The Short-Run Dynamics of Prices and the Balance of Payments

Abstract

The purpose of this study is to analyze theoretically and empirically the short-run behavior of prices and the balance of payments in a small open economy with a fixed exchange rate. Following the presentation of the theoretical framework, the experience of Mexico during 1950-73 is analyzed. The model is based on what is known as the monetary approach to the balance of payments. This approach, as is frequently presented,' deals with long-run equilibrium situations when all relative prices are fixed. This long-run equilibrium view was applied to test empirically the theory for several countries,2 using the assumption that there are no serious barriers to the international movement of capital and that all goods are traded.3 These assumptions imply that goods and capital markets are perfectly arbitraged and, therefore, that price levels and interest rates in all the countries always move together.