The Market for Foreign Exchange and the Stability of the Balance of Payments: A Theoretical Analysis

Summary

Haberler’s 1949 article is a theoretical reconstruction of the foreign-exchange market, aimed at clarifying when depreciation corrects a balance-of-payments deficit and when it may perversely aggravate it. He abstracts from speculative capital movements and treats demand and supply of foreign currency as arising chiefly from imports and exports. The central issue is not whether devaluation changes trade, but whether the induced changes in values move the exchange market toward equilibrium.

But the free price mechanism could not achieve that result; it would drive the exchange rate in the wrong direction.

The paper’s first contribution is to define this instability with precision. If a rise in the domestic-currency price of foreign exchange reduces excess demand for it, the exchange market is stable. If the derived supply curve of foreign currency slopes or shifts in such a way that depreciation increases excess demand, ordinary price adjustment fails. Haberler therefore treats the devaluation debate as a problem in comparative statics: the effect of depreciation depends on the elasticities and shapes of the underlying trade schedules.

His key methodological point is that exchange-market curves are derived from commodity-market curves but are not identical with them. Imports generate demand for foreign currency; exports generate supply of it. Yet the exchange market records values, not only physical quantities. A depreciation changes import quantities, export quantities, domestic-currency prices, and foreign-currency receipts in different proportions. Hence the analyst must not move directly from import and export demand curves to conclusions about foreign-exchange stability.

The demand and supply curves of foreign currency must be carefully distinguished from demand and supply curves of exports and imports.

This distinction permits Haberler to reinterpret the Lerner condition. Under simplifying assumptions, especially perfectly elastic supplies of traded goods, depreciation improves the balance if the sum of the relevant demand elasticities exceeds unity. But Haberler’s more general treatment allows finite supply elasticities and shows that the familiar rule is a special case of a broader stability condition in the exchange market itself.

It thus appears that Lerner's condition is nothing but the familiar stability condition to which we referred in Section II above: Equilibrium is stable, if the supply curve is positively inclined, or in case the supply curve is negatively inclined, if it is steeper than the demand curve, in other words, if the elasticity of demand is greater than the elasticity of supply.

A further theme is the danger of crude empirical inference. Import and export responsiveness cannot always be read from simple consumer-demand or producer-supply schedules. Imports may replace domestic production, while exports may be drawn away from home consumption as well as from expanded output. For that reason, trade elasticities relevant to exchange adjustment may be larger than narrow partial-demand estimates suggest. Haberler is therefore skeptical of sweeping claims that devaluation must fail because short-run elasticities appear low, though he acknowledges that primary-export economies may face severe inelasticities.

The article also complicates the initial-balance assumption. If imports and exports are not initially equal, the stability condition must be weighted by their relative magnitudes. Haberler further distinguishes the accounting currency in which the balance is measured. A depreciation may improve the shortage of foreign exchange while worsening the domestic-currency value of the trade deficit, or conversely. This matters especially in discussions of postwar dollar scarcity, where the binding problem is often the availability of foreign currency rather than the home-currency valuation of payments.

We must now carefully distinguish between the balance in terms of domestic and in terms of foreign currency.

Haberler closes by emphasizing the limits of the static apparatus. He holds aggregate domestic demand and other macroeconomic conditions constant in order to isolate movements along the relevant curves. In reality, depreciation can affect income, wages, credit, expectations, and policy, thereby shifting the curves themselves. These complications do not invalidate elasticity analysis; they show why it must be embedded in a wider theory of balance-of-payments adjustment. The article’s lasting value lies in separating commodity-market elasticities, derived exchange-market schedules, valuation conventions, initial imbalance, and macroeconomic feedbacks, thereby showing that devaluation is neither automatically curative nor necessarily self-defeating.