Volume 10, Issue 10, October – 2025 International Journal of Innovative Science and Research Technology

ISSN No: -2456-2165 https://doi.org/10.38124/ijisrt/25oct410

Theoretical Approaches to Rebalancing the

Balance of Payments: A Literature Review
Dr. Amadou Woury Diallo1
1
University of Dakar, Senegal

Publication Date: 2025/11/03

Abstract : The issue of rebalancing the balance of payments has received ongoing attention in economic literature,
prompting the development of various theoretical frameworks aimed at restoring external equilibrium. This review
critically examines the main strands of thought that have shaped this discussion. It first explores the automatic adjustment
mechanisms proposed by classical economists, emphasizing their reliance on price and income changes. It then examines
administered adjustment theories, including the absorption approach, the critical elasticities framework, and the
monetary approach to the balance of payments. By combining these perspectives, the review provides a structured
understanding of the conceptual development and policy implications of balance of payments adjustment strategies.

Keywords: Balance of Payments Adjustment, External Equilibrium, Automatic Mechanisms, Absorption Approach, Elasticities
Approach, Monetary Theory, Current Account Deficits, Macroeconomic Policy, International Economics, Disequilibrium
Dynamics.

JEL Codes : F10-F60, F31, F41, F43

How to Cite: Dr. Amadou Woury Diallo (2025). Theoretical Approaches to Rebalancing the Balance of Payments: A Literature
Review. International Journal of Innovative Science and Research Technology,10(10), 2129-2132.
https://doi.org/10.38124/ijisrt/25oct410

I. INTRODUCTION economic thought, and interventionist approaches, which

focus on policy intervention and structural changes.
Persistent current account deficits continue to be a
widespread issue in both advanced and developing II. AUTOMATIC REBALANCING METHODS
economies. These imbalances, often accompanied by FOR THE BALANCE OF PAYMENTS
increasing external debt, pose serious risks to macroeconomic
stability and highlight the importance of analyzing and Balance-of-payments imbalances have historically
addressing the current account. Since the introduction of played a key role in international economic theory. Classical
floating exchange rates in 1973, the current account has models highlight two main automatic adjustment
increasingly become the main indicator of a country’s need mechanisms: one involving changes in relative prices, and the
for macroeconomic adjustment, surpassing the broader other through fluctuations in overall income.
balance of payments (Salop & Spitaller, 1980). The need to
reduce, or ideally eliminate, current account deficits remains a  Adjustment Through Price Mechanisms
central focus in economic policy discussions. A substantial The classical theory of external adjustment, first
body of research has developed to explore how external explained by David Hume (1754) and later expanded by
equilibrium can be restored, producing various theoretical Ricardo, J.S. Mill, and Taussig, suggests a self-correcting
models with differing conclusions. These models range from process under the gold standard. In this system, national
classical automatic adjustment mechanisms to more currencies were defined in terms of gold at fixed gold points,
interventionist, policy-driven strategies. Despite these efforts, which helped anchor monetary values and enable international
persistent deficits are still a common feature of many settlements.
economies, especially in the Global South, making balance-
of-payments imbalances an ongoing concern in both In a balance-of-payments deficit, gold outflows decrease
scholarship and practice. This paper offers a critical review of the domestic money supply. According to the quantity theory
the main theoretical approaches to rebalancing the balance of of money, this reduction causes domestic prices to fall. Lower
payments. It analyzes their conceptual foundations, prices improve the competitiveness of domestic goods, boost
assumptions, and limitations. A distinction is made between exports, and cut imports, ultimately narrowing the trade
automatic adjustment mechanisms, rooted in traditional deficit.

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Volume 10, Issue 10, October – 2025 International Journal of Innovative Science and Research Technology
ISSN No: -2456-2165 https://doi.org/10.38124/ijisrt/25oct410

On the other hand, surplus countries receive gold the interwar period and the Great Depression, showed their
inflows, which increase the money supply and raise domestic limitations. The inability of these mechanisms to stabilize
prices. This inflationary impact reduces export external accounts during severe economic hardship led to a
competitiveness and boosts imports, thereby reversing the shift toward policy-driven, or managed, methods for balance-
surplus. Through these balanced movements of gold and of-payments adjustment, focusing on discretionary actions
goods, the classical model predicts an automatic return to and structural reforms.
external equilibrium.
III. ADMINISTERED APPROACHES FOR
However, this model has faced significant criticism. BALANCE-OF-PAYMENTS REBALANCING
Nogaro (1904) questioned the idea of a direct causal link
between gold flows and balance-of-payments results, pointing Adjustment policies involve coordinated fiscal,
out that international settlements often happen through monetary, and structural measures aimed at restoring external
financial instruments like bills of exchange rather than balance during balance-of-payments deficits. The limits of
physical gold transfers. Meade (1952) also challenged the idea automatic adjustment mechanisms, especially visible during
that the process is automatic, arguing that price-level the Great Depression, led to a shift toward policy-based
adjustments often reflect intentional policy interventions solutions. As external restrictions grew tighter and
aimed at achieving both internal and external balance. macroeconomic stability became more fragile, discretionary
intervention gained importance. The International Monetary
For such price-based rebalancing to work effectively, Fund (IMF), created as a key part of post-war monetary
several strict conditions must be met: real wage flexibility, a governance, formalized several frameworks for balance-of-
shared adjustment burden between surplus and deficit payments adjustment, including the absorption approach, the
countries, sufficient international reserves, open trade policies, elasticity approach, and the economic approach.
and the lack of fixed-currency debt obligations. Additionally,
effective adjustment requires that the total of marginal  The Absorption Approach
propensities to import stays below one and that import- Formulated by Sidney Alexander (1952), the absorption
demand price elasticities are greater than one. approach views the balance of payments as the difference
between a nation’s total output (aggregate resources) and its
Alternative perspectives, advanced by Bastable (1889), total expenditure (aggregate absorption). In this model, a trade
Wicksell (1918), and Viner (1937), shift the analytical focus deficit occurs when domestic absorption surpasses national
from relative prices to total demand. These scholars argue output, indicating that the country is consuming more than it
that, with prices held constant, a deficit indicates a decrease in produces. Therefore, adjustment requires a reduction in
total demand in the deficit country and a rise in total demand absorption, meaning a contraction in the overall demand for
in the surplus country. Equilibrium is thus reestablished goods and services.
through changes in demand rather than price adjustments. The
main difference from Hume is that, in these views, price Assuming supply constraints near full employment, this
changes are not necessary for rebalancing. approach advocates demand-management policies to decrease
domestic spending. Meade (1952) suggested using a mix of
 Adjustment Through Changes in National Income monetary and fiscal tools: tightening monetary policy with
The second automatic mechanism for rebalancing the higher interest rates to limit credit growth and reduce private
balance of payments operates through changes in aggregate consumption and investment; and balancing the budget
income, often analyzed using the foreign-trade multiplier through spending cuts (such as subsidies, transfers, and
framework. In this context, an exogenous rise in exports acts current expenses) along with raising indirect taxes to generate
as an injection into national income, while savings and revenue and restrain demand.
imports are leakages from the circular flow of income. The
size of the multiplier depends on the inverse of the sum of the Despite its analytical clarity and operational simplicity,
marginal propensities to save and to import. Equilibrium the absorption approach has limitations. It tends to view
occurs when total leakages equal the initial injection. external imbalances as merely an issue of excess demand,
overlooking structural factors like imported inflation, which is
An increase in exports leads to higher real income, especially important in developing economies. Additionally,
which then boosts demand for both domestically produced the recommended austerity measures might hinder economic
goods and imports. As income keeps rising, the growth in growth and, under certain conditions, worsen inflationary
imports eventually offsets the initial export gain, helping to pressures. When possible, supply-side policies aimed at
restore external balance. Conversely, a decrease in exports increasing productive capacity provide a more balanced
triggers a contractionary cycle, lowering income and import approach to external adjustment. Finally, the approach’s
demand. The speed and effectiveness of this adjustment narrow focus on the trade balance ignores the importance of
depend largely on the marginal propensity to import: the capital flows and financial account movements, which are
higher its value, the quicker imports respond, and the faster vital parts of the modern balance-of-payments framework.
the adjustment process spreads across trading partners.
 The Elasticity Approach
Although automatic adjustment mechanisms seem The elasticity approach, widely supported by the
appealing in theory, historical experience, especially during International Monetary Fund (IMF), focuses on using

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Volume 10, Issue 10, October – 2025 International Journal of Innovative Science and Research Technology
ISSN No: -2456-2165 https://doi.org/10.38124/ijisrt/25oct410

exchange rate adjustments, such as devaluation or Despite different ideas about external imbalance, both
depreciation, as a way to restore external balance. The the absorption and monetary approaches agree on a common
theoretical basis suggests that a decrease in the domestic policy: limiting domestic credit growth. Polak took this
currency's value improves external competitiveness by principle further by suggesting that central bank foreign
changing relative prices: imports become more costly in exchange reserves should always cover at least 20 percent of
domestic currency, while exports become cheaper in foreign domestic credit creation, strengthening monetary discipline
currency. These price changes are expected to impact trade and external solvency.
volumes over time, helping to improve the current account, as
long as trade flows respond to price changes. However, the monetary approach has faced criticism.
Kaldor (1970) questioned the assumed direction of causality
 The Success of this Mechanism Depends on Several Key in the model, arguing that a statistical correlation between
Elasticities: money and income does not necessarily indicate a causal
relationship. He argued that it is more likely for the level of
 The price elasticity of foreign demand for the country’s economic activity to influence the amount of money, rather
exports than the other way around. This critique emphasizes the need
 The price elasticity of the domestic export supply to be cautious when interpreting monetary dynamics and their
 The price elasticity of domestic demand for imports effects on external adjustment.
 The price elasticity of foreign import supply
IV. CONCLUSION
Two different effects influence the path of the trade
balance. In the short term, the price effect typically has a The persistence of balance-of-payments deficits has long
negative impact: import prices increase in domestic currency, been a key focus of study in international economics. The
while export prices decrease in foreign currency, which can state of external accounts, especially the current account,
worsen the current account deficit. Over the medium term, continues to influence macroeconomic policy discussions and
however, the volume effect may prevail if the relevant price remains a major concern for organizations like the
elasticities are sufficiently high. In these cases, export International Monetary Fund (IMF). In addition to identifying
volumes increase and import volumes decrease, resulting in the root causes, a significant body of research has examined
an improvement in the current account. This process is the theoretical and practical ways to address external
described by the Marshall–Lerner condition, which states that imbalances.
the sum of the absolute values of the export and import
demand elasticities must be greater than one for devaluation This review has categorized the main theoretical
to correct external imbalances effectively. contributions into two broad groups. The first includes
automatic adjustment theories, which depend on market-
While theoretically persuasive, the elasticity approach driven mechanisms, specifically price and income changes, to
relies on a level of price responsiveness that may not be restore balance. The second covers administered adjustment
realistic, especially in economies with rigid production models, which focus on policy interventions in handling
systems, limited export diversity, or high dependence on external disequilibria. Each group provides unique analytical
imports. Additionally, the delay between price changes and insights and policy recommendations, reflecting different
volume responses adds uncertainty to the policy’s success, assumptions about economic behavior and institutional
particularly in situations of severe external vulnerability. capacity.

 The Monetary Approach to the Balance of Payments Both strands have informed a broad range of empirical
In response to the social and economic costs linked to studies, and contemporary research increasingly uses dynamic
demand-compression policies, the International Monetary stochastic general equilibrium (DSGE) models to simulate
Fund (IMF) adopted the monetary approach to balance-of- adjustment processes under different structural conditions. A
payments adjustment, notably formalized in Polak’s (1957) promising area for future research is critically assessing how
model. This framework suggests a causal relationship from well DSGE frameworks improve our understanding of
changes in the money supply to variations in nominal income, balance-of-payments adjustment, especially in developing
depending on the level of leakages, mainly through imports. economies with structural weaknesses and limited policy
This view contrasts with the Keynesian paradigm, which options.
states that income levels determine the demand for money.
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Volume 10, Issue 10, October – 2025 International Journal of Innovative Science and Research Technology
ISSN No: -2456-2165 https://doi.org/10.38124/ijisrt/25oct410

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