The Balance of Payments Adjustment Mechanism in a Rational Expectations Equilibrium

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Discussion Paper

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This paper provides a choice theoretic, general equilibrium account of the balance of payments adjustment process and the determination of national price levels in a world comprised of countries populated by rational households. Balance of payments adjustment dynamics arise in the equilibrium of this model from the precautionary saving behavior of risk-averse households who self-insure against random productivity fluctuations by accumulating, via balance of payments surpluses in productive periods, buffer stocks of domestic money which can be drawn down to finance payments deficits, and thus a less variable profile of consumption relative to output, when productivity is unexpectedly low. Precautionary saving is shown to exhibit the partial-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.

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