The Balance of Payments Adjustment Mechanism in a Rational Expectations Equilibrium

Abstract

This paper provides a choice theoretic, general equilibriumaccount of the balance of payments adjustment process and the determinationof national price levels in a world comprised of countries populated byrational households. Balance of payments adjustment dynaniics arise in theequilibrium of this model from the precautionary saving behavior of risk-averse households who self-insure against random productivity fluctuationsby accumulating, via balance of payments surpluses in productiveperiods, buffer stocks of domestic money which can be drawn down to financepayments deficits, and thus a less variable profile of consumption relative to output, when productivity is unexpectedly low. Precautionary saving is shown to exhibit thepartial-adjustment-to-target behavior typically postulated in the monetary approach literature. The existence of a rational expectations equilibrium in which the distribution of international reserves among central banks is stationary is established.