¹ See Ingram, James C., “A Proposal for Financial Integration in the Atlantic Community,” Joint Economic Committee print, 11 1962 Google Scholar, for a valuable analysis of financial integration under fixed exchange rates; Johnson, Harry G., “Equilibrium under Fixed Exchange Rates,” American Economic Review, LIII, 05, 1963, 112–19Google Scholar, for a discussion of some of the advantages of closing the exchange rate margins; Kindleberger, C. P., “European Economic Integration and the Development of a Single Financial Center for Long-Term Capital,” Weltwirtschaftliches Archiv, Band 90, 1963, Heft 2, 189–210 Google Scholar, for a discussion of competition among financial centres as integration proceeds; and McLeod, A. N., “Credit Expansion in an Open Economy,” Economic Journal, LXII, 09, 1962, 611–40CrossRefGoogle Scholar, for a theoretical discussion of related topics.

² The foreign sector refers to all the transactions of the country as a whole with respect to the outside world.

³ For certain purposes it would be more elegant to define a separate market for foreign goods as distinct from domestic goods, but the present approach is satisfactory for the purpose on hand.

⁴ Caves, Richard E. arrives at essentially the same result in his paper, “Flexible Exchange Rates,” American Economic Review, LIII, 05, 1963, 120–29.Google Scholar

⁵ “The Appropriate Use of Monetary and Fiscal Policy for Internal and External Stability,” IMF Staff Papers, IX, no. 1, 03, 1962 Google Scholar; “The International Disequilibrium System,” Kyklos, XIV, no. 2, 1961, 153–72Google Scholar; and “Employment Policy Under Flexible Exchange Rates,” this Journal, XXVII, no. 4, 11, 1961, 509–17.Google Scholar In the latter paper (the main purpose of which was to show that commercial policy—import restriction or export promotion—was ineffective under flexible exchange rates) it was argued that both monetary and fiscal policies are more effective under flexible exchange rates than under fixed exchange rates. The apparent conflict with the present analysis lies in the different definition of monetary and fiscal policy and in the extreme assumption in the present paper of perfect capital mobility. In the earlier paper fiscal policy was taken to be an increase in government spending with interest rates maintained constant by the central bank, while capital inflows were assumed to be a function of the rate of interest alone; in other words no capital inflow takes place (because the domestic interest rate is constant) while the money supply is allowed to expand in proportion to the increase in income induced by the more expansive fiscal policy. In the present paper, I have defined fiscal policy as an increase in government spending financed by government bond issues with no change in the money supply. In both cases the underlying model is (in essence) the same and would yield the same results if the same assumptions were made about capital mobility and the same definitions were used.

It may puzzle the reader why I went to some length to alter the definitions of monetary and fiscal policy and thus to bring about a seemingly artificial difference between the conclusions based purely upon different definitions. The reason is that monetary policy cannot in any meaningful sense be defined as an alteration in the interest rate when capital is perfectly mobile, since the authorities cannot change the market rate of interest. Nor can monetary policy be defined, under conditions of perfect capital mobility, as an increase in the money supply, since the central bank has no power over the money supply either (except in transitory positions of disequilibrium) when the exchange rate is fixed. The central bank has, on the other hand, the ability to conduct an open market operation (which only temporarily changes the money supply) and that is the basis of my choice of this definition of monetary policy for the present analysis.

In an earlier paper I analysed some of the purely dynamic aspects of the adjustment process (“The Monetary Dynamics of International Adjustment Under Fixed and Flexible Exchange Rates,” Quarterly Journal of Economics, 05, 1960, 227–57Google Scholar) on varying assumptions regarding capital mobility, but the treatment of the perfect capital mobility case in that paper suffers from the defects I have tried to avoid in this paper by my different definition of “monetary policy.” However, the basic conclusions of that paper are not vitiated by the present analysis since the basic problem posed, in the flexible exchange rate case, that “monetary policy” exerts its influence on domestic incomes only indirectly through the exchange rate, still remains, with possibilities of cyclicity and even instability depending on the adjustment speeds; in the present case it can be shown that instability at least would be ruled out if the exchange rate adapted virtually instantaneously.

⁶ John Exter used a reservoir simile in “The Gold Losses,” a speech delivered before the Economic Club of Detroit, 05 7, 1962.Google Scholar

⁷ See the accounts of the Canadian experience by Clarence Barber in his submission to the Royal Commission on Banking and Finance, April, 1962, “The Canadian Economy in Trouble,” and by Harry Johnson from his speech to the Canadian Club of Toronto, November, 1962, “Canada in a Changing World.” Perhaps the most complete verification of the applicability of the conclusions to the Canadian case is provided in an econometric paper by R. Rhomberg to be published in the Journal of Political Economy.