The Monetary Approach to BalanceofPayments and ExchangeRate Determination

1
The Monetary Approach to Balance-of-Payments and
Exchange-Rate Determination
2
Introduction

• The Monetary Approach focuses on the supply and
  demand of money and the money supply process.
• The monetary approach hypothesizes that BOP and
  exchange-rate movements result from changes in
  money supply and demand.

3
Small Country Example

• A small country is modeled as
• (1) Md kPy
• (2) M m(DC FER)
• (3) P SP
• and, in equilibrium,
• (4) Md M.

4
Small Country Model

• The balance of payments is defined as
• (5) CA KA FER.
• For example, if FERlt 0, then CA KA lt 0, and the
  nation is running a balance of payments deficit.

5
Small Country Model

• (4) and (3) into (1) yields,
• M kPSy.
• Sub in (2),
• (6) m(DC FER) kPSy.

6
Small Country Model

• Fixed Exchange Rate Regime
• Under fixed exchange rates, the spot rate, S, is
  not allowed to vary.
• FER must vary to maintain the parity value of the
  spot rate.
• Hence, the BOP must adjust to any monetary
  disequilibrium.

7
Small Country Model

• Consider what happens if the central bank raises
  DC. Money supply exceeds money demand.
• m(DC? FER) gt kPSy
• There is pressure for the domestic currency to
  depreciate. The central bank must sell FER until
  M Md.
• m(DC? FER?) KPSy

8
Small Country Model

• There has been no net impact on the monetary base
  and money supply as the change in FER offset the
  change in DC.
• There results, however, a balance of payments
  deficit as ?FER lt 0.

9
Small Country Example

• Flexible exchange rate regime
• Under a flexible exchange rate regime, the FER
  component of the monetary base does not change.
• The spot exchange rate, S, will adjust to
  eliminate any monetary disequilibrium.

10
Small Country Model

• Consider the impact of an increase in DC.
• Again money supply will exceed money demand
• m(DC? FER) gt kPSy.
• Now the domestic currency must depreciate to
  balance money supply and money demand
• m(DC? FER) kPS?y.

11
Small Country Model

• The monetary approach postulates that changes in
  a nations balance of payments or exchange rate
  are a monetary phenomenon.
• The small country illustrates the impact of
  changes in domestic credit, foreign price shocks,
  and changes in domestic real income.

12
The Portfolio Approach to Exchange-Rate
Determination
13
The Portfolio Approach

• The portfolio approach expands the monetary
  approach by including other financial assets.
• The portfolio approach postulates that the
  exchange value is determined by the quantities of
  domestic money and domestic and foreign financial
  securities demanded and the quantities supplied.

14
The Portfolio Approach

• Assumes that individuals earn interest on the
  securities they hold, but not on money.
• Assumes that households have no incentive to hold
  the foreign currency.
• Hence, wealth (W), is distributed across money
  (M) holdings, domestic bonds (B), and foreign
  bonds (B).

15
The Portfolio Approach

• A domestic households stock of wealth is valued
  in the domestic currency.
• Given a spot exchange rate, S, expressed as
  domestic currency units relative to foreign
  currency units, a wealth identity can be
  expressed as
• W ? M B SB.

16
The Portfolio Approach

• The portfolio approach postulates that the value
  of a nations currency is determined by
  quantities of these assets supplied and the
  quantities demanded.
• In contrast to the monetary approach, other
  financial assets are as important as domestic
  money.

17
An Example

• Suppose the domestic monetary authorities
  increase the monetary base through an open market
  purchase of domestic securities.
• As the domestic money supply increases, the
  domestic interest rate falls.
• With a lower interest, households are no longer
  satisfied with their portfolio allocation.
• The demand for domestic bonds falls relative to
  other financial assets.

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Example - Continued

• Households shift out of domestic bonds.
• They substitute into domestic money and foreign
  bonds.
• Because of the increase in demand for foreign
  bonds, the demand for foreign currency rises.
• All other things constant, the increased demand
  for foreign currency causes the domestic currency
  to depreciate.

19
Spot Exchange Rate Domestic currency
units/foreign currency units
SFC
S2
S1
DFC
DFC
Quantity of foreign currency.
Q1
Q2