Balance of Payments 4

— BALANCE OF -
PAYMENTS
ADJUSTMENT:
Policy Issues
Chapter 14
The need for BOP adjustment, particularly of deficit disequilibrium, is

clear A nation’s ability to absorb deficits is broadly limited by its
stock of official international reserves —

gold and generally acceptable
foreign currencies — and the willingness of foreign countries to hold
itscurrency as part of their own international reser\ es Accommodating
short term capital borrowings can help in prolonging BOP deficit
adjustments, but they cannot be relied upon indefinitely Another
constraint to BOP adjustment is the desire on the part of countries to
achieve high levels of national income and employment consistent
with price stability Internal balance cannot be sacrificed for the sake
of external balance
In the previous chapter, we tried to show how BOP adjustment
tends to come about more or less automatically under two different
exchange rate systems —
one, where the exchange rate is fixed but
prices, interest rates, income levels and capital flows are free to
fluctuate, and second, where there is freely fluctuating exchange rate
system For the effective working of this automatic adjustment
mechanism, there is no need for any policy action by the government,
in fact, government non intervention is a condition
Balance of Payment Adjustment Policy Issues 321
should be stressed, however, that neither of the two self-
It
equilibriating systems conforms to reality There is very little
‘automaticity’ in BOP adjustment m the real world Government
intervention, today, is a fact of life in all countries —
developed or
underdeveloped The ‘visible hand’ of government is seen everywhere
— in controlling prices, interest rates, income levels or exchange rates
Indeed, BOP adjustment has become largely a matter of policy
Government have come to use a wide variety of policy instruments to
achieve BOP equilibrium, and the government policies designed to
produce ‘external balance’ cannot afford to ignore questions related to
‘internal balance’ As a matter of fact, in ordering national priorities,
internal balance claims a definite precedence over external balance,
practically, in every country in the world What we have essentially
today, are disequilibrium systems of national economies
Let us now proceed to discuss the BOP adjustment methods or
policy instruments They can be grouped under three broad categories
as follows
() Monetary and Fiscal Policy (Expenditure Changing Policy)
() Devaluation (Expenditure Switching Policy)
(c) Exchange Controls
Each one of them merits a detailed discussion, which we will
undertake in this chapter
MONETARY AND FISCAL POLICY: EXPENDITURE

CHANGING POLICY
Monetary policy exerts its influence on the economy through changes
in money supply (Af,) and interest rate (r), and fiscal policy does it
through changes in government expenditure (G) and taxes (7*) Let us
first consider the effects on BOP of the monetary and fiscal policy
“disturbances” (ie the effects of changes in monetary and fiscal
policies on the BOP equilibrium of a country) We will use the IS LM
BB framework of analysis to conduct our enquiry
(A) Changes in Government Expenditure and BOP Equilibrium
Let us suppose that we have an economy where there is internal

and external balance That means, initially, we are at point 1 in the
following diagram, with interest rates r0 and national income Yv At
this interest rate-income combination, we have full employment with
stable prices (internal balance) as well as BOP equilibrium (external
balance)
caused by
Let us now introduce a fiscal policy 'disturbance
shift the
increased government expenditure (TG) tG wdl immediately
!A diagram
IS schedule to the nght, from ISe to IS in diagram
t
(or
322 International Economics
IB) This would shift the JS LM equilibrium position from point 1 to

point 2 in the two diagrams, and at new equilibrium point 2, both the
interest rate (r) and income level ( Y) have gone up, from r0 to rv and
from Y0 to Yx respectively This is to be expected because (a) when G
increases, Y must increase by some multiple of the increase G, m
depending on the value of multiplier, and (6) when G increases, r must
increase, because increase in government spending will reduce the
amount of funds available for private investment thereby raising
interest rates
Now the question is, what are the effects of these changes on BOP
equilibrium? The answer depends on whether the situation in the
economy is as shown m Diagram 1A, or as shown in Diagram IB
Note that in Diagram 1A, the BB schedule is steeper than the LM
schedule, but in Diagram IB the LM schedule is steeper than the BB
schedule If it is an economy of the type shown m
Diagram 1A, then
one can say that this fiscal policy ‘disturbance’ has resulted BOP m
deficit, because point 2 lies to the nght of the BB schedule If,
however, the economy is of the type represented in Diagram IB, then
I
the result would be a BOP surplus because point 2 lies to the left of
the BB schedule Therefore, the BOP result of an -G depends very
much upon the slope of BB schedule in relation to the LM schedule
The BOP effects of G may be summarized as below
_TY—>TAf (current account deficit trend)
tg;
Tr-rfCapital inflow (capital account surplus trend)
Increase in government expenditure raises income levels, and

therefore, imports increase The exact amount, by which these imports
of goods and services will go on depends upon the marginal propensity
to import In any case, this has a negative effect on the BOP
situation
This the first result of TG The second result of TG would be to raise
is
interest rate and thereby induce net capital inflows into the country,
the exact amount of capital inflows depends upon the interest elasticity
of capital flows This, many case, would create a positive effect on the
BOP situation of a country The final outcome depends on whether the
negative current account effect is stronger or weaker than the positive
capital account effect If the negative current account effect is stronger
than the positive capital account effect (as in Diagram 1A), the result
would be a net overall BOP deficit And, if the positive capital account
is stronger than the negative current account effect (as in Diagram
IB) then the result would be one of overall BOP surplus

Similarly, one can analyse the effects of a decrease in government
expenditure on the BOP outcome In this case of a -iG, the IS schedule
would shift to the left leading to Ir and lY The results of these would
be a BOP surplus (in Diagram 1A) and a BOP deficit (in Diagram IB)
They are not shown in our diagrams 1A and IB and the readers can
work it out themselves
(B)Changes in Money Supply and BOP Equilibrium

The effects of -G on BOP equilibrium can be predicted only, if we
know the slope of BB schedule in relation to the LM schedule This
means, in turn, that we must know the value of income multiplier,
marginal propensity to import and interest elasticity of capital flows
The effect of fiscal policy change would be either a deficit or a surplus
depending on several variables In sharp contrast to this, the effects
of monetary policy changes on the BOP situation, are very clear cut
and straightforward We can confidently predict that an increase in
money supply would lead to a deficit, and a decrease in money supply
would lead to a surplus This is regardless of the relative slopes of the
BB and the LM schedules See the following graph
Diagram 2
The initial equilibrium is at point 1 with interest rate r0> and

national income level Y An increase in money supply — a monetary
0
policy ‘disturbance’ — would shift the LM schedule to the nght (from
LM0 to AM, inDiagram 2) so that the new equilibrium moves from
point 1 to point 2 The result is a decrease in interest rate, from r0 to
r, and an increase in national income from Y0 to Y, Note that point
2 lies clearly to the nght of BB schedule, regardless of whether the BB
schedule is a steeper one (such as BB,) or a flatter one (such as BB 2 )
in relation to the LM
schedule At point 2, which lies to the nght of
any BB schedule, there must be a deficit in the country’s BOP The
BOP result of an increase in money supply (MS) is, therefore,
unambiguous We can show the effects of TM as follows b
T Y TM (current account deficit trend)
TM.<^
i r 4-Capital outflow (capital account deficit trend)
An increase in money supply would only create negative current

and capital account effects leading, obviously, to a net deficit in the
overall BOP
In the similar way, one can work out the effects of a decrease in
money supply (iAf,) on the BOP situation of a country Needless to say
that lMt
would shift the LM
schedule to the left reducing Y and
increasing r This would create current and capital account surpluses
and an overall BOP surplus situation The new JS intersection LM
would be clearly to the left of the BB schedule, whatever may be the
slope of the BB schedule
From this discussion, therefore, we may conclude that the effects
of Tisca'i policy on the BuP situation of a country are somewhat
unpredictable, whereas the effects of monetary policy on the BOP are
highly predictable Putting it slightly differently in a prescriptive way,
we may say that it is better to use monetary policy for BOP
adjustment (or for achieving external balance), since the effects of
monetary policy changes are highly predictable with regard to BOP
The fiscal policy may then be used achieving an internal balance ( i e
full employment with stable prices) Before we go on further with the
discussion of monetary and fiscal policy in relation to internal and
external balance, let us briefly take a look at an alternative geometrical
representation of the relative impact of the two policies on the BOP
equilibrium of a countiy This is done in Diagram 3 ahead
Balance of Payment Adjustment Policy Issues
325
Originally, we have an IS LM intersection at point a (in Panel I)

giving us an equilibrium national income level, Y and interest rate,
0
r0 Income level Y0 in Panel II is equal to the income level Y0 in Panel
I At this income level y the trade deficit, or current account deficit
o
(represented in Panel III) is equal to Oj, because m Panel III the trade
balance schedule, 7X10, is drawn on the basis of the assumption of a
given marginal propensity to import, such that at income level OYa
there would result a trade deficit equal to the size Oj This is current
account result of OY0 level of national income The capital account
result stems from interest rate In Panel IV, you will see that at
interest rate, k r0 the net capital inflows — capital inflows minus
—
,
outflows are of the order of the size 01 The capital balance

schedule, K(r), is drawn on the basis of an assumption of interest
elasticity of capital flows, such that at interest rate r0 there would
,
result capital account surplus equal to the size, 01 You will, therefore,
clearly notice that at income level Y0 combined with interest rate r0 ,
there is a current account deficit of Oj which is exactly matched by a

capital account surplus of Ol, so as to give us an o\ erall balance in the
country’s BOP U e no net deficit or surplus in the overall BOP) Notice
that Oj is equal to Ol
Now, let us introduce policy ‘disturbances’ A fiscal policy disturbance
caused by, say increase in government expenditure would shift the IS
schedule to the nght, from IS0 to IS t (m Panel I) This will result in
increase in income from Y0 to y,, and increase in interest rate from
r 0 to These income and interest increases ha\e the effects on
current and capital account deficit and surplus increases, such that
there is once again an oi erall BOP equilibrium Because the curren*
i
326 International Economies
account deficit which has now gone up from Oj to OP is matched by

an equivalent increase in capital account surpluses from 01 to On
Notice that Op is equal to On
Similarly, one can work out the effects of a decrease in government
expenditure (downwards IS shift) on the BOP equilibrium The BOP
equilibrium, which existed initially, will continue to remain so, m
spite of fiscal policy disturbances
If, however, there is a monetary policy disturbance caused by an
increase in money supply, the result on the BOP situation would be

to cause disequilibrium In Panel I, the LM schedule would shift to the
nght, from LM 0 to LM, causing national income to increase from Y0
to Y, (as in the case of fiscal policy disturbance) but interest rate to
decrease from r0 to r2 (unlike the case of fiscal policy where it increases
from r0 to r,) These income and interest changes resulting from
monetary policy disturbances, cause current account deficits to increase
from Oj to Op (as in case of fiscal policy) but capital account surpluses
to decrease from 01 to Od (unlike fiscal policy disturbance where it
increases from 01 to On) The overall BOP result would be to create
a net deficit equal to the size pd ( e Op minus Od)
In the same way, one can work out the effects of a decrease in
money supply (resulting in a leftward shift in the LM
schedule) This
would cause income to fall and interest rates to rise That in turn
would reduce current account deficits and increase capital account
surpluses such that we have an overall net BOP surplus The reader
can work it out graphically himself, and it is not shown here in
Diagram 3 on page 325
This analysis again tells us that BOP changes are relatively more
sensitive and more definitely predictable with respect to changes in
monetary than fiscal policy All this is subject to certain
policy rather
underlying assumptions One can therefore argue that monetary
policy is a more appropriate policy instrument for BOP adjustment (or
external balance), and fiscal policy is a more appropriate instrument
for achieving or preserving internal balance We shall now turn to this
appropriate assignment question to examine it m detail
ASSIGNMENT PROBLEM: MONETARY AND FISCAL

POLICY FOR ACHIEVING INTERNAL AND EXTERNAL
BALANCE:
MUNDELL MODEL
Robert A. Mundell published an article m the IMF Staff Papers
(March 1962) titled The Appropriate Use of Monetary and Fiscal
Policy for Internal and External Stability In this article he argued

that a country could adopt a policy of fixed exchange rates and
assign
monetary policy to achieve external balance and fiscal policy to
achieve internal balance If, however, the government turned around
and applied monetary policy for achieving internal balance and fiscal
policy for external balance (retaining the fixed exchange rate policy)
the consequences to the economy would be disastrous, because this
kind of inappropriate assignment would exacerbate the problems of
inflation and unemployment as well as balance of payments We will
examine Mundell’s model below
The need for governments to formulate and apply policy measures
to attain BOP equilibrium arises only under a system of fixed
exchange rates In a freely fluctuating exchange rate system, external
balance is achieved automatically, but that does not guarantee internal
balance Similarly, in a system where prices interest rates and

income levels are flexible external balance can occur without exchange
rate flexibility, but once again this will be achieved at the expense of
internal balance We live in a world where crucial pnees (of goods and
services, capital, real national income and exchange rate) are not
allowed to vary freely mresponse to market forces Achieving internal
and external balances consistent with relatively stable exchange rates
have become matters of government policy Internal balance refers to
domestic full employment with price stability External balance refers
to equilibrium in the BOP (te when any imbalance in the capital
account, of opposite sign) These are the two objectives (or targets) of
government policy, and they have to be achieved under a system of
fixed exchange rates
We need policy instruments to achieve these two targets Monetary
and Fiscal policies are the two instruments, which are available to
government The problem, then, is one of appropriate assignment of
the two instruments — monetary policy and fiscal policy —for
achieving the two objectives —

internal and external balance
Jsterna) balance is achieved by reducing inflation and
unemployment to zero External balance is achieved by reducing BOP
deficits and surpluses to zero An expansionary monetary policy, by
reducing interest rates and raising income levels can help in eliminating
domestic unemployment or external surpluses in current and capital
accounts Similarly, an expansionary fiscal policy can help in
ebminating unemployment and BOP surpluses on current account A
contractionary monetary policy can be used to get nd of domestic
inflation or BOP deficits arising out of current and capital account
transactions Similarly, a contractionary fiscal policy can eliminate
inflation or BOP deficits on current account Expansionary fiscal and
monetary policies constitute expenditure increasing policy measures,

contractionary monetary and fiscal policies constitute expenditure
reducing policy measures The mixed package is labelled as “expenditure
changing'’ policy
Then what meant by assignment problem9 Why does the need
is
arise to assign a particular policy —

monetary or fiscal —
to a
particular objective —
eliminating inflation or unemployment9 As a
matter of fact, the problem of assignment does not arise m all the
cases, it anses only in certain number of cases Let us first list all
possible cases and then identify those cases which involve appropriate
assignment problem The four possible cases of internal and external
imbalance are
I Unemployment surplus
II Inflation surplus
III Unemployment deficit
IV Inflation surplus
It is assumed here that unemployment and inflation are as
mutually exclusive as BOP deficits and surpluses This means that

inflation and unemployment cannot co exist, just as BOP deficit
cannot co exist with BOP surplus In today’s world, however, we see
inflation and unemployment not only co existing but growing together
We call this situation as one of stagflation In the world of theory, all
the same, we retain the assumption that a country may have either
inflation or unemployment but not both at the same time BOP
deficits and surpluses, both in theory and reality, belong to a mutually
exclusive category
In respect of case I and case
the problem of assignment does not
II,
anse for the following reasons Take, for instance, a combination of

domestic unemployment and external surplus (t e case I) All we need
to do, is to make both the policies — —
monetary and fiscal expansionary
at the same time Increase in money supply (Af ) would reduce interest
rates (r) and thereby stimulate private investment and mcome levels
Increased government expenditure (G), likewise would tend to increase
income levels The resulting increases m
income levels would eliminate
unemployment When mcome increases imports of goods and services
will increase, eliminating current account surpluses, and interest rate
decreases would induce capital outflows and thereby eliminate capital
account surpluses Monetary and fiscal policies, both of the expansionary
nature, reinforce each other, and the combmed net outcome is the
elimination of unemployment and BOP surplus Internal and external
balances are achieved simultaneously Symbolically we can write the
329
results as follows
t N (elimination of
^ employment)
tnv:
t M (elimination of current
account surplus)
Monetary Policy TMsIr
(expansionary)
t Capital outflows (elimination of
capital account surplus)
T N (elimination of unemployment)
Fiscal Policy TGir"
(expansionary)
T M (elimination of current account
surplus)
In the above expression, Nstands for employment and for M

imports of goods and services The other symbols are already familiar
Now take case II, which is a combination of domestic inflation with
external deficit Both these problems coll for a contractionary policy
treatment. Without having to explain the whole process in so many
words, we can just as comprehensively express the whole operation
mechanically with the help of the same symbols as before
IN (elimination of
inflation)
•l/ly'
J-Af (elimination of current
account deficit)
Monetary Policy TAfsTr
(contractionaiy)
T Capital inflows (elimination of
current neenunt deficit)
lY (elimination of inflation)
Fiscal Policy •iGiyr
(contractionary)
IM (elimination of current account
deficit)
Therefore, by making both the policies contractionary, we can

achieve internal and external balance as represented above Hence,
case I and II are simple and straightforward cases, and they do not
involve any problems of assignment We can use both the policies for
both the objectives
,
Cases and IV, however, involve problems of assignment, because

III
the situations, they represent, are indeed complex as we will see
below The assignment problem essentially poses the following
questions Do we assign monetary policy for achieving internal balance
or for achieving external balance 7 , secondly, do we assign fiscal policy
for external balance or internal balance 7 If our assignment is
'appropriate', it would lead to 'convergence', or solving problems of
internal and external imbalances If, however, we make an
'inappropriate' assignment, it would then lead to ‘divergence’, or
aggravating problems of internal and external imbalances Convergence

takes us towards the solution or back to equilibrium, whereas
divergence takes us away from equilibrium, worsening the problems 1
Robert Mundell has argued that (a) assigning monetary policy for
external balance and fiscal policy for internal balance would be an
“appropriate" assignment, (6) fiscal policy for external balance and
monetary policy for internal balance would be an “inappropriate’
assignment In order to fully understand Mundell’s model, it is first
essential to know the internal balance schedule and the external
balance schedule —their slope and significance
Internal balance schedule, YY, may also be called as internal
equilibrium line It is positively sloped as you see in diagram 4 A on
page 331
The vertical axis measures the interest rate, which is an instrument
of monetary policy, and the horizontal axis measures government
expenditure, which is an instrument of fiscal policy If we are at any
point on the YY line, we are guaranteed full employment with pnee
stability (i e zero rate of inflation and unemployment) Point a, for
example, is a combination of low interest rate and low government
expenditure Low r would guarantee high levels of investment, income
and employment, and combined with low level of government
expenditure there would be full employment with no inflation If at
point a should the government expenditure be high, it would only lead
to inflation Point a, on XY line, is, therefore, one of full employment
with zero inflation Similarly, at another point such as b on the YY
line, we have a combination of high interest rate and. high level of
government expenditure Here, the high level of r would cause low
levels of investment, income and employment, and therefore high le\ el
of G is necessary to achieve full employment with price stability So,
whether we are at point a with low r combined with low G, or we are
at point b with high levels of r and G, there must be internal
equilibrium all along the YY line To the left of YY, at a point such
as d, there must be unemployment or a “deflationary gap” m the GNP
because at point d either the rate of interest is too high causing
investment to be low (relative to point a) or the government expenditure
13 too little (at point d
relative to point e) to ensure full employment
in the economy At point d, there must be unemployment which can
be eliminated either by reducing r (to go from point d to a, vertically
down) or by increasing G (to go from point d to e, horizontally
straight) That means, if we are at point d, we need to apply either an
expansionary monetary policy (to reduce r and return to point o) or an
expansionary fiscal policy (to increase G and go to point e ) to restore
internal equilibrium
If, however, we are to the nght of the YY line at a point such as
point f, we must have inflation or an “inflationary gap" in the GNP

of the country Because, at point f, there is excessive government
expenditure (compared to point 6) causing inflation, or alternately the
interest rate is too low at point f (compared to point n) which is
causing excessive private investment and inflationary GNP increases
Point f must, therefore, be one of inflation, and this inflation can be
eliminated either by a contractionary monetary policy (which raises r
and takes us from point f to n), or by a contractionary fiscal policy
(which reduces G and takes us over to point b from point /)
In Diagram 4B above, the external balance schedule is BB line,
which may also be referred to as the external equilibrium line G and
r represent the same as they do m
Diagram 4A BB schedule is also
positively stopped, and at any point on the schedule, there is BOP
equilibrium, with no overall deficits or surpluses At any point such as
a on the BB schedule, there is a combination of low r and G, low r
creates capital outflows which must be offset by low level of G, which
guarantees low levels of income and imports Similarly, at a point
such as b on the BB schedule, high level of r is combined with high
level of G to ensure BOP equilibrium Here, the high level of G creates
high levels of income and imports (i e current account deficits) which
must be offset by a high level of r to create net capital inflows (ue
capital account surpluses) The current account deficits are offset by
capital account surpluses to yield us an overall BOP equilibrium at a
point like 6 on the BB line
If we are to the left of BB

schedule, at a point such as d, we must
have an overall BOP surplus, and this surplus can be eliminated
either with the help of an expansionary monetary policy (which
reduces r and takes us down from point d to a) or with the help of an
expansionary fiscal policy (which raises G and takes us over from
point d straight to e) restoring BOP equilibrium Monetary policy
would reduce capital account surplus, whereas fiscal policy would
reduce current account surplus The effect is, however, the same, viz
to return to BB line from point d
If we are to the right of BB schedule, at a point such as f, we must
have an overall BOP deficit This is either because G is excessive,
causmg current account deficits (at point f relative to point b) or
because r is too low, causing capital account deficits (at point f relative
to point n ) In any case, f must be a point of BOP overall deficit As
a policy measure to get rid of this deficit, we can use either a
contractionary monetary policy (which wall raise r and take us up from
point /"to n ) or a contractionary fiscal policy (which will reduce G and
take us back from point f to b) We return to external equilibrium
eliminating BOP deficit, which exists at point f
We can now place the internal and external balance schedules on
a single graph as m
Diagram 5 on page 333, and you can see that the
YY and BB lines divide the diagram into four zones of disequilibrium
The two lines intersect at point E, which is a situation of internal
as well as external equilibrium With a combination of interest rate
and government expenditure obtaining at point E, the economy
achieves full employment with pnee stability, and an overall BOP
equilibrium Zone I represents a case of unemplo>ment surplus,
because if we are at any point in that zone, we are clearly to the left
of both the YY line and the BB line An expansionary monetary and
fiscal policy will help economy in returning to point E Similarly, if we
are at any point in Zone II, we are clearly to the right of both the
schedules, and, therefore, it must represent a case of inflation deficit
combination The simple rule adopt and apply contractionary,
is to
monetary and fiscal policy They

will restore the economy to a
complete balance and return it to full equilibrium point at E We have
discussed these two cases in detail earlier and there is no need to go
into their details again We have also indicated earlier on, that these
two cases (Zone I and II situations) are rather simple and straight
forward and that they do not involve assignment problem
The problem of assignment arises only in the cases of disequilibrium
that lie between the YY and BB lines on either side of the point E
Zone III is a case of unemployment deficit, because, if we are at any
point in that zone, we are to the left of YY line (representing
333
unemployment) but to the nght of BB line (indicating external deficit)
Zone IV represents a case of inflation surplus at any point in
that
zone, the economy is to the nght of YY line (indicating inflation)
but
to the left of the BB line (signifying external surpluses) Cases
represented in Zone III and IV call for a careful assignment of
appropriate policy instrument to achieve the two balances
Note carefully the slopes of the two schedules Although both the
lines — YY and BB — have a positive slope, the YY line is steeper
than the BB line This is based on the assumption that Internationa]
capital movements are more sensitive to the interest rate changes
than would the domestic private investment be Suppose for example,
we increase government expenditure by a given amount starting from
point E We have then moved into Zone II, a zone of inflation and
external deficit To get rid of the deficit, a smaller r increase would do
(to reach up BB schedule), but getting nd of inflation requires a larger
increase in r (to reach up YY schedule) In the same way, starting
again from point E, a given reduction m government expenditure Will
send the economy into Zone I, a zone of domestic unemployment and
external surplus Getting nd of unemployment and reaching back YY
line requires a much greater reduction in G than would be necessary
to reach back BB line to get nd of the BOP surplus All along, there
is the assumption that international capital flows are more sensitive
than domestic investment with respect to a given interest rate change
This is, what gives us a steeper YY lme in comparison with the BB
line Suppose, on the contrary, that this assumption is unrealistic
Then it is possible for the two lines to have an identical slope so that
they overlap each other to giv e us one single line * In that case. Zone
III and IV would completely disappear, and we would be left essentially
with only two simple and straight-forward cases represented in Zone

I and II. The assignment problem would never arise, if this was the
case Similarly, it is arguable that BB line could be steeper than the

yy line In that case, Zone III would be a case of inflation-surplus, and
Zone IV, a case of unemployment deficit One can use these arguments
to criticize MundelTs model, which is, however, based on the assumption
that yy line is steeper than the BB line Let us now follow Mundell’s
model, and see where the assignment would be appropriate and where
it would be inappropriate
APPROPRIATE AND INAPPROPRIATE ASSIGNMENT:

AN EXAMINATION
The question of assignment, as we have noted before, arises only in
the following cases Unemployment-deficit case (Zone III m
Diagram
5) and Inflation-surplus case (Zone IV in Diagram 5) The former
represents broadly a less de% eloped country’s case smee LDCs suffer
from high levels of unemployment and BOP deficit disequilibrium
The de\ eloped countries fall roughly into the latter category, because
they generally enjoy BOP surpluses, while suffering no senous problems
of unemployment Let us now turn to assignment problem as such
Zone III: Unemployment Deficit Case

all, it should be noted, that regardless of which policy is
First of
assigned to it, the problem of unemployment would require an
expansionary policy treatment, because unemployment can be

eliminated only by expanding national income This can be accomplished
either by an expansionary monetary policy (Tilf and Tr) or by an
#
expansionary fiscal policy (tG) The problem of external deficit, on the
contrary, requires a contractionary policy treatment, because deficit
can "be eliminated "by reducing current account deficits or increasing
capital account surpluses or by doing both A contractionary fiscal
policy would reduce imports by reducing income (via lG), while a
contractionary monetary policy would eliminate deficits by reducing
money supply (and Tr), thereby creating capital account surpluses We
have therefore, two types of choice of policy-mix They are
(a) We can assign monetary policy (expansionary) for unemployment,
and fiscal policy (contractionary) for BOP defiat We will then have a
policy package containing 4-r and lG This would turn out to be an
inappropriate assignment as it will only lead to divergence away from
equilibrium, as you can see in Diagram 5 Starting from a point such
as Hm Zone III, you go on pursuing this policy of r and G and you
will realize that you are moving farther and farther away from the
equilibrium point E
(6) Alternately, we can
assign monetary policy (contractionary) for
BOP deficit problem and fiscal policy (expansionary) for solving the
problem of unemployment This would give us a policy package
containing Tr and T G
This would turn out to be an appropriate
assignment as it would lead us towards convergence 1 e taking us
back from point H
to point E Starting with point H, we go on
pursuing a policy of tr and tG, and this, m
course of time, will return
us to point E
It, therefore, follows that the policy of appropriate assignment is
one of assigning monetary policy for external balance and fiscal policy
for internal balance The same rule holds good for the other case as
we shall see now
Zone IV: Inflation-Surplus Case

The problem of inflation requires a contractionary policy action,
and getting rid of the BOP surpluses calls for an expansionary policy
treatment We have again two types of options they are,
() We assign monetary policy (controctionaiy) to get nd of
inflation, and fiscal policy (expansionary) to get nd of BOP surpluses
Expressed symbolically, this package contains a policy of r and G
This, os you can sec in Diagram 5, will only lead to divergence, taking
us away from equilibrium
Start from a point such as R
in Zone IV and go on following a
policy of -rand -G, and you will only keep going farther and farther
away from point E Such an assignment of policy instruments must,
therefore, be utterly inappropriate for the existing situation of inflation
and deficit (Note, however, that this policy of Tr and TG which is
inappropriate for “inflation-surplus" situation, is precisely the one,
that is appropriate for “unemployment-deficit" situation, which we
examined just before)
() Alternately, we can assign monetary policy for the problem of
BOP surplus elimination, and fiscal policy for getting nd of inflation
Such a combination of expansionary monetary policy and a
contractionary fiscal policy will yield us a combination of Tr and TG,
expressed symbolically This would be the appropnate assignment of
policy instruments to achieve desired policy objectives
Start from point R
again, but this time you go on following a policy
of Tr and lG alternatively, and you will eventually converge and
return to the full equilibrium point E (Note, once again, that the
policy of Tr and TG which is appropriate for “inflation -deficit" case was
shown to be inappropriate earlier, to a case of “unemployment deficit*
in Zone III in Diagram 5)
SOME COMMENTS AND CRITICISMS

ON MUND ELL’S MODEL
We are now xn a position to make some critical observation and
comments on Mundell’s model of appropnate assignment of monetary
and fiscal policies for achieving internal and external balance m a
regime of fixed exchange rates We can list them as follows with a
brief comment
(1) First, the results do not depend on which agency — monetary
or fiscal authority — acts first Whichever agency starts first or starts
later ( i e whether we have a sequence of J-r and IG or a sequence of
4 G
and then 4-r) the outcome would be the same in Zone IV Similarly,
in case of Zone III, it does not matter whether we have TrtG sequence
or a sequence of tG and then Tr The outcome is convergence
regardless of the sequence
(2) Secondly although monetary policy should be used
, to achieve
external equilibrium and fiscal policy to achieve internal equilibrium,
there is no implication to suggest that the agencies responsible for
these policies should take turns, and act as though they operate
independently, or without the knowledge, of the other In fact, a more
sensible strategy would be for the two agencies to consult and act
together, so as to approach E along a more direct path than the zigzag
one of our illustrating in Diagram 5
(3) Thirdly, clear implication of Mundell’s model is that, monetary
policy is relatively more powerful in restoring external balance, than
a fiscal policy would be The monetary policy has a double-barrelled
impact on the BOP, i e through the capital account as well as the
current account Fiscal policy, on the other hand, operates only on
imports i e only thraugjh current account operation. The. fiscal policy.,
however, has an edge over monetary policy in obtaining internal
balance This is Mundell’s principle of effective market classification,
according to which “an instrument should be matched with the target
on which it exerts the greatest relative influence ” 3
model assumes that the authorities know exactly
(4) Fourthly, the
how far away is from the point (such as E in Diagram
the economy
4) of both internal and external equilibrium It also assumes that the
monetary and fiscal apparatus of the country is such that the agencies
can act with mathematical precision In addition to all these, the one
assumption, that is most unrealistic, is with regard to the belief that
inflation and unemployment cannot coexist The reality is that they
are not a problem apart and today they do co exist and form, what is
called ‘stagflation’, or a combination of high levels of unemployment
.
and inflation The “seesaw” relationship between inflation and

unemployment, posited by the Philip’s trade off theory has given way
to rightward shifts m the Philip's curves This lends a senous blow to
Mundell’s model
(5) Fifthly, when monetary policy is assigned the
task of preserving
external equilibrium, the capital flows induced to achieve that
equilibrium are, essentially of short term character The external
equilibrium, thus, obtained, would also turn out to be a short term
nature No nation can go on indefinitely with a short term capital
it would
inflow offsetting deficits in its trade balance At any rate
create a precarious BOP equilibrium situation The
prescribed policy-
eliminating a
mix for internal and external balance is incapable of
negative trade
current account deficit, since it only ensures that a
offset by a positive capital
balance, whatever its size turns out to be, is
flow ,
also overlooked in this model, is the

degree
Furthermore, what is
of responsiveness of international capital

movements to changes in
in government
and of income and employment to changes
interest rates,
little is known about
expenditure It would do well to remember that
interest rate differences
sensitivity of capital flows to international
business conditions
Such flows vary with money market sentiments,
that the efforts of one
and political situations It is also conceivable
or inflow o capi a
country to encourage or restrict the outflow
countries One natio
be frustrated by the opposite action of other
and interest rat
alone cannot control the interest differential,
capital flows
differential alone cannot ensure desired .
Similarly, the relation between

investment demand and mtere
expectations, an
rates depends on business outlook and .
the lip Fiscal po icy is n

be many a slip between the cup and
especi y, > a®
sluggish Legislative action is slow to obtain,
‘
.
.
they
m taxes is called for Increased government expenditures .after
ore imp em
take long before they
’
are authorized, may
ere ***
longer still before their effects are fully felt
action lags and production lags For these
and o er re
and ex ern
’
m
tuning* required to achieve both internal
•
difficult, and in
some
means of monetary and fiscal policy would be
circumstances even impossible, to realize
(6) Finally, it is perhaps wise to
recommend
as a
"h Tnnnptarv
monetary
and fiscal policy should be applied together internal

internal equilibrium This is particularly >inl» Internal
external balance
ce .
balance usually takes precedence over

balance also means much more today — it means controlling both

-
inflation and unemployment at the same time This is a very crucial

point, which Mundell's model fails to recognize
What instrument could then be used to bring about external
balance** The answer is not easy, but the options are many* the
countries can abandon fixed exchange rates and allow floating exchange
rate systems, they can resort to currency devaluations or rev aluations
as the situations demand, they can exercise controls over trade,
capital movements, and foreign exchange Essentially we know, before
we adopt any of them, whether they suppress symptoms or cure the
disease A case by case study is necessary to examine their ments,
because countries differ from one another and situations within and
between countries differ as well
We have, so far, examined the Expenditure Changing Policy in
relation to the goals of internal and external equilibrium Now let us
proceed to examine the other policy —Expenditure Switching Policy
or a policy of Devaluation
Devaluation: Expenditure Switching Poucv

A country dev alues its currency in order to correct its BOP deficit
disequilibrium, currency revaluation is undertaken to solve BOP
surplus problems Surpluses are not usually difficult to live with, and
it is relativ ely less difficult to deal with surpluses It is the BOP deficit
disequilibrium which presents a more senous problem, and it is also
a more difficult problem to deal with We will, therefore, restrict
ourselves to the discussion of devaluation as it relates to the problems
of deficit disequilibrium in the BOP of a country
Devaluation means reduction in the external value of the country’s
currency unit, undertaken by gov ernment fiat or official proclamation.
Devaluation should be distinguished from depreciation Currency
depreciation is the result of market action, ue. it takes place when the
market demand for foreign exchange exceeds the supply of foreign
exchange in the foreign exchange market Depreciation is a natural
result of imbalance between demand for and supply of foreign exchange
Depreciation is, indeed, a means by which the equilibrium is restored
m the foreign exchange market, it is also a means by which the
equilibrium is restored in the foreign exchange market, it is also a
means by which a deficit disequilibrium m
the BOP of a country is
under a system of freely floating exchange rates
corrected,
Devaluation by contrast, is currency depreciation undertaken by
government action. Market situation for foreign exchange may have
played an important and indirect role in prompting or prodding
governments to undertake such action, nev ertheless, devaluation is an
Balance ofPayment Adjustment Policy Issues 339
official government action undertaken deliberately and legally Currency
depreciation is, however, the automatic result of a natural tendency
Effects of devaluation are virtually the same as those of depreciation
The international monetary arrangements established in 1944, by
the Bretton Woods Agreement, and which endured until its collapse in
1971, approved official changes in exchange rates (or in the par values
of member countries' currencies) as a policy instrument to combat a
"fundamental disequilibrium" in the BOP of a nation This meant
altering its declared par value in terms of gold or the US dollar
Lowering of that par value constitutes an act of devaluation A major
objective of the Bretton Woods Agreement was to promote exchange
rate stability And
the Agreement, therefore, did not contemplate
frequent use of devaluation, it was meant to be used only as a last
resort 1 e when all other measures to correct BOP disequilibrium were
exhausted or proved ineffective or onerous The use of devaluation, the

Agreement spelled it out, was to be limited to situations of "fundamental
disequilibrium" in the member countries’ BOP The term "fundamental
disequilibrium" was never defined by the IMF, but it was abundantly
clear that it meant serious and prolonged disequilibrium in the BOP
The IMF regarded devaluation, as a drastic step to be taken by a
member country only as a last resort
Effects of Devaluation
Devaluation is an instrument of BOP deficit adjustment It is an
act of lowering the external value of a unit of home currency in terms
of gold, or SDRs or an internationally accepted foreign currency (such
as US dollar) For instance, when the pound sterling was devalued in
September 1949 in terms of the US dollar, the old exchange rate of
£1=$4 03 was changed to a new exchange parity of £1=$2 80 As a
result, the British pound sterling was said to have been devalued by
approximately 30 per cent
Analysis of the effects of devaluation upon deficit imbalance was
traditionally undertaken in terms of a partial equilibrium framework
This may be termed as macro-economic approach, or elasticity approach,
in this approach, only relative commodity prices were considered
important to determine the possible effectiveness of devaluation All
that was considered necessary to know, was the pnee elasticities of
the demand for and supply of goods and services imported and
exported by a country Later on it was realized that such a partial
equilibrium approach was unrealistic and inadequate, because
devaluation causes not only changes mrelative prices of exported and
imported goods, but also it would cause income changes in the
economy This resulted in a no\el approach to the question of
effectiveness of devaluation —a general equilibrium or a macro-

economic approach, which incorporated income changes mto the analysis
on devaluation The second approach was perhaps inspired by the
advent of a new revolution m —
economics the Keynesian revolution of
the late 1930s and early 1940s The best known macro approach to
devaluation is the one, that was developed by Sidney Alexander, who
developed the so called Absorption approach to devaluation during the
1950s * We will now discuss the two approaches at some length In the
meanwhile, it should be noted that measures like devaluation are
used to switch domestic and foreign spendings away from foreign
goods and services to the domestically produced one This is the
reason, why devaluation is also called as an Expenditure Switching
Policy
The Elasticity Approach

Devaluation is supposed to improve the BOP situation for a
country The question, then, is one of how trade balance and capital
flows are likely to respond to devaluation First, we wall consider the
response of commodity trade to devaluation
Suppose, for example, the authorities in the home country (Malaysia)
reduce the par value of the dollar (Malaysia’s home currency) vis a / is
the foreign currency (say, British pound) from £1=$4 to £1=$5 This
amount to 25% devaluation of the dollar against the pound vould
make Malaysia’s exports to Britain cheaper, because an item sold for
$20 (or £5) by Malaysia to Britain before devaluation, would now be
sold for only £4 after devaluation The British would find Malaysian
goods cheaper after devaluation, this would therefore expand Malaysia’s
exports to Bntain Furthermore, devaluation would make Malaysia’s
imports from Britain more expensive, because an item selling, for, say,
£5 mBritain used to cost $20 prior to devaluation for Malaysia (at
£1=$4), but after devaluation the same item would cost $25 to
Malaysia (at post-devaluation exchange rate of £1=$5) This will have
an effect of reducing Malaysia’s import demand for Bntish goods and
services In brief, devaluation would make Malaysia’s exports cheaper
and imports costlier This would promote Malaysia’s export expansion
and import reduction
Whether it would improve Malaysia’s trade balance, te value of
exports minus the value of imports, depends on two factors, (a)
elasticity of foreigndemand for Malaysian exports (6) elasticity of
domestic demand for imported goods in Malaysia As a general rule,
if the foreign demand for Malaysian exports is inelastic, then Malaysia
will not be able to increase its foreign exchange earnings, because
even though devaluation has made Malaysian goods cheaper for
Balance of Payment Adjustment Policy J^ua 341
foreign countries, the foreign countries’ demand Malaysian goods
for
has failed toexpand This will fail to improve Malaysias BOP
situation Similarly, if Malaysia’s demand for imported goods, is
inelastic, then the level of Malaysia’s imports will remain the same as
before, but devaluation has made imports costly to Malaysia This
would mean that after devaluation, Malaysia would be spending more
number of dollars on the fixed quantity of imports This would worsen
Malaysia’s balance of trade If, on the other hand, foreign demand for
Malaysia’s goods was sufficiently elastic with respect to price and that
Malaysia’s demand for imported goods was also sufficiently elastic
with respect to price, then de\aluation would improve Malaysia’s
BOP
Let us take some examples to illustrate the mechanics of
devaluation Suppose devaluation has altered the exchange rate from
£1=$4 to n new rate of £1=$5 The exchange rate has been changed
with a view to (a) stimulate export demand and increase export
earnings, and to (6) reduce import demand and, therefore, to reduce
import spendings The way it works, is as follows
(1) First, devaluation would make imports costly to Malaysians
A pocket calculator, let us say, was priced to £20 in Britain In order
to import one pocket calculator, a Malaysian had to pay $80 at the
predevaluation exchange rate of £1=$4 (i e he had spent $80, convert
them into pounds and obtain £20 to buy one pocket calculator) After
devaluation, the same item would cost Malaysians $100, because at
the new exchange rate of £1=$5, they can obtain £20 by paying $100
Note that the price of calculator has not changed in terms of pounds,
after devaluation, only the dollar pnee of the calculator hns gone up,
because of devaluation In other words, the cost and price structure in
Britain remains unchanged, before or after devaluation, only
dexaiuntion makes this British product costly to Malaysians by
raising the dollar price of pounds To Malaysians, therefore, the
import price of the calculator has gone up What effect does it has, on
import demand and import spendings in Malaysia7 The answer
depends on the elasticity of domestic demand for foreign (imported)
goods in Malaysia As such then? ore three possible effects, and they
are illustrated graphically as in Diagrams 6 A, B, C on page 342
In Diagrams A, B, C on page 342 import prices are measured along
the vertical axis and the import quantities along the horizontal axis,
P and P, nre the pre* and post devaluation import prices (respectively)
of pocket calculators in all the three graphs, q 0 and q, nre the pre and
post devaluation import quantities (respective!} ). and devaluation
causes a movement from point I to 2 along the import demand curve,
M m all the three diagrams Notice, however, that in
Diagram 6A,
there is no change in import spending despite devaluation Import
pnce has gone up from P0 to P resulting m a reduction in import

l
demand from q0 to q l This has produced no change m import

spendings, because the area of the rectangle Pflqfl (after devaluation)
is of the same size as the rectangle P0 lq^I (before devaluation)
suggesting that devaluation has made no difference to the level of

import-spendings In Diagram 6B, devaluation has resulted in an
increase in import spendings equal to the difference between the two
rectangles — minus P 0q H In Diagram 6C, by contrast,
devaluation has resulted in a decrease m
import spendings From this,
it is clear that the success of devaluation m
reducing BOP deficit (via,
a reduction m import spendings) depends upon the elasticity of import
demand curve in the devaluing country If the import demand is
inelastic (as in Diagram 6B) devaluation fails, if it is elastic (as in
Diagram 6C) devaluation succeeds, if it is unit-elastic (as in Diagram
6A) then devaluation would neither improve nor worsen BOP deficit
situation This is the question of the elasticity of domestic demand for
foreign goods, or the import demand question
Inelastic import Elastic Import demand

Unit elastic import demand
demand
BjUpraro £4 Dxggrnja CE Diagram BC
(2) Secondly, there is the question of export-demand elasticity or
the elasticity of foreign demand for the domestic goods exports
Devaluation would reduce the export pnce and thereby stimulate
export demand (and hopefully export earnings) Let us say, for
example, that an export product of Malaysia such as a batik shirt is
—
sold for $20 to any buyer domestic or foreign At the pre-devaluation
exchange rate of £1=$4, the foreigner paid £5 for a batik shirt because
the dollar pnce of a batik shirt of $20 would come to £5, expressed as
pound pnce of that item at the exchange rate of £1=$4) But when the
exchange rate has changed to £1=$5 after devaluation, the same batik
shirt would be sold for only £4 a piece Note carefully that the
domestic cost pnce structure of batik shirt production has not changed
after devaluation The dollar pnce of that product is $20, both before
and after devaluation, but the pound pnce of one batik shirt has gone
Balance ofPayment Adjustment Policy Issues 343
down from £5 to £4 a piece after devaluation
due to exchange rate
change In any case, devaluation would make Malaysian exports
cheaper to foreign buyers (and not to the domestic buyers) What
effects does this price reduction have on foreign demand and foreign
earnings 7 The answer depends upon the elasticity of foreign demand
for domestic goods The following set of three graphs 7A, 7B 7C try &
to show the
results
In the below three graphs, export prices and export quantities are
measured along the vertical and horizontal axis, respectively Export
X
demand curve, A> is drawn with a negative slope, showing that
foreign demand is sensitive to export price changes In Diagram 7A,
export demand is unit elastic so that a fall in export pnce from P to
0
P, will result in an increase in export demand from q 0 to 7 But this<
,
has made no difference to export earnings, because export earnings

after devaluation (rectangle P,2q, H
) are the same as they were before
devaluation (rectangle P 0 lq 0 H) In Diagram 7B, where the export

demand curve is inelastic, devaluation has resulted in a reduction in
export earnings— from P0 lq># H level to P, 2q 0 H
level of earnings In
Diagram 7C, however, there has been an increase in export earnings
after devaluation— from P0 lqJH to P 2q H
x x
level And notice that
demand is very elastic with respect to
export export price in Diagram
7C We can, therefore, say that devaluation succeeds in eliminating
the BOP deficit (via increase in export earnings) if the export demand
is elastic, it would fail in doing so, if the export demand is inelastic
And when export demand is unit elastic, as in Diagram 7A, devaluation
would neither improve nor worsen BOP deficit situation in the
devaluing country In sum, we can say that more elastic are the
import and export demands, more successful will be the devaluation
in terms of reducing a BOP deficit (or creating a surplus), and if the
import and export demand elasticities are lower for a country,
devaluation will fail to reduce a BOP deficit In fact, it will increase
the size of deficit and worsen the BOP situation in the country
Diocnun 7A DUpram 7B Diagram 7C

The above generalizations gne only a broad indication of when

devaluation could succeed or fail m its objectives More precise
formulation of elasticity conditions and requirements are discussed
below with the help of Marshall Lerner conditions But in the
meanwhile, one point deserves attention, viz the terms of trade
changes caused by devaluation Devaluation reduces export prices and
raised import prices and thereby it turns the terms of trade against
the home (or devaluing) country These are the commodity (or net
barter) terms of trade which are worsened, and this is not by accident
—
but by a design undertaken by the devaluation policy action It may
sound strange that a countiy should deliberately engineer adverse
terms of trade for itself* But there is nothing strange or irrational
about it, if only one remembers that by turning the commodity terms
against itself, the country hopes to improv e its income terms of trade
I e in terms of mere as mg export earnings by reducing export pnee and
reducing import spendings by increasing import prices Devaluation

worsens commodity terms only to improve income terms of trade for
the devaluing country
What has been stated above, is too general It is necessary to be
more specific in order to predict the effects of devaluation on the BOP
situation This would be possible, if we use the so-called Marshal 1
Lerner Conditions The Marshall Lerner conditions state that the
success of devaluation in improving trade balance depends upon the
sum of elasticities of demand, given infinite elasticities of supply More
specifically, the Marshall Lerner conditions suggest the following rules
for effectiveness of devaluation
(1) If the sum of elasticities of demand for exports and imports is
greater than 1 (or exceeds unity), devaluation would improve trade
balance (re reduce deficits)
(2) If the sum of those elasticities, is equal to 1 or unity, devaluation
would leave the trade balance unchanged
(3) If the sum of those elasticities, is less than 1, devaluation
would result m worsening trade balance (re it would increase the size
of deficits)
Let us illustrate the three cases with numerical examples It
should be noted here that we can conduct the discussion on Marshall
Lerner conditions either in terms of the currency of the devaluation
countiy (re dollar in our case) or in terms of the foreign currency (re.
pound sterling), but not in terms of both currencies We will do it in
terms of dollars, or some currency 5
In Table I, we assume that elasticity of demand for exports and
imports is Vi each, so that the sum of the two elasticities of demand
Balance of Payment Adjustment Poltcy Issues 345
equals 1 Let us assume a 10% devaluation of dollar We write Jf and
M t
to stand for export-elasticity and import elasticity of demand
respectively, X, represents the sum of these two elasticities Row 1
shows change in dollar receipts from exports, note that devaluation
does not change the dollar pnee of exports But as a result of
devaluation, there is increase in export quantity by 5%, since export
elasticity of demand is Vi and there is 10% fall in pnee of exports to
foreigner Thus dollar earnings from expanded exports will increase by
5% In Row 2, you will see that there has been 10% increase in import
pnees due to devaluation, and given the import elasticity of demand
equal to Yi this increase of 10% in import pnee, would result in 5%
,
increase in quantity imported Therefore import expenditures will nse

by 5% Devaluation brought about (o) 5% increase in export receipts
and (b) 5% increase in import expenditures The net result is no
change in foreign exchange earnings Thus, if the sum of the two
elasticities, is equal to 1, the trade imbalance remains unchanged, and
the deficit is not reduced
In Table II, we assume export elasticity of demand to be V* and
import elasticity of demand to be H so that the sum of the two
elasticities would be equal to 3/4, or less than 1 We again assume
10% devaluation as before In Row 1, you will see that export quantity
increase s by 2 5% 0 e V* of 10% devaluation) which will raise export
earnings by 2 5% This is positive effect of devaluation trade balance
In Row 2, there is shown a 10% increase m import pnee causing 5%
reduction in import quantity, this has an effect of increasing import
spendings by 5% (10% price increase minus 5% decrease mimport
quantity) Devaluation has caused 5% increase in import expenditure
but only a 2 5% increase in export earnings, creating a net overall
increase in foreign exchange expenditures of 2 5% Thus, when the
sum of the two elasticities is less than 1, devaluation must worsen
balance of trade situation
Finally, let us assume export elasticity of demand of 1 and import
elasticity of demand also of 1, which will give us a sum of the two
elasticities equal to 2 (te greater than 1) We will assume a 10%
devaluation as before With export elasticities of 1, there must be 10%
increase in export quantity as a result of 10% devaluation This must
bring about an increase in export earnings by 10% Th*s is seen in
Row 1 in the Table III
In Row 2, a 10% increase in import prices, brings about a 10%

decrease in quantity of imports, as a result, there is, we note, net
increase m
foreign exchange spendings In this case, devaluation has
7-7
5% 10%
Quantity
Price
— in
in
%Change
%Change
Elasticity=
Devaluation;
10%
Balance of Payment Adjuntment Policy Ixvici 347
1)
than
greater
(i.e.
=2
E#
III:
Table
resulted m a 10% increase in export earnings without involving any

change in import spendings, the result has been a net increase in
foreign exchange earnings by 10%, which would contribute to an
improvement in balance of trade
From this analysis, it is clear that the success of devaluation
depends upon the elasticities of export and import demand But note,
however, that Marshall Lerner conditions apply only to commodity
trade or current account balance Before we can judge the total effect
of devaluation on the BOP improvement, we have also to consider the
effects of devaluation on capital flows, i e the effects of devaluation on
capital account improvement Two observations are m
order (a) If
devaluation could induce sufficient capital inflows into the country,
the BOP situation of the country would improve, even if the sum of
elasticities of export and import demand, is less than 1, (6) if
devaluation induce sufficient capital inflows or if it actually
fails to
causes increased capital outflows, then devaluation would worsen the
BOP situation of a country even though the sum of elasticities of
demand happens to be greater than 1 Normally, one would expect
devaluation to bring increased capital inflows, because after devaluation
one unit of foreign exchange (£) would buy the foreigners greater
number of dollars Therefore, one could reasonably expect an inflow of
foreign short-term and long-term funds into the devaluing country
Devaluation also discourages individuals and firms in the devaluing
country from moving their capital out of the country, because, after
devaluation, they will have to pay greater number of dollars to buy
one unit of foreign exchange (£) In bnef, devaluation is supposed to
() encourage exports and discourage imports of goods and services
and thereby help improve current account balance It also tends to
encourage unilateral transfers into the devaluing country and
discourage unilateral transfers out of the country, reinforcing current
account surplus tendencies, (6) encourage international capital
movements into the country, rather than out of the country, this
would improve capital account balance The two tendencies (a) and —
() acting together, are supposed to bring about an improvement tn
the overall BOP situation of a country
Marshall-Lemer conditions assume that supply is infinitely elastic
in the export sector of the devaluing country There is, however, no
guarantee of the existence of such a situation Devaluation, of course,
tends to create favourable demand conditions (m the foreign countries)
so that the devaluing country can promote its exports If, however, the
devaluing country is not in a position to increase its export production.
, ™
349
devaluation has to succeed, the
the export earnings cannot go up If
surpluses and export capacity
country must have large exportable
of devaluation,
Many of the LDCs may not be able to get the best out
bottlenecks in export
on account of their supply rigidities and
production The supply inelasticities, therefore set a serious limitation
to the success of devaluation m correcting BOP deficits
for removing the BO

Furthermore, devaluation may be a remedy
deficits of a single country But if
many countries are suffering from
of competitive
BOP deficits at the same time, there is a real danger
the other countries
exchange rate depreciation and retaliation by
to any country
When that happens, devaluation brings no gains
This success of devaluation also
depends upon the nature o
country is Pursmng to
monetary and fiscal policy which the devaluing
control its domestic economy Tor
example, if the coun ry
monetary po in
a vigorously expansionary fiscal and
and emp °^me
achieve higher levels of national income
'
building up in
be seriously inflationary pressures ^ • an(1
struc ure
would change the domestic cost and price
conferred by devaluation mayt
the export price advantage
costs and pn«. of
more than offset by rising levels of
depends, t ere ° r >
goods Success of devaluation also Evaluation
Devaluation
fs the country in controlling
domestic costs and
mus e
cannot be successful in isolation, there a chance to
to give devaluation
fiscal and other policy measures
succeed types of
ndvtsable for certain
Finally devaluation may not be
,
countries (a) If the devaluing

country
financial train,
^ column „r fore.cn
because devaluation
debt, might come under heavy
,t mports
debt,
increases the burden of foreign n d capital goods
,
.
arc inelastic and made up of because

tQ dQVO l u ation,
and services, such a country would s
impo
devaluation raises import prices and adjustment A
Above nil. devaluation can bring oc h,cvcd
long term BOP adjustment of a
more
are brought
disequilibrium
cau m
only when the underlying forces
under control They, in turn.
terms of cost pnee production structu
traded goods and services It ,s 0150
tLy X
domestic adjustments
«
i^rnationally
bnng under control
tof the connin'

international capital and
mvestmen corrective
u KUO nlnnt, other
Devaluation can only supplement, U ation, at best, is °n *y
nature ev£1 l
measures of a more fundamental

—
a palliative but not a permanent cure for the disequilibrium BOP

situation of a country
We will now discuss briefly the second approach to devaluation
the absorption approach
The Absorption Approach

So far, we have discussed devaluation mterms of the elasticity
approach, where devaluation is supposed to work on the BOP situation
through its price effect There are no changes in the domestic cost-pnce
structure in the economy Devaluation directly reduces export pnces
and raises import pnces, and given favourable import and export
demand elasticities, it will improve trade balance Symbolically, this
conventional micro approach can be stated as
B=X-M
where X and M denote values of exports and imports and B stands for
balance of trade Note carefully that the effects of devaluation are
directly on these external variables
The absorption approach, developed by Sidney Alexander, takes a
macro approach to the question of devaluation Alexander thought
that the conventional micro approach is inadequate insofar as it
ignores the income effect of devaluation Devaluation affects domestic
economic variables such as consumption, investment and national
income, and this has to be taken into account in predicting the result
of devaluation on the BOP situation of a country Symbolically, the
absorption approach can be stated as follows
B=Y-A
where F is national income, A is “absorption" or domestic expenditure,
and B is the balance of trade The equation suggests that devaluation
can improve trade balance IB) only jJjt .increases national .income (F)
more than it increases absorption (A) let us discuss it m some more
details
National income must equal domestic expenditure plus net exports
In other words
Y=(C+I+G)+(X-M) (1)
200=(120+80+20)+(60-80)
For we have put in numerical values for all
illustration purposes,
the variables m
Equation 1 above Note that (C+7+G) is ‘domestic
expenditure’ and (X-M) is net foreign expenditure X~M has a negative
value, denoting a deficit in trade balance We can write Equation 1 as
follows
Y=A+B (2)
200 =( 220 )+(-20 )

Balance ofPayment Adjustment Policy Issues
35 j
In Equation 2, A stands for “absorption”, which is
a sum of
domestic expenditure (or C+I+G) and B stands for “balance of trade”
(or X~M) National income ( Y) must equal absorption (A) plus trade
(B) By rewriting Equation 2 we get
Y'A-B (3 )
200 -220= -20
or B-Y-A (4)
-20= 200-220
Equation 4 suggests that trade balance (B) is the excess of income
(Y) over absorption (A) If the trade balance is negative as in the above
case, there must be negative excess of income over absorption In
Other words, the balance of trade deficit must be equal to the excess
of absorption (or domestic expenditure) over national income At the
cost of some repetition, let us have the following formulations again
B*=Y~A
-20 = 200-220
1 e (X-Jtf)=(YMC+/+G> (5)
(60-80)= (200H220)
-20 = -20
The balance of trade deficit is 20, and devaluation is supposed to
eliminate this deficitHow would devaluation accomplish this result7
Suppose devaluation, by making exports cheaper, raises the value of
exports by 20 This would mean that after devaluation the total
exports have gone up from 60 to 80 in terms of value Since the level
of imports is 80 and the post devaluation level of exports is also 80,
can we not then say that devaluation has produced trade balance 7
What more is there, to discuss about absorption then if this is all that
must happen 7 Increase in exports will generate income effects and
other effects on domestic economic variables This is the crux of the
macro approach or the absorption approach The macro results of
devaluation may be summarized as follows
T M (depending on m, or marginal propensity

to import)
Devaluation-tXTy.
TCtj (depending on marginal propensity to

consume b, and to invest, g)
Increase in exports (X) of 20 cause national income (Y) to go up

depending on the value of multiplier (A) Higher the % alue of multiplier,
greater is the national income increase and more favourable is
the
BOP result (Because, note that the trade deficit is the measure of the
gap between national income and national expenditure And trade
deficit will be reduced as national income nses ) So far, the results of
devaluation (TX and tY) are favourable to deficit reduction or
elimination Note that X
and Y are on two sides of the expression in
equation 5, and increase in values of X
and Y are both conducive to
deficit elimination Unfortunately, this is not the end of the sequence
of operation There are further effects and they are not favourable to
deficit reduction
When Y increases as a result of increase in X, what are then the
further effects of tY** Well, there are two effects of tY (a) first,
increase in Y induces increase in Af, the exact amount of tAf depending
upon the marginal propensity to import (m) Higher the value of m,
worse it would be for the deficit elimination, (6) secondly, increase in
Y would induce increases in consumption and investment, the increment
in C and I depending upon the marginal propensity to consume (6)
and marginal propensity to invest (g) Higher the values of b and g
more unfavourable would the situation be for devaluation to reduce
the deficit in trade balance C and I, together with G, determine
absorption Increase in absorption is not conducive for deficit reduction
(see Equation 5) Alexander calls the sum of 6 and g as marginal
propensity to absorb (e), so that, we can wnte
(e=6+g)
From obvious that higher the marginal propensity to
this, it is
absorb, or the value of “e”, lesser are the chances of success of
devaluation in eliminating trade deficit
As a general rule, we can state that with a given value for m
(marginal propensity to import)
(a) The trade balance will improve if e is less than 1
(b) The trade balance will worsen if e is greater than 1
(c) The trade balance will neither improve nor worsen if e is equal
to 1
Let us illustrate these three case situations with numerical
examples to show the effects of devaluation on trade balance through
income effect
Case I: e=6+g=2 (No change in BOP situation). Assume
following values marginal propensity to import (m)=20%, marginal
propensity to consume (6)=80%, and marginal propensity to invest
(g)= 20% Initial values of national income components are assumed
to
be consumption (C)=:120, Investment (/)= 80, Government expenditure

(G)=20, Exports (X)=60, Imports (Af)=80 and national income (10=200
‘
Policy Issues
Balance of Payment Adjustment
defiat (B) » equal to the difference
Thismoan, that balance of trade
absorption, as shown be.ow
between national income and
B=Y~A
X-M=V-(C+7+G)
60-80=200*7220)
-20= -20 ,
Assume that a given rate

that increase in exports (AX) is
equal to 4
.
5
value of multiplier
income (AY) by 200, because the
. .J-o
1 -b-g+m 1- 8-2+2 2
AY=AX *=40x5=200
follows,
We can calculate other values as
AC=AY6=200x 8=160
A7=AYg=200x 2=40
AM=AYm=200x 2=40
AX=(we already know this)=40
-nines we can
their ong
By adding these above increments to
write
X-M=Y-<C+7+G)
100-120= 400-1280+120+20)
trade deficit
In the above case, you clearly notice that d
u
the same B-X-M=20), even though ^“'
(niz ^°mcome effect The
of exports by 40 (i e AX=40) This is
becaus e
e by 200 (i
export increase of 40 resulted m (o) an increase i
200 ie(
AY=200) and (6) an increase in absorp l °*V. = there has

AA=AC+A7+AG=200) In other tact
or u Remains ,n nor
been AX=AM and AY=M The original deficit ement
resulted neither in
Devaluation, in this case, has m
marginal
is because
in a worsening of the BOP situation, this
propensity to absorb equal to unity
is assume.
Case II: e>l (Worsen, ng of the BOP
«*»«-*“* us
“
incre ase
, T *
as before, that a given degree of devaluation that the

we retain the
c„ um ntion
in exports equal to 40, similarly, values of b
and
us now assume that
1
value of m is 20% But let tyt0 absorb
margins P
E are 90% and 20% respectively, so that
than 1 in 1
(ie 6+g) will have a value greater se
The multiplier will have a value equal
to ,
,
1
=
1
= J— =10
X-b-E+m 1- 9-2+2 1
With AY=40, we will have AY= AY.fe=(40xl0)=400 Increase in

absorption will be more than the increase in income (AA>AY), because
AC=AY6=400x 9=360
A/=AY£=400 x 2=80
AM=AC+A/=360+80=440
As a result of devaluation, increase in absorption (AA=440) has
been more than the increase in income (AY=400) by 40 This must
mean that the BOP deficit must have gone up by that amount ( viz
A4-AY=40) It is shown as follows,
AX=40 (due to devaluation)

AM=AY m=400x 2=80
AAf-AX= 80-4 0=40
Youwill notice that import surplus (AAf-AX) has gone up by 40
This added to the original deficit of 20 will yield us a total trade deficit
of 60 i e 40 more than the original deficit This can be seen in the
following expression
(Z+AXHA/+AM)=(Y=AYH(C+AC)+(/=A^-f-Gl
(60+40M80+80)=(200+400)-{(120+360)+(80+80)+20)}
(100M160)=(600M660)
-60=-60
Therefore, if the marginal propensity to absorb has a value greater
than 1, then devaluation would increase the trade deficit and worsen
the BOP situation of a country
Case III: eel (BOP improvement). As before, we stick to the
assumption that a given degree of devaluation has resulted in an
increase in exports equal to 40, and that the value of M
is 20% We
assume in this case, however, that marginal propensity to absorb, e,
is less than 1 We will assume that the value of 6 and g are 50% and
20%, which will yield a value of 7 (te less than 1) for marginal
propensity to absorb
In this case, the value of multiplier will be equal to 2, because
k= — 1
1-b-g+m
=
1- 5-2+2
1
=
5
*
=2
With AX=40 and the value of k=2, the increase in income, AY, will
be equal to 80 But the increase in absorption will be equal to 56 Note
the following values
AC=AY6=-80x 5=40
AJ=AYg=80x 2=16
AA=AC+A7=40=16=56
Hence, as a result of devaluation which raised the level of exports
in
by 40, the increase in income (AY=80) has exceeded the increase
355
absorption (AA=56) by an amount equal to 24 This must mean that
the trade deficit must decrease by 24 Recall that the size of the
original trade deficit (B=X—M~—20) was 20 Devaluation reduces trade
deficit by 24, which means it has created a net trade surplus equal to
4 Or m
other words, there is a negative trade deficit of 4 which is the
other way of saying that there is a trade surplus of 4 Look at the
following expression and the values in them
(X+AX}-<M+AM}-( F+ AyMC+AC)+(/+ A/)+ G
(60+40M60+16)=(200+SOK120+40)+(80+16)+20
(100W96M280W276)
+4=+4
There has been a trade surplus (X-M) equal to 4 which corresponds
to the surplus of income over absorption (Y~A) of also 4 Thus we
notice that when the marginal propensity to absorb is less than 1 then
devaluation would succeed in reducing the trade deficit, it may even
convert trade deficit into a trade surplus, as it has happened in case
III
In this way, the value of marginal propensity to absorb, determines
the chances of success or failure of devaluation m correcting BOP
deficits in current account Besides marginal propensity to absorb, e,
there are other factors which have a bearing on the success or failure
of devaluation, and let us list them below
() Devaluation may turn the terms of trade against the country
An adverse movement in the terms of trade serves to reduce real
income of the country Real income drops and so will absorption If e
is greater than 1 absorption falls by more than real income contributing
,
to an improvement in the BOP situation of the country

( ) Devaluation could operate through the non income effects os
well One such non*mcome effect would be the real balance efTect
Consider for example, a situation where devaluation increases prices
If nominal BUpply of money is held constant, the rising prices would
reduce the real value of money supply and raise the real interest
rates If individuals wish to maintain their real balances dunng a
period of nsing prices, they will have to save more To allow this
greater saving, absorption must fall, and this reduced absorption
would contribute to an improvement in trade balance Increased
savings nnd reduced expenditures on goods and services must bring a
fall in real income, and if e is greater than 1 absorption will fail by
,
more than income, contnbuting to a further improvement m trade

balance
(c) income distribution in the devaluing
If devaluation affects
country, then it will affect trade balance via absorption If income
should move away from people or groups with a high marginal
propensity to absorb towards those with relatively lower marginal

propensities to absorb, then to that extent, there will be reduction in
absorption and a movement towards improvement in trade balance
Income distribution may be considered as another non-mcome effect of
devaluation
(d) Money illusion is still another non income effect When money
incomes rise, and if people begin to buy more believing that they have
become better off, even though prices have risen to such an extent
that real incomes have fallen, then there would be an increase in

absorption as a result of the money illusion This would not help
devaluation in importing trade balance as such
One can discuss, m
fact, a large number of other effects The
important point about absorption approach is, that the changes in
trade balance situation must be viewed in relation to the economy as
a totality The elasticity approach of the Marshall Lemer formula
considers trade balance isolating it from the rest of the economy The
absorption approach sends a message that if devaluation is to succeed
in eliminating external deficits, then nation as a whole must be
producing more output of goods and services than it is consuming or
absorbing by way of higher consumption and investment expenditure
This is indeed the contribution of the absorption approach
CRITIQUE OF ABSORPTION APPROACH

The absorption approach is deceptively simple, although conceptually,
it is a neat and straightforward mechanism For one thing, there are
—
so many factors income and non income factors —
affecting the trade
balance, that empirically they make predictions extremely difficult.
Many of the included forces are not quantifiable, e g income distribution
effects, money illusion etc Furthermore, it is very necessary to
incorporate the changes in capital flows resulting from devaluation in
order to completely predict the effects of devaluation on the BOP
changes
Alexander’s analysis is based entirely on the equation B=Y-A,
where would improve only if aggregate supply, Y increases by more
B
than aggregate demand, A (or when aggregate demand, A decreases
by more than the decrease m aggregate supply, V) In two strongly
worded papers, Fntz Machlup sharply criticized the absorption analysis
6
discussed above According to Machlup, absorption analysis of
Alexander was nothing more than theorizing based on Keynesian
identities and tantologies Machlup further criticized Alexander for his
neglect of relative price effects Without explicitly admitting that he
was responding to Machlup’s criticisms, in 1959 Alexander produced
absorption
a second paper that attempted to combine the elasticities and
Balance of Pay merit Adjustment Policy Issues 357
approaches 7
Tsiang has severely criticized the "synthesis" of elasticity
and absorption approaches by Alexander as being no synthesis at all,
and in fact, Alexander was not even original in this synthesis exercise,
because even before Alexander-Machlup debate, such a synthesis was
already attempted by Harberger 8 In fact, Alexander himself admitted
that his synthesis equation was essentially a simplification and
generalization of results first obtained by Harberger
However, Tsiang does not say that Alexander contnbuted nothing
to devaluation analysis Quite to the contrary in fact, he argues that
although a complete answer was not provided, Alexander provided
useful insights into macro ways of looking into devaluation issues, and
Alexander offered his own synthesis based on these insights 9 Several
others, besides Alexander and Tsiang, have attempted a synthesis of
elasticity and absorption approaches 19
In analysing the devaluation policy problems to counter a BOP
deficit disequilibrium, it is throughout assumed that the deficit is
located in the current account, and likewise, it is to be set nght by
readjusting current account credits and debits Devaluation la not
discussed generally in relation to how it can change the course of
capital movements in and out of the country
INTERNAL AND EXTERNAL BALANCE EXPENDITURE-

CHANGING AND SWITCHING POLICIES
The most pertinent problem of economic policy in any country is, how
to achieve internal and external balance jointly or simultaneously We
shall discuss here how an economy can achieve both the balances by
(a) using expenditure changing policies (monetary and fiscal policies)
to achieve internal balance, and (6) using expenditure switching
policies (devaluation) for external balance The model assumes a
system of fixed exchange rates but disregards capital movements for
the time being
The following diagram is used to illustrate the policy problems of
a country in this situation National income is measured along the
vertical axis and imports are measured along the horizontal axis At
a certain level of national income, such os Yf in the diagram, their is
full employment with stable prices, re internal balance Since the
analysis is in terms of short run situation, the full employment level
of national income is assumed to be constant The vertical line of
external balance shows the amount of imports needed to produce
equilibrium in the BOP M0
level of imports show s the le\ el of imports
that guarantees external balance
It is to be noted that if the actual level of national income is
anywhere above the internal balance line, there must be over full
employment or inflation, if the national income is below that line,
35 B Intcmahanzl Ecar oit.es
there must be unemploynnent or deflation in the economy Similarly,

if the economy is to the left of the external balance line, there must
be a BOP surplus, and to the nght of that line there must be a BOP
deficit, because the actual imports would then be more than the level
of imports, M0
which gi\es external balance.
Both internal and external balances are simultaneously achieved
at point P where the internal and external balance lines cross each
other The two lines divide the graph into four panels. In Panel I if
we are at point such as a there will be combination of unemployment
and BOP surplus The desired policy mix would be an expansionary
monetary and fiscal policy package to get nd of domestic unemployment
The same package will also help m
getting nd of the BOP surplus
because increase m
income and decrease in interest rates, that result
from such a monetary fiscal policy^ package, will also wipe out the
external surpluses There is, therefore no need to alter exchange rate.
The solution rather simple and straightforward Similarly, if we are
is
at any point such as b in Panel II with a combination of inflation and
BOP deficit, once again the solution is rather simple All we need, is
a package of monetary and fiscal policy, which is contractionary in
nature Such a policy package gets nd of inflation as an internal
problem and also BOP defiat as an external problem The reduction
in go\ emment expenditure and higher interest rates, resulting from
such a policy mix, will lead to the restoration of full employment with
External
balance
(3) lnflat on surplus (2) lnflat on def cl
r /
b
Internal
P balance
(i) (<)
4
Unemployment deficit
Unemployment surplus
M; M
Imports
Diagram 8.
Balance of Payment Adjustment Policy hiuev
359
stable pnees as well as BOP equilibrium There is, once again, no need
to alter exchange rates m
this situation
But if the economy is at a point such as d in Panel III with
domestic inflation and external surplus, then (a) it is necessary to use
contractionary monetary and fiscal policy to get nd of inflation which
while they achieve internal balance aggravate external disequilibrium
Note for example, that contractionary monetary-fiscal policy package
would reduce income and raise interest rates which tend to create
current and capital account surpluses and aggravate BOP surpluses
which already exist in the economy, (6) it is, therefore, necessary to
alter the exchange rate, le it is necessary to revalue the currency
Currency revaluation would return the economy to BOP equilibrium
By the same token, if we are at a point like e in Panel IV, we will have
unemployment-deficit combination of problems The policy prescription
appropriate to this situation would be as follows (a) an expansionary
monetary-fiscal policy package to expand the economy and eliminate
unemployment The side effect of doing this, would be to accentuate
BOP deficit disequilibrium Because the expansionary monetary fiscal
policy mix results m
higher levels of income and lower interest rates
which, in turn, cause current and capital account deficits in the BOP
Since, there is already BOP deficit situation, the result is to increase
the size of external deficit Hence there is need for a separate policy
instrument to take care of the BOP deficit problem (h) a policy of
devaluation will be necessary to get nd of the external deficit
In this way, msituations represented in Panels III and IV, there
is need for an appropriate policy assignment In Mundell's model we
are not free to alter the exchange rate, but here we are free to do so
through a policy of currency devaluation for revaluation, as the
situations demand In any case, in this model, we assign both
monetary and fiscal policy for internal balance and currency devaluation
or revaluation for external balance Your will recall that in Mundell's
model, we assign monetary policy for external balance and fiscal polity
for internal balance, the equilibrium exchange rate is not permitted to
chnngp m Mundell's model In thi3 present model we have argued that
a judicious use of devaluation combined with monetary and fiscal
policy mix would enable the country to achieve both internal and
external balance
This concludes our analysis of expenditure changing and
expenditure switching policies as alternative or joint instruments of
attaining and maintaining internal and external balance in an economy
We will now discuss another policy instrument often used in solving
BOP deficit problems tor the exchange controls
3G0 International Economics
Exchange Controls
It should be noted at the very outset that, exchange controls, like
currency devaluations, form a part of expenditure-switching policy
package Because, they too, like devaluation, aim at directing domestic
spending away from foreign supplies and investment Exchange controls
try to divert domestic spending into consumption of domestically
produced goods and services on the one hand and into domestic
investment on the other
A common characteristic of the BOP adjustment process under
both fixed and flexible exchange rates is, that neither of them involves
direct interference with the operation of market forces They allow
countries to import from the cheapest source of supply in the world,
and similarly, they allow countries to sell in any countiy where it is
most profitable to do so International payments can be made m any
currency, in any amounts, and for any purpose Currencies remain
fully convertible Exchange controls differ radically from all these,
insofar as they disregard market forces and replace them with
government decisions based on national needs
Exchange controls represent the most drastic means of BOP
adjustment A full-fledged system of exchange controls establishes a
complete government control over the foreign exchange market of the
country Foreign exchange earned from exports and other sources
must be surrendered to the government authonties The available
supply of foreign exchange is then allocated among the various buyers
(importers) according to the criterion of national needs and established
priorities From a purely BOP standpoint, the sole purpose of exchange
controls, is to ration out the available supply of foreign exchange in
accordance with national interests Viewed in that light, a BOP deficit
is impossible under complete exchange control systems, because the
foreign exchange receipts from exports, foreign aid and capital inflows
are administratively allocated to imports, capital flows and transfers
abroad of precisely equal or lesser magnitude These are the most
severe forms of exchange control
There are also a vanety of milder forms of exchange control which
merely limit certain sources of demand for foreign exchange, thereby
they try to minimize their pressure on the BOP deficit For example,
a country may restrict foreign tounsm or foreign study by the
nationals of the country, m order to save foreign exchange Similarly,
some of the capital transfers abroad by domestic residents may be
restricted, again to conserve scarce foreign exchange Further, imports
again
of non-essential goods and services may be drastically curtailed,
such
to conserve foreign exchange How mild or how severe will be
seriousness
restrictions on the use of foreign exchange depends upon the
Balance of Payment Adjustment Policy Issue* 3G1
of the foreign exchange situation prevailing in the country nt n given
point of time Partial exchange controls such ns these may be scrapped
if a more basic improvement in the foreign exchange earnings
has
occurred Or else if the foreign exchange situation is fast deteriorating
in the country, the trend may be a reverse one uz a movement from
partial exchange controls to general and more severe forms of exchange
control
From the start of World War II until 1951 partial or complete
exchange controls characterized the system of international trade and
payments throughout the world This was largely the result of the
War itself and of its aftermath — the so called era of “US dollar
shortage* Exchange controls were gradually removed during the mid
1950 s, partly at the urging of the IMF and partly due to Western
European economic recovery Still there arc even today many countries
of the Third World and all the countries of the communist bloc who
continue to maintain strict exchange controls As long ns the countries
of the \v orld particularly of the Third World continue to struggle with
the problems of economic development and social reconstructions
exchange controls will continue to be with us for years to come
Objectives of Exchange Controls

A wide variety of arguments has been advanced to justify imposition
of exchange controls of different forms
(1) First there is n BOP disequilibrium argument Countries
which are faced with limited export capacity or export market are
forced to resort to drastic import restrictions in order to prevent
senous structural imbalances in the BOP Import substitution and
import contraction measures mny be forced upon n country which has
to live with n limited amount of export earnings nnd capital inflows
Insufficient capital inflows —
either of an autonomous or of an
accommodating nature —mny force countnes to resort to unwanted
exchnngo controls purely out of BOP considerations Sometimes
ideological constraints which lend countnes to reject foreign aid
foreign loans nnd foreign investment mny give birth to exchange
controls in one form or nnothcr
(2) Secondly exchange controls are often justified ns a way of
preventing “capital flights" from the country Adverse political or
military dev elopments mny cause massive capital outflows The affected
nntion will nnturnlly be interested in halting such massive and
“destructive" capital outflows Such a flight of capital if allowed to
proceed unchecked may cause complete exhaustion of the foreign
reserves nnd greatlj destabilize the foreign exchange rate of the
country
(3) A exchange controls, is based on the

third, justification for
argument that they permit national economies and their policy
architects a “broad freedom of action” not only m times of national
emergency, but in more normal times as well Exchange controls
“insulate” the national economy No matter, what happens internally,
the external BOP situation will remain unaffected Hence, authorities
can expand national money supply without limit, and government
spending can be as liberal as the political considerations permit or
compel The goals of rapid economic growth and full employment can
be pursued without restriction, because none of those measures is
going to affect the BOP situation of a country
In that case exchange controls are warranted by the desire to
pursue domestic policies of economic development Any pressure, that
growth policies exert on the external payments situation, will be
handled by exchange controls with no worry
By insulating the economy from BOP disequilibrium, exchange
controls provide greatly increased freedom of domestic economic policy
Exchange controls, thus, leave the way open for successful economic
growth, if the policies are wisely followed, or else they may open doors
wide open for senous inflation of domestic prices, costs and profits, if
there is mismanagement of the economic policy It is arguable whether
exchange controls really promote economic growth by permitting
governments^ to follow “independent” domestic policies to promote
national income and employment growth Nevertheless, there is ground
for justification of exchange controls as a policy means to create
autonomous economic growth, without having to worry about any
external disequilibrium
(4) Fourthly, governments have also imposed exchange controls in
order to facilitate servicing of foreign debt, i e repayment of foreign
loans and interest payments on those loans For doing so, governments
have to compulsorily acquire all the foreign exchange receipts of
exporters and other foreign inflows coming into the country This was
the object of exchange controls m
many debtor countnes during the
1930’s Unable to float new foreign loans to repay their outstanding
foreign debts some countries were forced to resort to exchange controls
Such countries obviously could not rely upon exports alone to create
the necessary foreign exchange supplies to pay off their external
debts
(5) Fifthly, exchange controls have also been invoked by
some
countnes with a view to maintain their exchange rates stable vis a
vis the currencies of other countnes with which they had
important
economic and trade relations For example, the members of the
stability of
sterling area took exchange control action to maintain
Balance of Payment Adjustment Policy Issues 3 S3
their exchange rates in relation to the British pound sterling, after
abdonment of gold standard by England in 1931
(6) Finally, a country may resort to exchange controls for many
miscellaneous reasons Exchange controls may be imposed to over
value domestic currency in relation to foreign exchange, in order to
obtain cheap imports of essential raw materials and intermediate
capital goods Some
of the less developed Countries are charged with
this allegationOvervaluation of currency through exchange control
mechanism, may also be used to liquidate a country’s external debt
more cheaply in terms of home currency For example, countries of
central Europe had incurred large debts afltfcr World War I in terms
of pound sterling and the US dollars Consequently, some of these
countries like Austria, Hungary, Germany qtc undertook deliberate
overvaluation of their currencies through exchange control, in order to
lighten their foreign debt burdens in terms of their home currencies
Likewise, a country may use exchange controls to deliberately
undervalue their currencies in order to make their exports cheaper
and imports dearer In 1971, Japan and West Germany were accused
of keeping their currencies deliberately undervalued The United
States forced Japan and West Germany to revalue their currencies to
make them more realistic t e to conform official par values of their
currencies with the market values Back in 1930’s, some countries of
Europe maintained the foreign exchange value of their currencies at
artificially low levels to remain competitive
A country may also employ some form of foreign exchange controls
in order to ovoid temporary ups and downs in her foreign exchange
rate These temporary fluctuations are attributed to speculative
exchange speculators
activities of the foreign m
the country It is often
very say in advance, what is a temporary fluctuation and
difficult to
whether it was caused by speculative activity, although one can look
back and say which fluctuation was temporary or due to speculative
activity England, mcollaboration with the Exchange Equalization
Fund, pursued this kind of exchange rote control policy
Exchange controls give enormous powers to the government
bureaucrats and politicians, because these are the people, who are
vested with the authority to issue import licences, allocate foreign
exchange among several competing buyers, etc Exchange controls,
once introduced, become a source of illegal income and corruption,
they are also a source of wielding enormous power, influence, and
distributing favour The politicians and bureaucrats will be unwilling
to do away with exchange controls even when they ore no longer
needed for the country Exchange controls could thus become part of
a political and bureaucratic culture Exchange controls, then come to
stay almost indefinitely, and they may even become immortal, because
they could be a perpetual source of income to many politicians and
bureaucrats under the table This is the political economy of exchange
controls
METHODS OF EXCHANGE CONTROL

Exchange controls may be broadly classified into two groups direct —
and indirect exchange controls Among the direct methods mention
may be made of intervention and regulation in matters concerning
exchange rates, foreign exchange restrictions, multiple exchange rate
policies etc Indirect methods of exchange control include import
tariffs, export subsidies, bilateral and multilateral clearing
arrangements, etc Let us discuss some of these methods here
(a) Foreign Exchange Rate Regulation through Intervention

The government may intervene m
the foreign exchange market
with a view to raise or reduce the external value of its home currency
This intervention takes the form of large scale buying or selling of
home currency by the government in the foreign exchange market.
The idea is to support or “peg” the external value of the currency to
a chosen rate of exchange In the absence of such pegging or gov emment
support through intervention there is a nsk that the free market rate
of foreign exchange would diverge from the pegged rate Put simply,
government will sell foreign exchange when the pnce of foreign
exchange is rising excessively on the foreign exchange market, and
government will buy foreign exchange when the foreign exchange rate
is gomg downexcessively causing appreciation of domestic currency in
terms of foreign currency Since both depreciation and appreciation of
currency are regarded as undesirable, there is need government
for
intervention in keeping exchange rates relatively stable Exchange
rate stability is necessary to facilitate and promote healthy growth of
international trade and capital movements Exchange rate stability is
threatened off and on by BOP deficit and surplus pressures on the one
hand and by the speculative buying and selling of foreign exchange of
a destabilizing type, on the other Hence, the need for government
intervention to “smoothen out” such ups and downs m
the exchange
called
rate movement from time to time In colourful language, this is
as a policy of “dirty float”, discussed m
the last chapter in some detail
_ i f 365
Policy Issues
Balance of Payment Adjustment
Several countr.es have

undertaken such exchange rate control
^
1933 The
history New Zealand did it in
oohc.es at various times in
established by the USA the UK
and
Exchange Stabilization Hinds attempts
respectively, represent their
France in 1932, 1934 and 1936 through the
currencies at a fixed rate
L peg exchange rates of their
purchase and sale operations of
home and f“re '^
country its home currency
to sell
wi
an
It is relatively easier for a
buy excess amount of foreign
exchange to prevent ®P r “
se cvcry
ovmcu^^^
foreign exchange (or appreciation
country has unlimited supplies
of its
of it
^
thot th(!
more
S P s and ECt
to th p
governments have to do, is to go res ervos at
hand, the S cx chMlge
currency notes On the other Therefore, if the
rather s
the disposal of a country are y exchange
appreciating due y of foreign
foreign exchange rate is it
st forel5n currency),
de the domestic cuiTency is depreciating g " f ted quantities
of
to sell
would not bo easy for governments exchange rate
foreign exchange to prevent “ "f° types -
ha a be of both the
Government intervention, however, wit^ which
complexity or the case
pegging up or pegging down The
they can be undertaken are,
however, quite different
(6) Exchange Restrictions exchange

This is another, and
perhaps more
exchange
controls In this case, all foreign
severe,
^ receipts must
for home
currency,
and exc
be surrendered to the government government
and foreign exchange can be purchased ^regulations
r
nuthonties Non compliance with currency punishable with
crime
laiddown by the governments are a
death as in Germany m 1931 into the
exchange coming
Government will acquire all foreig „ Y rhance to buyers
on
that oreipi
country, and it will allocate or sell example, foreign
national priori i
tho basis of predetermined foreign tour,
0f
made available lor and
exchango may not be Qn d BerV \ces,
travel or study or for non-essential
impo o “blocked
w called as
so forth
accounts”
A country may practise a system o
i e not allowing the
creditors o
^ acC ounts to
wfl3 done
during
accoun
use their currency holdings in their refugee 3
could
to
Germany Many Jews who fled
Hitler’s lhons of
ml
0 had
not draw money from their accounts, tj. eir
accounts
government may
accounts, e
marks in their German bank
been blocked by the Germau government S.™ foreign
J.
not allow capital transfers away
fro gfoortng
t0
investment by nationals may not be permi
366 International Ecvro~u.es
foreign exchange One can visualize any numberof measures which

governments may take to conserve scarce foreign exchange, and they
all constitute foreign exchange restrictions as a form of exchange
controls
(c) Multiple Exchange Rate Policies

Multiple exchange rates were first employ ed by Germany and later
they were followed by other countries like Argentina, Brazil, Chile,
Ecuador, Peru and many others In the case of this policy, different
exchange rates are fixed for imports and exports of different goods
Ev en for different categories of imports, different exchange rates are
applied Argentina maintained a higher complex system of multiple
exchange rates, because she was not a member of the IMF The
S3 stem was administered quite efficiently for a long time
The mechanism of multiple exchange rate is % ery simple. Suppose
for example, the government considered imports of some raw materials
and capital goods as essential to the economic development of the
country, then the foreign exchange rate used in the case of such
imports would be lower, say £1=$3 rather than the standard exchange
rate of, saj £1=$4 In terms of dollars (home currency) the importer
pay’s a lower price for obtaining a given amount of pounds (foreign
exchange) This would make imports of such goods cheaper, because
the dollar price of pounds fixed for their imports is lower On the other
hand, imports of non-essential luxury goods maj be subjected to a
higher foreign exchange rate, say £1=$8 This would raise the dollar
value of pounds and make import of the luxury goods rather very
expensive The same discriminatory exchange rate policy could be
apphed to export goods as well — to encourage exports of certain types
of goods and services more than others
The policy of multiple exchange rates is also called selective
devaluation policy as opposed to general devaluation policy In the
case of general devaluation policy, imports of all goods and services
are made expensiv e, regardless of whether they are essential or non
essential types of imports Similarly, general devaluation would make
all the exports attractiv e regardless of what the export commodity is
Multiple exchange rate policy undertakes selective dev aluation xe. it

would make essential imports cheaper and non-essential imports
expensive, and it would make some exports attractive and other
exports unattractive Multiple exchange rate policy will have different
exchange rates not only for different goods (imported and exported)
but also for different countries with which the home country is
trading
3 07
The advantage of multiple exchange rate policy to the practising
country lies in the fact that it eliminates the need for employing
quantitative restrictions on imports (or exports) and licensing of
imports (or exports) To that extent, this system can eliminate
inefficiency and corruption that usually go with import licensing and
quantitative restrictions on imports This is perhaps the great merit
of multiple exchange rates ms a vis physical controls on imports
However, there are several shortcomings associated with the multiple
exchange rate systems For example, the system introduces complexity
and lot of confusion with regard to the number of exchange rates
applicable to number of commodities in relation to number of countries
Sometimes, they can harm healthy economic development of a country
The example of Chile is worth noting in this connexion The scheduling
of imports of essential food stuffs at low exchange rates hampered the
development of agricultural sector in Chile From being a net exporter
of agricultural products in the 1930 s, Chile had become within a
decade 1 e by the late 1940’s a net importer of these products
Multiple exchange rate system was not the only factor responsible for
this unhealthy development, but it certainly was one of the important
factors contributing to it Similarly, in Peru, when meat imports were
subsidized by low exchange rate policy, there was a drastic fall in the
home production of meat. From near self sufficiency in meat production
the domestic meat production in Peru dropped down to less than half
of the total domestic consumption, and this was due to multiple
exchange rate policy pursued by Peru Ecuador had a similar experience
with wheat flour All this is not meant to suggest that multiple
exchange rate policy is a great source of danger, what is suggested,
however, is that a judicious selection of rates and of commodities
imported and exported is very vital in order to make best use of this
system of multiple exchange rates
( d ) Exciiance Clearing Agreements

Exchange clearing agreements can be bilateral or multilateral,
private or official The world has witnessed all such different types of
agreements over the past several years
Bilateral cleanng arrangements lead to a system of international
trade and payments of a barter nature Among the earliest forms of
bilateral trade were barter deals undertaken by private firms These
were common during the 1930’s and e\en thereafter, although they
were superseded by more formal arrangements after World War II
Thus, in the early 1930 s, German coal producers arranged for the
export of coal worth 9 million marks to Brazil, and they obtained in
exchange, an equal value of imports of coffee from Brazil German
fertilizer was similarly exchanged for Egyptian cotton In a
general
3G8 International Economics
sense, if all exports and imports of a country are earned out in such
a bilateral barter fashion, there would be no BOP deficits or surpluses
in any country There would even be no need to use money or foreign
exchange in settling international trade and payment obligations
Such bilateral cleanng arrangements are employed by Communist
countnes m trading with one another
The one problem with such arrangements is, that the exporter has
to play the role of an importer as well, and exporters may not be
accustomed to playing such dual roles Germany evolved a novel
device of exchange cleanng which had the advantage of relieving the
exporter from also performing the unaccustomed functions of an
importer This led to a system of barter cleanng agreements between
igovemments i e the central banks of the two trading nations Let us
illustrate how it functioned, with the help of a simple example The
exporters in country A, who ha\e exported goods of a given value to
country B, receiv e payments from the central bank of their country in
the home currency The central bank of country A then receiv es from
central bank of country B the equivalent value of exports in terms of
foreign exchange (i e countiy B's currency) This means the foreign
exchange earnings from exports have directly gone into the official
reserves of central bank of country A, and that the exporter in country
A has received payment for his exports in home currency, from the
central bank of his country (country A) The question now is from
where did the money come to pay exporters m home currency fay the
central bank of country A 7 The answer is simple The debtors Ue
those, who have imported goods from country B ) m country A would
pay for their import purchase in home currency to the central bank of
country A In this way the central bank in country A collects payments
from importers (m home currency) and pays that amount (in home
currency? to exporters m the country Export earnings m foreign
exchange collected by central bank in country A from the central bank
of country B, will “go back” to central bank in country B, when central
bank in country A has to pay for country A’s imports from country B
As a matter of fact, there need not be any foreign exchange movement
between country A and B, they can be settled by book transfers
between the two central banks The importers and exporters, in the
two countries, make or receive their payments by the central banks
of their respective countnes in their respective home currencies
Central bank of the two countnes make book transfers only between
themselves This arrangement will do away with the necessity of
having to deal m foreign exchange transactions between trading
nations It will also ensure BOP balance in both the countnes,
provided, of course, neither country has an export surplus or an
import-surplus vis a-vis the other country Many European countnes
Balance ofPayment Adjustment Policy Issues 3G9
had entered into such exchange clearing agreements during 1930’s

The basic principle in all these agreements remained the same (as
described above), but details varied from agreement to agreement
Sometimes, the payments from one country (say country A) to another
from country
country (say country B) were so much larger than those
country A, that country A had to place the balance (after
making
B to
country B to
alldue payments to country B) at the free disposal of
import whatever it wanted to import from country A to set off the
balance This happened between Germany and the

Balkan countries
World War II, when Germany had to make net payments
to the
before
countries had to
Balkan countries To settle the payments, Balkan
Germany Hence the
accept unwanted commodities of high pnee from
large Balkan imports of aspirin and
harmonicas from Germany
should be in
bnef assessment of bilateral clearing arrangements
A
order at this point Such arrangements of BOP settlement are strictly
limited to commodity trade between
countries At best, they can cover
of payments, particularly
service transactions as well But other kinds
clearing arrangements in
capital flows, are excluded from bilateral
of these agreements, whether they are
any case, a clear disadvantage that
all trade and Payments is
limited to only merchandise trade or
m
the presence of such e*hang.
they distort the patten, of trade - e
conform to the d.ctates of
control arrangements trade cannot
advantage, which requires trade
multilaWism A partnd
comparative
however, be found by going from
solution for this problem may,
bilateral clearing arrangements to w
hat are ca e
The r composed
payments agreements or payments union p functioned
““ C n “
as “
csse "" al ' y f
of the UK and most of the commonwealth,
a multilateral payments agreement the
European nv 1 ^
illustration
(EPU) which existed from 1950 to 195 8 »
of multilateral payments agreements
Excep
gr«
^
’
nCTeemen ts
Post-World War II were bilateral payrne
arrangements,
agree P°
The Bank for International Settlements, countries
credi or 3
supposed to settle payments between ^ Cooperation
European Ec0 "°
belonging to the Organization for
agreement proved to be an
”U
=
u^ Twas
group but the ^.cSs!to«ment,
immediately superseded by the Intr,T
Eu
after considerable pressure from
the U ^^ Thls agreero ent
_„UiHteral
linked
clearing,
“ed“ "on
15
successful multilateral
ba.an£
for restoration of trade balance

Even creditor
example in the
»
the balance is restored administrative y ^

to expand money
central bank has P
country with an export surplus, the
supply in order to pay the exporters m terms of home currency This

will mean increase in money income in the surplus country, which
would then lead to import increases The country’s creditor position is,
then, automatically destroyed The debtor country, on the other hand,
is simultaneously being subjected to deflationary pressures as a result
of its imports exceeding exports The money supply tends to shrink,
because substantial deposits of local currency would be made into the
clearing account by the importers, thus retiring money from circulation
This will reduce imports from the import surplus countries and ensure
trade balance In both cases, i e in debtor and creditor countries, the
tendency for restoration of BOP balance is clear
(e) Indirect Methods of Foreign Exchange Control

The four methods of exchange control, that we have discussed so
far viz
(; exchange rate regulation through intervention, exchange
restrictions, multiple exchange rates, and exchange clearing
agreements) belong to the category of direct exchange control methods
Some other methods like private compensation, transfer moratorium,
12
etc also belong to the category of direct exchange control methods
Among the indirect methods of exchange control mention may be
made of import restrictions Tariffs and import quotas are the chief
instruments of indirect methods of exchange control
Tariffs and quotas on imports, are indirect exchange control
methods insofar as they become necessary as soon as direct exchange
control methods are adopted ma country To the extent that tariffs
and quotas succeed in cutting down import expenditures, without
materially reducing export receipts, they will contribute towards an
improvement in the BOP balance of a country As we have discussed
the effects of tariffs and quotas in an earlier chapter, we do not wish
to repeat them here again However, it is necessary to emphasize that
not all tariffs and quotas can be automatically considered as indirect
forms of exchange control For instance, import duties levied for
revenue consideration or to stimulate domestic industrialization, can
not be considered as indirect exchange control methods Similarly,
export subsidies with a view to expand exports need not necessarily
fall into the category of exchange controls Only when the objective of
import duties or quotas or export duties or subsidies is explicitly to
support the foreign exchange rate or improve the BOP situation, can
they be truly considered as indirect methods of exchange control In
reality, however, it is very difficult to identify whether a given import
tariff or export subsidy is introduced for considerations of revenue or
foreign exchange earning (saving to improve BOP situation The same
kind of difficulty extends also to non tariff barriers which a country
may impose Their objectives are so numerous that it is almost
37 j
impossible to identify with certainty that they are meant solely to
improve the BOP situation of a country
THE COSTS OF ADJUSTMENT

As Kindleberger has put it, disequilibrium in the BOP can be
“suppressed, corrected or financed" A country facing a BOP deficit

disequilibrium is forced to chose between exchange rate depreciation
domestic deflation and exchange controls Whatever method a country
chooses to deal with deficit problems, has its own benefits and costs,
and each country has to weigh benefits against costs before it decides
to adopt any policy instrument to deal with the deficit For instance,
from the standpoint of economic or allocative efficiency alone, exchange
controls are disastrous, because export industries come into being or
are expanded not because they are efficient but because they are
sheltered by protection in the form of import tariffs or production
subsidies Quantitative restrictions on imports give protection to the
high cost industries
But considerations of allocative efficiency, alone, are not a sufficient
guide in choosing right policy instruments to deal with external
disequilibrium External equilibrium has to be achieved without
destroying internal equilibrium le domestic employment and price
stability These are national, political and social requirements Today,
we live in nation states, where considerations of ones* own nation's
and society, come before any other world considerations Every country
tnes to shift os large a burden of adjustment costs as possible to other
countries Policies such as devaluation and exchange controls allow
the deficit country to save itself from imposing a deflation upon itself
Another thing to note is that it is the less developed countries who
suffer BOP deficit problems Their problems are more of resource
creation and mobilization rather than resource allocation They need
to accelerate their rate of economic development through
industrialization and other measures, and they need to achieve it now
and faster by all possible means They could not, in a way, be so
bothered about world allocation of resources and conformity with the
law of comparative advantage They feel that the world system today
is one of neither free trade nor fair trade In their view, international
system of trade and payments, is based on the principle of the survival

—
of the fittest competition is free but not fair Rich countries exploit
the poor countries, because the strong can always exploit the weak
BOP adjustment, it is often forgotten, is alwajs a mutual process by
definition, for every deficit country, there must be a surplus country
Just as a deficit country should try to correct its deficit, the surplus
countries should take steps to get nd of their surpluses Fairness
demands this, but the surplus nations (who are usually the nch
nations) do not wish to take policy measures to remove their BOP

surpluses As long as they continue to enjoy surpluses, the deficit
countries (who are usually the poor countries) will continue to suffer
BOP deficits The burden of BOP adjustment, m
the spint of New
International Economic Order, must fall evenly on both the deficit
countnes and the surplus countries This is not happening in the
world today The implication of all this is very simple unless and until
surplus countnes agree to take policy measures to remove their
surpluses, the problems of BOP deficits in deficit countnes will not be
solved We all agree that BOP disequilibrium, whether it is surplus or
deficit disequilibnum, is bad Then, why, do the surplus countnes not
take steps to remove their surpluses 9 Is it entirely up to the deficit
countnes to eliminate their own deficits, and thereby also remove the
surpluses of nch countnes 9 These are some of the ponderables, and
they are extremely relevant in the context of BOP policy issues that
concern the countnes of the world today, more than ever before
ASSIGNMENT PROBLEM: MONETARY-FISCAL AND

EXCHANGE RATE POLICY TOR ACHIEVING INTERNAL
AND EXTERNAL BALANCES. TREVOR SWAN’S MODEL
Trevor Swan developed a model in 1955 (before Robert Mundell
did in 1962) in which he argued that a country should achieve internal
as well as external balances simultaneously by using a flexible
exchange rate policy on the one hand and monetary and fiscal policy
package on the other This is m
contrast with Mundell’s model where
you have a fixed exchange rate policy and the monetary and fiscal
policies act separately rather than together to achieve the goals of
internal and external balance
According to Swan, the role of attaining external balance should
be given to the flexible exchange rate system, while monetary and
fiscal policy package should take care of internal balance If the
countnes adopted a different pattern of assignment, like for instance
assigning flexible exchange rate policy for producing internal balance
and monetary-fiscal policy package to produce external balance, the
consequences would be undesirable We will study Trevor Swan’s
model below
First, we denve the internal and the external balance schedules
with exchange rate ( R ) on the vertical axis and the domestic demand
(£) on the horizontal axis Aggregate demand, it should be remembered,
is made up of (a) the domestic demand which is influenced by the
monetary and fiscal policies, and (6) the foreign demand which is
influenced by the changes in exchange rate
The internal balance schedule (YY) is a negatively sloping curve as
in Diagram 9 At any point on the YY line there is internal balance
Balance ofPayment Adjustment Polity Unites
373
(fullemployment with pnee stability) At point A the exchange rate is

high (or the value of domestic currency is low) which will keep the
level of foreigndemand at a high level And this is combined with low
level of domestic demand to keep the economy at the level of aggregate
demand (domestic and foreign) high enough to ensure full employment
without generating inflation At point B we have low exchange rate
(or high value for domestic currency) which will keep foreign demand
at low level But this is offset by the high level of domestic demand
at point B such that the aggregate demand is once again at a level
high enough to guarantee full employment with zero inflation
At point C, however, both the foreign and the domestic demand
levels are high, and tins would result m
excess aggregate demand
causing over full employment or inflation This can be remedied either
by reducing foreign demand through currency revaluation (or
appreciation) or by reducing domestic demand through contractionary
monetary and fiscal policies
At point D, however, there will be unemployment because 0) the
level of foreign demand is too low due to overvalued currency and (u)
the level of domestic demand is too low due to inappropriate monetary-
fiscal policy combination This can be remedied either by currency
devaluation (thereby simulating foreign demand) or by easing monetary
and fiscal policies (thereby stimulating domestic demand)
In summary, at any point on the internal balance schedule (TY)
there is no inflation or unemploj7nent At any point to the right of YY
(such as point C) there is inflation At any point to the left of YY (such
as point D) there wall be unemployment
economy is at point C, it is possible to achieve internal

If the
balance and (a ) move to point A by adopting contractionary monetary
and fiscal policy stance or ( b ) move to point B by revaluing the
currency A movement from C to A involves domestic demand
contraction, while a movement from C to B involves foreign demand
contraction
Similarly, if the economy is stuck at point D with unemployment,
the remedy would he in (a) domestic demand expansion through
expansionary monetary and fiscal policy combination, thereby taking
the economy from D to b, or (6) foreign demand expansion through
currency devaluation, taking the economy from D to A
We now move to derive the external balance schedule (BB) in
Diagram 10
(exchange rate)
At arty paint on BS hne there is external balance (or Balance of

Payments equilibrium) At point I the domestic demand is low enough
to keep imports low level and the value of domestic currency is high
enough to keep exports at low level The combined result of low level
of imports and exports is a BOP equilibrium with small size of trade
At point II by contrast, the domestic demand is high, generating high
level of imports, and the value of domestic currency is so low as to
cause high level of exports The net lesult is again BOP equilibrium
at point II, despite high levels of imports and exports
At point III, however, there will be BOP surplus because (a) the
domestic demand is low ensuring low levels of imports and (6) the
foreign demand is high ensuring high level of exports
At point IV, there will be BOP deficit because (a) the domestic
demand and the level of imports are high and (6) the foreign demand
and the level of exports are low
Points III and IV, therefore, are points of external disequilibrium
The policy pattern that is required to remedy the situation m these
two cases will be as follows
If the economy is stuck at point III with BOP surplus, we need to
either (a) expand domestic demand through easy monetary and fiscal
policy so as to increase the level of imports, or (6) allow currency
appreciation so that external demand and export levels will go down
In the first case we take the economy from point III to II and m the
second case we take the economy from point III to I Either way we
restore BOP equilibrium by getting nd of the surplus
If, however, the economy is stuck at point IV with deficit
disequilibrium our policy choice will have to be either (a) to move from
point IV to I, which involves contractionary monetary and fiscal policy
stance, and this will reduce domestic demand and import levels, or (6)
to move from IV to II by a process of currency devaluation, thereby
stimulating foreign demand and the level of exports
We can now put the two schedules (YY and BB ) together in one
diagram as in Diagram 11 below
R (exchange rate)
Dinfrnm II
In Diagram 11, the economy is in full equilibrium only at point H

At this point there is internal as well as external equilibrium (or
balance) The objective of economic policy is to attain this equilibrium
position at point H, which is the point of intersection between the YY
and the BB lines At any other point on Diagram 11, the economy is
four such
m a state of disequilibrium (or imbalance) We can identify
situations
1 Unemployment surplus at point I
2 Inflation deficit at point II

3 Inflation surplus at point III
4 Unemployment deficit at point XV
We will not discuss situations 1 and 2 above since they do not
require assignment exercise They also do not conform to the real
world situations that exist in the first or the third world We will
therefore examine only situations 3 and 4 set out above
Inflation-Surplus Case
Let us assume that the economy is stuck at point A with inflation
and trade surplus (Diagram 12)
We apply exchange rate policy for eliminating inflation, and
monetary-fiscal policy to get nd of trade surplus In that case, our
exchange rate policy has to be one of currency revaluation or
appreciation, and our monetary fiscal policy has to be one of expansion
We thereforemove from point A and go to point B and from point B
to point C The problem is not solved because we have not arrived at
pomt H
(full equilibrium) We then contmue to use exchange rate
policy to attain internal equilibrium and monetary fiscal policy to
attain external equilibrium So we move from C to D, then from D to
E,E to F and F to G In doing so, you wall notice that we are moving
furtheraway from the goal (point H), and the economy continues to
diverge The problem is not solved, but made worse instead Therefore
such an assignment must be inappropriate
R (exchange rate)
Diagram 12
however, we turn around and assign exchange rate policy to
If,
achieve external equilibnum and monetary-fiscal policy to achieve

internal balance, we would reach our goal (point H) In Diagram 12
we start from pomt A We undertake currency revaluation and go
straight to point J We
then expand domestic spending by using an
expansionary monetary fiscal policy, taking us from point J to We K
then undertake currency depreciation (or devaluation) and move from
M
KioL Thereafter we move from L to by cutting domestic spending
through a contractionary monetary fiscal policy package This way we
go on repeating but always using exchange rate adjustment to attain
external equilibrium, and monetary fiscal policy to attain internal
balance This involves currency revaluations and devaluations as well
as tightening and easing monetary fiscal policy depending on the
situation In this way as we move from A to J to to L to K
etc we M
are moving towards economic convergence and soon we will take the
economy to point H, where we have full equilibrium
Hence, the appropriate thing to do would be to assign exchange
rate policy to achieve external equilibrium and monetary fiscal policy
to achieve internal equilibrium We will once again see how this is
valid for a situation where we have unemployment deficit conditions
Unemployment-Depicit Case
Diagram 13 shows how a country is stuck at point A with
unemployment (as internal disequilibrium) and trade deficit (as external
disequilibrium)
R (exchange rate)
G — BB
E
— ——
- —— j
V
"YY
E (domestic demand)
i
Diagram 13
If we assign, inappropriately though, exchange rate instrument to
achieve internal balance and monetary' fiscal policy to achieve external
balance, we will be moving from point A to point D to point C and
so
fourth As you can see from Diagram 13, this kind of movement,
fact
instead of leading the economy to convergence at point H, will in
move the economy away from the convergence This will only make
matters worse as both unemployment and trade deficit problems get

out of control
If, however, we assign (appropriately though) exchange rate policy
for achieving external equilibrium and monetary- fiscal policy for
internal equilibrium, we wall move the economy towards convergence
For instance, we start from point A and move to point J (to restore
trade equilibrium by currency devaluation) and then move from J to
K (eliminating unemployment by using expansionary monetary fiscal
policy package) We then mov e from K
to L (currency devaluation) and
from L to M
(contractionary demand management policy using
monetary fiscal policy) By using this process, soon we will succeed in
landing the economy at point //where we have neither unemployment
nor trade deficit
In Trevor Swan’s model, unlike Robert Mundell’s model, we are
using exchange rate policy (currency devaluation/revaluation) to achieve
external equilibrium In Mundell’s model we achieve external
equilibrium by using monetary policy And in Swan’s model we
achieve internal equilibrium by using monetary fiscal pobey package,
but in Mundell’s model by contrast we use only fiscal policy for
achieving internal equilibrium
In Mundell’s model we do not use exchange rate as an instrument
of solving disequilibrium —
internal or external
In a world of flexible exchange rates, as we do have since 1971,
Trevor Swan’s model has a greater applicability than does Robert
Mundell’s model of fixed exchange rates
NOTES
1 Among other important contributions to this body of anal} sis, we
cite the major one by Robert A. Mundell, *The Appropriate Use
of Monetary and Fiscal Policy for Achieving Internal and External
Balance Under Fixed Exchange Rates”, IMF Staff Papers, 9,
March 19 S2 This approach to the BOP problem began in the
1950s with the work of James E Meade 77ic Theory of Economic
Policy, Vol The Balance of Payments (New York Oxford
1
University Press, 1951)Jan Tinbergen, Harry Johnson and
Manna von Neumann Whitman are some of the other major
contnbutors to the BOP analysis which discusses the use of tools
for the realization of both internal and external equilibrium
2 See for further details Ellsworth PT and J Clark Leith, The
International Economy (New York Macmillan, 1975), pp 395-
396
Balance cf Payment Adjustment Policy Issues 379
3 Robert A Mundell, International Economics (New York
Macmillan, 1968), p 8
4 There are at least three important works of Alexander which
deserve mention See Sidney Alexander, “Devaluation versus
Import Restriction as a means for Improving Foreign Trade
Balance”, IMF Staff Papers, April 1951 (pp 379 96), “Effects of
Devaluation on Trade Balance”, IMF Staff Pear, Apnl 1952 (pp
263-78), also reprinted in Caves R E and H G Johnson (eds
Readings in International Economic (Homewood Richard D
Irwin, 1968), and "Effects of Devaluation A Simplified Synthesis
of Elasticities and Absorption Approaches”, American Economic
Review, March 1959 (pp 22 42)
5 This discussion is based heavily upon the material presented in
Richard I Leighton, Economics of International Trade (New
York McGraw-Hill, 1970), pp 176-181
6 Fntz Mnchlup, “Relative Prices and Aggregate Spending in the
Analysis of Devaluation”, American Economic Review, June 1955,
pp 255-278, and “The Terms of Trade Effects of Devaluation
Upon Real Income and the Balance of Trade", Kyklos, Fasc 3, 9
(1956) pp 417-450
7 See footnote 4 for this reference
8 A.C Harbcrger, “Currency Depreciation, Income and the Balance
of Trade", Journal of Political Economy, February 1950, pp 47-
GO Repnnted also in Caves and Johnson (eds ) op ctf
9 S C Tsiong, “The Role of Money in Trade Balance Stability
Synthesis of the Elasticity and Absorption Approaches", American
Economic Review, December 1961, pp 912 936 Reprinted also in
Caves and Johnson (eds ) op cit
10 For details and summary of these synthesis attempts, see chapter
1, titled "Approaches to the Analysis of Devaluation A Brief
Survey”, pp 3-34, in John F Kyle, The Balance of Payments in
a Monetary Economy (Princeton University Press, 1976)
11 The EPU members included Austria, Belgium, Luxembourg,
Denmark, France, Germany, Greece, Iceland, Italy, the
Netherlands, Norway, Portugal, Sweden, Switzerland, Turkey
and the entire Sterling Area led by the UK
12 For further details, the interested reader may refer to Ingo
Walter, International Economics (New York Ronald Press, 1968),
pp 384-385
QUESTIONS
1 Using IS LM frame work of analysis, discuss the effects on BOP
of the following fa) changes in money supply, (6) changes in
government expenditure
2 Discuss Robert Mundell’s model concerning the appropriate use

of monetary and fiscal policies for internal and external balance
under a system of fixed exchange rates
3 Critically evaluate devaluation as an instrument of BOP
adjustment using both the elasticity approach and absorption
approach Do you consider devaluation as an appropriate polio
for less de\ eloped countries suffering from BOP disequilibrium 7
4 What are exchange controls 7 What are their objectives7 Do >ou
advocate use of exchange controls for BOP adjustment7 Discuss
with particular reference to less developed countries
5 Discuss Trevor Swan’s model of External and Internal
Equilibrium
REFERENCES
Ellsworht P T and J Clark Leith, The International Economy (New York. Macmillan
1975) Chapter 21 (pp 375*390) and Chapter 22 (pp 391-107)
Leighton Richard I, Economics of International Trade (New \ork. McGraw Hill,
1970) Chapter 10 (pp 169 185)
Mundell FLA., The Appropriate Use of Monetary and Fiscal Policy for Interna] &
External Stability, IMF Staff Papers March 1962
Scammel WM ,
International Trade and Payments (Toronto The Macmillan 1974)
Chapter 16 (pp 387-40S)
Swan T W ,
“Longer Run Problems of the Balance of Pa3Tnents’ in H W Arndt and
WJM Corden (eds ) The Australian Economy, A Volume of Readings, (Melbourne
University Press, Melbome, 1955)
Sodersten Bo, International Economics (New "Yrok Harper and Row, 1970' Chapter
18 (pp 319 337)
Walter Ingo, International Economics (New York Ronald Press, 1968) Chapter 15
(pp 353 375, Chapter 16 (pp 376-395), and Chapter 17 (pp 396-106)

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— BALANCE OF -

The need for BOP adjustment, particularly of deficit disequilibrium, is

stock of official international reserves —

MONETARY AND FISCAL POLICY: EXPENDITURE

(A) Changes in Government Expenditure and BOP Equilibrium

Let us suppose that we have an economy where there is internal

IB) This would shift the JS LM equilibrium position from point 1 to

_TY—>TAf (current account deficit trend)

Increase in government expenditure raises income levels, and

IB) then the result would be one of overall BOP surplus

(B)Changes in Money Supply and BOP Equilibrium

The initial equilibrium is at point 1 with interest rate r0> and

T Y TM (current account deficit trend)

An increase in money supply would only create negative current

Originally, we have an IS LM intersection at point a (in Panel I)

outflows are of the order of the size 01 The capital balance

there is a current account deficit of Oj which is exactly matched by a

326 International Economies

account deficit which has now gone up from Oj to OP is matched by

increase in money supply, the result on the BOP situation would be

ASSIGNMENT PROBLEM: MONETARY AND FISCAL

Policy for Internal and External Stability In this article he argued

balance Similarly, in a system where prices interest rates and

achieving the two objectives —

monetary policies constitute expenditure increasing policy measures,

arise to assign a particular policy —

mutually exclusive as BOP deficits and surpluses This means that

anse for the following reasons Take, for instance, a combination of

In the above expression, Nstands for employment and for M

Therefore, by making both the policies contractionary, we can

330 International Economics

Cases and IV, however, involve problems of assignment, because

aggravating problems of internal and external imbalances Convergence

If, however, we are to the nght of the YY line at a point such as

point f, we must have inflation or an “inflationary gap" in the GNP

If we are to the left of BB

monetary and fiscal policy They

with only two simple and straight-forward cases represented in Zone

case Similarly, it is arguable that BB line could be steeper than the

APPROPRIATE AND INAPPROPRIATE ASSIGNMENT:

Zone III: Unemployment Deficit Case

expansionary policy treatment, because unemployment can be

Zone IV: Inflation-Surplus Case

SOME COMMENTS AND CRITICISMS

Balance of Payment Adjustment Policy Issues 337

and inflation The “seesaw” relationship between inflation and

also overlooked in this model, is the

of responsiveness of international capital

Similarly, the relation between

the lip Fiscal po icy is n

and fiscal policy should be applied together internal

balance usually takes precedence over

balance also means much more today — it means controlling both

inflation and unemployment at the same time This is a very crucial

Devaluation: Expenditure Switching Poucv

exhausted or proved ineffective or onerous The use of devaluation, the

effectiveness of devaluation —a general equilibrium or a macro-

The Elasticity Approach

pnce has gone up from P0 to P resulting m a reduction in import

demand from q0 to q l This has produced no change m import

suggesting that devaluation has made no difference to the level of

Inelastic import Elastic Import demand

has made no difference to export earnings, because export earnings

devaluation (rectangle P 0 lq 0 H) In Diagram 7B, where the export