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Unit 12 : Equilibrium and Disequilibrium in BOP

rate of about 1 percent per year. One would not be surprised if the Bank of Canada tried to offset this Notes
decline, particularly the sharp decline in late-1967 and early 1968, by manipulation of the domestic
source component. In this respect, you should keep in mind that the basic theoretical framework that
we are applying here was not understood at that time, apart from the special case where there was
perfect capital mobility, then interpreted as an extreme situation where domestic and foreign assets
are identical. The instability of the month-to-month changes in the stock of official foreign exchange
reserves during 1968 may have reflected failed attempts by the Bank of Canada to control the stock of
base money. Finally, notice the 5 percent increase in the real exchange rate that occurred over June,
July and August of 1970. Were the nominal exchange rate held fixed, this would have implied a
5 percent increase in Canada’s equilibrium price level over the three month period. It is not surprising
that the country abandoned the fixed exchange rate. Indeed, the real exchange rate increased by an
additional 5 to 6 percent between late-1970 and late-1972, making the abandonment of the fixed
exchange rate a wise decision.
Despite these Canadian hassles, the above discussion of balance of payments disequilibrium seems
tame in comparison to what one reads in the popular press. One reads about international currency
crises as edgy investors shift funds from currency to currency, creating havoc with the payments
system. In fact, most of the time things are very quiet. But occasionally the ability of a country to
maintain its fixed exchange rate parity comes into question. Major movements in a country’s real
exchange rate, as demonstrated for Canada, particularly downward ones that by pressing down on
the domestic price level will lead to increased unemployment, are a good reason to expect abandonment
of a fixed exchange rate. Another very real possibility is that the government is under political pressure
to finance some of its expenditures by printing money---that is, having the central bank buy bonds
from the treasury which will use the money so obtained for public expenditure. Or it may be that the
government is under pressure to expand the money supply to deal with a difficult domestic
unemployment situation in the face of a forthcoming election. Whatever its cause, such monetary
expansion is inconsistent with maintaining the nominal exchange rate fixed. It becomes a reasonable
bet that the country’s currency will devalue in the future.
The spectre of a potential future devaluation presents big expected profit opportunities. If the domestic
currency in fact devalues there are enormous gains to having one’s assets denominated in foreign
currencies while if devaluation does not occur little is lost by holding these currencies. Not surprisingly,
huge shifts of funds out of domestic currency denominated and into foreign currency denominated
assets occur under these conditions. To maintain the exchange rate in the face of these speculative
pressures, the authorities must sell large quantities of foreign exchange reserves. This seems to put
them in danger of eventually running out of reserves, in which case devaluation becomes inevitable.
As official reserve holdings continue to fall, the pressure mounts. Of course, the country’s authorities
can easily, and costlessly in terms of effects on employment and prices, avoid running out of reserves-
--all they have to do is reduce the domestic source component of the money supply, something they
may be reluctant to do under less-than-full-employment conditions.
Although governments can borrow official reserves from the governments of other countries in
emergency circumstances or, better still, costlessly create them by reducing the domestic source
component of base money, they must eventually put their house in order. This means either
abandoning the fixed exchange rate, thereby proving the speculators to be right, or establishing
credibility in the eyes of asset holders that the domestic money supply will be allowed to be determined
endogenously at the fixed exchange rate, regardless of the real exchange rate shocks and public
finance demands that may arise.
Speculative pressures on the exchange rate sometimes also arise under flexible exchange rates. When
investors think that a currency will depreciate in the future, they will shift funds out of assets
denominated in that currency now. This means that the prices of those assets will fall and interest
rates on them will rise to reflect a forward discount on the currency expected to depreciate. Under
these circumstances, central banks may “lean against” movements in the external value of their
currencies by purchasing and selling foreign exchange. Balance of payments disequilibria can thus
arise even when the exchange rate is flexible although these are of minor consequence and probably
should not even be referred to as disequilibria.

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