National income at factor cost

Looked at from the point of view of national income accounting, the problem is fairly simple. The best approach is to study the generation of income by various types of expenditure. Income-creating expenditures can be classified under three major headings: domestic private consumption, domestic private net investment, and domestic government expenditures on goods and services. Part of each of these, however, is a payment for indirect taxation which does not create income for factors of production at home, and therefore has to be deducted from the total. On the other hand, government subsidies, which enable goods and services to be purchased at less than factor cost, should be added to total expenditure; for they too form part of the incomes of factors of production. A part of each category of expenditure may also be spent on goods and services supplied by foreign countries and thus fail to generate income at home. This too should be deducted. On the other hand, foreign residents’ and government expenditures on goods and services produced at home contribute to the creation of incomes of domestic factors of production, and hence should be added to the domestic income-creating expenditures.

The national income, as earned by the domestic factors of production in their participation in the productive process, may therefore be said to equal the sum of domestic private consumption plus domestic private net investment plus domestic government expenditures on goods and services minus indirect taxation plus subsidies minus imports plus exports. And, since interest and profits on foreign investment are, in fact, payments for the services of foreign-owned capital, they may be treated as invisible exports for the receiving country and as invisible imports for the paying country along with other “invisible” items. From this equation, it can be readily seen that the contribution of the balance of payments to the domestic flow of income equals the difference between exports and imports, including both invisible and visible items.¹

The national income thus computed, which is the sum total of the earnings of the various factors of production from their participation in production, is identical with the value of net national product at factor cost or net national expenditure at factor cost. Its variations therefore accurately represent the inflationary or deflationary effects of domestic and foreign expenditures upon output and prices, exclusive of indirect taxes.

National disposable income

As the source from which domestic current expenditures flow, however, a slightly different concept of national income is required, viz., national disposable income in the sense of the aggregate of the current receipts of all domestic residents and the government, of which the recipients can freely dispose without reducing their assets or increasing their liabilities. To obtain the aggregate disposable income of private individuals and firms, the direct taxation (including social security contributions) which they pay to the government has to be subtracted from their earnings as factors of production; and transfer payments (e.g., national debt interest, social security benefits, etc.) which they receive from the government, and the net transfer payments which they receive from abroad (i.e., net donations and remittances), have to be added. The disposable income of the government is equal to incomes from government-owned factors of production plus total tax proceeds minus transfer payments to domestic residents minus net international transfer payments (i.e., donations, reparations, etc.) made by the government to foreign countries (or plus net international transfer payments received from abroad). Thus net total national disposable income may be computed as follows:

Net national disposable income = total earnings of domestic owned factors of production (i.e., national income at factor cost)—direct taxation + transfer payments from the government to domestic residents + net transfer payments received by private residents from abroad + total tax proceeds—transfer payments from the government to domestic residents + net transfer payments received by the government from abroad. . . . . . . . . . . . . . (1) = domestic private consumption + domestic private net investment + government expenditure on goods and services + subsidies—indirect taxation + exports—imports—direct taxation + total tax proceeds + net international transfer payments received (both by the government and by private residents). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (2) = private consumption + private net investment + government expenditures on goods and services + subsidies + net current account surplus of the balance of payments. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (3)

When private disposable income is added to government disposable income in equation (1), transfer payments from the government to domestic residents cancel out. In equation (2), where net national income at factor cost is rewritten into its components according to the equation in the preceding section, the two minus items, indirect and direct taxation, cancel out with total tax proceeds and net export surplus (including all the invisible trade items) plus net international transfer payments received are equivalent to the current account balance of the balance of payments.

These equations show how the balance of payments stands in relation to national income in social accounting. Only the current account of the balance of payments is directly involved in the computation of either national income at factor cost or of national disposable income.² The items in the capital account do not come into the picture.

Changes in stocks; donations

These equations hold even if part of the exports recorded in the balance of payments are not currently produced but have come from existing stocks and inventories, e.g., exports of surplus property and reparations in the form of capital equipment. These exports do not, of course, create income in the exporting country and are really of the nature of capital transactions. But, if they are listed as current exports in the current account of the balance of payments, they would be exactly offset by a simultaneous domestic disinvestment in the national income account. That is to say, the positive export item in such cases is exactly canceled out in the social accounting by an item of negative investment, and there is thus no change in national income. Nor does it matter if imports entered in the balance of payments do not always drain off the income-creating expenditures of domestic residents up to their full recorded value, as when government imports are distributed to the domestic population at prices below cost. For in these cases any divergence between the domestic expenditure on imported goods and services and the actual cost of imports may be regarded as being exactly offset by a corresponding increase in government expenditure in the form of subsidy to the consumers of these imports. That is to say, the negative import item is partly or completely canceled out by a simultaneous increase in the positive item of government subsidies, and to that extent national income will not be reduced by the import in question.

Imports such as UNRRA relief goods, which are assumed to be distributed free to the domestic population, usually take the form of a donation by a foreign government to the domestic government. There is then a contra-entry of donation in the current account of the balance of payments. The whole transaction may be analyzed for the purpose of social accounting as follows: It may be assumed that the donation first increases the transfer income of the recipient government in the national disposable income. Then this item of national disposable income is spent to subsidize the import of relief goods and thus also becomes an item in national income at factor cost. But in national income at factor cost the new item of subsidy will be exactly offset by a corresponding negative import item. Thus, there will be no change in national income at factor cost. The only remaining effect is in the national disposable income where the transfer income of government registers an increase equal to the donation. As pointed out above, however, only the national income at factor cost—which is identical to the value of net national product and net national expenditure at factor cost—is relevant for the determination of output, employment, and prices. Therefore, the whole transaction will have no direct inflationary or deflationary effect upon domestic output and prices, even though national disposable income would register a rise.³

Capital and gold movements

With all these precautions in mind, the balance in the current account of the balance of payments may be regarded, from the point of view of social accounting, as the net contribution (positive or negative according as the balance is a surplus or a deficit) of the balance of payments to the flow of domestic national disposable income. Items in the capital account may be ignored entirely as mere contra-entries of the balance on current account. For, according to the principles of social accounting, international capital transactions merely change the form of assets and liabilities of the domestic residents; that is to say, a capital export is an exchange of domestic capital assets for foreign assets, or more generally an increase of foreign assets (or a decrease of foreign liabilities) against a decrease in domestic assets (or an increase in domestic liabilities); a capital import is an exchange of domestic liabilities for foreign liabilities, or more generally an increase of foreign liabilities (or a decrease of foreign assets) against a decrease in domestic liabilities (or an increase in domestic assets). Such transactions by themselves, therefore, do not create incomes. Furthermore, since the balance of payments must always balance, the balance on capital account must always equal and be opposite in sign to the balance on current account. In other words, export surplus plus net “donations” is identical with net capital export or net foreign investment. Thus, if the effect of the balance on current account upon domestic income is analyzed, there is no need to repeat the analysis with respect to the capital account.

Since it has been shown above that the items on current account of the balance of payments have such different significance from the items on capital account in the accounting of national income, it might not be out of place to digress at this juncture to discuss the place of gold movements in the balance of payments. International movements of gold, insofar as the gold is not currently mined in the country concerned, have been alternatively treated as current commodity imports or exports by some economists, notably Mrs. Joan Robinson, or as capital transactions by others. From the restricted point of view of social accounting, it is indeed a matter of indifference which of these views is accepted. If gold is treated as a commodity, then it logically follows that an increment to the stock of gold owned by domestic residents or the government must be regarded as part of domestic investment and a decrement as disinvestment, in the same way as changes in the stock of any other commodities. If, on the other hand, gold is treated as a title to goods and services from abroad like other foreign assets and exchange, then logically an increment in the stock of gold must be regarded as foreign investment and a decrement as foreign disinvestment, and the movements of gold should obviously be put in the capital account. In either case, however, the outcome in social accounting is exactly the same. For example, an increase in imports accompanied by an equivalent export of gold taken from stocks may be recorded in social accounting (1) as an increase in imports offset by an equal amount of exports (i.e., gold) but accompanied by a further negative item of domestic disinvestment of the same amount, or (2) as a net increase in imports on current account accompanied by an equivalent opposite change in the capital account. In either case, the impact on national income is a decrease equal to the increase in imports. Thus economists who are chiefly concerned with the social accounting aspect of the balance of payments often regard the allocation of gold movements to the capital or the current account as a mere matter of convenience. Indeed, it appears more convenient to treat gold movements invariably as current exports and imports, for this method has the advantage of putting all gold movements upon the same footing whether the gold is currently produced or taken out of stock.⁴

If the intention is to go beyond social accounting and to analyze the monetary effects of gold movements, however, then it is not just a matter of convenience whether gold is treated as a commodity in the current account or as a foreign asset in the capital account. That part of gold transactions which comes out of, or increases, the monetary reserves of the country concerned should certainly be treated as foreign assets and be entered in the capital account; for from the point of view of the monetary authority, gold is an international reserve just as foreign exchange and other liquid foreign assets. The movement of such monetary gold would have the same effect on the monetary situation of the country as the movement of other foreign exchange reserves. Consequently, it is only logical to put monetary gold on the same footing as foreign exchange and assets; while the movements of nonmonetary gold, i.e., exports of newly mined gold and imports of gold for industrial and consumption purposes, should be regarded as current commodity exports or imports.

If monetary gold in the reserves of the monetary authority is consistently treated as foreign assets, then any increment in its stock must be regarded as foreign investment and any decrement as foreign disinvestment. Consequently, the logical conclusion is that domestic gold output sold to the central bank should be entered as a foreign investment item (capital export) on the capital account of the balance of payments against a contra-entry of export of nonmonetary gold on the current account, as the Fund’s Balance of Payments Manual has proposed. From the point of view of national income accounting, however, again it makes no difference whether the gold output sold to the monetary authority is regarded as foreign investment or domestic investment. If it is regarded as domestic investment, then its impact on national income is to increase it by that amount. If, instead, it is regarded as a foreign investment accompanied by a contra-entry of export of nonmonetary gold, then its impact on national income is to increase it by the amount of the supposed export of nonmonetary gold.

In accordance with the Balance of Payments Manual, this paper will treat monetary gold as foreign assets, and outward and inward movements of monetary gold as capital imports and exports (or foreign disinvestment and investment), respectively. Private gold hoardings, however, will be treated as a nonmonetary commodity or domestic assets for the sake of convenience.⁵

Static nature of social accounting approach

Such a treatment of the relation between the balance of payments and domestic income has the charm of being extremely systematic. It is, however, all too static. Its limitation is inherent in the fact that different expenditures are listed as independent items in the social account, whereas in fact they may be interdependent in the sense that one expenditure may induce another or a series of others. The indirect effect of a transaction upon national income through its influence on other expenditures is not revealed at all by such a balance sheet study of the constituents of national income. An obvious example is that an increase in exports unaccompanied by a simultaneous increase in imports would produce a series of reactions upon domestic consumption and investment which is known as the multiplier effect. If exports are treated merely as an item in the accounting of national income and their influence on other domestic expenditures is neglected, the effect of the balance of payments upon domestic income will not have been fully grasped. Or again, capital import, which does not figure in the national income account at all because it does not involve by itself any creation of domestic income, may, nevertheless, induce an increase in domestic investment by altering the availability of liquid investible funds to the domestic investor and thus constitute an active cause of an expansion of domestic income. Such indirect influences might easily be lost sight of if the problem of the balance of payments is approached merely from a social accounting point of view. Indeed, as noticed above, even the impact of current transactions upon domestic income as expressed in the social account may sometimes be quite nominal, if they are canceled out by concomitant changes in other domestic expenditures which are entered as independent items in the social account.

Direct impact

The direct impact of international transactions upon domestic income hardly needs further explanation after our discussion of the place of the balance of payments in social accounting. Only the items on current account may have a direct impact upon domestic income, and their total impact may be measured by the net balance on current account, provided that items which are offset by concomitant and opposite changes in domestic expenditures have been deducted therefrom.

Indirect effects through multiplier

It is now generally recognized that any autonomous change in the current account items of the balance of payments will have repercussions upon domestic income far beyond its immediate impact; for the spending of the income created, or the cessation of the spending of the income drained away, will produce a series of changes in other items of domestic expenditure. In other words, since many items of national expenditure, e.g., consumption, import, and investment, are at least partially dependent upon domestic income, the initial increment (or decrement) in income due to the impact will induce, via the income effects, some increases (or decreases) in these income-creating expenditures, which will in turn induce further increases (or decreases) in themselves, and so on ad infinitum.

This process is now known as the multiplier principle (the nomenclature of Keynes and Kahn), and the marginal functional relationship between consumption and income is called the marginal propensity to consume. Similarly, the marginal functional relationships between imports and income and between investment and income may be called the marginal propensities to import and to invest, respectively, since these expenditures are also now known to depend partly upon income. In a sense, even exports may be said to be dependent partly upon domestic income. When domestic income increases, exports may decline because of the competition of rising domestic demand with foreign demand, or they may increase because rising domestic income stimulates imports, which, in turn, increase income in the countries that produce those imports, thereby increasing their demand for exports.

If factors other than income variations that may affect domestic national expenditures are either assumed away as absent, or subsumed, if possible, into the functional relations between income and various expenditures (i.e., into the various marginal propensities); and if these functional relations can be assumed to be stable and their derivatives, i.e., the marginal propensities, to be constant, with their sum less than one; then the final effect upon the level of income of a given stream of autonomous expenditure may, provided that the stream is continuous and constant for some length of time, be calculated as a multiple of that stream, which is determined by all the marginal propensities. Such a multiple is called the multiplier.⁶

The choice of the multiplicand. The multiplier analysis should, however, be applied with caution to the estimation of the effects of the balance of payments upon domestic income. Recent discussion,⁷ as well as our preceding exposition, has shown that the multiplier as a means of forecasting these effects upon income should be applied only to what may be called “autonomous” expenditures, i.e., expenditures that are determined by factors other than domestic income and that do not change in response to domestic income. In other words, we should use as the multiplicand of our multiplier only those expenditures that may be regarded as independent variables in the determination of income; whereas expenditures which vary with the changes in income at home, i.e., the induced expenditures, cannot be regarded as a prime mover which sets the multiplier process in motion, but are rather part of the outcome of the multiplier process. These induced expenditures should rather be taken into account in the multiplier itself, whose magnitude is determined from the marginal functional relationships between all the induced expenditures and the domestic income.

Although from our discussion of the social accounting aspect of the balance of payments the net balance on current account, adjusted for concomitant offsets of domestic expenditures, appears to represent the additional income injected into the domestic income stream from outside, it is now also clear that some items on current account, viz., imports and exports of both goods and services, are to some extent dependent upon domestic income movements and are to that extent induced expenditures. The balance on current account is therefore as much an outcome of the changes in domestic income as an impulse that would cause its flow to change. Not all the items involved can be regarded as the prime mover which sets the multiplier mechanism going. Thus the multiplier should be applied only to the autonomous elements of the balance on current account.

In the analysis of an actual balance of payments, it is indeed an almost impossible task to draw an exact distinction between autonomous and induced expenditures. This does not mean, however, that the multiplier analysis is incapable of application in practice. As first approximations, it is often feasible to pick out certain changes in international transactions as being the autonomous ones and to use them as the multiplicand of the multiplier to estimate their effect on income, provided that the choice is based upon the exchange and trade system of the country concerned and the circumstances under which the changes occurred.

To illustrate the significance of the trade and exchange system upon the choice of the multiplicand, three different cases might be distinguished. First, for a country which has a more or less stable exchange rate and no over-all quantitative restriction of imports, it might be permissible, as a fair approximation, to regard changes in imports as induced largely by income movements, if there is no obvious reason to expect a change in the demand function for imports. On the other hand, if the domestic demand of the country for its own exports is quite insignificant, and if that country imports from a large number of countries only a small fraction of the total exports of the rest of the world, it is permissible to regard changes in exports as entirely autonomous. In such cases, changes in exports (net of their import content and exclusive of exports out of stocks which are directly offset by domestic disinvestment) may be taken as the multiplicand of the multiplier, in the formulation of which marginal propensity to export may be omitted, since exports are taken to be independent of income.

Second, if the country has a general quantitative import control which keeps imports at the planned level, changes in the amount of imports must also be regarded as autonomous, since they are determined by government planning rather than by the variation of income. The change in the net balance of trade rather than in exports alone should then be taken as the multiplicand, and the marginal propensity to import, being zero in this case, would also disappear from the multiplier.

Lastly, if the country studied has a perfectly flexible rate of exchange which is determined entirely by the market demand and supply of foreign exchange, without any pegging operations by the monetary and banking authority, then changes in imports may be said to be dependent upon changes in exports because of the influence of the latter upon the exchange rate, and vice versa. In the absence of any capital movement, an increase in the value of exports would always bring about an equal increase in the value of imports through the adjustments of the exchange rate, and there would be no multiplier effect on income. Only when there is a concomitant increase in net capital exports will there be a resultant increase in the net export surplus, and only then will the increase in exports bring about an expansion through the operation of the multiplier. Therefore, in the case of a perfectly flexible exchange rate, it is more reasonable to take the change in the net balance of trade as the multiplicand than to take the change in exports alone, and both the propensity to export and the propensity to import may be omitted in the formulation of the multiplier, since exports and imports are instantaneously adjusted to each other by the perfectly flexible exchange rate rather than by the mechanism of income variation. This may be the reason why Keynes himself took the view that the net export surplus rather than exports should be treated on an equal footing with domestic investment for the application of the multiplier. These three cases are sufficient to show that the choice of the multiplicand from the balance of payments must be made with close reference to the exchange and trade system of the country studied.

Whether or not items other than exports and imports in the current account may be treated as the multiplicand of the multiplier should be determined by the same criterion, viz., whether they are autonomous or induced in the particular institutional framework of the country concerned. Here again it is extremely difficult to be theoretically exact, but in a rough and ready way perhaps investment incomes and governmental donations may be treated as largely autonomous, and private remittances may be treated as largely dependent upon income.

Therefore, too much reliance must not be placed upon the apparent quantitative exactness of the multiplier analysis. Apart from the difficulty of choosing the appropriate multiplicand, it must be kept in mind that the multiplier effect can be fully worked out only when the multiplicand remains constant for some considerable time. Since the autonomous elements on current account of the balance of payments are seldom an even flow over time, it is quite probable that the multiplier effect will rarely have a chance to work itself out to the full theoretical extent because of the ever changing multiplicand. Furthermore, and what is more important, the multiplier analysis takes account only of the changes in expenditure induced by changes in income, whereas the effects upon expenditure of the changes that may be brought about simultaneously in other factors by the international transactions—such as changes in the interest rate or in the supposedly stable functional relations between income and various expenditures—are generally assumed away, if they cannot be tucked into the various marginal propensities and thus linked to the changes in income. Therefore, the multiplier effect should not be looked upon as constituting the total effect of the international transactions on current account. It should be supplemented or modified by other indirect influences which have not been taken into account in the various marginal propensities.

Indirect effects through consumption and investment functions

That an international transaction may indirectly affect the domestic income flow through its direct influence upon the propensity to consume or the marginal efficiency of investment at home can best be explained by two illustrations.

Propensity to consume. It has been pointed out above that when an import of consumers’ goods is offset simultaneously by a corresponding increase in government expenditure on subsidy, such as occurs when imports of relief goods are distributed free to the domestic population, the deflationary impact on income is nullified and no multiplier effect will be generated. It cannot be taken for granted, however, that this whole transaction has no effect upon domestic income. For, even though the deflationary impact of the import and its potential multiplier effect may in this way be completely offset by the corresponding government subsidy, so that no domestic income disbursement is absorbed, yet the propensity to consume, and hence the consumption expenditure of the domestic population, may be reduced by such imports, for freely distributed imports are equivalent to a rise of real income of the population at home. Normally, at least a part of the increase in real income might be saved, unless those whose real incomes rise—i.e., the recipients of free imported goods—have, with respect to increases in real income, a marginal propensity to consume equal to unity. Consequently, although their money incomes have not changed, their propensity to consume out of their money incomes may be reduced. Thus, such imports might be expected to have a contractive effect upon domestic money income, even though there is no direct impact on it. It is, therefore, incorrect to say that government imports which were not sold to the domestic population at their full import values would to that extent fail to bring any relief whatever to an inflationary domestic monetary situation.

Normally, however, the deflationary effect of imports which do not absorb the income disbursements of domestic residents will be smaller than that of imports which do. For only when the people who receive government subsidized imports have a marginal propensity to save equal to unity, with respect to changes in real income, will the deflationary effect be the same in both cases. But this is, of course, very unlikely. On the other hand, if those who receive government subsidized imports have a marginal propensity to save equal to zero, which is not unlikely when the recipients of subsidized imports are utterly destitute, then such imports would have no deflationary effect at all.

Domestic marginal efficiency of investment. Assume that the imports which are distributed free to domestic residents consist of capital goods, such as reparations in kind. The deflationary impact and its multiplier effect are again offset by a simultaneous increase in government subsidy. But there may still be an indirect effect upon domestic money income exerted in the following way. The increase of such capital equipment would stimulate domestic investments which are complementary to them, or, in other words, raise the schedule of the marginal rate of return of those investments. On the other hand, it might also lower the marginal efficiency schedule of other investments which are competitive with them. In the case of reparations in kind, however, the capital equipment imported is likely to be of a kind that is in particularly short supply and which more or less constitutes a bottle-neck in reconstruction at home. Consequently, complementarity rather than competitiveness is likely to be the predominant relation with other domestic investment projects. The net result will be a stimulus to domestic investment expenditures which, in turn, will bring about an expansion of domestic money income. Thus such imports, with their direct deflationary impact canceled out, may even exert an indirect inflationary effect upon domestic income.⁸

Generally speaking, the import of capital goods or technical “knowhow” would have such effects upon the domestic marginal efficiency schedule of investment whenever and only when capital goods or technical services previously not available become available to domestic investors or when they could be purchased at costs lower than their original expected market prices. For it must be assumed that domestic investors, in their estimation of the marginal efficiency of various investment projects, will have taken into account the possibility of obtaining the foreign capital goods at their prevailing prices. Therefore, only when the investors are accorded special facilities, which enable them to obtain foreign capital goods which had hitherto not been available, or to obtain them at prices lower than they expected, will their expectations of marginal returns from associated investments be upset.

Thus, apart from the case of reparations in kind, the ECA assistance to European countries, to the extent that it takes the form of capital goods, must also have an effect upon the marginal efficiency of domestic investment in those assisted countries. Here again complementarity might be expected to be the dominant relation to other domestic investments. Likewise, an increase in imported capital goods due to a sudden cheapening of their prices, caused by, say, exchange depreciation or technical improvements in the exporting countries, might have the same sort of effect upon the marginal efficiency of other domestic investments. In this case, however, it is uncertain whether complementarity or competitiveness will be more important.

In this respect the import of technical assistance in a backward country would have the same effect as the import of scarce capital goods. And it may be safely stated that its relation to domestic investment is generally highly complementary.

Indirect effects through the wage-price spiral

Imports and exports might affect the level of money income indirectly through their effect upon the prices of wage-goods and consequently upon the general wage level. For a country with an inflationary tendency at home, an increase in imports of consumption goods (especially in the form of free gifts, as under UNRRA) would have some stabilizing effect on the cost of living, and consequently would relieve the pressure of the working class for higher money wages. It therefore constitutes an anti-inflationary influence for a country under the strain of either an actual, or a threatened, wage-price vicious spiral. On the other hand, an increase in exports of consumption goods in a country which has already reached the critical stage of full employment of labor and productive capacity might start or aggravate such a vicious spiral.

It is, however, very unlikely that a reduction in exports or an increase in imports of wage-goods will bring about a downward wage-price spiral in view of the rigidity of money wages in the downward direction in countries with organized labor.

Indirect effects through availability of liquid funds and rate of interest

Role of capital movements. So far, the capital transactions of the balance of payments have been neglected altogether. It has been shown that capital transactions have no direct impact on domestic income, since, by themselves, they do not involve income creation or disbursement. And since they do not create income or drain away income in the first instance, neither can they be expected to produce the secondary effect upon income through the multiplier process, which is consequent on the primary effect upon income. Moreover, direct effects upon the propensity to consume and the marginal efficiency of capital can be expected only from the import or export of real consumers’ or capital goods in the circumstances described in the preceding section. Finally, there looms large the indisputable truism that the balance of payments must always balance, which implies that the net balance on capital account which is usually identified as the net capital export or import (or net foreign investment or disinvestment) must always be equal to the balance on current account. Thus, it is natural to think that net capital movement must not be considered as a separate force affecting domestic income, but rather as the mere contra-entry in bookkeeping to the net balance on current account.

However, if the problem of capital movements is dealt with by taking the net capital movement as the mere contra-entry of the balance on current account, a paradox is soon reached. For, from the discussion up to this point, it may be roughly stated that the current account of the balance of payments has an inflationary or deflationary pressure upon domestic income according as there is a surplus or deficit, if for the time being the complications of concomitant offsets, etc., are neglected. Since surplus on current account implies a net capital export and deficit a net capital import, it appears that an increase in capital exports is inflationary while an increase in capital imports is deflationary. This is prima facie so contrary to common sense as to arouse a strong suspicion that there must be something wrong. For it is known that a sudden cessation or a serious cut of capital imports from abroad, such as happened to Europe in the latter half of 1928, constitutes a depressing rather than an inflationary factor. Such a paradoxical result must be due to the omission of one further important factor in the analysis, and to the fact that the analysis of the problem of capital movements by reference to the net balance on current account does not suit our purpose of explaining the effects of capital transactions. The factor omitted is the indirect influence of the international transactions upon domestic income through their effect on the domestic supply of liquid funds and the conditions of credit.

Before this question is considered, however, it must first be shown that not all transactions on capital account are mere contra-entries of current transactions. For this purpose, transactions on capital account may conveniently be classified as either compensatory or stabilizing capital movements by the monetary authority, or what for want of a better term we shall call “independent capital movements.” The last consist of the demand for, or supply of, foreign claims, securities, and other foreign assets, which are motivated by considerations of the relative advantage or disadvantage (including risk), for each particular case, of having one’s assets or liabilities in the form of one currency rather than in another, or by a specific purpose, in each particular case, other than the stabilization of the exchange rate. This definition of independent capital movements would include all private long-term and short-term capital movements, speculative as well as non-speculative, and government borrowing and lending for specific projects (i.e., what the Balance of Payments Manual terms special official financing). The stabilizing capital movements of the monetary authority, however, differ from these independent movements in that they involve no consideration of the relative advantage or disadvantage of changes in the forms of assets or liabilities, but arise merely as a response to a demand for, or supply of, foreign claims and balances, with the over-all purpose of keeping movements of the exchange rate within bounds.⁹ Obviously, only the monetary authority and the banks acting as its agents can afford to undertake stabilizing capital movement without a direct profit motive. The monetary authority must indeed also review periodically the advisability of maintaining a stable exchange rate by financing from its reserves the deficit on the exchange market or absorbing the surplus into its reserves, but it does not consider in each particular case the advantage or disadvantage of the change in the form of its assets involved in the transaction.

Independent capital movements have not been termed “non-compensatory” or “non-stabilizing,” because independent capital movements may sometimes behave also in a compensatory or equalizing manner. For instance, dealers and speculators, who have an inelastic expectation about changes in the exchange rates, would supply foreign exchange when they see that an increase in market demand relative to supply tends to raise the rate unduly in their opinion, and would buy foreign exchange when they see that an increase of supply relative to demand tends to lower the rate excessively, in either case because they expect the present tendency soon to be reversed. Such speculative capital movements help to stabilize the exchange rate and to finance the deficit and absorb the surplus in the market in a way similar to the compensatory capital movements of the monetary authority. But they are strictly for profit making in each transaction and do not necessarily always have a stabilizing or compensatory effect. For should the expectation of such dealers and speculators become elastic—i.e., if a fall in the exchange rate should make them expect further declines, or a rise lead them to expect further increases—their supply and demand would be highly destabilizing and, instead of helping them out, would put a heavy strain upon the compensatory capital movements of the monetary authority. Thus, it is ultimately the compensatory capital movements of the monetary authority which adjust the net balance on capital account to the balance on current account. Independent capital movements are free to change independently of the net balance on current account.¹⁰

Assumption about monetary framework. The effect of current and capital international transactions upon the demand and supply of liquid funds and terms of credit in the country concerned and indirectly upon its income flow cannot be discussed in a theoretical vacuum, but has to be analyzed in the framework of a specific monetary system, for it is concerned with the monetary mechanism of international payments.

Let it be assumed first that, in the particular country concerned, the monetary authority or the central bank attempts to maintain some sort of stability in the exchange rate of its own currency by buying and selling the foreign exchange and claims offered or demanded by authorized persons (i.e., by compensatory capital movements), and that there is no deliberate policy of offsetting the effect on the domestic money market of the foreign exchange dealings of the central bank, such as was practiced by the prewar Exchange Equalization Account in Great Britain. Let it be assumed further that the commercial banks observe strictly a legal or conventional reserve ratio between their cash reserve in the forms of currency and deposits with the central bank and the amount of their current deposits, and that they are not in the habit of keeping excess reserves and therefore are not in a position to create additional credit unless their cash reserve is increased.

Export surplus counterbalanced by independent capital export. Consider first the case of a surplus on current account (an export surplus). This implies supply of foreign exchange by exporters in excess of the demand for foreign exchange by importers. This excess supply must be taken up either by capital exporters or by the monetary authority by means of a compensatory capital export. Suppose first that it is taken up by independent capital exporters. The liquid funds necessary for the purchase of foreign exchange must come from the domestic money market. There will thus be an increase in demand for loanable funds in the money market. The proceeds obtained by the exporters from their sales of foreign claims, however, will go to meet their obligations to producers or to replace their inventories of goods exported, and hence will not be available for lending on the money market. Therefore, this transaction would represent a net increase in demand for loanable funds on the money market. The rate of interest would tend to rise. How much it would rise depends upon the elasticity of other demands for loanable funds, i.e., domestic investment demand for funds, and the elasticity of supply of loanable funds, i.e., savings and particularly dishoardings. The rate of interest must rise unless the elasticity of demand for cash balances, i.e., the liquidity preference, is infinitely large (hence the supply of dishoarding is infinitely elastic), or the elasticity of supply of bank credit is infinite (a possibility which is, however, excluded by our assumption that the commercial banks are not in a position to create additional credit unless their cash reserves are increased). If the demand for cash balances is infinitely elastic, the additional demand for loanable funds can be easily met without any perceptible rise in the rate of interest by the dishoarding of idle balances, and consequently there will be no decrease in investment demand for finance funds and no increase in ex ante savings. The increase in domestic income created by the impact of the export surplus may then be regarded as a net increase.

If the demand for cash balances (i.e., liquidity preference) is not infinitely elastic, the rate of interest must rise and consequently at least part of the additional demand for loanable funds by capital exporters will be met by reducing the investment demand for finance funds, which implies a decrease in investment expenditures, and/or by increasing ex ante savings, which implies a reduction in consumption expenditures. This deflationary influence of an independent capital export counterbalancing an export surplus of goods and services must be set against the inflationary effects of the export surplus discussed above, the analysis of which completely neglected the effect of international transactions upon the demand and supply of loanable funds and the rate of interest.

If the elasticity of liquidity preference and hence the supply of dishoardings were absolutely zero, then the rate of interest would rise so much that the whole amount of liquid funds, which the exporters obtain from the capital exporters and use to pay the producers for the surplus exports, would come from a reduction in investment and consumption expenditures. The additional income created by the export surplus would then be completely offset by a corresponding interest-induced reduction in domestic investment and consumption expenditures. There would be no inflationary effect upon income at all.

This is, admittedly, highly unlikely. The normal case would be an elasticity of demand for cash balances greater than zero but smaller than infinity. It may be very large in times of depression and slump, but would become smaller and smaller as the level of activity rises toward boom, and as credit conditions become more stringent. Thus, under normal conditions, the independent capital exports which counterbalance the export surplus will have some deflationary effect upon investment and consumption expenditures, which must be set against the inflationary effect of the export surplus. And as long as the export surplus persists and continues to be counter-balanced by independent capital export, there will be continuous pressure upon the rate of interest to rise higher and higher (for further dishoardings can be called forth only by further rises in interest), until income has risen so much through the operation of the multiplier process, which is now damped down by the interest-induced reductions in investment and consumption, that the supply of ex ante savings is finally sufficient to cope with the demands for loanable funds, both for domestic investments and for taking over surplus foreign assets from the exporters.

Export surplus counterbalanced by compensatory capital movement. The situation is entirely different if the export surplus is counterbalanced by a compensatory capital export by the monetary authority. For if the exporters sell their surplus foreign exchange to the central bank, their demand for loanable funds is met by a creation of money by the central bank. There is, therefore, no pressure on the domestic money market. Furthermore, since the credit and notes of the central bank constitute the cash reserves of the commercial banks, the additional money created by the central bank, when passed into the hands of the commercial banks, will induce them to expand their credit by a multiple of the increase in their cash reserves, the multiple being equal to the reciprocal of their reserve ratio. Thus, after a certain lag of time, the supply of loanable funds will be greatly increased.¹¹ As long as the export surplus persists and continues to be offset by compensatory capital export of the central bank, the additional demand for loanable funds by the exporters is always counterbalanced by the credit expansion of the central bank, but each credit expansion by the central bank will be followed by a further multiple credit expansion by the commercial banks. Thus, there will be a strong downward pressure upon the rate of interest. Unless the elasticity of hoarding is infinite, the rate of interest must fall. Domestic investment, and possibly consumption as well, might be stimulated, and the inflationary effect thus produced upon income would be superimposed upon the impact and the multiplier effects shown above, when only the incomeinduced changes in consumption and investment expenditures were taken into account and interest-induced changes were neglected.

Import surplus counterbalanced by independent capital import (portfolio). Mutatis mutandis, it can be shown that an import surplus counterbalanced by a simultaneous independent capital import for portfolio investment will tend to lower the rate of interest by increasing the supply of loanable funds to the money market. For the liquid funds which the importers hand over to the capital importers for the purchase of foreign exchange are not current net savings, but are the proceeds of the sale of imported consumers’ and producers’ goods which are to be directed to the replenishment of the inventories of the importers. Through the sale of foreign exchange by the capital importers to the importers, however, these funds become available to the money market for net investment at home just as if they were net savings, while the inventories of the importers can now be replenished by the foreign exchange provided by the capital importers. Therefore, an import surplus offset by an independent capital import represents a net increase in the supply of loanable funds to the money market.

This additional supply of loanable funds to the money market would tend to lower the rate of interest, unless it encounters an infinitely elastic demand schedule for idle cash balances, or unless it meets with a corresponding increase in the demand (in the schedule sense) for idle cash balances. In either of these events, the rate of interest, of course, would not be affected. Thus, at a time of depression, when the rate of interest has already fallen so low that it barely covers the minimum liquidity preference (hence the demand for idle cash balances is very elastic), the additional supply of loanable funds brought to the money market by capital importers cannot be expected to have any effect upon the rate of interest and investment expenditures. Or, in the special case where the capital imported is “hot money,” which has escaped from abroad to take temporary refuge from the hazards of exchange depreciation, and which consequently does not seek investment in any form on the domestic money market, the additional supply of loanable funds may be simply absorbed by a corresponding additional demand for idle cash balances on the part of the capital importers (the foreign capitalists). Then of course the rate of interest and investment expenditures will not be affected, whatever the elasticity of demand for cash balances.

In normal cases, however, imported capital usually seeks investment in the domestic money market, and with a fairly high level of activity at home, the demand for liquidity is not likely to be infinitely elastic or perfectly inelastic. Therefore, the rate of interest will probably fall or the terms of credit will become easier, and domestic investment expenditures might thus be increased. That is to say, not all of the additional supply of loanable funds transferred to the money market by capital importers from the importers of goods and services will be absorbed into idle balances; at least part will find its way into additional investment expenditures. To that extent, therefore, domestic income will be increased.

This probable inflationary effect of an import surplus offset by independent capital imports must be set against the deflationary effects of the import surplus, in the previous discussions of which the indirect effects via the money market and the rate of interest were entirely neglected.

As long as the import surplus persists and continues to be counterbalanced by independent capital imports, there will be a continuous additional supply of loanable funds to the money market. This would constantly tend to lower the rate of interest (for successive decisions to hoard, i.e., to make successive additions to idle balances, can be induced only by successive decreases in the rate of interest), until the multiplier effect of imports, which is now much damped down by the interest and liquidity effect, has again restored, by successively lowering the level of income, the equilibrium between the investment demand for loanable funds and the supply of ex ante savings plus the supply of loanable funds which the import surplus, together with its counterpart, independent inflow of portfolio investment, would transfer to the money market.

Import surplus counterbalanced by independent capital import (direct investment). This discussion of independent capital imports has treated portfolio investment in securities on the domestic money market by capital importers as the typical case of independent capital imports. In doing this the traditional theoretical analysis of the money market has been followed, viz., all the supplies of loanable funds have been put on one side and all the demands on the other, even though it is very well known that there may be some cases where the demand for and supply of loanable funds arise from the same person, i.e, where the investor provides his own investible funds.

This practice is logically permissible and simplifies the matter greatly insofar as the money market concerned is a perfect one, in the sense that each individual can borrow or lend any amount of loanable funds at the same ruling market rate of interest. On such an assumption, if an investor (in the restricted sense of the person or corporation who actually carries out the investment project, not one who invests money or buys securities) finances his own investment expenditures, it may be imagined that he, as the supplier of loanable funds, lends the funds to himself as the investor. Since the rates at which he can lend and borrow are both the same ruling market rate of interest, it would make no difference if he lent his funds to somebody else and then borrowed the funds for his investment projects from somebody else again. His investment expenditure will be determined by the prevailing market rate of interest, which, being the rate at which he can lend his own funds or which he can obtain by investing them in other securities, measures the marginal opportunity cost of his investment expenditures. By the same token, the capital importer who imports capital from abroad to finance his own investment project may be treated as if he first lent out the capital he imported from abroad on the domestic money market (i.e., puts it into securities) and then raised the investible funds for his investment expenditure from the market. Thus, to the extent that the domestic money market is perfect, the above discussion of independent capital imports for portfolio investment on the domestic money market can be taken to cover all cases of independent capital imports.

If, however, the domestic money market is highly imperfect, so that each individual borrower is confronted with an individual supply curve of credit which rises sharply as he approaches the limit of his borrowing capacity,¹² there will usually be a considerable gap between his marginal borrowing rate and his marginal lending rate on the money market. Consequently, the marginal costs of credit to an investor would be quite different in the two cases where he finances his own investment and where he raises the investible funds from the domestic money market. It is, therefore, no longer permissible to treat the cases where the investors themselves provide the loanable funds for their own investment expenditures as virtually the same as the cases where the supplier of credit and the investor are different persons brought together by the money market.

Likewise, in the discussion of international capital movements, the cases of domestic investors borrowing directly from foreign capital markets and of foreign capitalists directly carrying out investment projects in the country into which they import their capital (i.e., where the capital importer and the investor are the same person) have to be dealt with separately from capital imports in the form of portfolio investment. For in these cases, the marginal cost of investible funds to the investor is not the marginal borrowing rate which he would have to pay if he raised the same amount of funds from the domestic money market, but his marginal borrowing rate on the foreign money market plus a certain premium for the risk of exchange fluctuation, or his marginal lending rate on the domestic money market, whichever is the higher.¹³ There is a strong presumption that both these rates are much lower than his marginal borrowing rate on the domestic money market; for his domestic marginal lending rate must be lower than his domestic borrowing rate if the domestic money market is at all imperfect, and his marginal borrowing rate abroad plus the allowance for the additional risk of exchange depreciation in the future must also be lower, if capital is to be imported at all.

Therefore, such capital imports (viz., direct borrowing from abroad by domestic investors and capital imports by foreign capitalists for direct investment) have a direct influence upon domestic investment decisions without first affecting general credit conditions or the system of interest rates on the domestic money market, and will generally lead to a more or less equal amount of domestic investment. It is still true, however, that they bring about the investment expenditures because they make investible funds available to the investors at a lower marginal cost, or more exactly because they shift the individual supply curve of credit, with which the investor is confronted on the domestic money market before the capital import, both to the right by a distance which represents the amount of capital he imported and downward to a certain extent.¹⁴

Such capital imports would therefore have an inflationary effect upon domestic income, via the domestic investments that they finance, which would be sufficient to offset the deflationary effect of an equal amount of import surplus on current account. And insofar as they are offset by simultaneous imports of goods and services, there will probably be no effect upon the general credit or liquidity position of the domestic money market. If the foreign exchange arising from capital imports intended for domestic investment is spent directly on foreign capital goods, that is, if the investment expenditures induced by such capital imports are directed exclusively toward imports, then obviously there will be no impact or multiplier effect upon income, nor will the domestic money market be affected. If the investment expenditures induced are on domestically produced goods and services, but are offset by additional imports in other sectors of the economy, the impact and multiplier effects on income still cancel each other out. The additional supply of liquid funds in domestic currency provided by the importers of goods out of their sales proceeds would just be met by the additional demand for liquid funds in domestic currency on the part of capital importers for their own domestic investment expenditures. (There is reason to regard the demand for funds for these investment expenditures as additional, for they are obviously extra-marginal investments which would not have taken place under the credit conditions of the domestic money market, but were induced only by the capital imports which made credit available to them at a much lower marginal cost of borrowing.) Consequently, there will be no net change in the demand and supply of loanable funds on the domestic money market, and hence there will be no effect upon domestic interest rates and credit conditions.

Import surplus counterbalanced by compensatory capital import. If the import surplus is offset by compensatory capital imports of the central bank, however, the case would again be entirely different. For the liquid funds which the importers hand over to the central bank for the purchase of foreign exchange will be mopped up by a corresponding monetary contraction of the central bank. There is, therefore, no increase in the supply of loanable funds to the domestic money market. Furthermore, a contraction of money by the central bank will reduce the cash reserves of the commercial banks and, under the assumption that the commercial banks keep a rigid reserve ratio, will compel them to contract their credit by a multiple of the loss of their cash reserves. Thus, after a certain time lag, the supply of loanable funds in the domestic money market will be severely reduced by the recall of loans, or sale of bills and securities, by the commercial banks. The rate of interest will certainly rise unless there is an infinitely elastic supply of dishoardings out of idle balances. Such a deflationary influence must be added to the deflationary effects of an import surplus which were discussed in the preceding sections on the multiplier relation.

Counterbalancing capital movements. An independent capital export which is counterbalanced by a simultaneous independent capital import in the form of portfolio investment will now be considered. Although the decision of the capital exporters to raise funds from the domestic capital market represents an additional demand for loanable funds, the funds which they borrow will in effect pass into the hands of the capital importers in exchange for foreign assets and will thus flow back into the domestic market. Thus, prima facie, it appears that there will be no net change in the demand and supply of loanable funds, apart from the effects of any slight difference in timing between the outflow and inflow of funds. The matter, however, is not so simple; for the funds which the capital exporter raised might partly come out of his own hoardings of cash, because the greater attractiveness of foreign assets, which induce him to hold them instead of domestic assets, would also induce him to prefer foreign assets to cash balances. When these funds become available to the money market again via the capital importer, the supply of loanable funds would then be greater than if there had been no foreign capital transactions, the increase being the dishoarding of capital exporters induced by the greater attraction of foreign assets. Hence there would be a slight downward pressure on interest rates, or a slight tendency for the terms of lending to be easier, which might give some stimulus to investment expenditures although its quantitative significance is uncertain.

If, however, the independent capital import is “hot money” seeking only temporary refuge and not investment, the effect upon the money market would likely be the reverse; for the liquid funds raised by the capital exporter, which presumably come only partly from dishoarding, would be entirely absorbed into hoardings by refugee capitalists. There would then be a net reduction in the supply of (or a net increase in the demand for) loanable funds on the domestic money market. Interest rates would tend to rise, or credit conditions would tend to be more stringent, and investment expenditures might thus be discouraged.

If the capital import is by the domestic investor himself in order to finance his own investment expenditures, the case would be different. It has been shown above that such capital imports would lead to more or less the same amount of investment expenditures on the part of capital importers, irrespective of their effect upon the domestic money market. The resulting investment expenditures would of course have an inflationary effect upon domestic income according to the multiplier principle. When such capital imports are counterbalanced by independent capital exports, however, the inflationary effect of the investments directly induced by the former would be at least partly offset by the indirect influence through the money market. For the loanable funds which capital exporters raise from the money market to buy the foreign assets of the capital importers will not flow back to the money market, but will be met by the additional demand for loanable funds in domestic currency on the part of the capital importers themselves for their own investments.¹⁵ Thus, this would represent a net increase in the demand for loanable funds on the domestic money market. The rates of interest would tend to rise and hence other domestic investment expenditures might be reduced.

However, the deflationary effect exerted through the money market is not likely to offset completely the inflationary effect of the investment directly induced by such capital imports; for the increase in demand for loanable funds and the consequent rise in the rate of interest would probably elicit some dishoardings (and usually some credit expansion, which has been temporarily excluded by the assumption of the monetary framework), with the result that other investment or consumption expenditures will not be curbed by the same amount as the additional demand for funds for investment on the part of capital importers. Hence, the net effect is likely to be inflationary, unless the investment expenditures have some import content, in which case there is another offsetting factor, imports, which have already been discussed above in connection with this kind of capital import.

If an independent capital export is counterbalanced by a compensatory capital import by the central bank, however, things will again be different. For the funds which the capital exporters raised from the money market will be canceled by a corresponding reduction in the central bank money supply. Thus, the capital exporters’ demand for funds must be regarded as a net additional demand for loanable funds. Furthermore, the contraction of credit by the central bank will reduce the cash reserves of the commercial banks. Under the assumption that the commercial banks observe a rigid reserve ratio, this would force them to contract their credit by a multiple of the loss of their cash reserves. Thus the effect upon the money market of an independent capital export offset by a compensatory capital import of the central bank may be depicted as a net additional demand for loanable funds equal to the amount of capital export, followed after some lag by reductions in the supply of loanable funds several times the original capital export. Therefore, there will be a tendency for the rate of interest to rise, or to put it more generally, for the terms of credit to become harder; investment and consumption expenditures might be reduced, which would cause the national income to decline, unless there is an infinitely elastic supply of dishoarding out of idle balances which prevents the rate of interest from rising.

On the other hand, when an independent capital import is counterbalanced by a compensatory capital export by the central bank, the proceeds which the capital importers obtain from the central bank for the sale of foreign assets represent an additional supply of loanable funds for investment. Where the independent capital import is for portfolio investment in securities in the domestic money market, this would produce a downward pressure on the rate of interest or on the terms of lending, which might call forth an increase in domestic investment expenditures, unless it encounters an infinitely elastic demand for idle cash. Where the independent capital import is by the intending investor himself, this would directly help to finance a more or less equal amount of his investment expenditures without any pressure upon the domestic money market.

Furthermore, since the proceeds obtained by the capital importers from the central bank are central bank money, a multiple expansion of credit will be generated when the proceeds reach the commercial banks. Thus there will be secondary increases in the supply of loanable funds amounting to several times the original capital imports. Unless the demand for idle balances is infinitely elastic, there will be a further tendency for the rate of interest to fall and the terms of credit to be easier. Consequently, investment expenditures will be further stimulated, with further inflationary effects upon domestic income.

Capital movements and domestic income. With the above analysis in mind, it is not difficult to see how capital imports and exports may act as active agents in bringing about expansions or contractions of domestic income, instead of being merely the passive camp-followers of export or import surpluses as the social accounting method of analysis seems to suggest. For a spontaneous increase in independent capital imports—which under the monetary framework postulated above will probably first be counterbalanced by a corresponding compensatory capital export by the central bank—would most likely stimulate domestic investment by lowering the domestic rate of interest or more generally by increasing the availability of loanable funds to domestic investors in the manner shown above. The increase in investments thus induced would cause domestic income to expand. The expansion of income and/or the investment expenditures themselves may in their turn bring about an increase in imports according to the propensity to import. Thus an independent capital import may be an active cause of an import surplus, instead of being merely a necessary contra-entry of an already existing import surplus.

Compensatory capital movements and compensatory official financing. Because the government and the monetary authority are usually in very close relation and are sometimes one and the same, special attention is needed in dealing in the balance of payments with the foreign borrowing and lending of the government. When the government borrows from abroad for budget purposes or to finance a specific reconstruction project, the effect upon the domestic money market and income is precisely the same as that of a private capital import destined to finance a specific investment project. But when the government borrows for the explicit purpose of exchange stabilization, the borrowing must be regarded as that of the monetary authority itself (the term “monetary authority” thus covers both the central bank and the government). In such transactions, the increase in foreign liabilities of the monetary authority is exactly offset by an increase in its foreign assets. No net compensatory capital movement is, therefore, involved, nor any independent capital movement. Not until some of the foreign assets thus obtained by the monetary authority are sold to importers or to independent capital exporters will there be any compensatory capital import. The government would in fact hand over the foreign exchange proceeds to the central bank to be set against the retirement of a portion of the government’s debt to the central bank. There would be no change in the supply and demand of loanable funds in the domestic money market. Alternatively, the effect of the compensatory capital export of the central bank against government borrowing from abroad may be regarded as being canceled out by the repayment of the government’s indebtedness to the central bank.

Similarly, if a grant received by the government is handed over to the central bank for stabilization purposes against a retirement of government debt, there would be no effect upon the money market. For the money created by the compensatory capital export of the central bank against the foreign donation received by the government is canceled out by the repayment of debt to the central bank. There is no change in the demand and supply of loanable funds in the money market. The donation would merely increase the government’s disposable income by that amount, according to our principle of social accounting, and since the government does not spend any of the donation, but saves it all for debt retirement, there will be no effect on national income at factor cost. In fact, such donations may be regarded as a direct grant to the monetary authority, even though the government has acted as an intermediary.

The relation between our concept of compensatory capital movements and the compensatory official financing of the Fund’s Balance of Payments Yearbook may be expressed as follows. The net compensatory capital movements of the monetary authority according to our definition are measured by the loss of foreign exchange reserves of the monetary authority in order to offset the excess demand for foreign exchange in the market. In accounting, this amount is equal to the original reserves of the monetary authority plus addition to its reserves due to the stabilization loans borrowed by the monetary authority, or by the government on its behalf, and the stabilization grant received minus the remaining reserves. This may be considered equivalent to compensatory official financing strictly interpreted.

Modification of monetary framework: excess reserves. This analysis of the effect of international transactions upon the domestic money market needs some modification, if the monetary framework is different from that postulated above. It is, of course, impossible to give a separate analysis for every possible monetary system. Allowance will be made here for only one variation in the assumptions so far made, which will make the postulated framework more realistic. It has been assumed that the commercial banks always maintain a rigid conventional or legal reserve ratio between their current deposits (checking accounts) and cash reserves. In fact, the reserve ratio may not be rigidly observed. In times of depression, particularly, the commercial banks may have ample excess reserves above the legal minimum, which enable them to expand or contract credit on their own initiative without any change in their cash reserves. In such cases, our analysis of the effect of international transactions would have to be modified.

Where there is an export surplus, or net independent capital import, counterbalanced by compensatory capital export of the central bank, the additional cash created by the central bank in this operation will not necessarily induce a multiple credit expansion of the commercial banks. For if the commercial banks do not observe a rigid reserve ratio, a small addition to their reserves need not impel them to expand their deposits according to that ratio. Moreover, the fact that the commercial banks possess excess reserves and are able to expand or contract their credit supply on their own initiative implies that the supply of bank credit is highly elastic with respect to the rate of interest. That is to say, whenever there is a sudden increase in the demand for loanable funds in the domestic market which tends to raise the rate of interest, additional bank credit would come to the rescue and fill the gap between the demand for and supply of loanable funds, thus helping to stabilize the rate of interest. Conversely, when there is a decline in the demand for loanable funds or an increase in their supply from other sources, the excess supply of loanable funds would be drained away by a withdrawal of bank credit. Thus where the commercial banks possess ample excess reserves and are not in the habit of keeping a fixed conventional reserve ratio, there will be an additional factor, apart from hoarding and dishoarding due to an elastic demand for idle cash balances, making for rigidity in the rate of interest and hence tending to offset the effects of international transactions upon the supply and demand of loanable funds. Therefore, if the elasticity of the supply of bank credit with respect to the rate of interest is infinite, independent capital imports and exports might have no effect upon domestic income, except that where there are direct capital imports by domestic potential investors in an imperfect domestic market, the availability of funds from foreign sources on better terms than they could obtain at home at the margin might increase their investment expenditures.

However, the assumption of an infinitely elastic supply of credit by the commercial banks which pay no attention at all to their reserve ratios is hardly more realistic than our previous assumption of a perfectly inelastic supply, with respect to the rate of interest, of bank credit which is determined solely by the amount of cash reserves. Under normal conditions, the commercial banks may not strictly observe a reserve ratio, but with a given cash reserve the more credit the banks create, the higher will be the rate of interest they will ask for their loans or the harder will be the terms for the credit they grant. And an increase in their cash reserves will make them more willing to grant additional credit at easier terms, even though it may not impel them to expand their credit by the full multiple required by a rigid reserve ratio. Conversely, a decrease in their cash reserves will undoubtedly make them less willing to grant new loans or even to renew old ones except at stiffer terms, even though it may not force them to contract their credit by the full multiple of the loss of reserves as demanded by a rigid reserve ratio. Thus our original conclusions with regard to the effect of international transactions upon domestic income via their effect upon the supply and demand of loanable funds need to be modified in degree but not in substance. And in times of high activity, as during a boom, when any slack in cash reserves is likely to have been already taken up more or less fully, the condition of the banking system would approximate to the situation postulated earlier. Besides, in times of high activity, liquidity preference (and hence hoardings into and dishoardings out of idle cash balances) is not likely to be highly elastic. Consequently, both these factors, tending to make the rate of interest rigid and to offset changes in the supply and demand of loanable funds brought about by international transactions, will be less operative in times of high activity than in times of low activity and depression. This suggests that independent capital imports or exports will have greater inflationary or deflationary effects upon domestic income under high activity than under slump conditions.