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International Monetary Economics

International Monetary Economics

For an integration of international monetary economics with the theory of international trade, see INTERNATIONAL TRADE, article on THEORY.

I. Balance of PaymentsRobert A. Mundell


II. Exchange RatesEgon Sohmen


III. International Monetary OrganizationEdward M. Bernstein


IV. Private International Capital MovementsPeter B. Kenen



From the earliest times trade has involved discrepancies in values exchanged, settled in credit or money, and these discrepancies constitute the origin of the concept of “balance of payments.” The generic meaning of the term today is the excess of receipts over payments of any economic entity, although the concept was initially applied to, and received its greatest elaboration in, the theory of international trade. The term itself entered the English economic literature during the mercantilist period, eventually replacing “overplus,” “remayne,” “overvalue,” “balance of accounts,” “balance of remittance,” and “grand balance of payments” (Viner 1937, pp. 1, 13, 14).

In its original usage a “balance of payments” meant an “excess of payments over receipts” and under the gold standard this excess meant a gold outflow. But the term soon acquired the neutral meaning of the “state of the balance of international accounts,” whether negative or positive. Thus, one speaks of a “balance of payments problem” whether gold is flowing in or out, and the term “balance of payments theory” is used to cover the entire subject, not just that aspect of it pertaining to an excess of payments.

The mercantilists used the adjectives “favorable” and “unfavorable” to identify, respectively, inflows and outflows of gold, but these terms were rejected during the classical reaction to mercantilism on the grounds that goods, not gold, constituted true wealth and that there was nothing intrinsically favorable about an export of goods in exchange for gold. Alternative terms like “active” and “passive” and “positive” and “negative” came into temporary favor, but they proved equally unsatisfactory; there is nothing “passive” about a gold outflow, for example. The terms in favor today are “surplus” and “deficit,” and their identification with accounting practice renders them free of any important ambiguity.

The balance sheet of international accounts, or “accounting balance of payments,” is a statement recording transactions between residents (or citizens) of a given country and the rest of the world. Transactions are either debit items, which arise from purchases, or credit items, which arise from sales. Sales of goods, of claims, and of gold and foreign exchange are credit items, and purchases of goods, of claims, and of gold and foreign exchange are debit items.

All transactions (sales or purchases) have a dual character—a sale of something implies a purchase of something else. When a good is sold for money the ownership of the good and the ownership of money change hands in opposite directions, the ratio between the two payments being the money price of the good. It follows that the value of the goods payment equals the value of the money payment, so that the sum of debit items arising from purchases is equal to the sum of credit items arising from sales.

The identity between debits and credits is preserved even when transactions include gifts, reparations payments, and other unrequited transfers. In the balance of payments accounts an unrequited transfer to foreign residents is recorded as a debit, and the means by which the transfer is financed (a sale of goods, of claims, or of gold or foreign exchange itself) is recorded as a credit. Thus, the accounting balance of payments is a tautology, and therefore it has no economic (market) significance. Its significance lies rather in its role as the basis on which accounts are organized and as the starting point from which balance of payments analysis proceeds.

The accounting balance of payments records both regular transactions and transactions made to settle any gap between regular purchases and sales (U.S. Congress 1965). The problem in constructing a useful operational definition of the balance of payments is thus the problem of separating “regular” transactions from “settling” transactions, a distinction best suited to the purpose of balance of payments analysis.

The balance of payments, if operationally defined in this way, can be regarded as an “error signal” announcing the need for a change in economic policy, a signal of actual or potential threat to the existing exchange system. Since exchange rates are typically “pegged” to some international asset at a fixed price (usually with a small margin between buying and selling rates), the authorities must maintain stocks of the international asset, and the balance of payments ought to reflect present or future threats to the size of those stocks. It is this feature of the present exchange-rate system that suggests a definition of the balance of payments as the change in international reserves, thus converting the burden of finding an operational definition of the balance of payments into the problem of determining which assets are to be counted as international reserves.

Of the assets to be counted among reserves the most important—in the sense that it is the most immediately useful—is the one to which the currency is pegged. To a country whose currency is pegged to gold the most important reserve is gold; to a country whose currency is pegged to the U.S. dollar the most important reserve is the U.S. dollar; and so on for countries whose currencies are pegged to the pound sterling, the French franc, or some minor international currency.

Most countries also hold (what they regard as) reserves in assets that are close substitutes for the asset to which they peg their currencies. The United States (as of 1966) pegs the dollar to gold and holds the bulk of its reserves in gold; the United Kingdom, however, pegs the pound sterling to the dollar yet holds the bulk of its reserves in gold. Other countries hold gold, dollars, and sterling in varying proportions that reflect not their immediate exchange stabilization needs but the asset preferences of the monetary authorities in charge of the reserves (Kenen 1963). Since gold, dollars, and sterling are all acceptable reserve assets, substitutable for one another at a fixed price (within small margins), a central bank can diversify its portfolio of assets beyond that immediately needed for working balances.

There is a third category of assets, the changes in which are (and should be) incorporated into the balance of payments. In 1946, when operations of the International Monetary Fund (IMF) began, each member country deposited with the IMF a subscription, of which 25 per cent was paid in gold and 75 per cent in its own currency; on the basis of this subscription that country can “draw” (that is, borrow) other convertible currencies, depositing in exchange additional quantities of its own currency. In other words, when a country draws from the IMF it sells its own currency to the IMF and acquires in exchange a foreign (convertible) currency that it “needs,” and when a country repays a drawing on the IMF it “repurchases” its own currency, paying for it with a convertible foreign currency. Drawings from the IMF constitute a credit item in the balance of payments, and repurchases constitute a debit item, since drawings represent a receipt of foreign exchange and repurchases a payment. To these transactions a country must add the transactions of other member countries in its currency when they draw or repurchase, and the net sum of all such transactions in the time during which the balance of payments is measured is called the change in the Net Fund Position (the Net Fund Position is the difference between the subscription or quota and IMF holdings of the domestic currency). Since changes in the Net Fund Position affect a country’ss liquidity in the sense that they alter the country’s capacity to defend its exchange system, those changes should be counted in an operational definition of the country’s balance of payments, along with changes in gold and in holdings of convertible currencies.

Before analyzing the implications of this definition in a global context, it is necessary to clear up a source of some confusion among nonspecialists about the “time dimensions” of the balance of payments.

The balance of payments—the change in reserves over time—is a flow per unit of time. But items recorded in the balance of payments accounts (like the national income accounts) represent the accumulated flow over a specified period of time. The balance of payments of a country over, say, a year is the integral of the flow during the year and thus is a stock.

Suppose reserves, R, fluctuate between time t = t0 and time t = t1 according to the equation R = R(t). Then the balance of payments equation, B(t) = dR/dt = R’(t), reflects the slope of the function R(t); conversely, R(t) reflects the integral of B(t) over past history. If the time from t0 to t1 is, say, a year, then B, the balance of payments over the year, is

where The stocks of reserves at given periods of time are therefore related to the balance of payments by equations like

Analogous concepts apply to every entry in the balance of payments accounts. Thus, if C(t) represents the net balance of payments (surplus) on capital account at time t, then Dtl, the accumulated net debtor position of a country at time t1, is

where Dto represents the initial debtor position at time t = t0.

International consistency of definitions . Analytical precision requires that balance of payments definitions be internationally consistent. To develop the analysis in a global context, then, we divide a country’s accounting balance of payments into regular and settling transactions. Thus, if Bi denotes the balance of regular transactions of country i and B’i the balance of settling transactions, we have a balance of payments identity, true for each of n countries in the world:

Since represents the net exports of the settling items (balance of payments deficit), < 0 implies increasing international reserves. Specifically,+ dRi/dt s 0, where K* is the level of reserves in country i and

For all countries,

(where R represents world reserves), and unless both sides of the identity equal zero it appears that the global balance of regular transactions, can be other than zero!

The apparent paradox is, of course, easily dismissed. The balance of the payments of the world as a whole is identically zero; this identity has become known as Cournot’s law because of the extensive use Cournot made of the proposition. Cournot’s law, however, does not imply that the balance of payments of the world excluding the transactions of the monetary authorities is necessarily zero. The inequality dR/dt > 0 simply means that the monetary authorities are acquiring, collectively, reserve assets from the private sector, whereas dR/dt > 0 means they are losing reserve assets to the private sector.

Assume, for example, that central banks peg their currencies to gold and hold no other reserve assets, as is the case under (one version of) the gold standard, and start with the accounting identity (1) above. The settling transactions, , are central bank net trade in gold (net purchases if positive, net sales if negative) with private markets. If we now separate the net balance of trade in gold from Bi, the balance of regular transactions, we have the relation

and equation ( 1 ) becomes

where denotes net exports of gold from the private sector and includes everything else in Bi. Then, since we can rewrite (5) as

For all countries,

where the summations extend over all countries. But represents the net exports of (nongold) commodities in the world as a whole and must be zero, and so of course

The net private exports of gold in the world as a whole equals the sum of the gold purchases of the monetary authorities (Høst-Madsen 1962).

When gold production exceeds the disappearance of gold for use as hoards, in industry, and in the arts, world monetary reserves increase, and when gold production falls short of total private uses, world monetary reserves decrease. In other words, there is an excess of surpluses over deficits, or an excess of deficits over surpluses, in the world as a whole, depending on whether gold production exceeds, or falls short of, new private purchases of gold.

A similar analysis can be developed for the key currency system. Assume that countries hold re-serves not only in gold but also in the national currency of a particular country—for example, the United States—designated country 1, and proceed as before by dividing the balance of payments accounts of the typical country into regular and settling transactions.

A distinction must now be made between the reserve center (country 1) and the rest of the world. For the other countries, 2, ..., n, the settling transactions are composed of sales of both gold and dollars, whereas the settling transactions of the reserve center will be gold sales alone or gold sales plus an increase in the dollar assets held by foreign countries, depending on whether a net or gross concept of reserves for the reserve center is used.

Denote the gold assets of country i by G, and its dollar assets by C1i. Then the balance of payments of the n countries can be defined as follows, using a net concept of reserves for the reserve center.

where Ll , the liabilities of the reserve center to the rest of the world, is identically equal to since the “dollar liabilities” of the United States (country 1) are the same as the dollar assets of the rest of the world.

Under this (net) concept of the first country’s balance of payments, the excess of surpluses over deficits in the world as a whole is the same as under the gold standard, since

But had we used a gross concept of the reserves of the key currency center, the balance of payments of country 1 would instead have simply been written B1dG1/dt with dL1/dt incorporated (with a positive sign) in B^ as a capital movement. In that case the excess of surpluses over deficits in the world as a whole would have been

that is, the increase in world monetary gold holdings plus the increase in monetary liabilities of the reserve center.

What consideration should lead us to prefer the use of a net to a gross concept of reserves, or vice versa? This is a controversial question. If one country were the sole creator of international monetary reserves (assuming monetary gold is constant), and if its currency were universally acceptable for the payment of international debts, it would be fulfilling the role, for all practical purposes, of an “international bank,” and to regard its balance of payments as zero would be consistent with the concept of the balance of payments as an error signal.

At the present time there is no international legal tender and therefore no legal justification for treating one country’s deficit as being any different from any other country’s deficit, even though in practice the U.S. dollar and the British pound closely approximate true international reserve media. In a formal sense, then, it may be better to adopt the net concept of reserves of the key currency country and thus treat an increase in key currency liabilities to foreign monetary authorities as a deficit of the key country. Adopting that convention means modifying the concept of the balance of payments as an error signal and thus qualifying the extent to which a deficit in the balance of payments requires a change in policy or is a threat to the existing exchange system. The net definition preserves symmetry, but at the cost of the usefulness of the balance of payments as an error signal. Instead of regarding a zero balance as a target of policy, the reserve center must try to generate a deficit acceptable both to itself and to the rest of the world, so as to permit an appropriate growth of foreign holdings of its currency and reserves.

Let us now complete the system by allowing for an arbitrary number of reserve currencies (as under a multiple-currency system) and also IMF transactions. Let C1i be the holdings of the currency of country i by the monetary authorities in country j; Li, the outstanding short-term liabilities of country i to monetary authorities in the rest of the world; Gi, the monetary gold holdings of country i; and Fi, the Net Fund Position of country i defined as country i’s quota less IMF holdings of country i’s currency.

Then the balance of payments equation can be comprehensively represented by the following equations:

The excess of surpluses over deficits still equals the increase in monetary gold reserves in this system, since


The latter identity follows from the definition of a change in the Net Fund Position of a country, every increase in IMF holdings of one currency implying a decrease in its holdings of another currency.

Approaches to analysis . The balance of payments is related to other aspects of the economic system because it describes the transactions of all the residents of the country with the rest of the world. These connections have given rise to three approaches to balance of payments analysis that can be compared most simply by assuming at first that there are no capital movements (this means that the balance of trade and the balance of payments are the same).

The “elasticity approach” works directly (Robinson 1937) on the balance of payments equation,

where X is the value of exports and M is the value of imports. By differentiating (13) with respect to an exogenous parameter (say, the exchange rate), a criterion can be established which shows the effects of a change in the parameter on the balance of trade, assuming that export and import prices adjust to equate the demand and supply of exports and imports. In the literature the usual method of analysis has been to assume that exports depend on the price of exports and imports on the price of imports (an inadequate vestige of partial equilibrium analysis) and then to translate these relations into elasticities.

A second method, the “absorption approach,” makes use of the fact that, from national income accounting,

where Y is income and E is domestic expenditure (Meade 1951), or “absorption” (Alexander 1952). This equation directs attention to the fact that the balance of trade can be improved by a policy change, such as a devaluation, only if income is increased by more than expenditure.

A third approach, which may be called the “monetary approach,” stresses the fact that the balance of payments implies a change in the foreign reserves of the monetary authorities (the central bank) and that the central bank’s total assets, which can be divided into “foreign assets” (reserves) and other assets (for example, government bonds), must equal its monetary liabilities. Thus, the increase in reserves (R), which equals (in the case of no capital movements) the balance of trade, must be equal to the difference between central bank credit creation and new central bank money. When the banking system is taken as a whole, and interbank transactions are canceled, this means that

where H is hoarding (additional domestic money holdings) by the public and C is credit creation by the banking system as a whole. This approach, which is valid even when there are capital movements, directs attention to the fact that the balance of payments cannot be improved unless credit creation is less than hoarding (Johnson 1958).

It is not meaningful to question the validity of the three approaches. The terms can be defined so that they are all correct and assert identical propositions, even if capital movements are included. Suppose, for example, that all variables are defined as ex post, realized entities. Then from national income accounting we have Y = E + B; from banking accounts we have H ≡ C + R; and from the balance of payments accounts we have R = B – T, where T represents net capital exports. It follows, then, that R ≡ B – T ≡ Y – E– T ≡ H – C.

The identity of the three approaches, when they are properly interpreted, does not mean that each approach is not in itself useful. The fact that an improvement in the balance of payments must imply an increase in Y – E – T, an increase in R, and an increase in H – C provides additional checks on the logic of balance of payment policies.

Anatomy of disequilibrium Recognition of the alternative categories that lead to the three approaches to the balance of payments serves as a useful introduction to policies of adjustment of the balance of payments and to the extent to which adjustment is discretionary or automatic. As we have seen, the three approaches are the same if the categories are denned ex post— that is, as realized variables. However, differences in the approaches become apparent when we conceive of the categories as ex ante— that is, as representative of intentions.

Let us define three concepts where the variables are now conceived of in the ex ante sense :

L ≡ Y – E – T,

which we may identify with the excess flow demand for money in the economy;

F ≡ T – B,

which we may identify with the excess flow demand for foreign exchange; and

X = E + B – Y,

which is the excess demand for domestic goods, and let us assume that ex post and ex ante balance of payments are identical. These three identities, which are interdependent since the arguments on the right sum to zero, can be used for anatomizing disequilibrium situations and thus for providing a guide to economic policy.

To do so we must introduce explicit functional relations expressing how X, F, and L are “determined.” We may, for example, express these categories as functions of, say, the price level of domestic goods (P), the exchange rate (π), and the money supply (M). Then we would have three equations in three unknowns:

But these equations would not be sufficient to give us a determinate system, since the equations are not independent; that is, if excess flow demand for money is zero and excess flow demand for foreign exchange is zero, then excess demand for domestic goods must be zero. We have one degree of freedom and can thus fix arbitrarily any one of M, π or P. If we fix M we have a flexible-exchange, flexibleprice system with a constant money supply; if we fix P we have a flexible-exchange system with domestic price level stabilization and a constant money supply; and if we fix π we have a fixed-exchange system with a variable money supply.

As an example we may suppose that the exchange rate, π is fixed. Then graphs of the equations, drawn under plausible assumptions, intersect at a common point (see Figure 1).

Each of the numbered sectors in Figure 1 corresponds to a particular set of equilibrium conditions. Thus, in sector 1, X > 0, F > 0, and L > 0; in sector 2, X > 0, F > 0, and L > 0; and so on for each of the sectors.

From this information and from knowledge of the position of disequilibrium, it is usually possible to determine the directions in which the variables (M and P in this case) must move in order to restore equilibrium. In other words, by investigating the naturethe anatomyof the disequilibrium we can find the location of the equilibrium point.

This analytical approach has many applications. In the context of the preceding discussion we may hold another variable—say, M—constant and measure on the axes fluctuations in P and TT. Or we may analyze quite different foreign trade systems using interest rates, real income, or money income as variables. But the principles of analysis remain the same, and the subject is ideally suited to dynamic analysis, since any disequilibrium situation implies monetary, price level, exchange rate, or income adjustments tending to restore equilibrium.

The exchange market. Balance of payments adjustment should be explained in the context of present institutional arrangements. Exchange rates are pegged through central bank (or treasury) intervention in the exchange market at “support points.” When the domestic demand for foreign exchange sufficiently exceeds the supply, the price rises until it reaches the upper support point at which the central bank sells reserves from its own stock in exchange for its own currency; similarly, when the supply of foreign exchange sufficiently exceeds demand the price falls until it reaches the lower support point at which the central bank intervenes by purchasing foreign exchange to prevent further appreciation of the domestic currency. (Intervention may also take place between the support points.)

The mechanism is illustrated in Figure 2, in which the demand and supply of dollars in exchange for German marks is plotted. To simplify, dollars are taken to represent all foreign exchange, and the market is taken to encompass all transactions, including those in connected forward markets (Machlup 1939-1940).

The DD curve plots the demand curve for dollars on the part of German residents as a function of the price of dollars, on the assumption that the mark prices of German goods and the dollar prices of foreign goods are constant. The area under the curve at any given price represents the sum of marks that German residents will pay for the quantity of dollars represented on the abscissa; in this sense the demand for dollars by German residents simultaneously represents the supply of marks offered by German residents in exchange for dollars.

The curve SS represents the supply of dollars offered by the rest of the world in exchange for

marks at given exchange rates, again on the assumption that the mark prices of German goods and the dollar prices of goods in the rest of the world are constant. The curve SS simultaneously represents the supply of dollars and the demand for marks, the latter being indicated by the area described at any price–quantity relationship on the supply schedule.

The free market price would be P0, determined by the intersection of SS and DD, at which the quantity Q0 of dollars would be exchanged for P0,Q0 of marks. It is assumed that the initial price P0 is within the support points, which are taken to be of one per cent below and above the “par value,” which is DM 4.00 per dollar in accordance with the IMF “par value” prevailing in 1966.

Suppose now that in the rest of the world there is a spontaneous increase in the demand for German goods. This implies an increase in the supply of dollars, at any given price, so that SS shifts to the right—to, say, S’s’. Such a shift in a free market would mean that the price of the dollar would fall below the (lower dollar and upper mark) support point of DM 3.97 per dollar. But the free market adjustment would be prevented by the German central bank which would step into the market at the rate DM 3.97 per dollar (or perhaps even sooner) to prevent the appreciation of the mark beyond the set limits.

Specifically, at the rate DM 3.97 = $1 there will be an excess supply of dollars equal to the horizontal distance on the graph between DD and S’s’ at that rate, an amount equal to Q1Q2 dollars; this means an excess demand for marks equal to the shaded area on the graph. To stabilize the rate at DM 3.97 the German central bank will buy up Q1Q2 of dollars and supply to the market the area ABQ2Q1 of marks; the former (distance) represents Germany’s balance of payments surplus expressed in dollars and the latter (area) Germany’s surplus measured in marks.

The process of stabilization just considered automatically produces equilibrating forces tending to correct the disequilibrium. The German central bank is taking up the excess supply of dollars on the mar ket, and (barring the creation of additional dollars in the rest of the world) this must eventually reduce spending in the part of the world using dollars, thereby shifting the supply curve S’s’ to the left as prices in the rest of the world fall (or interest rates rise). Similarly, the additional supplies of marks created by the German central bank must eventually shift DD to the right as German prices (the prices of German goods) rise (or interest rates fall). After price levels or interest rates have adjusted, a new equilibrium would be established at the dollar support point indicated by the intersection of D’D’ andS“S”.

This automatic adjustment process may, however, be resisted by the monetary authorities. The practice of “sterilizing” the monetary effects of foreign exchange (or gold) purchases and sales has become widespread as countries look for means of adjusting the balance of payments other than that implicit in price level (or interest rate) adjustments. Central banks may prefer to delay adjustment for a time by allowing reserves to be built up or depleted.

Adjustment and the “world price level.” The pre-ceding analysis is applicable to a single small economy facing the rest of the world; small countries have to correct balance of payments disequilibria by their own individual actions. But in the context of the world economy, balance in n – 1 countries implies balance in the nth country, so there is an extra degree of freedom. The problem of what country, if any, is to be spared the adoption of corrective policies, how adjustment should be divided between countries, and to what use the extra degree of freedom might be put can be termed the “redundancy problem” or the “degree of freedom problem,” but equally correctly it might be called the “international standard problem,” for its solution involves the establishment of an international standard and consideration of the question of the world price level.

One use to which the extra degree of freedom might be put is for the main key currency country to stabilize its domestic price level, ignoring the balance of payments constraint, and to leave balance of payments adjustment to the other countries; the larger the key currency country the more closely this policy approaches a policy of world price stability. An alternative is to make price level adjustments inversely proportional to the size of the country. As we shall see, this would in a rough way correspond to the analogue of a common currency and would under certain assumptions exactly correspond to the policies necessary to achieve world price stability.

The problem may be seen clearly in the context of either a flexible-exchange rate arrangement (Sohmen 1961) or a pure gold standard system; as a by-product the stability of these systems will also be investigated. Consider first the case in which the authorities express their exchange rates in terms of an abstract unit of account, such as the “1944 gold dollar” (which is the IMF unit of account), and adjust their exchange rates when their balances are in disequilibrium according to the equations

where Bi is the balance of payments (surplus) of the zth country, πi the price of its currency expressed in terms of the IMF unit of account, and on a constant determined by policy. We know that


From this, by integration over time,

The “absolute” level of exchange rates, weighted by the constants l/αi is fixed. What does this mean?

The balance of payments equations are homogeneous of degree zero (that is, increasing all ex-change rates by a factor k will leave each country’s balance of payments unchanged), and this seems to imply that absolute prices are indeterminate. From a static viewpoint this is correct, since the doubling of exchange rates that are expressed in abstract units of account is a mere accounting change that cannot affect real balances of payments. But the dynamic system explicitly rules out such a doubling; if some exchange rates are rising others must be falling, and this fact preserves the level of absolute prices for the countries involved. If, for example, there are two countries, the dynamic adjustment is restrained along the line

(l/α1 + (l/α2) P2 = a constant

by Cournot’s law that the sum of all balances of payments is zero.

The meaning of the restraint is that by the appropriate choice of speeds of adjustment for the various countries (that is, a choice of the α1) weights can be given to the exchange rates of the various countries to preserve a specified absolute exchange rate “level.” If, for example, world monetary authorities stabilized a weighted average of exchange rates, where the weights reflect the size of countries, the α would be large for small coun-tries and small for large countries.

The adjustment mechanism under the gold standard, as under the preceding synthetic exchange rate system, was more or less automatic in the sense that central banks were expected to react to gold outflows and inflows by more restrictive and less restrictive monetary policies, respectively, which would in turn react upon price and wage levels, lowering them in the deficit countries and raising them in the surplus countries. These price changes, in turn, were expected to shift expenditure from surplus to deficit countries, thus reducing and eventually eliminating the disequilibrium. Recent studies suggest that the element of discretion under the gold standard was greater than has hitherto been supposed, but the theory is correct in its broad outline even if its practice has been somewhat oversimplified.

To understand the formal mechanism of adjustment under the gold standard system it is helpful to translate a simplified model of that system into mathematical terms. Let Bi represent the balance of payments surplus or gold outflow of the ith country expressed in terms of gold, and let Pi rep resent the gold price of the goods produced in country i. The balances of payments can then be written as functions of the prices of home-produced goods in each country in the system, so that

where Gf is the gold stock of the ith country and dGi/dt its change over time. The authorities of each country were expected to keep that country’s gold stock at a given proportion of its money supply, so that

where r{ is the ratio of gold reserves to the money stock (Mi) in the zth country. This relationship can be adjusted to take account of gold coins in circulation or lags in the response of banks to excess reserves, but this is an unnecessary complication for our present purposes.

There was a further relationship connecting the money stock to the price level in each country according to the quantity theory of money, which, in one of its versions, can be written

where Oi is total production in the ith country and Vi is the income velocity of money. To simplify drastically we shall assume that both Oi and Vi are constant. [See MONEY, article on QUANTITY THEORY.]

Equations (21) and (22) complete the system, for by differentiating them we get


Substituting from (25) into (20) then gives


The presence of the national income term (PiOi) in equation (27) indicates that the larger is the size of the country the smaller will be the percentage change over time in the domestic price level in relation to any given balance of payments surplus, and this leads to the theorem that given Vi and ri, the time rate of adjustment of the price levels to disequilibria in the balance of payments will be inversely proportional to the size of the country (Mundell 1965, pp. 16-19). More generally, if we use βi to represent the balance of payments of the zth country expressed as a proportion of its national income we have

which shows that the percentage adjustment in the price level is directly proportional to the payments disequilibrium expressed as a fraction of income.

This formula relates the adjustment of the price level to balance of payments disequilibria, but it would not be correct to identify this with the “speed of correction” of the balance of payments unless the percentage adjustment in prices and in the balance of payments were identical. The speed of correction is identified with the term Ki in the equation

where K{ is, for simplicity, taken to be a constant. What will determine the magnitude of K{?

To investigate the meaning of Ki assume, for the moment, that every other price level except that of the adjustment country is constant. Then

where bii expresses the change in the zth country’s balance of payments when the price level rises. Substituting into (30) for dPi/dt from (26) then gives

It follows then from (29) that

The expression bii/Oi is a dimensionless ratio, since bii is an elasticity factor weighted by a quantity; specifically, bii is proportional to the “elasticity of the balance of payments.” Hence, the speed of correction can be written

where d is the elasticity factor and cri is the share of exports in domestic output. (Note that Ki is a pure number per unit of time identical in dimension to income velocity V-,. .)

Until now we have assumed that only one country’s price level is adjusting. If we relax this assumption the formula for the speed of correction must be modified. Specifically, instead of (30) we must write

to allow for simultaneous price adjustments in all countries. Substituting for dPj/dt from equation (26) as before, we get

and we cannot find a unique rate of correction without considering the entire system of equations.

The world price level under the gold standard system is determined by the monetary gold stock. Summing over the equations (see (21) and (22)),

we get

But what determines changes in the monetary gold stock?

Central bank acquisition of gold is a residual demand: official reserves rise or fall according to whether there is an excess private supply or demand. Excess private demand is the difference between consumption-plus-hoarding and production-plus-dishoarding and will depend upon the general price and cost levels in each country. (Excess demand tends to rise with national price levels both because demand increases, via substitution effects, and because supply decreases as costs rise and profits in gold mining fall.) It follows, then, that the system of differential equations ex-pressing the gold standard mechanism can be written as follows:

where B0 is the excess flow demand for gold outside central banks. Since it follows that

which indicates that changes in the world price level are determined by private demand and supply conditions for gold.

To investigate the stability of the gold standard system it is convenient to make explicit the forms of the functional relationships

by expanding them in a Taylor series about their equilibrium values and omitting all but the linear terms. We then have the system

where αi = Vi/riOi and Poj is the equilibrium price level in country j. The system (41) has a solution of the form

where the λ’s are the roots of the nth-order characteristic equation

For stability, Pi must approach Poi as t approaches ∞ which means that every λj must have negative real parts.

For arbitrary values of the bij , of course, nothing can be asserted about stability. But under the assumption that an increase in the price level worsens that country’s balance of payments and improves the balance of payments of every other country, progress can be made. In that case it is known that the system is stable if and only if the principal minors of the matrix of the system oscillate in sign as follows:


For these conditions (the so-called “Hicks conditions”) to be satisfied the column or row sums must be negative (or at least not positive). Now let us write for the column sums and for the row sums and inquire into the meaning of bi0 and b0j.

We know that ∑BidG/dt, the increase in the monetary gold stock, and this provides the clue to the interpretation of the row and column sums. From the preceding section we know that the increase in the monetary gold stock is the difference between current private supply of and demand for gold and that the excess demand for gold depends on the prices. Assuming this relationship to be linear in the prices, the system can be written as follows:

The column sums of the coefficients on the right are zero, so that On the assumption that each boj > 0 (that is, that an increase in the price level in the jth country causes an excess demand for gold) every column sum in the original matrix is negative, and from stability proofs in other branches of theory we can conclude that the gold standard system is stable.

Robert A. Mundell


Alexander, Sidney S. 1952 Effects of a Devaluation on a Trade Balance. International Monetary Fund,. Staff Papers 2:263-278.

H0st-Madsen, POUL 1962 Asymmetries Between Balance of Payments Surpluses and Deficits. International Monetary Fund, Staff Papers 9:182-199.

Johnson, Harry G. 1958 International Trade and Economic Growth: Studies in Pure Theory. Cambridge, Mass.: Harvard Univ. Press; London: Allen Unwin. → See especially Chapter 5, “Towards a General Theory of the Balance of Payments.”

Kenen, Peter B. 1963 Reserve-asset Preferences of Central Banks and Stability of the Gold Exchange Standard. Princeton Studies in International Finance, No. 10. Princeton Univ., Department of Economics, International Finance Section.

Machlup, Fritz (1939-1940) 1963 The Theory of Foreign Exchanges. Pages 104-158 in American Economic Association, Readings in the Theory of International Trade. Homewood, III.: Irwin.

Meade, James E. (1951) 1952 The Balance of Payments. Rev. ed. Oxford Univ. Press.

Mundell, R,obert A. 1965 The International Monetary System: Conflict and Reform. Montreal: Private Planning Association of Canada, Canadian Trade Committee.

Robinson, Joan (1937) 1963 The Foreign Exchanges. Pages 83-103 in American Economic Association, Readings in the Theory of International Trade. Homewood, III.: Irwin.

Sohmen, Egon 1961 Flexible Exchange Rates: Theory and Controversy. Univ. of Chicago Press.

U.S. CONGRESS, JOINT ECONOMIC COMMITTEE 1965 Balance of Payments Statistics of the United States: Report of the Subcommittee on Economic Statistics. Washington: Government Printing Office.

Viner, Jacob 1937 Studies in the Theory of International Trade. New York: Harper.


The national currencies of different countries are bought and sold against each other on the foreign-exchange markets. Exchange rates are the prices of one currency in terms of another (e.g., the price of one pound sterling on a particular day may be $2.801). There are a variety of forms in which a currency may be offered on the foreign-exchange markets. Unless otherwise specified, the term “exchange rate” (to be quite exact, the spot rate of exchange) applies to the rate for sight deposits. Bank notes and coins sell at different rates that reflect their higher handling costs. The forward-exchange market is yet another type of market for national currencies. On this market, claims to future delivery of a currency are transacted.

Although foreign-exchange markets in different countries may be widely separated geographically, arbitrage (simultaneous purchase and sale of a currency at different locations) guarantees that the exchange rates between any pair of currencies in different markets hardly differ from each other see Speculation, hedging, and arbitrage]. Only the existence of exchange controls (a term used for all forms of government licensing of foreign-exchange transactions; see section 4 below) may prevent arbitrage from performing this function.

A currency is said to have appreciated if its price in terms of other currencies has risen. Depreciation indicates a movement in the opposite direction. The term “devaluation” is generally reserved for the downward adjustment of a currency under the system of adjustably-pegged exchange rates (see section 3).

1. Demand and supply of foreign exchange

Most transactions in foreign exchange arise in connection with international trade. Unilateral transfers (private gifts, governmental grants-inaid, or reparations) constitute another component of the demand and supply of foreign exchange. Capital movements (acquisitions of assets in one country by the residents of another) are a third source. Finally, there are transactions of the monetary authorities for the purpose of limiting the movement of exchange rates.

A widely held view is that the dominant factors determining the equilibrium values of exchange rates at any time are the price levels in different countries. An acceptable version of thispurchasing power parity theory (an expression coined by Gustav Cassel) of the foreign exchanges cannot claim that exchange rates always move exactly in proportion to the relative movements of certain aggregate price indices. No single price index for an economy can serve as an exact indicator of the relative “purchasing power” of a currency, and not all commodities and services whose prices enter into any one of the customary price indices can be traded internationally. In addition, sustained changes in capital movements may clearly affect the long-run equilibrium values of exchange rates even without changes of commodity prices. The relative competitiveness of the industries of different countries on the world markets, indicated primarily by the prices they charge, is nevertheless a factor of crucial importance for the rating of national currencies on the exchange markets. For given levels of capital transfers and the prices of all other commodities, a rise in the price of any commodity that can be traded internationally will tend to cause depreciation of the currency in question. The legitimacy of a purchasing power parity theory in this limited sense cannot be denied.

The issue of whether or not changes in price levels should be regarded as the principal cause of disturbances in the foreign-exchange markets has frequently been the source of controversy. The first extensively documented debate of this kind was the “bullion controversy” during the time of the Napoleonic wars. After the suspension of specie payments by the Bank of England in 1797, the pound sterling had on several occasions depreciated noticeably on the foreign-exchange markets. The “bullionists,” headed by David Ricardo, attributed the decline to the fact that, in their view, prices in Great Britain were too high (Ricardo 1810). The “anti-bullionists,” on the other hand, pointed to the heavy load of financial transfers to Britain’s allies on the Continent as the basic cause. The dispute can be simply resolved by saying that the pound had depreciated because, with the increased level of capital movements to other countries, prices of actual and potential export goods were too high to make possible a sufficient export surplus at the previous exchange rate. The same issues have been debated, and opinions have divided on exactly the same lines, in connection with the balance of payments difficulties of the United States in the late 1950s and the 1960s.

During the German hyperinflation in the early 1920s, an extreme version of the anti-bullionist argument was used to deny the claim that domestic inflation was the cause of the rapid depreciation of the reichsmark. According to this view, currency depreciation in the wake of capital flight was, on the contrary, the original source of domestic inflation. As prices rose, expansion of the money supply by the Reichsbank only served to satisfy the growing need for cash to finance the rapidly increasing money value of transactions. The proponents of this school of thought overlooked the fact that capital flight would not have occurred in the first place if domestic policy had been less conducive to inflation.

Equilibrium exchange rates may be affected by changes in consumer preferences, techniques of production, the level of business activity, or by governmental policies that lead to changes in world demand for the exports of different countries. Central banks can affect the levels of exchange rates by changing interest rates and thereby influencing international capital flows or by direct purchases and sales on the foreign-exchange markets. Finally, governments may exercise an influence on the private demand for foreign exchange, and hence on equilibrium exchange rates, by the imposition of exchange controls (see section 4).

Although attention usually centers on the effects of all these forces on thespot markets of foreign exchange, it should be recognized that they exercise their influence onforward markets as well. An importer who has to make a payment in foreign currency three months hence, for example, may relieve himself of the speculative risk involved by purchasing the required amount of this currency forward. Failure to do so makes him a foreign-exchange speculator.

Coverage on the forward-exchange market is not, on the other hand, a form of insurance, in which other market participants would necessarily have to assume, against payment of an insurance premium, the exchange risk of which commercial traders relieve themselves. In the absence of official intervention the bulk of forward exchange demanded by importers in a given country will, as a rule, be supplied by exporters who face an exchange risk of the opposite type. Even if disequilibrium between commercial offers and demands for forward exchange develops, there is no need for speculators to enter. If the pressure of excess demand or supply of forward exchange were to lead to an appreciable change of the forward rate in question, arbitrage would develop between this and other forward markets as well as between it and the spot market (“covered interest arbitrage”). To arrive at an equilibrium, these capital movements have to establish a difference between spot and forward rates that is approximately equal to the difference between the earnings from investments in fixed-interest securities of the relevant maturity in the two countries involved (for details, see Sohmen 1961, chapter 4).

2. Effects of exchange-rate changes

Let us assume that the rating of a currency on the exchange markets falls as a result of autonomous capital movements or of deliberate government action. The effects of depreciation on the physical quantities of exports and imports are practically certain. If the foreign prices of a country’s exports were to remain unchanged (a condition that would be approximately satisfied if the country produced only a negligible part of the total world supply of its export commodities), their prices per unit in terms of domestic currency will rise in the exact proportion of depreciation. If, at the opposite extreme, domestic prices were to remain constant, the unit prices of exports in terms offoreign currencies must fall in proportion to the depreciation. In the real world, depreciation will usually lead to an intermediate result. The implied movement of domestic and foreign prices of exports will tend to encourage increased production as well as an increase in the quantities demanded abroad. The effect of depreciation on the physical quantities of imports will be the exact opposite: they will tend to fall.

With both unit values and quantities of exports rising, depreciation must necessarily increase the value of exports in terms of domestic currency. This is not, however, assured for the value of exports in terms of foreign currencies. The percentage fall in their foreign prices may, on the average, be greater than the percentage increase of the quantities sold. The value of exports in terms of foreign currencies would then be lower after depreciation. By similar reasoning it can be seen that depreciation always lowers the value of a country’s imports in terms of foreign currencies, whereas the effect on their value in domestic currency is uncertain. The combined effect of depreciation on thebalance of trade (the value of exports minus the value of imports) depends on the elasticities of supply and demand of all exportable and importable goods and services as well as on the value of the trade balance before depreciation (Robinson 1937; Vanek 1962, chapter 5).

In a simple theoretical model with only two commodities, infinite supply elasticities, and an initial trade balance of zero, the criterion for an improvement of the balance of trade after depreciation reduces to the condition that the sum of the demand elasticities of imports and exports must exceed unity.

There have been frequent attempts to estimate the values of the demand elasticities of internationally traded commodities in order to find out whether or not these elasticities are high enough to assure with reasonable certainty that currency depreciation will lead to an improvement of a country’s balance of trade (see the survey by Cheng 1959). The difficulties associated with the attempt to estimate demand elasticities are so formidable, however, that the significance of these findings is rather doubtful (Orcutt 1950).

A corollary of the proposition that currency depreciation may fail to improve the foreign balance if demand elasticities are too low is that the foreign-exchange market is unstable under these conditions. It cannot be concluded, however, that a system of flexible exchange rates would then be unable to function. In the real world, perverse reactions will, if they occur at all, be confined to a limited range of exchange-rate values. Freely fluctuating rates must always come to rest in a region where the condition that depreciation improves the trade balance is fulfilled (cf. Sohmen 1961, chapter 1).

It should be emphasized that one can meaningfully discuss the role of price elasticities of inter-nationally traded commodities only if it is assumed that the monetary authorities succeed in keeping the general price level reasonably stable. The possibility that the values of demand elasticities may be too low for stability is not to be confused with the possibility that general inflation may thwart the expected effect of depreciation.

Some authors have questioned the relevance of the “elasticity approach” to balance of payments problems, on the grounds that measures affecting the level at which resources are being used by the domestic economy (the level of “absorption”), for example, fiscal and monetary policies, will always be vastly more important for a country’s balance of payments than the effects of changes in relative prices brought about by exchange-rate movements. From the simple identity, X – M ≡ Y – A, which states that the excess of exports (X) over imports (M) will always have to equal the excess of a country’s real output (Y) over its real expenditure or absorption (A), it is easily deduced that any increase in the value of the left-hand side implies a corresponding increase in the expression on the right. Especially under conditions of full employment, depreciation will, in the view of protagonists of the “absorption approach,” be totally ineffective unless it is accompanied by policies designed to reduce real domestic expenditure (Alexander 1952). This school tends to neglect the possibility of improvements in the efficiency of resource allocation that may occur as a result of the restoration of equilibrium in the foreign-exchange markets and the subsequent removal of artificial barriers to trade and capital movements. Such improvements may raise the level of output sufficiently to allow for an increase of exports relative to imports, even with constant domestic expenditure (Machlup 1955).

The discussion of elasticities in international trade concentrates on the reactions to adjustments of exchange rates to a new (and thereafter constant) level. The role of expectations concerning future exchange-rate movements will also be significant, as long as governments are not committed to keeping exchange rates immutably stable for all eternity. Expectations are particularly important in the case of capital movements. Any change in exchange rates has a decisive influence on the profit-ability of existing fixed-interest investments. The willingness to undertake capital transfers will there-fore depend crucially on expected future changes of exchange rates[seeSpeculation, hedging, and arbitrage].

3. Alternative monetary systems

Common currency

A common currency provides an extreme example of rigidly and unalterably fixed exchange rates between the monetary units of the member regions. The existence of a common monetary unit enforces identical monetary policies in every region as a consequence of the fact that exchange rates between regional currency units can never deviate from their ratios of 1:1.

Pegged exchange rates and gold standards

A system of pegged exchange rates between different national currencies can be brought about by official interventions on the foreign-exchange markets. As a rule, currencies are not held at one single rate that would be immutable over time. Instead, a parity is established between any pair of currencies around which exchange rates can move within prescribed limits. Historically, the classic example of such a system was thegold standard. Currency parities were automatically established by central banks fulfilling an obligation to buy and sell unlimited quantities of gold at a fixed price in terms of their national currencies. Gold arbitrage limited the movements of exchange rates within the “gold points,” determined by the costs of shipping gold from one country to another. As soon as an exchange rate tended to move beyond these limits, it became profitable to buy gold from one central bank and sell it to another. Since a sustained gold outflow threatened to exhaust their reserves, central banks losing gold were forced to raise interest rates. A sufficient rise of interest rates relative to those abroad had the usual consequence of inducing an inflow of capital, reversing a tendency toward depreciation and bringing the gold outflow to a halt. Over the longer run, monetary contraction also tends to restrain domestic demand, to lower domestic prices relative to those abroad, and thus to favor exports and reduce imports.

During the era of the historic gold standard, many central banks began to feel that the holding of gold was a rather unrewarding practice. By holding deposits with foreign banks in countries practicing the gold standard or by holding short-term government obligations of such countries, they could earn interest on their assets while feeling certain that they nevertheless had immediate access to gold whenever required. This system, known as thegold-exchange standard, became particularly widespread during the 1920s. Its viability was always threatened, however, by the possibility that too many holders of monetary assets denominated in gold-standard currencies might simultaneously present their claims for conversion into gold, for the central banks of the gold-standard countries would always hold gold amounting to only a fraction of the total claims against them.

No country is now practicing the gold standard, properly speaking, in the sense that its currency would be redeemable into gold for the general public. The United States has, however, entered an obligation to honor all demands of the monetary authorities of other countries for conversion of their dollar claims into gold for “legitimate monetary purposes.” The exact meaning of this qualification has never been specified.

The “adjustable peg” and the IMF

A basic feature of the systems described so far was the constancy of currency parities. The present system, as incorporated in the Articles of Agreement (1944) of the International Monetary Fund (IMF), differs from them in that parities (around which exchange rates are allowed to fluctuate up to 1 per cent of parity on either side ) may be altered in case of a “fundamental disequilibrium” (art. iv, 5). As originally envisaged, parity adjustments under this arrangement (commonly described as the system of the “adjustable peg”) were to be carried out after consultation with the IMF, and only with its approval if the change exceeded 10 per cent of the initial par value. The impossibility of providing an operationally meaningful definition of a “fundamental disequilibrium,” and the obvious danger of snowballing speculation whenever the intention of carrying out a parity adjustment becomes known to a wider circle, have made this provision in the Articles of Agreement a dead letter. Inevitably, parity adjustments are always prepared in the greatest secrecy and usually without prior consultation with the IMF.

Flexible exchange rates

In a system of flexible exchange rates, central banks do not intervene on the exchange markets with the purpose of restricting exchange-rate movements within narrow limits. Such a system is generally held to be compatible with minor purchases and sales of foreign exchange to iron out small fluctuations, as long as these interventions do not go against a basic trend. An active use of monetary policy to prevent undesirably wide fluctuations of exchange rates is, of course, perfectly compatible with a system of flexible rates. Since there is no obligation, however, to subject monetary policy exclusively to the goal of avoiding a depletion of foreign-exchange reserves at constant currency parities, it may be used more freely for other objectives, such as full employment or price-level stability.

4. Exchange controls

Currency conversion may be subject to various kinds of restrictions. The most severe form of ex-change controls would be one under which a special permission is required for every single transaction on the foreign-exchange markets. There may, on the other hand, be a general permission for certain types of transactions (e.g., all those related to commercial trade), while others may require individual licensing. The IMFArticles of Agreement (art. VIII, 2 ) require member countries to guarantee currency convertibility for commercial payments but not necessarily for capital movements. Apart from exchange controls, properly speaking, other measures of limiting the demand for foreign exchange, such as tariffs, quotas, and special taxes on the purchase of foreign assets, have been used for the purpose of balance of payments adjustments. Exchange restrictions may differentiate between residents and nonresidents of a country in the relative freedom granted each group to carry out foreign-exchange transactions. The restoration of convertibility for nonresidents by most countries of western Europe at the end of 1958 was one of the most important postwar steps toward full currency convertibility.

The most common reason for introducing exchange controls is the threat of exhaustion of a country’s gold and foreign-exchange reserves if its government is committed to supporting exchange rates at levels at which there is a sustained excess demand for foreign exchange. Convertibility has, however, been interfered with on some occasions in order to check a persistent excesssupply of foreign exchange. Switzerland and West Germany, for example, have during the 1960s used a ban on interest payments on bank deposits of nonresidents to reduce an excessive capital inflow. A system of flexible rates, being defined as one in which the central bank is not committed to intervening on the exchange markets, is intrinsically more compatible with full convertibility than a system of pegged rates.

The existence of exchange controls makes possible the division of the foreign-exchange market into separate compartments with different exchange rates. Such systems of multiple exchange rates were in use in some countries during the 1930s and became particularly widespread after World War II. They may take the form of having one exchange rate for commercial transactions and a different one (perhaps a flexible rate) for capital movements. There may also be differences between the exchange rates applied to exports and to imports of different commodities.

Bilateral clearing agreements may require approximate balancing of the trade flows between two countries. The foreign-exchange proceeds from the exports to the partner country will then generally not be convertible into other currencies. This practice leads, among other things, to implied cross rates of exchange between different currencies that will generally be at variance with each other. Considerable efficiency losses may result for the countries concerned, not only from administrative waste but also as a result of the distortion of the price structure brought about by arrangements of this kind.

5. Fixed versus flexible exchange rates

One of the most basic issues in comparing alternative monetary systems centers on the relative advantages offixed versusflexible exchange rates. It is somewhat misleading to state the alternatives in this simple manner. The word “fixed” suggests stability, whereas “flexible” carries a connotation of instability. The absence of official interventions on the foreign-exchange markets does not imply that exchange rates would necessarily have to be unstable. Sufficiently flexible monetary policy can always assure as high a degree of stability of exchange rates as may be desired. The system incorporated in theArticles of Agreement of the IMF, on the other hand, does not guarantee permanent stability of exchange rates. It is therefore illegitimate to claim for this system the advantages of a common currency area, in which the constancy of “exchange rates” is assured by a unified monetary policy.

The disadvantage of relatively greater exchange-rate instability, if it should indeed occur under flexible rates as a consequence of inadequate monetary and other policies of certain governments, has to be weighed against the restrictions of trade and payments to which governments frequently see themselves forced by balance of payments difficulties associated with a system of pegged rates (see 4 above). Apart from this danger, the possibility that certain governments may from time to time be forced to apply monetary policies conflicting with the goals of full employment or price stability has been pointed out as the most objectionable feature of pegged rates. It was primarily this feature that brought about the demise of the gold-exchange standard during the great depression of the 1930s. Apart from the fact that there is greater leeway for monetary policy to pursue domestic objectives if exchange rates are flexible, given changes in interest rates also have a substantially more powerful effect on domestic employment under flexible exchange rates. This is a consequence of the fact that capital movements induced by interest-rate changes do not, as under fixed rates, operate primarily on the foreign-exchange reserves of the central bank but immediately induce changes of the balance on current account. The capital out-flow encouraged by a lowering of domestic interest rates, for example, brings about currency depreciation, which in turn induces an increase of exports and a reduction of imports. This change results in an immediate rise of effective demand and hence of employment. The opposite follows in the case of an attempt to combat an inflationary boom by monetary contraction (Sohmen 1961, chapters 2, 4; Mundell 1963).

Egon Sohmen

[See alsoInternational trade; andInternational trade controls.]


Alexander, Sidney S. 1952 Effects of a Devaluation on a Trade Balance. International Monetary Fund, Staff Papers 2:263–278.

Cheng, Hang Sheng 1959 Statistical Estimates of Elasticities and Propensities in International Trade: A Survey of Published Studies. International Monetary Fund, Staff Papers 7:107–158.

Friedman, Milton 1953 Essays in Positive Economics. Univ. of Chicago Press. → See especially pages 157–203, “The Case for Flexible Exchange Rates.”

Haberler, Gottfried (1933) 1936 The Theory of International Trade, With Its Applications to Commercial Policy. London: Hodge. → First published in German.

International Monetary Fund 1944 Articles of Agreement, International Monetary Fund, United Nations Monetary and Financial Conference, Bretton Woods, N.H., July 1 to 22, 1944. Washington: The Fund.

Johnson, Harry G. 1958 International Trade and Economic Growth: Studies in Pure Theory. London: Allen & Unwin; Cambridge, Mass.: Harvard Univ. Press.

Keynes, John Maynard (1930) 1958-1960 A Treatise on Money. 2 vols. London: Macmillan. → Volume 1: The Pure Theory of Money. Volume 2: The Applied Theory of Money.

Machlup, Fritz (1939-1940) 1963 The Theory of Foreign Exchanges. Pages 104-158 in American Economic Association, Readings in the Theory of International Trade. Homewood, III.: Irwin.

Machlup, Fritz 1955 Relative Prices and Aggregate Spending in the Analysis of Devaluation. American Economic Review 45:255-278.

Mundell, Robert A. 1963 Capital Mobility and Stabilization Policy Under Fixed and Flexible Exchange Rates. Canadian Journal of Economics and Political Science 29:475-485.

Orcutt, Guy H. 1950 Measurement of Price Elasticities in International Trade. Review of Economics and Statistics 32:117-132.

Ricardo, David (1810) 1951 The High Price of Bullion. Pages 47-127 in David Ricardo, Works and Correspondence. Volume 3: Pamphlets and Papers,1809-1811. Edited by Piero Sraffa. Cambridge Univ. Press.

Robinson, Joan (1937) 1963 The Foreign Exchanges. Pages 83-103 in American Economic Association, Readings in the Theory of International Trade. Homewood, III.: Irwin.

sohmen, Egon 1961 Flexible Exchange Rates: Theory and Controversy. Univ. of Chicago Press.

Vanek, Jaroslav 1962 International Trade: Theory and Economic Policy. Homewood, III.: Irwin.


International transactions under a system of fixed exchange rates give rise to surpluses and deficits in the balance of payments of transacting countries, as the two preceding articles have pointed out. These surpluses and deficits must be settled. This article discusses the mechanisms for international settlements—both arrangements that evolved more or less spontaneously, such as the international gold standard, and formal organizations, such as the International Monetary Fund.

The gold standard

The classical gold standard

The universal use of silver, or silver and gold, for the coinage of money created a fixed tie between the currencies of the principal trading countries and established, in effect, an international monetary system. In the seventeenth and eighteenth centuries silver and gold coin were regarded as providing a national currency, and although some silver coins had a wide international circulation, this did not alter the essentially national character of the monetary system. The present international monetary system may be said to have begun in 1816 when England based its monetary system on the gold sovereign and limited the legal tender of silver coins. The primacy of gold emerged in the nineteenth century with the growth of world trade, in which England played a major role as exporter and importer and as shipper and entrepôt dealer. Sterling became the currency in which much of the world’s trade was conducted, and drafts in virtually all currencies could be bought and sold for sterling. Nevertheless, until the 1870s silver remained one of the two standard money metals. In the next thirty years, however, bimetallism was abandoned nearly everywhere. The shift from bimetallism was justified as necessary to make the national monetary systems conform to the international monetary system based on gold.

Under the classical gold standard each country defined its monetary unit as a specific quantity of gold and undertook the free coinage of gold in this monetary unit or a convenient multiple of it. This established a mint parity for each currency in terms of other gold standard currencies. Foreign exchange rates could vary from the mint parity only within narrow limits created by the cost of shipping gold from one center to another. Prior to World War I, the dollar exchange rate for sterling, for example, could not ordinarily be higher or lower than $4.8665, the mint parity, plus or minus about two cents per pound sterling, which is the cost of shipping gold between New York and London.

In the late nineteenth century gold coins formed an important part of the money in circulation. The value of all other forms of money was maintained by requiring their redemption in gold coin, which necessitated a close but indirect tie between the stock of gold and the money supply. This tie was reinforced in all gold standard countries by national legislation requiring gold reserves against bank notes, and sometimes against deposits held with the central bank.

Because of the considerable amount of coined gold in circulation and the high ratio of gold re-serves to the money supply, domestic money was virtually equivalent to foreign exchange. An inflow or outflow of gold acted quickly to increase or decrease the domestic money supply. The maintenance of the gold value of the currency became the primary objective of economic policy. Central banking techniques, such as a flexible bank rate, were devised to assure a prompt response of the monetary system to the balance of payments and to avoid or minimize gold movements, particularly the outflow of gold.

The classical gold standard came to an end with World War I. Even before this, innovations were introduced, consciously or unconsciously, that loosened the tie between national monetary systems and gold. Since 1941 there have been many major changes in the gold standard, so that the present international monetary system is basically different from the gold standard from which it gradually evolved.

Redemption and convertibility

The classical gold standard, in which gold coins circulated widely, was not well adapted to the needs of highly developed industrial countries. With the growth of banking, the circulation of gold coins became small relative to the use of bank notes and bank deposits. The tie between gold coins and other forms of money was retained by requiring the redemption of bank notes in gold and by requiring central banks to maintain a gold reserve against their note issue. Redemption was an essential part of the mechanism by which exchange and bullion dealers kept exchange rates within the range established by mint parities and the cost of shipping gold.

The use of gold coin as money was virtually brought to an end by World War I. In all belligerent countries, gold coins were withdrawn from circulation and gold reserves were concentrated in the central banks. When the United Kingdom restored the gold standard in 1925, it adopted the gold bullion standard. The national currency was made redeemable in gold bars of 400 ounces (about $8,270 at the parity of 1925). Thus, gold was readily available for gold and exchange arbitrage but not for circulation.

In the United States, redemption of currency into gold coin was maintained until 1933. During the great depression, a considerable amount of gold coin and gold certificates went into hoards. After the dollar became de facto depreciated, Congress abrogated the gold clause in contracts and made all obligations payable in legal tender—that is, in any form of currency or coin. The Gold Reserve Act of 1934 established a new gold standard for the United States at $35 a fine ounce, with gold used only for international settlements. Gold could no longer be coined, and private holding of gold coin by U.S. residents was forbidden, a prohibition extended in 1961 to the holding of gold abroad.

Under the classical gold standard, governments did not ordinarily intervene in the exchange market. The foreign exchange value of currencies was maintained by foreign exchange and bullion dealers through gold and exchange arbitrage. In the 1930s, when currencies were no longer firmly tied to gold, most countries began intervening in the exchange market to keep exchange rates within a desired range.

The concept of the redemption or convertibility of money into gold is now entirely different from that of the classical gold standard. No country undertakes the domestic redemption of money into gold, although in some countries private holding of gold is permitted and gold may be acquired in private transactions. But all of the leading countries do maintain the convertibility of their currencies into foreign exchange, at least for nonresidents, through the exchange market.

Gold and international monetary reserves

International monetary reserves under the classical gold standard consisted largely of the gold coin in circulation (in the United States, also gold certificates) and the gold reserves held by the monetary authorities as backing for the currency and other central bank obligations. Although most of the gold reserves were legally committed to backing the currency, the reserve requirements could be suspended in time of crisis. In addition to required reserves, the monetary authorities usually held some free gold so that an outflow of gold did not necessarily compel an immediate contraction of the money supply. In some instances, countries held foreign exchange reserves in addition to gold reserves.

While bankers and exchange dealers were developing the practice of holding sterling in order to carry on their exchange business, some governments were evolving the gold exchange standard by pegging their currencies to gold standard currencies. This form of the gold standard was devised to maintain stable exchange rates when direct redemption of the currency in gold was not feasible or when creating exchange by shipping gold would have involved long delay and high costs.

The wide use of the gold exchange standard grew out of World War I. As an interim step in restoring the gold standard, some continental European countries pegged the exchange rate to gold standard currencies—at first the dollar and later sterling—by drawing on or building up balances of dollars and sterling. At the end of 1928, the foreign exchange reserves held by all countries are estimated to have constituted one-fourth of all monetary reserves. The great depression and the devaluation of virtually all currencies entailed considerable loss (as measured in terms of the gold equivalent) from the holding of foreign exchange reserves.

Since 1939 there has been an enormous increase in the holding of foreign exchange as monetary reserves. The United Kingdom financed much of its overseas wartime expenditures through the sale of sterling for national currencies. At the end of 1950, after sterling had been devalued, these holdings amounted to nearly $10,000 million. Since then, the gross sterling liabilities have increased very little.

Foreign official holdings of U.S. dollars increased moderately during the war but were soon drawn down. At the end of 1949 they amounted to only $2,900 million. When foreign countries rebuilt their reserves, a major part was in the form of dollars. From 1950 to 1957, inclusive, the increase in official dollar holdings was over $5,000 million. From 1958 to September 1966, when U.S. payments were in persistent deficit, a larger proportion of the settlements was in gold, although official dollar holdings increased by about $4,800 million.

At the end of September 1966, the gold reserves of all countries outside the communist bloc amounted to $41,000 million and their total foreign exchange reserves were $23,500 million. In addition, $21,000 million of gold and currencies was held by the International Monetary Fund as a common reserve for all its members, and it had general arrangements to borrow up to $6,000 million from ten of its members (the Group of Ten).

Modification of the gold standard

No aspect of the gold standard reveals more clearly the change in its nature than the attitude toward gold parities. The maintenance of the historic parity of the currency in terms of gold was long regarded as a matter of national honor. After specie payments had been suspended for 20 years, England adopted the gold standard in 1816 and resumed the redemption of Bank of England notes in 1821, despite the deflation that this entailed. During the Civil War, the premium on gold in terms of green-backs rose as high as 150 per cent in the United States. Nevertheless, a deflation was undertaken that made it possible to resume specie payments in 1878.

The concern to maintain historic gold parities ended with World War I, and the great depression. The war brought inflation, and the currencies of all belligerents depreciated, except the dollar. While France and Italy stabilized the exchange value of their currencies and adopted new gold parities during the 1920s, the United Kingdom undertook a prolonged deflation to restore the prewar parity of sterling. In Germany, where the mark had been destroyed in the hyperinflation, a new currency was established at the end of 1924 at the old parity with gold.

War is the great destroyer of the gold standard. The need to finance war expenditures results in an expansion of the currency and in inflation. The wartime expansion of money and credit exhausts the money-creating power of gold standard countries. Since gold production is adversely affected by the higher level of costs, the growth of the gold base for the monetary system is much reduced after a war. This explains the widespread fears of a gold shortage in the 1920s.

The uneven wartime inflation also generates centers of deflation after the war. The countries that attempt to restore the historic parities of their currencies must undertake a deflation that reduces their imports and puts pressure on international prices, particularly of basic commodities. The countries that stabilize at a depreciated exchange rate may set the value of their currencies too low because the new parity is based on an exchange rate that reflects a capital outflow that is brought to an end when the currency is stabilized. Thus, the countries with the newly established parities tend to have a payments surplus and to draw reserves from the deficit countries. These errors were fortunately avoided after World War II, for reasons that will be discussed below.

During the great depression the international gold standard collapsed, and from 1933 to 1937 countries followed a policy of extreme nationalism. Currencies were devalued competitively, tariffs were raised and other restrictions on trade were intensified, and exchange controls and multiple currency devices were introduced. Because currency depreciation was generally associated with monetary expansion, the domestic effects of devaluations were favorable. On the other hand, they intensified the depression in the gold-bloc countries—France, the Netherlands, Belgium, and Switzerland.

Currency devaluations began early in the depression. In September 1931 sterling was depreciated by about 30 per cent. On January 31, 1934, the dollar was formally devalued by 41 per cent and, in 1935 and 1936, the currencies of the gold-bloc countries were devalued. The gold standard, so laboriously restored from 1925 to 1930, was abandoned by every great trading country by 1936. The great depression swept away not only the newly established parities but also the historic gold parity of the dollar, sterling, the Netherlands guilder, and the Swiss franc. It was not until the link between gold and currencies was severed that the depression could be brought to an end and a slow recovery begun.

Under the classical gold standard, as we have seen, the maintenance of the gold value of the currency was the primary, if not the sole, objective of economic policy. In the past generation, the objectives of policy have been broadened to encompass the economy as a whole. In the United States, the Employment Act of 1946 states that the objectives of economic policy are to promote maximum employment, production, and purchasing power, within the framework of monetary stability. Other countries have formally or tacitly adopted similar objectives.

Formal international organizations

Bank for International Settlements

The only enduring international financial institution created in the interwar period is the Bank for International Settlements (BIS). The concept of a politically independent bank which would be the focal point for international financial cooperation gained great support during the 1920s. By a convention signed at The Hague in January 1930, when the Young Plan on German reparations was adopted, the Swiss government undertook to grant a charter to the BIS. The moratorium on war debts and reparations payments sharply limited this phase of its work. In the crisis of 1931, however, the BIS took an active role in the emergency credits provided by governments and central banks. At the end of March 1966, the resources of the BIS amounted to nearly $2,600 million. It frequently participates in credits granted by central banks to deal with pressures in the exchange market. In recent years, the BIS has acted as agent for the European Payments Union, the European Steel and Coal Community, and the European Monetary Fund. The BIS is the center for frequent meetings of governors of central banks. Its research and statistical work is of a very high order.

The International Monetary Fund

The lessons of World War I were well remembered in the formulation of international financial policy during and after World War II, and the monetary problems of the postwar period were not left to improvisation. Instead, the United States and the United Kingdom prepared independent plans for international monetary cooperation. These plans are best known under the names of their principal authors—the White Plan and the Keynes Plan. Other plans were proposed by Canada and France.

The Keynes Plan proposed the creation of an International Clearing Union (ICU) based on an international unit, the bancor, with a value fixed (but not unalterably) in terms of gold. The bancor was to be accepted as the equivalent of gold by member countries in the settlement of international balances. Central banks of member countries would keep accounts with the ICU. The ICU would not have subscribed capital; instead, countries were to be given overdraft facilities up to a prescribed quota based on their international trade. Countries with a surplus in international payments would accumulate credit balances; those with a deficit would build up debit balances. Moderate interest charges would be levied on both debit and credit balances. As the ICU would be a closed payments system, with bancor holdings not convertible, the debits and credits would necessarily be equal and there could be no question of the adequacy of its resources for meeting the reserve credit requirements of its members within the quota limits. The members of the ICU would agree among themselves on the initial par values of their currencies in terms of bancor, which could be changed thereafter only with the permission of the ICU. Under certain conditions of persistent deficit, the ICU could request a member to devalue its currency and could require it to repay part of its indebtedness out of its gold and foreign exchange reserves. In general, the ICU was not to concern itself with the domestic economic policies of its members.

The White Plan proposed the creation of an International Stabilization Fund (ISF) to maintain orderly exchange arrangements. Each member country would have to agree on a par value of its currency defined in terms of an international monetary unit (unitas) equivalent to $10 in gold. Changes in parities could be made only after consultation and with the approval of the ISF. Members would not be permitted to impose exchange controls without the approval of the ISF and would be obligated to remove existing exchange controls. To provide the ISF with resources, members would be assigned quotas and would subscribe gold and their own currencies to the amount of these quotas. Members could purchase foreign exchange from the ISF with their own currencies—up to one-fourth of their quotas annually, with maximum net credits not to exceed 100 per cent of their quotas. Drawings in larger amount could be made only with special approval after waiver of the quota limits. Members would have to repay drawings in gold and convertible foreign exchange when their reserves increased.

The ISF would have been given wide powers under the White Plan. Members acquiring currencies in settlement of international payments could sell them to the ISF either for their own currencies or for foreign exchange. Thus, the ISF would have assured the convertibility of any currency acquired by a member in settlement of a balance-of-payments surplus. As the reserve credits of the ISF were to be given in specific currencies, the operations contemplated could exhaust its holdings of the currency of a country with a large and persistent surplus. The plan, therefore, provided that if it appeared that a currency would become scarce, the ISF would issue a report to the surplus country with recommendations designed to restore the ISF’s holdings of the scarce currency.

The principal differences between the two plans may be summarized as follows. The ISF would have had wide powers of intervention through international financial operations undertaken on its own initiative. The ICU would have been a passive institution, providing reserve credit facilities only on the initiative of its members. The ISF contemplated the use of the exchange market for settling international balances; the ICU contemplated the clearing of such balances through its accounts. The ICU would not itself have held gold or currencies, and the role of gold in international payments would have been circumscribed. The ISF would have had its own resources of gold and currencies subscribed by members, and gold was to have a significant role as reserves and in international settlements. Finally, under the ICU the responsibility for restoring international equilibrium would be shared by debtor and creditor countries, while under the ISF it would have fallen primarily on debtor countries. The reserve credit facilities would have been far larger under the ICU and would have been available on more generous terms.

After two years of preliminary discussion, President Roosevelt invited 44 countries to the Monetary and Financial Conference at Bretton Woods, New Hampshire, which met July 1-22, 1944. The report of the commission on the International Monetary Fund (IMF) provides an authoritative history of the negotiations from the first publication of the tentative proposals to the Final Act adopted at Bretton Woods (Rasminsky 1948). The IMF followed in form the proposal of the United States, but included many details from the British and Canadian proposals.

The International Bank for Reconstruction and Development (the World Bank) was also established at Bretton Woods to make loans for long-term reconstruction and development with funds borrowed in private capital markets. The greater part of the capital of the institution, subscribed by member countries, was a guarantee fund to be called on to meet losses and defaults. While the World Bank retained the basic principles of the U.S. plan, a number of important safeguarding provisions were added. [SeeForeign aid, article oneconomic aspects.]

Operations of the IMF

The IMF was organized in 1946 and began exchange operations in 1947. Its first task was to establish initial par values for the currencies of its members, which were usually based on the exchange rates that prevailed after the war. The Articles of Agreement of the IMF require all countries to establish the parity of their currencies in terms of gold and to maintain exchange rates within one per cent of parity. This obligation can be met by intervening in the exchange market to keep currencies within the prescribed range or by undertaking to buy and sell gold freely in settlement of international transactions. The United States is the only country that has accepted the obligation of buying and selling gold freely under this provision of the Fund Agreement.

The IMF was aware that changes in parity would become necessary. Initial par values were designed to enable countries to maintain exports until their productive capacity had been restored or until a recession halted the expansion of world trade. By 1949, coincident with a U.S. recession, a major readjustment of parities had become necessary, and the devaluations were approved promptly in September 1949. In fact, it has never been difficult for IMF members to change their parities. To September 1966, the IMF has approved about forty major exchange-rate adjustments. In some instances, the IMF has urged members to establish more realistic parities, and it has accepted fluctuating exchange rates where they were necessary to avoid restrictions on trade.

An important objective of the IMF is to eliminate foreign exchange restrictions and to maintain the convertibility of currencies. During the postwar transitional period, members were permitted to retain and modify wartime exchange restrictions and, when necessary, to impose new exchange restrictions temporarily with the approval of the IMF.

The convertibility of currencies in connection with current international transactions was required by the Fund Agreement after the transition period. Under this provision, balances of a member’s currency held by central banks of other members must be converted by the member either in the currency of the country requesting the conversion or in gold. In practice, the obligation is fulfilled when countries support their currencies in the exchange market, without exchange control, using monetary reserves or the resources of the Fund for this purpose. Beginning in 1950, the IMF began an annual examination of restrictions in effect and consulted with members on their further retention. The great trading countries gradually relaxed and removed their exchange restrictions, but it was not until February 1961 that all of them had made their currencies convertible. As of September 1966, 27 of the 104 members of the IMF, including all of the large industrial countries, had accepted the obligation of convertibility.

The IMF periodically reviews the economic and financial position of its members and advises them on their policies. Such review is an essential part of a proposal by a member to change the parity of its currency or to draw on the resources of the IMF outside quota limits. The staff of the IMF must, therefore, maintain a continuous review of the economic situation of all member countries. From time to time, members request the IMF to study specific problems and to prepare programs for monetary reform. These studies have been very useful, although members have occasionally experienced political difficulty in implementing the recommendations. The IMF also has a comprehensive training program for technicians of member countries. The research work of the IMF staff has been outstanding. The IMF is an indispensable source of statistical information, and its publications are noted for careful analytical work.

A major purpose of the IMF is to provide resources with which members can meet balance-of-payments deficits while taking corrective measures. The need for resources for this purpose has grown steadily. The original quotas assigned at Bretton Woods (which measure the gold and currencies subscribed to the IMF) amounted to $8,800 million. Since the Soviet Union did not accept membership, other countries delayed taking up membership, and China never paid its subscription, the IMF began operations with less than $7,000 million of resources. The addition of new members, the upward adjustment of individual quotas, and two general increases in quotas brought the resources of the IMF to about $21,000 million by 1966.

For various reasons, drawings on the IMF in the first ten years (1947 to 1956) amounted to less than $2,000 million. From 1957 to 1966, however, drawings amounted to nearly $11,000 million. As these data indicate, the IMF has become the world’s major source of reserve credit. For this reason, members must have assurance that they can use their quotas in time of need. Under present policies, countries have virtually complete assurance that they can draw on the resources of the IMF to the extent that they have provided net resources (gold tranche drawings) to the IMF. They have the benefit of the doubt on drawings in the first credit tranche (25 per cent of the quota). As a member’s drawings become larger relative to its quota, it must meet more exacting tests to assure that its policies will be conducive to the restoration of its balance of payments. In recent years, the IMF has shown flexibility in devising methods that give its members greater assurance on drawings. Under appropriate circumstances, the IMF will make stand-by arrangements under which a country can draw an agreed amount. The IMF has also established a policy of providing compensatory credits for countries whose exports have declined temporarily. Such credits are available with somewhat greater ease than ordinary quota drawings. The resources of the IMF are a revolving fund for use by all members. If drawings were not repaid at an appropriate time, the IMF would become illiquid and could not provide needed reserve credit. Under the Articles of Agreement, drawings must be repaid when a country’s reserve position has improved rather than at a fixed date, although the IMF may require repayment of drawings that have been outstanding for an excessive period of time. The IMF now generally requires countries to repay drawings in three years, with an outside limit of five years. Repayments of drawing on the IMF amounted to $7,700 million as of September 1966. The IMF makes a moderate transactions charge for drawings, and levies continuous use-charges (interest) on net credit extended to its members.

The IMF seeks to promote exchange stability, to maintain orderly exchange arrangements among members, and to avoid competitive exchange depreciation. Nevertheless, a country is not expected to deflate its economy in order to restore its balance of payments; it may instead propose a change in the par value of its currency. The Fund Agreement states that the primary objectives of economic policy are to facilitate the expansion and balanced growth of international trade, and to contribute thereby to the promotion and maintenance of high levels of employment and real income and to the development of the productive resources of all members. This is by no means inconsistent with exchange stability, assuming the revision of parities when necessary.

Regional monetary arrangements

The European Payments Union (EPU), the most important of the regional arrangements for international monetary cooperation, was established in July 1950 to facilitate multilateral settlements among the European countries that participated in the Marshall Plan. Originally, any participating country with a surplus in its bilateral payments arrangements with another participating country could offset this surplus against a deficit with other participating countries. Beginning in July 1956, multilateral settlements were made through the exchange market, with the central banks of the sur-plus countries acquiring the currencies of other members and presenting them for monthly settlement. The settlement provisions for cumulative surplus and deficit positions were gradually strengthened. The EPU was liquidated in December 1958 when most of the participating countries made their currencies convertible among themselves.

The European Fund (EF), a part of the European Monetary Agreement, was established on liquidation of the EPU. Its 16 members include all the countries of western and southern Europe that were in the EPU, and Spain, which was not. The EF provides its members with short-term credits, not exceeding two years, to meet temporary overall balance-of-payments difficulties. Through March 1966, there were 25 drawings totaling $315 million, of which $195 million was repaid.

In 1963, the Council for Mutual Economic Assistance (COMECON) agreed to establish an International Bank for Economic Cooperation (IBEC) to facilitate multilateral clearing within the Soviet bloc. The capital of IBEC is 300 million transferable rubles ($330 million at the parity of exchange), of which the Soviet Union subscribed 116 million rubles. The eight members of IBEC include all of the European countries in the Soviet bloc and Mongolia. Operations were begun on January 1, 1964. IBEC may grant credits to the monetary authorities of the COMECON countries for settlement needs within the system, seasonal credits to offset fluctuations in export receipts, promotion credits to increase trade within the bloc, balance-of-payments loans to finance deficits, and loans for multinational construction projects. IBEC may also accept deposits from member countries in transferable rubles, in gold, and in fully convertible Western currencies. While IBEC has undertaken considerable clearing operations and has extended short-term credits, the persistent imbalance in the payments among participating countries has led Poland (a payments surplus country) to propose that settlement be made in convertible currencies to enable participating countries to finance their deficits with the West. The financing of trade between the Soviet bloc and the West has become an important function of IBEC.

In 1952, seven central banks founded the Center for Latin American Studies (CEMLA), which now has 20 members—17 in Latin America, plus Jamaica, the Philippines, and Surinam—as well as a number of collaborating members. At present, the functions of CEMLA are limited to discussions, training programs, research, and publications.

International monetary reform

Changes before 1966

The International Monetary Fund (IMF), as formulated at Bretton Woods, reflected the conditions that its founders foresaw in the early postwar period. Because the IMF was not intended to finance relief, reconstruction, and development, its resources were expected to be adequate for a period in which the United States would be in surplus and during which drawings of members would be tightly controlled.

International payments problems have become far different from those that confronted the IMF immediately after the war. World trade and investment have increased enormously. The pattern of world payments has shifted from a large surplus in the United States and a deficit in Europe to a large deficit in the United States and a surplus in Europe. The IMF has had to adapt its policies to the new situation. This has involved three major steps: giving members greater assurance of access to IMF resources, increasing the quotas of members, and strengthening the liquidity of the IMF. Policies on drawings were gradually liberalized. A general increase in quotas by 50 per cent was made in 1959-1960 and by another 25 per cent in 1966. But these quota increases could not of themselves increase the liquidity of the IMF sufficiently to give members assurance of being able to make drawings within their quota limits.

Because the IMF provides resources to its members in specific currencies, it must have enough of the currencies of the surplus countries to cover an adequate proportion of the undrawn quotas of members that may have deficits. So long as the United States was a surplus country, the IMF was well supplied with currencies on which its members could draw, particularly with its conservative policy on drawings. After the United States became a deficit country in 1958, net drawings on the IMF in dollars would have meant that the United States was financing the payments of other deficit countries. If the IMF was to be the means through which surplus countries financed the deficit countries, it had to increase its holdings of the currencies of the surplus countries of continental Europe. This could not be done merely through a general increase in quotas, as the larger holdings of the surplus currencies would be matched proportionately by the larger drawing rights of deficit countries. A reasonable differential increase in the quotas of the continental European countries would have strengthened the liquidity of the IMF, but not sufficiently.

The IMF’s need for the currencies of the surplus countries was greatly increased by the restoration of currency convertibility in Europe, the easier movement of short-term funds between the major financial centers, and the growth of foreign holdings of U.S. dollars. An economic or political crisis anywhere in the world could touch off a large-scale flight from the dollar and from sterling that would require resources far greater than those of the IMF. To avoid a breakdown of the international payments system in a crisis, the IMF needed access to massive credits from all potential surplus countries. At the annual meeting of the IMF in 1961, the United States took the initiative in discussions designed to assure the IMF supplementary resources in time of need. An agreement—General Arrangements to Borrow (GAB)—was reached by ten countries (International Monetary Fund 1962, pp. 234-245) to provide $6,000 million of their currencies to the IMF under specified conditions if needed to forestall or cope with an impairment of the international monetary system. By September 1966, the IMF had borrowed nearly $1,000 million under GAB.

With the convertibility of European currencies, the freer movement of short-term funds among the major financial centers made it desirable for the United States to undertake forward and spot ex-change transactions to offset exchange rate movements which could disrupt the exchange market and result in a drain on U.S. gold reserves. The policy of intervention in the exchange market, which had been common prior to the war, was resumed in 1961. To facilitate these exchange operations, the Federal Reserve entered into reciprocal currency arrangements (swaps) with the Group of Ten, Austria, Switzerland, and the Bank for International Settlements under which they agreed to provide their currencies against dollars and the Federal Reserve undertook to provide dollars against their currencies. At the end of September 1966, the reciprocal currency arrangements provided for aggregate U.S. swaps of $4,500 million (see Federal Reserve Bank of New York).

The United States has drawn on the IMF to meet its own needs and to facilitate the use of dollars in repayments to the IMF. Dollar-holding countries repaying drawings on the IMF must do so in gold or in the convertible currency of a member country whose currency is held by the IMF in an amount less than 75 per cent of that member’s quota. Until 1958, virtually all drawings and repayments in currency were in dollars. After the United States made drawings on the IMF to meet part of its own payments deficit, IMF holdings of dollars exceeded 75 per cent of the quota, and dollars could no longer be used for repayments. To enable dollar-holding countries to repay the IMF, the United States has drawn European currencies and Canadian dollars, which are eligible for repayments to the IMF, and has exchanged these currencies for dollars. Such drawings and repayments do not affect IMF holdings of eligible currencies and are therefore regarded as technical drawings. They do increase IMF holdings of dollars and reduce its holdings of the currencies of the repaying countries.

Because the currencies of members of the IMF are defined in terms of gold, and gold is used for the settlement of international balances, confidence in currencies requires assurance that the official price of gold in monetary transactions, $35 an ounce, will be maintained. Private trading in gold is common in the Far East, the Middle East, and in some European countries. The price of gold in these markets reflects speculative attitudes toward local currencies as well as the persistent demand for gold for hoarding. The London gold market, which had been closed at the beginning of the war, was reopened in 1954. This is a dollar market, as buyers must acquire the sterling for gold purchases with dollars. Gold supplies for this market come mainly from South Africa and the Soviet Union. In October 1960, the price of gold in the London market rose to more than $40 an ounce. Such a rise in the price of gold could seriously impair confidence in the major currencies and undermine the international payments system. For this reason, the central banks of eight countries agreed to share the responsibility for maintaining an orderly gold market in London, supplying gold when demand exceeds supply and absorbing gold when supply exceeds demand. The share of the United States in this arrangement (the London gold pool) is 50 per cent. The pool has succeeded in avoiding excessive fluctuations in the price of gold. This has held down speculation, although it has facilitated the accumulation of gold in hoards.

Providing for the growth of reserves

International monetary reserves consist of gold; dollars, sterling, and other foreign exchange; and net creditor claims (the gold tranche) on the IMF, which have some of the characteristics of reserves. The world monetary system is basically the gold exchange standard, supplemented and strengthened by the IMF. The gold exchange standard has been subject to periodic criticism and re-examination since the 1920s. The attitude of most countries toward it has been ambivalent. On the one hand, it is regarded as necessary to provide reserves for a growing world economy in which the increase of monetary gold is inadequate. On the other hand, it is criticized as limiting the self-corrective features of the automatic gold standard and imparting an inflationary bias to the world economy. In particular, it is said that because reserve centers can finance a substantial part of their payments deficits through the accumulation of their currencies by foreign monetary authorities, they can delay corrective measures to restore their payments position. While the gold exchange standard has worked well in the postwar period, it involves risks that could seriously weaken the international monetary system.

The gold exchange standard is not a reliable method of providing monetary reserves. The monetary reserves of all countries outside the communist bloc have increased from $13,000 million in 1928 to about $70,000 million in 1966, of which over $6,000 million is in net creditor claims (gold tranche) on the IMF. This growth of reserves, although adequate for the period as a whole, has been the result of fortuitous conditions that cannot recur. The general devaluation of currencies from 1931 to 1937 increased the dollar price of gold by 70 per cent. Because of this, gold reserves rose from about $10,000 million in 1928 to over $25,000 million in 1937. Without the revaluation of gold, the gold reserves of $41,000 million in 1966 would have been worth only $24,000 million, even if the same volume of gold had gone into monetary reserves. From 1939 to 1945, monetary reserves in sterling increased by about £3 billion U.K. as the United Kingdom paid for much of its overseas military expenditures in sterling. Finally, from 1950 to 1966, monetary reserves in dollars increased by about $10,000 million as foreign monetary authorities accumulated dollars in settlement of U.S. payments deficits. The growth of foreign exchange reserves cannot continue at such a rate. There has been no increase in monetary reserves in sterling since 1951, and the world cannot be expected to absorb dollars in monetary reserves on the scale of recent years.

The U.S. payments deficit was the principal source of the increase in monetary reserves from 1958 to 1966. The gold reserves of all countries outside the communist bloc increased by about $4,000 million in this period, while foreign exchange reserves increased by about $6,000 million, mainly in dollars. Once the U.S. payments position is restored, there will be little or no increase in monetary reserves in the form of foreign exchange. The increase of monetary reserves will then have to come almost wholly from newly mined gold and from gold sales of the Soviet Union not absorbed by industrial uses or by private hoards. From 1960 to 1966, the increase in gold reserves, including those of the IMF, has averaged about $500 million a year—slightly more than one per cent of total gold reserves and about three-fourths of one per cent of total monetary reserves. The reserve needs of the world cannot be met out of increments of monetary gold and should not be met by much larger accumulations of foreign exchange.

The growth of foreign exchange reserves has sharply changed the composition of the world’s monetary reserves. In 1937, gold constituted 91 per cent of total monetary reserves of all countries outside the communist bloc. In 1949, gold constituted 76 per cent of total monetary reserves, excluding net creditor claims on the IMF (gold tranche). In 1966, gold constituted 64 per cent of the total of such monetary reserves. Since gold is the only ultimate reserve asset and since foreign exchange holdings are convertible into gold, the steady growth in foreign exchange reserves relative to gold exposes the world to the danger of a monetary crisis if there should be a flight from dollars and sterling into gold. It is essential to have a more rational system of providing for the growth of monetary reserves and to reduce the present sensitivity of the world economy to gold as the ultimate reserve asset.

Robert Triffin has proposed (1960) that the reserve system be reformed by changing the IMF into a world central bank. The present net positions of members of the IMF would be converted into deposits for creditor countries and loans for debtor countries. Members would be required to hold part of their reserves as deposits at the IMF, denominated in an international currency unit. These deposits could be made from existing holdings of dollars and sterling. No further reserves would be created in foreign exchange, and present reserves in the form of dollars and sterling would gradually be liquidated. The future growth of reserves would take place through loans and investments of the IMF. As it would be very difficult to maintain a large revolving portfolio of short-term loans, primary reliance for the growth of reserves would have to be placed on investments, much as the Federal Reserve increases bank reserves through the purchase of U.S. government securities. Maxwell Stamp, formerly an adviser to the Bank of England, has proposed that the investments of the IMF be in bonds of the World Bank or other development agencies, thus linking the creation of reserves with the financing of development (Stamp et al. 1965).

Another proposal for providing monetary reserves suggests the creation of a new reserve asset, the Reserve Unit, backed by the currencies of the leading countries and having a guaranteed value in gold (Bernstein 1963). Each participating country would deposit an agreed amount of its own currency with the IMF, which would act as trustee, and would receive in return a corresponding amount of Reserve Units. The participation of each country would be based on its quota in the IMF, perhaps supplemented by its commitment under GAB. In order to assure the acceptability of the Reserve Units, the participants would initially be limited to a group of ten or fifteen countries whose currencies have unquestioned standing in world finance. Other countries would become participants in the issue of Reserve Units as the acceptability of their currencies for backing the new reserve asset is established. To enable all countries to share equitably in the creation of reserves, the participating countries would provide the IMF with their own currencies for use in its operations, in the same proportion to the issue of Reserve Units that the quotas of the nonparticipating countries bear to the total quotas of the IMF. The issue of Reserve Units could be at a rate that would assure an adequate but not excessive increase in aggregate monetary reserves. Reserve Units could be used either alone or with gold and dollars in the settlement of international balances. Variant forms of the Reserve Unit plan have been proposed by Robert V. Roosa, former Under Secretary of the U.S. Treasury for Monetary Affairs (1965), and by a committee of experts of the United Nations (United Nations Conference . . . 1965). The report of this committee (the UNCTAD proposal) envisaged the participation of all members of the IMF in the issuance of Reserve Units and the use of the principal currencies backing the Reserve Units for financing development.

Another method of providing for the growth of reserves would be to increase the resources of the IMF and to give members assured access to these resources through special drawing rights, which could qualify as reserves. Whatever method of creating reserves is adopted, it is essential to strengthen the IMF in order to enable it to perform its functions as the central institution for inter-national monetary cooperation and the principal agency concerned with international monetary re-serves. If the issue of Reserve Units is to have a truly international basis some means must be found for placing the administration and management of the system in the IMF, with all its members sharing directly or indirectly in the new reserves that are created.

Coordination of national monetary policies

International monetary cooperation includes the pro-vision of credits, the setting of monetary standards, and the coordination of national monetary policies. Central banks of the leading countries have always been generous in providing short-term credits to one another to meet temporary needs in a period of crisis. With the establishment of the IMF these financial needs have been met systematically on a relatively large scale and under more liberal repayment provisions.

While countries have generally been in agreement on what constituted appropriate international monetary standards, these were not codified and made into an international obligation until the establishment of the IMF. Standards for international behavior on exchange rates, on exchange control, and on currency convertibility are part of the statutes of the IMF. Despite the difficulty in securing complete conformity with these standards, they have been very helpful in maintaining an orderly international monetary system.

Much the most difficult aspect of international monetary cooperation is the coordination of national monetary policies. The maintenance of a balanced pattern of international payments is a responsibility of both deficit and surplus countries. Obviously, it is of great importance that the measures taken by the large industrial countries should be harmonious and that they should be conducive to monetary stability. These countries have accepted the principle that their policies should be subject to multilateral surveillance. The Organization for Economic Cooperation and Development, which includes all of the large industrial countries except the Soviet bloc, undertakes a regular review of the economic situation and the economic policies of the participating countries. In time, these discussions may lead to an accepted code of responsibilities for deficit and for surplus countries in restoring and maintaining a balanced pattern of international payments.

Edward M. Bernstein


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League of Nations 1932 Report of the Gold Delegation of the Financial Committee. Geneva: The League.

National Industrial Conference Board 1966 Gold and World Monetary Problems. New York: Macmillan.

Rasminsky, Louis 1948 Report on the International Monetary Fund. Volume 1, pages 864–913 in United Nations Monetary and Financial Conference, Bretton Woods, New Hampshire, 1944, Proceedings and Documents. Washington: Government Printing Office.

Roosa, Robert V. 1965 Monetary Reform for the World Economy. New York: Harper.

Russell, Henry B. 1898 International Monetary Conferences. New York: Harper.

Stamp, Maxwell; Triffin, Robert; and Bernstein, Edward M. 1965 The Reform of the International Monetary System. Moorgate and Wall Street [1965], Summer.

Triffin, Robert (1960) 1961 Gold and the Dollar Crisis: The Future of Convertibility. Rev. ed. New Haven: Yale Univ. Press.

United Nations Conference on Trade and Development, Geneva,1964 1965 International Monetary Issues and the Developing Countries: Report of the Group of Experts. New York: United Nations.

U.S. Treasury Department 1948 Preliminary Draft Outline of a Proposal for an International Stabilization Fund of the United and Associated Nations. Volume 2, pages 1597–1615 in United Nations Monetary and Financial Conference, Bretton Woods, New Hampshire, 1944, Proceedings and Documents. Washington: Government Printing Office. → See also the texts of a proposal for an International Clearing Union (United Kingdom) and for an International Exchange Union (Canada) in Volume 2, pages 1548–1573 and pages 1575–1596.

Willis, Henry P. 1901 A History of the Latin Monetary Union: A Study of International Monetary Action. Univ. of Chicago Press.


Private international capital movements are transactions that create or transfer financial claims between the residents of different countries. The participants are banks, individuals, and corporations. The claims are common stock, bonds, money-market instruments, deeds to real property, promissory notes, and bank deposits.

A capital-exporting country is one that obtains new claims on foreigners larger than its new liabilities; its citizens use current savings to acquire foreign assets, not just for domestic capital formation. A capital-importing country is one that incurs new liabilities larger than its new foreign claims; it draws on foreign savings to supplement its own. A creditor country is one whose total foreign claims exceed its total foreign debts. A debtor country is one whose total foreign debts exceed its total foreign claims. The United States is a net creditor and an exporter of private capital. It was also a net creditor in the 1930s but was importing capital rather than exporting it: its total foreign claims were larger than its foreign debts, but it was repatriating its past investments. The United States was a net debtor before 1914 but exported capital between 1896 and 1914; it was repaying its past foreign borrowings.


Most governments classify capital movements by maturity, separating “long-term” and “short-term” foreign claims. But this method of classification does not reveal very much about investors’ motives. Stocks and bonds (long-term claims) may be bought to make quick gains, while three-month commercial loans (short-term claims) may resemble long-term credit because they are renewed repeatedly. Furthermore, long-term bonds may be bought near redemption, to serve as close substitutes for money-market paper.

The following method of classification, using U.S. data for purposes of illustration, may be more illuminating.

Direct investments

Direct investments are international transactions between related enter-

Table 1 — U.S. private capital exports, 1962 (millions of dollars)
Sources: Based on data in U.S. Department of Commerce 1963a and 1963b.
Total private foreign investment 4,475
Direct investment (including reinvestment) 2,759
Purchases of long-term foreign securities (net) 961
Purchases of new foreign issues1,076 
Purchases of outstanding issues (net)55 
Less redemptions of foreign issues—170 
Other long-term lending and investment (net) 248
Short-term investment (net) 507
In short-term dollar claims (net)487 
In short-term foreign-currency claims (net)20 

prises—“parent” companies and their foreign affiliates. Direct investment starts when a firm creates a new foreign affiliate or buys a controlling interest in an established foreign firm. Direct investment continues as the parent buys more stock in its affiliate, reinvests its profits, or makes loans to its affiliate. The affiliate may be separately incorporated under foreign law (a subsidiary), or a simple extension of its parent (a branch). It may compete with its parent, making the same product for sale abroad, or may complement its parent, producing components or raw materials. In some cases, several firms may share a foreign affiliate; the Iraq Petroleum Company is jointly owned by British, Dutch, French, and American companies. In other cases, one firm may exercise control; this arrangement dominates in manufacturing and the service trades.

In recent years direct investment has accounted for over half of private American foreign investment (see Table 1), and for three-fifths of total U.S. private foreign claims (see Table 2).

Table 2 — U.S. private foreign assets, 1962 (millions of dollars)
* Division estimated.
Sources: Based on data in U.S. Department of Commerce 19636; and [U.S.] Board of Governors of the Federal Reserve System 1963.
Total private foreign assets 59,810
Direct investments 37,145
Mining and smelting3,183 
Public utilities, trade, and other8,089 
Other long-term claims 15,431
Foreign dollar bonds6,373 
Other foreign securities5,429 
Bank loans and other long-term claims3,629 
Short-term claims 7,234
Bank loans and acceptance credits*3,877 
Supplier credits and other dollar claims*2,445 
Foreign currency claims912 

Portfolio investments

Transactions in stocks, bonds, and money-market instruments, involving independent firms or individuals, are classified as portfolio investments. Bank deposits should also be included here, being close substitutes for short-term securities. New issues of foreign securities are the chief component of American portfolio investment, but purchases of “seasoned” securities are also large (see Table 1). Most foreign bonds sold in New York are denominated in U.S. dollars, but American investors have also bought securities valued in other currencies, such as Canadian and European stocks and bonds and British treasury bills.

Transactions in government securities lie on the edge of private portfolio investment. Most statisticians treat capital as “private” if the lender is an individual, bank, or corporation. They treat capital as “public” if the lender is a government or inter-governmental institution. Thus American purchases of World Bank bonds are treated as private capital, while World Bank loans to private enterprise are treated as public capital. The dollar bank deposits of foreign governments are likewise treated as public capital, even though the debtor is a private institution.

Bank loans and supplier credits

Major banks have always made short-term loans to foreigners. Recently, however, commercial banks have also made long-term loans, some of them for five years or more. Supplier credit is also familiar to foreign trade and finance, and may be growing in volume and duration.

Bank lending differs from portfolio investment because the lender cannot ordinarily sell his claims prior to maturity. In one important case, moreover, the lender does not even transfer cash to the foreign borrower: When a British bank supplies “acceptance credit,” it endorses a foreigner’s promise to pay. The bank thereby enables a British exporter to sell his goods for cash—to sell off a foreigner’s promissory note. The buyer of the foreign bill puts up the cash but has recourse to the bank that has endorsed the foreign note. London was the chief source of bank loans and acceptance credit prior to World War II, but New York has outdistanced London in the last few years. At the end of 1962, U.S. bank loans and acceptance credits totaled $3,900 million (see Table 2).

Major manufacturers also finance foreign sales without recourse to banks. They provide supplier credits that range to several months or years. Short-term supplier credits are quite common; they arise whenever an exporter delivers goods before taking payment. But other supplier credits are longer and more formal, with scheduled repayments. Data on supplier credits are very scarce; few countries collect any statistics on the business claims and debts of foreigners. But these credits may be large and are most surely volatile. Several writers have described huge “leads and lags” in international payments—variations in cash flows relative to trade flows, resulting from changes in total supplier credit.


Private investment has played a major role in the evolution of the world economy. In the nineteenth century, it opened up the vast interior of the United States and other regions for new settlement. It aided economic reconstruction after World War I, then made a larger contribution to the inter-national financial collapse of the 1930s. Private investment grew large again in the 1950s, propelling the economic integration of the Atlantic economy and aiding development at the periphery. But the source, destination, and composition of private capital were different in each period.

Before World War II

Britain was the world’s largest foreign investor in the nineteenth century. By 1914, her overseas assets totaled $18,000 million (see Table 3). France and Germany also supplied capital, but on a smaller scale.

Table 3 — Value of major foreign investments, 1913–1914 (millions of dollars)
Source: Adapted from North 1962, p. 24.
Investments by: Investments in: 
United Kingdom18,000Europe12,000
France9,000North America10,500
Germany5,800Latin America8,500
United States3,500Asia6,000
Other countries7,700Other countries7,000

British claims included important direct investments, but most British assets were foreign bonds. Britain made large loans to foreign governments, then made larger loans to private enterprise. In the third quarter of the nineteenth century “financing governments per se appeared less attractive than financing productive enterprises. Railroads were the great favorite, and European capital was often coupled with European emigrants, entrepreneurs, and engineering talent in the construction of overseas railroads” (North 1962, p. 15).

Some European capital went to the tropics—to the less developed countries of our own day. But these investments were quite small compared to those in the newly settled temperate-zone areas and were less successful in fostering development (Nurkse 1961, p. 136).

The interwar period

Britain continued to ex-port capital in the 1920s but was overtaken by the United States. The United States began to repay its own debts after 1896 and became a net creditor during World War i, when the Allied Powers sold off most of their dollar assets to buy war materiel.

Although U.S. direct investment was quite large, U.S. foreign lending was still larger. In 1924-1928, $5,700 million of foreign securities were issued in New York. Germany sold a full $1,100 million; Canada and Latin America accounted for $2,300 million. After 1928, the United States ceased ex-porting capital (see Table 4). Repayments on old loans overtook new lending, and European funds sought safe haven in the United States. In fact, every major supplier of capital became a net importer in 1930–1938; the debtor countries were hard pressed to meet their obligations and many were compelled to default on interest and principal.

Table 4 — Foreign investment in the interwar perioda (millions of dollars)
a. Measured by the balance on current account and gold movements; includes public capital.
b. Switzerland, Sweden, and the Netherlands.
Source: Based on data in United Nations 1949.
Net capital exports:  
United States5,990–4,964
United Kingdom3,425–893
France (to overseas territories)3,037–94
Other countries61,044–402
Value of foreign investments, 7929:  
United States7,5007,100
United Kingdom7,9008,900

The postwar period

The United States has made huge foreign investments since World War II. This time, however, direct investment has been larger than new lending; yet U.S. purchases of new foreign securities have grown enormously since 1958. The market for foreign bonds has finally revived, and some observers look for “financial integration” by way of New York (Kindleberger 1963).

Other countries also made new foreign investments in the late 1950s. The creation of the European Common Market inspired large capital movements within western Europe, especially direct investment. In addition, western Europe has supplied impressive sums to the less developed countries (see Table 5). Yet European lenders are still hampered by controls. Although most major currencies are “convertible,” many European governments still restrict capital transfers by their own citizens. Very few countries grant free access to their capital markets, and most countries regulate commercial-bank lending to foreigners.

Table 5 — Flow of long-term capital to the less developed countries, 1961 (millions of dollars)
* Western Europe, Canada, and Japan.
Source: Based on data in Organization for Economic Cooperation and Development 1963.
Public grants and credits3,4862,6396,125
Private capital1,2181,9573,175
Direct investment9701,1862,156
Other lending250661911
Flow through international agencies– 2110108

Private capital movements and economic welfare

Foreign investment redistributes world savings, allowing more rapid capital formation in countries that borrow and less rapid capital formation in countries that lend. Foreign investment reallocates resources, changing the pattern of output and trade. But economists have been slow to stress these effects; for many years, they treated foreign trade and foreign investment as though there were no connection between them. As Caves puts it: Classical international trade theory lived apart from the general theory of domestic production and exchange solely because of its assumption that factors of production are immobile among nations. Thus it paradoxically ignored the relations between the international movements of goods and factors, or at best dealt with them in asides about “colonial trade,” in the century of the greatest international factor movements of modern times. (1960, p. 121)

The classical analysis

Although economic theory did not connect trade and investment, it used very similar methods and models to explain both of them. In each case, it sought to assess the impact on world output and income. Thus, the case for free trade evolved from a demonstration that free trade would permit specialization, allowing every country to make the best use of its resources. With pure competition everywhere, the return to capital (the interest rate) would equal the “marginal product” of capital—the contribution of the last dollar of capital to local output and income. If, then, one country had higher interest rates and attracted foreign funds, global output would be increased; capital would have moved to the country where it had the highest productivity and could increase output most.

This theory of capital movements was indifferent to the distribution of income between countries. Yet the allocation of world savings that maximized world output would not necessarily be the “best” for the capital-exporting country. The capital-exporting country would maximize its own income by investing less abroad and more at home than required to achieve maximum world income (Jasay 1960). But the classical theory of capital movements, like classical trade theory, was “cosmopolitan” it barely explored this sort of conflict.

The factor-endowments analysis

The analyses of foreign trade and foreign investment were not fully integrated until economic theory had connected foreign trade to the international distribution of capital, labor, and natural resources. This approach to trade theory argues that specialization and trade result from perceptible differences in national endowments. Countries that are short of capital will import capital-intensive goods; countries that are short of labor will import labor-intensive goods. A capital shortage will be reflected in the return on capital (the interest rate), and capital-intensive products will be relatively costly. A country with a capital shortage will therefore import capital-intensive products and will export other goods. Hence, trade will substitute for capital movements, relieving capital scarcity where it is most severe and reducing interest rate disparities. Conversely, international capital movements will alter foreign trade because they will make endowments more similar and will level interest rate differences.

But carried to its logical conclusion, modern theory reaches an anomalous conclusion: If there is pure competition and free trade, there will not be any foreign investment. In the models most often used to analyze foreign trade, free trade will equalize all factor prices, including interest rates, removing the motive for capital movements. In consequence, the theory of capital movements has become an austere catalogue of reasons for predicting imperfect factor-price equalization (see for example, Meade 1955, part 3). Capital movements will occur only when there are trade barriers or when certain standard assumptions are violated.

Trade theory has another puzzling implication: Mundell has shown that trade barriers could evoke capital that would be completely destructive of trade (Caves 1960, p. 124). If private capital will move to obliterate differences in interest rates, the smallest trade barrier will become prohibitive. Tariffs or transport costs will alter relative interest rates, causing capital to flow. The capital transfer will not cease until it has brought interest rates back to equality. When this has happened, however, costs of production will also be equalized, and there can be no more trade.

The factor-endowments approach to trade theory can be reformulated to forecast trade and investment. The necessary modification was suggested some years ago (Iversen 1935, p. 26). Trade theories usually calculate the interest rate from the rental income on capital goods (machinery, etc.). They should instead perceive that every factor of production embodies some capital and that all factor payments include some interest. This same point is also stressed by recent writers on investment in humans. [SeeCapital, human.] If this more general concept of capital were used, trade theory would no longer forecast equal interest rates under free trade and would not preclude capital movements (Kenen 1965).

The taxation of foreign-source income

If private investment is to foster an efficient international allocation of capital, it must fulfill the classical injunction, transferring capital from countries where its productivity is low to countries where its productivity is high. In actual fact, however, investors respond to the after-tax return on capital, not to the pretax return, which reflects productivity. Hence, substantial differences in national tax rates will distort the international allocation of capital.

Differences in tax rates are quite large and are sometimes reinforced by differences in definitions of income (U.S. Congress 1962, part 1, p. 179), although tax treaties and national tax policies offset or overlay some of the differences. Many governments have entered into bilateral tax treaties that forestall the “double taxation” of foreign-source income. Under these treaties, each government forgoes its right to tax income earned in the other, or allows its own citizens a tax credit for their payments to the other. The United States goes much further, granting a tax credit for all income taxes paid to other governments in respect to income earned abroad.

Yet the U.S. tax system is not completely neutral. American corporations do not pay U.S. taxes on income from subsidiaries until they receive that income in dividends. Hence, they can defer their U.S. taxes by reinvesting income earned abroad. Even if it were completely neutral, moreover, it might still be imperfect. When two tax systems differ only in their rates, tax credits impose “export neutrality” on investors in the high-tax country (Musgrave 1960, pp. 84–85). They face the same total tax bill whether they invest at home or abroad. Yet export neutrality does not ensure efficient allocation if companies can shift their taxes onto their customers by charging higher prices. In this case, “import neutrality” would be needed to achieve an efficient allocation of capital. On this principle, all firms producing for a single market would be taxed at the same rate, no matter where their owners lived. Unfortunately, one cannot secure both kinds of neutrality unless all tax rates are the same.

Although many countries seek export neutrality in their taxation of foreign-source income, several have departed from this principle to stimulate private investment in the less developed countries. The United States has considered a special tax credit for U.S. firms investing in Latin America and other low-income areas. Other governments give similar concessions.

Private capital movements and financial policy

There are two ways to finance an export of capital—with compensating movements of public capital, including gold and foreign-exchange reserves, or with compensating movements of goods and services. As government financing is necessarily limited, a continuing capital outflow must be offset by an increased net transfer of goods or services.

The transfer problem

Few international financial problems have had more study than those involved in transferring capital by changing the flow of trade. Ricardo, Thornton, Cairnes, and other early writers give complete descriptions of the “transfer problem.” Later economists reviewed the same issues in the debate on reparations after World War I (Iversen 1935, chapter 5). But modern transfer theory differs from its antecedents because it employs the new tools furnished by macroeconomic analysis. It concludes that capital movements will induce some trade changes but warns that these may not suffice to offset the entire transfer of capital (Meade 1951, pp. 88–94). A financial transfer from one country to another will depress aggregate expenditure in the capital-exporting country and will augment aggregate expenditure in the capital-importing country. These changes in spending will decrease the imports and increase the exports of the capital-exporting country. But the change in its trade balance may not be as large as the capital flow. In this case, public policy must impose secondary changes in total spending or must allow exchange rate changes.

Transfer analysis can also be used to study repatriation. Had this been done in the 1920s, the international financial crisis of the 1930s might not have been so severe. Because few borrowers looked to the problems of repayment, too few were ready to service all their debts when foreign lending came to an end. Similar problems exist today. Many of the less developed countries may be too heavily burdened by foreign debt (Avramovic & Gulhati 1960). But the new transfer problem differs from its predecessors because direct investment has been relatively large and this type of investment need not be repaid on a fixed schedule. Furthermore, direct-investment income tends to rise and fall along with the host country’s total foreign earnings. When, therefore, earnings are high and dividends have to be paid, foreign-exchange receipts may also be high, allowing easy transfer.

Direct investment and overseas production

But standard transfer analysis ignores a host of major problems connected with direct investment. The output of direct-investment affiliates may compete with exports by the parent company and may reenter the parent’s home market. Hence, direct investment can generate complex payments problems and can cause major changes in the structure of employment. American companies already manufacture more abroad than they export from the United States, and their output has been growing very fast. Furthermore, direct-investment enterprises can account for a substantial share of output and employment in the host country (Dunning 1958, chapter 2).

Interest rates and capital movements

The recent increases of portfolio investment and of U.S. short-term lending have given rise to new research on the influence of interest rates. One comprehensive study (Bell 1962) assigned them a small role. But other studies (U.S. Congress 1963, pp. 153–208) take a rather different view. They contend that some flows are quite interest-sensitive, responding to the key rates in New York, London, and the “Eurodollar” market.

If interest rates are this influential, governments may be compelled to regard monetary policy as an international financial instrument and forgo its application to domestic aims. [SeeMonetary Policy.] They may sometimes be able to control capital exports by intervening in the foreign-exchange market; by altering the costs of “forward” foreign-exchange transactions, they can offset interest rate differences (Einzig 1961, chapters 32, 44–46). But many governments balk at systematic intervention, fearing that they would invite speculative flows. Furthermore, many capital transfers do not involve forward transactions and would not be halted by changes in the cost of forward cover (U.S. Congress 1963, pp. 156–158).

Exchange rates and capital movements

Speculative capital flows were very large in the 1920s and have reappeared in the postwar period. They can take many forms, ranging from “leads and lags” in commercial payments on through outright purchases of foreign securities. At one time, most economists held that speculation would be destabilizing. They favored fixed exchange rates to discourage speculation. As Nurkse put it:

Anticipatory purchases of foreign exchange tend to produce or at any rate to hasten the anticipated fall in the exchange value of the national currency, and the actual fall may set up or strengthen expectations in a further fall. The dangers of such cumulative and self-aggravating movements under a regime of freely fluctuating exchanges are clearly demonstrated by the French experience of 1922–26. Exchange rates in such circumstances are bound to become highly unstable, and the influence of psychological factors may at times be overwhelming. (League of Nations 1944, p. 118)

But some economists take the opposite view—that fixed exchange rates are more likely to induce destabilizing speculation. Under fixed exchange rates, speculators can assault a weak currency too easily because they are not penalized for error. If they are proved wrong, they can reverse their positions at very little cost. With flexible exchange rates, by contrast, errors could be very expensive. Speculators might be compelled to buy a currency at a higher price than the one at which they sold it. Critics of the present system also argue that exchange-rate changes would be self-limiting if the exchange rate were free to fluctuate (Meade 1951, chapter 17). As the price of a currency falls, it becomes a bargain and speculators will begin to buy it, halting the price decline. But this argument implies that speculators use some notion of “normality” to judge exchange-rate variations. In the absence of strong views as to the “normal” rate, speculation could still be destabilizing.

Peter B. Kenen


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