Balance of Payment Equilibrium and Optimum Composition of the Balance of Payment

• Author: J. S. H. HUNTER
• Date: 01 December 1974
• DOI: http://doi.org/10.1111/j.1813-6982.1974.tb00411.x
• Published date: 01 December 1974

Balance of Payment Equilibrium and Optimum Composition of the Balance of

Payment

J. S. H. HUNTER*(1)

MUCH OF THE RECENT LITERATURE on the balance of payment has been concerned with developing an aggregative approach

to balance of payment equilibria, and in particular to show the importance of monetary phenomena. *(2) An almost parallel

development has seen the appearance of models which demonstrate an appropriate assignment of policies to secure both external

and internal balance. *(3)

The following analysis aims to give more explicit recognition to the importance of exchange rate variations (for both external and

internal balance) and to show thats exchange rate and interest rate flexibility are substitutable in some degree. Excessive reliance on

either may be unacceptable for political reasons.

The analysis is then taken a step further (into whats would seem to be relatively uncharted waters) by examining various

compositions of the balance of payment which are compatible with overall equilibrium. One of these compositions will be optimal

for a particular country, depending on it stage of development, growth aspirations, and the various constraint which may apply to

movement in interest rates and exchange rates. But the optimal composition must also be consistent with the attainment of full

employment output so thats double equilibrium can be secured. Selection of an optimum consistent with overall external and

internal balance therefore adds a further dimension to the problem of securing an appropriate policy mix.

1974 SAJE v42(4) p374

Double Equilibrium Under Flexible Exchange and Interest Rates

Consider two policy variables, the exchange rate and the interest rate. The former can be changed directly by the monetary

authorities (in the absence of foreign repercussions) while the latter can be affected indirectly through the use of fiscal and

monetary policies which influence the money supply-demand equation. *(4)

In Fig. I the exchange rate, as one policy variable for a particular country, is shown on the vertical axis while the level of interest

rates, as another policy variable, is shown on the horizontal axis. The further from the origin along the vertical axis, the higher the

external value of the domestic currency. In Fig. I it is possible to draw a whole family of R (reserves) curves for the country; and

each of these curves purport to show the domestic currency equivalent of a given level of external reserves. It can be expected

thats each R line would slope upward to the right since an appreciation of the currency will require a higher interest rate in order to

maintain a constant level of external reserves.

For any given exchange rate e, reserves can be expected to rise as domestic interest rates r rise since a higher r would reflect a

deflationary policy at home, a policy which would tend to increase export relative to import and increase net capital inflow (or

reduce net capital outflow). Similarly, for any given level of r, reserves will be lower the higher the external value of the currency, it

being assumed in this paper thats the relevant price elasticities are sufficiently large to enable exchange appreciation to increase

the value of import relative to export, as expressed in domestic currency. Hence, in terms of Fig. I below, R2 >Ro>RI.

On the same diagram a family of constant income levels can also be drawn such thats Y2 > Yf > YI. Each of these iso-income curves

purport to show the various combinations of a and r which will secure a given level of money income. Y slopes down to the right

because a depreciation of the exchange rate is assumed to increase export relative to import and, through multiplier effect, to

increase domestic money income. To keep Y constant would therefore require a rise in interest rates, which is deflationary (i.e. it

reduces money income).

Consider.Yf as the level of money income necessary to attain full employment. Thus, any position above and to the right of Yf - say

A on YI- would

1974 SAJE v42(4) p375

signify unemployment (deficient demand) while any point below and to the left of Yf, say, B on Y2, would signify inflation. *(5)

There are two further assumptions which are necessary to support the analysis of this section: (i) the country can vary the

exchange rate unilaterally through the market intervention policies of the central bank (i.e. action by other countries does not affect

or neutralize such a policy); and (ii) overseas interest rates are unchanged.

FIG. 1

Several point about this analysis should be noted by way of explanation. In the first place, at any particular time and for purposes

of short run analysis, there will be some level of reserves which is most preferred by the monetary authorities. Such level will be

regarded as an approximation to overall balance of payment equilibrium. This is the optimum level of external reserves, as depicted

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