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THE INCOME MECHANISM

With prices and wages unchanged, variations in real income and employment
constitute a second aspect of automatic adjustment. The initial drop in Outlands
spending on Inlands exports reduces Inlands real income. The deficit-induced
fall in the money supply exacerbates this decrease. As they become poorer,
Inlanders cut back on their purchases of nontraded goods, imports and
exportable goods and domestic goods made with factors capable of shifting
into export production. The initial fall in Inlands exports is partly allayed as
Outlanders take advantage of Inlands more eager sales efforts, which may
include faster deliveries of exports. The income mechanism also works in
Outland, where spending and real income rise as permitted by the slack in
productive capacity that we tacitly assume. With the rise in income promoted
by the increase in cash balances, Outlands decrease in purchases from Inland
is restrained for this second reason. This dual restraint along with the moneyand-income-induced fall in Inland imports help restore payments equilibrium.
We do not consider the alternative case of a rise in Inlands money supply
since numerous scenarios exist. For example, we could assume implausibly that
only real income rises. Or we could assume that prices only rise, but they do not
fall. At any rate, changes in real income are part of the adjustment process.
The variation of real income as one corrective of external imbalance
represents a departure from a theoretically ideal system frictionlessly maintaining equilibrium on all goods and factor markets through prompt price and
wage adjustments. Regrettable though the fact may be, changes in real income
represent one mechanism in the automatic adjustment process under fixed rates.

THE OPERATION OF THE WICKSELL PROCESS

More directly influencing the balance of payments than price and income
changes are the monetary developments to which those changes are themselves
a response. After the real disturbance, the drop in Outlands demand for Inlands
exports, cash balances shrink in Inland as the deficit drains reserves. Cash
balances become and remain smaller than before not only in nominal amount
but also in real purchasing power, at least until prices and wages have fully
responded to the monetry shrinkage. (They probably remain smaller even
afterwards, since discontinuance of the subsidy constituted by pegging the
exchange rate at what had temporarily become a disequilibrium rate now
represents a fall in real incomes from private points of view, in conformity with
the countrys worsened economic position. With their real incomes reduced,
Inlanders tend to hold smaller real balances.) Meanwhile, concerned not to let

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their cash balances shrink too far, Inlanders cut their purchases of both
nontraded and traded goods and probably become more eager to make sales. The
Wicksell Process comes into play and helps terminate the deficit.
Moreover, the Wicksell Process provides part of the answer to the skeptical
question sometimes asked: how can a mere change in its price level correct a
countrys tendency, as evidenced by its deficit, to consume and invest in excess
of its current production? The answer focuses on what accompanies, and indeed
helps to cause, the price change. The monetary contraction resulting from
Inlands deficit leaves money temporarily in excess demand. The operation of
the Wicksell Process helps remove this excess demand for money by shrinking
spending and hence the prices of nontraded goods and services and factors of
production. By reducing the relative price of nontraded to traded goods and by
making traded goods less attractive for Inlanders to buy, the Wicksell Process
helps eliminate the payments deficit.
When domestic monetary expansion constitutes the disturbance, Inlanders
increase their spending abroad as well as at home as the Wicksell Process
unfolds. The deficit removes this excess supply of money, thereby restoring
external balance. If money were to leak abroad rapidly enough, unrealistically rapidly, changes in prices and production in Inland would not even be
necessary. No excess supply of money would occur in the sense of Walrass
Law. Inlanders purchases of goods and services in excess of current national
production, or overabsorption, would be the real counterpart of the money
creation and leakage. This unusual case illustrates how a payments deficit could
prevent monetary disequilibrium and frustration from arising after a monetary
expansion. In the limiting case, the authoritys purchase of domestic assets
would not cause any monetary expansion in the first place, for its loss of foreign
exchange reserves would keep pace with its acquisition of domestic assets from
the start, leaving high-powered money and thus the money supply unchanged.

TRANSMISSION OF BUSINESS FLUCTUATIONS UNDER

FIXED RATES
Examples already considered suggest a double relation between domestic
business conditions and foreign trade. Inflation, depression, external surplus
and external deficit do not go together in any simple way. Causation depends
on the nature of the initial disturbance.
On the one hand, the adjustment process operates. Suppose a deficit in
Inland results from decreased Outland demand for its exports, as in the case of
the real disturbance analyzed above. The adjustment process that helps terminate
Inlands deficit may cause depression there. Conversely, the adjustment process

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that helps eliminate an imposed surplus in Inland may create inflation there. In
short, Inlands deficit results in depression and its surplus results in inflation.
On the other hand, a transmission process operates. Monetary expansion in
Outland can cause inflation and a corresponding payments deficit. The inflation
is then transmitted to Inland through an imposed surplus. Conversely, monetary
contraction in Outland can cause a depression and a corresponding payments
surplus. The depression is then communicated to Inland through an imposed
deficit. In this process, Outlands inflation goes together with its payments
deficit, and its depression goes together with its payments surplus. When Inland
is on the receiving end of the transmission process, we speak of imported
inflation or imported deflation in Inland. We conclude that the same factors
that operate in the adjustment process also operate in the international transmission of business fluctuations.

IMPORTED INFLATION
Imported inflation occurs through two main channels involving (1) monetary
and (2) direct price transmission (compare Yeager, 1976b; Rabin, 1977 and
Rabin and Yeager, 1982).
The Monetary Channel of Imported Inflation
Inflation can be transmitted among countries in a manner similar to Humes
price-specie-flow mechanism. As we have just seen, inflation in Outland (taken
to be the rest of the world) and its accompanying payments deficit impose a
surplus on Inland. Monetary expansion in Inland then results in imported
inflation there. Because the prices of Inlands nontraded goods are not
determined directly on world markets, Inlands overall inflation rate may temporarily lag behind Outlands. The monetary channel of imported inflation then
operates to align Inlands rate with the worldwide average by increasing the
prices of Inlands nontraded goods.
Inflation can be imported even though the current account remains in balance.
The monetary effects of an overall payments surplus are the same whether the
surplus occurs mostly on capital or mostly on current account. In either case it
expands high-powered money and the money supply.
Two related aspects of the monetary channel are shortage-of-goods and
spending effects. First, Inlands current account surplus spells withdrawal of real
goods and services. Less than the full value of its current production is available
for satisfying demands in Inland, resulting in underabsorption. Second, the
increase in Outlands spending on Inlands traded goods and services also
operates in the expansionary direction. While these two aspects by themselves

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may help explain a once-and-for-all rise in Inlands price level, they cannot
account for a continuous rise in prices (unless, perhaps, the trade surplus itself
keeps growing implausibly for some autonomous reason). In the process of
imported inflation, these two aspects must be subordinate to the monetary consequences of an overall payments surplus.
The Direct-Price-Transmission Channel of Imported Inflation
Under fixed rates, an increase in the price of traded goods in Outland spreads
to Inland according to the law of one price. Commodity arbitrage keeps each
good selling in Inland and Outland at the same price translated at the exchange
rate, apart from transportation costs and the like. The increase in the price of
traded goods may then raise the price of Inlands nontraded goods through
linkages involving factor prices and substitutabilities in production and consumption. Especially if Inland is a small open economy with a large traded
goods sector, it may not be unrealistic to assume that its overall inflation rate
is directly tied to the inflation rate for traded goods in the outside world. Its
price level comes close to being an externally imposed exogenous variable.
For the direct-price-transmission channel to operate, a payments surplus need
not actually develop in Inland. An externally imposed increase in its price level
raises the nominal demand for money, which can then be satisfied through a
payments surplus. But if the authority expands the money supply sufficiently
by buying domestic assets instead, it keeps the surplus from developing. It may
well make this choice, reasoning that if its commitment to a fixed rate makes
inflation inevitable in any case, it may better buy domestic securities instead of
foreign exchange. When the direct-price-transmission channel dominates, the
role of money is to accommodate externally imposed price increases.
An Eclectic Theory of Imported Inflation
When the outside world is inflating, an economy with a fixed exchange rate
catches the inflation through either of the two channels. The direct-price-transmission channel may dominate at some times, the monetary channel at others.
The two channels are complementary; they are two sides of the same coin
(Fellner, 1975, p. 129).
A payments surplus coupled with inflation at home may trace to a combination of both channels. However, a price rise of traded goods followed by a
price increase of nontraded goods does not necessarily indicate that the directprice-transmission channel has dominated. At issue here is the sequence of
price rises. Quite conceivably, monetary expansion through a payments surplus
may have inflated the prices of nontraded goods, although with the typical lag

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mentioned in the monetarist literature. In this case the monetary channel may
have dominated (compare pages 25960 below).
Imported Inflation Versus Domestic Inflation
A country adhering to fixed rates may face a choice between accepting imported
inflation and inflating at home. If the authority wants to acquire additional
foreign exchange reserves, it may choose the former course. If it refuses to give
foreigners the loans that the acquisition of reserves represents, it chooses the
latter. Under fixed rates the country cannot resist worldwide inflation. It must
either import it or keep in step with it through domestic policy.

THE EXCHANGE RATE MECHANISM: FLOATING RATES

We explore how a system of freely floating rates operates to maintain the
exchange rate regime. We assume that the dollar is the medium of exchange
in Inland and the peso in Outland. For a real disturbance we again suppose
that Outlands tastes shift partially away from Inlands exports. The old
exchange rate leaves Inlands dollar in excess supply and Outlands peso in
excess demand on the foreign exchange market. Depreciation of the dollar
under market pressures raises the dollar prices of Inlands imports and also of
its exports (other, presumably, than the particular goods for which foreign
demand may have dropped off). On the other hand, appreciation of the peso
cuts the peso prices of Inlands exports. Outlands increased purchases of them,
other than of the particular exports affected by the initial shift of tastes,
represent a movement along its existing demand schedule as a function of peso
prices. From Inlands point of view, the demand schedule as a function of
dollar prices has strengthened for some of its exports, producing the increase
in their dollar prices mentioned above. The important fact is that Inlands
imports and exports both rise in price relative to prices of its nontraded goods
and factors of production. This relative price rise causes Inlanders to cut down
on importing and on domestic consumption of exportable goods and to concentrate more than before on production for export. The fuzzy dividing line
between traded and nontraded goods may shift so as to make more goods than
before profitably exportable.
Opposite effects occur in Outland, where appreciation of its peso causes an
apparent decline in Inland demand for its exports, lowering their peso prices as
well (although their dollar prices rise). Since the peso prices of Outlands
imports from Inland also fall, nontraded goods and factors of production rise
in price relative to traded goods. Outlanders shift toward buying traded goods
from Inland and away from producing them. Loosely speaking, the smaller