Labour Party (UK)/Tutorials

The balance of payments constraint

Demand management involves the use of fiscal policy or monetary policy to stimulate the economy when it growth rate is expected to fall below the level necessary to prevent the development of an unacceptable rate of unemployment. For partocipants in the Bretton Woods agreement, that process is subject to a constraint arising from the commitment to maintain a fixed rate of exchange between their currency and the United States dollar. It is a constraint on a country's ability to stimulate its economy because the effect of the stimulus is to increase its demand for imports from abroad without producing a coresponding increase in its exports. That imbalance is termed a balance of payments deficit and it means that those imports that are not paid for by an equal value of exports have to be paid for in the currencies of their suppliers urrency - and since the country's reserves of foreign currency is not unlimited. Were it not for the commitment to maintain a fixed exchange rate, the imbalance could be corrected without the use of foreign exchange reserves by allowing the exchange rate to fall. Under the terms of the Bretton Woods agreement, however, the required fall in the exchange rate can only be brought about by a procedure termed "devaluation" (see below)

A balance of payments constraint can also be caused by inflation because that can reduce the demand for the country's exports by increasing their prices, and the same effect can result from a relative decline in productivity.

Devaluation

A step reduction in the rate of exchange of the currency has the effect - other things being equal - of relieving the balance of payments constraint by reducing the prices of exports and increasing the prices of imports. There are two complications, however. One is that the reduction in the prices of exports can be offset if wage-earners demand increased pay to compensate for the rise in the prices of imported goods. The other is that the expectation of a devaluation of the pound may prompt currency speculators to sell pounds with the intention of buying them back at a lower price - causing a "run on the pound" that the government has to counter by buying pounds using its limited foreign exchange reserves.

The International Monetary Fund

The International Monetary Fund was created for the purpose of assisting member countries who experience balance of payments problems by drawing upon its members' pooled reserve of - what is effectively an international currency termed "special drawing rights"