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The Elasticity Approach to the Balance of Payments

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DOI: 10.1007/978-1-349-21806-6_5

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 BALANCE-OF-PAYMENTS THEORY
AND THE UNITED KINGDOM EXPERIENCE
 Also by A. P. Thirlwall

* GROWTH AND DEVELOPMENT: with Special Reference to

Developing Economies
* INFLATION, SAVING AND GROWTH IN DEVELOPING
ECONOMIES
* FINANCING ECONOMIC DEVELOPMENT
* REGIONAL GROWTH AND UNEMPLOYMENT IN THE
UNITED KINGDOM (with R. Dixon)
* KEYNES AND INTERNATIONAL MONETARY
RELATIONS (editor)
* KEYNES AND LAISSEZ-FAIRE (editor)
* KEYNES AND THE BLOOMSBURY GROUP
(editor with D. Crabtree)
* KEYNES AS A POLICY ADVISER (editor)
* KEYNES AND ECONOMIC DEVELOPMENT (editor)
NICHOLAS KALDOR
THE ESSENTIAL KALDOR (editor with F. Targetti)
FURTHER ESSAYS ON ECONOMIC THEORY AND
POLICY: Vol. 9 COLLECTED ECONOMIC ESSAYS OF
NICHOLAS KALDOR (editor with F. Targetti)
* EUROPEAN FACTOR MOBILITY: TRENDS AND
CONSEQUENCES (editor with fan Gordon)
DEINDUSTRIALISATION (with S. Bazen)
* ECONOMIC GROWTH AND THE BALANCE OF
PA YMENTS CONSTRAINT
(with J. McCombie)

Also by Heather D. Gibson

* THE EUROCURRENCY MARKETS, DOMESTIC

FINANCIAL POLICY AND INTERNATIONAL INSTABILITY
* ECONOMIC INTEGRATION AND FINANCIAL
LIBERALIZATION: PROSPECTS FOR SOUTHERN EUROPE
(editor with E. Tsakalotos)

* Also published by Palgrave Macmillan

Balance-of-Payments
Theory and the
United Kingdom
Experience
FOURTH EDmON

A. P. Thirlwall
Professor of Applied Economics
University of Kent at Canterbury

and

Heather D. Gibson
Lecturer in Economics
University of Kent at Canterbury

M
© A. P. Thirlwall 1980, 1982, 1986
© A. P. Thirlwall and Heather D. Gibson 1992
All rights reserved. No reproduction, copy or transmission
of this publication may be made without written permission.

No paragraph of this publication may be reproduced, copied

or transmitted save with written permission or in accordance
with the provisions of the Copyright, Designs and Patents Act
1988, or under the terms of any licence permitting limited copying
issued by the Copyright Licensing Agency, 90 Tottenham Court Road,
London W1P 9HE.

Any person who does any unauthorised act in relation to

this publication may be liable to criminal prosecution and
civil claims for damages.

First published 1980 by

THE MACMILLAN PRESS LTD
Houndmills, Basingstoke, Hampshire RG21 2XS
and London
Companies and representatives
throughout the world
ISBN 978-0-333-56648-0 ISBN 978-1-349-21806-6 (eBook)
DOI 10.1007/978-1-349-21806-6

A catalogue record for this book

is available from the British Library.

Second edition 1982

Third edition 1986
Reprinted 1988
Fourth edition 1992
Reprinted 1993
Contents
Preface to the Fourth Edition x
Acknowledgements xiii

1 Balance-of-Payments Accounting and the Foreign-

Exchange Market 1
Concepts of the balance of payments 1
The accounting balance of payments 2
Balance-of-payments equilibrium 5
More on the concept of equilibrium 13
The foreign-exchange market 22
Tbe demand for dollars 23
The supply of dollars 25
Capital movements and speculation 30
Tbe forward rate of exchange ~2

2 The Capital Account of the Balance of Payments 37

Tbe components of the capital account 38
Official Reserves 41
Special Drawing Rights (SDRs) 46
Tbe Balancing Item 49
Tbe capital account and the net external wealth
of the UK 51

3 Exchange Rate Determination S9

Tbeories of exchange rate determination 60
Purchasing Power Parity 60
Current Balance Model 65
Tbe importance of theories of expectations
forrnadon 66

v
vi Contents

The Mundell-Fleming Model 69

Exchange Rate Overshooting Models 77
The Portfolio Model of exchange rate determination 85
Speculative Bubble Models of exchange rate
determination 91
Exchange rate determination: what have we learnt 94
Exchange rate systems and policies 96
Fixed versus flexible exchange rates 97
Types of exchange rate regime 102
Controls on capital movements 121
Exchange rate policies in the 1990s 127

4 The Balance of Payments and the National Economy 129

The integration of the balance of payments into the
national accounts 129
The conflict between balance-of-payments
equilibrium and other objectives of economic policy 131
Income equilibrium in an open economy and the open
economy multiplier 136
The open economy multiplier relating imports to
expenditure 139
The 'new' open economy multiplier with foreign
repercussions 145
Balance-of-payments adjustment 148
The classical price-specie flow mechanism 150
The elasticity approach 150
The absorption approach 152
The monetary approach 153
5 The Elasticity Approach to the Balance of Payments 155
The Marshall-Lerner condition derived 155
Devaluation and the response of firms 162
Lags and the J-curve effect 166
Devaluation and inflation 168
Devaluation and the terms of trade 177
The difficulties of measuring price elasticities 178

6 The Absorption Approach to the Balance

of Payments 183
The direct effect of devaluation on income 185
Contents vii

The direct effect of devaluation on absorption 186

The interaction between changes in income and
changes in absorption 188
Strengths and dangers of the absorption approach 190
The monetary aspects of balance-of-payments deficits 192
Domestic credit expansion 193

7 The Monetary Approach to the Balance of Payments 195

8 Simultaneous Internal and External Balance 203

Internal and external balance under flexible exchange
rates with no capital movements 205
Internal and external balance under fixed exchange
rates with capital movements 209
Internal and external balance in an IS-LM curve
framework 214
The use of monetary and fiscal policy under alternative
exchange-rate regimes 216
The assignment of policies in the United Kingdom 217

9 A History of the UK Balance of Payments 219

1854 to 1939 219
1940 to 1950 225
1951 to 1959 228
1960 to 1969 231
Devaluation, 1967 239
1970 to 1979 243
Since 1980 251
Appendix: a polemic on floating the pound, 1972 258

10 Import Functions 272

The determinants of imports 272
Imports and capacity 274
Imports and labour-market bottlenecks 278
Imports and income (estimates of income
elasticities) 281
Imports and relative prices (estimates of price
elasticities) 285
Import penetration 286
viii Contents

11 Export Functions 291

The determinants of exports 291
Exports and capacity 292
Exports and world income (estimates of income
elasticities) 298
Exports and relative prices (estimates of price
elasticities) 299
Export performance in manufacturing 304
The United Kingdom's declining share ofworld
exports 306
North Sea oil and the balance of payments 315
Appendix: Commodity and geographie composition
of UK exports and imports 319

12 The Balance-of-Payments Equilibrium

Growth Rate 323
The determination of the balance-of-payments
equilibrium growth rate 324
A fundamental law of growth 328
The model with capital ftows 332
Use of the model for forecasting and simulation 333
Conclusion 336

13 Export-Led Growth 337

The importance of export-Ied growth 337
Models of export-Ied growth 341
An export-Ied growth model with a balance-of-
payments constraint 347

14 The Balance of Payments as a Structural

Problem 351
Non-price factors determining exports and imports 354
The 'new' trade theories 359
Studies of non-price competition 361
Research and development effort 363
Contents ix

IS Deindustrialisation and the Balance of

Payments 366
Does deindustrialisation matter? 366
The causes of deindustrialisation 372
A trade strategy for the United Kingdom 378
The future 384

Notes 389
References 401
Index 423
Preface to the Fourth
Edition
This book has three main purposes: first, to provide an elementary
exposition of the balance of payments and of balance-of-payments
adjustment theory; secondly, to describe the historical evolution and
contemporary position of the United Kingdom's balance of pay-
ments, and thirdly, to critically appraise conventional balance-
of-payments adjustment mechanisms, particularly in the light of the
poor record of changes in nominal (and real) rates of exchange in
rectifying balance-of-payments disequilibria in the world economy in
the last decades. We emphasise the importance of non-price factors
as determinants of export and import performance, which are
reflected in the income elasticities of demand for exports and
imports.
As far as the United Kingdom is concerned, it is argued strongly in
the book, particularly in Chapters 12, 13 and 14, that the balance of
payments should be viewed in a growth context, and that at the heart
of the UK's poor post-war growth performance relative to other.
industrialised count ries is its relative neglect of the tradeable goods
sector which is reflected in a low propensity of other countries to buy
UK exports and a high propensity in the UK to import foreign goods
(particularly manufactures). This problem cannot be tackled by ex-
change rate depreciation or monetary manipulation. It requires real
economic policies of a structural nature related to the wider charac-
teristics of goods, such as their quality, design, reliability, marketing
and delivery. Exchange rate depreciation simply ossifies the indus-
trial structure and makes producers temporarily more competitive in
the export of goods with given characteristics which were the source
of payments weakness in the first place. In our view, the UK's
inferior economic record in relation to other countries is largely a
function of its balance-of-payments strait jacket caused by the slow
x
Preface to the Fourth Edition xi

growth of exports and high propensity to import, and until this

underlying weakness is rectified, the UK will be condemned to a low
growth rate (and the spectre of rising unemployment) whatever other
domestic policies are pursued.
The idea that countries may be constrained in their growth per-
formance by balance-of-payments weakness leads to the concept of
balance-of-payments constrained growth. We formally derive a for-
mula for a country's growth rate consistent with balance-of-payments
equilibrium which turns out to be a remarkable predictor of growth
rate differences between advanced industrial countries since the
Second World War.
Since the book was first published in 1980, it has been widely used
as a preliminary text on balance-of-payments theory, and as a source
of reference on the performance of the UK balance of payments. This
fourth edition provides the opportunity to bring up to date all the
tables relating to the balance of payments, imports and exports, the
commodity and geographie composition of trade, the exchange rate,
and so on, and also the text relating to the history of the UK balance
of payments. The tables and text now extend to 1989/90.
In addition, the analysis and exposition has been extended in
several places. The most significant change. which has led to co-
authorship of the book, has been the addition of two new chapters on
the capital account of the balance of payments and on the determina-
tion of exchange rates. A detailed analysis of these two topics was a
major omission from previous editions.
Other changes include the following: the book continues to argue
strongly that the focus of balance-of-payments policy ought to be on
the current account, but in Chapter 1 there is a fuller account of why
the current account of the balance of payments matters for the
functioning of the real economy. It has become fashionable in some
quarters to argue that current account deficits do not matter if they
are not government induced and can be voluntarily financed. We
argue that they do matter. Chapter 4 on the balance of payments and
the national economy retains one of its distinctive features of present-
ing the foreign trade multiplier relating imports to expenditure rather
than to income, which is obviously more realistic if the import
coefficients of various components of domestic expenditure differ. In
this chapter, the worsening trade-off between the balance of pay-
ments on current account and the level of unemployment in the UK is
also highlighted. Chapter 9 extends the history of the UK balance of
payments to 1990 with particular emphasis on exchange rate policy
xii Preface to the Fourth Edition

and the worsening current account deficit in the latter years of the
1980s. Chapters 10 and 11 contain up to date information on import
penetration and export performance in the UK. Chapter 12 on the
balance-of-payments equilibrium growth rate reports recent work by
other researchers of applying the model of balance-of-payments
constrained growth to a range of countries for the most recent years.
We also show how the model can be used for simulation and forecast-
ing purposes. Chapter 14 on the balance of payments as a structural
problem has an extended discussion of non-price factors as determi-
nants of trade performance, and gives the results of some tests of the
theories of non-price competition. The link between balance-
of-payments weakness and deindustrialisation in the UK is further
developed in a new Chapter 15.
In the original writing of the book a debt was incurred to a number
of organisations and individuals. The Economic and Social Research
Council (formerly the Social Science Research Council) financed the
initial research on the structural aspects of the UK balance of pay-
ments. The Treasury and Department of Trade and Industry pro-
vided statistics. Mr John Goy and Mrs Julia Stevens of the University
of Kent Library obtained and checked references. The editors of
Banca Nazionale dei Lavoro Quarterly Review, Applied Economics,
the Oxford Bulletin of Economics and Statistics, the Journal of
Common Market Studies and the National Westminster Bank Quarter-
Iy Review gave permission to reproduce certain material which first
appeared in their journals. Finally, colleagues - Richard Disney,
John Craven, Charles Kennedy, Bob Dixon and Thea Sinclair - read
the first edüion and helped to improve the book with their construc-
tive comments on various chapters. For this new edition we must also
thank Euclid Tsakalotos for constructive criticism; Keith Povey and
Steven Gerral'd for editorial assistance, and Celine Noronha for
typing various drafts of the manuscript.

A. P. THIRLWALL
HEATHERD. GIBSON
Acknowledgements
The authors and publishers wish to thank the following who have
kindly given permission for the use of copyright material:

Cambridge University Press, for tables from Abstracts of British

Historical Statistics, by B. R. Mitchell and P. Deane; The Controller
of Her Majesty's Stationery Office, for tables from U .K. Balance of
Payments, Key Statistics, and Economic Progress Reports; Lloyds
Bank Ltd, for a table from Lloyds Bank Review (January 1975), by
M. Panic; Institute for International Economics, for a table from The
Exchange Rate System, by J. Williamson; National Westminster Bank
Ltd, for a table based on figures from National Westminster Bank
Quarterly Review (May 1975); Organization for Economic Co-
operation and Development, for a table derived from OECD Man-
power and Labour Force Statistics; Martin Robertson & Company,
for an extract from Modern Capitalism: Its Growth and Transform-
ation, by J. Cornwall (1977); Financial Times for a diagram by
T. 0' Shaughnessy in an article published 1 February 1989; Heine-
mann Publishers for the use of text from Deindustrialisation, by
S. Bazen and A. P. Thirlwall.

Every effort has been made to contact all the copyright-holders, but if
any have been inadvertently omitted the publishers will be pleased to
make the necessary arrangement at the earliest opportunity.

xiii

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