Theories of adjustment of the balance of payments under fixed exchanges

Abstract

Any system of stable exchange rates is one in which the quantity of money in each country is determined primarily by the balance of payments. Discrepancies in the balance of payments may be settled temporarily by movements of gold or by changes in the balance of international short-term indebtedness, but to eliminate discrepancies caused by secular changes and secure real adjustment the domestic money supply must be adjusted. The traditional classical theory of this adjustment process was the only explanation of the mechanism of re-equilibrium until the recent studies carried out by Harrod and Whale, who applied the Keynesian theory of employment to international trade problems. Harrod's theory2 is merely a development of the classical, but Whale's analysis of the working of the pre-1914 gold standard has given an alternative explanation of the mechanism of re-equilibrium. These various theories of the mechanism of adjustment of the balance of international payments will be examined in turn and an attempt will be made to determine the validity of Whale's theory, which has been found to fit better the known facts of the working of the pre-1914 gold standard, in the new setting of the fixed exchange relationship between Ireland and Great Britain within the sterling area.