NATIONAL BUREAU OF ECONOMIC RESEARCH
NATIONAL BUREAU OF ECONOMIC RESEARCH

The Adjustment Mechanism

Maurice Obstfeld

NBER Working Paper No. 3943 (Also Reprint No. r1766)
Issued in December 1991
NBER Program(s):   ITI      IFM

This paper studies the mechanisms of international payments adjustment at work under the Bretton Woods system of fixed exchange rates, 1945 to 1971. I argue that two market failures, imperfect international capital mobility and imperfect wage-price flexibility, are central to understanding the adjustment problems of that period. Imperfect capital mobility implied that even intertemporally solvent governments could face international liquidity constraints. Wage-price inflexibility implied that countries suffering from simultaneous reserve loss and unemployment might need to undergo lengthy transitions before returning to balance. By the 1960s, when trade had been substantially liberalized and partial convertibility restored, the main remaining adjustment weapon was currency realignment: devaluation could eliminate an unemployment-cum-deficit dilemma in a stroke, while revaluation could relieve the inflationary pressures in surplus countries. The currency-realignment option proved incompatible with the growing efficiency of the international capital market, however. Under the classical gold standard, high capital mobility had supported the credibility of fixed exchange rates. Under Bretton Woods fixed gold parities did not have primacy among other economic objectives; and increasing capital mobility undermined the regime as governments proved unwilling to stand by key systemic commitments.

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Document Object Identifier (DOI): 10.3386/w3943

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