Abstract

The term “balance of payments” may be defined in a number of ways. In the narrowest definition, the term refers to changes in the international reserve position of a central bank. When a central bank follows a policy of fixing the exchange rate between its currency and a reserve currency, it does so by offering an infinitely elastic supply of the reserve currency in exchange for the domestic currency at a price equal to the established par value. When domestic currency is exchanged for the foreign currency, the central bank is said to be running a balance of payments deficit. The main issues relating to the process of balance of payments adjustment, under this definition, are concerned with the factors that induce a balance of payments deficit and the adjustment mechanism through which a balance of payments deficit restores equilibrium in the local financial markets. Throughout most of this paper, the narrow definition of the balance of payments will be taken to be the appropriate one.