The change in the money supplies alters prices in both countries. The reduc-
tion of the U.S. money supply causes Americanpricesto fall. The expansion of
the money supply in Japan causes Japanese prices to rise. As American prices
fall and Japanese prices rise, American goods becomerelatively less expensive
than Japanese goods. Consequently, American and Japaneseresidents shift their
purchases away from Japanese products and toward American goods. American
imports (and hence Japanese exports) fall, and American exports (and hence
Japanese imports) rise. As American imports (and Japanese exports) fall and
American exports (and Japanese imports) rise, the payments imbalanceis elimi-
nated. Adjustment underfixed exchange rates thus occurs through changesin
the relative price of American and Japanese goods brought about by the changes
in moneysupplies caused by intervention in the foreign exchange market.
In floating exchange-rate systems, balance-of-payments adjustment oc-
curs through exchange-rate movements. Let’s go back to our U.S.—Japan sce-
nario, keeping everything the same, exceptthis time allowing the currencies to
float rather than requiring the governments to maintain a fixed exchangerate.
Again,the $4 billion payments imbalance generates an imbalancein the for-
eign exchange market: Americansare selling more dollars than Japanese resi-
dents want to buy. Consequently, the dollar begins to depreciate against the
yen. Because the currencies are floating, however, neither governmentinter-
venesin the foreign exchange market. Instead, the dollar depreciates until the
marketclears. In essence, as Americans seek the yen they need, they are forced
to accept fewer yen for each dollar. Eventually, however, they will acquire all
of the yen they need, but will have paid more than $4 billion for them.
The dollar’s depreciation lowers the price in yen of American goods and
services in the Japanese market andraises the price in dollars of Japanese
goodsandservices in the American market. A 10 percent devaluation of the
dollar against the yen, for example, reduces the price that Japanese residents
pay for American goods by 10 percentandraises the price that Americans pay
for Japanese goods by 10 percent. By making American products cheaper and
Japanese goods more expensive, depreciation causes American imports from
Japan to fall and American exports to Japan to rise. As American exports
expand and importsfall, the payments imbalanceis corrected.
In both systems, therefore, a balance-of-payments adjustment occurs
as prices fall in the country with the deficit and rise in the country with the
surplus. Consumers in both countries respond to these price changes by
purchasing fewer of the now-more-expensive goods in the country with the
surplus and more of the now-cheaper goodsin the country with the deficit.
These shifts in consumption alter imports and exports in both countries, mov-
ing each of their payments back into balance. The mechanism that causes
these price changes is different in each system, however. In fixed exchange-
rate systems, the exchange rate remains stable and price changes are achieved
by changing the moneysupplyin orderto alter prices inside the country. In
floating exchange-rate systems, internal prices remain stable, while the change
in relative prices is brought about through exchange-rate movements.
Contrasting the balance of payments adjustment process under fixed and
floating exchangerates highlights the trade off that governments face between
exchangerate stability and domestic price stability: Governments can have
a stable fixed exchangerate or they can stabilize domestic prices, but they
cannotachieve both goals simultaneously. If a government wants to maintain
a fixed exchangerate, it must accept the occasional deflation and inflation
caused by balance-of-payments adjustment. If a governmentis unwilling to
accept such price movements,it cannot maintain a fixed exchangerate. This
trade-off has been the central factor driving the international monetary system
toward floating exchange rates during the last 100 years. We turn now to
examine howthis trade-off first led governmentsto create innovativeinter-
national monetary arrangements following World WarII and then caused the
system to collapse into a floating exchange-rate system in the early 1970s.
