Balance-of-Payments Theory Anne O. Krueger Journal of Economic Literature, Vol. 7, No. 1 (Mar., 1969), 1-26. Stable URL: butp//links jstor.org/sici?sict=0022-05 15% 28196903%297%3A 1% 3C1%3ABT%3E2,0.COW3B2- Journal of Economic Literature is currently published by American Economic Association. ‘Your use of the ISTOR archive indicates your acceptance of JSTOR’s Terms and Conditions of Use, available at hhup:/www.jstororg/about/terms.hml. JSTOR’s Terms and Conditions of Use provides, in part, that unless you have obtained prior permission, you may not download an entire issue of a journal or multiple copies of articles, and you may use content in the JSTOR archive only for your personal, non-commercial use. Please contact the publisher regarding any further use of this work. Publisher contact information may be obtained at hup:/ www jstor.org/journalsaea.himl Each copy of any part of a JSTOR transmission must contain the same copyright notice that appears on the sereen or printed page of such transmission, STOR is an independent not-for-profit organization dedicated to creating and preserving a digital archive of scholarly journals, For more information regarding JSTOR, please contact support @jstor.org. hupslwww jstor.org/ ‘Tuo Jan 402:15:08 2005Balance-of-Payments Theory By Anne O, Krurcer Professor of economics, University of Minnesota, The research underlying this Paper was support ied in part by the National Science Foundation’s grant ‘number GS-1198, I am indebted to Professors John C. Hause, James M. Henderson, Harry G. Johnson, Peter B. Kenen, and Takashi Negishi for helpful comments on an easlier deaft of this paper. They bear no responsi- bility for remaining errors and omissions. TERNATIONAL. economics has two main branches: international trade and inter- national monetary economics. The field of international trade is centered upon inter- national movements of goods and factors. The field of international monetary eco- nomics is centered upon the monetary as- peets of international economic relations. Both subfields have underlying analytical structures upon which applied research is based. The field of international trade has central body of theory with which most ap- plied questions can be analyzed.* By con- trast, there is no “theory of international monetary economics.” Instead, there are several related bodies of theory, each useful in dealing with a certain range of questions. ‘The fundamental positive and normative question in the theory of international mon- etary economics is what are the implica- tions of alternative mechanisms by which countries can maintain budget constraints consistent with other economic goals. The theory relating to this question historically has been called balance-of-payments the- ory, or payments theory. A wide variety of questions falls within the domain of pay- ments theory. The number of possible pol- “nm recent years, the pure thery of international trade fas bein extensively surveyed and. synthe: Sed. The fntrerted reader can oe Bhagwat (7] {sh Caves {12}, Chipman {16}, Corden [18], Kemp 44), and Mondell (65. In addition, tere are or- callent surveys of two specialized brenches of tade theory: Lipsey’s [35] review of customs union theory and’ Bhagwat’s (9) survey of commercial poli. icy combinations that might be adopted to meet the extemal constraint is virtually without limit. As in other fields, it is the task of the theorist to abstract from all these combinations and formulate meaning- ful questions under assumptions which iso- Inte the essential features of the problem, In payments theory, this is done by isolat- ing three prototype mechanisms for meet- ing the external constraint: (1) exchange rate adjustment, (2) exchange control, and (3) adaptation of the domestic economy to the dictates of the external constraint. In principle, at least, any actual mechanism could be analyzed as @ particular combina- tion of these three. In its positive aspect, payments theory covers the analysis of equilibrium positions and comparative statics questions under each of these mechanisms, In its normative aspect, the central questions are the welfare implications of each alternative mechanism. ‘This survey focuses upon balance-of-pay- ments theory as described above. In recent years, there has emerged a closely related body of analysis pertaining to the present international monetary system and possible modifications of it. ‘This analysis draws upon balance-of-payments theory, and con- tributions to the theory have emerged from it. Tt differs from the normative aspect of payments theory, however, in that the pres- ‘ent system and alternatives to it are evalu- ated upon the assumption that certain fea- tures of the present system cannot be2 Journal of Economic Literature changed. As such, it represents a combina- tion of second-best analysis in balance-of- payments theory and applied research. Space limitations preclude coverage of that body of theory here.* Any author of a survey is confronted with difficult choices as to the scope and em- phasis of his article. Even omitting the analysis of the present system, a review of payments theory is especially hazardous be- cause the theory itself is in a state of change. Despite its essentially monetary na- ture, payments theory has lagged far be- hhind developments in monetary theory. Analyses incorporating even the rudiments of portfolio choice are just beginning to emerge. The analysis of capital flows be- tween countries as an integrated part of payments models has only begun to receive attention. Indeed, despite some suggestive efforts in this direction, there is no widely accepted theory incorporating both current and capital account items. The most thor- ‘oughly explored models in payments theory are those which consider only current ac- count transactions and a means of payment. Except where otherwise noted, this survey is limited to a review of models which ana- lyze these transactions. To date, such models constitute the core of payments theory. ‘The nature of the balance-of-payments constraint, and some of the problems in model-building inherent in balance-of-pay- ments theory are examined in Part 1. In art 2, the basic models and analyses of ex- change rates adjustments and their effects are presented. In Part 3, exchange control regimes are analyzed, Part 4 covers the analysis of policy options to maintain exter- nal and internal balance. “Two cleo of papers dang with the sb tag Felner oo Sa nd Ga at Shee mnches of theory have been developed with re- id to the phenomena of Key correncies and fiquidty. "The most siguicant contutions tothe key, literature are. those of Kenen [47] and Johnson [99]. Yeager [86] provides « isxssion of liquidity. CS 1. Some Preliminaries LI The External Constraint The first problem of balance-of-payments theory is to formulate the nature of the ex- temal constraint. Since theory allows for, and countries are, running deficits (how- ever defined) it is not sufficient to say that the external constraint means there can be no deficits. Analytically, a deficit only im- plies a net change in a country’s asset posi- tion. If the current account is the focus of analysis, then @ current account deficit im- plies that the country’s excess receipts of goods and services from abroad are offset By a reduction in assets. Such a reduction might take the form of gold shipments, net international borrowing, sale of foreign- held securities, or other financial transac- tion. It might arise because foreigners wished to lend, because domestic residents wished to deplete their assets, or because private citizens responded to prevailing prices with an excess demand for goods (with the government fixing the price of for- eign exchange and satisfying excess de- ‘mand for foreign exchange). It is obvious that none of these asset re- ductions could continue indefinitely, and that some of them would be self-correcting and others not. It is inherently unsatisfac- tory to define the external constraint in such a way that it is only operative when no one will lend to a debtor country at any rate of interest, and equally unsatisfactory to define it so that no asset transactions ‘Any alance-of payments model. which precisely formulated the external constraint ‘would, of necessity, be intertemporal. Since most models to date are stati, the issue of the nature of the constraint is avoided by focusing upon current account transactions and assuming that deficits must eventually be corrected. Hence, the question of the * Usually theorists talk in terms of the trade balance only. With the exception of debt-servicing