ABSTRACT

The argument for using the exchange rate as the primary tool for balance-of-payments adjustment goes back to the first week of elementary economics. When a market is out of equilibrium, a price change is the preferred solution, and if a market remains in disequilibrium, it is typically because government intervention or some other rigidity has precluded the necessary price adjustment. If the market for foreign exchange is viewed as being analogous to the market for corn, the same argument holds, and exchange rate changes are the obvious answer for payments disequilibria. A supply and demand graph for foreign exchange may make this point clearer (see Figure 17.1).