Economic Theory and Western European Intergration by Scitovsky Tibor;

Author:Scitovsky, Tibor;
Language: eng
Format: epub
ISBN: 1461021
Publisher: Taylor & Francis Group

A. THE THEORY OF THE BALANCE OF PAYMENTS

In searching for the market forces that tend towards balance-of-payments equilibrium, it is natural to begin with a survey of the accepted theories. There are two of these: the classical theory and the modern or income theory of the balance of payments.

1. The Classical Theory

The classical theory is a dynamic equilibrium theory: dynamic, because it deals with a process of adjustment over time, equilibrium, because it asserts the existence of a tendency towards balance-of-payments equilibrium. Its earliest formulation is David Hume’s, who argued that a flow of specie from one country to another will lower prices in the first, raise them in the second, and that this divergent movement in the two countries’ price levels will continue until balance-of-payments equilibrium is reestablished and specie ceases to flow. This is nowadays regarded as a crude mechanistic formulation of the classical theory; but in Hume’s day it may have been quite realistic even in this form. For one thing, prices were probably more flexible then than they are now; for another, money in Hume’s day was, if not the only, certainly the most important store of value. Hence, a significant change in the stock of money implied a significant change in the total accumulated stock of wealth; and such a change is generally believed to affect expenditures out of given incomes (the Pigou effect), and thus—when prices are flexible—also prices.

Since Hume’s time, there has been a great accumulation of wealth in the Western countries, most of it held in forms other than specie; and this implies that a given percentage change in a country’s stock of monetary reserves now represents a much smaller percentage change in its inhabitants’ accumulated stock of wealth and is likely therefore to have a much smaller impact on their propensity to spend. Indeed, this impact is generally held to be negligible in advanced economies; and later restatements of Hume’s theory have stressed therefore the role of monetary policy. According to these, the flow of gold does not change price levels automatically but causes the two countries’ monetary authorities to change their policies; and it is they who, in an effort to stop the gold flow, engage in policies of contraction and expansion respectively and thus cause the price changes that re-establish balance-of-payments equilibrium. A further refinement of the theory showed that the influence of monetary policy on the balance of payments may be exerted through its effect not only on prices but also on levels of income and economic activity. Some writers have also argued that during the decades before World War I the effectiveness of monetary policy in maintaining balance-of-payments equilibrium has been due to the effect of bank rates on the international flow of speculative short-term capital no less than to their effect on price, income and activity levels.

Today, this entire body of theory is all but relegated to the history of economic doctrine, not because it ceased to be true, but because we have realized and, what

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