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November-December 1967

LY REVIEW
Bank Size
and Deposit Variability

.

The Balance of Payments
Adjustment Problem .

• .

• page 3
.

.

page 10

Index of Monthly Review
Articles in 1967 • • • • • • page 19

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BANK SIZE AND DEPOSIT VARIABILITY
By Frederick M. Struble
Carroll H. Wilkerson
th e findin gs o bta ined in an e mpirical
study o f de pos it va ri ability at m e mber
ba nk in the T e nth Fede ral R ese rve District
we re rt;pO rted in a n a rticl e in the Jul y-Au gust
196 7 iss u o f thi s R t view. rl he vide ncc s ug1csted that mos t Di stri c t bank s ex pe ri c nc ' d
a mo de rate dec line in th va ri ability o f their
to tal depos its b twee n 196 1 a nd 1966. T he
ra tio o f time a nd sav ings depos its to to tal
deposits inc reased ma rkedly o ve r thi
ix-year
pe riod , a nd this shift in composition a ppea red
to be primarily res ponsible for moderating
the deg ree of va ri ation in total de posits. Support for this inte rpre tation w as p rovided by
a furth e r finding of the study whic h indicated
th at to ta l tim e a nd sav in gs deposi ts were subject to less fluctu a ti o n th a n total de ma nd depos its in eac h ye ar o f thi s pe ri o d . Y ea r-toyea r c ha nges in depos it co mpos itio n w r no t
co nsi tentl y refl ec ted in th va ri ab ili ty of to tal
de pos it , howeve r. l n fo ur o f th e six years,
th e va ri a bility o f to tal de po it re ma ined esse nti ally unchange d e ven th o ugh th e ra ti o of
time and sa vings depos its to total depos its increased each year.
The fa ilure of total depos it fl uctu atio ns to
decline m o re sys te ma ti ca ll y w ith th e inc reases
in the propo rti o n o f tim e a nd avin g depos its
was a ttributable in pa rt to co in cide nt c ha nges
in th e degree o f var iat io n of bot h de ma nd depos it a nd tim e a nd savi ngs deposit . C ha nges
in th e va ri a bili ty of eac h o f the. e depo it ca tegor ies t nded to rein force the effects of the
cha nge in de po it mi x in so me years a nd to
offse t th e effec ts in o th ers . In additi on , it a p-

S

O M£ OF

Monthly Review

•

November-December 1967

pea rcd th at the te nde ncy for outflows from
dema nd deposits to offset inflows into time
a nd sav ings deposi t , and vice versa, va ri ed
fr om yea r to year.
These fin di n 1 s have o bvio us implica ti o ns fo r
arnil ys is c1llc mptin g to a ppraise th e rc htiv
de rt;C o f var iati o n in t ta t d e po its a t diffe re nt b a nks ov r a g ive n pe ri o d o f time. They
indica te th at co m para ti vely hi gh ra tios of time
a nd savings d e posits in total depos its will tend
to produce re latively low degrees of fluctuation
in to tal de posits. At the same time, however,
thi s ev ide nce wa rns that di ssimilarities in the
pro po rtio n of time and savings deposits in
to tal de pos its at diffe rent banks m ay not provide a n infa llible indication of eithe r the di rec ti o n o r am o unt o f di sparity in the va ri ability
o f th e ir to ta l de pos its. A ba nk with a high
propo rti o n o f tim e a nd a vin gs deposits m ay
ex per ie nce g rea te r va ri ability in its total depos its th a n a nothe r ba nk b eca use ( a ) the
va ri ability of e ithe r o r bo th its dem a nd deposits
a nd time a nd savings deposits m ay be relatively hi gh a nd / or (b) the degree of synch ronization b etween its de mand a nd time
a nd savings flows m ay be compa ratively low.
Differences a mong b anks in the va ri ability
o f th e ir d e ma nd depos its or time and savings
de pos its o r in th e degree of synchronizatio n
be twee n va ri a ti o ns in each o f these depo it
catego ri s may a ri se for ma ny di ff re nt rea o n .
O ne of th e mos t impo rt ant of the e may be the
d i sim il arit ies whi ch ex ist in the compos ition
o f de ma nd de pos it a nd time and savings depos its a t diffe re nt banks. Dive rsity in the
3

Bank Size and Deposit Variabilit y

composition of either of these deposit catego ries will tend to crea te different degrees of
fluctuation , if so me depos its comprising these
broad categories tend to be more un sta bl e
th an others. Di sparities in th e variability of
tota l demand depos its or to tal time and savings
deposits a mong banks may also exist because
the variability of a ny subca tegory of either
may not be th e sa me at all banks.
l t is widely thou ght th at dissimilarities in
bank size give rise to sys tem atic differences
in the deg ree of total demand depos it fluctuations- a nd by implication in the degree of
total depo. it fluctuation s. Opinions differ, however, as to whether th e re lations hi p betw en
si ze a nd var iab ility is direct or in verse. Th e
more traditi o nal view is that demand deposit
variability te nd s to be hi gher at la rge banks.
T hi s hypo th es is is ba -eel o n the assum ption
th at th e composition of dema nd deposits at
large r b ank s tends to produce higher degrees
of var ia tion . The alternative hypo th esis, advanced more rece ntl y, is that conditions unique
to large-scale banking tend to reduce the variability of the various categories comprising
total demand deposits and therefore to increase
the stability of these deposits . T he findings
o f rece nt em pirica l inves ti gations tend to support the latter hypot hesis, although thi evidence is far from suffi cie nt to permit a co nclusive resolution of thi s question.
A mo re detailed revi ew of the altern ative
positions on the issue of bank size and deposit
variability and of the recent empirical findings
related to this iss ue will b e presented in the
next section of this article. Following this
discussion, addition al empirical evidence obtained from exa minati o n of depos it fluctuations
at individual banks in th e Tenth Federal R eserve District will be reviewed. T hese d ata
refl ect the relative stab ility of total d emand
deposits , total tim e and savings depo its, a nd
total deposits at six size groups of banks. In
add ition, evidence indicati ng the degree of
variation in several subcategories of demand
4

deposits by size of b ank is presented. This
inform ation, together with data reflecting differences in the composition of deposits at
different sized banks, permits determination of
whether the relationship between size and deposi t variability is due to differences in deposit
composition sys temat ically associated with size,
to differe nces not attributable to d eposit composition, or to so me combination of these two
co nditi ons.
CURRENT THINKING ON SIZE AND
VARIABILITY

Trad iti o nall y the demand deposits of large
brn1ks w re thou ght to be more un stable th an
those at smaller ba nk s. Thi s hypoth e is was
ba se I primarily on the know! d r th at the
propo rti o n of demand deposits du e to other
banks -deposits ass umed to be subj ect to
relatively high degrees of variation-in total
demand deposits is generally greater at larger
banks. Evidence indicating th at the turnover
rates of demand deposits are higher at large
banks also has been offered in support of this
conclusion, on the assumption that relative
deposit turnover rates provide a good indication of relat ive deposit variability.
Neither of the e a rguments provides conclu ive proof fo r thi s hypo thes is, however.
Deposit turnover rates -the ratio b etween total
debits to a deposit ca tegory over some period
a nd average deposit balance for thi s periodmay give a mi sleading indication of relative
deposit variability. The variability of a deposit
category is determined not only by the magnitude and frequency of debits but also by
the magnitude and frequency of credits. The
more simultaneous are debits with credits, the
lower will be the resulting degree of depos it
fluctuation . Con eq uently, if debits and credits
tend to be more closely synchronized as the
turnover rate of deposits increases, it is possible th at fluctuations in the level of these
depo sits may remain unch anged or m ay even
decline.

Bank Size and Deposit Variability

The pres umed effect of interb ank deposits
on the vari ability of total demand deposits
also is subj ect to qu es tion on seve ral grounds.
First, the assumption th at these deposits are
mo re vari able th an other types of d emand
deposits has never been firmly established
in empirical fa ct . Second, even if interbank
deposits do va ry more th an other types of
demand depos its, it does not fo ll ow necessa rily
th at they will tend to increase the va ri ability
o f total demand deposits. It is conceivable
th at inte rba nk deposit fluctu ations m ay be
closely sy nch ro nized with flu ctu ations in other
demand depos its; thu s th ey may tend to redu ce th e va ri ability o f tota l demand depos its.
F in a ll y, it is poss ib le th lit th va ria bility o r
othe r ty pes o f de ma nd cl pos its may be substa nti all y lowe r a t large r ba nks, sufficientl y
so to mo re th an offse t the effects of th e hi gher
propo rti ons of interbank deposits.
It is this final possibility which is stressed
prima rily by those asserting th at the va ri ability
of total demand d eposits-and presumably
the va riability of total deposits -may be lower
at larger banks th an at smaller banks. Several
conditions inherent in large-scale bankin g h ave
been cited as ca pabl e o f crea ting thi s inverse
relatio nship . First, la rge r banks have a grea ter
numbe r o f depos it cu to mcrs and in mos t cases
these customers receive their inco mes from
a wide number o f different industri es and occupations. A s a res ult, there would appear to
be a greater tendency for withd rawals by some
depositors to be offset by the additions of
other depositors, since seasonal, cyclical, and
trend factors affecting different industries and
occupations are less likely to coincide. Moreover, it is likely th at the depos it customers
of large ba nks a rc located in a wider geographic a rea and thi s should red uce th e chance
for natural ca tas tro phes, such as drought,
fl ood , ha il , a nd to rn adoes to affect coincidentally the eco no mi c fo rtun es of a large propo rtion of th ese depos ito rs. F inally, it has been
contended th at th e larger the size of a bank's
Monthly Review

•

Novembe r-December 1967

total deposits -particularly relative to the total
deposits of all banks in a given area- the
greater is the probability th at funds will flow
a mong its deposit accounts. That is, a check
drawn o n one account in the bank is more
likely to be deposited in another account in
th e same bank.
The res ults of recent empirical studies of
depos it flu ctu atio ns at different sized banks
sugges t th at the var iability of both total demand deposits and total deposits is inversely
related to b ank size, although the findings
have not been enti rely consistent. G ra mley
fo und th at th e var iab ility of both total demand
deposits and tota l d posits at large banks in
the Te nth Fede ra l R serve Di stri ct ge nerall y
was b low that at smalle r banks over the
pe ri od J 949-56. J n a subseq uent empiri cal
inves tigation, R angarajan obtained results
which support G ramley's fi nding. H e found
that at a sample of banks in the Third Federal R eserve District in 1962 an inverse relationship existed between the variability of demand deposits and the size of these accounts.
In contrast to th ese two studies, Fraser , in
his exa mina ti o n of deposit fluctu ations at a
small sa m ple of b anks in the Eleventh F ederal
R ese rve Di stric t in 1966, was unable to find
any sys temati c relati onship between size and
de pos it variability. 1
It is wo rth emph as izing that the findings
o f th ese studi es do not necessa rily contradict
the assertion th at greater proportions of interbank deposits at large banks tend to increase
the variability of their total demand deposits.
Instead, it is conceivable that this tendency
See Ly le E. Gra mley, " D eposit Instability at Individual
Banks," Mo nthy Review, Federal Rese rve Bank of
Ka nsas
ity, Septe mber 195 7, pp. 3-7; rep rinted in
Essa ys 0 11 Commercial Banking, published by the Federa l
Reserve Ba nk of Ka nsas C ity , August 1962, pp. 4 1-55;
. Ra nga rajan, " Deposit Variab ility in Indi vid ual Banks,"
T he Nat ional Bank in g R eview, Vol. 4, N o. l , Septembe r
1966, p p. 61-71; and D onald R. Fraser, " A N ote on
D eposit Instability," Business R eview, Federa l Reserve
Bank of D allas, March 1967 , pp. 3-7.
1

5

Bank Size a nd Deposit Varia b i li ty

may be more than offset by lower degrees of
variation in all deposit categories. An attempt
to distinguish between these possibly conflicting tendencies will be made in the following
sections of this article by comparing differences
in the relative vari ability of different demand
deposit categories and dispa rities in the composition of these deposits at various size groups
of banks. A furth er question , which has not
been extensively exa mined as yet, is the relationship betwee n the variability of total time
and savings deposits at banks of different size.
This also will be considered.
DATA AND PROCEDURE

Fluctuations in wee kly levels of to tal deposits a nd other maj r depo it catego ri es occurring at member b anks in th e T enth Federal
Reserve District over the six-year period 196166 were measured in order to obtain the evidence to be presented. 2 The same technique
was employed for measuring the variability
of deposits at individual banks as that used
in the previous study reported in the JulyAugust Review. Since an extensive description
of this procedure is provided in the earlier
articl e, di scu sion of this technique will be
kept quite short. Briefly , the procedure meaures the average weekly fluctuation in total
depo it ( or in other deposit categories) which
occur over one yea r th at can be attributed
to all factors other than deposit growth .
This technique was used to obtain measures
reflecting the weekly variation occurring on
average over a year in total deposits and
other relevant deposit categories at each bank
included in thi s study. Indexes of the variability of each deposit category fo r each year
at six group of b anks of different sizes were
then constructed by averaging the relevant
~of th e 836 memb er banks in the District, on ly those
banks which were organ ized during the period and a
few other banks subject to unusua l condi tions we re n ot
included in the study. Weekly deposit levels were based
on dai ly average figures.

6

variability measures obtained from individual
banks. Inspection of the relationship between
the index of variability of each deposit category and b ank size indicated that the relationship was essenti al1y the sa me in each year.
This was particularly true for the relationship
between the relative order of deposit variability
and bank size. Since it is this relationship
which is most pertinent to the question under
di scussion, the indexes for individual years
were averaged to facilitate presentation and
discus ion of this evidence.
EFFECTS OF DEPOSIT SIZE AND DEPOSIT
COMPOSITION ON THE VARIABILITY OF
TOTAL DEMAND DEPOSITS AND TOTAL
TIME AND SAVINGS DEPOSITS

Data reflecting the variability of three m ajor
demand deposit categories- U. S. Government
deposits, deposits due to b anks, and all other
demand deposits- by size of bank (by size
of total deposits) are presented in Table 1.
This evidence clearly suggests:
1. These three deposit categories are subject to decidedly different degrees of
variation.
2. The relative o rder of variation among
these depo it catego rie - a lthough not
the re lat ive mag nitudes o f difference are the sa me at ba nks in the various
size groups.
3. As the size of a bank increases, the
va riability of each of these deposit categories declines.

The inverse relationship between bank size
and the variability of interbank deposits and
"other" demand deposits is particularly apparent for, with two minor exceptions, each
of the e deposit categories systematically beco mes more stable as b ank size increases . An
inver e rela ti on hip between the variability of
U. S. Govern ment demand deposits and b ank
size also is apparen t between the lowest size
class of banks a nd the $10-$24. 9 million size
cl ass. Moreover, the variability of these deposits at the two largest size classes of b anks

Bank Size and Deposit Variability

is below that measured at the two smallest
size classes.
Taken together these findings suggest that
the variability of total demand deposits will
tend to be inversely related to bank size unless
differences in demand deposit composition ,
systematically related to bank size, more than
offset thi tendency. The interaction of these
two possible factors can be seen by examining
Table 2. Measures of the variability of total
demand deposits for the six groups of b anks
together with the ratios of U . S. Government
deposits and interbank deposits to total demand
depo its in th ese variou s group are presented
in thi s tabl e. A g ne rally inv rse relati onship
b twc n bank size and th variability f total
dem a nd d po its is obs rvabl c, cv n though
the proportions of th e more va ri able depo it
categoric in total dema nd depo its systematicaJJy increase with bank size.
Examination of the differences between total
demand deposit fluctuations in the $10-$24.9
million size group and the $25-$99.9 million
size group will indicate one exception to this
generalization. This exception appears to be
attributable to th e fact th at the proportions of
U. S. Treas ury deposits and interb ank deposit
are greater at the larger size group of banks.
It will b noted , however, that the variability
of total demand deposits is lower at the $25$99. 9 million size group than at the three
smallest size groups, despite the higher proportions of interbank deposits and U. S. GovTable 1
V AR IABILITY OF MAJOR DEMAND DEPOSIT
CATEGORIES BY SIZE OF BANK
Average Weekly Per Cent Variation Per
Year, 1961-66

u. s.
Size of Bank

Government

Less than $2 million
$2 -$4.9 million
$5-$9.9 million
$10-$24.9 million
$25-$99.9 million
$100 million and over

Monthly Review

36.5
32.0
25.6
24.4
31.2
28 .6

•

Interbank
21.0
16.2
19.1
14.7
14.0
7 .6

Other
Demand
4.5
4.4
4.3
3 .8
3.8
3 .6

November-December 1967

Table 2
VARIABILITY OF TOTAL DEMAND DEPOSITS
AND PRINCIPAL RATIOS BY SIZE OF BANK
(AVERAGE 1961-66)

Size of Bank

-----

Ratio U.S.
Ratio
Government Interbank
Variability Deposits to Deposits to
Total
of Tota!
Total
Demand
Demand
Demand
Deposits
Deposits
Deposits
(Per Cent)

Less than $2 m illion
$2 -$4 .9 million
$5 -$9.9 million
$10 -$24.9 million
$25 -$99.9 million
$100 million a nd ov e r

4 .6
4 .5
4.4

(Per Cent)
1.6
1.9
2.4

3.8

2.4

4.0

3.3

3 .5

3.3

(Per Cent)
.7
.8
1.6
4.3
19.5
24 .1

crn m nt depo ·its at the large r bank . E vid ntly ,
th lower va ri ability of int rb·rnk dcp it
a nd "oth e r" demand deposits, in particul ar,
relative to th a t at the three smallest size group
had a sufficiently strong effect to more than
compensate for the effects of the higher proportion of more volatile deposits at the larger
b anks.
The variability of total demand deposits at
the largest size group of banks is substantially
below th at for the $25-$99.9 million size
group- and, in fact, is lower than that for any
othe r ize group. This relationship is establi shed eve n though th e proportion of interbank
deposits ma kes a furth er sharp jump from
the immedi ately preceding size group . The
substa nti ally lower va riability of interbank deposits at this larges t size group of banks relative to that at the $25-$99 .9 million size
group appears to account in part for the failure of this shift in composition to have a more
marked effect on the variability of total demand deposits. Moreover, as indicated in Table
I , the variability of "other" demand deposits
at the la rgest sized banks is lowe r than at any
other siz group. In addition, the variability
of total demand deposits at th e la rge t size
group of banks (Table 2) is below the variability of each component category of demand
deposits at this size group (Table 1). This
suggests that size may not only reduce the
7

Bank Size and Deposit Variability

Table 3
VARIABILITY AND COMPOSITION OF TOTAL
TIME AND SAVINGS DEPOSITS BY SIZE
OF BANK (AVERAGE 1961-66)

Size of Bank

Variability of
Total Time and
Savings Depo sit s

Ratio Savings
Deposits to
Total Time
and
Savings Deposit s

(Per Cent)
Less than $2 million
$2-$4.9 million
$5-$9 .9 million
$10-$24.9 million
$25-$99.9 million
$100 million and ov er

3 .2
2 .2
1.8
1.6
2.1
2 .5

54.1
56.7
64 .3
71.1
68 .7
67 .3

variability of individual deposit categories but
also may increase the de re of synchronization
b tween ou tfl ows from o ne deposit catego ry
and inflows into another deposit category.
Banks of different size also appear to experience different degrees of variability in their
total time and savings deposits. As indicated
in Table 3, the variability of total time and
savings deposits appears to be inversely related
to bank size over the range of the four smallest size groups of banks. This inverse relationship may be entirely due to differences in the
composition of these depo its rather than to
systematic differences in the variability of
time deposits and avings deposits at banks
of different size. That is, sav ings depos its are
generally thought to be subj ect to less fluctuation th a n time deposits / and the systematic
increase in the ratio of savings deposits to
total tim e and savings deposits over the four
smallest size ranges of banks may account entirely for the decline in the variability of total
time and savings deposits. However, the
"See the a rticle, "De1 osit Variabi lit y at Commercial
Banks," in th e July-August iss ue of this Re view for a
disc ussion o f thi sup position and a review of the evidence
supporti ng it. It wa s imposs ible to derive estimates of
the variab ility of time depos it s and savings deposits
at different sized banks because, until quite recently ,
deposit data supplied by Distri ct member banks did not
distinguish between the various subca tegor ies of time
and savings deposits.

8

variability of total time and savings deposits
is hal f as great at the $10-$24.9 million size
group as at the smallest size class of banks
while the ratio of savings deposits to total
time and savi ngs deposits at the larger size
class of banks is only about 30 per cent above
that for the small est banks. Thus there is
some reason to conclude that the drop in variability is cau ed not only by differences in
composition but also by differences in the
variab ility of either or both time deposits and
savings deposits between these different size
banks. The possible moderating influence of
size on the variab ili ty of each of these subca tego ri s of tim and savings dep sit i far
fro m entirely indicat d by the data , however.
1 he relatively higher variation in total time
and savings deposits in th e two largest size
groups which have only moderately lower ratios
of savings deposits to total time and savings deposits would if anything suggest that size increases variability. On the other hand, there
is no apparent reason to believe that size, per
se, should affect the variability of either time
deposits or savings deposits in a different manner than it affects the variability of the various
subcategories of demand deposits. The most
plau ibl e explanation would appear to be th at
size alone docs tend to reduce the variability of
each, but that other conditions confronting
large r banks are suffici ently strong to more
than offset the effects of the greater number of
time and savings deposit customers. One of
these conditions is that the very largest banks
account for most of the dollar volume of
certificates of deposit in denominations of
$100,000 and over, deposits which, on the
basis of recent empirical findings, appear to
be subj ect to greate r variab ility than other
types of time and savi ngs deposits. In addition,
it may be th at depositors a t la rge banks are
more se nsitive to alternative investment opportunities and, as a consequence, shift their
resources more actively between bank deposits
and other forms of investment.

Ban k Size and Deposit Va ri abili ty
EFFECT S OF DEPOSIT SIZE A ND DEPOSIT
COMPOSITION O N TOTAL DEPOSIT
VA RIA BILITY

The evide nce presented in the two preceding
sectio ns of thi s paper supports the followin g
ge nera lizations: (a) total demand deposits a re
more variable than total time a nd savings depo its a t banks in a ll izc groups; (b) the va ri ability of tota l demand de posits te nd s to decline
sys te matica lly as bank size inc reases; and ( c)
whil e the relation ship between bank size and
the variabi lity of to tal tim e a nd sav in gs de pos its
appears to be inve rse ove r the range o f the four
sma ll es t size gro ups of banks, vari ab ility o f
th cs de pos its c.1ppcars to b re lative ly hi 1 h ~1t
th two larg ' st s iz ' groups of bank s. For ea sy
refe re nce, the data o n whi c h th ese ge ne ra lizations a rc based arc rc prc cntcd in T ab le 4 ,
along with da ta re flectin g the va riability a nd
composition of total deposits by size of bank.
A generally inverse relationship b etween the
variability of total deposits and bank size is
clearly observable in this evidence. Over the
range of the four smallest size groups of b anks
the effects of diffe rences in size and in deposit
composition appea r to reinforce each otheras bank s ize in crcas s, th e va riabiliti es o f demand depos its and tim e and sa vings de pos its
sy tcmatica lly decline as docs the ra ti o of demand de posits to tota l deposit . On th e other
Table 4
VARI ABILITY AND COMPOSITION OF TOTAL
DEPOSITS BY SIZE OF BANK
(AVERAGE 1961-66)
Variability
of

Size of Bank

Variability
Total
Ratio
Vari of
Time
Demand ab ility
and
to
of
Total
Demand
Savings
Total
Total
Deposits Depo sits Deposits Deposits
(Per Cent)

Less than $2 million
$2 -$4 .9 million
$5-$9.9 million
$10-$24.9 million
$25 -$99.9 million
$100 million and over

Mo nth ly Rev iew

4.6

4 .5
4.4
3.8
4.0
3.5

•

3.2
2.2
1.8
1.6
2.1
2.5

72.8
68 .0
65 .3
63.7
67.4
74 . 1

3.6
3.1
2.9
2.5
2.7
2.7

November-December 1967

hand , th ese factors appear to counteract each
other in the la rge r size classes . That is, the
mode rating e ffects of size on the va riability of
total demand depos its appear to be offset in
part by th e grea te r proportion of these deposits
in the tota l deposits o f larger b a nks. The relatively hi gher var ia bility of total time and
sav in gs deposit a t la rger ba nks also co ntributes to thi s mod~ra ting te ndency. For example, the hi gher ratios of demand deposits
to total deposits in th e two la rgest size groups
acco unt at leas t in part for the greater varia bility of total dcpo its in these size cl asses
th a n in th e $ I 0-$24.9 milli o n size group. Ove ra ll , howeve r, th e g nc rally lowe r var iabi lity
o f total dc ma n l de posits :1t th ese lar rc r banks
t nd s to be predominant. The variabi lity o f
to ta l deposits at both the $25-$99 .9 million
and over $100 million size classes of b anks
is below th at for the three smalles t size groups.
SUMMARY

The ev idence presented in thi s study tends
to support th e hypothesis th at total dem and
deposits and total deposits are more stable
a t large r ba nks. Exceptions to this inverse
rel ationship between ba nk size and d eposit
va riability appenr to he expla in able primarily
in terms of a dive rgence in the compo ition of
de posits at different sized ba nks. Inte rbank
dem a nd depos its were found to be subject to
a rela tively high degree of va ri a tion , a findin g
which suggests th a t the greater proportion of
these accounts in the total demand deposits
of larger banks does tend to make their total
demand deposits more unstable. Thus the logic
behind the traditional view th at demand deposi ts a re more variable at la rger banks appears to be correct up to a point. However,
thi s hypothes is fails to consider the poss ibility
that th e variabi li ty of each de posit category
composing total dema nd deposits may decline
as they increase in size and d ecline sufficiently
to more th a n offset the effects of the more
volatile composition o f deposits at large banks.
9

The Balance of Payments
Adjustment Problem
B y Tl1011w.,· F. Davis
indust ri al co untri es today h ave
a common des ire to ac hi eve a number of
economic policy goals a nd objectives, such as
full employment , a steady rate of economic
growth, and relatively stabl e price levels. At
the same time, these countries also seek to
avoid prolonged imbalances in their international payments positions and to achieve a
m ax imum degree of freedo m in thei r internation al trade relatio ns. The simulta nco u. atta inment of all these policy o bjecti ves, however,
has proven to be a difficult task a nd has presented policyma kers and th eoretici ans alike
with a numbe r of difficult problems. One of
these probl e ms is the b ala nce of pay ments
adjustme nt problem. Broadly defi ned , thi s is
the problem of avo iding m ajor and persistent
imbalances in the ex ternal positions of countri es in a manner that is simultaneously consistent with th e attainment of other eco nomic
policy objectives a nd in harmony with th e
policy objectives of other countries.

prese nt internati nal m o ne tary ystem. 1 A a
res ult of these efforts, it has become widely
accep ted th a t the avo id ance of persistent payme nts imbala nces is a pre requi site to a soundly
functi onin g inte rnational payments system. It
is recognized, for example, th at if countries
experience persistent deficits in their international payments they may not only impose
a burden o n th e real reso urces a nd monetary
stab ility of other co untri es, but may, throu gh
the proces , o f financing the defic it , contribute
to infl a ti o nary press ures in th e world.
on ver ely , if co untri c experie nce pe r istent surplu ses in th eir ex te rn al pos itions, they m ay,
throu gh the process of accumul atin g inte rnati o nal reserves , induce other countries to
impose defl ation a ry measures domestically and
restrictive practices internationally. The continuation of such payments di sequilibria clea rly
would be prejudicial to the stability of foreign
exc ha nge rates , the future growth of inte r-

The balance of payments adju stm e nt p ro blem , of course, has been a subj ect o f co nce rn
to ma ny countries for a numbe r of years. H oweve r, thi s problem recently has rece ived increas ing a ttention as a n o utgrowth of efforts
to examine and apprai se the viability of the

'See, for exa mple, Ministerial S tate111 ent of th e ,ro 11p
of T en and A 1111 ex Prepa red by Deput ies, August 1964;
T he Co 1111111111iq11e of Ministers and Gol'ern ors a11d R eport
of Deputies, July 1966 ; T he natance o f Paym ents Adjust111e11t Process. A Repo rt by Working P a rty No. 3 of the
Econom ic Poli cy Commi ttee of the OECD, August 1966 ;
and Fellner, Machlup, Triffin and others, M aintaining
and R esto ring Balan ce in Tnt ernational Paym ents, 1966.

M

10

OST MA J O R

The Balance of Payments Adjustment Problem

nation al trade, a nd would threa ten confidence
in th e payments syste m as a whol e.
R ecent inte res t in th e adju stment p ro blem
also has de veloped o ut o f curre nt e ffo rts to
insure th a t within the framewo rk o f th e p resent
inte rn ation a l mo neta ry system a n adeq ua te
supply o f inte rn a ti o na l moneta ry reserves w ill
be crea ted in the future to p ro perl y fin a nce
payme nts imba la nces .2 A s a res ul t o f the e
efforts, it has bee n recogni zed th a t th e speed
and effi c ie ncy by whi c h pay me nts imbala nces
a re a dju sted is cl osel y inte rre la ted with th e
amount o f needed inte rn a ti o nal rese rves . For
ex ampl e, if pay me nts adju stm e nts work rapid ly,
less inte rn ,1tional r se rves will b , needed th ,tn
if th e adju stment s wo rk slow ly. V iew ·d ;tlt c rna tivc ly, if a n ·xcess ive a mo un t o f r serves ;1re
c reated , co untri c mi ght be enco uraged to delay
or for ego nee ded payme nt adju stm ents; whereas, if a n insuffi c ie nt amount o f reserves are
crea ted , countries might be forced to undul y
accelera te adju stm ents th at could ca use undesirable di sturba nces to their dom estic and
internationa l economies. A s a result o f th is
inte rrelation ship b etween rese rve creati o n a nd
payments a dju stm e nts, inte rest has been stimu lated in th e a dju stm e nt p rocess itsel f a nd in
ways in whi c h th e a dju stm ent p roc ss m ight
be improved .

ln view of thi s recent inte res t, the intent
of thi s a rticl e i to di sc uss so me o f th e major
issues involved in th e b ala nce of p ay me nts adjustment problem a nd to review some of the
economic policy measures th at have b ee n suggested to cope with the problem.

2
At th e Anm~ ::i l M eetin g o f th e Int e rn a ti o na l M o ne ta ry
F und ( IM F) 111 Se pt embe r 1967, a reso lutio n was adop ted
to pre pa re a n A m en dm e nt to th e IM F Art i.cles of Ag ree m e nt th a t wo uld a uth o ri ze the JM F to create a ne w
int erna tio na l rese rve fac ility . U nd er this Amend m ent
whic h will b e s ubmitted eventu a ll y to m e m be rs of th ~
IMF for ratifica tio n, th e new faci lit y is to take the for m
of spec ia l dra win g rig ht s, and is inte nd ed to m ee t the
~eed , a~ and wh en it ar ises, fo r a sup plem e nt to ex isting
mte rn a t1on a l r ese rve assets.

Monthly Review

•

November-December 1967

MECHANISMS OF ADJUSTMENT
It is widely acce pted tod ay th at to achieve
a fun da me nt a l a dju stm e nt o f b ala nce of payments di scq uilibri a it is necessa ry for m oney
incomes , costs, a nd prices in defic it countries
to fall re lat ive to those in surplu s countri es.
T hi s w ill I ad in turn to a rea ll oca ti on o f produ c ti ve reso urces in th e ex po rt a nd impo rtco m pet in g in d u tri es of the co untri es co ncern ed
necessa ry to cor rec t th e di sequilibri a . Th e ad ju stm e nt ca n be b ro ught a bou t either by a
c hange in fo reig n excha nge ra tes of th e coun tri es co ncerned or by a c ha nge- in th e a pprop ri a te di rec ti on- in the abso lu te I vc ls o f
1110 ncy inco mes, ·os ts, ; 111d p ric s in th e respect ive co unt ries.
T he class ica l go ld sta nda rd o fte n is c ited as
the syste m in w hi c h thi process o f a dju tme nt
occurred a uto m a ti call y . U nde r th e " ideal" gold
sta nda rd , c harac terized by fi xed foreign exc hange ra tes a nd fl exible prices a nd waoes
b
'
gold fl ows res ul t in g fro m pay ments imbala nces
wo uld a uto m a ti caJly re duce th e m o ney supply
in de fi c it countries a nd increase th e money
suppl y in sur plu s co un tries. This in turn wo uld
indu ce a red uc ti o n in inco mes, pri ces, a nd
cos ts in def ic it co untri es, a nd a n ex pa nsio n
in inco mes, p r ices, a nd cos ts in surplu co un tr ies. T hese c ha nges in inco me a nd cos ts
usua ll y wo uld be accom pa ni ed b y c ha nge in
interes t ra tes, initi a ted a uto m a tically b y interna tio na l go ld fl ows a nd suppo rted by dom es tic
moneta ry policies. In deficit countries, interest
rates would b e increased to furth er da mpen
economi c activity a nd to a tt ract an inflow of
fore ign ca pita l, the la tte r se rvin g to te mporarily
fin a nce th e d efic it . In surplu s co untri es, on the
o th er ha nd , inte res t rate wo uld be d ecreased
to timul a te to ta l sp e ndin g a nd to ncou rage a n
o utfl o w of ca pital.
Th e in adequac ies o f th e cl ass ica l gold sta nd a rd beca m e ev ide nt in the interwa r period
w hen m a ny co untries simulta neously were
fa ced with m ass ively depressed levels of eco11

The Bala nee of Payments

nomic activity a nd e mployme nt. At th e sa me
time , countries also we r confronted e xtern ally
with la rge speculative a nd precautionary flow s
of interna tion al capital which undermin ed th e
stab ility of foreign exchange rates. These difficulties were compounded because th e achi eveme nt of both exte rn a l a nd intern al equ ilibria
unde r th e go ld standard wa s im peded by th e
tend ency of prices a nd wages to be infle xible
in the dow nward direc tion. Recogni zing th at
the gold sta ndard syste m was unworkabl e unde r
th ese condition s, co untri c - out of conce rn
for th eir ow n do mes tic eco no mi cs- elected to
abandon th e syste m in th e mid- I 930's, leavin g
in its wak e a ra sh o f co mpe titi ve dcva lu ~1tions
.ind a web o r restric tive 111 as urcs o n inte rn~i ti o n,tl trade and payme nts whi c h co ntinu ed
in fo rce until after World War II .
The prese nt sys te m of maintaining and restoring ex te rn al equilibria , u ually refe rred
to as th e gold-excha nge standard , evolved out
of the expe ri ences of the 1930's a nd w as
formally incorporated into the Articles of
A greement of th e Inte rn at ional Monetary Fund
(IMF) and the General Agreement on Tariffs
and Trade (GATT ) afte r World W ar 11. While
a numbe r o f improve me nts have bee n made in
the sys tem to ,1dapt it to c hanges in po twar
conditions , its c ·sc ntial a im re main s th at of
facilitating ex tern al ad ju stm e nts with th e least
impairment to th e o bj ectives of full employme nt, economic growth , fre edom o f inte rn a tional trade, a nd stability in foreign excha nge rates .
Under the system , the mainte nance of exte rnal
equilibria is entrusted prima rily to four main
instruments: ( 1) the use of gold, foreign exchange reserves, a nd drawings on the IMF to
fin a nce te mpo ra ry payments imbalances; (2)
the use of re tri.ction s o n capital flow s whe n
ncccs a ry to sa fegua rd exc ha nge ra tes, provided
these res tri c tio ns do not impa ir payme nts for
current acco unt t ra nsac tions; (3) the u e of
res tricti o ns o n impo rts, provided th ey a re imposed in a nondi scriminatory manner in accordance with the provi sions of GATT; a nd
12

( 4) the right to change foreign exchange rates
as allowed by the IMF for purposes of correcting fund a mental payments di sequilibria. The
present sys tem , therefore, is a n attempt to prese rve some of th e bette r fea tures of th e gold
sta nd a rd , such a the relative stability of excha nge rates, and at the same tim e to provide
cou ntries a grea te r deg ree of freedom from the
a utom a tic adj ustment mechani sm of the gold
stand a rd by a ll ow ing them to pursue domestic
eco nomic policies consistent with a minimization of restrictio ns on trade a nd payments.
M ost observers would ag ree that the prese nt
sys te m has wo rk ed quite effect ively over the
pa st two decades. The sys te m's all wance for
"co nt ro ll ed " c ha n 1 cs in ro rc i 1 n e xchan e rat s
under cond itio ns o r fund a me ntal di quilibria
has, for in tance , s ucce sfully avoided the competitive deva lu a tio ns of the 1930's. Al so, by
e ncouragi ng a liberalization of trade and payments res trictions -particularly after the postwar transitional period-the system h as greatly
fac ilitated the rapid expansion in international
trade and economic growth that has occurred
in the world economy. The eas ing of trade restriction s also has contributed to the adjustme nt of pay me nts imbal a nces. During the
1950's, for e xa mpl e, cer tain surplu s countries
in Wes te rn E urope found it more desira bl e to
c heck th eir surplu ses by lowering trade restric ti ons than by re strainin g dom estic demand. D eficit countri es bene fited from these
trade libe ralizations and were able to adjust
their positions with little or no restraint on
their domes tic economies. Aiding in the adjustment process during this period was the
lac k of any great pressure to rapidly correct
payme nts imbala nces, as most major urplu
co untries were ce king to build up their depi cted inte rn a tion al r se rve , while the majo r
deficit co untry, the United States, wa s willing
to a llow a reduction in its more th a n a mple
' tock of net rese rves by selling gold or by inc reasi ng its li ab ilities to foreign monetary authoriti es.

Adjustme nt Problem

It should be emphasized that the effectiveness of the present system during the past
several years also has been due partly to the
continued tendency of payments imbalances
to be automatically eq uilibrated . This a utom atic
tendency operates as follows: A surplu s on
current account, for exa mpl e, arising pe rh aps
out of a n increase in foreign dema nd for a
country's exports, will te nd to increase na tion al
income a nd dom es tic liquidity in th e s urplu s
country, a nd in turn ge ne rate a rise in that
country's demand for imports- a nd a decrease
in its allocation of resources to expo rts- so
as to reve rse the cur re nt acco unt imbalance.
onverscly, a paym nts deficit t nd s to damp n
eco nom ic activity an d rcducL: domes ti c liqu idi ty
in a deficit co untry, caus in g a decline in its
dema nd for foreign goods a nd assets. lt shou ld
be noted th at th e impact of this eq uilib rati ng
mechani sm varies widely a mong countries, depending upon , among other things, th e size
of a country's foreign transactions relative to
its national income, the responsiveness of its
exports and imports to changing economic
conditions, a nd the differences existing between countries' fin a ncial a nd instituti on al arrangeme nts. D espite th e variability of its impact, however, th e eq uilibratin g tendency of
payments imbala nces is a n impo rta nt reason
explaining why ma ny countries throu gh th e
years ha ve not ex pe ri enced larger deficits and
surpluses relative to their total foreign transactions and national income.
Although the present system of adjusting
international payments disequilibria has been
quite effective in recent years , most observers
also would agree that the system still is confronted with a numbe r of difficulties. One of
these difficulti es is th at if the a utom a tic eq uil ibra tin g te nde ncy inh ere nt in the system is
allowed to operate fully , it m ay not o nly have
an uneve n impact on various co untri es, but
more importa ntly it may run counter to domestic policy objectives of full employ ment ,
stable prices, a nd steady economic growth .
Monthly Re v iew

•

November-December 1967

This would be the case for surplus countries,
for exam pl e, unless there is sufficient scope in
their economies to expa nd output and employment without incurring undesirable increases
in th eir price levels. It also would be the case
for deficit co untries, unl ess the level of aggrega te demand in their economi es is excessive
and enda ngering a so und rate of economic
growth at reaso nably sta ble prices. These fortuitous conditions, of course, are not always
present. As a conseq uence, many countries
have found it necessary to adopt eco nomic
policy m eas ures to offset or retard the automatic equ ilibrat ing mechanism. Specifica11y ,
auth riti es in a deficit count ry sometimes may
seek to offset the automatic reduction in economic activity and domesti c liquidity resulting
from a payments deficit by employ ing expa nsionary monetary and fiscal policies designed
to increase employment and output. On the
other hand , a uthorities in a surplus country
sometimes may elect to "sterilize" the liquidity
and income effects of a payments surplus by
adopting contractionary monetary and fiscal
policies to prevent an unsustainable rise in
economic activity a nd a n upward movement
in prices. The adoptio n of th ese offsettin g
pol icy mea sures, however, while perhaps warranted in view of various dom est ic conditions
and objectives , has made it more difficult for
inte rn ational payments disequilibria to be adjusted by relative changes in incomes, costs,
a nd prices.
A further difficulty confronting the present
system is th at today, even more than in the
1930's, prices and wages in most industrial
co untri es tend to be largely inflexible in the
downward direction . One of th e consequences
of this downward inflex ibility in prices and
wages is that it ha s made the correction of
payments imb ala nces through ab solute declines
in th e leve ls of prices a nd wages highly unlikely.
Another consequence is th at no country tod ay
is likely to restrain a nonexcess ively hi gh level
of domestic eco nom ic activity in order to cor13

The Balance of Payments

rect a payments deficit, since with money wage
rates irreducible, a decline in economic activity
tends to cause an increase in unemployment.
To be sure, adjustments of deficits are still
possibl e under these conditions, provided prices
and wages increase more rapidly in surplus
countries th an in deficit countries. However,
surplus countries may not be willing to see
or allow the ir prices and wages to increase,
nor may m a rket forces in surplu s countrie
be conducive to such increases if th eir economies are characterized by less th an full employment conditions. Thu s, at times, deficit
co untri es may be fa ced with the undes irable
ta sk o f mak in r pa yments adjust m nts th zi t
might co nfli c t with th ir full emrl oym nt ohjec tives.
The co nst raints imposed on th e present adjustm ent process by the tendency of prices
and wages to be downwardly inflexible need
not necessarily , however, preclude equilibrating
adjustments being made through changes in
prices and costs. It often h as been pointed out,
for example, th at if average labor productivity
in deficit countries is increased faster th an
average mon ey wage rates, labor costs per unit
of output can decl ine without increas ing unem ploy ment. And , by virtu e of thi s reducti o n in
unit labor cos ts, it might th ereby be po sibl e
for deficit countries to achieve so me reduction
in their average prices. A variation of thi s
theme, although a less des irabl e one from
the standpoint of achieving adju stment, is when
labor productivity and money wage rates in
deficit countries increase at the same pace,
serving to hold unit labor costs constant. In
this case, however, the likelihood of price reduction s in deficit countries is reduced considerably . A thi-rd a lte rn ative is when prices,
wage rates, and costs increa e in deficit coun tri es, but a t a slower rate th an in surplu s
countries. This alternative is perhaps the leas t
desirable because it involves adjusting payments
imbalances by means of differential rates of
inflation between countries. In brief, then ,
14

while the downward inflexibility of prices and
wages does not represent an absolute impediment to the adju stment process, it does pose
difficult and sometimes undesirable alternatives. It also has the important implication
that if payments adjustments are to be achieved
through relative changes in prices and wages,
these adju stments are very likely to proceed
at a comparatively slow pace.
Another source of difficulty often pointed
out as confronting the present adju stment process is the growi ng tendency in many countries
today to rega rd th ei r fore ign exchan ge ra tes as
immutably fix ed. Co ntributin g to thi s tendency
is th vi ew that a dev:.iluation by a country
shou ld be strongly res isted because it r presents a blow to that co untry's financial presti ge
and a threa t to future confidence in its currency. By the sa me token , a n upward revaluation by a country also is likely to be strongly
resisted beca use of the adverse repercussion s
a revaluation is likely to have on that country's
export and import-competing industries. Also
contributing to the tendency of fixity in exchange rates is the possibility that large destabilizing speculative and precautionary capital
fl ows will occ ur in anticipation of, and perhaps
as a consequence o f, changes in foreign exchange rates. P ara doxically , th e removal of
many restrictions on ca pital movements since
195 8, while und eni ably res ulting in a b etter
allocation of capital throughout the world,
has increased substantially the scope for these
capital flows . To be sure, many cooperative
efforts between countries have been made in
recent years to moderate the impact of these
destabilizing ca pital movements, such as the
network of currency swa p agreements establi shed by central banks of countries .:i Nonetheless, it often is cl aimed th at the desire to
avoid th ese capital flow s ha s increased th e

1
: For a discuss ion of these swa p ag reements, see "Treasury and Federal Reserve Foreign Exchange Operations,"
Federal R eserve Bulletin , September 1967 .

Adjustment Problem

emphasis on the need to avoid changes in
foreign exchange rates.
Frequent and excessive changes in foreign
exchange rates are, of course, recognized as
undesirable from th e standpoint of maintaining
stability in inte rnational trade a nd payments.
It is also of recognized importance th at reservecurrency countries , such as the United States,
maintain the values of their currencies in
order not to jeo pardize th e stability of the present inte rnational fin a ncial system. It should
be reca ll ed, howeve r, that under th e provisions
of the l MF, occasion al change in exchange
rates arc permitted in order to co rrect a funda mental r~1ym cnts di s quilibrium . H cnc , to th e
xtcnt that this provi sio n is us d too spa ringly,
particularly by no nr sc rv -c urrency co untri ,
th e adju stment process tends to be deni ed an
importa nt instrum ent by which payments imbalance can be corrected.
In view of these and other difficulti es, most
informed observers have concluded that improvements can and should be made in the
present system of adjusting international payments imbalances.• Some of the economic
policy meas ures which have been suggested
to achieve this improvement arc reviewed in
the following sectio n.
POLICY PRESCRIPTIONS

In a dynamic world economy, periodic imbalances in the intern ational payments position
of countries are bound to occur. Some of
these imbalances, of course, are likely to be
temporary or seasonal in nature, and will not
warrant corrective ch anges in economic policies, incomes, costs, and price . Other imbalance , however, a rc likely to be of a mo re per-

•These difficulties a lso h ave led some observers to conclude that the present system should be drast ica ll y
altered to ac hieve a gr a ter degree of au toma ticity in the
adjustment process. Those taking thi s view usua ll y
advocate either a return to the gold standard syste m or
the establishment of a system of flexibl e foreig n exc hange
rates.

Monthly Review

•

November-December 1967

sistent and fundamental nature. Therefore, it is
esse ntial for policymakers to be able to distinguish properly between these two types of
imbalances. Toward th at e nd, the United
States and other member countries of the
OECD have recently established an "early
warnin g sys te m. " This sys tem is designed to
improve the collection, qu ality, and analysis
of re levant stati stical information and to faci lita te consultations between membe r countries
wheneve r it i believed necessary to change
or adopt econom ic policy measures for international payments purposes. 6
The need to id ntify impendin g or actu al
paym ·nts imbalances of a no ntc mporary nature
how v r, is o nl y a pr Jude to th e mo re diffi cu lt ta sk o f pr scribing approp ri a te policy
mcasur s to correct the imbala nces. Complicating the task of prescribing policy measures
is that payments imbalances requiring adjustment are often caused by a wide diversity of
factors, such as changes in productivity, alterations in the availability of raw materials,
shifts in the dem and for goods and financial
assets, changes in a country's military and
foreign aid obligation , etc. D es pite the causal
diversity of imbalance , it has often b een found
q ui te useful when prescribing policy mca ures
to di stingui h analytically between three common causes of imbalances. These common
causes are: ( 1) inapprop ri a te levels of agg regate dem and ; (2) inappropri ate interna tional
competitive positions due to structural disparities in costs and prices; and (3) excessive
outflows or inflows of capital , not supportable
nor warranted by a country's current account
a nd in ternation al reserve position . In di stingui shing between these common cau e , recog-

Many of the poli cy meas ures reviewed in thi s sec ti on ,
as we ll as the ag reement to es tab li sh a n "early wa rning syste m ," are discu ssed more fu lly in: The Balance
of Pay 111 e11ts Adj11s1111e111 Process, A R eport by Workin g
Pa rty No. 3 of the Economi c Policy Committee of the
OECD, August 1966.
0

15

The Balance of Payments

nition is given, of course, to the fact that other
cau ses of imbalance sometimes do exist and
th at, in practice, two or more of these common
causes often arc operative at th e same time.
It also is recognized th at even thou gh it is
possib le to identify properly the cause of an
imbalance, it may not be expedi ent nor desirable in some cases to treat th e cause directly
throu gh th e application of policy m easures . For
exa mpl e, if a country's payments pos ition has
moved into surplu s beca use its co mpetitive
position has improved as a result of an increase
in productivity and lower costs, it would clearly
not be de irabl c fo r th at country to impose
re ·tri ct io ns on furth er increases in productivity
in .in atte mpt to reduce its surplu s. Given
th ese exce ptio ns, tho ugh, th
ide ntifi ca ti on
o f payments im bu lanccs acco rding to their
common cau ses has proven to be a particularly useful device both for determining appropriate policy meas ures and for judging th e
probable duration of the imbalances.

In the case of payments imbalances due to
inappropriate levels of aggregate demand , the
recommended policy measures generally are
considered to be quite straightforward . Since,
by definition , aggregate demand is either execs ivc or deficient, it is clear th at both mone ta ry and fi scal I olic i s hould be empl oyed to
re tore aggrega te dema nd to a I vcl that is appropriate with ex te rnal b alance . For exa mpl e,
when a country run s a pay ments deficit due
to excessive demand pressures, monetary and
fiscal policies should act to restrain domestic
demand. Conversely, when a country experiences an external surplu s and at the same
time suffers from unemployment, as did the
United State in the 1930' , the appropriate
remedy is an e~pa nsion of dom estic de mand
by mon eta ry a nd fi scal policic . Since in both
o f these cases th ere is no a ppa rent conflict
in the presc ription of policies to achieve both
internal and exte rn al balance, the problem
of payments imbalances resultin g from inappropriate levels of demand often is cited as
16

being a "simple" case from the standpoint of
prescribing policy measures .
It should be emphasized, howeve r, that a
"s imple" case of an external deficit due to
excessive demand conditions may readily deteriorate i.nto a more difficult situation as soon
as demand conditions cause prices and wages
to increase . lf thi s occurs , it then becomes
more difficult to treat th e cause of the imbalance through policies aimed at restraining aggrega te demand , because the application of
such policies with wages downwardly rigid
wi ll tend to lead to an increase in unemployment. To avo id this situation , therefo re, it is
ge ne rall y presc ribed that wh ene ver payments
imbal~inces :ire du e to excess ive demand conditi o ns, monetary a nd fi sca l po lici es should b
empl oy d as soo n as poss ible to reduce aggrega te demand. And , as an obvious corollary to
thi s presc ription , it follows that all countries
should endeavor to develop, improve, and
make more fl exible those monetary and fiscal
policy instruments by which they are able
to influence aggregate demand.
External imbalances associated with cost
a nd price di sparities, irres pective of whether
they have bee n due to aggrega te demand or
structural cha nges, pose a more difficult task
for policy maker . The remedy in thi s case i
clea rl y for cost-price tructures in deficit countri es to fall relative to those in surplu s countries. A s indicated ea rli er, however, such an
adjustment may create policy conflicts for
deficit countries, which are experiencing slack
demand and high unemployment conditions,
and for surplu s countries, which are unwilling
to see or allow an increase in their price levels.
Und er these conditions, it is widely accepted
that deficit cou ntries should not be called on
deliberately to usta in slack dema nd conditions
for exte rn al purposes, nor should surplus
co untri es be asked for th e sa me reason to
tol era te an increase in the ir price levels. In
practice, though, surplu s countries may not
be able to prevent completely a ri se in their

Adjustment Problem

prices because of the equilibrating tendency
of a payments surplus. And to the extent this
occurs, external adjustments will be facilitated .
A more desirable way for surplus countries
to make adjustments would be, of course, by
unil aterally reducing their restrictions on international trade and payments. Such actions
would not on ly help correct th eir ex ternal
surplu cs, but also would serve to moderate
upw ard press ures on their dome ti c prices. l n
th e event th at furth er remedi al action is necessary, surplu s countri es th en would be advi ed
to make UJ ward revaluations in th eir exchange
rate.
or co untries with cx tcrn;d ddi its du e to
unfavorabl · cos t-price structures, th · most advisable policy pr sc ripti on- as ,tllud ·d to ea rlier- is to keep money wage increases b low
productivity increa cs. Failing th at, the rate
of money wage incrca es should be kep t in
line with productivity increases . An appropriate way to accomplish such a price policy is
to adopt measures which stimulate investment
and increase productivity, particularly in ex port
and import-competing industries. Increased
restrictions on imports usually arc not prescribed, since th ey tend to lead to hi gher
dom es tic prices for imports and ;1 lower rate
of eco nomic effici ency in import-competing in dustries. Finally, deficit countries can , if necessary, devalue th eir currencies, provided it is
recognized that devaluation in and by itscH
is not likely to be a successful remedy if action
is not taken to prevent a reemergence of adverse cost-price structures. An additional proviso regarding exchange rate adjustments ,
whether by deficit or surplus countries , is
that under th e prese nt intern ation al monetary
system it i · considered preferable th at nonrescrve-currcncy rates be moved in relation
to re erve-currcncy rate , rather th an vice
vcr a.
When excessive outfl ow or inflows of capital
are the prim ary cause of payme nts imbalances .
the general policy prescription i to make some
Monthl y Review

•

November-December 1967

adjustments in interest rates to alter the capital flows. For example, countries in deficit
due to large capital outflows are usually advised to adopt monetary policies leading to
hi gher interest rates, so as to di sco urage capital
outflows and encourage capital inflows. On
th e other hand , countries in urplus because
of abnormally hi gh capital receipt u ually
arc advised to decrease intcrc t rates. If moneta ry policies have to be so altered, however,
and if it is al o de ired to maintain a given
balance in intern al demand , it will th en be
nccc sary to make off cttin g change in fi scal
policies. But a change in th e policy " mi x"
to alter intern at i nal ap ita l fl ows is conditio ned, in th e first instan ·e, hy interes t rates
in oth r co untries, .1 nd by th e obv i us n cd
to avoid an inappropr iate level of interest
rates intern ation all y. Additionally, a change
in the policy " mix" may not be th e most
advi sabl e remedy to use on a continuing basis
if (I) und esirabl e repercussions may result
internally on the composition of aggregate
demand and economic growth , and if (2)
th e imbalances in capital flows are due to
factors other than interest rates, such as structural changes in th e intern at ional demand for
capital, and res tri cti ons on th e effici ent operati on of intern ati onal capital ma rkets. Hence,
while at tim es interest rate adju stments may
be an appropriate tec hnique to alter imbalances
in capital flow s, th ey should not be considered
as a pan acea, nor as a substitute for needed
actions of a more fundam ental nature.
In the event that adjustments in interest
rates to alter excessive capital flows appear
neither feasible nor desirable, it is· sometimes
prescribed th at countries employ selective measure to directly control the size and nature
of capital movements. For exa mple, selective
control s often arc advoca ted to prevent the
development of large- cal c ca pital flows which
may be tempora rily des tabilizing in nature or
refl ective of noncompetitive market condition
abroad. Al so, the use of selective mea ures ,
17

The Ba lance of Payments

whether to encoura ge or di ·courage capital
flow s, so metimes is considered des irable in the
interes t of making internal monetary policy
more effective. There are, however, a number
of reaso ns why th e continued reliance on capital controls is not con sidered advi sabl e. For
in stance , it often is po inted out that a minimization of cap ital controls is th e be ·t ass ur<1nce th <1 t ove r th e long run th e world's supp] y
of c<1pital will be mos t effi ciently and appropriately alloca ted amon g countries. Furthermore,
it is commonly beli eved that th e effec tiveness
of c<1pital control s often tend s to dimini h with
th e passage of time. And fin all y, prolonged
reliance on ca pital ·ontrol s 111,1y well be sy111ptom~1tic of th e need to mak ' more basi adju stm ent s to ·o rr 'C t p;1yments imbalances
between co untri es. Thus , as in th e case of
interes t rute adju stm ents, reliance on capital
controls may be appropriate at tim es but should
not be considered as a permanent solution to
ex tern al di sequilibria.
CONCLUSIONS AND IMPLICATIONS

The policy prescriptions cited above for
eac h of th e three common ca uses of payments
imbalances, whil e neither ex hau stive no r mu tu ally excl usiw, ,ire ge nerally cow iclercd to b
th e mo t app rup ri<1te mea ns to acco mpli. h
improvements in th e prese nt adju stm ent mec hani sm. In ge neral, th ese policy presc ripti ons
hold that, under th e prese nt system of relatively fixed foreign exchange rates and with
internal prices and wages tending to be inflexibl e in th e downward direction , th e appropriate speed of adjustm ent depends on th e
nature and ca use of th e payment imbalance.
In cases wh ere _p,1yments imbalance. ar du e
to excess ive or defici ent levels of agg r ga te
demand , it is reco mm end ed th at adju stment
be accompli shed as soo n as poss ible through
pro mpt and effecti ve use of monetary and fi sca l
policies des igned to suppl ement th e automati c
eq uilibrating m chani sm. In oth er cases. for
18

exampl e when imbalances are du e to internation al cos t-price di spariti es , it is suggested
that th ere may be no particular virtue in
speedy adjustm ent along the lines of the automatic equilibrating process if a slower adjustment process will permit countries to achieve
their intern al policy objectives of full employment, eco nomic growth , and price stability .
In those cases where a slower adjustmen ~
process is dee med des irabl e, however, it is
necessary th at all countries recognize and acce pt certain conditions and responsibilities
without which such an adjustment process
will not be effecti ve. Fire t of all , it is cs ntial
th at durin th e tim e in which th e slow r ad justm nt process is workin g, an aclequnt suppl y of int ernation,d liquidity should be mad
ava il abl to enab l co untries to sa ti factorily
acco mmodate extended pay ments imbalances .
Secondly , it i impera tive that to prevent possibl e abu ses in the creation or extension of
addition al international liquidity, countries
should promptly initiate and maintain economic policies designed to eventually correct
payments imbalances. For all countries , this
implies the adop tion of monetary and fiscal
policie. aim ed at m aintaining a growth rate
in internal demand that is con istent with
th eir productive potenti al and also consi tent
with relati ve price sta bility intern ationally. In
addition , sur plu s co untri es should be willing,
if neces ary, to reduce res trictions on their
intern ati onal trade and pay ments, while deficit
countries should refrai n from imposing addition al restrictions on th eir trade and payments, except possibly on a strictly temporary
bas is. Finally, if under th ese conditions, payments imbalances ap pea r likely to continue,
it would then be entirely approp ri ate for nonre erve-c urrency co untri es to mak either upward or downward alterati ons in their forei gn
exchange rates .
For th e United States, which has bee n
experiencing sizable de fi cits in its internati onal
pay ments positio n for the pa t evera l yea rs,

Adjustment Problem

the implications of th e foregoing policy prescriptions arc quite clear. To correct its payments defi cit, it would be inappropriate for
the United States, as a rese rve-currency country , to alter unil atera ll y it foreign exc hange
rate becau e such act ion would be detrimental
to th e continued stab ility of the intern atio nal
monetary y tem. Moreover, it wo uld be undesirable fo r the United States, as th e largest
capital expo rter in the world today , to view
the use of selective co nt rols over its capital
outfl ows, such as the Intcrest Eq ualization
Tax , as a permanent olution to its balance
of payments difficulties. Rath er, the most appropriate so lu tion, albeit a slow work in r one,
is for th L: United States to make its •nods ;ind
servicL:s more co mpctitivL: wi th fo r ' i •n produced 1 oocls and se rvi cs, both at home and
abroad. Clea rl y, th e best way to acco mpli sh

Index of

thi s in a nondisc rimin atory manner is for
th e United States to prevent an upward movement in its average level of prices and wagesso as to improve its cost-price structure relative to other countries-and to achieve b alanced eco nomi c growth domestically . The importa nce of price stabi lity in the United States
ca nn ot be overempha ized because it is not
onl y a key element in the ac hi evement of longrun balance in th e United States external positi on, but it is also a cru cial ingredient in the
atta inm ent of a ustai nablc econom ic growth
rate intern all y. H ence, th e policy prescription
for th e United States, whi ch is si multaneo usly
co nsi. tent with in te rn al and externa l balance ,
is th e vigorous and fl exible pursuance of m net.1ry and fi sc;,,tl policies dcs i •nee.I to promote
and mainta in a no ninfl ati onary an I stable rate
of eco nom ic grow th .

MONTHLY REVIEW

Agriculture and
Technology

May-June

A look at Some Measures
of Inflation

.November-December

The Budget, Fiscal Action, and
Short-Run Economic
Change: Part l
January-February
The Budget, Fiscal Action,
and Short- Run Economic
Change: Part 2

March -April

Deposit Variability at
Commercial Banks

July -August

Educational Expenditures in
the United States
September-October

Monthly Review

•

1967

Farm lending by
Commercial Banks
in the Tenth Federal
Reserve District

January-February

Financial Intermediaries
and the Postwar Home
Mortgage Market

January-February

March -April

The Balance of Payments
Adjustment Problem
November- December
Bank Size and Deposit
Variability

Articles in

November-December 1967

The Impact of
Farm Prices on
Wholesale and Retail
.... September-October
Price Levels
The Process of Federal
Spending and Economic
Activity

July-August

Specialized Mortgage
Marketing Facilities

July-August

The U. S. National
Income and
Product Accounts

May-June
19