter shows that the Marshall-Lerner condition
is also the necessary condition for a stable foreign exchange market under floating
rates. Thus highly variable exchange rates seemed to imply low trade elasticities.
Second, many countries on fixed exchange rates have found their trade balance wors-
ening after a devaluation, rather than improving.

6
You are asked to show this in Problem 5b at the end of the chapter.
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298 Chapter 16 ■ The Foreign Exchange Market and Trade Elasticities

This is especially true of oil importers. Because the demand for oil is relatively
inelastic in the short run, many small countries discover that a devaluation against the
dollar raises their oil import bill proportionately when expressed in domestic currency,
thus worsening their trade balance. When a deficit country is advised to devalue its cur-
rency, it often argues that its elasticities are too low for a devaluation to help.
A third factor that originally contributed to the rise of elasticity pessimism was
that early econometric estimates of the demand elasticities were low, frequently less
than half. However, there were a number of problems with these estimates. They
ignored the possible simultaneous existence of an upward-sloping supply relationship,
problems of aggregation, errors in the measurement of the variables, and the crucial
role of time lags.7 Some studies measure only relatively short-run elasticities, but abun-
dant evidence indicates that the factor of time is important. Elasticities are higher in
the long run, which makes the Marshall-Lerner condition more likely to hold.

The J-Curve
Some studies that allow for lags of import demand in response to changes in relative
prices have found that only about 50 percent of the full quantity adjustment takes
place in the first three years; 90 percent occurs in the first five years. For example, the
dollar depreciated substantially between 1985 and 1987, but because of these lags, the
favorable effect on the quantities of exports and imports did not begin to show up until
the end of 1986, and the effect on the dollar trade balance did not begin to show up
until the end of 1987.
In this case, contrary to what we have assumed, dollar prices of imports did not
respond immediately or fully to the exchange rate. Many importers, rather than passing
exchange rate changes immediately through to import prices, at first absorbed in their
profit margins much of the difference between foreign currency prices and domestic
currency prices. The delayed pass-through to import prices added an extra lag at the
beginning, before the elasticities could even begin to come into play. The United States
is unusual in how small a portion of an exchange rate change tends to be immediately
passed through to import prices.
There are a number of reasons why demand elasticities rise over time, and why the
quantities demanded are slow to respond even after the change in the exchange rate is
passed through to import prices. First, there is a lag because of the imperfect dissemina-
tion of information, during which importers recognize that relative prices have changed.
Second, there is a lag in deciding to place a new import order. In the case of firms’
imports of inputs, it may take months or years before inventories are depleted or
machinery is worn out and replacements are needed. Also, a firm may be tied to a par-
ticular supplier, through implicit or explicit contracts. In the case of consumers’ imports,

7
Faulty measurement of prices is particularly common in foreign trade. For example, importers in some coun-
tries underinvoice, that is, they understate the price of their imports so as to minimize the import duty they
must pay. Also, where laws require exporters to turn over all their foreign exchange earnings to the govern-
ment, exporters might understate their prices to retain some of the scarce foreign exchange for themselves.
Such measurement errors in the price data make it more difficult to discern a statistical relationship.
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16.2 ■ Empirical Effects of Devaluation on the Trade Balance 299

changing habits takes time. For example, when the price of energy jumps, continued
strong demand causes many observers to assert that energy demand is essentially
inelastic. With the passage of time, however, energy demand falls considerably. The
adjustment process requires not only overcoming the momentum of old patterns of
consumption but also changing where people live and what kind of cars they drive.
Third, after a new import order has been placed, there may be production and
delivery lags before it is filled. Much internationally traded merchandise is still trans-
ported by ship, requiring weeks or months in transit. Payment is typically not made
before delivery, even though the contract may have been signed months earlier.
The fourth reason why trade quantities respond more fully with the passage of
time, and the reason that can potentially draw out the process the longest, is that pro-
ducers sometimes relocate their factories to the country where costs are lower because
of an exchange rate advantage, regardless of whether it is the home country of the pro-
ducer or the country where the goods are sold. For example, when the yen appreciated
strongly from 1985 to 1995, some Japanese firms that had previously been exporting
with great success found that they were losing out to competition from countries with
lower cost. To compete more effectively, they moved some operations to other coun-
tries with lower-valued currencies. Sales in the world market that were previously
counted under Japan’s exports came to be counted under the host countries’ exports.
Thus the response of export and import quantities after an exchange rate change is
greater in the long run than in the short run because companies are able to relocate
their plant and equipment. The transition costs are large. For this reason, a company is
unlikely to relocate until the change in the exchange rate has lasted long enough to
convince the company that the fluctuation is not transitory. Such an endurance test
may take as long as five or ten years. Indeed, even after the exchange rate has returned
to old levels, a company that decided to move operations abroad when the dollar was
high might never move back, after having incurred the costs of moving. The word
hysteresis is used to describe such not-easily-reversed reactions.
The tendency of the elasticities to rise over time results in the commonly observed
phenomenon of the J-curve. The trade balance following a devaluation is observed first
to worsen and then to improve, in the J-like pattern of Figure 16.3. (The figure assumes
an initial trade balance of zero.) At the moment of the devaluation, quantities have had
no time to adjust and the Marshall-Lerner condition fails. In fact, if quantities do not
respond at all initially, then only the negative valuation effect remains: The trade bal-
ance worsens by the initial level of exports times the percentage decrease in their for-
eign currency value caused by the devaluation.8 However, as time passes, export
demand begins to pick up and import demand begins to fall. A point is reached where
the curve crosses the zero axis, which means that the elasticities are high enough to
sum to one and the trade balance is back at zero. After that point, the Marshall-Lerner
condition holds and the trade balance moves into surplus. The surplus must run for a

8
If it takes time before the exchange rate change is passed through to domestic prices of imports, the initial
worsening in the trade balance is spread over a longer period. The downward sweep of the J would then be
more round than as shown in the figure.
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300 Chapter 16 ■ The Foreign Exchange Market and Trade Elasticities

FIGURE 16.3 TB
The J-Curve
In the aftermath of a devaluation,
the trade balance (1) worsens initially
because of the perverse valuation
effect, then (2) gradually improves over (3)
time as the elasticities rise, and finally +
(3) surpasses its starting point when the 0 Time
Marshall-Lerner condition is satisfied. –

(1) (2)

while if the reserves accumulated are to outweigh the reserves lost during the initial
period of deficit.
All this assumes that exporters in the home country continue to supply whatever
quantity is demanded at the same fixed price. This may get increasingly harder, espe-
cially if they are operating close to full capacity. The exporters in the devaluing country
will be tempted to raise their prices in response to the increasing demand.Alternatively,
their workers may demand higher wages in response to the greater cost of imported
consumer goods, and the firms will be “forced” to pass through the higher labor costs in
the form of higher prices. However, we will stay with the fixed-price assumption until
Chapter 19.

16.3 Summary
The exchange rate is defined as the price of foreign exchange in terms of domestic cur-
rency. Under a floating exchange rate system, the central bank does not intervene in the
foreign exchange market, and the exchange rate is determined by supply and demand
in the market: An increase in the demand for foreign exchange causes an increase in the
price of foreign exchange (a depreciation of the domestic currency). Under a fixed
exchange rate system, an increase in demand for foreign exchange means that the cen-
tral bank has to supply the difference—the net demand for foreign exchange, which is
the balance-of-payments deficit—out of its foreign exchange reserves.
This chapter adopted the first and simplest model of what determines the balance
of payments. Part IV does not include capital flows; this chapter looked only at the
effect of the exchange rate on the trade balance, holding constant the level of income,
interest rate, price level, and other macroeconomic variables that we introduce in sub-
sequent chapters. A devaluation of the currency (or, under floating exchange rates, a
depreciation) increases the quantity of exports demanded by foreign residents and
decreases the quantity of imports, working to improve the trade balance. A third effect
that works to worsen the trade balance, however, is the higher cost in domestic currency
CAVE.6607.cp16.p291-306 6/6/06 12:00 PM Page 301

Chapter Problems 301

of any given quantity of imports that have prices set in foreign currency. Only if the sum
of the import and export elasticities is high enough, as in the Marshall-Lerner condition,
will the quantity effects dominate and the trade balance improve after the devaluation.
Empirically, the elasticities do appear to be high enough for a devaluation to
improve the trade balance, but only after enough time has passed. In the short run, the
trade balance often worsens, which gives rise to the J-curve pattern of response.

CHAPTER PROBLEMS

1. The newspaper reports that the dollar/euro exchange rate has risen.
a. Does this news mean that the value of the dollar has risen or fallen? The value of
the euro?
b. Does this mean that the dollar/yen rate is more likely to have gone up than down?
c. Does this mean that the euro/yen rate is more likely to have gone up than down?
(Hint: If neither the dollar/yen rate nor the euro/yen rate has changed, what does
that imply for the dollar/euro rate?)
2. Assume that the United States is currently exporting 10 million calculators at a price of
$10 apiece and importing .002 million BMWs at a price of 100,000 euros apiece, and
that the current exchange rate is 50 cents per euro. Calculate in a table the effect of a
10 percent devaluation of the dollar on each of 12 variables under each of four sets of
assumptions about the elasticities (assuming infinitely elastic supply and no income
effects). Round off.

BEFORE THE AFTER THE 10%

DEVALUATION DEVALUATION
5
(a) (b) (c) (d) (e)
Export
1
Elasticity: 0 ⁄2 1 4

Import
1
Elasticity: 0 0 ⁄2 1
(1) Export quantity 10m
(2) Import quantity .002m
(3) Export price $10

5
Expressed (4) Import price
in (5) Export earnings
$ (6) Import spending
(7) Trade balance
(8) Export price

5
Expressed (9) Import price 100,000 euros
in (10) Export earnings
euros (11) Import spending
(12) Trade balance
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302 Chapter 16 ■ The Foreign Exchange Market and Trade Elasticities

3. a. In the example from Problem 2, comment on the trade balances in (b) and (c) ver-
sus those in (d) and (e).
b. In which case is spending on imports in dollars very close to what it was before the
devaluation? Why?
c. In which case are earnings from exports in euros very close to what they were
before the devaluation? Why?
d. Starting from a position of importing .003 million BMWs, with everything else
remaining the same, what would be the initial trade balance in dollars? For given
elasticities, for example, (d), would the devaluation cause the trade balance to
improve (i.e., the trade deficit decrease) by more than, less than, or the same
amount as in Problem 2? (A numerical answer is not necessary but is fine if you
can’t do it intuitively.)
4. The trade balance expressed in domestic currency, with prices normalized to 1, is
TB 5 X(E) 2 EM(E).
a. Illustrate the effect of a devaluation graphically; that is, repeat Figure 16.2,
but with domestic-currency prices on the vertical axis.
b. If the import elasticity is greater than 1 and the export elasticity is greater than 0,
then the Marshall-Lerner condition holds. Is this condition sufficient to imply
that TB, the trade balance expressed in domestic currency, improves? (You may
assume the starting point is TB 5 0.) Explain why, in terms of export revenue and
import spending.

Extra Credit
5. a. If you know calculus, prove that the Marshall-Lerner condition is still the correct
condition necessary and sufficient for a devaluation to improve TB, the trade bal-
ance expressed in domestic currency, starting from TB 5 0.
b. Starting from TB , 0, is the Marshall-Lerner condition too strong or too weak for
a devaluation to improve the trade balance?
c. The trade balance expressed in domestic currency is equal to the exchange rate
times the trade balance expressed in foreign currency: TB 5 E TB*.
i. Does it follow that if the trade balance is in surplus when expressed in foreign
currency, then it is also in surplus when expressed in domestic currency?
ii. Does it follow that dTB / dE 5 E dTB* / dE? Why not?
iii. If initially TB , 0, which is greater: the left-hand side in the preceding ques-
tion or the right-hand side?
iv. Which side is greater if initially TB . 0?
v. Which is greater if initially TB 5 0?
d. Assume we start from a position of deficit, and the elasticities sum approximately
to one.
i. Notice from the supplement to Chapter 16 that if E M . X initially, the
Marshall-Lerner condition is more than sufficient to imply dTB* / dE . 0.
For example, if both elasticities are half, that is enough for a devaluation to
improve the trade balance in foreign currency. Conversely, from 5(b) we know
that dTB / dE , 0 under these conditions. Can the trade balance improve in
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Appendix 303

terms of foreign currency while worsening in terms of domestic currency?

(Refer to your answers to Questions c (ii) and c (iii).)
ii. If a devaluation brings the trade deficit back to zero in terms of foreign cur-
rency, then it must also do so in terms of domestic currency, because E times
zero is zero. There is an apparent contradiction between this fact and the
answer to (i). What is it? How do you reconcile the apparent contradiction?
6. It is possible (if old-fashioned) to stay within the partial equilibrium elasticities
approach and yet relax the assumption that supply is infinitely elastic. The Bickerdicke-
Robinson-Metzler condition for a devaluation to improve the trade balance is

eMeX (1 1 sM 1 sX) 2 sMsX (1 2 eM 2 eX)

.0
(sM 1 eM)(sM 1 eX)

where sM and sX are the supply elasticities of imports and exports, respectively.
a. Prove that in the limit, as sM and sX go to infinity, the formula reduces to the
Marshall-Lerner condition.
b. Does the presence of the supply elasticity terms make the condition more or less
stringent than the Marshall-Lerner condition?

SUGGESTIONS FOR FURTHER READING

Bergsten, C. Fred, ed. International Adjustment and Financing, The Lessons of

1985–1991 (Washington, DC: Institute for International Economics, 1991). Did the
1985–1897 dollar depreciation reduce international trade imbalances as promised?
At least one contributor, Paul Krugman, answers yes.
Mussa, Michael. “Exchange Rate Adjustments Needed to Reduce Global Payments
Imbalances.” In C. Fred Bergsten and John Williamston, eds., Dollar Adjustment:
How Far? Against What? (Washington, DC: Institute for International Economics,
2004), pp. 113–138. The same issue, with respect to the sharp rise in U.S. deficits
after 2001.

APPENDIX

Stability of the Foreign Exchange Market

The focus now turns from the comparative statics of the foreign exchange market, con-
sidered in Section 16.1, to the question of stability under a floating exchange rate. The
theoretical question of whether a market equilibrium is stable (as in Chapter 3) is not
the same as the question of whether the market price moves around a lot. The theoret-
ical question is the following: If an equilibrium price is displaced slightly, will it tend to
return to its original value?
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304 Chapter 16 ■ The Foreign Exchange Market and Trade Elasticities

(a) E (b) E
S
S

ED ED
D D′ D D′
0 0
Quantity of foreign exchange Quantity of foreign exchange

(c) E

D D′

FIGURE 16.A.1 S

Stability in the Foreign Exchange Market

The market is stable if the increase in the price of
foreign exchange that results from an increase in
demand for foreign exchange works to eliminate the ED
excess demand. In cases (a) and (b) the market is stable, 0
but in (c) it is not. Quantity of foreign exchange

Think of foreign exchange traders as individuals who buy from and sell foreign
exchange to each other on the floor of centralized exchanges in New York and else-
where, or, in the case of the trading divisions of banks, on a network of telephones and
computer terminals. Assume that whenever foreign exchange traders find that demand
exceeds supply, they raise the exchange rate; whenever supply exceeds demand, they
lower it. Consider the following three cases.
1. Assume that the demand curve slopes down and the supply curve slopes up, as in
Figure 16.A.1(a). If the curves are derived from import spending and export earn-
ings, respectively, this first case is the one where the elasticity of demand for
exports is greater than one. In response to an increase in demand, from D to D9,
the traders raise the exchange rate. This raises export revenue, reduces the excess
demand for foreign exchange, and thus constitutes a move toward the new equilib-
rium. The market is stable.
2. Next, assume that the demand curve slopes down and the supply curve slopes down
also, but more steeply, as in Figure 16.A.1(b). Again, in response to an increase in
demand, the traders raise the exchange rate, causing a move toward equilibrium.
CAVE.6607.cp16.p291-306 6/6/06 12:00 PM Page 305

Appendix 305

Again the market is stable. This is the case where the elasticity of demand for
exports is less than one (so the increase in the exchange rate lowers export rev-
enue) but the sum of the two elasticities is nevertheless high enough to satisfy the
Marshall-Lerner condition.
3. Finally, assume that both curves slope down, but the supply curve is less steep, as in
Figure 16.A.1(c). This is the case where the Marshall-Lerner condition fails. This
time, when the traders respond to the increase in demand by raising the exchange
rate, they cause a move away from the new equilibrium. At the higher exchange
rate, excess demand is even greater, so the traders raise the exchange rate again,
and the situation is farther still from equilibrium. The market is unstable.
These examples show that the required condition for stability is that the supply
curve slopes up or, if sloping downward, is steeper than the demand curve.
As a practical matter, a floating exchange rate usually will not shoot off to infinity.
One possibility is that there are two stable equilibria surrounding an unstable one,
much as is shown in Figure 3.A.1. Even if the market is stable in the technical sense,
however, it may be unstable in the sense that the market-clearing price is highly vari-
able. Very small changes in demand may produce large jumps in the exchange rate.
High variability in the exchange rate may create uncertainty and imply high costs for
importers and exporters. These are cited as an argument against floating exchange
rates. This chapter showed that if the demands for exports and imports are relatively
inelastic, then the curves representing the supply and demand for foreign exchange will
be relatively steep. Resulting exchange rates may be highly variable if the exchange
rate is called on to clear the trade balance.
CAVE.6607.supp.pS1-S58 6/7/06 10:39 AM Page S-43

Supplement to Chapter 16 S-43

SUPPLEMENT TO CHAPTER 16: Import and Export Elasticities

Under what conditions does a devaluation improve the trade balance? The answer
when producers are assumed to supply exports and imports with infinite elasticity is the
Marshall-Lerner condition. First we prove this. Then we relax the assumption of infinite
elasticities.

Proof of the Marshall-Lerner Condition

For notational simplicity, we adopt the normalization P 5 1 and P* 5 1 in the proof of
this proposition. Then the trade balance expressed in foreign currency is
TB* 5 (1 / E)XD(E) 2 MD(E)
Differentiate with respect to E.
dTB* / dE 5 2(1 / E2)X 1 (1 / E)(dXD / dE) 2 dMD / dE
Multiply by E2 / X. The derivative is positive if
21 1 (E / X)(dXD / dE) 2 (E2 / X)(dMD / dE) . 0
Using the definitions of the elasticities,

eX ; (dXD / dE)E / X eM 5 2(dMD / dE)E / M,

the condition becomes
21 1 eX 1 (EM / X)eM . 0
Starting from a position of balanced trade, EM 5 X, the equation reduces to the
Marshall-Lerner condition asserted in Chapter 16.

When Supply Elasticities Are Finite

Consider the case where supply of X and M is not infinitely elastic. Figure 16.S.1 illus-
trates this general case. True, a devaluation still shifts the import demand curve and the
export supply curve (which was a horizontal line in Figure 16.2) down. In addition, it
remains true that import spending falls and that the effect on export revenue is
ambiguous because any given quantity of exports translates into a smaller value when
expressed in foreign currency. Thus the basic conclusions are similar, but the relevant
condition necessary for the trade balance to improve includes supply as well as demand
elasticities. (See Problem 6 at the end of Chapter 16.)
CAVE.6607.supp.pS1-S58 6/7/06 10:39 AM Page S-44

S-44 Supplements for Selected Chapters

FIGURE 16.S.1
Effect of a Devaluation with Less Than Infinitely Elastic Supply
The devaluation can lower prices when expressed in foreign currency. Panel (a) shows the effect
on imports, and (b) shows the effects on exports.

(a) Imports (b) Exports

Price in Price in
foreign foreign
currency, currency,
P* P/E

XS (P )
MS (P* )

XS (P )

MD (EP* )

MD (E
P* ) XD (P/E )

0 M 0 X
CAVE.6607.cp17.p307-326 6/6/06 12:04 PM Page 307

CHAPTER 17

National Income
and the Trade Balance

T
his chapter examines the interaction of income and the trade balance. We use the
simple Keynesian multiplier model familiar from introductory macroeconomic
textbooks but open up the model to international trade. This will turn out to
make quite a difference.
Here Keynesian means simply that prices are assumed to be fixed (in terms of the
currency of the producing country, as in Chapter 16) and therefore that changes in
demand are reflected in output instead of price.This assumption is realistic for the short
run, especially in an economy with unemployed labor and excess capacity. Empirical
observation shows that prices are not perfectly flexible (to come in Chapter 19). In
addition to the short-run realism, a second reason for continuing to hold prices fixed
here concerns the structure of the remainder of the book. It helps to encounter new
variables one at a time. Chapter 16 focused on the effect of changes in the exchange
rate. This chapter adds the effect of changes in income. Only in Chapter 19 will we be
ready for changes in the price level, followed by international capital flows and other
factors. The introduction of all these variables at once would be quite confusing, so
they will be introduced one by one.

17.1 The Small-Country Keynesian Model

In contrast to our assumption in Chapter 16, this section recognizes that import demand
depends on more than just relative prices. (We continue to assume that suppliers fix
prices in terms of their own currencies, so that the relative price of imports is simply the
exchange rate, E.) Here we see that import demand also depends on income, Y.
M 5 Md(E,Y) (17.1)
The marginal propensity to import out of income1 is represented by m.
M 5 M 1 mY (17.2)

1
From this point on, imports are defined in domestic, not foreign, units. In other words, if the economy is the
United States, M (like Y and the other variables) is expressed in dollars. Because the price level is assumed to
be fixed, this is the same as expressing everything in units of U.S. output: number of automobiles, bushels of
wheat, and so on.

307
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308 Chapter 17 ■ National Income and the Trade Balance

This linear import function is analogous to the standard Keynesian consumption

function

C 5 C 1 cY (17.3)

where c is the marginal propensity to consume. The essence of the Keynesian consump-
tion function is that households’ consumption increases, but less than proportionately,
in response to an increase in households’ disposable income.
Equation 17.2 does not show the exchange rate explicitly because the first step will
be to consider the case of a fixed exchange rate. Although many countries have highly
variable exchange rates, there are several reasons for beginning with the case of a fixed
exchange rate. First, it will provide a greater understanding of the 1950s and 1960s,
when almost all countries had fixed exchange rates. Second, it will aid in understanding
the many countries that, today, still have fixed exchange rates. Twelve European coun-
tries, for example, have adopted the ultimate mechanism for fixing their exchange rates
(vis-à-vis each other) by joining the European Economic and Monetary Union (EMU)
and adopting the euro as their currency, created in 1999. Third, it will make it easier to
evaluate the frequently heard proposals to restore stability in exchange rates—from
ambitious schemes for a complete return to firmly fixed rates to more moderate pro-
posals for target zones.2 Finally, with the exchange rate held fixed, it is easier to under-
stand how the economy operates—before proceeding to what happens when the
exchange rate can change.
The demand for exports (foreigners’ imports) should be a function (analogous to
Equation 17.1) of relative prices and foreigners’ income, Y*.

X 5 Xd(E, Y*) (17.4)

Most countries are small enough that, although developments in the rest of the world
have important implications for the domestic economy, any impact of the domestic
economy on the rest of the world can be safely ignored. Thus this section begins with
the Keynesian small-country assumption that foreign income is exogenous. (This is in
contrast to the very different classical small-country assumption, which is that relative
prices are exogenous. That assumption is ruled out when export prices are set in
domestic currency.) Now we have the simplified export demand function,

X 5 Xd(E)

or, staying with a fixed exchange rate for the moment,

X 5 X. (17.5)

In other words, exports are given exogenously. Thus, from Equations 17.2 and 17.5, the
trade balance is given by

TB 5 X 2 M 5 X 2 (M 1 mY) (17.6)

2
Discussed in Section 27.6.
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17.2 ■ The National Saving-Investment Identity 309

The Determination of Income

The definition of equilibrium in the Keynesian model is that output supplied, Y, is
equal to output demanded. In the closed economy, demand comes from three sources:
consumption by households (C), investment by firms (I),3 and spending on various
goods and services by the government (G). In the simple Keynesian version with which
this chapter begins, investment, like government expenditure, is taken to be exogenous
(which is shown by a bar over the letter), even though consumption is endogenous. The
open economy factors a fourth source of net demand for domestic goods—that coming
from foreign residents—into the total demand for domestic goods. Net foreign demand
for domestic goods is the trade balance, or net exports (TB 5 X 2 M). So the equilib-
rium condition is as follows:
Y5C1I1G1X2M
5 C 1 cY 1 I 1 G 1 X 2 (M 1 mY)
Solving for the equilibrium level of income,
A1X2M
Y5 (17.7)
s1m

where, for notational simplicity, we have defined the exogenous component of aggre-
gate demand as A ; C 1 I 1 G, and the marginal propensity to save as s ; 1 2 c.
(The part of each additional dollar of income that is not consumed must be saved.)
If government spending goes up by $1 billion (5 DG 5 DA ), by how much does
income go up? DY 5 $(1 / (s 1 m)) billion.The parameters s and m are fractions totaling
less than 1 because imports are a subset of total consumption. It follows that the multi-
plier is greater than 1: An autonomous increase in spending of a given amount raises
income by a greater amount. The explanation is that those who produce the goods and
services to which the spending goes see an increase in their income and so raise their
spending; this, in turn, raises the incomes of other producers, who raise their spending,
and so forth. The infinite series has a finite sum for the same reason as in a closed econ-
omy: At each round of spending, some “leaks out” of the system through saving, so each
round is smaller than the previous round. Notice that in the special case of a closed
economy, where m 5 0, the multiplier reduces to the familiar 1 / s, or 1 / (1 2 c). In gen-
eral, however, the open-economy multiplier is less than 1 / s because of a second leakage
from the spending stream: through imports.

17.2 The National Saving-Investment Identity

To look at the Keynesian model graphically, it will be easier to work in terms of saving,
which is equal to disposable income minus consumption, than in terms of consumption
itself. To do so, first recognize that, in addition to decomposing GDP into the sectors to

3
Investment includes not only additions to plant, equipment, and inventories by firms but also residential
construction.
CAVE.6607.cp17.p307-326 6/6/06 12:04 PM Page 310

310 Chapter 17 ■ National Income and the Trade Balance

which the output is sold (C 1 I 1 G 1 X 2 M), an alternative is to decompose income

from the viewpoint of those who earn it and dispose of it: consumption (C), saving (S),
and taxes (T ).4
C 1 S 1 T ; GNP ; GDP 1 NFI
5 C 1 I 1 G 1 X 2 M 1 NFI
NFI is net factor income, which includes investment income from abroad. Subtract C
from both sides and rearrange.
S 1 (T 2 G) 2 I 5 X 2 M 1 NFI
Think of the government budget surplus (T 2 G) as government saving or, inasmuch
as the number is often negative, think of the government budget deficit (G 2 T) as
government “dissaving.” Define total national saving as NS 5 S 1 (T 2 G). Then the
equation is
NS 2 I ; CA (17.8)
Equation 17.8 is called the National Savings Identity. It is described as follows:
National saving exceeds investment by an amount equal to the current account bal-
ance, which is the rate of accumulation of claims on the rest of the world. Intuitively, all
national saving, NS (whatever is left over after financing the government), goes into
building up either the stock of capital or the stock of foreign claims. For example,
beginning in the 1980s, a very low rate of U.S. national saving, consisting especially of
high federal budget deficits, translated into high deficits in the current account balance,
as Table 17.1 shows. In the late 1990s U.S. national saving increased because the federal
budget deficit was eliminated, and indeed was turned into a surplus. But private saving
remained low and investment rose faster than national saving. The result, by definition,
was a rising current account deficit. Since 2001, record current account deficits have
been associated with a return to large government deficits and low national savings.
Another way of viewing Equation 17.8 is in terms of the funds available to finance
domestic investment, I. Investment must be financed either by the nation’s domesti-
cally generated savings, NS, or by funds made available for the use of the home country
by the rest of the world, that is, foreign lending to finance the domestic trade deficit. In
Italy most investment is financed domestically, whereas in the United States more
investment is in effect financed abroad.

17.3 Multipliers
Now consider Figure 17.1, where the horizontal axis represents income, Y. The saving
gap, NS 2 I, is an increasing function of Y, with slope s. Higher income means higher

4
If we wish to include government transfers such as unemployment compensation and social security in the
model, then T should be defined as taxes net of these transfers. If there are international transfers, they should
also be added in along with NFI.
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17.3 ■ Multipliers 311

TABLE 17.1
U.S. National Saving, Investment, and Current Account
Net State and Net Net
Private Government Local Federal National Domestic Current
Saving Saving Saving Saving Saving Investment Account
(% of GDP) (% of GDP) (% of GDP) (% of GDP) (% of GDP) (% of GDP) (% of GDP)
(1) (2) 5 (3) 1 (4) (3) (4) (5) 5 (1) 1 (2) (6) (7) < (5) 2 (6)
(average)
1961–1964 9.9 1.4 0.9 0.5 11.2 10.4 0.8
1965–1968 10.6 0.7 0.9 20.2 11.3 11.3 0.5
1969–1972 9.4 20.4 0.8 21.3 8.9 9.6 0.1
1973–1976 10.2 21.6 0.6 22.2 8.6 8.8 0.7
1977–1980 9.4 20.9 0.6 21.4 8.6 10.1 20.1
1981–1984 10.3 23.5 0.2 23.7 6.8 8.2 20.7
1985–1988 8.6 23.1 0.4 23.5 5.5 8.6 22.8
1989–1992 7.5 23.3 0.1 23.4 4.2 6.2 20.8
1993–1996 6.5 22.7 0.2 22.9 3.8 6.7 21.3
1997–2000 4.9 1.2 0.5 0.7 6.1 8.5 22.6
2001–2004 4.4 22.4 20.1 22.2 2.0 6.6 24.5

Note: “Net” means net of depreciation of the capital stock.

Source: National Income and Product Accounts, Bureau of Economic Analysis, U.S. Department of Commerce.

FIGURE 17.1 TB
Fiscal Expansion in the NS –I
Keynesian Model slope: s
The saving-investment line slopes X
M
up because higher income, Y,
means higher national savings,
NS. An increase in government NS 
I
spending of DG shifts the
 Y0 D1 C
line down. Point D is the new
intersection with the X 2 M line. 0 Y


G
D
D2

A
Y
X
M
slope:
m
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312 Chapter 17 ■ National Income and the Trade Balance

saving.5 The other line in the figure represents the trade balance, X 2 M, a decreasing
function of Y, with slope 2m as given by Equation 17.6: Higher income means higher
imports. Equation 17.8 states that equilibrium occurs where the two lines cross. Fig-
ure 17.1 shows the initial intersection as occurring when saving equals investment and
exports equal imports. But the choice of this location is arbitrary; equilibrium could
occur as easily above or below the zero axis.

The Multiplier Effect of a Fiscal Expansion

Let us consider as our first experiment a fiscal expansion DG. It shifts the NS 2 I line
down by that amount because NS 5 S 1 (T 2 G). It raises equilibrium income to point
D, the intersection on the new line NS9 2 I in Figure 17.1. Notice in the graph that the
change in income is less than in the closed-economy case: A closed-economy equilib-
rium would occur where the NS9 2 I line crosses the zero axis at point C, which lies far-
ther to the right than D.
The multiplier for government spending, or for other autonomous components of
spending, follows from Equation 17.7:

DY 1
5 (17.9)
DA s1m

Again, DY / DG, the multiplier effect on income, is smaller in the open economy than in
the closed economy because there is leakage through imports in addition to the leak-
age through saving. The multiplier formulas could also be derived geometrically. (See
Problem 3 at the end of the chapter.)
The convenient aspect of this graph is that it depicts not only income, Y, measured
on the horizontal axis, but also the trade balance, TB 5 X 2 M, measured on the verti-
cal axis. In Figure 17.1, the fiscal expansion pushes the trade balance into deficit
because the higher income draws in more imports. Algebraically,
DTB 5 2DM 5 2 mDY
Now use the multiplier, from Equation 17.9, to substitute for DY.
m
DTB 5 2 DG (17.10)
s1m

Equation 17.10 shows that the effect of a fiscal expansion on the trade balance is
clearly negative.
In short, the trade balance has been countercyclical in the United States, as in most
countries. Historical swings in the U.S. trade balance reflect the economy marching up
and down the X 2 M line in Figure 17.1. In the macroeconomic expansions of the

5
If it is recognized that tax revenues, T, depend positively on income, then the slope of NS is higher than s (by
the amount of the marginal tax rate). For simplicity in what follows, taxes will be treated as if they were exoge-
nous. The marginal tax rate is introduced, however, in problem 1 of Chapter 18. We also ignore the distinction
between the current account and trade balance in Figure 17.1; that is, we assume away investment income and
international transfers.
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17.3 ■ Multipliers 313

1976–1978, 1983–1989, 1992–2000, and 2002–2005 periods, imports rose and the trade
deficit widened (as at point D). In the recessions of 1980, 1990–1991, and 2001, the
trade deficit shrank.

The Multiplier Effect of an Increase in Exports

Now consider the effect of a devaluation. Assume that the Marshall-Lerner condition
is satisfied. This analysis could apply equally well to other exogenous sources of
improvement in the trade balance, such as a shift in tastes away from foreign goods or
an exogenous increase in foreign income. Algebraically, these changes are represented
as an increase in X 2 M. Graphically, they are represented as an upward shift in the
X 2 M line by the distance DX in Figure 17.2.6 If changes in income could somehow be
ignored (as in Chapter 16), the trade balance would improve by the vertical distance
D X . The magnitude of DX depends on the magnitude of the devaluation and of the
elasticities. An elasticity of 1, for example, would imply that exports increase by the
same percentage as the devaluation.
In addition to the obvious effect of raising the trade balance, however, the devalu-
ation stimulates income. Algebraically, from Equation 17.7,
1
DY 5 DX
s1m

FIGURE 17.2 TB
Devaluation in the NS – I
Keynesian Model
The devaluation shifts up the s
s+m ∆X
X 2 M line (assuming the
Marshall-Lerner condition is
met). Income, Y, rises. The trade ∆X
balance also rises, but less than
+
it would if income were held
0 Y
constant.
–
(X ′ – M ) – mY
∆Y

(X – M ) – mY

6
For simplicity, the exogenous increase in net exports is represented by DX , even though it could be a fall in
imports as well as a rise in exports. One might want to think of the special case where the import elasticity is 1,
so total import spending is unaffected by changes in the exchange rate, and the entire improvement in the
dollar trade balance comes from export earnings X.
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314 Chapter 17 ■ National Income and the Trade Balance

The higher income means higher imports, according to the marginal propensity to
import, and so the improvement in the trade balance is less than if income were held
fixed.
DTB 5 D X 2 mDY
1
5 DX 2 m DX (17.11)
s1m
1
5 DX
s1m

The key point is that s 11 m , 1; the trade balance improves by less than the full exoge-
nous increase in net exports because of the higher imports that are drawn in by higher
income. Yet the effect is still positive: Imports do not go up as much as exports.

17.4 The Transfer Problem

Our model can be applied to an old problem in international macroeconomics. As
was discussed in Section 3.4, the transfer problem originated with war reparations
payments, such as those from Germany to France after World War I; yet it can be
applied whenever there is a transfer of income from one country to another. More
recent examples abound. The OPEC price increase at the end of 1973 could be mod-
eled as an exogenous transfer from the oil-importing countries to OPEC. The 1982
international debt crisis could be modeled as an exogenous transfer from debtor
countries to creditor countries (the transfer is the increase in debt-service require-
ments). The 1991 payments from Japan, Germany, Saudi Arabia, Kuwait, and other
countries to the United States in connection with military operations against Iraq
constitute the best example because they were literally unilateral transfers in the bal-
ance of payments.
The important issue is the extent to which the recipient country will spend the
transfer on imports and the transferor will cut back on its imports. Recall that the cur-
rent account is defined as the balance of trade on goods and services plus transfers
received (or minus transfers paid). Let us consider a small country that has just
received a transfer. If it spends the entire transfer on imports and its trade balance
worsens by precisely this amount, then the overall current account is unchanged at the
existing exchange rate. In this case, the transfer is considered “fully effected,” meaning
that the financial transfer leads to the intended matching transfer of real goods. If the
recipient spends most of the money on its own goods, its overall current account will
improve at the old exchange rate—the negative effect on the trade balance will be
smaller than the transfer. In this case the transfer is “undereffected.”
Now consider a country making a transfer T, say Saudi Arabia in 1991.7 We saw
in the model of Chapter 3 that a transfer may or may not be undereffected. In the

7
Here it is assumed for simplicity of notation that the money for the transfer is raised by taxation of the
public, T.
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17.4 ■ The Transfer Problem 315

Keynesian model, however, the transfer is necessarily undereffected.8 The change in

the trade balance is less than the transfer. Why?
Recall the National Saving Identity, Equation 17.8:
NS 2 I ; CA
If the government finances the transfer with taxes, the budget balance is unchanged.
Given that I is exogenous, if S were also unchanged it would follow from the National
Saving Identity that the trade balance would increase by exactly the transfer, T. But
disposable income falls by the amount of the transfer. In a Keynesian model, that leads
to a fall in S. Therefore the trade balance must rise by less than the transfer.
The point is demonstrated graphically in Figure 17.3. Note that the horizontal axis
is disposable income Yd, not output GDP, because both saving and imports depend on
Yd, not Y, once the distinction is acknowledged. The current account, CA, depends on
disposable income with the same slope as the trade balance (2m, the marginal propen-
sity to import). If there is no transfer, then the trade balance coincides with the current
account. An outward transfer, T, shifts the CA line down. Saving-investment equilib-
rium is given at point R, where the new CA line intersects NS 2 I. At this lower level of
disposable income, imports have fallen and thus the trade balance is in surplus at point
S. Yet the trade balance, TB, is not as large as the outward transfer, T. The overall
current account, CA 5 TB 2 T, necessarily goes into deficit at point R. So long as the
NS 2 I curve is not flat—that is, so long as the marginal propensity to save is greater
than zero—the transfer is undereffected.

FIGURE 17.3
Transfer Worsens the
Total Current Account
A transfer, T, to a foreign
country improves the domestic
trade balance, X 2 M, because TB
imports fall when domestic + S
disposable income falls. NS – I
Nevertheless, in the Keynesian E
0 Yd
model the overall current
CA T X–M
account, X 2 M 2 T, falls.
– T

R
X–M–T

8
The first to show this was not Keynes, but Lloyd Metzler, “The Transfer Problem Reconsidered,” Journal of
Political Economy (June 1942): 397–414.
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316 Chapter 17 ■ National Income and the Trade Balance

17.5 For a Large Country: The Two-Country Keynesian Model

So far we have assumed exports to be exogenous with respect to income. This section
relaxes that assumption, taking into account how exports depend on developments in
the rest of the world. In the examination of a large country, developments in the rest
of the world, in turn, depend on developments in the home country. The rest of the
world, which we aggregate into a single foreign country, and the home country are
interdependent.9

Repercussion Effects
If income, Y*, increases in the foreign country, foreigners import more from the home
country.
X 5 X 1 m*Y*
The foreign marginal propensity to import is represented by m*. In Equation 17.7, X is
replaced by the new expression for exports, resulting in the new formula for equilib-
rium income.
A 1 X 2 M 1 m*Y*
Y5 (17.12)
s1m

Obviously, domestic income depends positively on foreign income. Figure 17.4 graphs
this relationship. The slope DY / DY* is m* / (s 1 m), which is less than 1 unless the for-
eign country is much more open to imports than the home country.
The relationship explains how expansion in one country is transmitted to its trad-
ing partners through the trade balance. For example, in 1977–1978 the United States
pressured Germany and Japan to expand their economies. The plan, known as the loco-
motive theory, was to help pull the rest of the world out of recession. Often the United

FIGURE 17.4 Y m*
Slope: s+m
Transmission from Foreign Income
to Domestic Income
When foreign income, Y*, rises, imports
into the foreign country rise—that is,
exports from the domestic country rise;
as a result, domestic income, Y, also rises.

0
Y*

9
The Keynesian two-country model was developed by James Meade, The Theory of International Economic
Policy, Vol. I: The Balance of Payments (London, Oxford University Press, 1952), Chapters 4 and 5.
CAVE.6607.cp17.p307-326 6/6/06 12:04 PM Page 317

17.5 ■ For a Large Country: The Two-Country Keynesian Model 317

States has been the locomotive pulling the world out of recession. In each episode, the
smaller, more open, and developing countries were anxious for the big industrialized
countries to expand because the economies of the smaller countries depend particu-
larly on foreign income. Of course, contraction is transmitted across countries, as well.
The prime example is the Great Depression of the 1930s, when declining income in one
country would result in declining imports, and thus declining income, among its trading
partners.
Now we are ready to drop the assumption that foreign income is exogenous. The
rationale has been that the domestic economy is too small to affect foreign income.
However, when a country as large as the United States (or the European Union or
Japan) expands, and consequently imports more from its trading partners, those
imports are a large enough component of world demand to raise income and expendi-
ture significantly among the trading partners. Then a large enough fraction of the for-
eign expenditure is spent on domestic goods, so that foreigners’ imports from the home
country in turn rise significantly. In other words, part of the spending that leaks out,
flows back. The result is that income increases in the home country, the place that
began the expansion, by more than one would expect based on its spending alone (the
model in Section 17.1). The feedback through the trading partner can be called a reper-
cussion effect. To model the repercussion effect, we now consider two countries that
are each large enough to affect the other’s income.

The Solution to the Two-Country Model

To make foreign income endogenous, the foreign country is modeled analogously to
the home country, recognizing that its exports are the home country’s imports. That is,
they are a function, M 1 mY, of the home country’s income. Similarly, its imports are
the home country’s exports; they are a function, X 1 m*Y*, of the foreign country’s
income. Then the solution for equilibrium foreign income is

A* 1 M 1 mY 2 X
Y* 5 (17.13)
s* 1 m*

where A* represents the autonomous components of foreign expenditure and s* the

foreign marginal propensity to save. This is simply the other country’s version of
Equation 17.12.
Equilibrium income for each country is indicated algebraically by solving the two
equations simultaneously.10 The multiplier for a domestic expansion turns out to be

DY 1
5 (17.14)
DA m*m
s1m2
s* 1 m*

The important point is that it exceeds the small-country multiplier s 11 m derived in

Section 17.1. (In terms of either Figure 17.5 or the appendix figure, the expansion

10
You are asked to do this in Problem 8a at the end of the chapter. Also see the appendix.
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318 Chapter 17 ■ National Income and the Trade Balance

FIGURE 17.5 TB
Repercussion Effect
Increases the Multiplier
NS – I
The effect of a fiscal expansion
is greater in the two-country
model (point D9), than in the
small-country model (point D)
because some of the spending
that leaks out of the country + NS ′ – I
through imports leaks back in 0 Y
through exports. B
–
D′
X–M
(two-country)
D

X – M (small-country)

results in a move to the new intersection at D9, whereas the intersection would be at
point D if foreign income, Y*, were kept constant.) Why? Some of the expenditure
stream that leaks out as imports now returns as exports. For every dollar increase in
domestic income, imports go up by m; because the other country’s exports go up by m,
its income goes up by s* 1m m*, and so it imports more from the home country. This effect
is represented by the term (m*m) / (s* 1 m*) in Equation 17.14. Because it reduces the
denominator, it increases the multiplier. The small-country multiplier is the special case
where a negligibly small proportion of foreign expenditure falls on domestic goods
(m* < 0), so this term can be ignored. Conversely, the multiplier is still necessarily less
than the closed-economy multiplier, 1 / s, as long as m and s* . 0. It is not possible for
all of the expenditure that leaks out through the trade balance to come back, as long as
any foreign income is saved.
We can continue to use a version of the X 2 M 5 NS 2 I graph of Figure 17.1.
Because

DTB 5 m*DY* 2 mDY (17.15)

we can substitute

m
DY* 5 DY
s* 1 m*

from Equation 17.13 and so find the new slope of the X 2 M line:

m
DTB 5 m* 1 s* 1 m*
2 m DY2
ms*
DTB / DY 5 2 (17.16)
s* 1 m*
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17.5 ■ For a Large Country: The Two-Country Keynesian Model 319

Notice that the slope is close to 2m, the slope of the TB line in the small-country case,
if m* is small. In general, however, the slope is less in absolute value than 2m, as evi-
denced in Figure 17.5. It is possible to see from the intersection with the NS9 2 I line
at point D9 the proposition already shown algebraically: An expansion (rightward shift
of NS 2 I) has a greater effect on domestic income in the two-country model than in
the small-country model because there is less leakage through the trade deficit.

Empirical Evidence on Growth and Import Elasticities

Figure 17.6 shows the U.S. balances for goods and services and the current account (as
shares of GDP) for the last half century. In the 1970s the trade balance went into deficit
for the first time since World War II, but it was small enough that the current-account
balance still averaged zero. More recently, however, the trade deficit has far exceeded its
previous record. These large trade deficits have generated concern throughout the U.S.
economy. They represent lost output and employment in those sectors or firms that rely
on overseas customers for a rising share of their sales, as well as in those sectors or
firms that face tough competition from rapidly rising imports. Furthermore, the equally
large current-account deficits mean that the country is rapidly going into debt to for-
eign investors. Members of Congress and editorial writers rail against the deficits, some
adopting protectionist views. Why have these deficits occurred?

FIGURE 17.6
U.S. Trade Balance and Current Account Balance, 1946–2005

Current account balance

2 expressed as a share of GDP

1 Balance on goods and services,

expressed as a share of GDP
0

1
Percentage of GDP

2

3

4

5

6

7
1960 1964 1968 1972 1976 1980 1984 1988 1992 1996 2000 2004

Source: Department of Commerce (Bureau of Economic Analysis).

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320 Chapter 17 ■ National Income and the Trade Balance

Part of the answer is that in 1983–1984, and again in 1992–2000 and 2002–2005, the
United States was expanding more rapidly than were its trading partners. As is seen
from Equation 17.15, if the home country expands faster than the foreign country, the
home country suffers a worsening trade balance—assuming that the two countries
have the same marginal propensity to import.
What happens if both countries expand together, i.e., if income growth is equal?
If the two countries have the same elasticities of import demand with respect to
income, then there is no effect on the trade balance. The elasticity of demand with
respect to income is the marginal propensity to import (m 5 DM / DY) divided by the
ratio of imports to income: (DM / DY) / (M / Y). The usual way to think of it is the
percentage change in imports that results from a given percentage change in income,
(DM / M) / (DY / Y). There is evidence that imports are more elastic with respect to
income in the United States than they are in many of its trading partners.11 The devel-
oping countries and Japan have lower income elasticities.
One implication that follows for developing countries and any other countries
exporting goods that face highly income-elastic demand is that their incomes tend to
be procyclical: When the world is in recession, demand for their goods tends to fall
more than demand for goods produced by other countries, and so their incomes fall
more than proportionately. The high variability in income is particularly severe for
developing countries producing a single commodity, such as copper or oil, that serves
as an intermediate input in other countries’ production processes with little scope for
substitution.
A second implication would also follow if these elasticities were assumed to apply
to long-run, as well as short-run, changes in income: There will be a long-run secular
trend in the trade balance in favor of these countries and against the United States, and
other producers of manufactured goods, who face demand that is less income-elastic.
Indeed, this could be part of the explanation for the long-term trend toward deficit in
the U.S. trade balance reported in Figure 17.6.
It has been suggested, however, that the long-term income elasticities are in reality
not as high as the short-term elasticities when care is taken to separate long-term
growth in income from exogenous trends such as increased supply capacity in the
newly industrialized countries. Some have discerned a secular trend in trade adverse to
the raw materials produced by developing countries. The NIEs, such as Hong Kong,
Singapore, South Korea, and Taiwan,12 have achieved strong trade positions through
policies of growth led by exports––not of traditional raw materials but of manufac-
tured goods, beginning with labor-intensive manufactures such as textiles and elec-

11
Some empirical evidence on how the income elasticities of import demand vary across countries was pre-
sented in a famous paper by Hendrik Houthakker and Stephen Magee, “Income and Price Elasticities in
World Trade,” Review of Economics and Statistics, 51, no. 2 (1969): 111–124.
12
These four entities are sometimes called newly industrialized economies, or NIEs, instead of NICs, in defer-
ence to the People’s Republic of China, which retook responsibility for the British colony of Hong Kong in
1997 and has never recognized the independence of Taiwan.
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17.6 ■ Summary 321

tronics. The pattern that fits them best—and now China—is the product cycle.13 For
any given technology, a secular trend exists against the United States and in favor of
those countries able to adopt the technology to produce the same goods at lower cost.
Yet the United States and other technological leaders have always innovated and
stayed one step ahead, at least up until now.

17.6 Summary
This chapter added a second factor, national income, or GDP, to the exchange rate in
the determination of the trade balance.When income increases, the demand for imports
increases, and that, in turn, works to decrease the trade balance. Because the trade bal-
ance is a component of income, the determination of both variables must be considered
simultaneously.
Because we have maintained the assumption that the prices of domestic goods are
fixed (in terms of domestic currency), the resulting model is Keynesian: Changes in
demand are reflected in output, not in prices. This assumption is more realistic in the
short run than the long run.
The most important conclusions were evident even in the simplest form of the
model where the level of foreign income is held constant. This form is realistic given
the assumption that the domestic country is too small to affect foreign income. The first
conclusion concerned changes in government spending: (1) Such changes have a multi-
plier effect on national income because at each round of spending some proportion of
the income earned is passed on in a new round of spending; but (2) the effect on
income is smaller than in closed-economy textbooks because at each round of spend-
ing some income leaks out of the country in the form of higher import spending and a
higher trade deficit. Feedback effects via foreign income, which only need be taken
into account if the home country is large, work to increase the effect of an expansion
on domestic income.
The next conclusions concern devaluations: (3) If the Marshall-Lerner condition is
met, a devaluation will raise the trade balance, as in Chapter 16,14 and this in turn will
improve income because of the multiplier, but (4) because the higher income means
higher imports, the increase in the trade surplus will be less than it was when income
effects were omitted.
Other important questions can also be explored with the simple Keynesian model.
(5) When a country makes an exogenous transfer to its trading partner (reparations, for-
eign aid, or interest payments), it will generally experience an improvement of its trade
balance that is smaller than the amount of the transfer; thus, its total current account will
deteriorate (at a given exchange rate). Chapter 18 will consider further applications.

13
See the discussion of the product cycle in Chapter 9.
14
The appendix to Chapter 18 explores a qualification to this conclusion that arises if saving depends on the
terms of trade the “Laursen-Metzler-Harberger” effect.
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322 Chapter 17 ■ National Income and the Trade Balance

CHAPTER PROBLEMS

1. In the Keynesian multiplier process, at each round of spending some proportion of the
income is passed on by its recipients as a new round of spending. The number of rounds
is infinite. Does this mean that the total effect on income is infinite? Why not?
2. The multiplier is greater than 1 if s 1 m , 1. Does this condition hold? Do you think
M , C or M . C? Why?
3. Look carefully at the geometry of Figure 17.1.
a. What is DG divided by Y0C, that is, by the horizontal distance from point Y0
to point C? (Remember the definition of the slope of a line.) Then what is
Y0C / DG? What have you just shown about the fiscal multiplier in a closed
economy?
b. What is the vertical distance D2D, expressed relative to DY? What is the distance
D1D, expressed relative to DY? Now take the sum of the two vertical distances:
What is D1D2 / DY? Then what is DY / DG? What have you just shown about the
multiplier in an open economy? How does it compare to the answer in (a), and
why, intuitively?
4. Would you expect the multiplier to be highest in Australia, Luxembourg, or Singapore?
5. Consider an increase in a country’s budget deficit.
a. What must happen to private saving, investment, or the current account, according
to the national saving identity?
b. In the Keynesian model (leaving out any interest rate effects on investment),
which of these alternatives, or what combination of them, results from a tax cut?
What is the answer if investment is allowed to depend on the interest rate (as at
the end of Chapter 18)?
(For parts c–e, assume tax revenue depends on income, as in footnote 5 or
Problem 1 of Chapter 18.)
c. If there is a recession because of an exogenous fall in C, what is the effect on the
budget deficit? Are the effects on private saving and the trade balance the same
as in 5b?
d. If there is a recession because of an exogenous fall in exports, what are the effects
on the budget deficit, saving, and the trade balance?
e. Are your answers to question b consistent with your answer regarding the
national saving identity in question a?
6. This question concerns the Keynesian model.
a. Recall that the definition of equilibrium is that output supplied is equal to output
demanded:
Y 5 A 1 TB
where Y 5 Output
A 5 Aggregate Demand, and
TB 5 Trade Balance
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Chapter Problems 323

Assume that Aggregate Demand is given by

A 5 A 1 cYd,
TB 5 X 2 M 2 mYd
and disposable income is given by

Yd 5 Y 2 TP

where TP 5 tax payments, here assumed exogenous.

Solve for equilibrium output.
b. What is the tax multiplier DY / DTP? In this Keynesian model, how does the
effect of a tax cut compare to the effect of an increase in government spending?
Why?
c. In the mid-1990s, the U.S. government advised Japan to cut taxes, to revive eco-
nomic growth. The Japanese government rejected the advice, arguing that the
multiplier effect would be very small. What do you think were the grounds for its
argument?
7. Consider a new transfer DT made by a small country to abroad, say by Saudi Arabia in
1991. The question posed by the transfer problem is the net effect on Saudi Arabia’s
current account.
The three lines in Figure 17.3 are represented by three equations:
NS 2 I 5 2 A 1 sYd
where A includes all exogenous components of domestic spending;

TB 5 X 2 M 2 mYd ; and

NS 2 I 5 CA 5 TB 2 T

Solve for:
a. DYd. This is the change in disposable income, equal to the change in output minus
the change in the transfer.
b. DTB.
c. DCA. Is the transfer undereffected or overeffected, or does it depend on the
parameters?
8. This question concerns the two-country model.
a. Solve Equations 17.12 and 17.13 simultaneously, to determine Y.
b. Use Equations 17.16 and 17.14 to solve for the effect of a spending rise on the
trade balance:

DTB DTB DY
5
DA DY DA

c. Compare your answers in b with the analogous expression in the small-country

model. In which case is the fall in the trade balance greater and why?
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324 Chapter 17 ■ National Income and the Trade Balance

9. In Section 17.4 we applied the transfer problem to a small country, but the problem is
more often applied to two countries of approximately equal size (such as France and
Germany).
a. The transfer, DT, can be viewed as an exogenous decrease in the income of the
transferring country and an exogenous increase in the income of the recipient
country. The answer to 8b gives the effect of the first factor on the trade balance,
and the analogous equation for the foreign country gives the effect of the second
factor. Show that
DTB ms* 1 m*s
5
DT s*s 1 ms* 1 m*s
b. Is the ratio necessarily less than 1? What if the marginal propensities to save are
zero? How would the special case when the domestic country is so small that the
foreign country spends almost nothing on its goods look?
c. Show the effect on the current account, DCA 5 DTB 2 DT. Does the current
account of the transferor improve or worsen?

SUGGESTIONS FOR FURTHER READING

Goldstein, Morris, and Mohsin Khan. “Income and Price Effects in Foreign Trade.” In
Ronald Jones and Peter Kenen, eds., Handbook of International Economics, Vol. II
(Amsterdam: Elsevier, 1985), Chapter 20, pp. 1041–1105. Econometric estimates of
the elasticities of demand for imports and exports, including the distinction
between short- and long-run elasticities of demand with respect to income.
Hooper, Peter, and Jaime Marquez. “Exchange Rates, Prices and External Adjustment
in the United States and Japan.” In Peter Kenen, ed., Interdependence and the
Macroeconomics of the Open Economy (Princeton: Princeton University Press,
1995). Empirical analysis of the U.S. trade deficit and Japanese surplus.
Sachs, Jeffrey. “The Current Account and Macroeconomic Adjustment in the 1970s,”
Brookings Papers on Economic Activity, 1 (1981), pp. 201–268. A clear exposition
of the current account as the outcome of a two-period saving decision (as in the
appendix to Chapter 22), with special reference to the oil shocks of the 1970s and
countries’ responses.

APPENDIX

The Two-Country Model in Graphical Form

Figure 17.A.1 presents graphs of the two simultaneous equations: Equation 17.12,
which gave Y as a function of Y*, and Equation 17.13, which gave Y* as a function of
Y. The latter graph is analogous to Figure 17.5. It must be turned on its side in Fig-
CAVE.6607.cp17.p307-326 6/6/06 12:04 PM Page 325

Appendix 325

FIGURE 17.A.1 Y
Simultaneous Solution for Both
Countries’ Incomes Effect of Y on Y*
TB = 0
D
A relationship runs from domestic income,
Y, to foreign income, Y*. A domestic D
expansion shifts the domestic line up so D Effect of Y* on Y
that the new intersection occurs at D9.
The increase in Y is greater than in the
small-country model—which ignored
the repercussion effect of higher income B
abroad (point D).

0 Y*

ure 17.A.1 to show it on the same axes as Figure 17.5. Equilibrium income for each
country is indicated graphically at the intersection of the two lines, point B.
Consider now an increase in domestic spending. In terms of Figure 17.5, the domes-
tic income line shifts up vertically by the amount of the simple open-economy multi-
plier (the amount Y would rise if we were still holding Y* constant). The expansion
results in a move to the new intersection at D9, whereas the intersection would be at
point D if foreign income, Y*, were kept constant. Why? As we learned in Section 17.5,
the multiplier is larger in the two-country model because of the repercussion effect.
Figure 17.A.1 can also be used to illustrate the point about an adverse trend in the
U.S. trade balance. The line that gives U.S. income, Y (as a function of foreign income,
Y*), shifts out faster than the line that gives foreign income (as a function of U.S.
income). In terms of Equations 17.12 and 17.13, A increases faster than A*. The inter-
section moves up faster than it moves to the right. At point D0 it lies above the trade
balance equilibrium schedule (the slope of which is m* / m, as we can see by setting
DTB 5 0 in Equation 17.15). The United States goes into deficit because its imports go
up faster than do those of its trading partners.
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The section on
CHAPTER 18
the liquidity trap
(p.341) has an
Spending and the Exchange update for ZLB..

Rate in the Keynesian Model

C
hapter 17 developed the Keynesian model for determining income and the trade
balance in an open economy. In this chapter we consider some further applica-
tions of the same model, including how governments can change spending in
pursuit of two of their fondest objectives—income and the trade balance. We begin
with the question of how changes in spending are transmitted from one country to
another. Throughout, we focus particularly on the role that changes in the exchange
rate play in the process. We bring together the analysis of flexible exchange rates from
Chapter 16 with the analysis of changes in expenditure from Chapter 17.

18.1 Transmission of Disturbances

Section 17.5 showed how income in one country depends on income in the rest of the
world, through the trade balance. The effect varies considerably, depending on what is
assumed about the exchange rate. This section compares the two exchange rate
regimes, fixed and floating, with respect to the international transmission of economic
disturbances. This comparison is one of the criteria that a country might use in deciding
which of the regimes it prefers.

Transmission Under Fixed Exchange Rates

Our starting point will be the regime of fixed exchange rates. For simplicity, return to
the small-country model of Section 17.1. In other words, ignore any repercussion
effects via changes in foreign income. As Equation 17.9 implies, an internal distur-
bance, such as a fall in investment demand DI , changes domestic income by
DY 1
5 (18.1)
DI s1m

in the small-country model. Recall that the multiplier here is smaller than in the
closed-economy multiplier because some of the change in aggregate demand “leaks
out,” or is transmitted to the rest of the world. An external disturbance such as a fall in
export demand, DX, changes income by the same amount.
DY 1
5 (18.2)
DX s1m

327
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328 Chapter 18 ■ Spending and the Exchange Rate in the Keynesian Model

In this case some of the foreign change in aggregate demand is transmitted through the
trade balance to the home country.
The two-country model would serve as well here. The domestic spending multi-
plier would be a little higher, as in Equation 17.14, because some import leakage
returns in the form of exports. The same applies to the export multiplier. The important
point is that under fixed rates, disturbances are generally transmitted positively from
the country of origin to the trading partners via the trade balance.

Transmission Under Floating Exchange Rates

Now assume that the central bank does not participate in the foreign exchange market.
Thus the exchange rate adjusts automatically to ensure BP 5 0. Continue to assume no
capital flows (or transfers), so TB 5 0 as well. In the case of an internal disturbance, a
fall in investment demand DI would cause a fall in income and a consequent trade
surplus under a fixed exchange rate. The S 2 I 2 G line shifts up, as is seen in Fig-
ure 18.1(a). However, under floating exchange rates a surplus is impossible because the
central bank is no longer in the business of buying or selling foreign exchange. In
response to what would otherwise be an excess supply of foreign currency, the price of
foreign currency automatically falls—that is, the domestic currency automatically
appreciates. The effect of an appreciation of the currency is the same as it would be if
the government deliberately increased the value of the currency: Imports are stimu-

FIGURE 18.1
Insulation Under Floating Exchange Rates
Panel (a) shows how domestic disturbances are “bottled up” inside the country. A fall in
investment, I, has a greater effect on income under a floating rate than under a fixed rate
because the currency appreciates and discourages net exports. Panel (b) shows how the country
is “insulated” from foreign disturbances. A fall in foreign demand causes the domestic currency
to depreciate, which stimulates net exports.

(a) Internal Disturbance Under Floating Rates (b) External Disturbance Under Floating Rates

TB TB

NS – I ′

NS – I NS – I
+ +
0 Y 0 Y
– –

X–M X–M
X ′′ – M X′ – M
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18.1 ■ Transmission of Disturbances 329

lated and exports discouraged, and the X 2 M line shifts down. The shift will be what-
ever is required to restore the trade balance to equilibrium. The required change in the
exchange rate could be computed if the trade elasticities were known.
Whatever the exchange rate change, the ultimate effect is such that the trade bal-
ance remains at zero: DTB 5 0. From Equation 17.6,

DTB 5 DX 2 mDY

So floating exchange rates imply that

DX 5 mDY
The downward shift in the component of net exports attributable to the appreciation
must be sufficient to offset the decrease in imports attributable to lower income. To
compute the change in income, note from Equation 17.7 that

DI 1 DX
DY 5
s1m
D I 1 mDY
5
s1m
DI
DY 5 s (18.3)

Compare this to the multiplier under fixed rates shown in Equation 18.1. The internal
disturbance has a greater effect under floating rates than under fixed rates. The distur-
bance induces an exchange rate change that reinforces the effect on aggregate
demand. In fact, the disturbance has the full closed-economy multiplier effect. The rea-
son is that when the exchange rate fluctuates to keep the trade balance at zero, it
reproduces the effect of a closed economy. All disturbances are bottled up inside the
country rather than being partially transmitted abroad. The point can also be shown
graphically. The X 2 M line becomes irrelevant. Equilibrium income is determined
wherever the NS 2 I line crosses the zero axis because the floating exchange rate auto-
matically ensures that the X 2 M line crosses there as well. Because the NS 2 I line
has slope s, a disturbance that shifts it up by DI reduces income by DI /s.
Now consider the case of an external disturbance. A downward shift of the X 2 M
line, as in Figure 18.1(b), would cause a fall in income and a trade deficit on a given
exchange rate. The incipient trade deficit causes the currency to depreciate automati-
cally, however, shifting the X 2 M line back up until balanced trade is restored. At this
point the effect on income is eliminated as well: DY 5 0. The floating exchange rate
insulates the economy against foreign disturbances. Again, by adjusting to keep the
trade balance at zero, it reproduces a closed economy.
To sum up, floating rates (in the absence of capital flows) restrict the effects of dis-
turbances to the country of origin. This result suggests one possible basis on which a
country could choose between fixed and floating exchange rates. If the goal is to mini-
mize the variability of domestic output, then the absence of international transmission
is desirable to the extent that disturbances originate abroad because the home country
is insulated from them. Floating would be better than fixed. However, the absence of
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330 Chapter 18 ■ Spending and the Exchange Rate in the Keynesian Model

transmission is undesirable to the extent that disturbances originate domestically; the

floating rate prevents these disturbances from being passed off to the rest of the world.
Fixed is better than floating.
Conversely, if the goal is to allow each country to pursue its own independent poli-
cies, then the absence of transmission constitutes an argument for floating exchange
rates. In the late 1960s when the world was still on fixed rates and excessive expansion
in the United States was transmitted to the European countries as unwanted inflation,
floating rates were suggested as the ideal solution. They would allow each country to
pursue its preferred policies independently.
The conclusion that floating rates prevent transmission extends to the two-country
model. As long as the trade balance is always zero, income must be determined by
domestic demand. Chapter 25, however, will show that this conclusion does not extend
to models with capital mobility, as then the trade balance need not equal zero. Further-
more, although foreign disturbances have no effect on domestic output and employ-
ment in the model of this chapter, they do affect domestic real income. The currency
depreciation illustrated in Figure 18.1(b) turns the terms of trade against the home
country: The price of imports rises in domestic terms, causing a fall in the real purchas-
ing power of a given quantity of domestic output. Domestic residents will feel poorer
even though national output is unchanged. Such changes in the terms of trade can have
further implications; they are considered in the chapter appendix.

18.2 Expenditure-Switching and Expenditure-Reducing Policies

Chapter 17 explained the use of the Keynesian model in determining income and the
trade balance. This section uses the model to show the most effective ways for govern-
ment policy makers to combine the tools at their disposal to achieve their policy goals.

Adjustment to a Current Account Deficit

Consider a country running a current account deficit. It has two broad choices: financ-
ing the deficit or adjustment. By financing we mean that the country chooses to con-
tinue running the deficit for the time being, either by borrowing from abroad (on the
private capital account) or by running down its central bank’s holdings of reserves (on
the official reserves transactions account). Let us say that the country instead wishes or
is forced to adjust—that is, to change macroeconomic policies in such a way as to elim-
inate the current account deficit. How, specifically, can it do this?
Expenditure-reducing policies and expenditure-switching policies are alternative
ways to reduce a trade deficit. Measures to reduce overall expenditure, such as reduc-
tions in government expenditure or increases in taxes, work to reduce a trade deficit
because some of the eliminated expenditure would have fallen on imports. Con-
versely, measures to increase expenditure increase the trade deficit, as was evidenced
in the prior chapter (for example, in Figure 17.1 and Equation 17.10). There are also
expenditure-reducing policies other than fiscal contraction, in particular monetary
contraction. Monetary policy will be covered at the end of the chapter.
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18.2 ■ Expenditure-Switching and Expenditure-Reducing Policies 331

Expenditure-switching policies are those that, for any given level of expenditure,
work to improve the trade balance by switching expenditure away from foreign goods
and toward domestic goods. In the case of domestic expenditure, the result is a fall in
imports. In the case of expenditure by foreigners, the result is a rise in exports to them.
The expenditure-switching policy focused on so far is devaluation, as in Figure 17.2 and
Equation 17.11.
Expenditure-reducing and expenditure-switching policies are equally valid ways
of eliminating a trade deficit. The most important difference between the two is that
the former accomplishes this by reducing income and employment, whereas the latter
does so by—or, more precisely, with the effect of—raising income and employment.

Types of Expenditure-Switching Policies

There are several possible expenditure-switching policies. One is price deflation, which
makes domestic goods more attractive to residents of both countries. In practice, price
deflation can usually be achieved only by expenditure reduction. The period of low
income and high unemployment that must be endured before wages and prices come
down can be long and painful. We continue to assume, in the Keynesian model, that
because of the existence of minimum wage laws, unions, contracts, implicit contracts,
money illusion—for whatever the reason—wage and price deflation is so difficult in
the short run as to be ruled out.
Devaluation is the expenditure-switching policy on which we will continue to focus:
Taking rigid prices as given, it works to cheapen domestic goods on world markets.
Direct trade controls can also be expenditure-switching policies. A common form
of direct trade control is a tariff, which raises the price of imports and thus discourages
domestic residents from buying them. An export subsidy, which lowers the price of
exports and encourages foreign residents to buy them, is also sometimes used. A uni-
form 10 percent import tariff combined with a uniform 10 percent export subsidy
would have the same effect on the relative prices facing each country as a 10 percent
devaluation. The devaluation analysis would apply, in large measure unchanged.
In practice, tariffs and subsidies are enacted more often to help specific industries
that are in trouble or that have sufficient political clout than to further macroeconomic
purposes. Pure trade theory provides some persuasive microeconomic arguments
against them, as explained in Part III. Nevertheless, these measures are sometimes
imposed for macroeconomic reasons. In the 1930s the United States adopted the
Smoot-Hawley tariff in an effort to switch expenditure toward domestic goods gener-
ally. Policies of this type, which are designed to switch spending to domestic products at
the expense of other countries, are called “beggar-thy-neighbor.”1 The consequences in
that case were disastrous, as was seen earlier in this text. Trading partners responded by
putting up tariffs of their own to protect their trade balances, and the result was a global
collapse in trade. Following World War II, the GATT was set up to negotiate reductions
in tariffs.

1
“Beggar” is used as a verb here, meaning “to impoverish.”
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332 Chapter 18 ■ Spending and the Exchange Rate in the Keynesian Model

Partly as a consequence of the success of the GATT (now the WTO), protection
has shifted emphasis away from tariffs and toward other direct controls on trade, that
is, toward nontariff barriers. One nontariff barrier is the quantitative restriction or
quota. Some quotas, those imposed on industrialized countries on imports of textiles
from labor-abundant countries, were abolished in 2005 under the terms of the Uruguay
Round of negotiations concluded in 1994.
The economic analysis of an import quota is similar to the analysis of a tariff, in
that a quota raises the domestic price. The two would be practically equivalent if the
government auctioned off the licenses to import, so that the revenue accrued to the
domestic government instead of to the importers fortunate enough to get the licenses.
In practice, governments rarely auction off quotas. In the case of a tariff, the fact that
the revenue goes to the domestic government is an obvious advantage from the
national viewpoint, relative to a voluntary export restraint where the “revenue” goes to
the foreign country. If the alternative is a domestically imposed quota, then the rev-
enue generally accrues to domestic residents, as with a tariff. From a macroeco-
nomic viewpoint, however, there is still an important difference between a tariff,
under which the revenue accrues to the domestic government, and a quota, under
which the revenue accrues to the domestic private sector. An increase in tariffs, like
any tax increase, reduces the private sector’s disposable income and constitutes a con-
tractionary fiscal policy. Thus it has an expenditure-reducing side in addition to the
expenditure-switching side and may have a bigger effect on the trade balance than
would a domestically imposed quota.
Another nontariff barrier used sometimes when a government has a pressing trade
balance crisis is advanced deposits on imports. An importer must place on deposit with
the government a certain amount of money for a certain length of time, such as six
months, without interest. The effect is the same as a tariff equal in amount to the inter-
est on the deposit lost by the importer. Like a tariff, this barrier withdraws money from
circulation and thus has an expenditure-reducing effect, in addition to the expenditure-
switching effect.
The topic here is barriers to trade; barriers to capital flows will be discussed later.
Nevertheless, one device for discouraging the outflow of money bears mentioning: the
two-tier exchange rate. Suppose that South Africa is experiencing a substantial outflow
of capital and downward pressure on the price of its currency. Because it wants to
avoid worsening its inflation, as would follow if it devalues the South African rand, the
central bank maintains its fixed exchange rate for current-account transactions but
requires parties making capital-account transactions to use the competitive foreign
exchange market. There the exchange rate is left free to find its own level. Those clam-
oring for foreign currency to buy foreign assets—that is, to export capital from South
Africa—find the supply limited to the flow of currency made available by foreign resi-
dents desiring to export capital to South Africa. Capital exports and imports would be
equated by the market-determined exchange rate for capital transactions, and no net
international capital transfers could take place. This device could similarly be used to
avert a revaluation when a country is experiencing capital inflows. The two-tier foreign
exchange market is difficult to administer because it requires elaborate controls. If the
price of the South African rand is higher in the competitive market for capital-account
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18.2 ■ Expenditure-Switching and Expenditure-Reducing Policies 333

transactions, those exporting capital to South Africa have an incentive to gain access to
its currency at the cheaper rate for current-account transactions. In addition, South
African importers who must buy foreign exchange at the (for them) less favorable
current-account rate have an incentive to sell South African rand to buyers in the
capital-account market. Controls must keep these parties apart if the system is to work.
Capital controls can impair economic efficiency because they keep capital from
moving to where it earns a higher return. If the difference in returns faced by the
lender is also a difference in real social productivity, the control imposes a welfare cost.
One cannot be dogmatic, though, about the welfare costs of capital controls because
governments use the interest rate—the return to capital—extensively as a policy vari-
able. When the central bank is influencing the price of credit, the connection between
the market price and social productivity of capital is no longer certain.
Another barrier that has been used by developing countries is multiple exchange
rates. The government charges a higher price for foreign exchange when it is used to
purchase luxury consumer goods than when it is used to purchase, for example, capital
goods or—considered most essential of all—spare parts and fuel.

The Swan Diagram

Assume that the government authorities have two policy goals. First, they want to
attain external balance: for example, a trade deficit equal to zero. Second, they want to
attain internal balance: output equal to full employment or potential output. (The situ-
ation in which demand exceeds potential output, Y, can be considered undesirable
because it leads to inflation.) There is a general principle that attaining two different
policy goals requires two independent policy tools. In this case the two policy tools are
expenditure-switching and expenditure-reducing policies, or, for concreteness, devalua-
tion and government expenditure.2 Each policy will be considered in isolation before
we consider the use of both at once.
As already seen, government fiscal expansion raises output but worsens the trade
balance. If the government were restricted to the use of fiscal policy, this would repre-
sent a dilemma. The government could adopt a contractionary fiscal policy to achieve
external balance (TB 5 0) at the expense of unemployment (Y , Y), at point X in
Figure 18.2(a), or could adopt an expansionary fiscal policy to attain internal balance
at the expense of a trade deficit (TB , 0), at point N. The government cannot, how-
ever, attain external and internal balance simultaneously, except by coincidence. Such
simultaneous balance demands another policy tool.
A devaluation also raises output, but it improves the trade balance. This presents
another dilemma: whether (1) to choose a low exchange rate—that is, revalue to
achieve internal balance (Y 5 Y) at the expense of a trade deficit (TB , 0) at point N
in Figure 18.2(b); or (2) to choose a high exchange rate—that is, devalue, to achieve
external balance (TB 5 0) at the expense of excess demand (Y . Y) at point B.

2
The general principle originated with Jan Tinbergen. The application to the open economy was developed by
James Meade. The application of the principle to an economy with international capital mobility, which we
study in Chapter 22, was developed by Robert Mundell. All three won Nobel Prizes.
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334 Chapter 18 ■ Spending and the Exchange Rate in the Keynesian Model

FIGURE 18.2
Dilemma: External Balance or Internal Balance?
Panel (a) shows how the government, using just fiscal policy, can attain either a zero trade balance
at point X or full employment at N, but not both. Panel (b) shows how the government, using just
exchange rate policy, again can attain either one goal at B or the other at N, but not both.

(a) Fiscal Policy (b) Exchange Rate Policy

TB TB

NS – I

+ NS ′ – I + NS – I

0 Y 0 Y
– X Y – X Y B
X′ – M
N N

X–M X–M

Obviously, to attain balance in both sectors, both policies must be used together. The
case depicted in Figure 18.2 requires an intermediate exchange rate policy together
with an intermediate fiscal policy.
Heavy use has been made of Figure 18.2, the diagram of income and the trade bal-
ance, with one schedule that holds for a given level of government expenditure and
another that holds for a given level of the exchange rate. Now the situation will be
inverted, shifting to a diagram of expenditure and the exchange rate, with one schedule
that holds for a given level of income and another that holds for a given level of the
trade balance. Same model, new graph.
Assume that, by coincidence, the starting point is a position of both external and
internal balance, point A in Figure 18.3(a). To begin, consider external balance. If the
government increases expenditure, it must also devalue to maintain external balance,
as at point B. Otherwise, it will go into deficit. For trade balance equilibrium to hold,
G and E must vary together: Higher expenditure must be accompanied by a higher
exchange rate. This means that the combinations of G and E that imply external bal-
ance in Figure 18.3(b) are represented by an upward-sloping line: the BB schedule.
It is quite likely that the economy is at a point off the line BB. At any point, F, that
is below and to the right of BB, E is too low or G too high for external balance. This is
a point of trade deficit. Total expenditure is too high, or too large a fraction of expendi-
ture falls on foreign goods. It is necessary to reduce expenditure (cut G) or switch
expenditure toward domestic goods (raise E) to return to balanced trade. Similarly, at
any point, S, above and to the left of BB, E is too high or G too low, for external bal-
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18.2 ■ Expenditure-Switching and Expenditure-Reducing Policies 335

FIGURE 18.3
Policy Combinations That Give External Balance
After a fiscal expansion, there must also be a devaluation if the trade balance is to be restored to
its original level. In panel (a), the axes represent the policy goals. In panel (b), the axes represent
the policy instruments.

(a) (b)

TB E

NS – I BB
S
B

NS ′ – I
+
Y Deficit
0 Y A F
– A B

F
X′ – M

X–M
0
G

ance. This is a point of trade surplus. G would have to be increased or E reduced, to

return to balanced trade. Only under a floating exchange rate regime will the economy
necessarily be on the BB line. In that case, the exchange rate adjusts automatically,
so as to maintain an external balance. Under fixed rates it is possible to be anywhere
on the graph.
Now consider internal balance. Return in Figure 18.4(a) to point A and the exer-
cise of an increase in government expenditure. Now observe, however, that the govern-
ment will have to revalue if it wants to maintain internal balance, as at point N.
Otherwise, the economy will suffer from excess demand. To stay at the same level of
demand, output, and employment, G and E must vary inversely: Higher expenditure
must be accompanied by a lower exchange rate. This result yields the YY schedule in
Figure 18.4(b). The combinations of G and E that imply internal balance are repre-
sented by a downward-sloping line.
Again, it is perfectly possible that the economy is off the line YY. At any point, F,
above and to the right of YY, the exchange rate E is too high, or too large a fraction of
expenditure falls on domestic goods. It is necessary to reduce expenditure (cut G) or
switch expenditure toward foreign goods (reduce E) if the country is to return to
potential output. Similarly, at any point, U, below and to the left of YY, E is too low or
G is too low for internal balance. This is a point of excess supply or unemployment. G
or E would have to be increased to return to full employment. In general, there is no
reason necessarily to be on the YY line.
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336 Chapter 18 ■ Spending and the Exchange Rate in the Keynesian Model

FIGURE 18.4
Policy Combinations That Give Internal Balance
After a fiscal expansion there must also be a revaluation of the currency if the level of output is
to be restored to its original level. In panel (a), the axes represent the policy goals. In panel (b),
the axes represent the policy instruments.

(a) (b)

TB E

Y
NS ⫺ I

NS ⬘ ⫺ I
⫹ F
Y A Excess
0 Y
demand
⫺ A

F U N
Y
N

X⬘ ⫺ M X⫺M 0
G

Figure 18.5 shows the BB and YY schedules together, in a graph known as the
Swan diagram.3 There are four zones. Zone I indicates a combination of trade deficit
and excess demand, Zone II a deficit and unemployment, Zone III a trade surplus and
unemployment, and Zone IV a surplus and excess demand. There is only one point of
full equilibrium, A. Again, both tools are needed to attain it. For example, many coun-
tries find themselves at a point like P1: deficit and unemployment. They could raise G
to reach full employment at the expense of a greater deficit or cut back G to attain bal-
anced trade at the expense of greater unemployment. The correct strategy is to cut G
and devalue, attaining internal and external balance simultaneously at A. Of course,
policy-making is not always this easy in practice. For example, the symptoms at point
P2 are the same, deficit and unemployment, and yet the correct strategy here is to
devalue and raise G. In practice, this might only be discovered by experimentation:
devaluing and then waiting to see what happens before deciding whether to change
expenditure. (Appendix B carries this analysis further.)

3
The Swan diagram was invented by Trevor Swan, “Longer-run Problems of the Balance of Payments,” 1955;
reprinted in R. Caves and H. Johnson, eds., Readings in International Economics (Homewood, IL: Richard
Irwin, Inc., 1968): pp. 455–464. It was further developed in W. Max Corden, “The Geometric Representation of
Policies to Attain Internal and External Balance,” Review of Economic Studies, 28 (1960): pp. 1–22.
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18.3 ■ Monetary Factors 337

FIGURE 18.5 E
The Swan Diagram of Y
Internal and External B
Balance IV
The BB schedule shows the
combinations of spending, G,
and the exchange rate, E, that Excess
give the desired trade balance. N1 demand
B1
The YY schedule shows the Surplus
combinations that give the
desired level of output. Only
by deliberately using both III A I
independent policy instruments
could the government attain B2
both policy goals at point A. N2
Unemployment

II
Trade deficit
B
P2 P1 Y
0
G

18.3 Monetary Factors

The discussion of policies to change the level of expenditure has so far focused on fiscal
policy. However, it is easy enough to put monetary policy into the Keynesian model.
The mechanism of transmission from the money supply to income is the interest rate.
Assume that expenditure, in particular, investment—which has been treated previously
as exogenous—is now a decreasing function of the interest rate. The interest rate is the
cost of borrowing to firms. If it falls, firms are more likely to undertake investment pro-
jects. Households may raise their expenditure as well and so reduce savings. Residential
construction and purchases of consumer durables (automobiles, household appliances,
and so forth) are often particularly sensitive to interest rates.
Figure 18.6 shows how a decrease in the interest rate shifts the NS 2 I line down.
Equilibrium occurs at a higher level of income, Y2 . Y1. Thus an inverse relationship
between the interest rate and income is traced out, describing equilibrium in the goods
market. This relationship is none other than the IS curve, from the familiar closed-
economy IS-LM analysis of intermediate macroeconomics courses.
What would make the interest rate fall to begin with? The obvious answer is mon-
etary policy. The central bank usually sets the interest rate directly. In the 1980s, how-
ever, it was more common to treat the central bank as setting the money supply. The
interest rate then adjusted to equilibrate the money supply with money demand.
Individuals balance their portfolios between money and other assets, such as stocks
and bonds. Their demand for money is a decreasing function of the rate of return on
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338 Chapter 18 ■ Spending and the Exchange Rate in the Keynesian Model

FIGURE 18.6 TB
Effect of a Fall in the Interest Rate, I NS – I 1

If monetary policy lowers the interest rate

from i1 to i2, then it stimulates investment NS – I 2
from I1 to I2. The saving-investment line shifts + Y1 Y2
out, raising the level of income from Y1 to Y2. 0 Y
This inverse relationship between i and Y is –
the IS curve.

X–M

i1

i2

IS
0 Y1 Y2 Y

alternative assets, represented by the interest rate. Yet even though money pays no
interest, people must hold some to undertake transactions. The demand for real money
balances is thus an increasing function of real income. If income were to go up, and
nothing else changed, the demand for money would go up. For a given real money sup-
ply, to maintain equilibrium in the financial markets (demand equals supply) something
else must change: The interest rate must rise to make bonds more attractive and money
less attractive. Only then will money demand be equal to the existing money supply.
Thus the lower part of Figure 18.7 traces a positive relationship between the interest
rate and income, describing equilibrium in the financial market. For a given real money
supply, the two variables must move together, precisely because they have offsetting
effects on money demand. This relationship is the familiar LM curve. The intersection
of the two curves, IS and LM, gives the equilibrium level of income and interest rate.
Notice that there is a unique critical level of income that implies a zero trade bal-
ance, Y1, in the upper panel of Figure 18.7. Anywhere to the right of Y1 is a point
of trade deficit because imports are too high. Anywhere to the left of Y1 is a point of
surplus because imports are too low. An expenditure-switching policy that shifts the
X 2 M line will change the critical level of income consistent with TB 5 0.
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18.3 ■ Monetary Factors 339

FIGURE 18.7 TB
Monetary Expansion NS – I

The upward-sloping LM curve gives equilibrium

in the money market. An increase in the money NS – I ′
supply shifts the LM curve out, driving down +
E
the interest rate, i, at point M, and as a result 0 Y
increasing income, Y. The trade balance – Y1 M
worsens.

X–M

i TB = 0
LM
LM ′

Deficit
M

IS
0 Y1
Y

Monetary Expansion
The following analysis will begin from a point where the equilibrium level of income
given by the IS-LM intersection also implies a zero trade balance, point E in Fig-
ure 18.7. We will consider in turn the effects of three policy changes: a monetary expan-
sion, a fiscal expansion, and a devaluation.
The monetary expansion shifts the LM curve to the right. For the higher money
supply to be willingly held, either the interest rate must fall or income must rise. In fact,
both happen; the interest rate falls and stimulates investment and thus income. The
new equilibrium occurs at point M. Because this is to the right of the TB 5 0 point,
clearly the higher level of expenditure stimulated by the expansion has pushed the
country into trade balance deficit.

Fiscal Expansion and Crowding-Out

Figure 18.8 depicts an increase in government expenditure, DG. The fiscal expansion
shifts the IS curve to the right: Any given interest rate and consequent level of invest-
ment, which previously implied a particular level of income, now imply a higher level of
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340 Chapter 18 ■ Spending and the Exchange Rate in the Keynesian Model

FIGURE 18.8 TB
Fiscal Expansion with Crowding-Out
of Investment
An increase in spending shifts the IS curve
to the right by the amount of the simple +
E
Keynesian multiplier. However, the actual 0 Y
increase in income is somewhat less than F
–
this, at point F, because an increase in the
demand for money drives up the interest rate
and crowds out investment.
X–M

i TB = 0
LM

Deficit
F

E
∆G
s+m

IS ′

IS
0
Y

income. In fact, the distance that the fiscal expansion shifts the IS curve to the right can
be precisely stated. The simple Keynesian multiplier analysis of Section 17.1 showed
that, for a given interest rate, income increases by DY 5 s 11 mDG (Equation 17.9).
Previously, that formula was the complete answer to the question of how much income
increases because the interest rate was assumed to be constant. Now it only answers
the question of how much the curve shifts because the interest rate is no longer neces-
sarily constant. The increases in expenditure and income raise money demand, forcing
the interest rate up, which in turn discourages private investment. The new equilibrium
occurs at point F. Income is still higher than at point E, but some of the effect of the fis-
cal expansion has been offset by the crowding-out of investment. The overall effect on
income is somewhat less than the full open-economy multiplier effect.4

4
The NS 2 I schedule has not been explicitly drawn in the upper half of Figure 18.8. It initially runs through
point E. Then the fiscal expansion shifts it to the right, by DG / (s 1 m), and the increase in i immediately shifts
it part of the way back to the left. It ends up intersecting the X 2 M line at point F.
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18.3 ■ Monetary Factors 341

Notice that the economy is again in trade deficit at point F because of higher
imports. In this model, monetary and fiscal expansions operate in the same way. Both
raise expenditure, thus raising income and worsening the trade balance. They differ
only in their implications for the composition of the given level of output, a monetary
expansion favoring private investment and a fiscal expansion favoring government
spending (or, in the case of a tax cut, favoring consumer spending).
1-page attachment on ZLB
The Liquidity Trap and Japan in the 1990s appears at bottom of page.
The Keynesian model omits such concerns as inflation and government borrowing.
Many a country has justified a fiscal expansion as a supposedly temporary measure
aimed at counteracting a recession, only to be stuck for years thereafter with an unsus-
tainable buildup in debt, entrenched inflation, and high interest rates. For such reasons,
the Keynesian model is generally regarded as a poor guide to fiscal policy-making in
practice, perhaps even as obsolete.
The example of Japan in the 1990s, however, illustrates that the Keynesian model
is still relevant. Bubbles in the Japanese stock and real estate markets in the late 1980s
collapsed after 1990, leading to a period of deflation, unemployment, and slow growth.
Despite a decade of recession, almost reminiscent of the Great Depression of the
1930s, goods prices in Japan did not decline enough to restore equilibrium.
Furthermore, the response of the Japanese economy to monetary and fiscal policy
suggested that it may have been caught in a rare case of a liquidity trap. In an effort to
stimulate the economy, the Bank of Japan lowered interest rates, virtually to zero. After
that, further reductions in interest rates were not possible. This is the definition of a liq-
uidity trap; further increases in the money supply are simply absorbed by the public
without bringing about a reduction in the interest rate. In terms of Figure 18.8, the
LM curve becomes completely flat, like the horizontal dotted line that runs through
point E.
The liquidity trap has two strong implications for policy. First, monetary policy
becomes ineffective. A monetary expansion still “shifts the LM curve to the right,” but
because the curve is flat in this range, there is no stimulus to the demand for goods.
Thus the Bank of Japan declared in the late 1990s that no further stimulus to output
was possible. Second, fiscal policy becomes more effective. Because the LM curve is
flat, there is no increase in the interest rate to crowd out private spending as at point F;
instead the full multiplier effect shows up.
In 1997 the government of Japan raised taxes, out of concerns that accumulating
fiscal deficits were saddling the next generation with rising levels of debt. Unfortu-
nately the immediate effect was to reduce consumption and send the economy into a
renewed recession. The multiplier effect was alive and well.

Devaluation and Crowding-Out

We now turn from the two kinds of policies affecting the level of expenditure to an
expenditure-switching policy, devaluation. Figure 17.2 showed that, assuming the
Marshall-Lerner condition holds, a devaluation shifts the X 2 M line up by some
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342 Chapter 18 ■ Spending and the Exchange Rate in the Keynesian Model

FIGURE 18.9 TB
Devaluation with Crowding-Out
A devaluation shifts the IS curve to the right D
by the amount of the simple Keynesian L
multiplier (at point L). However, the actual +
E
increase in income is somewhat less than 0 Y
this because investment is crowded out –
at D. The trade balance improves. X′ – M

X–M

i ( TB = 0) ( TB = 0) ′
LM

D Surplus

L
E
∆X
s+m

IS ′

IS
0
Y

positive amount, called DX. For any given level of investment, equilibrium occurs at a
higher level of income. Thus, for any given interest rate, the equilibrium point in the
lower panel of Figure 18.9 shifts to the right. From Section 17.1, it is even possible to
state by how much it shifts to the right: For a given interest rate, DY 5 s 11 mD X. The
actual overall effect on Y is less, as can be seen at the new IS-LM intersection, point D.5
Like the increase in demand from the government sector, the increase in demand from
the foreign sector raises output, but the effect is partly offset by the investment
crowded out by higher interest rates.
Despite the move to the right, point D brings a trade surplus, not a trade deficit. As
shown in the upper panel in Figure 18.9, the critical level of income that implies a zero
trade balance has shifted to the right. Furthermore, the TB 5 0 line has shifted to the
right by more than the IS curve. How do we know this? Imagine for a moment a per-

5
In terms of the upper panel, the NS 2 I schedule has shifted to the left (again because of the increase in i), so
that it intersects X9 2 M at D.
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18.4 ■ Summary 343

fectly flat LM curve (the liquidity trap), such that the devaluation causes a move to
point L. Section 17.1 showed that the trade balance would improve, by
DTB 5 DX 2 mDY
1
5 DX 2 m DX
s1m
s
5 DX . 0
s1m
The marginal propensity to import times the increase in income is only a partial offset to
the improvement in the trade balance. When the LM curve has some slope, the change
in the trade balance is still DTB 5 DX 2 mDY, but now crowding-out means that DY is
smaller than the simple multiplier formula indicates. The marginal propensity to
import has even less of an offsetting effect on the trade balance. If there is a surplus at
L, there is an even greater surplus at D. This proves that the vertical TB 5 0 line shifts
right by more than income increases, leaving D to the left of the new line.6 Intuitively,
income would not have increased in the first place if devaluation did not, on net, stimu-
late the trade balance.
This section has shown how the effectiveness of fiscal expansion or devaluation in
stimulating demand is reduced by crowding-out, and how monetary expansion is an
alternative policy for stimulating expenditure. Most of this closely resembles material
covered in an intermediate, closed-economy macroeconomics course. Opening the
economy up to foreign trade has merely appended the trade balance as a function of
income.

18.4 Summary
This chapter used the Keynesian model developed in Chapter 17 to study two types of
exogenous policy changes: expenditure-switching policies such as devaluation, and
expenditure-reducing (or expenditure-increasing) policies such as government spend-
ing. It also examined the effects of changes in such policy instruments on the two policy
targets: internal balance (GDP at the full-employment level, for example) and external
balance (the trade balance at zero, for example). A general principle was demon-
strated: If a country is to attain both policy targets, the government must use two inde-
pendent policy instruments, such as fiscal policy and the exchange rate.
A second lesson concerned the regime of floating exchange rates, in which the
value of the currency adjusts automatically to equilibrate the balance of payments.
Under a regime of fixed rates, disturbances are transmitted from one country to
another. However, a regime of floating rates helps insulate countries from each other’s
disturbances because the exchange rate ensures that the balance of payments is zero.7

6
The TB 5 0 schedule shifts to the right by DX / m. (In other words, only if mDY 5 D X is TB unchanged.)
However, as can be seen in the figure, the IS curve shifts to the right by a smaller amount: D X / (s 1 m).
7
This chapter continues to assume the absence of international financial flows, so the overall balance of pay-
ments is the same as the trade balance. Part V will introduce capital flows; one consequence will be that float-
ing exchange rates do not provide complete insulation.
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344 Chapter 18 ■ Spending and the Exchange Rate in the Keynesian Model

A third lesson was that crowding-out effects via the domestic interest rate, which
must be taken into account if the central bank keeps the money supply constant,
decrease the effect of a fiscal expansion on domestic income.
The chapter concluded by introducing monetary policy into the model for the first
time, thus leading to the subject of Chapter 19.
Chapter 19 will return to the IS-LM graphs to analyze the effects of reserve flows,
and Chapter 22 will explore the effects of international capital mobility. Chapter 22 will
also present greater synergy between the financial markets and the foreign sector. The
existence of a balance-of-payments surplus or deficit will ultimately have much wider
implications for the entire economic system in those chapters.

CHAPTER PROBLEMS

1. Output is given by
Y 5 C 1 I 1 G 1 TB
where consumption (C), disposable income (Yd), investment (I), government expendi-
ture (G), and the trade balance (TB) are given as follows:
C 5 C 1 (1 2 s)Yd
Yd 5 Y 2 tY
I5I
G5G
TB 5 X 2 (M 1 mYd)
This model differs from Section 17.1 by the introduction of t, the marginal tax rate.
a. i. Solve for the equilibrium level of income Y0 as a function of exogenous
variables.
ii. What is the open-economy fiscal multiplier, DY0 / DG? Is it larger or
smaller than the multiplier in a closed economy, 1 / s? What is the intuitive
explanation?
iii. Is the multiplier larger or smaller than the open-economy multiplier in
Section 17.1? What is the intuitive explanation?
iv. What is the effect on the trade balance, DTB / DG?
b. Assume that export demand increases exogenously by DX—for example,
because of a devaluation that raises exports by DX 5 eDE (think of e as the
export elasticity times X / E)—and has no direct effect on imports in domestic
currency (import elasticity is 1).
i. What is the effect on income, DY / DX?
ii. What is the effect on the trade balance, DTB / DX? How does this answer
compare with the elasticities approach and why?
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Chapter Problems 345

iii. Assume (just for this question) that floating exchange rates are in effect so
that E always increases by the amount necessary to guarantee TB 5 0. What
is the floating-rate fiscal multiplier, DY0 / DG? How does it compare with the
fixed-rate and closed-economy multipliers in Problem a(ii)? What is the effect
of a fiscal expansion on the exchange rate, DE / DG?
2. This question concerns the relative virtues of the regimes of fixed and floating exchange
rates in automatically stabilizing real growth in the economy. Assume that the goal is to
minimize Variance (DY) in the presence of domestic disturbances DA and foreign dis-
turbances DX (which are assumed to be independent of each other). The variance is a
measure of variability that has the following three properties in general.
Variance (au) 5 a2 Variance (u)
Variance (b 1 v) 5 Variance (v)
Variance (u 1 v) 5 Variance (u) 1 Variance (v)
where a and b are parameters, or exogenous variables, and u and v are independent
disturbances. Assume the simple Keynesian model of Section 17.1.
a. i. How does Variance (DY) depend on Variance (DA) and Variance (DX) under
fixed exchange rates?
ii. Under floating exchange rates?
b. i. Which regime would be preferable if the variance of foreign disturbances is
much larger than the variance of domestic disturbances?
ii. Which would be preferable if the two kinds of disturbances are similar in
magnitude, and the country is very open (m is large)? Which is a better candi-
date for a fixed exchange rate, Australia or Luxembourg?
3. Compute the ratio of the slope of the internal balance line, YY, to the slope of the
external balance line, BB:

(DE/ DG) 0 Y5Y

(DE/ DG) 0 TB50

(Hint: The numerator refers to the change in E that is required to offset a given change
in G, in such a way as to leave Y at the original level of Y; it is given by

^
DY DY
2
DG DE
The logic applies analogously to the denominator.) How is this ratio relevant to the
assignment problem of Appendix B?
4. Choose a country. Read recent articles about its macroeconomy in the Financial Times
or the Economist. Where on the Swan diagram (Figure 18.5) do you think this country
falls?

Extra Credit
5. In this question the interest rate is allowed to vary. (Think of it as having been held con-
stant by monetary policy in the preceding problems.) In the preceding model, replace
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346 Chapter 18 ■ Spending and the Exchange Rate in the Keynesian Model

the exogenous specification for investment, I, with an equation in which it depends

inversely on the interest rate, i:
I 5 I 2 bi
and add an equation for the demand for money. (We now use M to stand for money.)
M / P 5 KY 2 hi
a. Derive the IS curve, giving Y as an inverse function of i. [For notational simplicity,
use a to denote the answer to 1a(ii).]
b. Combine your answer to 1a with the LM curve (the money demand equation, with
real money demand M / P equal to the exogenous real money supply M / P) to
solve for Y as a function of exogenous variables. Solve for i as well.
c. What is the fiscal multiplier DY / DG now? How does it compare with the answer
to 1a(ii) (call it a), and why? What happens if h is very high (i.e., money demand is
very sensitive to i)?
d. What is the monetary multiplier DY / D(M / P)? What happens if h is very high?

SUGGESTIONS FOR FURTHER READING

Johnson, Harry. “Toward a General Theory of the Balance of Payments” (1958).

Reprinted in Jacob Frenkel and Harry Johnson, eds., The Monetary Approach to the
Balance of Payments (Toronto: University of Toronto Press, 1976). The first half
interprets the absorption approach (TB 5 Y 2 A) as pointing the way to the mone-
tary approach to the balance of payments by emphasizing reserve flows.The second
half develops the distinction between expenditure-switching and expenditure-
reducing policies.
Krugman, Paul. Adjustment in the World Economy, Occasional Paper No. 24 (New
York: Group of Thirty, 1987). Argues, using the logic of the transfer problem, that
the U.S. trade deficit should not be eliminated by U.S. fiscal contraction alone, or
even together with foreign fiscal expansion. Depreciation of the dollar is also
needed.
Posen, Adam. Restoring Japan’s Economic Growth (Washington, DC: Institute for
International Economics, 1998). The experience of Japan in the 1990s suggests that
the Keynesian model is not dead.

APPENDIX A

The Laursen-Metzler-Harberger Effect

When a devaluation worsens the terms of trade, there may be real consequences
beyond the simple fact that purchasing power has fallen. This observation leads to the
Laursen-Metzler-Harberger effect.
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Appendix A 347

Expenditure and the Terms of Trade

Up to now,we have assumed that the marginal propensities to save and consume are spec-
ified in domestic terms. (In Equation 17.3, C and Y were both defined in domestic value
units.) This has meant that a change in the terms of trade between domestic output and
foreign output has had no effect on the NS 2 I schedule when the horizontal axis mea-
sures income in domestic terms, as in Figure 17.2. An increase in the exchange rate has
affected only the X 2 M line, shifting it up if the Marshall-Lerner condition is satisfied.
One implication has been that the Marshall-Lerner condition is the necessary and suf-
ficient condition for a devaluation to improve the trade balance. The change in income,
and therefore imports, reduces the effect on the trade balance but does not reverse it.
However, there is little justification in theory for measuring income in domestic
terms when determining saving. When the exchange rate rises, the terms of trade
worsen. (The terms of trade are defined as the price of exports divided by the price of
imports.) Any level of income given in domestic terms translates into less when mea-
sured in terms of foreign goods, or in terms of the appropriate consumption-weighted
basket of domestic and foreign goods. If consumption, saving, and imports were pro-
portional to income, it would not matter what numeraire we used for measurement. In
the Keynesian model, however, a fall in income is hypothesized to induce consumers to
reduce their consumption less than proportionately. In other words, the elasticity of
consumption with respect to income is less than 1:
DC/ DY c
5 ,1
C/Y (C 1 cY) /Y
It is argued that a fall in real income, even if it results from a worsening in the
terms of trade rather than from a fall in domestically measured income, should be
reflected in a similar less-than-proportionate fall in real spending. If measurements are
made in domestic terms, this is reflected as an increase in spending, or a decrease in
saving, for any given level of income domestically measured. In other words, an
increase in the exchange rate, in addition to shifting the X 2 M schedule up, shifts the
NS 2 I schedule down, as in Figure 18.A.1. Consumers reduce their savings to main-
tain living standards in the face of the worsened terms of trade. This terms-of-trade fac-
tor is called the Laursen-Metzler-Harberger effect.

The Condition for a Devaluation to Improve the Trade Balance

There are two implications of the Laursen-Metzler-Harberger effect. The first is that
the fall in saving, or increase in expenditure, has a negative effect on the trade balance.
Thus the trade balance could go into deficit (depending on the elasticities) even if the
Marshall-Lerner condition is satisfied. That is the way Figure 18.A.1 is drawn. If we
recall that the trade balance is equal to saving minus investment, it is intuitively clear
why the Laursen-Metzler-Harberger effect would work to reduce the trade balance
when it works to reduce saving.
Evidently the necessary condition for a devaluation to improve the trade balance
is more stringent than
eX 1 eM . 1
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348 Chapter 18 ■ Spending and the Exchange Rate in the Keynesian Model

FIGURE 18.A.1 TB
Increase in the NS – I
Exchange Rate with
the Laursen-Metzler-
Harberger Effect
As usual, the devaluation
shifts the X 2 M line up. NS ′ – I
If the saving rate depends
not just on income
measured in domestic
terms, Y, but also on the +
terms of trade, then the 0 Y
NS 2 I line shifts down as – A
households seek to protect L
their standard of living.

X′ – M

X–M

In the two-country context the necessary condition is

eX 1 eM . 1 1 m 1 m*
This condition will not be derived.8 Note, however, that in addition to the price effects
of the devaluation, the stimulus to domestic real income from increased exports will
raise imports to an extent that depends on the domestic marginal propensity to import,
and the fall in foreign real income from the fall in foreign exports will lower their
imports to an extent that depends on the foreign marginal propensity to import. Thus
the effect of the devaluation depends on the magnitudes of the elasticities compared to
the marginal propensities to import.

Implications for Transmission Under Floating Rates

The second implication of the Laursen-Metzler-Harberger effect has to do with the
question considered in Section 18.1, of the international transmission of disturbances.9
This is illustrated in Figure 18.A.2, with the economy initially at point A. It is no longer

8
The condition for a devaluation to improve the trade balance was originally derived by Arnold Harberger,
“Currency Depreciation, Income and the Balance of Trade,” Journal of Political Economy (February 1950):
1147–1160.
9
The transmission of disturbances that occurs despite floating exchange rates was the motivation behind the
original paper, Svend Laursen and Lloyd Metzler, “Flexible Exchange Rates and the Theory of Employment,”
Review of Economics and Statistics, 32 (November 1950): 281–299.
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Appendix A 349

FIGURE 18.A.2 TB
External Disturbance NS – I
Under a Floating
Exchange Rate NS ′ – I
In the presence of the
Laursen-Metzler-Harberger
effect, a fall in foreign
demand can actually raise
domestic output. The
reason is that the domestic
currency depreciates, +
which causes saving to 0 Y
shift down. – A C

X′ – M

X–M

true that a floating exchange rate completely insulates domestic output and employ-
ment from foreign disturbances. As before, a fall in exports due, for example, to a for-
eign contraction, leads to a depreciation to prevent the trade deficit that would
otherwise emerge at point B in Figure 18.A.2. In the standard Keynesian model, the
depreciation would increase exports and reduce imports, causing a return (instanta-
neously) to point A. With the Laursen-Metzler-Harberger effect, however, the wors-
ened terms of trade cause saving to fall. Thus the NS 2 I line shifts down, and a further
depreciation is necessary if the trade balance is to avoid going into deficit. Equilibrium
occurs when the depreciation is sufficient to restore the trade balance to zero despite
the fall in saving, point C in Figure 18.A.2. This point occurs at a higher level of income
than A, even though the chain of events began with a contraction of foreign income.
The disturbance is transmitted in reverse.

Temporary Versus Permanent Shifts in the Terms of Trade

The Keynesian consumption function on which the Laursen-Metzler-Harberger effect
is based cannot be applied to long-run permanent changes in real income.When there is
an adverse shift in the terms of trade, or any other reduction in real income, consumers
can only reduce saving (or borrow) to maintain expenditure levels if conditions are
expected to improve in the future, allowing the consumers to make up the lost savings
(or pay back the loan). It has long been recognized that the marginal propensity to con-
sume out of a permanent change in real income is higher than the marginal propensity
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350 Chapter 18 ■ Spending and the Exchange Rate in the Keynesian Model

to consume out of a temporary change in income. The latter will be close to zero in the
limit of a very short-lived change in real income, which has no effect on a rational indi-
vidual’s expectation of lifetime wealth or permanent income, and thus no effect on con-
sumption plans.10
It is reasonable to think of standard Keynesian propensities to consume and save
as applying in the intermediate case, in which a change in real income is observed but is
not known to be necessarily either temporary or permanent. Thus the Laursen-
Metzler-Harberger effect applies in this general, intermediate case. It should be modi-
fied, however, if there is additional information on the permanence of the change.11
One illustration was the sharp increase in the price of oil in 1973. For an oil-
importing country, this was an adverse shift in the terms of trade analogous to a deval-
uation. One might have expected all oil-importing countries to incur large trade
deficits because of the increase in their oil import bills. Yet the industrialized country
that ran the largest deficit was Norway, which had North Sea oil reserves it could
develop in the future. The Norwegians knew that their real income loss was temporary
and that they would be wealthier in the long run. Accordingly, they reduced saving rel-
ative to investment, borrowing from the rest of the world to finance the development
of their oil reserves. Norway’s current-account balance declined by 7 percent of GDP
from the period 1965 to 1973 to the period 1974 to 1979. Other oil importers who had
little prospect that their loss in real income would be temporary had no choice but to
adjust. The United States and Germany each had no change in their current-account
positions between the two periods. They increased exports of other goods to pay for
the higher oil import bill.

APPENDIX B

The Assignment Problem

Imagine a decentralized government in which the central bank determines the
exchange rate and the treasury determines fiscal policy, and the two bodies do not
coordinate policy effectively. Which agency, the central bank that sets E or the treasury
that sets G, should be responsible for external balance and which for internal balance?
This question is known as the assignment problem.

10
These ideas regarding the consumption function began with Milton Friedman’s permanent income hypothe-
sis and Franco Modigliani’s life-cycle hypothesis. The appendix to Chapter 21 shows that a country of optimiz-
ing consumers will borrow from abroad if it can expect income to be higher in the future than today.
11
The theory is updated to include explicit intertemporal utility maximization by consumers in Maurice
Obstfeld, “Aggregate Spending and the Terms of Trade: Is There a Laursen-Metzler Effect?” Quarterly Journal
of Economics, 96 (May 1982); and Lars Svensson and Assaf Razin, “The Terms of Trade and the Current
Account: The Harberger-Laursen-Metzler Effect,” Journal of Political Economy, 97, no. 1 (February 1983):
97–125. The first paper makes strong enough assumptions to rule out the Laursen-Metzler-Harberger effect.
CAVE.6607.cp18.p327-352 6/6/06 12:09 PM Page 351

Appendix B 351

Consider the consequences of assigning external balance to the central bank and
internal balance to the treasury. Call this assignment Rule 1. Whenever the trade bal-
ance is in deficit, the bank raises E; whenever it is in surplus, the bank lowers E.
Whenever output falls short of full employment, the treasury raises G; whenever it
exceeds full employment, the treasury lowers G. The analysis will be pursued here in
discrete time. Assume that the two agencies take turns. For example, the budget is
drawn up and enacted only at yearly intervals, and the exchange rate is changed only in
periodic devaluations or revaluations.
Start from point P1 in Figure 18.5. Let the central bank go first. Because of the
trade deficit, Rule 1 tells the bank to devalue until balanced trade is reached at B1.
Now the stimulus to net exports has moved the economy into the region of excess
demand. When it is time to set the annual budget, Rule 1 tells the treasury to contract
until internal balance is attained at N1. However, the reduction in expenditure has cre-
ated a trade balance surplus. The rule tells the central bank to revalue until balanced
trade is restored at B2. Now, however, unemployment means that the treasury will
expand until reaching full employment again at N2. Once again, a trade deficit tells the
central bank to devalue, and the counterclockwise cycle repeats.
As the graph is drawn, the line spirals in on the equilibrium point, A, where the
goal of simultaneous balance in both sectors is achieved. The reason for spiraling in
rather than spiraling out is that the YY schedule is steeper (in absolute value) than
the BB schedule. This claim can be demonstrated by making the slopes more extreme.
Try this yourself: Draw the external balance schedule to be much steeper than the
internal balance schedule. When Rule 1 tells the treasury to contract because of excess
demand at point B1, the trade surplus that opens up is larger than the initial imbalance.
When the central bank revalues, the country moves farther away from internal balance
than it was previously. This system is unstable, moving farther and farther from full
equilibrium.
Now try Rule 2. External balance is assigned to the treasury. Whenever the trade
balance is in deficit, the treasury cuts G; whenever it is in surplus, the treasury raises G.
Internal balance is assigned to the central bank. Whenever output falls short of full
employment, the central bank raises E; whenever it exceeds full employment, the bank
lowers E. Starting from a point such as P1, a reduction in G leads to unemployment, an
increase in E, and so forth. The path now progresses around the graph clockwise, not
counterclockwise as under Rule 1. If the YY schedule is the steeper one, as in Figure
18.5, there is a spiral out. Rule 2 does not work. Yet if the BB schedule is steeper, there
is a spiral in to equilibrium. Rule 2 works.
Thus the selection of the assignment rule should be based on the relative slopes of
the schedules. Which case is more likely, a YY schedule that is steeper than the BB
schedule, or one that is flatter? Problem 3 at the end of the chapter involves computing
the relative slopes of the two lines. It turns out that the YY line is steeper only if the
economy is not very open to imports. In that case Rule 1 should be used: Fiscal policy
should be used for internal balance. Otherwise—that is, for an economy that is highly
open—fiscal policy should be assigned to external balance. Intuitively, if the marginal
propensity to import is high, then expenditure-reducing policies are an effective way of
CAVE.6607.cp19.p353-390 6/6/06 12:16 PM Page 353

CHAPTER 19

The Money Supply,

the Price Level, and
the Balance of Payments

I
n Chapter 16, we considered the impact of changes in the exchange rate alone on the
balance of payments. In effect, income was held constant. In Chapter 17 we allowed
income to vary. Similarly, the interest rate was held constant in Chapter 17; then it
too was allowed to vary in Chapter 18. Chapter 19 will continue this pattern of letting
additional macroeconomic variables vary by introducing the price level, which was
assumed constant in the preceding chapters.
The determination of the price level, a monetary variable, had been relatively
neglected until its central importance was pointed out by economists of the monetarist
school of thought. This chapter considers not only changes in the price level but also
changes in a second monetary variable: the central bank’s holdings of international
reserves. These two variables are fundamental to the monetary approach to the bal-
ance of payments. The monetary approach was originally developed in the 1960s, in
large part at the University of Chicago but also at the International Monetary Fund. Its
central point was that the balance of payments is a monetary phenomenon. The mone-
tary approach to the balance of payments was and is often used by the IMF staff when
they must figure out why a country is running a balance-of-payments deficit and what
should be done about it.

19.1 The Nonsterilization Assumption

The monetary approach to the balance of payments is sometimes presented as an
object of controversy, a model in conflict with the previously discussed elasticity and
Keynesian approaches. The controversy is more apparent than real. This chapter will
show that no necessary connection exists between the monetary approach to the bal-
ance of payments and monetarism. The debate between monetarists (or their successor,
the new classical macroeconomists) and Keynesians is a proper object of controversy,
but it is not directly at stake here. The beginning of this chapter will apply the mone-
tary approach within the context of the Keynesian model of Chapter 17. The second
half will show how the price level is determined in the monetarist model.

353
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354 Chapter 19 ■ The Money Supply, the Price Level, and the Balance of Payments

The Definition of Sterilization Operations

What is at stake here is “sterilization.” It is important to understand the difference
between what happens when the central bank practices sterilization of international
reserve flows and what happens when it does not. This distinction is relevant for under-
standing the difference between how major industrialized countries, especially the
United States, conduct monetary policy today, and how it was conducted under the
classical gold standard of the nineteenth century and is to an extent still conducted
today in many small, open economies.
To begin, consider the definition of a country’s monetary base (sometimes called
high-powered money to distinguish it from broader definitions of money such as M1).
The monetary base consists of currency plus other liabilities issued by the central
bank—particularly deposits that government agencies or commercial banks hold at the
central bank. A checking account that an individual holds at his or her commercial
bank is included in M1, but not in the monetary base.
When a country runs a balance-of-payments deficit, its central bank is necessarily
buying the country’s own currency and selling international reserves.1 If the bank takes
no other action, then the monetary base is decreasing. One way of thinking of this is
that there is less domestic currency in the hands of the public.
Another way of thinking of the effect is to recognize an alternate definition of the
monetary base. Define it in terms of the assets held by the central bank: international
reserves (claims against the rest of the world) plus net domestic assets (the central
bank’s holdings of claims against its own government or citizens).

MB ; Res 1 NDA
where MB is the monetary base, Res is reserves, and NDA is net domestic assets, also
known as domestic credit. This definition of the monetary base is identical to the first
because the assets on the bank’s balance sheet must—by the rules of accounting—
add up to the same sum as the liabilities. (As noted earlier, the equality sign is drawn
with three lines for accounting identities.) As detailed in Chapter 15’s discussion of the
balance-of-payments accounts, a country’s overall balance of payments is the same
thing as the current period’s change in the central bank’s international reserves.2
BP ; DRes
If reserves fall in a given year (because the balance-of-payments deficit, DRes, is nega-
tive), and net domestic assets, NDA, are unchanged, then the monetary base, MB, falls
by the same amount.

1
The effect on the level of reserves is the same whether the balance-of-payments deficit arises in the trade bal-
ance or in the private-capital account. That is why we talk of the monetary approach to the balance of pay-
ments, rather than the monetary approach to the balance of trade. Nevertheless, this chapter will continue to
omit capital flows and so will restrict the discussion to the determination of the trade balance. Chapter 22 will
show how the monetary approach to the balance of payments changes in the presence of international capital
movements.
2
Assume here that the country’s currency is not held by other countries’ central banks, so their actions are not
relevant.
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19.1 ■ The Nonsterilization Assumption 355

The central bank sterilizes the reserve outflow if it prevents it from reducing the
domestic money supply. The most standard way of doing this is to create money by
expanding domestic credit at the same rate as the reserve outflow is contracting the
money supply, so there is no net effect. If DNDA 5 2DRes, then DMB 5 0. In the
United States, when the Federal Reserve wishes to expand domestic credit, it does so
through open market operations in which it buys U.S. Treasury securities on the private
market. In this way, any changes in the Federal Reserve’s holdings of reserves are ster-
ilized immediately.
When a country runs a balance-of-payments surplus, its central bank is necessarily
selling its own currency in the foreign exchange market, thus adding to its stock of
international reserves. Again, the central bank sterilizes the reserve inflow if it pre-
vents the increase in reserves from increasing the domestic money supply. The most
obvious way of doing this is to extinguish money by contracting domestic credit so that
no net effect on the total monetary base results. In the United States, the Federal
Reserve sells U.S. Treasury securities on the private market.
Most countries do not have as highly developed bond markets as does the United
States, and open market operations are less feasible. For these countries, expanding
domestic credit may be accomplished by buying securities directly from the treasury,
and so monetizing the budget deficit, or else by extending credit to domestic commer-
cial banks or other enterprises, especially any that may be owned by the government.
In some developing countries, the central bank lends money directly to such enter-
prises as public utilities, industrial development banks, and agricultural cooperatives.
Contracting domestic credit means cutting back on loans to the government, state-
owned enterprises, or the banking system. However, it is usually difficult to control the
budget deficit of the government or state-owned enterprises on short notice. In devel-
oping countries and other countries where the central bank is obligated to finance
these deficits, domestic credit is not a viable tool for sterilization, that is, for offsetting
reserve flows on a short-run basis. An alternative possibility is to allow the high-
powered money supply or monetary base—the liabilities of the central bank—to
change, but to offset the effect on monetary aggregates such as M1. M1 represents the
liabilities of the entire consolidated banking system, including not only claims on the
central bank (such as currency) but also claims on commercial banks (such as checking
accounts). Even on a relatively short-term basis, the central bank can regulate the
amount of credit banks extend to the public—for example, by varying the reserve
requirements to which banks are subject.
In many countries where the central bank has little short-run control over domes-
tic credit, reserve flows simply are not sterilized. In the nineteenth century this was
mostly true of countries that participated in the gold standard. If money is directly
backed with gold, then balance-of-payments deficits are necessarily financed by gold
sales that reduce the domestic money supply: They cannot be sterilized via offsetting
changes in the liabilities of either the central bank or the private banking system.3 A
handful of economies—Hong Kong, Estonia, Lithuania, and Bulgaria—have adopted a

3
Appendix A to this chapter explains the gold standard at somewhat greater length.
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356 Chapter 19 ■ The Money Supply, the Price Level, and the Balance of Payments

monetary institution, called a currency board, which is a sort of modern equivalent of a

strict gold standard. This arrangement requires 100 percent international reserve back-
ing for domestic currency. Thus reserve flows, by legislation, cannot be sterilized.4
If reserve flows are not sterilized, then a balance-of-payments deficit or surplus
implies that the money is, over time, decreasing or increasing. (If DNDA 5 0, then
DMB 5 DRes.) This is bound to have effects on expenditure and the entire system, and
it is the essence of the monetary approach. The monetary approach to the balance of
payments is less applicable to the United States or other major industrialized countries
under the current system than it is to many smaller countries, to which it is sometimes
applied by the IMF.

Hume’s Price Specie-Flow Mechanism

The monetary approach to the balance of payments can be traced back to eighteenth-
century philosopher and economist David Hume. Hume attacked the mercantilists,
who believed that a country’s power depended on amassing gold and silver (specie),
and who thus restricted trade to maximize the inflow of specie through the balance of
payments. Hume, like Adam Smith and other writers of the Enlightenment, believed in
maximizing the welfare of free, atomistic, rational individuals, not the power of an
autocratic state. He believed further that the welfare of the individuals residing in a
country depended on the economy’s productive capabilities, not on the country’s stock
of gold or money. Money goes where it is demanded, which is where goods are being
produced and sold. Assume that a country acquires a new stock of gold but is not espe-
cially productive. (Hume mentioned the example of tribute brought to Spain from the
New World.) Then the country will spend the gold on the goods of countries that are
productive. (Hume had in mind the England of the Industrial Revolution.) The gold
flows out through the balance of payments and will continue to do so until the coun-
try’s gold stock returns to what it was originally.
Hume attributed this process to the price specie-flow mechanism. If a country, pre-
viously in equilibrium, experiences an increase in its gold supply, then in the short run
its price level will be driven up. However, the higher price level will discourage export
demand and stimulate import demand, worsening the trade balance. The correspond-
ing outflow of specie will continue until it, and thus the price level, returns to its origi-
nal level and the trade balance returns to zero. The automatically equilibrating process
is described by Hume in terms that evoke the tendency of physical systems toward
equilibrium.
All water, wherever it communicates, remains at a level. Ask naturalists the reason;
they tell you that, were it to be raised in any one place, the superior gravity of that
part not being balanced must depress it, till it meet a counterpoise; and that the same
cause, which redresses the inequality when it happens, must for ever prevent it, with-
out some violent, external operation.

4
For a balanced description, see John Williamson, “What Role for Currency Boards?” Policy Analyses in
International Economics, 40 (Washington, DC: Institute for International Economics, 1995).
CAVE.6607.cp19.p353-390 6/6/06 12:16 PM Page 357

19.1 ■ The Nonsterilization Assumption 357

Can one imagine, that it had ever been possible, by any laws, or even by any art or
industry, to have kept all the money in Spain, which the galleons have brought from
the Indies? Or that all commodities could be sold in France for a tenth of the price
which they would yield on the other side of the Pyrenees, without finding their way
thither, and draining from that immense treasure? What other reason indeed is there
why all nations, at present, gain in their trade with Spain and Portugal; but because it
is impossible to heap up money, more than any fluid, beyond its proper level?
—David Hume: On the Balance of Trade

Mundell’s Income Reserve-Flow Mechanism

Harry Johnson and Robert Mundell revived Hume’s view in the 1960s under the
name, “the monetary approach to the balance of payments.” They were more specific
about price determination than Hume had been. First we consider Mundell’s income
flow mechanism, under which prices were assumed fixed for Keynesian reasons. This is
simply the Keynesian model of Chapter 18, plus an analysis of the effects over time
under the assumption of nonsterilization of reserve flows. One way to think of the
Keynesian model is with a perfectly flat aggregate supply curve, so that outward shifts
of demand are reflected entirely in output and not at all in price. As already men-
tioned, the assumption of a constant price level will be relaxed later in the chapter. At
that point we will consider the opposite extreme—a perfectly vertical aggregate supply
curve—in which increases in demand are reflected entirely in prices and not at all in
output. Chapter 26 will examine more closely where the aggregate supply curve comes
from and how its slope might be determined at some intermediate position between
flat and vertical.
We consider the effects of a monetary expansion. Given the Keynesian assump-
tion of fixed prices, the monetary expansion does not alter the price level. Instead, the
expansion shifts out the LM curve and raises expenditure and income, thus raising
imports and worsening the trade balance, as was detailed at the end of Chapter 18.
Figure 19.1 is a reproduction of Figure 18.7. The monetary expansion moves the econ-
omy from point E to point M. The deficit at point M means that reserves are declining
over time.
If the central bank sterilizes the reserve outflow, the money supply remains at the
new, higher level. The effect would be to keep income high and the trade balance in
deficit. The central bank could keep the economy at point M indefinitely, or at least
until it exhausts its international reserves. However, assume now that the central bank
is either unable or unwilling to sterilize the reserve outflow. Over time, the reserve out-
flow reduces the money supply. The LM curve gradually shifts back. The effect is that
expenditure and income fall, and the trade balance improves. The process continues as
long as the trade balance is in deficit, which is until the economy returns to E. Once the
trade balance is back at zero, no reason exists for reserves or any other variables to be
changing. Notice that in the long-run equilibrium, income has not changed from what it
was before the monetary expansion. Thus we have a central result under the monetary
approach to the balance of payments: A monetary expansion, although it raises income
and worsens the trade balance in the short run, has no effect on either in the long run.
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358 Chapter 19 ■ The Money Supply, the Price Level, and the Balance of Payments

FIGURE 19.1 TB
NS – I
Effects of a Monetary Expansion
over Time
In the short run, an increase in the money NS – I ′
supply raises output and worsens the trade +
E
balance. If the loss of reserves is not sterilized, 0 Y
however, then the money supply falls over – M
time and output returns to its original level
at E.

TB

i TB = 0
LM
LM ′

Deficit
M

IS
0 Y1 Y

Conversely, a monetary contraction reduces income and improves the trade balance in
the short run but has no effect in the long run. Only continuing growth in the money
supply (in excess of growth in money demand) could cause a continuing deficit.

19.2 The Purchasing Power Parity Assumption

The previous section defined the monetary approach to the balance of payments by
the assumption of nonsterilization. There is a second proposition often associated with
proponents of the monetary approach, however. It is called purchasing power parity
(PPP) and requires the assumption that goods prices are perfectly flexible. Thus the
time has come to consider the determination of the price level.
Unlike the nonsterilization assumption, which is simply appropriate or inappropri-
ate depending on what the central bank does, the assumption of price flexibility is a
bigger issue, one that generates ideological controversy. The issue is similar to the old
Keynesian–monetarist debate in closed-economy macroeconomics. Some writers con-
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19.2 ■ The Purchasing Power Parity Assumption 359

tinue to confuse the monetary approach (nonsterilization) with monetarism (perfectly

flexible prices). However, the difference is clear in a passage written by two of the cen-
tral figures in the area:
The monetary approach to the balance of payments . . . can be readily applied to
conditions of price and wage rigidity and consequent response of quantities—
employment, output, consumption—rather than money wages.5

Indeed the application to price and wage rigidity constitutes Mundell’s income mecha-
nism, developed in the preceding section.
The alternative view, entailed by PPP, is that prices are perfectly flexible and so
markets clear. This assumption is shared by the monetarists and their successors—
those who believe in real business cycles and proponents of other branches of new clas-
sical macroeconomics. These believers in price flexibility adopt the nonsterilization
assumption, but they have a slight quarrel with Hume’s price specie-flow mechanism.
Hume said that a monetary expansion will raise prices and worsen the trade balance,
which will lead to an outflow that in the long run returns the prices to their original
level. The alternative view asks how prices can be higher in one country than another
even in the short run. Why would consumers buy any goods at all from the country with
the higher prices? Would it not suffer an instantaneous trade deficit of unlimited size?

PPP: Definitions
Purchasing power parity, or PPP, is simply the name for the following equation:
P 5 EP*
where E is the exchange rate, and P and P* are the domestic and foreign price levels,
respectively. It could also be written,
E 5 P / P*
We are not ready to draw any conclusions about causality, about whether changes in E
cause changes in P or the other way around. PPP is just a condition, not in itself a com-
plete theory of determination of the price level or the exchange rate.
The equation has a long history. Many economists consider it discredited. Certainly
it is inconsistent with the Keynesian model, in which price levels are not free to adjust
whenever the exchange rate changes. However, some consider it a necessary and logi-
cal consequence of economic rationality. The right answer depends on how one defines
P and P*.6

5
Jacob Frenkel and Harry Johnson, “The Monetary Approach to the Balance of Payments: Essential Concepts
and Historical Origins,” in Jacob Frenkel and Harry Johnson, eds., The Monetary Approach to the Balance of
Payments (Toronto: University of Toronto Press, 1976), p. 25.
6
For a survey of PPP, see Kenneth Rogoff, “The Purchasing Power Parity Puzzle,” Journal of Economic
Literature, 34, no. 2 (1996): 647–648.
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360 Chapter 19 ■ The Money Supply, the Price Level, and the Balance of Payments

Arbitrage and the Law of One Price

If P and P* are defined to be the price, in domestic and foreign currency, respectively,
of the identical good, and if tariffs and transportation costs are low, then the formula is
indeed a logical consequence of economic rationality and competitive markets. Under
this interpretation, the equation is called the law of one price. It is practically a defini-
tion of what it means to be a single good. The law of one price should hold because of
international arbitrage.
When the price of the good in one country begins to rise above the price in
another country (expressed in a common currency), it will become profitable for inter-
mediaries to buy the good in the low-price country, sell it in the high-price country, and
pocket the difference. Such activity is what is meant by arbitrage.
For example, in 1985, when the dollar had appreciated to roughly double its 1980
value against the mark, luxury German automobiles were selling for higher prices in
the United States than in Germany. A so-called gray market developed rapidly, in
which people bought BMWs, Mercedes, and Porsches in Germany and shipped them to
the United States, either to use themselves or to resell. Another example of arbitrage
arose in 1995, when the dollar had depreciated and it was the yen that was at its highest
level in 40 years. Then arbitrage consisted of Japanese visitors to California loading up
on consumer goods that were cheaper than the same goods back home.
Arbitrage will tend to drive the price up in the low-price country, by adding to
demand there, and down in the high-price country, by adding to supply. The process
should continue until the price is equalized in the two countries. Hence the law of
one price.
An interesting question is why the arbitrage in 1985 was not powerful enough to
force retailers of German autos in the United States to lower their prices to match the
lower dollar prices of the autos sold in Germany. Evidently the costs involved in buying
an auto in Germany and shipping it to the United States are large enough that most
American customers preferred to continue buying from authorized dealers despite the
higher price. Part of the explanation is that a BMW bought in Germany is not precisely
the same commodity as a BMW bought from an authorized U.S. dealer. Even leaving
aside the shipping costs, some changes must be made in pollution control equipment to
satisfy U.S. regulations. Furthermore, when consumers buy automobiles from an autho-
rized dealer, one thing they get is a warranty, the ability to have mechanical problems
fixed at no cost. Needless to say, this is difficult to do if the dealer is in Munich.
Such frictions in the arbitrage process sometimes allow exporters to set different
prices in different customer countries. This phenomenon of the firm “pricing to mar-
ket”—setting prices with an eye more on prices of competing products in the customers’
market than on the price of the good in its country of origin—is especially a phenome-
non of the U.S. market. In other countries, exchange rate changes tend to be somewhat
more fully and rapidly passed through to the prices of imports. A possible reason is that
foreign firms in U.S. markets tend to be heavily outnumbered by domestic firms.
Because the law of one price is so basic, we have been implicitly assuming all along
that it holds. In the preceding two chapters even though we assumed that the price of
BMWs produced in Germany was set rigidly in terms of euros (refer to the discussion
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19.2 ■ The Purchasing Power Parity Assumption 361

of Assumption 3 in Section 16.1), we took as given that the price of BMWs in the
United States was simply the euro price times the dollar/euro exchange rate. In other
words, we assumed that arbitrage enforced the law of one price for BMWs, and we will
continue to do so, notwithstanding the anomaly just noted.
This is not as strong as the assumption that the price of American-made auto-
mobiles is equal to the euro price of German automobiles times the exchange rate.
Buicks and BMWs are, after all, different products. Arbitrage between the two does not
operate, given the reasonable assumption that consumers view American and German
automobiles as different products. This fact allows U.S. manufacturers to set their prices
in dollars with some degree of rigidity (at least in the short run), and at the same time
allows German manufacturers to set theirs in euros.

Reasons for Failure of PPP

The term purchasing power connotes a basket of goods rather than a single good. If
identical goods entered the domestic and foreign consumption baskets with identical
weights, and the law of one price held for each good, then PPP would necessarily follow.
We will use P and P* to refer to actual price indices in use, such as the producer
price index (PPI) or consumer price index (CPI). Such indices inevitably refer to dif-
ferent baskets of goods in different countries, which immediately allows the possibility
that the equation P 5 EP* will fail to hold. Note that aggregate price indices are
expressed relative to a base year (e.g., 2000 5 100) rather than in absolute dollar or
pound terms. Thus the concept here is known as “relative PPP,” rather than “absolute
PPP.”7 Relative to the base year, the domestic price goes up by the same percentage as
the foreign price level plus the percentage change in the exchange rate. If a bushel of
wheat or a ton of steel is now—and in the past has always been—more expensive in
France than China, this will not show up in the calculations of relative PPP. In other
words, the equation P 5 EP* holds only up to a multiplicative constant. For conve-
nience, the multiplicative constant usually is not shown explicitly. Another way of stat-
ing the proposition that relative PPP holds is to say that the real exchange rate, defined
as EP* / P, is constant over time.
There are four reasons why purchasing power parity can fail to hold. Each is asso-
ciated with its own typical pattern of movement in the real exchange rate.

1. Tariffs and transportation costs create a band in which prices can fluctuate
before arbitrage becomes profitable. Only if the price in one country exceeds the price
in the other by more than the size of any tariffs, other trade barriers, and shipping costs,
will arbitrage start to operate. We might rescue the law of one price by claiming that a

7
It is difficult to get the data necessary for computing absolute PPP; we cannot use standard statistics on price
indices that governments publish as we can when computing relative PPP. It means sending a team of
researchers to different countries to sample the prices of a standardized set of goods. Absolute price indices
are reported in the Penn World Tables. See Irving Kravis and Robert Lipsey, “Toward an Explanation of
National Price Levels,” Studies in International Finance, 52 (1983).
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362 Chapter 19 ■ The Money Supply, the Price Level, and the Balance of Payments

bushel of wheat delivered in New York City at noon on a particular day is a different
good than a bushel of wheat delivered in London, or delivered on a different day.
(Contracts for spot or forward delivery of agricultural and mineral commodities do, in
fact, specify time and place, and the price can vary accordingly, especially if there are
substantial tariffs or transportation costs.) In any case, PPP is defined to apply to price
indices that aggregate together, not only wheat, but all goods, so these geographical
factors clearly allow deviations from PPP. Figure 19.2(a) represents these deviations as
fluctuations of the real exchange rate within a band. The width of the band should be
twice the magnitude of tariffs and transportation costs.
2. Permanent shifts in the terms of trade between traded goods take place, such as
the upward shift that occurred between oil and manufactured goods in 1973 and 1979,
the reverse shift that occurred in 1986 and 1998, or the return of high oil prices after
2004. Oil and manufactured goods can have very different weights in the price indices
of the two countries, particularly if we consider producer price indices rather than
CPIs. An oil-producing country, for example, will experience a real appreciation of its
currency when the relative price of oil goes up, whether in the form of a nominal
appreciation of the currency or in the form of an increase in the producer price index,
P. If the oil price goes up by 50 percent and oil has a weight that is 20 percentage points
higher in an oil-exporting country than in another country, then the effect on the real
exchange rate will be 10 percent. To take another example, automobiles could have the
same weight in two countries’ price indices, but if Japan produces smaller, more fuel-
efficient cars, then it is likely to experience a real appreciation in the event of an oil
price increase that causes demand to shift toward its products.
In the case of tariffs and transportation costs, when the real exchange rate nears
the top of the band it cannot go much farther. However, in the case of permanent shifts
in the terms of trade, no natural limit exists on how far the real exchange rate can drift
in one direction or the other. In the absence of any particular theory predicting changes
in the terms of trade, the real exchange rate can move up from its current position as
easily as down. Accordingly, in Figure 19.2(b), the shifts in the terms of trade are shown
as “permanent”: When a change in the real exchange rate is observed, there is no way
to know whether it will in the future continue to move further in the same direction or
will reverse itself. When changes in a variable such as the real exchange rate are not
predictable, we say that the variable follows a “random walk,” like a drunken reveler
walking down an empty street. This description is just a statement of our ignorance
of what the real exchange rate will do, however; it does not take the place of an eco-
nomic theory.
3. Even if the traded goods baskets are identical in both countries, if the indices
include prices of nontraded goods and services, which cannot be arbitraged internation-
ally, PPP may fail. If the prices of nontraded goods in each country happen to move
proportionately to the prices of traded goods, then PPP will still hold. If there are shifts
in the relative prices of traded goods and nontraded goods, PPP will fail. (Models with
nontraded goods are discussed at greater length in Chapter 20.)
Consider the real exchange rate defined in terms of consumer price indices.
Ereal 5 E(CPI* / CPI) (19.1)
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19.2 ■ The Purchasing Power Parity Assumption 363

FIGURE 19.2
Patterns of Deviation from Purchasing Power Parity
(a) Tariffs and transportation costs create a band within which the real exchange rate can fluctuate. (b) Permanent
shifts in the terms of trade move the real exchange rate unpredictably. (c) A long-term trend in the relative price of
nontraded goods (e.g., upward in a rapidly growing country) will cause a trend in the real exchange rate. (d) The
real exchange rate works its way back to equilibrium after a devaluation as goods prices adjust, but the process
can be slow.

(a) Band Created by Tariffs (b) Permanent Shifts in Terms of Trade

and Transportation Costs

EP*/P EP*/P

0 Time 0 Time
(c) Trend in Relative Price (d) Slow Adjustment of Goods Prices
of Nontraded Goods

EP*/P EP*/P Devaluation

P rising

P falling

Revaluation

0 Time 0 Time
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364 Chapter 19 ■ The Money Supply, the Price Level, and the Balance of Payments

In each country, a weighted average of nontraded goods and traded goods constitutes
the CPI. The real exchange rate will change if the relative price of non-traded goods
(i.e., the price of nontraded goods in terms of traded goods) changes in either the for-
eign country or the domestic country.8 For example, the Japanese yen had come to
appear highly overvalued in real terms by 1995. The long-term trend in the yen over
the preceding half century had shown a strong real appreciation, in part because of an
increase within the Japanese price index of the prices of housing and other nontraded
goods and services (including golf-club memberships, a nontraded good particularly
important in Japan!).
Bela Balassa and others have identified a pattern based on differential economic
growth (the famous “Balassa-Samuelson effect”).9 Growth of a country’s income is
associated with increased productivity in traded goods, which then fall in price relative
to nontraded goods. In other words, the relative price of nontraded goods in terms of
traded goods rises. Growth also may cause a rise in the relative price of nontraded
goods and services if they are superior goods in consumers’ demand functions.10 Either
way, because the prices of traded goods are tied to world prices, a rise in the relative
price of nontraded goods can only mean an increase in the price of nontraded goods
relative to world prices. Therefore, the CPI, which includes nontraded goods, rises rela-
tive to world prices. The domestic currency will appear to appreciate by PPP calcula-
tions. The real exchange rate, E(CPI* / CPI), will appear to fall (i.e., either E will fall or
CPI will rise). That is why countries with strong growth rates tend also to have upward
trends in their relative prices and therefore in the real foreign exchange value of their
currencies, as is shown in Figure 19.2(c). In other words, such countries often show
downward trends in their real exchange rates.11
4. In Chapter 16, lags caused by imperfect information, contracts, inertia in con-
sumer habits, and so forth, rendered elasticities lower in the short run than in the long
run. This implies that two goods that are highly substitutable in the long run may be
very imperfect substitutes in the short run. This low degree of substitutability allows
prices to be “sticky” and allows large deviations from PPP in the short run without
inducing large-scale international arbitrage. For example, following a devaluation or
revaluation, firms do not readjust their prices fully but absorb the (finite) increase or
decrease in demand by varying the quantity sold. If the goods are close substitutes in
the long run, then prices will adjust to PPP eventually; if they did not adjust, demand

8
Refer to Problem 2c at the end of the chapter.
9
Bela Balassa, “The Purchasing Power Parity Doctrine: A Reappraisal,” Journal of Political Economy, 72
(1964): 584–596; Paul Samuelson, “Theoretical Notes on Trade Problems,” Review of Economics and Statistics
(May 1964): 145–154. This is the sort of “real trade theory” explanation for changes in the real exchange rate
that we would like to have, as opposed to the agnostic position that is content with describing the real
exchange rate as following a random walk.
10
“Superior” goods are goods that experience a relative increase in demand when real income increases. Jeffrey
Bergstrand, “Structural Determinants of Real Exchange Rates and National Price Levels: Some Empirical
Evidence,” American Economic Review, 81, no. 1 (March 1991): 325–334.
11
Evidence in time-series data is found to support the Balassa hypothesis in Jose De Gregorio, Alberto
Giovannini, and Holger Wolf, “International Evidence on Tradables and Nontradables Inflation,” European
Economic Review, 38, no. 6 (June 1994): 1225–1244. Such studies look at relative PPP. Cross-country evidence
on absolute PPP is summarized by Irving Kravis and Robert Lipsey, “National Price Levels and the Prices of
Tradables and Nontradables,” American Economic Review, 78, no. 2 (May 1988): 474–478; it too shows that the
price of non-traded goods relative to traded goods increases with the level of the country’s per capita income.
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19.2 ■ The Purchasing Power Parity Assumption 365

levels might rise or fall without limit. Figure 19.2(d) illustrates the process. If a sudden
increase in the nominal exchange rate occurs, with prices fixed in the short run it trans-
lates fully into an increase in the real exchange rate. This real depreciation stimulates
the demand for domestic goods, putting upward pressure on prices. As prices gradually
rise, the real exchange rate comes back down toward its long-run equilibrium. How-
ever, it is always possible that before equilibrium is reached, another sudden exchange
rate change will occur.
The precise nature of the microeconomics of sticky prices is not well understood,
but the empirical evidence is clear, as we will see in the following section. Of these four
ways in which PPP can fail, all contain some truth, but the last is the one with the most
macroeconomic content. From now on, any reference to the possibility of short-run
failure of PPP will usually be a reference to the macroeconomic, sticky-price interpre-
tation. Although permanent changes in the real exchange rate because of productivity
differences and other real factors do occur, they tend to be slow long-term trends.
Short-run deviations from those trends are the sort of PPP failure that we will be exam-
ining at length.

Empirical Evidence on PPP

Any empirical study of PPP shows very large deviations, at least in the short run.
Relative to the Bretton Woods period of fixed exchange rates, most countries’ real
exchange rates have been especially variable in the years since 1973, including Great
Britain and the United States. This is reflected in Figure 19.3, which graphs the real
pound sterling/dollar rate. A useful measure of variability is the standard deviation.12
The standard deviation of the real pound/dollar rate was 22 percent over the period
1973 to 2005. In general, it takes a band of two standard deviations either way to
encompass 95 percent of the fluctuations in a variable (assuming a normal distri-
bution). These numbers imply that departures from PPP as large as 44 percent occur
(2 times 22 percent 5 44 percent). These are large swings to be occurring regularly in
the relative prices of countries’ goods. In comparison, the standard deviation of the
real pound/dollar rate was only 9 percent over the fixed-rate period of 1945 to 1972.
Some of the variation in the real exchange rate during the earlier period was caused by
differences in inflation rates between the two countries, but much of the variation was
accounted for by a few discrete devaluations of the pound. The exchange rate was not
literally “fixed” permanently; it was “fixed, but adjustable.”
The 1973 increase in the variability of the real exchange rate against the United
States was particularly great for Japan. This is clear in Figure 19.4, which shows
monthly changes in the real yen/dollar rate.13 The pre-1973 versus post-1973 compar-
isons suggest strongly that fluctuations in the nominal exchange rate may be a cause of
fluctuations in the real exchange rate.

12
If you are familiar with the statistical concept of the variance, the standard deviation is simply the square
root of it.
13
Monthly variability in major exchange rates tripled after 1973. We have concentrated here on the U.K. case
rather than the Japanese one, or others, because the time series of data extends unbroken much further back
in history.
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366 Chapter 19 ■ The Money Supply, the Price Level, and the Balance of Payments

FIGURE 19.3
Two Hundred Years of Purchasing Power Parity Between the Dollar and the Pound
Changes in the real exchange rate are not purely random. Rather, it tends to regress slowly
toward its long-run equilibrium (until a new disturbance comes along). In the case of the United
States and United Kingdom, the long-run equilibrium appears to have been constant.

Real dollar/pound exchange rate

2.50

2.25

2.00

1.75

1.50

1.25

1.00
1790 1820 1850 1880 1910 1940 1970 2000

Sources: 1790–1990 James Lothian and Mark Taylor, “Real Exchange Rate Behavior: The Recent Float
from the Perspective of the Past Two Centuries,” Journal of Political Economy 104, 484–509 (1996);
and for 1990–2005: IFS (International Financial Statistics) and Federal Reserve.

Another explanation is that the greater variability in real exchange rates after 1973
was related to the greater magnitude of real worldwide disturbances, such as oil shocks,
and would have happened even under a regime of fixed exchange rates (in which case
the variability would have shown up in the price levels). This alternative view holds that
changes in the nominal exchange rate do not cause changes in the real exchange rate,
but that both occur in response to exogenous real disturbances such as productivity
changes.14 One problem with this view is that no one has identified these real shocks. It
would seem if there were a change in productivity or consumer tastes that applied to
hundreds of different industries in a country, such that all of them experience an
increase in price when the currency appreciates (relative to their counterparts in for-
eign countries), then we should be able to identify what that change is. A few cases, in
fact, do suggest explanations. The rapid fall in the value of the yen and the mark against
the dollar when the price of oil quadrupled at the end of 1973 surely resulted because
those two countries’ economies depended more on imported oil than the U.S. economy

14
Such theories have been constructed, for example, by Alan Stockman, “The Equilibrium Approach to
Exchange Rates,” Economic Review, Federal Reserve Bank of Richmond (March–April 1987): 12–31.
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19.2 ■ The Purchasing Power Parity Assumption 367

FIGURE 19.4
Nominal and Real Exchange Rates Both Became More Volatile After 1973

(a) Monthly Changes in the Nominal Yen/Dollar Rate

0.15

0.10
Percentage Change

0.05

–0.05

–0.10

–0.15
1957 1960 1963 1966 1969 1972 1975 1978 1981 1984 1987 1990 1993 1996 1999 2002 2005

(b) Monthly Changes in Real Yen/Dollar Rate

0.15

0.10
Percentage Change

0.05

–0.05

–0.10

–0.15
1957 1960 1963 1966 1969 1972 1975 1978 1981 1984 1987 1990 1993 1996 1999 2002 2005
CAVE.6607.cp19.p353-390 6/6/06 12:16 PM Page 368

368 Chapter 19 ■ The Money Supply, the Price Level, and the Balance of Payments

did. It is hard to see what changes in worker productivity or consumer tastes could
possibly explain the 50-plus percent real appreciation of the dollar between 1980 and
1985, however, and its reversal over the following three years, or the similar 1990–1995
real appreciation of the yen and its reversal over the subsequent three years.
One way to check if the comparison of the fixed-rate and floating-rate periods
might be contaminated by larger supply shocks after 1973 than before is to look at
Canada, the one country to have a floating exchange rate in the 1950s. The real
exchange rate in Canada was highly variable at the time, whereas those in fixed-rate
countries were much less so. Evidently the floating-rate regime made the difference.
Another piece of evidence is offered by the case of Ireland. From 1957 to 1970 the
Irish currency was pegged to the pound, and thereby to the dollar and mark as well,
until the currencies began to float against each other. From 1973 to 1978 the Irish cur-
rency was again pegged to the pound, which meant it floated against the dollar and
mark. Then from 1979 onward Ireland was in the European Exchange Rate Mecha-
nism, and the currency—the punt—was thereby tied to the mark, which meant it
floated against the dollar and pound. In each of the three periods, the choice of nominal
exchange rate regime for the punt corresponds very well with the observed degree of
real exchange rate variability vis-à-vis each of the three trading partners. Stickiness of
prices explains the pattern. Otherwise it would be quite a coincidence that real variabil-
ity vis-à-vis the mark, say, should fall and vis-à-vis the pound should rise at precisely the
same moment that the nominal variabilities, respectively, fall and rise as well.15
A third way of evaluating whether real exchange rate variability is related to the
exchange rate regime is to consider earlier historical experience. History demonstrates
that the variability of real exchange rates was larger under floating-rate regimes than
under fixed-rate regimes, not just during the period after World War II, but before the
war as well.16
These findings would be difficult to explain with perfectly flexible goods prices. It
seems more likely that prices are sticky and that nominal exchange rate variability is
indeed a primary source of real exchange rate variability. Estimates on the yearly
U.S.–U.K. data indicate that fluctuations in the nominal exchange rate are 84 percent
reflected as fluctuations in the real exchange rate (1973–2005).
There have been some studies of PPP, or the law of one price, for disaggregated
categories of goods matched across countries that are the smallest, most narrowly
defined, SITC (Standardized International Trade Classification) categories. These stud-
ies find large deviations even on these disaggregated data. This need not be interpreted
as a failure of economic rationality or the law of one price. One partial explanation is
that most foreign trade takes place under 30- to 90-day contracts, so prices cannot be
readjusted for 30 to 90 days after a disturbance. More fundamentally, manufactured
goods of different firms are actually different goods, as was noted earlier.17

15
Michael Mussa, Exchange Rates in Theory and in Reality, Essays in International Finance, 179 (Princeton:
Princeton University Press, December 1990).
16
Alan Taylor, “A Century of Purchasing Power Parity,” Review of Economics and Statistics, 84 (2002):
139–150.
17
Charles Engel, “Real Exchange Rates and Relative Prices: An Empirical Investigation,” Journal of Monetary
Economics, 32 (1993): 35–50.
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19.3 ■ Purchasing Power Parity in a Hyperinflation 369

Even goods that are marketed in the same location and differ in little more than
brand name—for example, a Japanese television set and the identical item manufac-
tured by the identical firm but under an American label—violate the law of one price.
Different manufacturers vary with respect to reputation or warranty offered, and dif-
ferent retailers vary with respect to their sales and maintenance service. Long-term
customer relationships are thought to be particularly important in Japan and give rise
to what are sometimes called implicit contracts: A Japanese corporation will hesitate
before raising prices when there is excess demand, in the anticipation that this will
build loyalty among customers, who will continue to buy from it in other periods of
excess supply.
This point recalls a distinction between homogeneous “auction goods”—for which
the law of one price holds instantaneously and worldwide, and heterogeneous “cus-
tomer goods”—for which the law of one price fails, at least in the short run. Auction
goods are usually basic commodities such as agricultural and mineral products, whereas
customer goods are usually heterogeneous manufactured goods that bear brand names.
The rapidly evolving semiconductor industry provides an example of each kind of
good. So-called commodity chips tend to be all the same regardless of the producer and
are sold in perfectly competitive markets resembling those for agricultural or mineral
commodities. Specialty chips are designed to fulfill more specific functions and tend to
fit better the description of customer goods.
If PPP holds in the long run but not in the short run, the obvious empirical ques-
tions become: How long is the short run? How quickly do deviations from PPP disap-
pear? The speed with which the real exchange rate adjusts back toward its long-run
equilibrium has been estimated at about 15 percent a year: The best guess in a given
year as to what will be the gap between the real exchange rate and its long-run equilib-
rium is 85 percent of what it was in the preceding year. After two years, 72 percent of
the gap will remain (.852 5 .72), and so forth. After four years, 52 percent of the gap
will remain (.854 5 .52). In other words, the half-life has been estimated at about four
years. This speed of adjustment is not implausibly slow, but it is sufficiently slow as to
be difficult to detect statistically in the data, given that large new disturbances come
along frequently. This is especially true if only a few years of data are available. We
must look at a long time period, such as the 200 years of data in Figure 19.3, for clear
manifestation of the tendency of the real exchange rate to return to equilibrium.18

19.3 Purchasing Power Parity in a Hyperinflation

Hyperinflation was defined by Philip Cagan as a sustained inflation in which the price
level goes up by more than 50 percent per month. Hyperinflations seem to attack like a
mysterious disease. They afflicted Central Europe in the early 1920s, a smattering of
countries at the end of World War II, Latin America in the 1980s, and several countries

18
Hyperinflation is one context in which PPP in a sense works well empirically (because the long run in effect
“telescopes” into a few years). This is explained in Section 19.3.
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370 Chapter 19 ■ The Money Supply, the Price Level, and the Balance of Payments

in the wake of the breakup of the Soviet Union in the early 1990s. The source is usually
simple enough: a government that has control of a printing press but controls little else.
Often it is a weak government printing money to fight a war.
In January 1994 the inflation rate in what remained of Yugoslavia (essentially
Serbia) reached 313,563,558 percent per month, almost equaling the preceding record,
which had been set by Hungary in 1945–1946. As with any hyperinflation, residents
tried desperately to buy marks or dollars, anything to avoid holding the domestic cur-
rency. Reporting at the peak, a Belgrade newspaper described the situation: “Yesterday
[morning] the price of the [Deutsche] mark on the black market was 2.0 million dinars,
and around 3:00 P.M. it was 2.5 million dinars. Belgrade dealers were reluctant to sell
marks, as they expected the exchange rate to reach 5 million dinars (per DM) by the
evening.”19
As mentioned in footnote 18, hyperinflation is one context in which PPP in a sense
works well empirically. Table 19.1 reports cumulative increases in the price level and in
the exchange rate for some memorable hyperinflations of the twentieth century. They

TABLE 19.1
PPP in Great Hyperinflations of the Twentieth Century
P final E final
Country Period P initial E initial
Austria 10 / 1921–9 / 1922 93 29
Germany 7 / 1922–12 / 1923 179 3 108 141 3 108
Poland 1 / 1923–1 / 1924 699 491
Hungary 3 / 1923–2 / 1924a 44 12
Hungary 8 / 1945–7 / 1946 381 3 1025 304 3 1025
Nat. Chinab 9 / 1945–5 / 1949 105 3 109 119 3 109
Bolivia 4 / 1984–9 / 1985 974 2,129
Peru 9 / 1988–8 / 1990 7,242 11,600
Argentina 4 / 1989–3 / 1990 204 294
Brazil 11 / 1989–3 / 1990 12 8
Ukraine 4 / 1991–12 / 1993 4,772 799
Belarus 4 / 1991–2 / 1992 8 6
The Congo 10 / 1991–9 / 1994 237,499 284,519
Tajikistan 1 / 1992–12 / 1993 1,088 743
Serbia 2 / 1992–1 / 1994 366 3 1020 8.3 3 1020
Armenia 9 / 1993–5 / 1994 139 99
a
Cumulative rise in exchange rate in Hungary is from average of March 1923 to average of March 1924.
b
China’s exchange rate change is the change in the price of gold rather than a direct exchange rate.
Sources: P. Cagan, “The Monetary Dynamics of Hyperinflation,” in Milton Friedman, Studies in the Quantity Theory of Money (Chicago:
University of Chicago Press, 1956); Bogetic, Dragutinovic, and Petrovic, “Anatomy of Hyperinflation,” Economic Review and Inter-
national Financial Statistics, IMF; T. Sargent, “The Ends of Four Big Inflations,” in Robert Hall, Inflation: Causes and Effects (Chicago:
University of Chicago Press, 1982); D. Paarlberg, An Analysis and History of Inflation (New York: Praeger, 1993); T. Hu, “Hyperinflation
and the Dynamics of the Demand for Money in China, 1945–1949,” Journal of Political Economy (January/February 1971); International
Monetary Fund.

19
The report was dated January 16, 1994, soon before a successful stabilization. As reported by Z. Bogetic,
D. Dragutinovic, and P. Petrovic, “Anatomy of Hyperinflation and the Beginning of Stabilization in Yugoslavia,
1992–1994,” World Bank (September 1994).
CAVE.6607.cp19.p353-390 6/6/06 12:16 PM Page 371

19.3 ■ Purchasing Power Parity in a Hyperinflation 371

FIGURE 19.5
PPP in Great Hyperinflations of the Twentieth Century

E final/E initial

1030

Hungary '45–46

1024

Serbia '92–94

1018

1012 Argentina '89–90

Nat. China '45–49
Bolivia '84–85
Tajikistan '92–93 Germany '22–23

Nicaragua '86–89
1,000,000
Zaire '91–94
Peru '88–90
Georgia '92–94
Armenia '93–94 Ukraine '91–93
Brazil '89–90 Poland '23–24
Austria '21–22
1
1 1,000,000 1012 1018 1024 1030
Belarus '91–92 Hungary '23–24 P final/P initial

are expressed as multiples—that is, the level at the end of the period divided by the level
at the beginning. In most of the hyperinflations reported, the increase in the exchange
rate was roughly of the same order of magnitude as the increase in the price level. Fig-
ure 19.5 graphs the cumulative change in the price level and exchange rate for each of
these hyperinflations. The points lie impressively close to the 45° line, supporting PPP.20
Yet there is another sense in which PPP works poorly during a hyperinflation. We
can see from Table 19.1 that the cumulative rise in the exchange rate never matches the

20
Similarly, Jacob Frenkel found that an OLS regression testing the time series relationship between the
exchange rate E and the relative price level P/P* in the German hyperinflation of 1920 to 1923 produced a
coefficient close to one. “Purchasing Power Parity: Doctrinal Perspective and Evidence from the 1920’s,”
Journal of International Economics, 8, no. 2 (May 1978): 169–191.
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372 Chapter 19 ■ The Money Supply, the Price Level, and the Balance of Payments

rise in the price level exactly. It is not uncommon for one variable to go up twice as
much as the other—a movement in the real exchange rate of 100 percent—or by more.
The explanation for these seemingly conflicting findings is that PPP holds fairly
well in the long run, but large short-run errors can push the exchange rate and the price
level away from PPP. In a hyperinflation, the long run arrives quickly. In terms of
Figure 19.5, the deviations from the 45° line are dwarfed by the magnitudes of the
hyperinflations.21 In short, as an explanation of the level of the nominal exchange rate,
PPP works well in hyperinflations. As a theory of the real exchange rate, it does not. We
examine these hyperinflations further in Chapter 27.

19.4 PPP in the Model of the Balance of Payments

We now adopt the assumption that prices are perfectly flexible, so that PPP holds.
P 5 EP* (19.2)
Why is PPP assumed here, when the empirical evidence just reviewed does not support
it? There are several reasons. First, just as assuming fixed prices allowed us to focus on
the determination of output in the preceding chapter, assuming flexible prices and full
employment is a simplification that allows us to focus on the determination of the price
level. (We will relax the assumption of full employment in Chapter 26 to study the com-
plete case, where increases in demand go partly into output and partly into prices.)
Second, some economic analysts write as if PPP does hold. It helps to understand their
viewpoint. Third, the flexible-price full-employment assumption is fairly realistic for
thinking about the long run, just as the rigid-price assumption is fairly realistic for think-
ing about most countries in the short run.
Finally, PPP is more realistic, even in the relatively short run, for thinking about
very small, very open economies. Hong Kong and Singapore are examples. Why is PPP
a good assumption for some countries but not for others?

The Aggregation of Traded Goods

for Small Open Economies
For most countries, even relatively large ones, prices of import goods can be taken as
given exogenously in the short run, fixed in terms of foreign currency, as was assumed
in the preceding three chapters. The reason is that a typical country constitutes a small
fraction of the world demand for any given product and so has very little monopsony
power. The situation is more varied when it comes to the country’s export goods. Many
countries have some monopoly power in their export goods. Even if the country is only
one of many that produces, for example, automobiles, foreign consumers will not treat
its autos as perfect substitutes for other countries’ autos because they are customer
goods. This makes it possible for producers to set a price for the product in domestic

21
This is a standard “errors in variables” problem in econometrics. N. Davutyan and J. Pippenger, “Purchasing
Power Parity Did Not Collapse During the 1970s,” American Economic Review, 75, no. 5 (December 1985):
1151–1158.
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19.4 ■ PPP in the Model of the Balance of Payments 373

currency without fearing an instantaneous large loss of demand when there are adverse
changes in the exchange rate or in the prices charged by foreign competitors. This was
the sort of country we considered in Chapters 16 through 18. But we now consider a
different kind of country.
Many countries are so small in world markets that they have little monopoly
power in their export goods and must take prices of export goods as exogenous, or
fixed in terms of foreign currency. In the case of agricultural and mineral commodities
and other auction goods, the output of different countries often can be considered per-
fect substitutes. Sugar or tin, for example, is basically the same regardless of where it is
produced. In addition, if the country doesn’t happen to produce a large proportion of
the world output of the agricultural or mineral product, then it is safe to assume it
accepts the world price. In other words, if it tried to charge more than the going price, it
would quickly find itself without customers. In the case of manufactured goods, some
labor-intensive products such as textiles are sufficiently similar among a wide range of
countries that their prices too can be taken as essentially given on world markets. Then
the analysis returns to the definition of a small country used in the first half of the
book: a country that is too small in international markets to affect world prices.
As these examples show, developing countries are more likely to take export prices
as given than are larger industrialized countries. (Note, however, that the assumption
that the country can sell any quantity it wants on the world market at the going price
can go wrong for another reason: Major customers may apply country-by-country
quotas to purchases of the commodity. Industrialized countries maintain such quotas
against sugar, for example.)
If a country is so small that it takes not only its import prices as given but its export
prices as well, then it is possible to aggregate the two kinds of goods together at their
(given) relative price. The composite commodity thereby created is referred to as
traded goods. Under the assumption that the small open country can buy or sell all of
the traded goods it wishes to, the trade balance becomes the quantity of traded goods it
chooses to produce minus the quantity it chooses to buy. With this analysis, the ques-
tion of how a given trade balance breaks down into imports and exports is left unan-
swered. The approach just tells us the overall trade balance, which is the variable we
are usually interested in.
In reality, the relative prices of some of the goods within this composite commod-
ity—the traded good—will sometimes change. When this happens, it will not be useful
to talk in terms of traded goods in the aggregate. Worldwide changes in the relative
price of oil, as occurred in 1973 and 1979 (upward), 1986 and 1998 (downward), and
2005 (again upward), are an important example. But such developments are usually
taken to be exogenous. For purposes of studying changes that do not affect the terms of
trade, such as changes that originate in macroeconomic policy, this aggregation will be
useful. The next chapter will also continue to aggregate all traded goods.

The Real Balance Effect

In previous chapters, a devaluation raised the trade balance to the extent that it low-
ered the price of exports relative to imports. One might think that once we rule out such
terms of trade, and indeed assume that purchasing power parity holds continuously,
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374 Chapter 19 ■ The Money Supply, the Price Level, and the Balance of Payments

that a devaluation can no longer affect the balance of payments. But this is not correct.
Here we briefly consider the real balance effect resulting from a devaluation.
Consider a 10 percent devaluation. Not only do the prices of imports follow the
price of foreign exchange E up by the same 10 percent, but under the assumption of
PPP, all prices rapidly go up by the same amount. When the price level P rises 10 per-
cent, if the nominal money supply is unchanged, then the real money supply M / P falls
by 10 percent. This is called the real balance effect because M / P is sometimes called
real money balances.
Nothing has happened to change money demand, so we now have excess demand
for money. Individuals respond by cutting back purchases of internationally traded
goods, thereby improving the trade balance. Thus is the improvement accomplished
with no change in the terms of trade. (Individuals also cut back purchases of interna-
tionally traded assets, if capital flows are in the model. Recall from the opening of this
chapter that its subject is the Monetary Approach to the Balance of Payments, not just
the Balance of Trade.)
As with the Hume and Mundell flow mechanisms of Section 19.1, the balance of
payments surplus sets in motion developments that are self-correcting. The surplus
implies that reserves are flowing into the country. Under a system of nonsterilization,
the money supply gradually rises. This endogenous monetary expansion, in turn, gradu-
ally reverses the fall in purchases of goods (and assets). The balance of payments
declines, eventually returning to zero.
Appendix C to this chapter presents this model algebraically and graphically. It
illustrates the effects not just of a devaluation, but of three other experiments as well: a
monetary expansion, inflation in the rest of the world, and supply-led domestic growth.
(The model is useful for thinking about how the global system operated under the gold
standard and Bretton Woods systems, the subject of Appendix A.) The common
denominator throughout the experiments, and throughout the chapter, is that effects
on the balance of payments are temporary and self-equilibrating.

19.5 Summary
This chapter introduced two new concepts into our study of economies that operate
under fixed exchange rates. The first concept was the flow of international reserves into
or out of a country through the balance of payments. This reserve flow changes its
monetary base endogenously over time if the central bank either cannot or does not
choose to sterilize (offset or neutralize). Such changes in the monetary base then have
further implications over time for the economy. The second concept was purchasing
power parity (PPP). The first of the two concepts is the one that defines most the mon-
etary approach to the balance of payments.
We studied the effects of two policy experiments: a change in the money supply
and a devaluation. An increase in the money supply creates an excess supply of money,
which leads to a higher level of private expenditure and a balance-of-payments deficit
in the short run, the same as at the end of the preceding chapter. The difference is that
under the nonsterilization assumption, the balance-of-payments deficit implies that the
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Chapter Problems 375

level of the money stock falls over time, which in turn gradually undoes the increase in
expenditure and the balance-of-payments deficit. A devaluation leads to a balance-of-
payments surplus in the short run, again as in previous chapters. The level of the money
stock rises over time, which in turn gradually undoes the balance-of-payments surplus.
Whatever the policy experiment, in the long run the balance of payments must be zero
under the monetary approach, so that the stock of reserves is no longer changing.
These results apply regardless of what is assumed about the second concept associ-
ated with the monetary approach to the balance of payments: purchasing power parity
(PPP). PPP states that the domestic price level is given by the exchange rate times the
foreign price level. There are a number of reasons why this relationship can fail in the-
ory, why the real exchange rate is not constant. The most important, at least in the short
run, is that prices are “sticky,” meaning that prices require time to adjust after a change
in the nominal exchange rate. Thus the fixed-price assumption (which we made in
Chapters 16 through 18 and will return to in Chapter 22) is realistic for the short run.
Nevertheless, in the last part of the present chapter we explored the implications of the
assumption of price flexibility and PPP. One motivation is to think about the long run.
Another motivation is to think about very small, open economies.
In the small open economy model a devaluation translates directly into a propor-
tionate increase in the domestic price level, so no change occurs in the real exchange
rate. Nonetheless, there is an effect on the balance of payments, through what is called
the real-balance effect. The increase in the price level reduces the real money balances
held by the public. In response to the resulting excess demand for money, people cut
back on expenditure, which in turn leads to the improvement in the balance of pay-
ments. The next chapter will include some additional effects that devaluations have for
small, open countries, especially developing countries. In particular, it will introduce
nontraded goods into the monetary model.

CHAPTER PROBLEMS

1. What effect does a revaluation of the currency upward have on income and the trade
balance, in the short run and in the long run? Answer diagrammatically for each of the
two monetary models.
a. The monetary model with fixed goods prices (Section 19.1).
b. The monetarist model with purchasing power parity (Section 19.4).
2. The real exchange rate is defined to be E (CPI* / CPI).
a. If PPP holds, what is the rate of change of the CPI when the foreign inflation rate
is 3 percent per year and
i. the nominal exchange rate is fixed?
ii. the domestic currency is depreciating at 7 percent per year?
iii. the domestic currency is appreciating at 3 percent per year?
b. Assume that PPP holds, the foreign price level is fixed, the parameter K mea-
sures the sensitivity of desired money balances to nominal income, and the
parameter d measures the sensitivity of the balance of payments to the excess
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376 Chapter 19 ■ The Money Supply, the Price Level, and the Balance of Payments

demand for money, as in Equation 19.5 in Appendix C. In each of the following

cases, what is the (short-run) effect on the balance of payments? Assume that
nominal GDP is initially $100 billion.
i. The central bank decreases domestic credit by $1 billion.
ii. Domestic output grows by 1 percent.
iii. The country devalues its currency by 1 percent.
c. Let CPI 5 Pna Pt(12a), where Pn is the price of nontraded goods, Pt the price of
traded goods, and a the weight given to the former in the consumption basket.
Define CPI* analogously. Express the real exchange rate as a function of the rela-
tive price Pn / Pt in each country. (Assume the law of one price for traded goods.)
d. If the domestic and foreign CPIs each give a weight of two thirds to nontraded
goods and one third to traded goods, what is the rate of change of the real
exchange rate if
i. the relative price of nontraded goods is rising at 3 percent per year in the
domestic country (and is constant in the foreign country)?
ii. the relative price of nontraded goods is rising at 3 percent per year in both
countries?
iii. the relative price of nontraded goods is constant, but within traded goods
there is an increase in EP *t / Pt—a shift in the terms of trade running against
the home country—of 3 percent per year?
3. a. Assume that the gold standard is in effect and that huge new deposits of gold are
discovered in California. What happens to the U.S. price level and trade balance,
and the world price level?
b. In The Wizard of Oz, Dorothy thinks that powerful men in the Emerald City
have the answers to her problems, only to discover at the end of her journey
that their power is based on sham and illusion and that she, the girl from Kansas,
knew the answers all along. What city do you think this is? (See Appendix A,
footnote 24.)

Extra Credit
Problems 4 and 5 deal with the monetary approach to the balance of payments. The
rate of change of the money supply is given by the balance of payments.
H 5 TB
Problem 4 maintains the fixed-price assumption of the Keynesian model of Chap-
ter 17. Problem 5 goes to the opposite extreme, fixed output.
4. Assume the model of Problem 5 in the problem set for Chapter 18.
a. Continuing Problem 5b, what is the initial, short-run effect of a fiscal expansion on
the balance of payments: DTBSR / DG? What happens over time? What is the effect
on income in the long run, defined as the time when the money supply is no longer
changing (H 5 0): DYLR?
b. Continuing Problem 5d from Chapter 18, what is the initial effect of a monetary
expansion on the balance of payments: DTBSR / D( M/P)? What is the effect on
income in the long run: DYLR?
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Suggestions for Further Reading 377

5. Think of the balance of payments, now equal to the desired rate of accumulation of
money balances, as a function of the gap between the actual current money supply, M,
and desired (long-run) money, Md, where the latter is proportional to nominal GDP:

H 5 2d(M 2 Md)
1
Md 5 v PY

a. Using BP to represent the balance of payments, which is equal to the nominal

trade balance in the assumed absence of capital flows, express it as a function
of M and PY. What is the effect of DM on DBP, and why?
b. Is the effect of a monetary expansion on the trade balance in the Keynesian model
of Problem 4b consistent with its effect in the monetarist model of 5a? (Note that
the Keynesian model used TB to denote the real trade balance; the nominal trade
balance is given by P times it. This made no difference when P was exogenous and
normalized to 1.)
c. For the first time, the assumption of a fixed price level is relaxed and replaced by
the assumption of purchasing power parity:

P 5 EP*

where the small open economy assumption (that the world price level P* is
exogenous) is adopted, along with the assumption that income is exogenous
because flexible prices guarantee full employment (Y 5 Y).
Returning to the monetarist notation of Problem 5a, what is the effect of a
devaluation, DE, on the balance of payments in the short run? In the long run?

SUGGESTIONS FOR FURTHER READING

Dornbusch, Rudiger. “Purchasing Power Parity,” in J. Eatwell, M. Milgate, and P.

Newman, eds., The New Palgrave, Vol. 3 (New York: Macmillan, 1987). A good
survey.
Eichengreen, Barry. The Gold Standard in Theory and History (New York: Methuen,
1985). Important papers, including Barro, Cooper, Hume, and Triffin, on how the
gold standard operated, and whether it did or did not correspond to the idealized
version represented by the monetary approach to the balance of payments.
Frenkel, Jacob, and Harry Johnson, eds. The Monetary Approach to the Balance of
Payments (Toronto: University of Toronto Press, 1976). Includes, among other rele-
vant papers, accounts of the overall monetary approach by the editors.
Mundell, Robert. International Economics (New York: Macmillan, 1968). Includes
“Barter Theory and the Mechanism of Adjustment” (Chapter 8), a classic refer-
ence on the monetary approach; “Growth and the Balance of Payments” (Chap-
ter 9), which makes the argument that real growth leads to a surplus, not a deficit;
and “The International Disequilibrium System” (Chapter 15), which develops the
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378 Chapter 19 ■ The Money Supply, the Price Level, and the Balance of Payments

model of the income-flow mechanism (although this paper, like much of the book,
allows for capital mobility, and thus is most relevant for our Chapter 22).
Wanniski, Jude. “The Mundell-Laffer Hypothesis—A New View of the World Econ-
omy,” The Public Interest, 39 (Spring 1975): 31–52. The author, a former editorial
writer for the Wall Street Journal, offered a heartfelt proclamation of the view that
changes in the exchange rate have no effect on relative prices and therefore no
effect on the trade balance.

APPENDIX A

The Gold Standard

The monetarist model is useful for thinking about the gold standard, the subject of this
appendix. The two-country version of the model, which is developed formally in the
supplement to Chapter 19, is particularly useful for thinking about international flows
of money between Britain and the United States under the nineteenth-century gold
standard—roughly the period 1880 to 1914.

The Idealized Gold Standard

There are many senses in which the world “lost its innocence” in World War I. The era
before 1914 often is recalled with fond, and sometimes overly idealized, nostalgia as an
era of unprecedented economic growth and stability under the gold standard. The defi-
nition of a gold standard is that central banks fix the value of their currencies in terms
of gold. This means that they set a price of gold in terms of domestic currency and then
stand ready to buy or sell gold to whatever extent is necessary to maintain that price.
They must, of course, hold reserves of gold to meet any fluctuations in demand.
A gold standard is a special case of a system of fixed exchange rates. It is easy to
show this: If the Federal Reserve has fixed the price of gold in terms of its currency
(i.e., in dollars/ounce) and the Bank of England has fixed the price of gold in terms of
its currency (in pounds/ounce), then they have in effect fixed their exchange rate (the
ratio of the two, in dollars/pound).
The nineteenth-century gold standard, when visualized in its idealized form as a
system of smooth and automatic adjustment to any disequilibrium, has two distinguish-
ing characteristics. They correspond to the two assumptions of the monetary approach
to the balance of payments laid out in the chapter.
First is the assumption that wages and goods prices are perfectly flexible and so
adjust quickly to maintain equilibrium in the labor and goods markets. In the chapter,
this cornerstone of the global monetarist view was discussed at length. Here it is worth
noting that the assumption of flexible prices and wages was less unrealistic in the pre-
1914 period than it is in the modern era of differentiated brand products, labor unions,
and myriad forms of government intervention in the marketplace (such as minimum-
wage laws).
CAVE.6607.cp19.p353-390 6/6/06 12:16 PM Page 379

Appendix A 379

The second aspect of the monetary approach to the balance of payments, the
emphasis on international reserve flows, takes on an especially simplified form in the
case of the idealized gold standard. The idealization leaves out reserves held in the
form of foreign currency and thus treats gold as the only form of international
reserve.22 Furthermore, it leaves out net domestic assets—purchases of domestic bonds
by the central bank—and thus treats gold as the only component of the monetary base.
Finally, it leaves out credit created by the commercial banking system, so that gold is
treated as the only component of the money supply. This need not mean that gold liter-
ally circulates among the public; it is enough if the banking system always holds exactly
the right amount of gold to back up one for one the domestic currency that it issues.
(This is called “100 percent reserve backing,” as opposed to the modern system of
“fractional-reserve backing,” under which the monetary base is only a fraction of the
money supply in the hands of the public.) It follows that under this idealized version of
the gold standard, the central bank could not sterilize international reserve flows even
if it wanted to. The money supply necessarily varies one for one with the country’s
holdings of gold, evaluated at the set price. This appendix will freely use the word gold
interchangeably with reserves, or money.
In truth, domestic credit creation and fractional reserve backing began long before
1914. Central banks did not in fact always allow reserve outflows to translate fully into
monetary contraction as they were supposed to under the rules of the game. It is proba-
bly true, however, that in the nineteenth century central banks made much less of a
practice of sterilizing reserve flows so as to set monetary policy where they wanted it
than they do today. It was only after World War I that central banks began to acquire
responsibility for the deliberate setting of monetary policy to respond to problems such
as unemployment. (One possible interpretation is that the motivation for them to do so
stems from the greater degree of rigidity of wages and prices in the modern era.23)

The Ups and Downs of the Gold Standard

When the world’s money was tied to gold, the world price level was determined by the
world supply of gold, relative to world real income, precisely as in Equation 19.S.4 in
the supplement. This relationship is the key both to arguments in favor of a gold stan-
dard and to arguments against it. The pro argument is that it prevents central banks
from creating money at an excessive rate and thus generating sustained inflation.
Excessive money creation and inflation have sometimes inspired proposals for a return
to the gold standard, or some related form of commodity standard.
There are several con arguments. Tying the money supply to gold prevents central
banks from responding to cyclical downturns with more expansionary monetary policy.
(This is not considered a disadvantage by the gold-standard proponents; they would

22
This ignores the fact that under the gold standard, central banks held much of their reserves in the form of
pounds sterling because they knew that the pound was convertible into gold.
23
See Robert Triffin, “Myths and Realities of the So-called Gold Standard”; and Donald McCloskey and J.
Richard Zecher, “How the Gold Standard Worked, 1880–1913,” both reprinted in Eichengreen, The Gold
Standard in Theory and History.
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380 Chapter 19 ■ The Money Supply, the Price Level, and the Balance of Payments

prefer that the government not have such discretionary power because they do not
trust that it has the good faith and competence to use the power well.)
A second objection is that tying the money supply to gold also prevents the steady
long-term growth in the world supply of money and reserves necessary to satisfy the
transactions demand that comes with growing output and trade. If there is no increase
in the supply of available gold, then money will get tighter and tighter, creating a drag
on world growth. The absence of major discoveries of gold between 1873 and 1896
helps explain why price levels fell dramatically over this period (53 percent in the
United States and 45 percent in the United Kingdom).24 Conversely, the gold rushes in
California in 1849 and in South Africa and Alaska in the late 1890s were each followed
by upswings in the price level of similar magnitude. Clearly, the system did not in fact
guarantee price stability. Opponents of the gold standard ask why one would want to
make the world economy hostage to chance gold discoveries and the other arbitrary
vicissitudes of supply and demand in the world gold market. They also question the
efficiency of a system that requires the use of resources to dig gold out of the ground
laboriously, only to bury it back in the ground at Fort Knox.25
After World War I, it was considered very important to Britain to restore convert-
ibility of the pound into gold. But at what exchange rate? This is the context in which the
idea of purchasing power parity was first debated. A misplaced faith in the ability of
wages and prices to adjust downward easily led the treasury minister,Winston Churchill,
to peg the pound at too high a value, that is, to set too low a price for gold in terms of
pounds. The result was a balance-of-payments deficit and severe contraction that ended
in collapse of the system, rather than in smooth adjustment to the disequilibrium.26
Officially, gold was also the reserve asset of the Bretton Woods system founded in
1944. World growth would have soon run into the constraint of a basically fixed supply
of gold, were it not for the fact that the dollar immediately became the de facto reserve
asset. Central banks held much of their reserves in the form of dollars because the dol-
lar was convertible into gold, in the same way that central banks had earlier held much

24
The deflation of these years inflicted economic hardship, in particular, on American farmers, who had debts
that were set in dollar terms but who produced commodities and owned land whose prices were falling in dol-
lar terms. This was the era of Snidely Whiplash threatening to foreclose on poor Nell’s farm and of the rise of
populism in the American Midwest. The populists wanted the United States to abandon the gold standard so
as to expand the money supply and get prices up. William Jennings Bryan, their candidate for president in
1896, warned that the farmers would not be “crucified on a cross of gold.” Incidentally, the book The Wizard of
Oz was really an allegory about populism. Oz stands for “ounces” (gold). Dorothy is the “innocent” from
Kansas, the Scarecrow represents the farmer, the Tinman is the downtrodden urban worker (with whom the
populists might have hoped to make a political alliance), and the Lion is William Jennings Bryan. Their ene-
mies are the Wicked Witch of the East, representing the East Coast bankers (who were suspected of conspir-
ing to keep money tight) and the Wicked Witch of the West, representing drought (only water can kill her).
25
A good introduction to the topic is provided by Richard Cooper, “The Gold Standard: Historical Facts and
Future Prospects,” Brookings Papers on Economic Activity, 1 (1982): 1–45. It includes the latter-day contro-
versy over proposals to return to the gold standard to restore price stability, and the statistics on the price level
swings that in fact characterized the nineteenth century.
26
John Maynard Keynes accurately predicted this outcome of the return to gold in 1925: “The Economic
Consequences of Mr. Churchill,” reprinted in his Essays in Persuasion (New York: Norton, 1963), pp. 244–270.
Much has been written on this interwar period. See Barry Eichengreen, Golden Fetters: The Gold Standard
and the Great Depression, 1919–1939 (New York: Oxford University Press, 1992).
CAVE.6607.cp19.p353-390 6/6/06 12:16 PM Page 381

Appendix A 381

of their reserves in the form of pounds. This is why the Bretton Woods system was
sometimes called a gold-exchange standard.
Before long, however, the new system came under increasing strain. The reason
was that, beginning in 1958, the United States ran balance-of-payments deficits. Foreign
central banks’ holdings of dollars rose relative to the gold in Fort Knox, and foreigners
(particularly Charles de Gaulle, the gold-conscious leader of France) began to doubt
the ability of the U.S. government to redeem its dollar liabilities in gold. This was the
beginning of the long, drawn-out breakdown of the Bretton Woods system.
The monetarist model can be used to illustrate the emergence of U.S. balance-of-
payments deficits in 1958. Let the countries in the two-country model of the chapter
supplement be the United States and Europe. In the 1950s the European economies
grew more rapidly than the U.S. economy as they recovered from the devastation of the
1940s. Their rapidly growing levels of income led to rapidly growing demand for money.
To acquire international reserves, they had to run balance-of-payments surpluses
against the United States. The model was used in the 1960s to show why the emergence
of U.S. deficits was a natural consequence of the system that had been set up in 1944.
The world monetary system was faced with the “Triffin dilemma.”27 If the United
States was allowed to continue running balance-of-payments deficits, eventually there
would be a crisis of confidence as foreigners all tried to cash in their dollars for gold
before it was too late, and thereby exhausted the U.S. gold reserves. Conversely, if steps
were taken to end the U.S. deficit, then the rest of the world would be deprived of suf-
ficient liquidity in the form of a steadily growing stock of reserves.
Economists and policy makers debated the problem throughout the 1960s. There
were two solutions proposed to increase the world supply of reserves, both of them
radical departures from the system agreed on at Bretton Woods. The first was to
increase the price of gold—that is, to devalue the dollar in terms of gold—thereby rais-
ing the nominal value of the world supply of reserves. The second was to create an arti-
ficial reserve asset, a sort of “paper gold.”
Eventually, both changes were made, although it had not been planned that way.
The artificial asset was the Special Drawing Right, which the members of the Inter-
national Monetary Fund agreed to create in 1968. By the time three batches of SDRs
were phased into use (1970–1972), other events had intervened. In August 1971, in
response to the worsening U.S. balance of payments.28 President Nixon unilaterally
suspended convertibility of the dollar into gold, not just for private residents, but for
foreign central banks as well. When the leading countries met at the Smithsonian Insti-
tution in December 1971 to agree on a new set of exchange rates, the realignments
included a 10 percent devaluation of the dollar against gold. This attempt to shore up

27
Robert Triffin, Gold and the Dollar Crisis (New Haven: Yale University Press, 1960).
28
The year 1971 was the first time since World War II that the United States ran a deficit, not just on the pri-
vate capital account, but on the trade account as well. The U.S. trade surplus had been diminishing steadily
since 1964. The cause was overly expansionary macroeconomic policies, as the Johnson administration—fol-
lowed by the Nixon administration—increased military spending on the war in Vietnam and domestic spend-
ing at the same time, and were reluctant to raise taxes to pay for it. Some have pointed out parallels between
that period and U.S. macro policy from 2001 to 2005.
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382 Chapter 19 ■ The Money Supply, the Price Level, and the Balance of Payments

the system of fixed exchange rates did not last long, and in March 1973 the system was
abandoned completely. The market price of gold increased twentyfold (in dollars) over
the remainder of the decade.

APPENDIX B

Reserve Flows After Spending Increase and Devaluation

Section 19.1 looked at the implications of reserve flow by focusing on the effects of
a monetary expansion. Now consider the effects of a fiscal expansion in the same
model (Mundell’s “income reserve-flow mechanism”). Figure 19.B.1 is a reproduction
of Figure 18.8. The fiscal expansion shifts out the IS curve, raising income. The higher
income at point F causes a trade deficit. The deficit means that reserves are declining
over time.

FIGURE 19.B.1 TB
Effects of a Fiscal Expansion over Time
In the short run an increase in spending raises
output and worsens the trade balance. If the
loss of reserves is not sterilized, then the money +
B
supply falls over time and output returns to its 0 Y
original level at B. F
–

TB

i TB = 0 LM ′ LM

Deficit
F

IS ′

IS
0 Y
CAVE.6607.cp19.p353-390 6/6/06 12:16 PM Page 383

Appendix B 383

As in the case of a monetary expansion, the central bank could sterilize the reserve
outflow to keep the money supply constant and remain at F. Under the assumption of
nonsterilization, however, the money supply falls over time. The LM curve shifts back,
income falls, and the trade balance improves. Eventually, income and the trade balance
return to B, where they were before expansion. There is one difference between the
new equilibrium at B and the old equilibrium at E. The interest rate is higher, meaning
that a reallocation of output between sectors has taken place: The government sector
has expanded at the expense of private investment. We thus have another result under
the monetary approach: A fiscal expansion, athough raising income and worsening the
trade balance in the short run, has no effect on either in the long run.
Finally, consider the effects of a devaluation. Figure 19.B.2 is a reproduction of
Figure 18.9. The devaluation shifts out the IS curve. At point D income has increased.
The devaluation shifts the vertical TB 5 0 line farther out than the IS curve, so the
trade balance improves at point D. As a consequence of the trade surplus, reserves are
increasing over time. The central bank could sterilize the reserve inflow to keep the

FIGURE 19.B.2 TB
Effect of a Devaluation over Time
In the short run a devaluation improves D
the trade balance and raises output. If the
inflow of reserves is not sterilized, then +
C
the money supply rises over time and 0 Y
output rises further to C. –
TB ′

i (TB = 0) ′
LM

LM ′

D Surplus

IS ′

IS
0 Y
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384 Chapter 19 ■ The Money Supply, the Price Level, and the Balance of Payments

money supply constant and remain at point D, but under the assumption of nonsteril-
ization the money supply rises over time and the LM curve shifts out. Income rises and
the trade balance worsens. Eventually, the trade balance returns to zero, at point C. In
this case, however, income ends up at a permanently higher level. The TB line in the
upper panel of Figure 19.B.2 shows the magnitude of the long-run increase in income.
The line’s slope is 2m, so
1
DYLR 5 m DX.

Intuitively, we can see that money keeps flowing in through the trade surplus until
income has risen enough for increased imports, DM, to cancel out the initial stimulus
of the devaluation, DX. This returns the trade balance to where it was before the
expansion.29 It is interesting to compare the effect of the devaluation to what it would
be in the simpler Keynesian multiplier model (at point F), that is, in the absence of
crowding-out:
1
DX.
s1m
The former is larger. Under the monetary approach to the balance of payments, the
long-run effect is not only greater than the short-run effect, but it is even greater than
the short-run effect without crowding-out. The conclusion that a devaluation is an
effective means of raising income even in the long run is a very “unmonetarist” conclu-
sion; it stems from the Keynesian assumption that prices are fixed. This assumption is
not realistic for the truly long run and is relaxed in Section 19.4.

APPENDIX C

The Determination of the Balance

of Payments in the Monetarist Model
This chapter considers only pegged exchange rates. This is probably just as well
because most very small, very open economies (such as Hong Kong) do in fact seek to
maintain a fixed exchange rate. The monetary approach under floating rates will be
taken up in Chapter 27. The goal here is to analyze the effect of monetary policy and
devaluation on the two target variables, income and the trade balance. Furthermore,
this section considers the small-country version of the monetarist model, which means
that the world price level is taken as exogenous.30 Because both the exchange rate and

29
The way Figure 19.B.2 is drawn, the long-run interest rate is lower, and therefore I is higher, after the deval-
uation than before. We know that this must be right. Otherwise, with X 2 M unchanged, Y 5 C 1 I 1 G 1
X 2 M could not be higher after the devaluation.
30
The supplement to this chapter relaxes the small-country assumption to look at the two-country version of
the monetary approach to the balance of payments, which is relevant when the country is large enough to
affect the world price level. (As long as world prices are perfectly flexible and PPP holds, it continues to be a
“monetarist” or “new classical” model, as opposed to the Keynesian model previously examined.)
CAVE.6607.cp19.p353-390 6/6/06 12:16 PM Page 385

Appendix C 385

the foreign price level are determined, by Equation 19.2 the domestic price level is also
determined. This method of determining the domestic price level is very different from
the Keynesian way in which it was exogenously set. The difference becomes obvious
when we consider devaluation as in Section 19.4. PPP states that the devaluation is
instantly reflected as a proportionate increase in the domestic price level, whereas in
the Keynesian model the domestic price level did not change.
Desired money balances are proportional to nominal income.31
Md 5 KPY (19.C.1)
Individuals adapt actual money balances to desired money balances through saving (in
excess of investment), represented by H. This part of the book ignores assets other
than money, such as bonds. (They will enter in Part V.) For this reason, saving can only
take the form of additions to holdings of money balances. H is thus equal to the change
in the money stock over time: It tells us how much the money supply is going up per
year. H is assumed proportional to the current gap between the desired money stock
and the actual money stock, M:
H 5 d(Md 2 M)
where d is the speed with which money balances are adjusted. This equation simply says
that individuals act to add to their money balances when money demand minus money
supply is positive. Now we use Equation 19.C.1 to substitute for long-run desired
money balances, Md.
H 5 d(KPY 2 M) (19.C.2)
Under the key nonsterilization assumption of the monetary approach, the rate of
change of the money supply, M, is the same as the rate of accumulation of reserves, the
balance-of-payments surplus, BP. The equation becomes
BP 5 H 5 dKPY 2 dM (19.C.3)
Equation 19.C.3 looks unlike any balance-of-payments expression seen before. An
increase in the money supply has a negative effect on the surplus, as in the last chapter.
Although the Keynesian model was quite specific about the channel through which the
increase in the money supply raises spending (it lowers the interest rate and thus stim-
ulates investment), the monetarist explanation is more general. A monetary expansion
worsens the balance of payments because individuals, when faced with an excess sup-
ply of money, increase spending to adjust their excessive money holdings back down to
the level of their money demand. (These two explanations can be made entirely consis-
tent if investment depends linearly on the interest rate.32)
Another difference between the two models is that the monetary approach says
the outflow occurs through the overall balance of payments, without differentiating

31
M here represents the money stock, not imports as in previous chapters. Desired money balances, Md, refers
to a long-run notion of money demand; it differs somewhat from the short-run notion of money demand in
IS 2 LM, where the interest rate adjusts so that money demand is always equal to money supply, even in the
short run.
32
The reduced form of the linear IS 2 LM system (i.e., with the interest rate substituted out) is the same as the
monetarist formulation. This is chapter Problem 5b.
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386 Chapter 19 ■ The Money Supply, the Price Level, and the Balance of Payments

between the current account or capital account, whereas the Keynesian approach spec-
ifies that it occurs through the trade balance. However, because we have not yet intro-
duced capital flows, it is difficult to tell the difference.
These differences are not especially important. The crucial difference between the
monetarist and Keynesian models, remember, is price flexibility.
The assumption of perfect wage and price flexibility in the global monetarist
model implies completely inelastic aggregate supply. Because income is always at the
full-employment level, Y 5 Y, the balance of payments in Equation 19.C.3 varies only
with the price level, P, and the money supply, M. Figure 19.C.1 graphs the relationship
between the balance of payments and the price level for a given M, with the balance of
payments measured on the vertical axis, and refers to it as the H schedule.33 As the
equation says, the vertical intercept is 2dM and the slope is dKY. Again, the reason the
schedule slopes upward is that a higher price level means a higher demand for money,
which causes residents to cut back on spending so they can earn the desired money bal-
ances through a balance-of-payments surplus.
The exogenous foreign price level, P*, and the given fixed exchange rate, E,
together determine the domestic price level, P 5 EP*, by Equation 19.2. This price
level, P, is represented in Figure 19.C.1 by a vertical line. Point B in the figure is the
starting point, a position of balance-of-payments equilibrium. Two policy changes will
be considered: monetary policy and devaluation.

FIGURE 19.C.1 BP
Monetary Expansion in the Monetarist
Small-Country Model
H = (δKY )P – δM
An increase in the money supply shifts the
H schedule. With the price level, P, tied down
by PPP, this leads to an excess supply of money
and a balance of payments deficit (BP , 0 at M).
P = EP*
Over time, money flows out of the country and
balance is restored (BP 5 0 at B). H = (δKY )P – δM ′

+
0 P
–
B

33
The symbol H stands for “hoarding,” defined as the accumulation of money through saving.
CAVE.6607.cp19.p353-390 6/6/06 12:16 PM Page 387

Appendix C 387

The Effect of a Monetary Expansion in the Monetarist Model

A monetary expansion shifts the H schedule down. The size of the downward shift is
determined by the size of the change in the vertical intercept (dDM). The economy
moves to point M. Any given P implies a certain level of money demand. At the level
implied by the exogenously given P 5 EP*, an excess supply of money is now evident
because money supply is greater than money demand. (Any point below the horizontal
axis is a point of excess money supply.) People will increase spending or decrease sav-
ing. In fact dissaving, a balance-of-payments deficit, can be read off the vertical axis at
point M.
Recall again the essence of the monetary approach—the identification of the
balance-of-payments deficit with the rate of decumulation of the money supply. The
H schedule shifts whenever the money supply changes. As time passes and money
flows out through the balance-of-payments deficit, the H schedule shifts upward. The
intersection with the price level line gradually moves upward from M. As the excess
supply of money is worked off, the deficit falls, as can be read off the vertical axis. This
process continues until (in the long run) the economy returns to point B, where money
supply again equals money demand and there is no further need for dissaving: The bal-
ance of payments has returned to zero. Only then, when the reserve stock is no longer
changing, has it reached long-run equilibrium.
Conversely, a monetary contraction initially shifts the H schedule upward, improv-
ing the balance of payments. However, the payments surplus itself leads to an increas-
ing money supply, which over time shifts the H schedule back down until, again, in the
long run it returns to balance-of-payments equilibrium.
In the case of either expansion or contraction, there is no long-run effect on the
level of the money supply, but there may be an effect on its composition. Expansion or
contraction of domestic credit is permanent. It is the foreign component of the mone-
tary base—international reserves—that changes to offset the change in domestic credit.

The “Real Balance” Effect of a Devaluation

Now consider the effect of a devaluation. An increase in the exchange rate from E to E9
means that the exogenous world price level, P*, translates into a higher domestic price
level, E9P*, represented by a vertical domestic price line that is farther to the right in
Figure 19.C.2. The higher value of P implies a higher level of domestic money demand.
With an unchanged level of money supply, there is an excess demand for money at
point D. (Any point above the horizontal axis is a point of excess money demand.)
People reduce their spending or increase their saving. A balance-of-payments surplus
results. That devaluation leads to a surplus is a common observation, but in this case the
cause is not a change in relative prices stimulating exports. There can be no change in
relative prices in this model. Rather, the higher price level raises the demand for nomi-
nal money balances. This is the real balance effect.
The balance-of-payments surplus at D means that the money supply is increasing.
Over time, the H schedule shifts down, as the excess demand for money is alleviated by
the increasing supply. In the long run it moves to point C, where money supply again
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388 Chapter 19 ■ The Money Supply, the Price Level, and the Balance of Payments

FIGURE 19.C.2 BP
Devaluation in the Monetarist
Small-Country Model P = EP* P = E ′P*

An increase in the exchange rate from E to E9 H = (δKY )P – δM

raises the price level, P, proportionately, leading
to an excess demand for money and a balance
of payments surplus (BP . 0 at D). Over time,
money flows into the country and balance is
restored (BP 5 0 at C). D

+
0 P
–
B C

equals money demand and the balance of payments is back at zero. The new equilib-
rium after the devaluation features not only a higher price level but a higher money
supply, with both nominal variables having increased in the same proportion as the
exchange rate.
Let us now consider an exogenous increase in the world price level, P*, as might
result, for example, from an expansion in the world money supply. It is instantly trans-
mitted as a proportionately higher domestic price level, P 5 EP*. It acts just like the
devaluation pictured in Figure 19.C.2 so far as the small country is concerned. The
excess demand for money shows up as a temporary balance-of-payments surplus.
Notice again that the favorable effect of the foreign price increase on the balance of
payments does not take place through relative prices, as in the elasticities or Keynesian
approaches, but rather through the effect of the price level on money demand.
Finally, consider an exogenous increase in domestic money demand. Such an
increase in money demand might result, for example, from an exogenous increase in
domestic output, Y. Because this section assumes full employment, the increase in out-
put must come from the supply side: an increase in the capital stock, labor force, or
productivity. In any case, the increase in money demand causes people to cut back
spending so that they can acquire the desired money balances. It acts like the decrease
in money supply previously considered, in that it creates an excess demand for money
and shifts the H schedule up. (More precisely, if the increase in Md comes from an
increase in Y, then it rotates the H schedule in the counterclockwise direction: Refer to
the slope, dKY. The point remains: A higher BP now corresponds to a given P.) The
cutback in spending thus leads to a balance-of-payments surplus. Over time money
CAVE.6607.cp19.p353-390 6/6/06 12:16 PM Page 389

Appendix C 389

flows in through the payments surplus, until equilibrium returns with a higher money
supply and a zero balance of payments, as always.
Notice the sharp contrast to the Keynesian model, in which an increase in income
caused an immediate trade deficit, rather than a surplus. The Keynesian model should
be thought of as correct for income growth induced by increases in spending because it
is a model in which the economy can be below full employment. The present result—
growth causing a payments surplus because of higher money demand—is appropriate
for exogenous supply-induced growth. A prime motivation for the development of the
monetary approach in the 1960s was the observed fact that the fastest growing coun-
tries, such as Japan, Germany, and other European countries, ran balance-of-payments
surpluses while the United States ran a deficit. That the monetary approach could
explain this situation accounted in part for its popularity.34

34
The argument was made by Robert Mundell, “Growth and the Balance of Payments,” in his International
Economics (New York: Macmillan, 1968), Chapter 9. For examples from the current era (in which Japan and
euroland have floating rather than fixed exchange rates and are growing more slowly than before), consider
the cases of China and some other newly industrialized economies of East Asia. They have tended to experi-
ence rapid supply-side growth with surpluses in their balances of payments.
CAVE.6607.supp.pS1-S58 6/7/06 10:39 AM Page S-44

SUPPLEMENT TO CHAPTER 19: The Monetarist Two-Country Model

of the Balance of Payments
Chapter 19 assumed that the home country’s money supply is too small to affect sub-
stantially the world money supply or world price level. To be sure, when international
reserves are flowing out through a balance-of-payments deficit, the rest of the world is
running a balance-of-payments surplus. However, it was assumed that the reserve flow
is just a drop in the ocean so far as the rest of the world is concerned. This supplement
relaxes the small-country assumption and moves to a two-country world. A domestic
monetary expansion will succeed in raising the price level in the world to the extent
that it raises the world money supply. As Appendix B mentioned, the two-country
model is useful for understanding the gold standard, as well as for understanding the
Bretton Woods system, with the United States in the 1960s increasingly playing the
role of the country with a balance-of-payments deficit, and Europe the role of the sur-
plus country.1

1
The model in this supplement is drawn from the first half of Rudiger Dornbusch, “Devaluation, Money, and
Nontraded Goods,” The American Economic Review, 65, no. 5 (1973): 871–880.
CAVE.6607.supp.pS1-S58 6/7/06 10:39 AM Page S-45

Supplement to Chapter 19 S-45

Determination of the Balance of Payments in the Two Countries

We model the foreign country just as we modeled the domestic country in the chapter.
The rate of increase of the foreign money supply, H*, is related to the foreign excess
demand for money. The foreign excess demand for money is, in turn, an increasing
function of foreign nominal income, or of the foreign price level, with foreign real
income determined at Y* by exogenous supply factors, and a decreasing function of
the foreign money supply, M*.
H* ; M* 5 dKY*P* 2 dM* (19.S.1)
We multiply through by the exchange rate to work in terms of domestic currency.
EH* 5 dKY*P* 2 dEM* (19.S.2)
Here we have applied PPP (P 5 EP*). Equation 19.S.2 represents the foreign pay-
ments surplus measured in domestic currency. Its negative is the domestic payments
surplus measured in domestic currency:
BP 5 2EH* 5 2dKY*P 1 dEM* (19.S.3)
This is a second equation describing the balance of payments, in addition to Equa-
tion 19.5. It represents, for a given foreign money supply, M*, a negative dependence of
the domestic balance of payments on the price level. An increase in the domestic price
level under fixed exchange rates is an increase in the world price level. As far as the
foreign country is concerned, it raises the foreign demand for money and leads to a for-
eign payments surplus, which is a domestic payments deficit.
The downward-sloping BP 5 2EH* schedule, Equation 19.S.3, is shown in Fig-
ure 19.S.1 on the same axes as the upward-sloping BP 5 H schedule, Equation 19.5.
Because both equations must hold, short-run equilibrium is given by the intersection of
the two schedules, at point A initially.

Determination of the World Price Level

It is possible to solve the two simultaneous equations for the world price level expressed
in domestic currency.
dKYP 2 dM 5 dKY*P 1 dEM*
M 1 EM*
P5 (19.S.4)
K(Y 1 Y*)
The numerator is the total world money supply measured in domestic currency. Con-
sidered in the aggregate, Planet Earth is, after all, a closed economy, so it makes sense
that the world price level should be proportionate to the world money supply. Equa-
tion 19.S.4 is shown in Figure 19.S.1 as a vertical line at the price level P.

The Effect of an Increase in One Country’s Money Supply

An increase in the domestic money supply shifts the country’s H schedule down by
dDM, precisely the same as in the small-country model of Figure 19.16: An excess
supply of money leads to “dishoarding.” The H schedule also can be viewed as shifting
CAVE.6607.supp.pS1-S58 6/7/06 10:39 AM Page S-46

S-46 Supplements for Selected Chapters

FIGURE 19.S.1 BP
Monetary Expansion in the Monetarist,
M + EM*
Two-Country Model P=
K (Y + Y* )
A monetary expansion of 1 percent will raise
the world price level by c percent, where c is
the domestic country’s fraction of the world’s P=
M ′+ EM*
money supply. As with a small country (where K (Y + Y* )
c 5 0), the expansion shifts the H schedule H = (δKY )P – δM
downward leading to a temporary excess
supply of money and balance-of-payments
deficit. ψ%
H = (δKY )P – δM ′
1%
+
0 P
– A B

-EH* = (δKY* )P + δEM*

horizontally to the right by the same proportion as the increase in the money supply: If
the price level were for some reason to increase by the same proportion as the money
supply, the excess supply of money would remain at zero.
When the country was small, the world price level was unchanged; but now it is
recognized that the monetary expansion will raise the world price level to the extent
that the domestic country is large. Define the domestic country’s share in the world
money supply.
c ; M / (M 1 EM*)
A 1 percent increase in the domestic money supply is a c percent increase in the world
money supply. As shown in Equation 19.S.4, it raises the world price level by c percent,
whether that is measured in terms of domestic currency, P, or foreign, P*. In Figure
19.S.1, the monetary expansion shifts to the right not only the domestic H line but the
price level line as well. This means that the money demand function must be evaluated
at a higher price level, at point M. Under the previous small-country case, c was negli-
gible, and so the price level rose negligibly. There was an increase in the money supply
of, say, 1 percent, with no increase in money demand. Now there is a 1 percent increase
in the money supply with a c percent increase in money demand. There is still an excess
supply of money (equal to 1 2 c percent of the original money supply), and therefore a
balance-of-payments deficit, but they are not as large as in the small-country case.
CAVE.6607.supp.pS1-S58 6/7/06 10:39 AM Page S-47

Supplement to Chapter 24 S-47

What is happening in the foreign country? Its money supply has not changed, but
it is faced with a c percent increase in the price level. Therefore, its demand for money
goes up by c percent. It has an excess demand for money (equal to c percent of its
money supply) that is the counterpart of the domestic country’s excess supply of
money, causing a foreign balance-of-payments surplus that is the counterpart of the
domestic country’s balance-of-payments deficit.
Over time, the domestic country loses gold to the foreign country. Under the non-
sterilization assumption, the domestic money supply falls and the foreign money sup-
ply rises. The domestic H schedule shifts upward and the negative foreign schedule,
2EH*, shifts upward as well. The economy follows a sequence of intersections, moving
upward from M along the new price level line. The transfer of money from the home
country to the foreign country gradually alleviates the excess demand in the foreign
country. Long-run equilibrium is reached when both countries return to a zero balance
of payments, at point B. There the supply of money equals the demand for money in
both countries. Because the price level has risen by c percent in both countries and the
demand for money is proportional to the price level, this can only mean that the supply
of money has increased by c percent in both countries. The world money supply has
increased by c percent. In the short run the expansion took place entirely in the
domestic country, but in the long run it is distributed equiproportionately across both
countries.
CAVE.6607.cp20.p391-408 6/6/06 12:21 PM Page 391

CHAPTER 20

Developing Countries and

Other Small Open Economies
with Nontraded Goods

I
magine the dilemma faced by the finance minister of a small developing country that
needs to improve its trade balance. Advisers urge that some combination of deval-
uation and contractionary demand policies be adopted. They base their reasoning on
standard macroeconomic models such as the ones developed in the preceding chap-
ters.1 The finance minister has little faith in these models, believing that they were
designed to fit the experience of relatively large industrialized countries, not small
developing countries. But the finance minister also does not believe the simple small-
country monetarist model developed in Chapter 19.2 A bit more realism is required.
This chapter departs temporarily from the central focus of the text to consider an alter-
native model that is particularly appropriate for typical developing countries.
If a country were so open to international trade and so small in world goods mar-
kets that purchasing power parity held, then, by definition, a devaluation could not
change relative prices. As we saw in Section 19.4, a devaluation could affect the trade
balance only through the real money balance effect. Hong Kong and Singapore were
cited as relatively close approximations of such an economy.
Even countries that are small in terms of world trade often have large internal mar-
kets, however. Indonesia and Australia, for example, are probably too small in world
markets to affect their terms of trade, but they are certainly not “small” countries in
other respects. This chapter will continue to consider countries that are sufficiently
small and open that they take the prices of all traded goods (exports and imports) as
determined outside the country and fixed in terms of foreign currency. However, the
existence of goods that are not internationally traded will also be recognized. The dis-
cussion will reveal that, as a consequence, such countries experience relative price
effects when they devalue, along with the real money balance effect already explored.

1
Such recommendations are often highly unpopular politically, especially when they are perceived to be
imposed by the International Monetary Fund (IMF). See Chapter 24 for more on the unpopularity of
devaluations.
2
Blind adherence to PPP (among other things) got the policy makers of the “southern cone” of Latin America
(Argentina, Chile, and Uruguay) into trouble in the late 1970s. Vittorio Corbo and Jaime de Melo, “Liberaliza-
tion with Stabilization in the Southern Cone of Latin America,” World Development, Special Issue, 13, no. 8
(August 1985): 893–916.

391
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392 Chapter 20 ■ Developing Countries and Other Small Open Economies with Nontraded Goods

20.1 Nontraded Goods

We first introduced nontraded goods in Section 4.6. Chapter 19 explained that the exis-
tence of nontraded goods is one reason why PPP fails to hold in practice.
The primary examples of nontraded goods are not goods at all, but services. Some
services, such as insurance, shipping, tourism, and computer programming, are interna-
tionally traded, and these have been growing in importance in recent years, especially
with the advent of the Internet. (Witness the public attention to overseas outsourcing.)
Nevertheless, most services are too localized to be traded internationally—for exam-
ple, personal services like those offered by barbershops and dry cleaners. Some larger
sectors, such as housing, utilities, and local transportation, also fit in this category.
Some goods are also nontraded, specifically those where the cost of transporting
them internationally is prohibitively high. Highly perishable food is a good example.
More commodities will qualify as nontraded in a country far removed from the rest of
the world geographically, like Australia, than in one centrally located, like Germany.
Prohibitively high trade barriers can also render goods nontraded. Particularly in
developing countries, transportation costs and trade barriers sometimes insulate much
of the economy from the rigors of international competition. In Latin America, for
example, high import tariffs and quantitative restrictions on imports of manufactured
goods historically have put into the nontraded category some industries that might oth-
erwise be in the category of traded goods. A final case is that in which cultural tastes
are such that foreigners are not interested in consuming the good in question. Who but
an Australian could love Vegemite?

Output of Traded and Nontraded Goods

We now develop the appropriate model for thinking about a small open economy with
nontraded goods.3 We recall that if the country is too small to affect its terms of trade,
then we can aggregate together tradable goods, for the reasons explained in Section
19.4. We begin by drawing the production possibility curve, or transformation schedule,
showing the different quantities of nontraded goods versus traded goods that the econ-
omy can produce if its labor and other resources are fully employed. Figure 20.1 shows
this curve, with traded goods measured on the horizontal axis. The curve has the usual
bowed-out shape, meaning that there are diminishing returns as more and more labor
is shifted out of nontraded goods into traded goods. Section 4.6 considered the special
case of Ricardian production, in which this production possibility curve was flat. In that
case the relative price of traded goods in terms of nontraded goods is determined
entirely by the relative labor costs of producing the two goods, which is a constant (the
slope of the line). In general, however, the relative price will vary and with it the quan-
tities of the two kinds of goods that are profitable to produce (as in Section 2.7).
Assume that the relative prices are given by the slope of the straight line in Fig-
ure 20.1. PN will denote the relative price of nontraded goods. PN ; Pn / Pt , where Pn

3
A country’s “openness” could be defined as the ratio of its production of traded goods to its total GDP. This
chapter focuses on countries that, although small as in the model of Section 19.4, are not 100 percent open.
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20.1 ■ Nontraded Goods 393

FIGURE 20.1 NTG

Output and Consumption of
Traded and Nontraded Goods
Production occurs where the
transformation curve is tangent to a
relative price line. Consumption occurs
where the budget line is tangent to an
indifference curve. As drawn, the two
points coincide, so output of traded
S
goods, TG, equals consumption of
traded goods, and the same is true
for nontraded goods, NTG.

TG

and Pt represent the (nominal) prices of nontraded goods and traded goods, respec-
tively. PN gives the number of units of traded goods required to buy one unit of non-
traded goods. When PN is low, nontraded goods are relatively cheap and the budget
line in Figure 20.1 is steep: A resident can buy a larger quantity of nontraded goods for
any given quantity of traded goods.
In the most general case, many combinations of outputs are “fair game,” including
points that lie inside the production possibility curve. These are points at which the
supplies of labor and other resources are not being fully utilized, so that output of both
goods is less than it could be. In this chapter, however, the discussion will be restricted
to the assumption that labor and other resources are fully employed, as in Chapter 19.
In this case, the quantities of output of the two goods, XN and XT, are given by the point
S, where the line is tangent to the curve. The output quantities are the outcome of sup-
ply decisions that firms make when faced with the prevailing prices. Keep in mind that
output of traded goods includes not only specific products that the home country
might currently be exporting but also specific products that might be imported if the
demand from domestic consumers exceeds domestic output.

Consumption of Traded and Nontraded Goods

The trade balance is given by the quantity of traded goods produced minus the quantity
of traded goods consumed. If some of the output produced remains after domestic resi-
dents have bought what they want, it is exported and the country runs a trade surplus.
There is no question as to whether there will be sufficient demand for the goods outside
the home country because under the small-country assumption, the rest of the world
will take all goods that the country has to offer at the going world price. If, however,
domestic consumption of traded goods exceeds domestic output, then the difference is
imported and the country runs a trade deficit. This way of thinking of the trade bal-
ance—as the difference between the output and the consumption of traded goods—is
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394 Chapter 20 ■ Developing Countries and Other Small Open Economies with Nontraded Goods

the same as in the small-country model of Section 19.4, the only difference being that
there all goods were traded goods. It is very different, however, from the way we
thought of the trade balance in Chapters 16 to 18—as foreigners’ demand for the export
goods of the home country minus domestic residents’ demand for the imports. In the
present model, with all traded goods aggregated together, it is impossible to say what
determines the level of exports and the level of imports. Fortunately, it is not necessary
to know either level to determine the difference of the two, the trade balance.
What determines the pattern of consumption? Assume, as in Figure 2.7, that we
can draw community indifference curves. Along any given indifference curve, con-
sumers are equally happy with the different possible combinations of nontraded and
traded goods consumed, CN and CT. The slope of the indifference curve is the marginal
rate of substitution between the two; it tells the amount of consumption of nontraded
goods the consumer is willing to give up to get one more unit of traded goods. Indiffer-
ence curves farther from the origin are better, of course, because more consumption
is better than less. The curves are convex because of the diminishing marginal rate of
substitution.
To attain the highest level of welfare available to them, consumers will determine
their quantities purchased, CN and CT at the point on an indifference curve where the
given price line is tangent, that is, where the marginal rate of substitution is set equal to
the relative prices of the two kinds of goods. It is possible that this will be the same
point, S, where production occurs. In that case the quantity of traded goods consumed
will equal the quantity of traded goods produced. If this happens, the trade balance is
zero. If we were to rule out gaps between expenditure and income, thereby ruling out
trade deficits or surpluses, as in most of the first half of the text, we would necessarily
be at S. Indeed, under this restriction, the relative price line would have to be deter-
mined endogenously by the unique point where the production possibility frontier was
tangent to an indifference curve.
Now we allow for countries to “spend beyond their means.” We assume expendi-
ture is at some level, A (measured in terms of traded goods: A ; CT 1 PNCN), that is
greater than the level of income, Y (also expressed in terms of traded goods: Y ; XT 1
PNXN). For example, there may have been an income tax cut or an increase in expendi-
ture on the part of the government that raised A. A and Y are measured along the hor-
izontal axis in Figure 20.2. The budget line is the one that passes through point A, with
consumers assumed to face the same relative prices as producers. (There are no taxes
or subsidies on the goods.) CN and CT are located where the budget line is tangent to
an indifference curve, at point F. This is where consumers attain the highest level of
welfare, given their budget constraint. In Figure 20.2, consumption of both goods
exceeds output. In the case of traded goods, the difference (CT 2 XT), which can be
measured horizontally on the graph, is simply the trade deficit. Consumers are satisfy-
ing their excess demand for traded goods abroad. In the case of nontraded goods, the
difference (CN 2 XN), which can be measured vertically, is the excess demand for non-
traded goods. According to the definition of nontraded, this excess demand cannot be
satisfied abroad but can be thought of as being satisfied out of inventories held by
firms (temporarily, until they run out).
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20.2 ■ Expenditure and the Relative Price of Nontraded Goods 395

FIGURE 20.2 NTG 2

B
Increase in Expenditure,
Followed by Decrease
in Relative Price of
Nontraded Goods 1
Assume expenditure
exogenously increases to
A, beyond income, Y. If
relative prices are unchanged,
F
consumption is at F, implying CN
excess demand for NTG and Excess
excess demand for TG. If the demand
XN
relative price of traded goods S
is increased, it raises output of
TG at X and may also lower X
consumption of TG at B.

XT CT Y A TG

Trade deficit

Other conditions could exist in these markets as well: a trade surplus if F occurs
anywhere to the left of S, and an excess supply of nontraded goods if F occurs any-
where below S. The next thing to consider is what determines these points of consump-
tion and output.4

20.2 Expenditure and the Relative Price of Nontraded Goods

This section will examine the effects of changes in the level of relative prices PN and
expenditure A. Subsequent sections will show how exogenous changes in exchange
rate policy and monetary policy bring about changes in relative prices and expenditure.
For the moment, take PN and A as given.
We examine the effect in the traded goods market first. Starting from a position of
zero trade balance, S in Figure 20.2, an increase in expenditure with no change in rela-
tive prices will move the country into trade deficit because a certain share of the new
expenditure falls on traded goods. Remember that importable and exportable goods
are aggregated together. It does not matter here whether the additional purchases are

4
Figure 20.2 is known as the Salter diagram because it originated with W. E. G. Salter, “Internal Balance and
External Balance: The Role of Price and Expenditure Effects,” Economic Record (August 1959): 226–238.
Salter, like a number of the other authors who developed the model that features both traded and nontraded
goods, was Australian. Australia fits the model relatively well because the two categories of goods are fairly
clearly drawn. (The model goes by various names: Australian, nontraded goods, dependent economy, and small
open economy.)
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396 Chapter 20 ■ Developing Countries and Other Small Open Economies with Nontraded Goods

imports or goods that would otherwise have been exported; in either case the result is a
worsening of the trade balance. When the new spending comes from the private sec-
tor—for example, in response to a tax cut—the deterioration in the trade balance is the
marginal propensity to spend on traded goods times the increase in expenditure. When
it is government expenditure that has increased, the import content could be either
higher (as it usually is in the case of military weapons, construction equipment, or other
capital goods) or lower (as in education or health services). For simplicity, assume that
the government’s marginal propensity to spend on traded goods is generally the same
as that of the private sector.

Maintaining Equilibrium in the Traded Goods Market

Let us now ask what would have to happen, after an increase in expenditure such as
that illustrated in Figure 20.2, to restore trade balance, without claiming that this will in
fact necessarily happen. To restore trade balance, the relative price of traded goods
would have to rise to eliminate an excess demand for traded goods. This could happen
if the country decides to devalue, that is, to increase the price of foreign currency. The
price of traded goods will rise by the same percentage as the price of foreign currency.
If the price of nontraded goods remains the same, or at least fails to rise as much as the
price of traded goods, then the relative price of traded goods will have risen.5 In other
words, the relative price of nontraded goods, PN, will have fallen.6
It certainly sounds plausible that an increase in the relative price of traded goods
will help eliminate an excess demand for traded goods, just as an increase in the rela-
tive price of chocolate will help eliminate an excess demand for chocolate. But we have
to see how this would work. In Figure 20.2 the change means that the relative price line
has become steeper (line 2 instead of line 1): Each unit of traded goods is now worth
more units of nontraded goods. The effect on production of traded goods will clearly be
favorable. As resources shift out of nontradables into tradables, we move down along
the production possibility frontier from S.
What incentive induces resources to shift from one sector to the other? Within the
tradable industry, the higher price at which firms can sell their products means that at S
the real wage in terms of traded goods, W / PT, is now below the marginal product of
labor. These firms thus find it profitable to hire more workers. They will continue to
hire workers until they reach the point at which the marginal product of labor is down
to the level of the new real wage. In a full-employment model with flexible wages, the
increased demand for labor from the tradables sector will quickly bid up the nominal
wage—not just in that sector, but throughout the economy, assuming that workers are

5
If the price of nontraded goods is fixed in terms of domestic currency because firms supply these goods with
infinite elasticity—the same assumption that we made for domestically produced goods in Chapters 16
through 18—then a devaluation is the only way that the country can increase the relative price of traded
goods. In this case, with nominal prices fixed, we could speak interchangeably of the nominal exchange rate
and the relative price of traded goods.
6
Incidentally, the relative price of traded goods in terms of nontraded goods in small open economies (particu-
larly in Latin America) is sometimes called the real exchange rate. Because others use the term “real exchange
rate” to denote the price of foreign goods in terms of domestic goods, we avoid this alternative use of the term.
CAVE.6607.cp20.p391-408 6/6/06 12:21 PM Page 397

20.2 ■ Expenditure and the Relative Price of Nontraded Goods 397

basically the same in both sectors. Firms in the nontraded sector now find that the real
wage in terms of their product has risen. They now find it less profitable to produce on
the same scale as previously, so they release labor and contract in size. Under the full-
employment assumption, the workers who lose their jobs in the nontraded sector are
the same ones hired in the expanded traded sector. We continue to move down the
curve until we reach X, the new point of tangency with the relative price line. By read-
ing off the horizontal axis, we can see that the quantity of tradable goods has risen.
The effect of the increase in the relative price of tradables on consumption is not
quite as clear as the effect on production. There is clearly a positive substitution effect:
The steeper relative price line means a move upward along any given indifference
curve to lower levels of consumption of traded goods. However, there is also an income
effect that may go the other way. It depends on what is assumed about the level of
expenditure. The experiment we are examining is an exogenous increase in expenditure
and the associated change in relative prices that would be necessary if balanced trade is
to be restored. In this experiment, when the relative price of traded goods rises, the
expenditure line remains tied down at its new bottom endpoint (expenditure remains
fixed at the new level, A, in terms of traded goods).7 The expenditure line swivels to its
new, steeper slope, the same slope as the new price line facing producers. The new con-
sumption point will be located at a point such as B, where the steeper expenditure line
is tangent to a new indifference curve. This point could be located either to the right or
left of the old point, F. Thus the consumption of traded goods could either rise or fall.
The trade balance is the difference between the production and consumption of
traded goods. Thus, even if consumption fails to fall because of the income effect, the
trade balance would still probably improve because of the unambiguously positive
effect on production. Assume that the production effect and the substitution effect in
consumption are large enough to outweigh the negative income effect in consumption;
therefore, the net effect on the trade balance is positive. The new trade balance is the
distance, measured horizontally, between X and B. If the increase in the relative price
of traded goods is large enough, then it will eliminate completely the trade deficit that
opened up when expenditure was increased. This is the case shown in Figure 20.2: B is
directly over X.
Now consider, on a graph of its own, the relationship between expenditure, A, and
the relative price of nontraded goods, PN, necessary to maintain trade balance equilib-
rium. Figure 20.3 shows expenditure on the horizontal axis and the relative price of
nontraded goods on the vertical axis. Again, S denotes the initial point of both external
balance (a zero trade balance) and internal balance (no excess supply or demand for
nontraded goods). Increased expenditure causes a horizontal move to the right (by
precisely the same distance as the movement of the expenditure point along the hori-
zontal axis in Figure 20.2). Point F lies in a region of trade deficit because expenditure
on traded goods has increased, and a sufficiently large increase in the relative price of

7
Because we are considering changes in relative prices, how we draw the graph depends in part on whether we
define expenditure in terms of traded goods or in terms of nontraded goods. In other words, the precise ques-
tion we are asking is slightly different, depending on whether we hold expenditure constant in terms of one
type of good or the other. Naturally, then, the precise answer is slightly different.
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398 Chapter 20 ■ Developing Countries and Other Small Open Economies with Nontraded Goods

FIGURE 20.3 PN
Equilibrium in the Traded
Goods Market
Trade
In the aftermath of an increase in deficit
expenditure, A, if the relative price of F
nontraded goods, PN, is decreased far S
enough, it will eliminate the excess
demand for TG, which is the trade deficit.
Thus equilibrium in the TG market gives
the downward-sloping BB schedule. B BB

traded goods would be needed to restore balanced trade. This is the same as a suffi-
ciently large decrease in the relative price of nontraded goods, represented by a move-
ment vertically downward from point F to point B in Figure 20.3. For each level of A,
there is a corresponding level of PN that is necessary to maintain balanced trade. We
can trace out a whole series of points representing combinations of A and PN, which is
downward sloping, as shown in the graph. We label this curve BB, for balance of trade.

Maintaining Market Equilibrium for Nontraded Goods

There is no reason why an increase in expenditure necessarily will be accompanied by
a decrease in the relative price of nontraded goods to maintain equilibrium in the mar-
ket for traded goods. This requires something like a deliberate decision by the govern-
ment to devalue. Notice in Figure 20.2 that, although the excess demand for traded
goods has been eliminated by the change in relative prices, there is now a large excess
demand for nontraded goods: Point B lies far above point X. Policy makers may be just
as concerned about equilibrium in the market for nontraded goods and the related
problems of employment and inflation as they are about trade balance equilibrium. We
now consider what would have to happen to maintain equilibrium in the market for
nontraded goods instead of traded goods.
We return to the initial increase in expenditure that moves the economy to point F
in Figure 20.2. Some of the increased expenditure falls on nontraded goods. Thus point
F is a point of excess demand for nontraded goods. The excess demand can be mea-
sured vertically as the gap between consumption and output, in either Figure 20.2 or its
equivalent Figure 20.4. In terms of Figure 20.3 or its equivalent Figure 20.5, the increase
in expenditure causes the move rightward from S to F, into a region of excess demand.
Eliminating this excess demand for nontraded goods would require that the rela-
tive price of nontraded goods rise. Again there are effects on both production and
consumption. The higher price of nontraded goods makes their production more prof-
itable. Resources shift out of the other sector into nontraded goods, causing a move up
along the production possibility frontier from S, as shown in Figure 20.4, until reaching
a point of tangency, X, with the new, less steep relative price line. Thus XN rises. The
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20.2 ■ Expenditure and the Relative Price of Nontraded Goods 399

FIGURE 20.4
Increase in Expenditure, Followed by Increase
in Relative Price of Nontraded Goods
Again, an exogenous increase in expenditure, A, beyond Y, moves consumption to F but leaves
output at S if relative prices are unchanged. If the relative price of traded goods is decreased,
it raises output of NTG at X and lowers consumption of NTG at G.

NTG
1

CN F

Excess
demand
X G
XN
S

Y A TG

higher relative price of nontraded goods also means that consumers substitute away
from them into the cheaper traded goods. The income effect, like the substitution
effect, reduces consumption of nontraded goods, as is seen when the relative price line
is rotated downward to the new tangency (line 3 instead of line 1). The income effect is
not ambiguous, as it was when considering the demand for traded goods. CN unambigu-
ously falls at point G.8
If the increase in the relative price of nontraded goods is sufficiently large, then the
upward movement of output and the downward movement of consumption will be suf-
ficiently large that the point X and the point G will be at the same horizontal level: The
excess demand for nontraded goods that opened up when expenditure increased will
have been eliminated. In terms of Figure 20.5, a sufficiently large increase in the rela-
tive price of nontraded goods, PN, returns the country to equilibrium in the domestic
market at point G. There is an entire set of combinations of A and PN, such as S and G,
that give equilibrium in nontraded goods. These points constitute the upward-sloping
internal balance schedule, NN. To recap the reason for the NN schedule’s upward

8
If expenditure had been set in terms of nontraded goods rather than in terms of traded goods, then a change
in relative prices would have an ambiguous effect on the demand for nontraded goods and an unambiguous
effect on the demand for traded goods. This is the method used in the dependent economy model in Rudiger
Dornbusch, Open Economy Macroeconomics, 2nd ed. (New York: Basic Books, 1989).
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400 Chapter 20 ■ Developing Countries and Other Small Open Economies with Nontraded Goods

FIGURE 20.5 PN II
Equilibrium in the Nontraded Excess
B Trade N
Goods Market supply
Trade deficit G
In the aftermath of the increase in surplus Excess
expenditure, A, if the relative price of demand
nontraded goods, PN, is increased far
enough, it will eliminate the excess III
F I
S
demand for nontraded goods. Thus Trade
equilibrium in the NTG market gives Excess deficit
the upward-sloping NN schedule. supply
Trade
N Excess surplus B
demand
IV

slope, an increase in expenditure A must be accompanied by a sufficiently large

increase in PN if the potential excess demand for nontraded goods is to be eliminated.
The external balance schedule, BB, and the internal balance schedule, NN,
together divide the policy instrument space into four quadrants, or four “zones of eco-
nomic unhappiness.” (I) Any point such as F has a trade deficit and an excess demand
for nontraded goods, as we have seen. Proceeding counterclockwise through the other
three regions, we have (II) trade deficit with excess supply of goods, (III) trade surplus
with excess supply, and (IV) trade surplus with excess demand. In general, the govern-
ment would need to set both policy variables, A and PN, to hit both targets. Only at
point S are both the traded and nontraded goods markets in balance simultaneously.
(The graph is conceptually the same as the Swan diagram derived in Chapter 18,
although the curves are flipped vertically because that chapter showed increases in the
exchange rate as movements up the vertical axis, rather than down.9)
To take an example, many Latin American countries in the period from 1974 to
1982 were at points like F, as the result of high levels of government spending: They
experienced excess demand for nontraded goods together with large trade deficits,
which they financed by borrowing from foreign banks.10 Many also had overvalued cur-
rencies, and thus were at points like G, even farther from external balance than F. After
1982, the typical Latin American country was obliged to cut the level of government

9
More substantively, the Keynesian model focused on the price of exports in terms of imports, whereas this
chapter uses the price of traded goods in terms of nontraded goods. Swan originally developed his diagram in
the context of the nontraded goods model, not in the context of the Keynesian model. Trevor Swan,
“Economic Control in a Dependent Economy,” Economic Record (November 1956): 239–256.
10
The other major source of financing for government deficits in the Latin American countries was printing
money. A point like G in Figure 20.5 is shown to correspond to a high rate of money growth and inflation, in
Rudiger Dornbusch, “Stabilization Policy in Developing Countries: What Lessons Have We Learned?”,
reprinted in his Dollars, Debts and Deficits (Cambridge, MA: MIT Press, 1986). It would follow that a prereq-
uisite to eliminating inflation is eliminating the budget deficit (while simultaneously undergoing a real devalu-
ation, if seeking to avoid excess supply of domestic goods in zone II, that is, seeking to move to S).
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20.3 ■ The Monetary Approach with Nontraded Goods 401

expenditure and devalue its currency to generate more foreign exchange earnings,
thereby helping to pay the interest bill on the debts that it had incurred. It moved into
region III of the diagram, with a trade surplus and an excess supply of nontraded goods.
Developing countries in Latin America and some other parts of the world were obliged
to increase their trade balances dramatically after 1982 in response to decreased avail-
ability of loans to finance their deficits. In the early 1990s, developing countries were
able once again to finance large trade deficits. Chapter 24 discusses this phase and its
subsequent reversal in the late 1990s.

20.3 The Monetary Approach with Nontraded Goods

Even if the government does not undertake any deliberate policy change in response
to a trade deficit or in response to excess demand for nontraded goods at a point like F,
two automatic mechanisms of adjustment may be set in motion. First, in response to
the excess demand for nontraded goods, producers of these goods would be expected
to raise their prices. If the market for nontraded goods operates with sufficient flexi-
bility, the prices of nontraded goods, and therefore PN, will rise sufficiently quickly to
restore equilibrium at G.
In practice this is likely to be a more gradual process. The adjustment process can
be especially slow if the country finds itself in a position of excess supply, as at point H
in Figure 20.6, because then a fall in the price of nontraded goods is required. There
may be a prolonged recessionary period, with unemployed labor if wages adjust slowly.
In such circumstances, a case can be made for speeding up the process by a change in
government policy. One possibility is to devalue the currency, thus accomplishing the
required reduction in the relative price of nontraded goods, and immediately jumping
downward in Figure 20.6 to equilibrium on the NN schedule. Another possibility is to
increase expenditure, moving to the right in the same figure. Unfortunately, a policy
change bringing the country closer to internal balance may move it farther from exter-
nal balance.

Reserve Flows
A second possible automatic mechanism of adjustment, which operates in response to
external imbalances, is the flow of international reserves we studied in Chapter 19
under the monetary approach to the balance of payments. As we saw there, the money
supply is one of the policy variables that determines the level of expenditure. When the
country is running a balance-of-payments deficit, at a point like F in Figure 20.5, its
level of reserves is decreasing over time. If the reserve loss translates into a reduction
in the total money supply, then it will exert a contractionary effect on expenditure. A
declining level of expenditure means a gradual movement leftward over time and a
diminishing balance-of-payments deficit. The movement stops at a point on the exter-
nal balance line, BB, because the rate of change of reserves is zero when the balance of
payments is zero. However, if the monetary authorities offset the effect of the reserve
loss on the money supply by expanding domestic credit (i.e., sterilize), then there will
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402 Chapter 20 ■ Developing Countries and Other Small Open Economies with Nontraded Goods

FIGURE 20.6 PN
Adjustment with Excess Supply II
of Nontraded Goods
B N
At a point to the left of BB, such as H,
excess supply of nontraded goods puts
Excess
downward pressure on the price of NTG.
supply
Even when the NN schedule is reached,
however, there is still a trade surplus.
If the reserve inflow is not sterilized, III H I
expenditure, A, increases over time. S

N E
IV
B

be no leftward movement. However, the country cannot continue to intervene in the

foreign exchange market forever. As the central bank’s level of reserves approaches
zero, the government will eventually be forced to react, either by reducing expenditure
or—if it is too late for that—by devaluing the currency.
This is precisely what happened in the Mexican peso crisis of 1994. Sterilization of
reserve outflows kept Mexico at a point like G for a while. But eventually the Banco de
Mexico used up its reserves, and in December 1994 it was forced to undergo a painful
devaluation and contraction of the real money supply, to return to S.
Similarly, when the country is running a balance-of-payments surplus, at a point
like H in Figure 20.6, its level of reserves is increasing over time. If the upward effect
on the money supply is not offset, then expenditure will be increasing. There is move-
ment rightward in the graph, with the balance-of-payments surplus gradually decreas-
ing over time, until equilibrium is reached somewhere on the BB schedule. Again, the
government can forestall this process by reducing domestic credit (sterilizing), which it
may choose to do if it is politically or emotionally attached to its trade surplus. Indeed,
unlike the situation facing a deficit country, there is nothing to force a surplus country
to adjust. For example, China has run enormous surpluses and allowed its reserves to
pile up to levels that surpass the largest and wealthiest countries in the world.

The Dutch Disease

Reserve inflows can create serious problems, however. One cause of potentially unde-
sirable reserve inflows is the Dutch disease, discussed in Section 5.8: a natural resource
boom, as experienced by the Netherlands in the 1960s (a producer of natural gas) and a
variety of other countries in the 1970s and again after 2002 (producers of oil, coffee,
and various other mineral and agricultural products).
Sometimes the commodity boom takes the form of high export earnings because
of high world prices today, perhaps prices that are only temporarily above their long-
run equilibrium; in that case the surplus should appear in the current account. On other
occasions, the commodity boom takes the form of newly discovered deposits that will
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20.3 ■ The Monetary Approach with Nontraded Goods 403

take time to develop; in that case the surplus should appear in the capital account, as
the country borrows to smooth spending, and in particular to finance imports of capital
goods necessary to develop the resource (e.g., equipment for drilling and pumping, in
the case of oil). Either way, the commodity boom results in a surplus in the balance of
payments.
Sometimes an analogy is drawn between the Dutch disease and other forms of
exogenous inflows, such as unilateral transfers, or capital inflows arising from monetary
stabilization or other sources. Many developing countries have experienced such
inflows intermittently, particularly in three boom periods: 1975 to 1982, 1990 to 1996,
and 2001 to 2006, as we shall see in Section 24.1. Whatever the cause of the reserve
inflows, the difficulty arises when real appreciation of the currency causes a loss of
competitiveness for exports of manufactured goods (or for any other tradable-goods
industry)—excluding, of course, the industry experiencing the export boom that is the
original source of the reserve inflow.
How does a reserve inflow lead to real appreciation of the currency? There are
two possible mechanisms. On the one hand, if the monetary authorities keep the
exchange rate fixed, then the monetary approach to the balance of payments indicates
that the reserve inflow will cause the money supply to swell, which may in turn lead to
increases in wages and the prices of nontraded goods. In this case the real appreciation
takes the form of inflation. On the other hand, the monetary authorities may respond
to the reserve inflow by allowing the currency to appreciate in nominal terms, bringing
about the real appreciation directly. To take an example, the value of Colombia’s cur-
rency tends to move with the international price of its leading export, coffee.
The real appreciation is an increase in the relative price of nontraded goods. In
many countries experiencing a commodity boom, revenues accrue to the government,
either because it owns the resource directly (the norm among oil exporters) or because
it is paid royalties or tax proceeds by the private owners. Typically the government
responds by raising spending, which is another source of increased demand and
upward pressure on the prices of nontraded goods. Not only are resources pulled into
the sector experiencing the commodity boom, but, less obviously, they are pulled into
the production of nontraded goods such as construction. Resources are pulled out of
the production of manufactures and other tradables—those that lie outside the boom-
ing commodity sector.
Even when events like the Dutch disease create difficulties for manufactured
exports, this does not mean that the country as a whole is worse off. A country would be
foolish to turn down a windfall gain on its commodity exports. After all, no country
would welcome a fall in the value of an exportable resource. Examples of sudden falls
in the price of a basic export commodity that lead to real depreciation and (often)
sharp recession include Chile in 1974–1975 (copper), Bolivia in 1985 (tin), and Russia in
1998 (oil).
One of the main respects in which the Dutch disease can indeed be a “disease” is
that the boom may turn out to be more temporary than the government had thought.
When world prices go back down, the country can be left with an atrophied export sec-
tor, “white elephant” investment projects, bloated government payrolls, unwanted real
estate construction, and sometimes even large international debts. The cycle of Dutch
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404 Chapter 20 ■ Developing Countries and Other Small Open Economies with Nontraded Goods

disease followed by commodity bust, which can be attributed to the combination of

volatile world commodity prices and poor institutions susceptible to procyclical gov-
ernment spending, often impairs long-run economic performance. It is one interpreta-
tion of what is called the “natural resource curse.” This is the observation that countries
rich in natural resources can experience lower long-run economic growth than those
without.

The Effects of an Increase in the Money Supply

in the Nontraded Goods Model
We now formally examine, within the context of the nontraded goods model, the impli-
cations of the two assumptions associated with the monetary approach to the balance
of payments: Goods prices are perfectly flexible, and reserve flows are not sterilized.11
The first assumption means that the automatic mechanism of adjustment in the home
(nontraded goods) market described earlier not only exists but operates instantly.
Whenever the economy finds itself at a point of excess demand for nontraded goods,
prices rise rapidly to clear the market, causing a jump vertically upward to the NN line.
Whenever the economy finds itself at a point of excess supply of nontraded goods,
prices fall rapidly to clear the market, causing a jump vertically downward to the NN
line. In short, we assume that the economy is always on the NN line. The second
assumption means that the other automatic mechanism of adjustment described ear-
lier, via the balance of payments, is in effect as well. It will not operate instantly, how-
ever. As long as large-scale, rapidly responding capital flows continue to be ruled out,
the rate of reserve flow is restricted to the same finite scale as the trade balance.
Consider first the effects of an increase in the money supply. Figure 20.5 showed
how an increase in expenditure—whatever its causes—resulted in a move from point S
to point F, featuring excess demand for nontraded goods and a trade deficit. A mone-
tary expansion is precisely the sort of policy change that would cause such an increase
in expenditure. Now that we are incorporating automatic adjustments in the market for
nontraded goods, however, we recognize that point F represents an equilibrium that
cannot last for long. Producers respond to the excess demand for nontraded goods by
raising the nominal price. This is equivalent to raising the relative price, PN, because the
nominal price of traded goods is tied down (by the exogenous foreign currency price of
traded goods and the fixed exchange rate). We move vertically upward from point F in
Figure 20.5 until we reach point G on the NN line, where the excess demand has been
eliminated. We assume that this adjustment takes place very rapidly, so that following
the increase in the money supply, we virtually jump from point S to point G.
At point G the country is still running a trade deficit. In fact, the increase in the rel-
ative price of nontraded goods has moved the country even farther from trade balance
equilibrium than it would be at point F (because the price change discourages the out-
put of traded goods and encourages the consumption of traded goods). The balance-of-

11
The model that follows was developed by Rudiger Dornbusch, “Devaluation, Money and Nontraded
Goods,” American Economic Review (December 1973): 875–880.
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20.3 ■ The Monetary Approach with Nontraded Goods 405

payments deficit means that reserves will be steadily flowing out of the country. Under
the assumption that the reserve outflow is not sterilized, the money supply is declining
over time. As the money supply declines, the level of expenditure, A, declines, so there
is a move leftward in Figure 20.5. At the same time, however, PN must decline, so as to
eliminate any incipient excess supply of nontraded goods that would otherwise result
from the declining expenditure and keep the country on the NN schedule. In other
words, the movement is down and to the left, until eventually we return to balance-of-
payments equilibrium at point S. Only when the rate of change of reserves, equal to the
balance of payments, is zero will there be long-run equilibrium. In the long run the
monetary expansion has changed absolutely nothing except the composition of the
central bank’s balance sheet: The original expansion in domestic credit has been offset
by an equal decrease in the central bank’s holdings of international reserves.

The Effects of a Devaluation

The primary motivation for introducing the monetary approach to the balance of pay-
ments in the presence of nontraded goods is to use it to study the effects of a devalua-
tion. A devaluation should improve the balance of payments through two independent
routes. First is the contractionary effect on expenditure introduced in Chapter 19 (the
real balance effect). Second is the effect of the decrease in the relative price of non-
traded goods, introduced in this chapter.
Consider an increase in the exchange rate. Under the assumption that the country
takes the world price of traded goods as given, this causes a proportionate increase in
the price of traded goods, Pt, expressed in domestic currency. The first effect of the
devaluation occurs even if, for some reason, there is no change in the relative price of
nontraded goods—that is, even if the prices of all goods rise by the same percentage.
For example, assume that n stands for nuts instead of nontraded. What would happen if
Pn, the price of nuts, along with Pt, the price of tin, rose by the same percentage as the
devaluation? In Figure 20.6 this constraint would prevent any movement off a horizon-
tal line through S. The economy moves from S to H. An increase in the price of traded
goods reduces the real money supply. The reduction in real money supply (or, equiva-
lently, the increase in nominal money demand) results in an excess demand for money.
At H, households and firms cut back their spending to restore their level of real money
balances.
In terms of Figure 20.1, the reduction in expenditure means that the budget line
shifts inward, with an unchanged slope if relative prices remain unchanged. Thus the
consumption point, the point of tangency with an indifference curve, occurs inside the
production possibility frontier. Both consumption of traded goods, CT, and consump-
tion of nontraded goods, CN, fall. Some of the decrease in spending takes the form of an
“excess supply,” or surplus, of traded goods.This is the first favorable effect of the deval-
uation on the trade surplus. The rest of the decrease in spending, however, takes the
form of an excess supply of nontraded goods. Inventories of nuts are piling up because
demand is lower than producers of nuts anticipated. Only if nuts really were a traded
good, so that the excess supply could be unloaded on the world market at the going
price, would the relative price of nuts and tin be unchanged (both Pn and Pt having gone
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406 Chapter 20 ■ Developing Countries and Other Small Open Economies with Nontraded Goods

up in proportion to the devaluation). Nuts are a nontraded good, however. To equili-

brate the market for nontraded goods, their relative price, PN, will have to fall. This
means that the budget line in Figure 20.1 will become steeper.
Because we have already derived the NN schedule, it is easier to see the effects by
turning back to Figure 20.6. The fall in the relative price of nontraded goods moves the
economy from point H to point E on the NN schedule. That is, if nuts are nontraded,
then their price does not rise by the same proportion as tin and other traded goods.12
The decline in the relative price of nontraded goods yields the second favorable effect
of a devaluation on the trade balance: As we saw earlier in the chapter, for any given
level of expenditure, a lower relative price of nontraded goods means that more traded
goods are produced and fewer consumed. The trade surplus is larger at point E, where
both effects are operating, than at point H, where only the real balance effect was
allowed to operate.13
The second aspect of the monetary approach now appears: the nonsterilization of
reserve flows. At point E the country is running a trade surplus. If the money flowing
into the country through the trade account is not offset elsewhere, then it will increase
expenditure, which reduces the trade surplus. We move up steadily along the NN sched-
ule: As expenditure rises, the price of nontraded goods must continuously rise to elimi-
nate what would otherwise be an excess demand for nontraded goods. Money continues
to flow into the country and expenditure continues to rise, until as always in the mone-
tary approach, in the long run the country is back at S and the trade surplus has been
completely eliminated.
This process illustrates some principles that recur throughout the study of devalu-
ation. First, to have an effect on the trade balance, some variable must be “sticky” in
the short run—in other words, it must be restricted from jumping discontinuously. A
nominal devaluation reflected as equal increases in all nominal magnitudes would have
no real effects. In Chapters 16 through 18, the sticky variable was the price of export
goods; thus the devaluation changed the relative price of export and import goods. In
the monetary approach to the balance of payments, the sticky variable is the stock of
foreign reserves. Because the devaluation changes the real money supply, it has an
effect on the trade balance in the short run, even in the absence of slow adjustment in
the goods or labor markets.
Second, the sticky variable adjusts over time. When it is the stock of international
reserves, it adjusts via the balance of payments. Analogously, when the sticky price
variable is the price level, it adjusts via excess demand. In the long run, when all adjust-
ments are complete, all nominal magnitudes have increased by the same percentage as
the devaluation, which is to say that no real magnitudes have changed.

12
The nominal price of nontraded goods, Pn, probably stays about the same in the short run, or rises a little
(less than the nominal price of traded goods). It is even possible, in theory, that Pn falls. It depends on the elas-
ticities of demand and supply of nontraded goods. All that is certain is that the relative price of nontraded
goods, Pn/Pt, falls.
13
To see the increase in the trade surplus graphically, think of successive waves of downward-sloping “iso-
trade-surplus” lines emanating from the BB schedule in Figure 20.6, each one corresponding to a different
level of the trade balance. Point E lies on an iso-trade-surplus line that is farther from BB than is H, so the
trade surplus is larger as a result of the fall in PN.
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Chapter Problems 407

20.4 Summary
Most developing countries (and industrialized countries as well) have a substantial
internal market where prices do not adjust instantly in response to a devaluation; in such
countries the PPP model of Chapter 19 is not applicable. However, many such countries
are too small in world markets to be able to set the price of their exports, so neither is the
Keynesian model relevant.This chapter examined the effects of exchange rate and mon-
etary policies in such small open countries with nontraded goods.
The trade balance can be thought of as the country’s excess supply of internation-
ally traded goods. We focused on two key variables: the level of expenditure and the rel-
ative price of nontraded goods (in terms of traded goods). One possibility is that these
variables adjust automatically to ensure equilibrium in the two markets. Whenever
there is a trade deficit, reserves flow out of the country; under the monetary approach
to the balance of payments, the level of expenditure falls until trade balance equilib-
rium is restored. Whenever there is excess supply of nontraded goods, the price of non-
traded goods falls until equilibrium in this market is restored as well.
In practice, these automatic mechanisms of adjustment are likely to work slowly at
best. Thus there is an argument for the government to use its available policy tools
to speed up the process.The government can adjust the level of expenditure by changing
the money supply.The government can adjust the level of the relative price of nontraded
goods by changing the exchange rate and thus changing the price of traded goods.
We saw that a devaluation works to improve the trade balance in a small coun-
try through two effects. In addition to the real balance effect studied in Chapter 19
(whereby the higher price level creates an excess demand for money and leads to a
reduction in spending), there is a second effect. When the price of traded goods goes up
in proportion to the devaluation, the relative price of nontraded goods goes down. In
response, resources shift out of the production of nontraded goods into production of
traded goods. Thus the trade balance improves by more than it would have if the price
of nontraded goods had gone up by the same proportion as the price of traded goods.
In the long run, however, all nominal magnitudes are likely to go up in proportion to
the devaluation, leaving no permanent effect on the trade balance.

CHAPTER PROBLEMS

1. The country of Lampong used to import grain but now produces enough to feed itself.
During the last few years imports have been essentially zero (as have exports). Does
this mean that grain is a nontraded good?
2. You are the governor of the central bank in the country of Salesia, which is running a
large balance-of-payments surplus as the result of recent discoveries of valuable natural
resources. You are worried that the inflow of reserves through the balance-of-payments
surplus is causing excessive growth in the money supply. Indeed, you have already
exceeded the year’s money supply target that you and the International Monetary Fund
team agreed on at the time of their last visit. But you don’t want to allow the currency to
appreciate, causing your exporters in the manufacturing sector to lose competitiveness.
What can you do?
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408 Chapter 20 ■ Developing Countries and Other Small Open Economies with Nontraded Goods

3. You have just been called in to advise the government of Gondar. The country has
been running a large trade deficit for years and is in trouble with its international cred-
itors. Other economic statistics, however, are unreliable. More than the usual number
of people seem to be wandering the capital looking for odd jobs. Also, prices for hotel
rooms, pedicabs on the street, and the local delicacy in the countryside have all fallen
since your last visit. In what quadrant of Figure 20.5 would you tentatively place the
country’s economy?
4. You are the finance minister of Khakistan. The country has started running a balance-
of-payments deficit as the result of a bad harvest in the countryside, but the rest of the
economy appears to be booming. Your foreign advisers suggest that you devalue your
currency to eliminate the payments deficit. Do you agree with this course of action? If
you are worried about inflationary pressures, how should you respond?
5. You are minister of trade in Santa Maria, which is undergoing an acute balance-of-
payments crisis. In desperation you are considering cutting off imports of cotton, which
is the country’s main import because it is used by the large textile industry. Is this a
good idea?
6. You are advising the prime minister of Phoenesia. Traded goods constitute half of
workers’ consumption basket. The other half consists of nontraded goods. The price of
nontraded goods, Pn, is a simple proportionate markup to wages, W. Industry and the
labor unions have agreed on a contract stipulating that two thirds of any increases in
the CPI will be passed through to wages.
a. For every 1 percent nominal devaluation, what is the effect on the price of
nontraded goods?
b. Assume that firms in the traded goods sector show an elasticity of supply (with
respect to Pt / W) of 1.0. If the government wants to increase output of traded
goods by 10 percent, how large an increase in Pt / W is required?
c. Putting together your answers to a and b, how large must the nominal devaluation
be to bring about the desired increase in output of traded goods? How large is the
resulting increase in the wage, W? In the CPI?14

SUGGESTIONS FOR FURTHER READING

Corden, W. Max. Economic Policy, Exchange Rates, and the International System
(Oxford, UK: Oxford University Press, 1994). Includes a verbal exposition of the
dependent-economy model of the balance of payments.
Dornbusch, Rudiger. “Devaluation, Money and Non-traded Goods,” American Eco-
nomic Review (December 1973): 871–880. The classic model of the monetary
approach to devaluation in small open economies. Nontraded goods are intro-
duced in the second half of the paper.

14
A simple version of the dependent-economy model along the lines of the calculations laid out in Problem 6
is sometimes known as the Scandinavian model. Nontraded goods are called the sheltered sector (sheltered
from international competition), and traded goods, the exposed or competitive sector.