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Balance-of-Payments Theory and the United Kingdom Experience by A.P. Thirlwall

By A.P. Thirlwall

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This will make imports cheaper and exports dearer , which again should tend to rectify the imbalance. It is clear from Figure lA , however, that a change in the exchange rate will not rectify imbalance in all circumstances ; it depends on the relative slopes of the demand and supply curves of foreign exchange. Starting from a position of imbalance where the demand for dollars exceeds the supply, a rise in the sterling price of dollars will restore balance as long as the demand for dollars is reduced by more than the supply .

It would then pay investors to switch funds from the United States to the United Kingdom provided that the interest gain is not offset by a lower rate of conversion of sterling to dollars when the investment matures than when the original investment in sterling assets was made. To ensure against this contingency investors will sell pounds (and buy dollars) forward at an agreed rate . The forward rate of exchange will fall below the spot rate of $ 2 to £1 , and funds will tend to move from the United States to the United Kingdom until the differential yield on investment in the United Kingdom is just offset by the forward exchange conversion loss in the United Kingdom .

Under the gold bullion standard each country fixed its currency in terms of gold, each country's currency was convertible into gold," and international settlements were made in gold. The exchange rate between two countries could not vary outside the so-called 'gold-export points' determined by the cost of shipping gold from one country to another. Suppose, for example, that the same amount of gold is bought and sold by the monetary authorities in country X for $2 and in country Y for £1. The exchange rate between country X and country Y would then be $2 to £1 .

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