CHAPTER20INTERNATIONALADJUSTMENTANDINTERDEPENDENCECHAPTEROUTLINEADJUSTMENTUNDERFIXEDEXCHANGERATESEXPENDITURESWITCHINGANDEXPENDITUREREDUCINGPOLICIESTHEMEXICANPESOCRISISTHEJCURVEEFFECTHYSTERESISEFFECTSTHEMONETARYAPPROACHANDTHEIMFADJUSTMENTUNDERFLEXIBLEEXCHANGERATESEXCHANGERATEOVERSHOOTINGPURCHASINGPOWERPARITYINTERESTDIFFERENTIALSANDSPECULATIVECAPITALFLOWSFOREIGNEXCHANGEMARKETINTERVENTIONSPILLOVERINTERDEPENDENCEEFFECTSTARGETZONES,CURRENCYBOARDS,ANDDOLLARIZATIONCHANGESFROMTHEPREVIOUSEDITIONTHEMATERIALINTHISCHAPTERHASBEENUPDATED,ESPECIALLYSOMETABLESANDFIGURES,BUTITSBASICORGANIZATIONHASNOTCHANGEDINTRODUCTIONTOTHEMATERIALINTHISCHAPTER,THEDISCUSSIONOFISSUESOFINTERNATIONALINTERDEPENDENCETHATWASINTRODUCEDINCHAPTER12,ISTAKENUPAGAINANDEXTENDEDBYTAKINGINTOACCOUNTTHEINTERACTIONOFPRICESANDEXCHANGERATESMECHANISMSTHROUGHWHICHACOUNTRYCANADJUSTTOABALANCEOFPAYMENTSPROBLEMAREDISCUSSEDUNDERFIXEDANDAFLEXIBLEEXCHANGERATESYSTEMSPARTICULAREMPHASISISGIVENTOINTERESTRATELINKAGES,TRADEFLOWS,ANDTHEINTERDEPENDENCEAMONGCOUNTRIESSINCETHESHORTRUNRESULTSDEVELOPEDINCHAPTER12INWHICHTHEPRICELEVELWASASSUMEDTOBECONSTANTREMAINLARGELYVALID,AGOODUNDERSTANDINGOFTHEMATERIALINTHATCHAPTERWILLBEOFGREATHELPINTHECOMPREHENSIONOFTHETOPICSDISCUSSEDHEREINACLOSEDECONOMY,PRICECHANGESAFFECTREALMONEYBALANCES,WHICHINTURNAFFECTINTERESTRATESANDTHUSPRIVATEINVESTMENTANDAGGREGATEDEMANDHOWEVER,INANOPENECONOMY,PRICECHANGESALSOAFFECTTHECOMPETITIVENESSOFDOMESTICGOODSONWORLDMARKETSTHIS,INTURN,AFFECTSNETEXPORTS,WHICHISALSOAPARTOFAGGREGATEDEMANDINBOTHCASESTHEECONOMYWILLULTIMATELYADJUSTTOTHEFULLEMPLOYMENTLEVELOFOUTPUTTHEADJUSTMENTPROCESSINANOPENECONOMYWITHFLEXIBLEPRICESISONLYSLIGHTLYMORECOMPLICATEDALTHOUGHCURRENCYEXCHANGERATESAMONGMANYMAJORCOUNTRIESHAVEBEENFLEXIBLEFORABOUTTHREEDECADES,ANINDEPTHDISCUSSIONOFTHEADJUSTMENTMECHANISMUNDERAFIXEDEXCHANGERATESYSTEMISSTILLBENEFICIALFORONE,ITPROVIDESAGOODBASISFORTHESUBSEQUENTEXAMINATIONOFISSUESRELATINGTOAFLEXIBLEEXCHANGERATESYSTEMINADDITION,FIXEDEXCHANGERATESSTILLEXISTINSOMEAREASOFTHEWORLDUNDERASYSTEMOFFIXEDEXCHANGERATES,THECENTRALBANKOFACOUNTRYRUNNINGABALANCEOFPAYMENTSDEFICITHASTODEPLETEITSRESERVESOFFOREIGNCURRENCYTOBUYITSOWNCURRENCYINDOINGSO,ITREDUCESDOMESTICHIGHPOWEREDMONEYANDTHUSMONEYSUPPLYTHISLEADSTOAREDUCTIONINAGGREGATEDEMANDANDADECLINEINDOMESTICPRICESIFTHECOUNTRYEXPERIENCESUNEMPLOYMENT,DOWNWARDPRESSUREONWAGESRESULTS,MOVINGTHEECONOMYAGAINTOWARDSTHEFULLEMPLOYMENTLEVELOFOUTPUTASDOMESTICPRICESFALL,THETRADEBALANCEIMPROVESANDEVENTUALLYTHEECONOMYREACHESASITUATIONOFINTERNALBALANCEANDEXTERNALBALANCETHISAUTOMATICCLASSICALADJUSTMENTPROCESSMAYTAKEAVERYLONGTIMEANDMAYREQUIREALONGRECESSION,SINCEITRELIESONADJUSTMENTSINPRICESANDMONEYSUPPLYBASEDONTHETRADEBALANCEIFTHEGOVERNMENTDOESNOTWANTTORELYONTHISAUTOMATICBUTSLOWMOVINGMECHANISM,ITCANIMPLEMENTPOLICYCHANGESTOSPEEDUPTHEADJUSTMENTPROCESSHOWEVER,POLICYMAKERSMAYFACEADILEMMAWHENATTEMPTINGTOREACHINTERNALANDEXTERNALBALANCESIMULTANEOUSLYPOLICIESTHATSERVETOSTIMULATETHEECONOMYTOREACHFULLEMPLOYMENTMAYHAVEANEGATIVEEFFECTONTHETRADEBALANCETHEBESTWAYFORTHEGOVERNMENTTOADDRESSTHISPROBLEMISTOEMPLOYACOMBINATIONOFEXPENDITUREREDUCINGANDEXPENDITURESWITCHINGPOLICIESEXPENDITUREREDUCINGPOLICIESMAYNOTALWAYSBEDESIRABLESINCETHEYARELIKELYTOCAUSEARECESSIONANDHIGHERUNEMPLOYMENTONTHEOTHERHAND,EXPENDITURESWITCHINGPOLICIES,SUCHASTHEIMPOSITIONOFTARIFFSORQUOTAS,IMPAIRFREETRADEANDINCREASETHECOSTOFLIVINGANALTERNATIVEEXPENDITURESWITCHINGPOLICYCOULDINVOLVETHEDEVALUATIONOFTHEDOMESTICCURRENCYTHISWOULDINCREASETHERELATIVEPRICEOFIMPORTEDGOODSANDDECREASETHERELATIVEPRICEOFEXPORTEDGOODSHOWEVER,ADEVALUATIONCANONLYBESUCCESSFULININCREASINGTHECOMPETITIVENESSOFDOMESTICINDUSTRIESIFANINCREASEINDOMESTICPRICESCANBEAVOIDEDFURTHERMORE,DEVALUATIONINITSELFISNOTLIKELYTOFULLYRESTOREEXTERNALBALANCEUNLESSITISACCOMPANIEDBYEXPENDITUREREDUCINGPOLICIESACOUNTRYTHATEXPERIENCESHIGHINFLATIONHASTWOOPTIONSFIRST,ITCANDEVALUEITSDOMESTICCURRENCYATARATECOMPARABLETOTHEINFLATIONDIFFERENTIALBETWEENTHECOUNTRYANDITSTRADINGPARTNERSSUCHACRAWLINGPEGEXCHANGERATEPOLICYLEAVESTHEREALEXCHANGERATEAPPROXIMATELYTHESAMEANDAVOIDSALOSSINCOMPETITIVENESSSECOND,ITCANCHOOSENOTTODEVALUEITSCURRENCYASTHERELATIVEPRICEOFFOREIGNGOODSDECLINES,THECOSTOFLIVINGDECREASESANDTHIS,INEFFECT,SLOWSDOWNDOMESTICINFLATIONBUTATTHECOSTOFASTEADYLOSSINCOMPETITIVENESSALLOFTHISASSUMESTHATWAGESANDPRICESALWAYSADJUSTFREELYTOACHIEVEALONGRUNFULLEMPLOYMENTEQUILIBRIUMHOWEVER,THEADJUSTMENTMAYBEDIFFICULTTOACHIEVEIFREALWAGESAREINFLEXIBLEASLABORATTEMPTSTOMAINTAINITSPURCHASINGPOWERINTHISCASE,DEVALUATIONLEADSTOHIGHERWAGEDEMANDSTOOFFSETTHEINCREASEINCONSUMERPRICESCAUSEDBYHIGHERIMPORTPRICESIFFIRMSPASSONTHEWAGEINCREASETHROUGHHIGHERDOMESTICPRODUCTPRICESANDTHECENTRALBANKINCREASESMONEYSUPPLYINANATTEMPTTOAVOIDUNEMPLOYMENT,THENRELATIVEPRICESREMAINUNCHANGEDANDTHENOMINALDEVALUATIONHASNOEFFECTONTHEREALEXCHANGERATETHISCOULDEASILYLEADTOAWAGEPRICESPIRALTHEREFORE,TODEVALUEITSCURRENCYMOSTSUCCESSFULLY,ACOUNTRYMUSTSIMULTANEOUSLYUSERESTRICTIVEDEMANDSIDEPOLICIESSINCEDEVALUATIONOFTHECURRENCYTENDSTOBEUNPOPULAR,GOVERNMENTSSOMETIMESWAITTOOLONGTODOITEVENINTHEFACEOFENORMOUSMARKETPRESSUREINSTEADTHEYMAYINCREASETHEPRICESOFFOREIGNGOODSTHROUGHTARIFFS,THEREBYINCREASINGINFLATIONANDDECREASINGTHESTANDARDOFLIVINGINADDITION,SPECULATIONABOUTANIMPENDINGDEVALUATIONMAYCREATEEVENMOREMARKETPRESSURETOAVOIDCURRENCYSPECULATION,GOVERNMENTSOFTENDENYPLANSTODEVALUETHEMEXICANBALANCEOFPAYMENTCRISESINTHE1980SAND1990S,WHICHAREPRESENTEDINBOXES202AND203,PROVIDEEXCELLENTEXAMPLESTHEFIRSTCRISISEMERGEDIN1982ANDENDEDINADEVALUATIONANDMAJORREFORMSWHICHINITIALLYWERESUCCESSFULASECONDCRISISOCCURREDIN1994/95ANDALSORESULTEDINAMAJORDROPINTHEEXCHANGERATETHEPROCESSBYWHICHACURRENCYDEVALUATIONORDEPRECIATIONMAYACTUALLYHAVEANEGATIVEEFFECTONTHETRADEBALANCEINTHESHORTRUNISKNOWNASTHEJCURVEEFFECTTHEREARETWOCONSEQUENCESOFANINCREASEINTHERELATIVEPRICEOFIMPORTSFIRST,THEVOLUMEOFIMPORTSREMAINSUNCHANGED,SOTHEVALUEMEASUREDINDOMESTICCURRENCYOFIMPORTSINCREASES,WORSENINGTHETRADEBALANCEBUTAFTERSOMETIMEHASPASSED,EXPORTSWILLRISESINCEDOMESTICGOODSARECHEAPERFORFOREIGNCONSUMERSANDIMPORTSWILLFALLSINCEFOREIGNGOODSAREMOREEXPENSIVEFORDOMESTICCONSUMERS,BRINGINGABOUTANIMPROVEMENTINTHETERMSOFTRADEIFSHOWNINADIAGRAM,THISRESPONSEOFTHETRADEBALANCETOTHEDEPRECIATIONOFTHEDOMESTICCURRENCYLOOKSLIKETHELETTERJ,THUSTHENAMETHEVALIDITYOFTHEJCURVEEFFECTHASBEENQUESTIONED,SINCEDESPITEARAPIDDEPRECIATIONOFTHEUSDOLLARAFTER1985,THEREWASNOASIGNIFICANTIMPROVEMENTINTHECURRENTACCOUNTDEFICITTHIS,HOWEVER,MAYHAVEBEENTHERESULTOFTHEHYSTERESISEFFECTTHISEFFECTISSEENWHENALARGEAPPRECIATIONINTHEVALUEOFTHEDOMESTICCURRENCYHASALONGTERMNEGATIVEIMPACTONTRADEPATTERNS,EVENAFTERTHECHANGEINTHEEXCHANGERATEHASBEENREVERSEDINTIMESWHENACURRENCYISHIGHLYOVERVALUED,FOREIGNANDDOMESTICMARKETSHARESMAYBEPERMANENTLYLOSTANDARETURNTOTHEINITIALEXCHANGERATEMAYNOTBEENOUGHTORETURNTOTHEINITIALTRADEPATTERNTHEMONETARYAPPROACHASSERTSTHATPERSISTENTBALANCEOFPAYMENTSDEFICITSAREPURELYAREFLECTIONOFEXCESSIVEMONETARYGROWTHINOTHERWORDS,BALANCEOFPAYMENTSDEFICITSEXISTBECAUSETHECENTRALBANKCAN,THROUGHSTERILIZATION,MAINTAINALEVELOFMONEYSUPPLYTHATISTOOHIGHTOACHIEVEANEXTERNALBALANCEINTHEABSENCEOFSTERILIZATION,ABALANCEOFPAYMENTSDEFICITTHATARISESFROMAMONETARYDISEQUILIBRIUMWILLEVENTUALLYALWAYSBESELFCORRECTINGHOWEVER,THISCANBEAVERYPAINFULPROCESSINVOLVINGAPERIODOFHIGHUNEMPLOYMENTTHEMONETARYAPPROACHTOTHEBALANCEOFPAYMENTSHASBEENUSEDEXTENSIVELYBYTHEIMFINDESIGNINGPOLICIESFORCOUNTRIESWITHBALANCEOFPAYMENTSPROBLEMSAPLANFORSTABILIZATIONDRAWNUPBYTHEIMFTYPICALLYINVOLVESABALANCEOFPAYMENTSTARGETITALSOSUGGESTSDOMESTICCREDITCEILINGSTOKEEPMONEYSUPPLYFROMGROWINGEXCESSIVELYTHISMONETARYAPPROACHRIGHTFULLYSUGGESTSTHATUNDERAFIXEDEXCHANGERATESYSTEMTHEECONOMYWILLACHIEVEINTERNALANDEXTERNALBALANCEINTHELONGRUN,ASPRICESANDMONEYSUPPLYADJUSTHOWEVER,ITSASSERTIONTHATEXCHANGERATEPOLICIESMAYNOTAFFECTACOUNTRYSCOMPETITIVENESSINTHESHORTRUNISINCORRECTINTHEDISCUSSIONOFTHEADJUSTMENTMECHANISMINAFREELYFLOATINGEXCHANGERATESYSTEMTWOMAJORASSUMPTIONSAREMADEWHENEVERACTUALOUTPUTISBELOWABOVETHEFULLEMPLOYMENTLEVEL,PRICESWILLBEGINTOFALLRISEANDTHEECONOMYWILLADJUSTTOAFULLEMPLOYMENTEQUILIBRIUMSINCECAPITALISHIGHLYMOBILE,DOMESTICINTERESTRATESCANNEVERDIVERGESIGNIFICANTLYFROMRATESINTHERESTOFTHEWORLDCAPITALWILLFLOWOUTOFINTOACOUNTRYINRESPONSETOINTERESTRATEDIFFERENTIALS,DEPRECIATINGAPPRECIATINGTHEDOMESTICCURRENCYUNDERSUCHASYSTEM,MONETARYEXPANSIONLEADSTOANINCREASEINOUTPUTANDADEPRECIATIONOFTHECURRENCY,BUTTHEEFFECTSAREONLYTRANSITORYINTHELONGRUN,MONETARYPOLICYISSTILLNEUTRAL,SINCECHANGESINTHEPRICELEVELANDTHEEXCHANGERATEKEEPREALMONEYBALANCESANDTHETERMSOFTRADECONSTANTASSUMETHEECONOMYISINITIALLYINALONGRUNEQUILIBRIUMATTHEFULLEMPLOYMENTLEVELOFOUTPUTMONETARYEXPANSIONWILLSHIFTTHELMANDTHEADCURVESTOTHERIGHTTHERESULTINGDECREASEINTHEINTERESTRATEWILLCAUSEANOUTFLOWOFFUNDSANDADEPRECIATIONOFTHECURRENCYNETEXPORTSWILLINCREASE,SHIFTINGTHEISCURVETOTHERIGHT,WHICHSHIFTSTHEADCURVEEVENFURTHERTHEEXCESSDEMANDFORGOODSANDSERVICESWILLCAUSEPRICESTORISEANDREALMONEYBALANCESTOFALLTHELMCURVEWILLSHIFTBACKTOTHELEFTANDINTERESTRATESWILLINCREASEAGAINTHISWILLRESULTINACAPITALINFLOWANDANAPPRECIATIONOFTHECURRENCYNETEXPORTSWILLDECREASEAGAIN,SHIFTINGTHEISCURVEBACKTOITSORIGINALPOSITIONINTHELONGRUN,WEWILLBEBACKATTHEFULLEMPLOYMENTLEVELOFINCOME,BUTATAHIGHERPRICELEVEL,SINCETHEINCREASEINMONEYSUPPLYCAUSEDTHEADCURVETOSHIFTTOTHERIGHTINTHISNEWLONGRUNEQUILIBRIUM,NOMINALMONEYSUPPLY,DOMESTICPRICES,ANDTHEEXCHANGERATEWILLALLHAVEINCREASEDPROPORTIONATELY,WHILETHEREALMONEYSTOCK,REALINTERESTRATES,ANDREALOUTPUTWILLALLHAVEREMAINEDUNCHANGEDANIMPORTANTFEATUREOFTHISADJUSTMENTPROCESSISTHATPRICESANDEXCHANGERATESDONOTADJUSTATTHESAMERATETHISIMPLIESTHATMONETARYPOLICYHASASHORTRUNEFFECTONTHECOMPETITIVENESSOFACOUNTRYWHENMONETARYEXPANSIONDRIVESINTERESTRATESDOWN,EXCHANGERATESADJUSTFAIRLYRAPIDLYBUTPRICESRESPONDMUCHMOREGRADUALLYTHEEXCHANGERATEWILLINITIALLYOVERSHOOTITSNEWEQUILIBRIUMLEVELANDONLYSLOWLYRETURNTOTHENEWLONGRUNEQUILIBRIUMPOSITIONTHISOVERSHOOTINGCAUSESVOLATILITYINTHEREALEXCHANGERATE,WHICHISCONSIDEREDTOBETHEMAJORDRAWBACKOFAFREELYFLOATINGEXCHANGERATESYSTEMGOVERNMENTSOFTENFEELCOMPELLEDTOINTERVENEINFOREIGNEXCHANGEMARKETSTOAVOIDANUNDESIRABLEINSTABILITYINTHEECONOMYASLO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ICHPRICESWEREKEPTCONSTANT,STUDENTSSHOULDALREADYBEFAMILIARWITHFIXEDANDFREELYFLOATINGEXCHANGERATESYSTEMSANDTHEFACTORSTHATMAYAFFECTTHEVALUEOFACOUNTRYSTERMSOFTRADETHEMAJORRESULTSDERIVEDINTHISEARLIERCHAPTERREMAINVALIDEVENWITHVARIABLEPRICESITMAYTHEREFOREBEAGOODIDEATOASKSTUDENTSTOREVIEWTHEMAINCONCLUSIONSOFCHAPTER12BEFOREASSIGNINGTHEMATERIALOFCHAPTER20ADISCUSSIONOFTHEAUTOMATICADJUSTMENTTHATTAKESPLACEINASYSTEMOFFIXEDEXCHANGERATESISSTILLOFVALUE,SINCEAGOODUNDERSTANDINGOFTHISMATERIALWILLHELPSTUDENTSTOBETTERGRASPTHEISSUESRELATINGTOTHEMORECOMPLEXWORLDOFFLOATINGEXCHANGERATESIFABALANCEOFPAYMENTSPROBLEMEXISTS,THEADJUSTMENTMECHANISMCANBEAUTOMATICEITHERTHROUGHACHANGEINMONEYSUPPLY,WHICHWILLAFFECTSPENDING,ORTHROUGHUNEMPLOYMENT,WHICHWILLAFFECTWAGES,PRICES,ANDCOMPETITIVENESSHOWEVER,ANADJUSTMENTALSOCANBEACHIEVEDTHROUGHACHANGEINPOLICYINASYSTEMOFFIXEDEXCHANGERATES,THECENTRALBANKCANCHANGETHEEXCHANGERATEFORPOLICYPURPOSES,RESPONDINGTOANEXPECTEDPROLONGEDCURRENTACCOUNTDEFICITWITHADEVALUATIONOFTHECURRENCYINASYSTEMOFFREELYFLOATINGEXCHANGERATES,ONTHEOTHERHAND,THEEXCHANGERATEWOULDMOVEFREELYTOLEADTOABALANCEINTRADEHOWEVER,CENTRALBANKSOFTENSEETHENEEDTOMANIPULATEEXCHANGERATESTOSOMEDEGREE,LEADINGTOASYSTEMTHATISKNOWNASDIRTYFLOATINGITISIMPORTANTTOPOINTOUTTHATTHETASKTHATPOLICYDECISIONMAKERSFACEISMUCHMORECOMPLICATEDINANOPENECONOMYWHEREANEXTERNALBALANCEISINCLUDEDINTHELISTOFPOLICYOBJECTIVESAGENERALRULEINPOLICYMAKINGISTHATTHENUMBEROFPOLICYINSTRUMENTSEMPLOYEDSHOULDBEEQUALTOTHENUMBEROFPOLICYTARGETSTHESHARPAPPRECIATIONOFTHEUSDOLLARINTHEEARLY1980S,WHICHCAUSEDASIGNIFICANTLOSSINCOMPETITIVENESSESPECIALLYINTHEMANUFACTURINGSECTOR,LEDMANYPOLITICIANSTOASKFORTHEIMPOSITIONOFTRADERESTRICTIONSHOWEVER,INTERNATIONALTRADEAGREEMENTSOUTLAWTHEFREEUSEOFTARIFFSUSINGTARIFFSORQUOTASINRESPONSETOACURRENTACCOUNTDEFICITISANEXPENDITURESWITCHINGPOLICYASANALTERNATIVE,GOVERNMENTSCANALSOEMPLOYEXPENDITUREREDUCINGPOLICIES,SUCHASMONETARYORFISCALRESTRICTIONTOHELPSTUDENTSTODISTINGUISHBETWEENEXPENDITURESWITCHINGANDEXPENDITUREREDUCINGPOLICIES,INSTRUCTORSSHOULDASKTHEMTODESIGNPOLICIESTHATWOULDREDUCEATRADEIMBALANCEWHILEMINIMIZINGTHENEGATIVEEFFECTONTHEDOMESTICECONOMYBYRECALLINGTHEFOLLOWINGNATIONALINCOMEIDENTITIESDERIVEDINCHAPTER2YCIGNXANDSTATRIGNX,WECANDERIVETHEFOLLOWINGEQUATIONSNXYCIGANDNXSTAGTRI,WHICHSHOWTHATAREDUCTIONINTHETRADEDEFICIT,THATIS,ANINCREASEINNETEXPORTSNX,CANBEACHIEVEDBYREDUCINGDOMESTICSPENDINGCIGRELATIVETONATIONALINCOMEYSIMILARLY,IFPRIVATEDOMESTICINVESTMENTIINCREASESMORETHANNATIONALSAVING,THENTHETRADEDEFICITWILLDECREASETHISCANBEACHIEVEDTHROUGHTHEUSEOFFISCALORMONETARYPOLICYBYNOW,STUDENTSSHOULDBEAWARETHATTHELARGEBUDGETDEFICITSOFTHE1980SWERELARGELYRESPONSIBLEFORTHECONCURRENTDRAMATICINCREASEINTHEUSTRADEDEFICIT,ALTHOUGHTHEREISNOONETOONERELATIONSHIPBETWEENTHETWOINOTHERWORDS,IFPRIVATEDOMESTICSAVINGISNOTENOUGHTOFINANCEPRIVATEDOMESTICINVESTMENTANDTHEBUDGETDEFICIT,FUNDSHAVETOBEBORROWEDFROMABROADTHERESULTINGCAPITALINFLOWSWILLCAUSEANAPPRECIATIONOFTHEDOMESTICCURRENCY,LEADINGTOATRADEIMBALANCEHOWEVER,FISCALORMON