The correction of BOP disequilibrium is a prime necessity for the country which experiences it. In the case of a deficit, a country can only sustain the deficit, without changing its exchange rate or resorting to controls on its imports as long as, its stock of international liquidity holds out.
In the case of a surplus, the forces impelling correction in less strong.
The surplus country will accumulate international liquidly and will continue to do so as long as the surplus persists. Such accumulation of international liquidity may have repercussions upon the price level of the surplus country.
Clearly the size of a country’s reserve holdings determine, in great part, the urgency of the need for adjustment if a deficit develops in its BOP. A country with large reserves may be able to tolerate a deficit for a long time, using its reserves to maintain its exchange rate by equalizing the demand and supply of its currency in the foreign exchange market. But ultimately and however large the country’s reserve holdings may be, action to adjust the deficit will have to be taken. Thus, the function of international liquidity is to finance deficit that are in process of being corrected, not to remove the need for correction.
We have seen that the greater the reserves held by a country the less is the pressure upon it to adjust a deficit in its BOP. Only when the reserves approach depletion, the country is compelled to take action for adjustment. The more efficient the adjustment mechanism is, the more quickly the BOP is brought back to equilibrium by it, the smaller the stock of international liquidity needs to be. The demand for international liquidity becomes greater the less efficient the adjustment mechanism.
The Classical Theory of BOP Adjustment:
Economic theory has furnished us with two different approaches to adjustment process-the classical approach which explains the adjustment as operating through changes in the price levels of countries as the force which restores equilibrium and the modern approach which explains the adjustment as operating through the changes in the levels of national income to restore the balance. These approaches are not alternative theories, mutually exclusive through the correctness and modernity of one and the obsolescence of the other. They are rather complementary ways of regarding the adjustment process.
Each approach springs from the general body of economic theory current at the time of its inception. The classical approach reflecting the Ricardian system with its emphasis on price changes, the quantity theory of money and flexibility of costs and prices. The income approach reflecting the Keynesian theory of income determination with its emphasis on income changes through multiplier effects.
Each approach dictates a different emphasis for policy—the classical approach implying price adjustment through monetary policy and income approach reflecting the use of fiscal policy for income adjustment. In the adjustment process price and income changes work in the same direction. The income approach has supplemented rather than supplanted the classical approach to BOP adjustment process.
The price mechanism can operate in two ways to produce BOP adjustment. The first and most obvious way is for prices to act directly, through changes in the price levels of countries; the second is indirect and occurs where changes in relative prices are brought about by changes in exchange rate between two currencies. The classical economists explained the BOP adjustment under two currency standards—the gold standard and the inconvertible autonomous paper currency standard.
The BOP Adjustment under the Gold Standard:
Under the gold standard, the classical economists pointed out, there was automaticity in BOP adjustment as it was developed from Mume to Marshall. The movement of goods in international trade is considered to be the result of differences in national price levels. The upward or downward movement of an individual country’s price level changes the direction and volume in which the goods flow and therefore changes the BOP of the country concerned.
With gold standard in operation differences between foreign receipts and payments would be offset by such gold flows as would, by enlarging or depleting the national monetary stock, produces appropriate price changes to alter the demand for the imports and exports of the country concerned and thus corrects the balance. In brief, the classical theory was one of the equalization of prices internationally, adjustment of prices as a result of gold movements being the means of establishing the normal relation of equality. At the heart of the classical approach lay the quantity theory of money which dominated ideas on general price level determination.
The classical theory of adjustment was based on a number of implicit assumptions:
(i) The validity of the quantity theory of money;
(ii) The efficiency of the banking arrangements whereby an increase in the money supply had an immediate impact on the domestic monetary situation;
(iii) Complete mobility of factors within the country concerned;
(iv) Completely flexible prices; and
(v) In the country and the world at large, a quick and considerable reaction of both demand and supply to price changes.
Some of these assumptions were, at least in the free economy of the 19th century, quite justifiable. In the early days, when the gold standard was a gold bullion standard, movements of gold in and out of an economy did directly augment or deplete the money supply; later when gold was held as a reserve to a domestic money supply which bore to it some specified ratio and when the whole paraphernalia of credit control and interest rates became involved, the connection between gold movements and the domestic money supply became more tenuous.
The most sweeping assumption inherent in classical theory of adjustment was that, when prices fell in a deficit country (following its loss of gold), demand for Its exports would rise by such an amount as would not only off set the fall in export prices but would actually raise total export revenue. On the import side it was assumed that since goods from abroad would become relatively dearer as home prices fell, domestic goods would be substituted for imported goods.
This assumption of high elasticity of demand for exports and imports in international trade was a vital one for the classical theory of price adjustment. Its non-fulfillment would abrogate the whole system. This is a theoretical and practical difficulty of some importance. To 19th century economists, who usually assumed that elasticities of demand were high, it did not appear so.
David Hume’s Price-Specie-Flow Mechanism:
Hume, an English classical economist, was the first economist to suggest a connection between exports and imports. He developed the price-specie-flow mechanism to show how an increase in exports would lead to an increase in imports, and the f50P disequilibrium would be automatically corrected through price mechanism. Thus, there is automaticity in BOP adjustment under the gold standard. Let us discuss how the BOP disequilibrium is automatically rectified.
Suppose the world is composed of two countries country I and country II. Country I’s exports exceeds its imports and therefore country ll’s imports exceeds its exports. Since exports exceed imports in country I, gold will flow into it and gold being the basis of currency and credit the supply of money will expand. Following the rules of gold standard, game, when gold is flowing into a country, the country is required to lower the rate of interest.
Given the marginal efficiency of capital, when the rate of interest is lowered, it would lead to expansion of investment activities. Now, country I will be confronted with general inflationary situation. Now country I is a very good market to sell but a very bad market to purchase. Thus, its exports decrease and imports increase.
Let us see what happens in country II. Country ll’s import exceeds its exports. Gold flows out of it and gold being the basis of currency and credit, the supply of money will contract and there will be a general deflationary situation, following the rules of gold standard game, country II will Increase the rate of interest. Given the marginal efficiency of capital, when the rate of interest is increased, the investment activities will contract and will aggravate the deflationary situation in the country, now the country is a very good market to buy but bad market to sell. Thus its exports expand and imports contract.
The above analysis shows how the initial excess of exports over imports in country I and excess of imports over exports in country II are automatically corrected through the changes in the levels of price between the two countries. Under the gold standard, the short-term capital movement was also playing a vital role in the BOP adjustment. We have seen how the market rate of interest prevailing in country is lower than the rate in country II. This will encourage short-term capital movement from country I to country II.
Classical economics assumed that a BOP disequilibrium could be adjusted by a change in relative price levels as between the deficit and surplus countries, however this price level change was brought about.
BOP Adjustment under Paper Currency Standard:
Under the gold standard, the exchange rate between currencies is fixed and the BOP adjustment is effected through the changing price levels between the countries. But under the paper currency standard, the adjustment of disequilibrium in BOP is bought about by the changes in exchange rates between currencies. The changes in exchange rates, ultimately bring about the changes in the relative price levels between countries.
The exchange rate for a currency is the price in foreign currency terms of a unit of the home country’s money. Thus, the price of the pound sterling in dollar terms is $2.4 and the exchange rate is said to be $ 2.4 = £ 1. Clearly an change in the exchange rate alters the price to the foreigners of all exports of the country concerned. In the example above, if the exchange rate were devalued to £1 = $ 1.2 then the prices of British goods would be halved to United States buyers. If the sterling dollar exchange rate were revalued to £ 1 $ 4.8, all British prices would be doubled for United Stated buyers.
Thus, a condition in which the price level is constant and the exchange rate varies is the same conceptually as one in which the exchange rate is fixed and the price level alters. Let us assume that domestic prices are constant and that when the BOP moves into deficit the exchange rate depreciates on the foreign exchange market until the relation between home and foreign prices has altered sufficiently, exports cheapening and imports becoming clearer to the home country, to adjust the BOP deficit. Such a system of adjustment finds institutional expression in floating exchange rate system.
Let us discuss how exports and imports are affected by changes in the exchange rate and in particular how far the BOP is improved by them. Any answer to this question involves us in considering the sensitivity of exports and imports to price changes, not only with regard to the way in which demand for them varies with price but also how supply reacts to it.
In short, we are concerned with the elasticities of demand and supply in foreign trade. These elasticities are relevant in deciding whether and how far depreciation improves the quantity, value of exports minus value of imports.
Suppose the world consists of two countries I and II. The national currency of country I is pound sterling and that of country II is dollar. In country I, exports exceed imports; so that the demand for dollar in the foreign exchange markets exceeds the supply of dollar. The external value of pound sterling declines in terms of dollar; in other words pound depreciates in terms of dollar. This means dollar appreciates in terms of pound. The deficit in BOP of country I has resulted in the depreciation of the value of its currency; and the surplus in the BOP of country II has resulted in the appreciation of the value of its currency.
The depreciation or devaluation of country I’s currency promotes its exports and restricts imports whereas the appreciation of country II’s currency promotes its imports and restricts its exports. This is how, the disequilibrium between the exports and imports is rectified through the variation in the exchange rate between the currencies. Thus the classicists held that the BOP disequilibrium is automatically rectified through the market mechanism.