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

The Monetary Approach to Balance-of-Payments and Exchange-Rate Determination. Introduction. The Monetary Approach focuses on the supply and demand of money and the money supply process.

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

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  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. Monetary Approach

  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. Monetary Approach

  4. Small Country Model The balance of payments is defined as: (5) CA + KA = FER. For example, if FER< 0, then CA + KA < 0, and the nation is running a balance of payments deficit. Monetary Approach

  5. Small Country Model (4) and (3) into (1) yields, M = kP*Sy. Sub in (2), (6) m(DC + FER) = kP*Sy. Monetary Approach

  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. Monetary Approach

  7. Small Country Model • Consider what happens if the central bank raises DC. Money supply exceeds money demand. m(DC + FER) > kP*Sy • There is pressure for the domestic currency to depreciate. The central bank must sell FER until M = Md. m(DC + FER) = KP*Sy Monetary Approach

  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 < 0. Monetary Approach

  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. Monetary Approach

  10. Small Country Model • Consider the impact of an increase in DC. • Again money supply will exceed money demand m(DC + FER) > kP*Sy. • Now the domestic currency must depreciate to balance money supply and money demand m(DC + FER) = kP*Sy. Monetary Approach

  11. Small Country Model • The monetary approach postulates that changes in a nation’s 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. Monetary Approach

  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. Monetary Approach

  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*). Monetary Approach

  15. The Portfolio Approach • A domestic household’s 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*. Monetary Approach

  16. The Portfolio Approach • The portfolio approach postulates that the value of a nation’s 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. Monetary Approach

  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. Monetary Approach

  18. 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. Monetary Approach

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

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