Balance of Payments
When governments fixed exchange rates, they needed to know if the price they had selected as the fixed rate was sustainable. Because in the real world we cannot observe the supply and demand curves for foreign exchange, deciding whether a government had pegged the price of its currency too high or too low was a problem. In an attempt to measure the gap between the supply and demand curve, countries collected balance of payments statistics. Balance of payments statistics balance because some use is found for each unit of foreign exchange provided, and each unit of foreign exchange used has a source.
To estimate the gap between the supply and demand curve, the government first tried to measure all the uses and all the sources of foreign exchange. It then attempted to separate those sources and uses of foreign exchange that take place naturally at the existing prices from those that are accommodating. For example, to maintain a price above equilibrium, the government could sell some of the foreign exchange (or gold) it owned, or it could borrow from other countries. These sources of foreign exchange would be accommodating. In practice measuring the gap was very difficult and several different ways of computing it from the statistics were developed.
The table below illustrates what the Balance of Payments can tell us by showing data for the United States for 1966, when the United States still had fixed exchange rates. Exports of goods and services include spending by American tourists abroad and also earnings that Americans receive from investments abroad. Both are payments for services. Remittances sent abroad and U.S. government grants are similar in that there is no flow of goods in return for them.
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(Amounts in millions of dollars) |
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Exports of Goods and Services $43,142 |
Imports of Goods and Services $38,063 |
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Foreign Capital Flow, net $2,532 |
U.S. Government grants, net $3,444 |
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Change in U.S. Reserve Assets $568 |
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Source: Federal Reserve Bulletin, April 1969, pp A70-71. |
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Capital flows represent purchases of foreign assets in the form of factories, foreign stocks and bonds, and debt of foreign governments. In 1966 the United States was exporting capital, that is, Americans were investing more in other countries than foreigners were investing in the United States. The errors and omissions category reflects the fact that these numbers are estimates, and this category will take whatever value needed to make sources balance uses.
The negative balance of -1357 suggests that in 1966 Americans wanted to use more foreign exchange than foreigners were supplying to the market. To keep the price of the dollar from falling, the U.S. government reduced its holdings of gold and foreign reserves, and foreign governments increased their holdings of U.S. dollars in the form of U.S. government debt, supplying foreign exchange as they did so. The first of these accommodating sources represents a form of dissavings, and the second a form of borrowing. Just as an individual cannot borrow and dissave forever, neither can a nation. The balance of payments deficit that these figures indicated was a warning to the United States that there were problems in its transactions with the rest of the world and that policy changes were in order. The policy change that the United States ultimately took was to abandon fixed exchange rates.
Copyright Robert Schenk