An International Adjustment Mechanism with Fixed Exchange Rates

Abstract

Traditionally one of the most interesting questions in international monetary economics has been whether or not there exists an automatic tendency for the balance of payments to adjust to imposed disturbances. While it has always been asserted that some such tendency exists, the type of adjustment mechanism upon which attention has been focused at any one time has varied with prevailing views concerning the operation of the domestic economy. It is well known, for example, that, with certain exceptions, the accepted theory before Keynes was that movements in relative prices between homeand foreign-produced commodities resulting from monetary changes consequent on international movements of specie ensured that the balance of payments would be self-correcting. It was thought that this process could, if necessary, be aided by a policy variation in interest rates, which meant, however, that the adjustment was only partially automatic. Though this theory of the self-regulating character of the balance of payments was successfully formulated by David Hume, the longlasting character of its success must be associated with the later neoclassical theory of the domestic economy-automatic full employment, the quantity theory of money and the non-monetary theory of the rate of interest.1 The tendency towards adjustment derived from Keynes' economics, supported by the prevailing conditions of unemployment in the 1930s, reflected a totally different mechanism. It was assumed that prices were constant, while adjustment would tend to come about through variations in income and employment. The direct effects of any initial change in imports or exports on the income flow, and consequently on the balance of trade, would, it was thought, be strengthened by the variation in the money supply and in the rate of interest which also would result from the initial change in the balance of trade. Currently it is accepted that the automatic adjustment process is hampered by the severing of the link between the domestic money supply and the balance of payments in the trading countries, and also by the other policy measures which have been brought into being in order to maintain full employment. There also seems to be some confusion concerning the effectiveness of the many policy variables available for the correction of external imbalance, for they sometimes appear to be effective and sometimes not. That this should be the case is not