ALTERNATIVE PORTFOLIO APPROACHES TO BALANCE OF PAYMENTS ADJUSTMENT
| Author | Richard Coghlan |
| Published date | 01 February 1978 |
| Date | 01 February 1978 |
| DOI | http://doi.org/10.1111/j.1467-9485.1978.tb01182.x |
Scottish Journal
of
Political Economy,
Vol.
25,
No.
1, February 1978
ALTERNATIVE PORTFOLIO APPROACHES
TO
BALANCE OF PAYMENTS ADJUSTMENT
RICHARD COGHLAN*
Bank
of
England
A
group of economists at Cambridge’ have recently developed
a
model of the
U.K.
economy, emphasising external currency flows under a regime of fixed
exchange rates,z which they believe provides a better guide to policy formula-
tion than the previous Treasury assumptions. The correct application of
policy suggested by this new model is that “the Budget should be used to
determine the foreign balance and the exchange rate to determine the level
of activity” (Neild,
1974).
In this paper I wish to develop, within a very simple model of rational asset
choice, the suggestion that changes in the private sector’s holdings
of
net
financial assets is stable, fairly small, and predictable; related predominately
to changes in national disposable income (Godley and Cripps,
1974,
p.
2
and Cripps, Fetherstone and Godley,
1974,
p.
2).
Which naturally implies
that the stock of net financial assets is in the main determined by the level
of
national disposable income3
(Economic Policy Review,
1976,
p.
49).
This forms the basic foundation underlying this Cambridge view, and
I
wish
to consider, firstly, how similar this approach is to a simple monetarist
model; and, secondly, whether the policy choices suggested by the “new
school” really are open to policy makers.
We begin, therefore, by comparing and contrasting the central assumptions
of the two models. The objective
is
not to analyse in depth the underlying
assumptions that have been made, but simply to take the arguments as
presented and determine what similarities exist. In order to bring out their
essential qualities in the simplest possible way, and to facilitate easy com-
parison, the models are developed within a unified framework of portfolio
*
I
would like to thank Andrew Bain, Wynne Godley, Peter Jackson, David Ulph and
an anonymous referee for the helpful suggestions they have made. This paper was completed
while the author was lecturing at Stirling University and does not represent the views of
the Bank of England.
Neild (1973), Godley and Cripps (1974; 1976), Cripps, Godley and Fetherstone (1974),
and various letters and articles in
The Times.
This
is
not to imply that the exchange rate is fixed absolutely for all time, only that it is
a
policy variable under the control of the domestic authorities, as opposed to being deter-
mined simply by the pressures of supply and demand.
It
would
be
possible to assume that income is proportional to wealth, which would
probably accord better with the assumptions
of
the monetarist model. In the latest
exposition of the Cambridge model (Cripps and Godley, 1976) the net acquisition
of
financial assets has been made
a
function of the
level
of
income. It is not clear what the
ha1 assumption will
be,
but for present purposes it is sufficient to employ both models in
their most basic form, with the demand for the stock
of
the financial asset in question
being determined by the level of income.
Received in
final
form: 7 September 1977.
13
14
RICHARD
COGHLAN
choice. An interesting conclusion of this paper is the importance, when
making comparisons of different economic models and of the various policy
alternatives within a particular model, of the time scale of the models
implicitly assumed.
THE
INTERNATIONAL
MONETARIST
In terms of comparative statics, comparing final equilibrium positions,
the argument is conducted in terms of price changes with real income fixed
at its full employment level. The model in its simplest form essentially
translates the basic quantity theory to an international setting and combines
this with the “small country assumption”; see, for example, Dornbusch
(1971), Swoboda (1973) and Johnson (1972; 1976). This latter assumption
requires the economy to be
so
small that prices and interest rates can be
thought of as being determined in world markets independently of the
individual country. Each country is therefore treated as the individual unit
making up
a
perfectly competitive market, and satisfying all necessary
conditions for such a market organisation: “The small country is
a
price
taker facing perfectly elastic demand and supply of assets and goods”
(Dornbusch, 1971, p. 389).
It is also assumed that all “real forces” in the
U.K.
maintain
a
constant
relationship with the rest
of
the world, and that the only disturbances in the
model are those originating in the public sector. With interest rates given
the domestic price level depends
ultimately
only on the world money supply.
Since the country is assumed to be too small to permanently affect the world
price level, an exogenous once-and-for-all change in the domestic reserve
assets4 of the banking system will have no lasting effect on income, prices or
the balance of payments. The balance of payments, on capital and current
account, is therefore automatically self-correcting, i.e., always tending to
zero. Any balance of payments deficit (or surplus) is simply the consequence
of
a
stock disequilibrium which, in the absence of deliberate offsetting action
by the government, will automatically resolve itself. Furthermore, this
approach “assumes-in some cases, asserts-that these monetary inflows
or outilows associated with surpluses or deficits are not sterilised-or
cannot be, within
a
period relevant to policy analysis” (Johnson, 1972, p.
235). Full employment is assumed at equilibrium; the only thing that
will
have changed when equilibrium is re-established will be the country’s stock
of reserves.
Given the existence of international capital flows there is obviously no
necessity for the equilibrium balance of payments on current account to be
zero,s indeed that would be most unlikely. All that really matters in this
model is the demand for and supply of money, regardless of the source.
Equilibrium in a comparative static sense requires there
to
be
no
change in the level
of
*
The definition
of
monetary policy
in
this model.
reserves.
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