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Unformatted text preview: 20 I NTERNATIONAL A DJUSTMENT AND I NTERDEPENDENCE FOCUS OF THE CHAPTER • This chapter extends the open economy analysis of Chapter 12 by allowing the domestic price level to change. Methods and strategies of foreign exchange intervention are explored in greater depth. SECTION SUMMARIES 1. Adjustment Under Fixed Exchange Rates In our discussion of fixed exchange rate regimes in Chapter 12 we assumed that the central bank would take preventative action to insure that balance-of-payments problems never occurred. In reality, this is a little idealistic. Central banks can, and do, finance temporary payments imbalances. This section asks what happens when one of these imbalances proves less temporary than the central bank had hoped. In order to finance a payments imbalance, a central bank must regularly intervene in the currency market, buying or selling foreign exchange. In a balance-of-payments deficit, the demand for foreign currency exceeds the supply and the central bank must step in regularly to make up the difference. It is limited by its reserves and cannot keep this up forever; ultimately it must devalue its currency. But if it chooses not to do this there is an automatic adjustment process that takes effect: the decline in the central bank’s reserves caused by its currency market intervention gradually erode the stock of high-powered money and reduce aggregate demand. As long as the central bank does not try to offset this by buying domestic bonds ( sterilizing its intervention) this will eventually repair the payments imbalance. If the payments imbalance occurs with output at or below potential output, a decline in wages and prices may also have to occur to bring the economy back into internal balance. This will reduce the real exchange rate (remember it’s the nominal exchange rate that’s fixed) and add a bit back to aggregate demand by raising net exports. This slow return to internal and external balance is called the classical adjustment process . 216 217 C HAPTER 20 A combination of expenditure switching policies policies which shift demand between domestically produced goods and goods produced in other countries and expenditure reducing (or expenditure increasing) policies policies which decrease (or increase) aggregate demand can achieve internal and external balance both more quickly and with much less pain than the classical adjustment process. We have already observed that devaluation could have than the classical adjustment process....
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- Spring '09