Price level, exchange rate, income and interest rate
The effects of the flexibility of exchange rates, incomes and interest rates on the balance of payments and on exchange rates were introduced progressively, first by developing the partial equilibrium analysis of the balance of trade, and finally by exposing a general Keynesian equilibrium approach to the balance of payments.
The idea that a fall (increase) in the domestic price level, or in the exchange rate, improves (deteriorates) the balance of trade has been questioned since the period between the two World Wars. C.F. Bickerdike (1920), Alfred Marshall (1923), and Joan Robinson (1937) stressed that, in addition to its equilibrating effects on the volumes of exports and imports, exchange rate variation has an opposite effect in so far as it modifies the price of any volume of imports; a fall in the exchange rate increases the volume of exports and decreases the volume of imports, but increases the price of imports. Therefore, the global effect depends on the respective strengths of both price and volume effects. Abba P. Lerner (1944) showed that the price effect dominates the volume effect if the sum, in absolute terms, of the price elasticity of the quantity of imports and the price elasticity of the quantity of exports is greater than one. These critical conditions, called Marshall-Lerner conditions, gave rise to an “elasticity pessimism” and mistrust of a flexible exchange rate regime. This mistrust was reinforced at the end of the 1960s, when it was found that the price effect occurs before the volume effect, initially worsening the balance of trade and subsequently improving it, resembling a J curve drawn in a plane whose horizontal axis measures time and whose vertical axis measures the balance of trade.
In 1929, a controversy about German war reparations arose, opposing John Maynard Keynes on the one hand and Bertil Gotthard Ohlin and Jacques Rueff on the other.
Keynes thought that Germany could not succeed in paying the reparations because the real transfer of goods - the German balance of trade surplus - following and clearing the monetary payment of war reparations, would necessitate an intolerable deflation in Germany. According to Keynes, any shift in the balance of trade requires a shift in the international terms of exchange. Ohlin and Rueff objected that, if financed by taxes in Germany, the payment would be a transfer in “buying power” from Germany to foreign countries. Therefore, the purchasing power becomes greater than income in foreign countries, and lower in Germany. Then, the domestic aggregate demand for goods increases in foreign countries, giving rise to a deficit in their balance of trade, and, symmetrically, the domestic demand for goods decreases in Germany, bringing about a balance of trade surplus. In this case, the real transfer occurs without involving a variation in price levels in either Germany or foreign countries. The adjustment process is similar to that described by Gervaise and relies on a spending effect.The spending effect is also at work in Roy Harrod’s analysis (1933) of the income multiplier effect of a variation in exports. An increase in exports gives rise to an increase in production, then in income, then in spending, and then in the demand for domestic-produced and imported goods. The demand for domestic goods induces new production, income and spending, whereas the demand for imported goods does not; imports, like saving and taxes, are a leakage in the multiplier process. The multiplier approach to the balance of trade enriches Keynesian macroeconomics: exports are included in the multiplicand; the propensity to import is included in the multiplier. The main result is that, given an initial equilibrium of the market for goods and the balance of trade, a shift in exports will induce shifts in both income and imports, which last until the market for goods is again at equilibrium.
However, except for very special conditions, the balance of trade is either in deficit or in surplus. Therefore, in order to equilibrate the balance of payments and maintain the exchange rate, a shift of the interest rate, either up or down, has to occur. This shift may have an undesirable effect on investment and therefore on income. In his 1930 Treatise on Money, Keynes had already emphasized the conflict between the domestic and external objectives of economic policy.The critical elasticities condition and multiplier analysis were synthesized in the absorption approach in the 1950s, mainly by Sidney Alexander (1952, 1959), in which absorption is the term used to designate domestic aggregate demand, that is, consumption and investment. Focusing on the equilibrium condition of the market for goods - income plus imports equals absorption plus exports - Alexander underlined that the gap between income and absorption equals the gap between exports and imports, that is, the balance of trade surplus or deficit. He concluded that the reduction of any balance of trade disequilibrium lies in the reduction of a disequilibrium between income and absorption. For example, a deficit, that is, income lower than absorption, would be removed by an increase in income, or a decrease in absorption, or an increase in income higher than the increase in absorption. A devaluation of the exchange rate would help to achieve this goal not only because it reduces the quantity of imports and increases the quantity of exports, but also because the increase in exports brings about an increase in production and then in income. Moreover, devaluation gives rise to an increase in the prices of imported goods, which causes a fall in the real balance and therefore in absorption. In addition, it gives rise to higher interest rates that will also lower the absorption. On the contrary, any increase in income increases absorption. Finally, several effects are at work and explain why the Marshall-Lerner conditions are satisfied or not. The introduction of the real balance effect and the interest rate underlined the need for a more general model. Robert Mundell (1960, 1961, 1962, 1963), a monetarist, and Marcus Fleming (1962), a Keynesian, provided this by incorporating the exchange market into the IS-LM synthesis.