relevance of balance of payments theories from classics up ... · relevance of balance of payments...

157

Dragoljub Stojanov1

RELEVANCE OF BALANCE OF PAYMENTS THEORIES FROM CLASSICS UP TO THE

PRESENT

(Possible Messages for the Economy of Croatia)

Abstract

In the course of the evolution of international economic relations and of the systems of international payments, the approaches to the balance of payments and foreign exchange rates have undergone certain transformations. Viewing the course of the development of these approaches, nowadays, from the standpoint of the contemporary approaches to the balance of payments and exchange rates, we can perceive that they have certain elements in common, but also, that they differ with respect to certain tenets.In the same manner we can discuss foreign indebtedness of a country emanating from the Balance of Payments (BoP) deficit and improper economic policy mix, together with debt «overhang» as a potentially constraining factor for the economic growth of a country.IntroductionApart from other features, the approaches to the balance of pay-ments and exchange rates differ also in respect of whether they

1 Prof., dr., sc., Dragoljub Stojanov, redoviti profesor, Ekonomski fakultet, Rijeka

UDK 336.14336.22

Dragoljub Stojanov: Relevance of balance of payments...EKONOMIJA / ECONOMICS, 13 (1) str. 157-178 (2006) www.rifin.com158

emphasize either the real or the monetary variables as determining factors. This article will attempt to interpret the approaches to the balance of payments and exchange rates from the viewpoints of the contemporary approaches to the balance of payments and exchange rates, but also from the standpoint of reconciliation of the real and the monetary factors and their role in these approaches. The basis for such an approach can be found in the function of monetary demand (Md). Namely, analyzing the function of monetary demand (Md) we can notice that it does not neglect the real factors, but, that it includes them. Moreover, we believe we can say that the function of monetary demand relies, in its origin, on real factors. The function of the demand for money encompasses: the given level of employment, the availability of production factors, and the given level of technology. Therefore, it proceeds from the aggregate production, i.e. from the GDP of national economy and is in no case only a monetary value.

Theories of Balance of Payments

1 The preliminary consistent tenets of the balance of payments and the approaches to the balance of payments can be found: in the works David Hume.2

Explaining his theoretical views, Hume’s intention was to deny the fundamental principles of the mercantile doctrine. Due to the in-sufficient development of capital transactions the basic principles of the mercantile doctrine in the sphere of the balance of payments, or more correctly, in the sphere of the trade balance, meant, when applied in practice, an orientation towards exports aiming at acquiring the precious metal as the basic source of social wealth. At the same time, stimulating their own production with a view to reducing the outflow of the precious metal, the mercantilists discouraged imports.Hume tried to explain the importance of the active trade balance for the accumulation of the precious metal, with his tenet that the relationship between monetary supply and monetary demand must automatically be balanced, and that, therefore, every effort to ac-cumulate the precious metal by means of an active exports policy or

2 W. Branson - Asset Markets and Relative Prices in Exchange Rate Determination - IFS, Princeton,

1930.

159Dragoljub Stojanov: Relevance of balance of payments...EKONOMIJA / ECONOMICS, 13 (1) str. 157-178 (2006) www.rifin.com

by means of an imports substitution policy is futile. Hume’s tenets ranged within the framework of the equation:

MS x V = P x Q3

wherein: MS = monetary supplyV = speed of the velocity of money P= pricesQ = production

The automatic model of establishing a balance between the supply of and demand for money, implicitly also meaning the stability of the balance of payments, proceeded from three essential tenets, namely:1. fixed volume of production (Q)2. stable demand for money3. constant speed of velocity of money.4

The monetary theory of Hume’s time was built on the premises of the classical economic theory. According to the classical theory, economy constantly strives towards a state of full employment. Full employment is a function of the available factors of production. The aggregate demand does not affect the level of employment. The effects of the demand are manifested in the change of prices and wages.Consequently, with the given speed of money circulation and the level of production, every decrease (increase) in the quantity of the money in circulation must cause a drop (a rise) in prices. An upward trend in prices caused by an increase in Ms reduces the competitive capabilities of the domestic economy exports. It discourages the exports and stimulates the imports. The imports are paid for in precious metal. Thereby the amount of money in circulation is reduced. As a result, the prices drop. A balance is achieved between the supply of money and the demand for it, and between the exports and the imports, that is, an equilibrated balance of payments. The mechanism: monetary mass-prices lead to the stabilization of the

3 Harry Johnson (1977) - Money, Balance of Payments Theory, and the International Monetary Problem - IFS, Princeton.4 M. Kreinin (1973) - The Monetary Approach to the Balance of Payments - IFS, Princeton.


balance of payments through inflationary and deflationary cycles. Prices and wages are variable magnitudes. Constant magnitudes are the levels of production, of employment and the speed of circulation of money.The monetary theory of Hume’s time dealt with the problems of price levels. The level of prices caused the appearance and the de-velopment of economic fluctuations. “The effects of the boost in prices consisted of a reallocation of income from rentiers to entrepreneurs, increasing the prospects for profit and encouraging investments. A drop in the prices, on the other hand, redistributed the income from the entrepreneurs to the rentiers, diminishing the prospects for a lucra-tive profit and depreciating the investments”.5

From the viewpoint of the contemporary approaches to the balance of payments and exchange rates, it is, nevertheless, interesting to point out that in Hume’s model we find the tenets of the so-called“global monetarism” such as:- full employment- constant speed of velocity of money- stability of money demand- integration of international commodity markets and the operation of the law of one price.6

In relation to the contemporary monetary theories in which money demands is a function of: the income, interest, and prices:

Md = f(Y, I, P)

Hume’s function of money demand is not specified in detail. However, implicitly, on the basis of the statement about the stable money demand and the statement about full employment, we can conclude money demand is a function of the income (Y), that is, of the given production and of prices:

Md = f(Y, P)

5 H. Johnson (1962) - Money, Trade and Economic Growth - George Allen and Unwin.6 M. Kreinin, op. cit.


According to the tenets of the law of one price, the price of a product “Z” is identical on all markets. International markets function on the principle of joined vessels. In Hume’s approach, an increase in Ms, and, consequently, an increase in the aggregate demand, leads to the appearance of a disparity in prices. Disparity in prices propels commodity arbitration on an international scale. Under the conditions of the system of fixed exchange rates of the gold standard the financing of additional imports was affected by means of an outflow of the money abroad, therefore, by decreasing the monetary supply and by its adjustment to the monetary demand.The period of the gold standard was known by the system of fixed exchange rates without an active intervention. The central bank was mostly passive.7 The rates ranged within the frameworks of the gold points. At that time, arbitrage of foreign exchange represented a special (portfolio) selection of the portfolio owner with respect to the different forms of property: gold and foreign exchange. Payment was effected in gold or in foreign exchange, depending on the tendency of the rate of exchange towards depreciation or appreciation. Thus, the supply and demand of foreign exchange were kept at a stable level even without an active intervention on the part of the central bank. If we recall that the balance of payments deficit reflected a surplus in Ms in relation to Md, and that the exchange rate was only a reflection of the state of the balance of payments and that Md was stable, then we can draw the conclusion that the basic determinant of the condition of the balance of payments and of the foreign exchange rate of the national currency at the time of the gold standard was monetary supply.Since the gold standard was a monetary system of fixed exchange rates, a process of adjustment of the balance of payments took place, and, accordingly, also a process of adjustment of Ms and Md by means of variations in prices and the income. Practically, Ms was adjusted to Md through a boost or a reduction in the monetary reserves. That me-chanism of adjusting Ms to Md reminds us very much of Johnson’s model of monetary approach to the balance of payments, under the conditions of fixed exchange rates. However, a significant difference lies in the fact that, according to the contemporary monetary approach,

7 The central bank at the time of grave recessions intervened in the operations of the open market. Normally it was passive. See: K. Marx, The Capita!, val. Ul, Kultura, 1948.


the role of the deflator of Ms is taken over by devaluation coupled with the existing inflexibility of prices and wages in a downward direction.The doctrine of the automatism of the gold standard prevailed in the international economic relations for about 200 years until the great economic crisis in the period 1929 - 1933. In the period between 1929 and the end of World War II, international economic relations were disintegrated. The policy of the adjustment of the balance of payments as well as the policy of exchange rates was under the influence of administrative methods of adjustment. In brief, this was a period of economic nationalism with the administrative regulation of international economic relations.2. Following the world economic crisis, the approaches to the balance of payments and the adjustment of balance of payments were affected by Keynes’s teaching.Wages no longer had down-ward flexibility. Full employment be-came the primary goal of economic policy. The practice of economic liberalism was replaced by the practice of interventionism. Internal bal-ance gained preference in relation to external balance. In the context of these transformations, Keynes moved the focus of his monetary theory from the theory of prices to the issue of employment and to the analysis of the rate of interest as a monetary phenomenon.Keynes’s theory was in fact a rejection of the tenet of the classicaltheory, relating to the tendency towards full employment, coupled with the introduction of a new concept of economic balance at the level of insufficient employment. In brief, Keynes’s concept is based on the interaction of: investments, income, consumption and saving, wherein production and employment are functions of investments, and demand is a function of investments and consumption.In the simpler version of Keynes’s analysis, investments are given as depending on the expected profit.8 Investments represent the basic determinant of the rate of income. In a state of equilibrium they are equal to saving.In the more elaborate version of Keynes’s analysis, the issue of determination of investments is given priority.9 From the viewpoint

8 For more details see H. Johnson (1962) - Money, Trade and Economic Growth Allen Unwin, p. 107-122.9 Ibid.


of contemporary approaches to the balance of payments and ex-change rate (the monetary and the portfolio theory of balance of pay-ments and of foreign exchange rate) this question is very important and interesting.Namely, in accord with Johnson’s interpretation of Keynes’s thought, investments are determined by the marginal efficiency of capital and of the rate of interest, wherein the rate of interest is a function of monetary demand and monetary supply. Monetary supply is determined exogenously. Monetary demand is comprised of two com-ponents, namely:a) of transactional demand for money, and it is, accordingly, a function of the income, andb) of speculative demand for money which is a function of the rate of interest.In this context Johnson states that a lower actual interest rate in relation to a certain normal level increases the attractiveness of cash accumulation and keeping of wealth in the form of money.10

Analyzing Keynes’s thought, Johnson further arrives at the following order of causalities: the rate of interest is a function of the monetary supply and monetary demand, the level of investments is a function of the rate of interest and of the marginal efficiency of the capital, the income and consumption levels are a function of the investments and of a tendency towards saving. According to this, Keynes’s system is an interdependent one. And the variables wield an influence on each other. In a feedback, monetary demand is a function of the income, which again depends on the tendency towards investing and saving.11 With such an interdependence of the systems we can further study the relationship between the relevant variables for the stability of the system. On the other hand we can study the relationship ( S – I) in the function of the interest rate (I-S analysis), and on the other hand, the relationship Y-i (income-interest rate) where the monetary demand will be equal to the monetary supply (L-M analysis).The balance (I-S) represents the stability of the real sector of economy, while the balance (L-M) represents the stability of the monetary sector of economy. From the mentioned relationships and states of

10 H. Johnson, op. cit. p. 112. 11 H. Johnson, op. cit. p. 112.


stability, Johnson reaches the following conclusion on the principles of Walras’s law: If the commodity market is stable, then stability on one of the two remaining markets (money market and capital market) also means stability on the third (capital market or money market).12

If we reinterpret Keynes’s thought in terms of contemporary ap-proaches to the balance of payments, we can concur that instability on the money market can cause instability on the commodity market, and even instability in the balance of payments. But, Keynes proceeded from the premise of insufficient employment and from the premise of stable prices. Stability of prices is derived from the premise of stable wages.13 Namely, prices could rise due to the following:a) a change in the level of employment b) a change in wagesc) a change in labor productivity.Keynes did not take into consideration the changes in labor productivity. Thus, the only variation left apart from the premise of stable wages was the one referring to the level of employment as a factor of price variations.14

So according to all the mentioned so far, we can conclude that the role of monetary factors in Keynes’s economic theory and analysis is very significant. The stability of the monetary demand and monetary supply is underlying the economic stability. From the viewpoint of contemporary approaches to the Balance of payments and foreign exchange rate, the detail referring to the function of monetary demand is of special significance. Monetary demand is a function of the yield and of the rate of interest, whereby the rate of interest is a factor affecting the composition of the structure of property-wealth (portfolio selection). Depending on the rate of interest the owner arbitrates on the alternative placement of his property in the form of accumulation of cash or its placement in the purchase of securities. The relationships between monetary supply and monetary demand represent the core of the monetary approach to the balance of payments and of the monetary approach to the exchange rate, whereas the possibilities of alternative placements

12 H. Johnson, op. cit.13 For details see: H. Johnson, op. cit.14 H.Johnson, op. mt., p. 108.


of property represent the basis of the so-called portfolio theory, that is, of the portfolio approach to the balance of payments and to the exchange rate.On the basis of Keynes’s economic thought, and especially on the principles of the multipliers of investments for the closed-type economy, Machlup formed his theory about the foreign trade multiplier in 1942.

In his theory of foreign trade multiplier, Machlup proceeded from the following fundamental assumptions:a) the assumption about insufficient employment b) the assumption about stable pricesc) the assumption about stable interest ratesd) the assumption about stable exchange rates and e) the assumption about stable wages.The theory and mechanism of the foreign trade multiplier proceedfrom the significance of the aggregate demand for national economy. Thereby, an increase in exports, caused by an increase in the foreign demand represents an impulse to the development. Imports representan outflow of the income. They reduce the previous surplus in the balance of payments, caused by autonomous exports, to narrower frameworks, i.e., they lead to a stability of the balance of payments.From the preliminary stage of the internal balance (I = S) and of the external balance (X = M), the economy, through the action of the multiplier, reaches a new state of stability at a higher level of yield. In this care the condition for new balance is:

After this conclusion, and using the premise of Walras’s law, and proceeding from the mechanism of the multiplier, we could make the following inferences: if X = M, i.e., if the balance of payments is stable at a given time t1 (when the effects of the multiplier have been exhausted) and if there is a balance between the saving and investments (S = I), then there should be a balance on the money


market, i.e., between the monetary supply and the monetary demand (Md = MS).Machlup points out that the process of reaching a balance between the commodity and the monetary (financial) funds, that is, the balance between Md and Ms, takes place gradually in the course of the period of activity of the foreign trade multiplier.15

According to the theory of foreign trade multiplier the state of balance of payments is defined by the level and the changes in the yield and by the given limited tendencies of consumption towards saving and imports. Consequently, this theory gives a secondary place to Ms, Md, and to the role of the rate of interest. Machlup16

underlines that changes in Ms and in the rate of interest could wield a certain influence on the internal and the external balance, but in spite of this, he abstracts from such alterations. In his opinion, the multiplier theory would become very complicated if these variables were included, whereas its meaning would remain unchanged.One of the basic premises of the theory of foreign trade multiplier in its rudimentary form is the assumption about the institutional stability of exchange rate with an active intervention. Such an assumptionabout the fixed exchange rate makes superfluous any further thinking about the theory of the exchange rate as corresponding to the theory of the foreign trade multiplier.3. The elasticity approach to the balance of payments appeared for the first time in the essays of Joan Robinson in 1950. That was the time when fixed exchange rates were built into the international monetary system, when economies throughout the world were recovering from the consequences of the war, and when international commodity markets were not as integrated as they are today, or as they were at the time of the gold standard. International markets of capital were just being organized.According to the elasticity approach to the theory of balance of payments, instability in the balance of payments is the result of disparity between the domestic and foreign prices. Therefore, the elasticity approach gives priority to the issue of prices. The disparities between prices are corrected by means of devaluation in the circumstances when prices and wages are not flexible in a downward

15 F. Machlup(1973) - International Trade and Multiplier of National Product transI., Svjetlost, Sarajevo, p. 40.16 See: F. Machlup, p. 55 & 36.


sense. By means of devaluation, lower foreign prices are brought to the level of higher domestic prices. The success of devaluation is contingent on the so-called Marshal-Lerrner’s conditions.The elasticity approach to the balance of payments is fundamentallybased on the premises of Marshal’s partial equilibrium. The foreign trade sector is viewed isolated from the overall economic developments. Starting from the disparity in prices, the elasticity approach has neglected, to a certain extent, the activity of the real factors and the feedback of the foreign exchange multiplier.But, although this is the approach of partial equilibrium, we think that the elasticity approach can hardly be separated from the overall economic stability, just as the balance of payments is not an independent category, but is a reflection of the total reproduction trends of the national economy. Therefore, the deficit in the balance of payments must be a reflection of the disproportions of certain variants in the national economy.The deficit in the balance of payments caused by the disparities in prices leads us to the conclusion that domestic currency has been appreciated. A currency becomes appreciated when its purchasing power starts to decrease, that is, when the domestic inflation rate is higher than the inflation abroad. An appreciated currency stimulates the absorption of imports and discourages exports, and this leads to the appearance of a deficit in the balance of payments. An excessive absorption or a deficit can be financed, in a system of fixed exchange rates, by raising foreign loans or by means of monetary reserves, however, not for long. The other alternative for the adjustment of the balance of payments is devaluation.Nevertheless, the following question is of special interest to us: how is it possible for the absorption to become greater than the income, i.e. how is it possible for the national currency to become appreciated? Neglecting the possibility of financing the excessive absorption by means of monetary reserves or by raising long-term foreign loans, and relying on the conclusion about the appreciation of currency, it turns out that domestic currency becomes appreciated because Ms is larger than Md.In this context it becomes understandable that devaluation leads to stability in the balance of payments. According to the elasticity approach, it is clearly emphasized that it corrects price disparities.


But, implicitly, it can be concluded that it also corrects the level of absorption and reduces it to a lower level by decreasing the real purchasing power. Devaluation establishes price parities, a balance between the absorption and the income, a balance between Ms and Md, and thereby also the stability in the balance of payments.In the contemporary reinterpretation of the elasticity approach, the exchange rate would be a function of relative prices:

r = P/Pf

Such a rate of exchange would reflect the basic premises of the PPP theory. And although commodity markets were not integrated at the time of the appearance of the elasticity approach, examples of successful devaluations show that a correction of the exchange rate represents, in the final analysis, a correction of relative prices.4. After World War II, there was no more discussion about insufficient employment. Instead of deflation, inflation became the main subject of discussions. Since commodity markets were not integrated either, (not even in the developed countries), devaluation often proved to be an inefficient method of adjusting the balance of payments. Therein, the so-called elasticity pessimism was developed. However, from the viewpoint of our analysis, it is significant that in the conditions of full employment, devaluation cannot have an effect on the rise in the income. In the conditions of full employment, additional export can be achieved by redistributing consumption, i.e. by reducing domestic consumption and directing it towards foreign markets. Proceeding from such observations, Alexander, in 1952, set forth his finding that the deficit in the balance of payments is the result of a surplus in the aggregate absorption in relation to the available production. According to the absorption approach to the theory of balance of payments, the correction of a deficit in the balance of payments by means of devaluation is possible because it produces the effects of redistribution of consumption and the monetary effects of deflation of monetary supply under the circumstances of an already present inflation. Devaluation is supposed to “calm down” the domestic market and to reduce consumption to a reasonable level. The export surpluses thus created must be directed to foreign markets. Devaluation also connects price disparities and facilitates export


orientation of the residents. However, it does not produce the effects of increase in the income, like the mechanism of the foreign-trademultiplier, just because now the conditions of full employment are taken into consideration.In addition to the direct effects of devaluation, the indirect effects are also significant. Among them the “cash effect” is particularly important. The “cash effect” and “monetary illusion effects” constitute the conditions of crucial significance for success of devaluation.The absorption approach gives greatest priority to the decrease in consumption through devaluation. It does not deal with the effects of prices and monetary factors. The absorption approach remains within the boundaries of Keynes’s thought, at the level of aggregate demand and aggregate production, but under conditions of full employment.The absorption approach, however, also bears in itself the elementsof the monetary approach to the balance of payments - the so-called“cash effect”, that is, the effect of deflation of the purchasing power in the circumstances of the present inflation. By reinterpreting the absorption approach we implicitly reach the conclusion that the deficit in the balance of payments is the consequence of a disharmony between the supply of and demand for money. Demand for money represents (at the time of the still undeveloped capital markets) primarily a transactional demand for money, therefore, such a demand for money which serves the purpose of production and circulation, more exactly, which serves the reproduction. In order to achieve an internal balance, commodity funds (supply) must be adjusted to the purchasing funds (demand). According to this, a surplus in the purchasing funds (monetary supply) in relation to the commodity funds (represented in the form of a function of the monetary demand) produces an effect of surplus absorption and a deficit in the balance of payments. The question how to adjust commodity and purchasing funds is of a completely different nature. According to Alexander, devaluation in the circumstances of full employment reduces the aggregate demand by means of deflating the residents’ purchasing power under conditions of an increase in prices.Since the state of the balance of payments is determined by the relationship between the income and the absorption, i.e., by the rela-tionship between Ms and Md, then, in the circumstances of a deficit in the balance of payments, the national currency is appreciated. An


equilibrium foreign exchange rate would have to reflect the parities of purchasing powers:

r = P/Pf

According to this, by correcting the rate through devaluation, two significant effects are achieved:a) the effect of a reduction of the nominal money supply through a boost of prices, and b) the effect of adjustment of relative prices.

5. Meade-Tinbergen-Mundell’s model, or the model of optimalcombinations of measures of economic policy, abandons the practice of achieving two goals by means of a single instrument, the goals being the internal and the external balance. Instead of that, Meade suggests two instruments for the realization of two goals. Financial policy and devaluation are two instruments which can be used in combinations as principle I or as principle II with the aim of establish-ing the internal and external balance.17

For the first time in the policy of the balance of payments, Meade joined the effect of expenditure, that is, the effect of income to the elasticity approach. Meade was one of the first to draw attention to the fact that devaluation cannot improve the balance of paymentsunder conditions of full employment without a parallel reduction of the absorption and of real wages. Meade regulates internal balance through financial policy (reduced absorption in the case of a deficit in the balance of payments), and through devaluation affects the process of the stabilization of the balance of payments.18

Tinbergen’s contribution to the theory of adjustment of the balanceof payments consists in his introduction into the analysis of as many instruments as there are goals set in an economic policy.Mundell has divided financial policy into monetary and fiscal policy. Thus, he expanded the domain of instruments of economic policy which do not affect only the current balance but also exert an influence 17 J. Meade (1951) - The Balance of Payments, Oxford University Press.18 P. Kenen and P. Allen (1979) - The Balance of Payments, Exchange Rates, and Economic Policy, IFS, Princeton.


on the international movement of capital. Although Mundell, in his works, did not associate the international movement of capital with the money market, he established the basis on which the contemporary approaches to the balance of payments and exchange rates have been, and still are building, and especially the portfolio approach.6. According to Keynes’s approaches to economic thought and according the neo-Keynesian concepts, it is expected that a country with an intensive economic development has a deficit in the balance of payments. Namely, an increase in the income leads to an increase in the consumption, and also in the demand for imports. However, the examples of the Federal Republic of Germany and Japan have shown that economies with the highest rates of growth can also have a surplus in the balance of payments.Harry Johnson’s monetary approach to the theory of the balance of payments, attempts to explain the phenomenon of the intensive economic development and of the surplus in the balance of payments, pointing out that the balance of payments is preponderantly a monetary phenomenon. According to this approach the decisive determinants of the state of the balance of payments are Ms and Md. Further on, Ms and Md are in a functional dependence on the state of the balance of payments. The supply of money and the demand for it are adjusted through the balance of payments with a passive role of the central bank. The devaluation of currency encourages export and leads to a surplus in the current account of the balance of payments. The surplus in the balance of payments increases monetary reserves. On the basis of the increase in the monetary reserves, an increase in the monetary supply is achieved. On the other hand, devaluation also leads to a growth of prices, thus reducing the residents’ purchasing power. The process of adjusting Ms and Md takes place automatically. The stability of the balance of payments is established on a long-termbasis, along with a balance between the production and consumption, and a balance between Ms and Md.The monetary approach to the theory of the balance of payments and to the adjustment of the balance of payments incorporates the elasticity approach. As a matter of fact, the given flexibilities are implied. It also includes the absorption approach by adjusting the income and the absorption by means of correcting the absorption. We consider that the interdependence of Ms and Md deserve special attention in the framework of the monetary approach. Namely, if


Md grows faster than Ms, this denotes that transactional demand for money also grows. If the monetary authorities do not compensate for the lack of monetary policy by means of an increase in Ms, then the residents turn towards the exports, achieving the necessary liquidity through a surplus in the balance of payments. The residents adjust the relations between their commodity and purchasing funds through economic relations with foreign countries. (On the basis of such tenets it becomes possible to explain why countries with an excessive monetary expansion in relation to monetary demand have a deficit in the balance of payments, of course, abstracting structural disproportions in economy which alone can lead to the phenomenon of a deficit in the balance of payments.)According to the fundamental premises of the monetary approach to the balance of payments under conditions of fixed rates, exchange rate reflects the relative relationships of prices which are a result of certain relations between Ms and Md. Furthermore, the exchange rate reflects the parities of purchasing powers:

r = p/Pf

In the international monetary system, the practice of fixed exchangerates prevailed until 1971. Due to that, we can say that the theory of purchasing power parity constituted the basis of the exchange rate policy in the post-war period, until the beginning of 1971.7. After 1971, the monetary approach to the balance of payments, implemented under conditions of fluctuating rates of exchange acquired elements of the monetary theory of exchange rates.That theory is founded on the premises of “global monetarism” and proceeds from the relations between the monetary demand and supply as the basic determinants of the exchange rate. Md is stable in the long term while Ms is variable. The growth of Ms affects absorption, increases it, and also leads to an upward trend in prices. According to the premises of the “law of one price”, commodity arbitrage leads to a deficit in the balance of payments. Over a short term, the deficit in the balance of payments causes a depreciation of the currency. The depreciation of currency deflates the nominal monetary supply, reduces absorption to the available frameworks and leads to a stabilization of the balance of payments. The exchange


rate of the currency is a function of Ms and of relative prices. On this occasion (due to the operation of the “law of one price”), the prices are adjusted on an international scale, while the exchange rate is a variable magnitude:

P=r x Pf

8. The portfolio approach to the balance of payments and the exchange rate represents a step forward in relation to the monetary approach and the monetary theory of foreign exchange rates. It gives priority to the relations on the capital market and the money market. The portfolio approach accepts certain premises of global monetarism such as: the integrity of international commodity markets and the “law of one price” full employment, stability of the demand for money, but, it also proceeds from certain new “premises” like: the integrity of international capital markets and the significant role of interest rates in the process of the international movement of capital.According to the portfolio approach, the state of the balance of payments and of the currency exchange rate is determined by the circumstances on three markets:19 on the money market, on the capital market, and on the commodity market. In essence, the relationship between Ms and Md determines the relations of balance or imbalance on all these markets.

Thus for example, an increase in Ms acts in the following manner:a) at the money market a decrease takes place in the interest rate and in the marginal utility of money. For that reason, wealth holders tend to change the structure of their portfolio, reducing the share of money in it and increasing the share of other forms of property.b) on the capital market – the owners buy securities. The price of securities grows, and the proceeds they yield decrease relatively. This directs the owner (who may own cash, domestic securities, and foreign securities) to buy foreign securities. The process of purchasing

19 See: W- Branson. op. cit. P. Kenen, op. cit. J. Levin - The Dynamic of Stabilization Policy Under Flexible Exchange Rates: A Synthesis of Asset ‘and Neo-Keynesian Approach - .oxford Economic Papers, XI 1980, R. Dornbush - Exchange Rate and Current Account - The American Economic Review, XII 1980.


foreign securities represents an outflow of capital. The processes on the money market and the capital market develop very rapidly.c) The outflow of capital leads the national currency towards depreciation. Due to that, the current account of balance of payments gradually moves towards a surplus. Namely, production is homogeneous, the preferences of consumers on an international scale are similar, and so the flexibility of imports and exports, in relation to price changes, is great. All this enables the export surpluses to be placed abroad (export is increased), and imports to be reduced along with a depreciation (devaluation) of national currency.d) The surplus in the current balance of payment acts in the direction of the appreciation of national currency. Thereby, the assets of the residents owning foreign securities are increased. The increase in their wealth increases their tendency towards absorption. Concur-rently, the appreciation of the currency reduces the surplus in the current account of balance of payment discouraging the exports and stimulating the imports. The process of adjustment ends with the stabilization of the balance of payments; then, stability is achieved both in the current and the capital account of balance of payments. In the frameworks of the national economy, absorption is adjusted to the income and monetary supply to monetary demand.All the processes take place continually, or as P. Kenen says, everything is like at the airport: as soon as one plane takes off, the other one lands. The changes on the capital market constitute the basic determinant of the exchange rate over a short term. Over a long period, there is an interaction between portfolio and the Neo-Keynesian approach, so the exchange rate is determined predominantly by the state and the relation between the commodity (supply) and purchasing funds (demand), i.e., by the relation between the monetary demand and supply. In the long run, the rate moves according to the parities of the purchasing powers of certain currencies.20

Great short-term oscillations of exchange rates are accounted for by the elements of rational expectations and by speculations.

20 The same views are expressed by: Branson, Friedman, Modigliani. See: W. Branson, op. cit. and P. Kenen, op. cit.


9. Balance of Payments Theories and Foreign Debt As we could possibly deduct form the previous analysis of Balance of Payments (BoP), theories differ from each other, first of all, according to the main determinates of BoP movements differentiating between a) monetary, and b) “real” economic variables. Monetary factors predominate within the following theories of BoP: classical theory, monetary approach to the BoP theory, monetarist’s theory of foreign exchange rate determination, and with portfolio approach to BoP and foreign exchange rate determination. Real economic factors dominate within the following theories and schools of BoP: foreign trade multiplier, elasticity approach, and absorption approach to the BoP.At the first glance, and very often, one could get an impression that the “real” and monetary determinates of BoP theory and policy are definitely separated and detached.However, the reconsideration of BoP theories that we have dealt with in this paper, together with the given reinterpretation of these theories, suggest that we might combine the effects of both: “real” and monetary factors implicit or explicit in those theories. The basis for such an approach we find in monetary demand function. Namely, analyzing monetary demand function (Md) one can see that (Md) does not live aside, but incorporate both: real and monetary side of an economy. Moreover, we consider that the function of (Md) emanates from “real” economy side. The demand for money function is determined by: a) the given level of employment of an economy, b) the factor of production endowments of an economy, c) the given level of technology. Therefore, we might conclude that the demand for money function (Md) depends upon the level of GDP of one economy, and in no case is only a monetary variable. In fact, (Md) is a monetary expression of “real” economy of a country.In that spirit we might draw a conclusion that an equilibrium between monetary supply and monetary demand represents an equilibrium between the monetary and the “real” sector of an economy, and consequently an equilibrium between saving and investment, that is, it finally represents a macroeconomic equilibrium of a country.Consequently, we conclude that an increase in a country’s net foreign indebtedness is equal to the current account deficit which has to be


financed by borrowing from abroad. “Using the national income accounting identities, the proximate causes of a current account deficit are:

where the current account (the trade account X-M plus net interest paid abroad, Rf) is equal to the sum of net private and public sector saving. It follows that if net foreign indebtedness is not to increase, the trade surplus must be large enough to finance interest payments abroad – what requires positive net domestic saving (i.e. public plus private).21

Otherwise, the debt “overhang” might become a constraining factor of economic growth of a country. The danger of debt “overhang” puts a heavily indebted country (debt service ratio over 30%) in a delicate position. A country has to adjust its BoP, that is, a country has to select the proper mix for its BoP policy. Many factors of determining nature might be at work in a country in that respect. If , for instance, a country is a so called “small open economy” on its definite way towards the EU and the Euro zone, that country has to follow “the rules of the game” of the Maastricht criteria. Those same criteria tie the hands of the country in selecting an adequate policy mix from the point of view of both: BoP and economic growth.Namely, it might happen to the country that the limited economic policy choice (constrained by predetermined criteria) directs the country more towards expenditure - changing policy mix than towards exchange-switching policy mix. If it happens that high unemployment burdens the country, together with a low level of productivity in comparison with the given desired level (the productivity of main foreign trade partners, particularly members of the EU), the country is likely to be faced with the necessity to select the pro-deflationary policy mix in order to reach the necessary trade surplus. The price of such an export increase, and import reduction, might be socially and politically painful for a country. Worse than that, if the country must by all means dramatically, and over short

21 Hallwood, P. - MacDonald, R. (2000) International Money and Finance, Blackwell


time span, increase its export competitiveness, that country might be faced with misery, regional economic tensions and might be farther from the predetermined strategy than expected at the time when the BoP deficit was a stimulating factor for the economic growth of a country.

Conclusion

The history of failed BoP policies all over the world is very rich. Latin America is good case in point, not to speak about the former Yugoslavia’s case during the 1980s which was accentuated and terribly worsened by improper economic policy mix (the application of monetary approach to the BoP – the strong role of devaluation under the conditions of imperfect and inflexible market structure)Hallwood and MacDonald point to the cases in Latin America in 1984 “when interest payments on international debt amounted to 5.5 percent of GNP. In Latin America the current account deficit (representing use of foreign saving ) fell from 4.4 to 1.3 percent of GNP between 1980 and 1989 , while domestic saving rate also fell (from 20 to 19.3 percent), with the result that the rate of investment fell by 3.8 percent of GNP to 19.6 percent… In Argentina, Brazil, and Mexico debt service has crowded out investment rather than consumption with private investment being sharply reduced-in 1985 to only 2.5 percent of GDP in Argentina, and 10 percent in Mexico.” 22

danas, sa stajališta suvremenih pristupa platnoj bilanci i deviznim

deficita platne bilance i neprikladnog «miksa» ekonomske politike, 22 Hallwood, P.- MacDonald, R. (2000) International Money and Finance, Blackwell


ekonomski rast zemlje.

Literatura

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Dornbush, R. (1980), Exchange Rate and Current Account, The American Economic Review, XII.

Hallwod, P.; MacDonald, R. (2000), International Money and Finance, Blaskwell.

Johnson, H. (1977), Money, Balance of Payments Theory and the International Monetary Problems, IFS, Princeton Un.

Johnson, H. (1962), Money, Trade and Economic Growth, George Allen & Unwin.

Kenen, P.; Allen, P. (1979), The Balance of Payments, Exchange Rates and Economic Policy, IFS, Princeton Un.

Kreinin, M. (1978), The Monetary Approach to the Balance of Payments , IFS Princeton Un.

Levin, J. (1980), The Dynamic of Stabilization Policy Under Flexible Exchange Rates: A Synthesis of Asset and neokeynesian Approach, Oxford Economic Papers, XI.

Marx, K. (1948), The Capital, vol. III, Kultura, Beograd.

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Panic, M. (2003), Globalization and National Economic Wefare, Palgrave.

Keynes, Friedman, Marx, Informator, Zagreb.

Ekonomski fakultet Sarajevo, Sarajevo.

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