By Peter Curwen (eds.)
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Additional resources for Understanding the UK Economy
GROWTH AGGREGATE EXCHANGE/ less - - . . 1 - - - - - - - ' - - - - - - - ' ---... ~ INTERNATIONAL RATE CAPITAL FLOWS pluslless ADJUSTMENTS TO RESERVES equals BALANCE OF PAYMENTS to be attracted in the short term by offering attractive rates of interest compared to those prevailing in the other financial centres, so a worsening current account deficit will result in an increase in interest rates in the UK. As a consequence of these inflows the exchange rate is strengthened, and can be prevented from falling below the lower limit permitted under the EMS.
This phenomenon clearly needed to be explained within the context of the Keynesian model, but the model was found wanting. After 25 years its Achilles heel had been exposed. Rather ironically, it was precisely at this point in time, at the beginning of the 1970s, that the exchange rate mechanisms introduced at Bretton Woods began to break down, to the point at which the UK felt obliged, in 1972, to move over to a floating rate (albeit a 'managed' one). This meant that balance of payments crises could now be dealt with via the exchange rate rather than via deflation (given the political will to accept currency depreciation), and thus allowed more freedom for demand to be managed in order to maintain full employment.
In other words, the fiscal stance which determines the PSBR has some bearing upon the money supply, as has the rate of interest which represents the cost of issuing or redeeming government securities (via an open market operation, for example). A sharp change in the size of the PSBR necessitates an adjustment to the structure of interest rates. When the interest rate changes it either attracts or deters a flow of international capital ('hot money'). This in turn affects the money supply, since if international capital flows into the UK then foreigners must first convert it into sterling, whilst if it flows out then UK residents must first turn sterling into foreign currencies.