Growth and the Balance of Payments under Alternative Exchange Rate Regimes: the Case of a Small Economy

Abstract

When secular growth and secular inflation are absent the current account and the capital account in the balance of payments each register a zero balance at the steady state. In such models, responses to any disturbance trace a sequence of stock flow equilibria along which agents are adjusting their stock of assets at the rate necessary to bring the current level of these assets to the level where any further accumulation or decumulation ceases. Viewed from a long-run perspective, imbalances in the current and the capital account of the balance of payments are a disequilibrium phenomenon since they cease to exist in the long run. In models where secular growth is present in the form of, say, population growth, secular imbalances in the balance of payments are the rule. For instance, unless all sectors other than the monetary authorities register a net indebtedness position of zero, secular imbalances in the capital account will prevail. Furthermore, unless the economy’s target level of wealth coincides with its target level of capital, secular imbalances in its current account will prevail. Finally a small and growing economy that pursues a fixed exchange rate policy which makes it necessary for it to hold foreign reserves will experience secular surpluses in its overall balance of payments. Only in this way can such an economy acquire the money balances necessary to equip every member of its growing population with the level of money balances desired and preserve the desired ratio of foreign reserves to money. Viewed from a long-run perspective, secular flows in the balance of payments are an equilibrium phenomenon.