THE ISSUES

This chapter begins with an overview of the adjustment process and goes on to introduce some strategic assumptions that will help us sort out the principal elements in that process. Thereafter, it examines three issues:

• How income and output are modified by international trade.

• How trade leads to economic interdependence.

• How trade can produce policy conflicts within and between individual countries.

The chapter will not analyze these issues completely. We will return to them frequently in subsequent chapters.

ELEMENTS IN THE ADJUSTMENT PROCESS

Chapter 12 used supply and demand curves to show how balance-of-payments adjustment is reflected in the foreign-exchange market. Under a flexible exchange rate, movements along the curves play the leading role. Under a pegged exchange rate, movements of the curves themselves play the leading role.

To review the main lines of the analysis, consider the effects of an increase in the domestic demand for foreign goods, services, or assets. It raises the domestic demand for foreign currencies, depleting dealers' inventories. Dealers enter the foreign-exchange market to rebuild those inventories, causing an outward shift in the demand curve for foreign currency. There is an excess demand for foreign currency at the initial exchange rate and, therefore, an excess supply of domestic currency.

If the exchange rate is flexible, the domestic currency depreciates. Foreign goods, services, and assets become more expensive in domestic markets, because the currency needed to buy them has become more expensive. Domestic buyers cut back their purchases, reducing the domestic demand for foreign currency.