MARINA V. N. WHITMAN University of Pittsburgh Global Mone tar/sn and the Monetary Approach to the Balance of Payments A DECADE OR SO ago, when the twin concerns about the balance of pay- ments of the United States and the functioningof the internationalmone- tary system began to impingeon the consciousnessof a public theretofore indifferentto such esoterica,the opinions of those who werealready paying attention fell into a neat dichotomy. Governmentofficials and "men of affairs," on the one hand, insisted that the continued health of interna- tional trade, investment,and the world economy requiredthe maintenance of the Bretton Woods system of pegged exchange rates, under which changes in rates were made infrequentlyand as a last resort. Academic experts,on the other hand, were nearly unanimousin pressingthe advan- tages of greaterflexibility of exchangerates, with many urging that gov- ernmentsabstain altogetherfrom interventionand allow exchange rates to be determinedby the interplayof supply and demand in the market- This paper was supported partially by financial assistance from the Departments of State, Treasury,and Labor under Contract No. 1722-520176.However, the views con- tained herein are solely the author's and do not necessarilyrepresent the official position of the U.S. government. I am grateful to Edmond Alphandery, Rudiger Dornbusch, Jacob A. Frenkel, Peter B. Kenen, Norman C. Miller, and to the discussants and members of the Brookings panel for their helpful suggestions. 491 492 BrookingsPapers on EconomicActivity, 3:1975 place, just like any other price.' The specter of competitive depreciation left over from the 1930s was replaced by concern about the rigidity of mechanismsfor payments adjustmentunder the Bretton Woods system. Furthermore,the postwarwave of "elasticitypessimism" had given way to "elasticityoptimism" as new empiricalstudies, better specifiedand using more sophisticatedstatistical techniques than their predecessors,indicated that demandelasticities were indeedhigh enough to ensureexchange-mar- ket stability and thus the effectivenessof exchange-ratechanges as an instrumentof balance-of-paymentsadj-ustment. A number of assumptions,explicit or implicit, underlaythe economic analysis of paymentsadjustment in the fifties and sixties and the resulting implicationsfor balance-of-paymentspolicies. To begin with, althoughthe problem was ostensiblyto restore equilibrium,or reduce disequilibrium, in the balance of payments,Keynesian analysis, with its emphasis on the components of aggregatedemand, focused on the balance of trade (net exports of goods and services), which is one of those components. Net exportswere assumedto be a functionof aggregatedemand and of relative prices at home and abroad;in the face of downwardrigidity of wages and prices in the domesticmarket, changes in the exchangerate were the most effective means of altering those relative prices-hence the stress on the elasticitiesof home demandfor importsand of foreigndemand for exports. Although some analysts explored the effect on the capital account of changes in the relativeprofitability of investing at home and abroad, the main body of analysis assumed that, whatever effects particularpolicies mighthave on the otheraccounts in the balanceof payments,the impacton the goods and servicesaccount would be dominant.2 One implicationof this approachis that, in a world of fixed exchange rates and Keynesian downward rigidity in wages and prices, the price- 1. For two of the best-known academicbriefs for flexible rates, see Milton Friedman, "The Case for Flexible Exchange Rates," in Richard E. Caves and Harry G. Johnson, eds., Readingsin IniternationalEconomics (Irwin, 1968), pp. 413-37, and Egon Sohmen, Flexible Exchange Rates, rev. ed. (University of Chicago Press, 1969). These essays were first published in 1953 and 1961, respectively. 2. This is true in particularof the classic work by J. E. Meade, The Thleoryof Iiter- national EconomicPolicy, vol. 1: The Balance of Payments(London: Oxford University Press, 1951). Surveyingthe literaturein the late 1960s, Krueger noted that "there is no widely accepted theory incorporatingboth current and capital account items. The most thoroughly explored models in payments theory are those which consider only current account transactions and a means of payment." Anne 0. Krueger, "Balance-of-Pay- ments Theory," Journalof EconomicLiterature, vol. 7 (March 1969), p. 2. Marinav. N. Whitman 493 adjustmentmechanism will not operate, at least in the deficit country, to restorepayments equilibrium automatically and painlesslyafter a distur- bance; rather,the restorationor maintenanceof such externalequilibrium must be an explicittarget of economic policy. In the absence of exchange- rate flexibilityto alter relative prices, the most obvious mechanism for eliminatingexternal imbalance is the Keynesianone: if exportsare a func- tion of foreign income (taken to be exogenouslydetermined) and imports a function of domestic income, then a reductionof domestic income will lead to an improvementin the tradebalance and thus in the balanceof pay- ments. Such a resolutionof externalpayments problems is, however,likely to be unacceptableto governmentscommitted to full employmentas the primarydomestic economic objective.3And so a vast literature,incorpo- rating capital mobility, quickly arose, directedtoward developinga com- bination of policy instrumentsthat would enable governmentsto achieve simultaneouslythe targets of internal balance (full employment)and ex- ternalbalance (payments equilibrium).4 But the proliferationof models of internal-externalbalance reinforcedrather than weakenedthe conviction that governmentswould have greatersuccess in achievingtheir domestic economictargets if they were able eitherto use exchange-ratechanges as an additionalpolicy tool (managedflexibility) or to exerciseother policy in- strumentsfree of the balance-of-paymentsconstraint imposed by pegged exchangerates (freelyflexible rates). Furthermore,some argued,while, un- der fixed rates, changes in foreign income and expenditurewould affect aggregatedomestic income by altering the level of exports and thus the trade balance, freely flexible rates would insulate the domestic economy from foreign demand shifts and ensure that such disturbanceswould be bottledup where they originated,rather than spreadingfrom one country to anothervia the Keynesiantransmission belt. 3. Furthermore,if the domestic economy is stable in isolation (that is, the marginal propensityto save exceeds zero), the Keynesian income-adjustmentmechanism will fall short of an automatic full restoration of external equilibriumin the wake of a balance- of-paymentsdisturbance, as long as the feedback effects of the resulting disequilibrium in the money market are either disregarded or assumed to be neutralized by policy actions. 4. See Marina v. N. Whitman, Policies for Internal and External Balance, Special Papers in InternationalEconomics 9 (Princeton University, InternationalFinance Sec- tion, 1970) for a survey of that literature.One practicalapplication in the United States was "OperationTwist" of the early 1960s, which sought to attract capital inflows with high short-terminterest rates while keeping long-term rates low to stimulate domestic expansion. 494 BrookingsPapers on EconomicActivity, 3:1975 Today, most major industrializedcountries are no longer bound to pegged exchange rates. But a funny thing happened on the way to this flexible-ratenirvana. The post-BrettonWoods world of managedflexibility has produced surprisesundreamed of in the analyses of the 1950s and 1960s;moreover, a small but influentialgroup of internationaleconomists has stood traditional balance-of-paymentsanalysis on its head. I have termed this group the "global monetarists"-"monetarists" because of their belief that macroeconomicphenomena can be analyzedbest in terms of the relationshipbetween the demandfor and the supply of money, and "global" because of their conviction that, as a first approximation,the world consists, not of separablenational economies, but of a single, inte- grated, closed economy. From these two fundamentaltenets arise a number of startlingpropo- sitions. Put in their most extreme form, they include the following: A change in the exchangerate will not systematicallyalter the relativeprices of domestic and foreign goods and it will have only a transitoryeffect on the balance of payments.Any exercise of monetarypolicy to change the domesticcomponent of the monetarybase will, underfixed exchangerates, be offsetby an equal and opposite changein the foreigncomponent of that base. Thus, exchange-ratepolicy cannot permanentlyalter the balance of payments and monetarypolicy cannot lastingly affect the domestic econ- omy, but a change in the exchange rate will have a direct impact on the domesticprice level, and monetarypolicy will have a direct effect on the country'spayments position (measuredby the change in its reservesunder a fixed-rate system, by the movement in its exchange rate under freely flexiblerates, and by a combinationof the two undermanaged flexibility). Not only are exchange-ratechanges ineffective as an instrumentof balance- of-paymentspolicy for the long run, they are also unnecessary;indeed, there is no need to make external balance an explicit target of national economicpolicy, since an automaticadjustment mechanism can be counted on to restore such balance in the wake of an exogenous disturbancethat moves a nation'sbalance of paymentstemporarily away from