The balance-of-payments accounts are a record of the international transactions of
the economy. The current account records trade in goods and services as well as
transfer payments. The capital account records purchases and sales of assets. Any
transaction that gives rise to a payment by a U.S. resident is a deficit item for the
United States.
The overall balance-of-payments surplus is the sum of the current and capital accounts
surpluses. If the overall balance is in deficit, we have to make more payments
to foreigners than they make to us. The foreign currency for making these
payments is supplied by central banks.
Under fixed exchange rates, the central bank holds constant the price of foreign
currencies in terms of the domestic currency. It does this by buying and selling
foreign exchange at the fixed exchange rate. It has to keep reserves of foreign currency
for that purpose.
Under floating, or flexible, exchange rates, the exchange rate may change from
moment to moment. In a system of clean floating, the exchange rate is determined
by supply and demand without central bank intervention. Under dirty floating, the
central bank intervenes by buying and selling foreign exchange in an attempt to
influence but not fix the exchange rate.
The introduction of trade in goods means that some of the demand for our output
comes from abroad and that some spending by our residents is on foreign goods.
The demand for our goods depends on the real exchange rate as well as on the
levels of income at home and abroad. A real depreciation or increase in foreign
income increases net exports and shifts the IS curve out to the right. There is equilibrium
in the goods market when the demand for domestically produced goods is
equal to the output of those goods.
The introduction of capital flows points to the effects of monetary and fiscal policy
on the balance of payments through interest rate effects on capital flows. An increase
in the domestic interest rate relative to the world interest rate leads to a
capital inflow that can finance a current account deficit.
When capital mobility is perfect, interest rates in the home country cannot diverge
from those abroad. This has major implications for the effects of monetary and
fiscal policy under fixed and floating exchange rates. These effects are summarized
in Table 12-6.
TABLE 12-6 Effects of Monetary and Fiscal Policy under Perfect Capital Mobility
POLICY
FIXED EXCHANGE RATES
FLEXIBLE EXCHANGE RATES
Monetary expansion
No output change; reserve losses equal to money increase
No output change; reduced net exports; exchange appreciation
Under fixed exchange rates and perfect capital mobility, monetary policy is powerless
to affect output. Any attempt to reduce the domestic interest rate by increasing
the money stock would lead to a huge outflow of capital, tending to cause a depreciation
that the central bank would then have to offset by buying domestic money
in exchange for foreign money. This reduces the domestic money stock until it returns
to its original level. Under fixed exchange rates with capital mobility, the
central bank cannot run an independent monetary policy.
Fiscal policy is highly effective under fixed exchange rates with complete capital
mobility. A fiscal expansion tends to raise the interest rate, thereby leading the
central bank to increase the money stock to keep the exchange rate constant, reinforcing
the expansionary fiscal effect.
Under floating rates, monetary policy is highly effective and fiscal policy is ineffective
in changing output. A monetary expansion leads to depreciation, increased
exports, and increased output. Fiscal expansion, however, causes an appreciation
and completely crowds out net exports.
If an economy with floating rates finds itself with unemployment, the central bank can
intervene to depreciate the exchange rate and increase net exports and thus aggregate
demand. Such policies are known as beggar-thy-neighbor policies because the increase
in demand for domestic output comes at the expense of demand for foreign output.
