INTRODUCTION

The theory of balance-of-payments adjustment in Chapters 13 and 14 originated in the 1950s, when many countries had tight controls on international capital movements. Therefore, the theory said very little about the capital account; it emphasized income and exchange-rate changes affecting the current account. Questions were raised occasionally about the effects of autonomous capital flows on the policies needed to maintain internal and external balance. But economists did not pay much attention to the role of capital flows in the adjustment process or to the implications of capital mobility for choosing optimal policies.

During the 1950s and 1960s, capital controls were liberalized, and other changes in the economic environment reduced the risks and costs of international lending and investment. There was thus an increase in capital mobility, and balance-of-payments theory began to take notice. Two economists, J. Marcus Fleming and Robert Mundell, made major contributions, and the model used in the next section of this chapter is thus known as the Fleming–Mundell model.

The 1970s brought another change in the economic environment, the shift in 1973 from pegged to flexible exchange rates. Having shown how capital movements can affect the adjustment process and the behavior of a flexible exchange rate, economists had then to show how a flexible exchange rate can affect capital movements.

When exchange rates are flexible, you must answer two questions before choosing between a domestic asset and a foreign asset: (1) Are rates of return higher at home or abroad?