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Monetarist approach to balance of payments

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Globalization has played a significant role in promoting economic relations among countries all over the world. In this era of globalization, it is fair to say that no country in the world is “an island” or self-sufficient. One of the key benefits of globalization is the ease of movement of goods and services across or among nations. Like the computation of GDP, countries keep records of its transactions with external economies over a given period usually quarterly or yearly. This record of transactions is referred to as Balance of Payment (BOP).

The balance of payments which is also referred to as the balance of international payments is a record of all international or financial transactions that are undertaken between residents of one country and residents of other countries during the year. These transactions include payments relating to imports and exports of goods and services, financial capital, and financial transfers (Saylor, n.d.; Riley, n.d.). A country’s balance of payments expresses the equilibrium between international commercial and financial inflows and outflows (Paun, et al., 2010). The balance of Payment can also be defined as a statistical record of all the economic transactions between residents of a reporting country and the rest of the world during a given period of time. The balance of payment is one of the most important statistical statement as well as an economic indicator of a country. It reveals the number/ quantity of goods and services a country has exported or imported over a period of time. It also reflects whether a country has been borrowing money or lending to the rest of the world (Pilbeam, 2013, p. 31). The BoP can be defined using different measures depending on the circumstance, thus, BoP can be defined using the Official Settlement, Current Account or Basic Balance definitions.

However, for many countries, the focus of attention is on the balance of payment on their current account and a lot of effort is concentrated on policies to reduce the current account deficit by increasing and reducing the value of exports and imports respectively. A balance of payment can be in surplus or deficit. A country’s balance of payments is said to be in surplus if inflows (funds from exports, and assets e.g. bonds) exceed. On the other hand, a balance of payment is said to be in deficit if outflows are more than the inflows.

Brief Description of Other Approaches

Over the years, economists (John Keynes, Marshall Lerner, Mundell and Fleming, Polak among others) have propounded various unique approaches in the analysis of BoP but with varying characteristics. There are three basic alternative theories or approaches to the balance of payments adjustment namely, the elasticities approach, the absorptions approach, and the monetary approach.

In the elasticities and absorption approaches the focus of attention is on the trade balance with resources not fully employed. The elasticities approach emphasizes the role of the relative prices (or exchange rate) in the balance of payments adjustments by considering imports and exports as being dependent on relative prices (through the exchange rate). A notable shortcoming of the elasticities approach is that it does not consider capital flows. On the contrary, the monetary approach focuses of attention on the balance of payments (or the money account) with full employment of resources, thus, this balance consists of the items that affect the domestic monetary base.

The absorption approach shows a significant improvement over the elasticities approach in the sense that, it views the external balance through national income accounting. Thus, the elasticity approach relates the balance of payment to the activities elsewhere in the economy instead of taking the partial equilibrium view of the elasticities approaches in analyzing the external sector in isolation. The monetary approach, like the absorption approach, stresses the need for reducing domestic expenditure relative to income, in order to eliminate a deficit in the balance of payments. (Ardalan, 2005, p. 37).

Background to the Monetarist Approach to BoP and Exchange Rate

In surveying the body of research dealing with the balance of payments, two major shortcomings are immediately apparent. First, there are no widely accepted theories of the balance of payments which simultaneously incorporate both the current and capital account. The great majority of models used in payments theory consider either the capital account or the current account separately. Second, there have been very few attempts to include even the fundamentals of portfolio choice theory in balance-of-payments models. This is particularly surprising in view of the essentially monetary nature Balance of payments theory.

The monetarist approach to the balance of payments theory addresses both shortcomings. Since this essentially involves an extension of the rudiments of monetary theory to the area of the balance of payments, it is henceforth referred to as a monetary view of the balance of payments (MBOP) (Kemp, 1975, p. 14).

The monetarist approach to the balance of payments and exchange rate determination asserts that changes in a country’s balance of payments or the exchange value of its currency are just a monetary phenomenon, thus can only be corrected by monetary measures.

The fundamental thinking underpinning the Monetary Approach is that a country’s balance of payment deficit is as a result of its money supply being greater than the demand for money, thus an excess supply of money is the only cause of the BoP deficit. When a government of one country expands its money supply faster than other countries or its required, the result is a worsening of the country’s top position.

Assumptions underlying the Monetarist Approach:

The monetary approach is based on the following assumptions:

The demand for money is a stable function of income, prices and interest rate. The supply of money is a multiple of monetary base which includes domestic credit and the country’s foreign exchange reserves.

The demand for nominal money balances is a positive function of nominal income. The theory Purchasing Power Parity-The law of one price’ holds for identical goods sold in different countries, after allowing for transport costs. There is perfect substitution in consumption in both the product and capital markets which ensures one price for each commodity and a single interest rate across countries.

The level of the output of a country is assumed exogenously.

All countries resources are assumed to be fully employed or utilized.

In summarizing the assumptions, the stable demand for money and the fixed aggregate supply sets the standard quantity theory of money principle that a change in money supply leads to a proportionate change in price level, which also results in an increase in nominal income. However, given the assumption that income (output) is fixed, the price remains the only determinant. However, the purchasing power parity (PPP) assumptions challenge the price changes in the quantity theory of money. PPP assumes perfect substitution in consumption of goods/services on the international market where price levels are exogenous. As a result, the foreign exchange reserve component of the money supply is the key determinant of the BoP deficit or surplus.

Given these assumptions, the monetary approach can be expressed in the form of the following relationship between the demand for and supply of money:

The demand for money (Md) is a stable function of income (Y), prices (P) and rate of interest (i)

Md=f(Y, P, i) ……… (1)

The money supply (Ms) is a multiple of the monetary base (m) which consists of domestic money (credit) (DC) and the country’s foreign exchange reserves (R).

Ms = DC + R ……….. (2)

Since in equilibrium, the demand for money equals the money supply,

Md = Ms ………. (3) and thereby;

Md = DC + R as MS = DC + R ….…(4)

A balance of payments deficit or surplus is represented by changes in the country’s foreign exchange reserves. Therefore;

R = ?Md – ?DC …….. (5)

or R = B ………….. ( 6)

where B represents the balance of payments which is equal to the difference between the change in the demand for money (?Md) and change in domestic credit (?DC).

A balance of payments deficit reduces the foreign exchange reserve (R) and the money supply. On the other hand, a surplus increases R and the money supply. When B = O, it means BoP equilibrium.

The automatic adjustment mechanism in the monetary approaches could be demonstrated below under both the fixed and flexible exchange rate systems using a hypothetical small country as an example

The balance of Payment Analysis under the Fixed Exchange Rate System

Under the fixed exchange rate system, a country’s monetary authorities intervene to regulate the value of the exchange rate. It is assumed that under fixed exchange rates the government’s control/regulation of currency flows is not possible on account of the law of one price globally. An attempt by the monetary authority to increases the domestic money supply under the fixed exchange regime results in a BoP deficit. People who have large money balances increase their purchase of more foreign goods and securities.

This tends to raise their prices and increase imports of goods and foreign assets. This leads to an increase in expenditure on both current and capital accounts in BoP, thereby creating a BOP deficit. To correct the BoP deficit, monetary authorities need to buy back the currency on the foreign exchange market. Thus, the outflow of foreign exchange reserves means a fall in Foreign Exchange Reserve in the domestic money supply. This process will continue until there will be BoP equilibrium.

On the other hand, a fall in money supply over money demand will result in a BOP surplus. Consequently, people acquire the domestic currency by selling goods and securities to foreigners. They will also seek to acquire additional money balances by restricting their expenditure relative to their income. The monetary authority on its part will buy excess foreign currency in exchange for domestic currency. There will be an inflow of foreign exchange reserves and the increase in the domestic money supply. This process will continue until money supply equals demand and BoP equilibrium will be restored. Thus, a BoP deficit or surplus in the fixed exchange regime is a temporary phenomenon and is self-correcting in the long-run (Ardalan, 2009).

The balance of Payment Analysis under the Floating Exchange Rate System

Under a floating exchange rate regime, the country’s monetary authorities do not intervene to affect the valuation of the exchange rate. This theory assumes that an appreciation of the domestic currency makes domestic goods and assets more expensive on international markets and, thus, applies downward pressures on the BOP.

According to the theory, an imbalance in the BOP will automatically alter the exchange rate in the direction necessary to obtain BOP equilibrium. When there is a BoP deficit or surplus, changes in the demand for money and exchange rate play a major role in the adjustment process without any inflow or outflow of foreign exchange reserves. Suppose the monetary authority increases the money supply, there is a BOP deficit. People having additional cash balances buy more goods thereby raising prices of domestic and imported goods. This results in the depreciation of the domestic currency and a rise in the exchange rate. Consequently, the rise in prices increases the demand for money thereby bringing the equilibrium of money demand and supply without any outflow of foreign exchange reserves. The reverse occurs when the demand for money exceeds supply in that it results in a fall in prices and appreciation of the domestic currency which automatically eliminates the excess demand for money. “The exchange rate will fall until the demand for money is equal to money supply and BOP is in equilibrium without any inflow of foreign exchange reserves” (Meghana, n.d.).

For example, it is argued that the Asian crisis prompted most investors to move to USD denominated assets. As a result, there is a large positive net portfolio investment in the U.S., leading to a surplus of the Current Account and of the BOP. According to the theory, this excess demand for U.S. assets should lead to an appreciation of the USD. This would, in turn, make U.S. goods and assets more expensive, and generate downward pressure on the Current Account and the Capital Account (the University of Colorado, n.d.).

Empirical evidence

Much of the empirical evidence tries to measure the extent to which a rise in the domestic money supply base results in a fall in the foreign exchange reserve in the fixed exchange regime. Pilbeam (2013) presents empirical estimates for some countries for the period 1976 to 1990 (Pilbeam, 2013, pg. 120). This evidence suggests mixed results. Studies from 1974-1976 confirm that the offset coefficient is correct.

However, researches conducted after 1982 suggests that earlier studies may have been overestimated because of the frequency of sterilization. This mixed position is as a result of certain assumptions such as price level and interest rates not holding in the real-world scenario.

Limitations of the Monetary Approach

While the monetary approach has been widely accepted as more realistic in that it takes into consideration both domestic money and foreign money as it does not lay emphasis on relative price changes unlike the Elasticity Approach, the monetary approach has been criticized by several economists and experts. Some of these criticisms are mentioned below.

  1. A survey of the monetary conducted by Boghton (1988) argued that almost all the assumptions propounded are open to empirical questions. Critics argue that the demand for money function can be highly unstable. Again, economies rarely obtain full employment due to involuntary unemployment in countries. There is also the argument of market imperfections which challenges the assumption of the law of one price. There may be price differentials resulting from the lack of information about prices, knowledge of identical goods and trade regulations in other countries. These assumptions hold well in the long run but are rarely fulfilled in the short run.
  2. Some critics have also argued that it is quite wrong to view countries balance of payment deficit or surplus as purely a monetary phenomenon. BoP adjustments may sometimes be as a result of expenditure-switching decisions operating through real flows and government budget rather than money demand.
  3. There is a weak link between BOP and Money Supply. The monetarist assumption of the direct link between BoP of an economy and its total money supply has been criticized as overly simplified and does not hold in a real-world phenomenon. For such an assumption to be valid, the monetary authority will have to offset the inflows and outflows of foreign exchange reserves in a deficit or surplus situation. This requires some level of sterilization of external flows which is not possible due to the globalization of financial markets.

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