7 - MONEY AND THE BALANCE OF PAYMENTS

Summary

It is common in elementary textbooks to introduce balance of payments adjustment as a manifestation of real disequilibrium. If relative prices are not compatible with clearance of all goods markets, as can happen when enough nominal prices and exchange rates are sticky, then the real imbalances will be reflected in payments imbalances. Each country will, given its competitive assumption that it can transact at the going market prices, plan to remain on its budget constraint, but since all these trades are not mutually compatible in disequilibrium, each will in fact end up violating the constraint.

An example will clarify this. Suppose that in a pure exchange of goods, the equilibrium price ratio between UK and Japan would be 62.5 bottles of whisky per television set. Now suppose the UK price of whisky is sticky at ℒ4 per bottle, and the Japanese price of TV sets at 100,000 yen per set. This will be compatible with equilibrium at an exchange rate of 400 yen/ℒ. But suppose this rate is also sticky at a value of 450. Then the Japanese can exchange each TV set for only 55 bottles of whisky, and the UK needs to offer only 55 bottles to acquire one TV set. Given a stability condition, called the Marshall- Lerner condition, there will be a world excess demand for TV sets and an excess supply of whisky. If trade is attempted under these prices, we will observe a UK balance of payments deficit: If they could sell all their whisky they would operate on their budget constraint, but in the prevailing state of real disequilibrium this plan fails to materialize.