Reducing Global Imbalances: Can Fixed Exchange Rates and Current Account Limits Help?

This paper analyzes the stability of foreign trade, currency markets and international portfolio balances with the help of a model of current account balances and internationally held assets. In particular, the paper considers the conditions for simultaneous equilibrium of trade and asset balances, and whether such equilibria are stable or not. The conditions under which those equilibria continue to exist, and are reachable, are then analyzed when the markets are distorted by the common policy prescriptions of fixed exchange rates or defined limits to the size of current account surpluses or deficits. A better approach is derived from the idea of a “trade space” defining the areas in which it is safe to allow trade deficits and net foreign assets or debt to operate. This allows us to investigate and draw conclusions about the best policy options to make the system stable in the long run with respect to current account imbalances and net foreign debt. First, institutional arrangements that ensure stability and maximize “trade space”; second, an exchange rate minimum as a circuit breaker to prevent debt escalation; third, policies to raise trade elasticities and lower portfolio adjustments in order to limit imbalances in size.