Published online by Cambridge University Press: 18 September 2009
Ever since the Plaza Accord, when the finance ministers of the group of five largest industrial countries agreed to a depreciation of the dollar, monetary, and exchange-rate policies have been used as an alternative to protection. It was no secret that the motivation for the Plaza Accord was the intent to ward off protectionist pressures in Congress. Devaluation of the dollar was looked upon as a means of improving US competitiveness in the face of increasing foreign penetration of domestic markets and a soaring trade balance deficit. The failure of the balance of trade to respond to changes in the exchange rate puts into question the economic theory that predicted it.
Classical international trade theory did not establish any connection between exchange rates or tariffs and the balance of trade. On the contrary, the classical model assumed that the balance of payments was self-adjusting at the level of the balance of trade determined by autonomous classical movements. Trade policy could affect the terms of trade and the level of prices but not the balance of trade.
There was one exception that was clarified by the development of the monetary approach to the balance of payments. With unchanged terms of trade, the imposition of a tariff would raise the equilibrium level of prices of the tariffed good and hence require a larger stock of money.