Mechanisms of

International Adjustment

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 CHAPTER OUTLINE
• Mechanisms of International Adjustments
• Price adjustments
• Income adjustments
• Disadvantage of automatic adjustments
• Monetary adjustments

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 Adjustment Mechanisms
• Adjustment mechanism
• Works for the return to equilibrium after the
initial equilibrium has been disrupted
• Current-account adjustment
• Automatic adjustment
• Discretionary government policies
• Automatic adjustment of the current-account
• Under a fixed exchange-rate system
• Adjustment variables: prices and income
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 Price Adjustments
• Gold standard, late 1800s to early 1900s
• Conditions for each member nation
• Money supply = gold or paper money backed by
gold
• Official price of gold – defined in terms of national
currency
• Buy and sell gold at that price
• Free import and export of gold
• Money supply - directly tied to current -account

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 Price Adjustments
• Quantity theory of money
• Classical price-adjustment mechanism
• Equation of exchange: MV=PQ
• M – money supply
• V – velocity of money
• P - average price at which each of the final goods is
sold
• Q – physical volume of all final goods produced

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 Price Adjustments
• MV=PQ identity
• Total monetary expenditures on final goods =
monetary value of the final goods sold
• Amount spent on final goods = amount
received from selling them

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 Price Adjustments
• Classical economists
• Assumptions
• Q is fixed at the full employment level in the long
term
• V was constant
• A change in M must induce a direct and
proportionate change in P

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 Price Adjustments
• Criticisms against the price-adjustment
mechanism
• Classical linkage between changes in a nation’s
gold supply and changes in its money supply no
longer holds
• Full employment – doesn’t always exist
• Prices and wages are inflexible in a downward
direction
• Stability and predictability of V - questioned

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 Financial Flows and Interest-Rate Differentials
• Factors affecting a nation’s capital and financial
account
• Interest-rate fluctuations in domestic and
foreign markets
• Investment profitability
• National tax policies
• Political stability

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 Income Adjustments
• Income adjustment mechanism
• John Maynard Keynes, 1930s
• Focus on automatic changes in income to bring
about adjustment in a nation’s current account
• Under fixed exchange rates
• Influence of income changes in nations with
current-account surpluses and deficits would help
restore equilibrium automatically

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 Income Adjustments
• Income adjustment mechanism
• Under fixed exchange rates
• Persistent current-account surplus
• Rising income - Increasing imports
• Current-account deficit
• Fall in income - Declining imports
• Effects of income changes on import levels will
reverse the disequilibrium in the current account

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 Income Adjustments
• The foreign repercussion effect
• Income adjustment mechanism
• And include the impact that changes in
domestic expenditures and income levels have
on foreign economies
• Both the rise in income of the surplus nation
and the fall in income of the deficit nation are
dampened

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 Income Adjustments
• Importance of the foreign repercussion effect
• Depends on the economic size of a country
• A small nation that increases its imports from a
large nation
• Little impact on the large nation’s income level
• Major trading nations
• Significant foreign repercussion effect

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 Disadvantages of Automatic Adjustment Mechanisms

• An efficient adjustment mechanism

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 Monetary Adjustments
• Monetary approach to balance of payments
• Balance of payments - affected by
discrepancies between
• The amount of money people desire to hold
• The amount supplied by the central bank
• Excess demand for money - fulfilled by inflows
of money from another country
• Excess supply of money - eliminated by
outflows of money to another country

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