The Balance of Payments
David addressed another constraint on the making of economic policy in Britain, namely the balance of payments. In a small open economy, trade is, of course, an important part of national economic activity.
In his 1991 book, David employed his skills as a teacher to explain how trade affects the economy (Worswick 1991: 206-231). The classical model, first laid out explicitly by Ricardo, shows that barter between two countries benefits both. When that model is extended to take into account exports and imports trading at some exchange rate, the balance of trade (the value of exports minus imports) affects the internal economy, particularly output, employment, wages and the domestic price level. David laid out the case for a tariff as a means to increase employment in the protected industry. But he shows that it does not increase overall employment; it diverts employment into the protected industry and at the expense of a loss of real income to consumers.In a small open economy, the difference between the value of exports and imports has been the focus of economic policy as another constraint on the attempt to maintain full employment and domestic price stability. David's 1981 article “The Money Supply and the Exchange Rate” rehearses the arguments of the policy debate between the Keynesians and the monetarists with respect to their different conclusions about the effects on the exchange rate and the balance of payments of changes in the money supply. For example, suppose there is a deficit in the balance of trade which policy makers believe will not correct itself soon enough. Then monetary policy could be undertaken to reduce the money supply and raise interest rates. This would cause an inflow of funds and a rise in the exchange rate causing a reduction in exports, a rise in imports and lower output and employment. On the other hand, if fiscal policy is tightened (higher taxes and/or lower government spending) in order to reduce demand for imports then domestic employment will fall as output is reduced.
This is because the negative effects on output of a tighter fiscal policy (due to reduced consumption and investment) are likely to outweigh the upward effect on output due to lower imports.In 1944, the Bretton Woods agreement fixed exchange rates to the US dollar. The IMF was set up at the same time to provide temporary funding for countries in deficit. The Marshall Plan also came into operation, providing significant amounts of aid from the US to the countries devastated by war. The explicit policy of maintaining full employment was affirmed by the UK government and led to a devaluation of sterling in November 1967. As noted, in 1972, sterling was allowed to float as the Bretton Woods system broke down. Devaluation had become another policy tool to help in achieving the goal of demand management when the balance of payments was also a significant policy objective along with full employment and only modest increases in prices.
10