THE MONETARY APPROACH TO THE BALANCE OF PAYMENTS Although David Hume (1752) identified some of the key ideas, the monetary approach is essentially a product of work conducted in the late 1950s, the 1960s and early 1970s. The approach is concerned with the determination of the BOP under a system of fixed exchange rates. Central Principle The balance of payments is essentially a monetary phenomenon. Balance of payments issues can most usefully be analysed in terms of the relationship between the demand and supply of money. Essential Assumptions 1. The demand for money is a stable function of a few well-defined variables. 2. The monetary consequences of BOP disequilibria cannot be sterilised over a period relevant for policy analysis. 3. Output, employment and other real variables are at their long-run equilibrium values. In most respects, the monetary approach can be viewed as an extension of closed economy monetarism to an open economy operating a fixed exchange rate. Consider the effect of a monetary expansion. Closed Economy 1. Increase in M ⇒ excess holdings of money by private sector. 2. Expenditure increases. 3. But if output is already at full employment level increased expenditure leads to excess demand in the goods market. 4. Prices increase, reducing real money balances until excess of expenditure over output is eliminated. Open Economy 1 & 2 as for closed economy. 3. Increased domestic expenditure spills over to the BOP, with increased demand for goods satisfied by imports. 4. BOP deficit causes money supply to gradually fall, until money holdings are returned to original level. THE DORNBUSCH CURRENT ACCOUNT MODEL (American Economic Review, 1973) Assumes zero capital mobility and that money is the only financial asset. Small Country Version Key Relationships Stock Demand for Nominal Money Balances M d = m1 PY (1) Money Supply MS = M = D+R (2) D = Domestic credit R = Foreign exchange reserves Expenditure, Income and Hoarding Domestic expenditure equals the difference between domestic income and desired saving. Desired saving is the desired rate of accumulation of nominal money balances – hoarding. EN = PY − H (3) H = Desired rate of hoarding EN = Nominal domestic expenditure Desired Rate of Hoarding The desired rate of hoarding represents the rate at which individuals wish to build up (or run down) money balances – sometimes referred to as the flow demand for money. Hoarding/dishoarding takes place in response to differences between the stock demand and stock supply of nominal money balances i.e. the difference between desired and actual money holdings: H = h( M d − M ) (4) h = desired rate of adjustment using (1): H = h(m1 PY − M ) (4´) The Balance of Payments Given zero capital mobility, the BOP consists purely of the current account/trade balance BN = TN BN = nominal value of BOP surplus TN = nominal value of trade surplus But: PY = EN + TN Therefore: BN = TN = PY − EN (5) But, from (3): PY − EN = H Hence: BN = H (5´) Rate of Change of Money Supply In absence of changes in domestic credit changes in money supply purely reflect changes in reserves: M = R = BN (6) M = rate of change of money supply R = rate of change of foreign exchange reserves Combining (6) and (5´) M =H (6´) (6´) indicates that, in absence of changes in D, the actual rate of accumulation of money balances is equal to the desired rate. Assumption of Continuous Full Employment Y = YF (7) Substituting (7) into (4´): H = h(m1 PYF − M ) (8) The Law of One Price Domestic output is assumed to be a perfect substitute for world output and therefore must sell at the same price: P = eP * (9) Given the small country assumption, P * is exogenously determined. The complete model can be summarised in terms of equations (6´) (8) and (9) M =H (6´) H = h(m1 PYF − M ) (8) P = eP * (9) Diagrammatic Representation Law of One Price Hoarding M Note H = 0 for P = m1YF Long-Run Equilibrium Long-run equilibrium occurs when, given the price level, determined by the law of one price, the desired (and actual) rate of accumulation of money balances is zero. i.e. when the stock demand for money is equal to the money supply. M 1 = Initial Money Stock Consider 1. Increase in domestic credit 2. Devaluation of domestic currency Increase in Domestic Credit Domestic Credit Expansion increases M from M 1 to M 2 The hoarding schedule shifts up and to the left. Given P there is an excess supply of money, leading to dishoarding. The resulting BOP deficit leads to a fall in M Over time M falls gradually at a decreasing rate, until equality between the stock demand for money and the money supply is restored, with M = M 1 Dishoarding ends, with expenditure equal to income. Summary of effects of domestic credit expansion 1. By assumption, there are no effects on output in either the short run or the long run. 2. In the short run the policy leads to an excess supply of money, induces an increase in expenditure over income and moves the BOP into deficit. 3. In the long run the cumulative BOP deficit returns the money supply to original level. Foreign exchange reserves fall by the extent of the expansion in domestic credit. M 1 = D1 + R1 = D2 + R2 ∴∆R = −∆D < 0 Transmission Mechanism ∆D > 0 ⇒ M S > M d ⇒ H < 0 ⇒ ∆EN > 0 Domestic expenditure increases through a real balance effect. Devaluation of Domestic Currency Initial value of P P = e1 P * 1 Value of P following devaluation P2 = e2 P*, e2 > e , P2 e2 where = P e1 1 Increase in P as a result of devaluation leads to rise in demand for nominal money balances, implying excess demand for money and a positive rate of hoarding. Positive hoarding leads expenditure to fall below income. The BOP surplus which results is reflected in an increasing money supply. As M increases the difference between the stock demand for money and the supply diminishes and is eventually eliminated, with M = M 2 . Hoarding ceases, hence expenditure equals income. Summary of Effects of Devaluation 1. No output effects in short or long runs. 2. The devaluation produces an immediate increase in P 3. In the short run, the increase in P which results from devaluation creates excess demand for money. This causes expenditure to fall below income, moving the BOP into surplus. 4. The new long-run equilibrium is characterised by a higher nominal money supply, reflecting increased reserves. Transmission Mechanism ∆e > 0 ⇒ ∆P > 0 ⇒ M d > M s ⇒ H > 0 ⇒ ∆EN < 0 Devaluation is an expenditure-reducing device. KEY ASPECTS OF THE DORNBUSCH MODEL The model identifies the source of balance of payments disequilibria as deviations of actual money holdings from desired money holdings. Its structure precludes the possibility of real factors (e.g. misaligned relative prices) in creating BOP disequilibria. Balance of payments disequilibria are self-correcting in nature, in the absence of sterilisation operation. Because of the assumption of continuous full employment, the model does not recognise the potential for conflict between internal and external balance. 3. For the domestic economy devaluation acts as an expenditure reducing device. The increase in P which it induces increases the demand for money above actual money holdings and induces hoarding. In contrast, in the Mundell-Fleming model, devaluation works as an expenditure switching device. TWO COUNTRY VERSION OF THE MODEL The world is assumed to comprise two economies – domestic and foreign countries – producing identical goods. The law of one price holds P = eP * but P* (along with P) is determined endogenously. Prices are perfectly flexible and adjust, given the exchange rate to maintain world goods market equilibrium. World goods market equilibrium requires world expenditure = value of world output. This, in turn, requires world hoarding be zero, i.e. any domestic hoarding be offset by foreign dishoarding (or vice versa). Hence, P and P* adjust, given e to ensure H = −eH * . Devaluation of Domestic Currency Devaluation increases domestic currency value of foreign money stock. Creates excess supply of money in foreign economy, increasing foreign expenditure above foreign income as foreign dishoarding takes place. At an unchanged value of P there is excess demand in the world goods market. P increases, raising the stock demand for money in the domestic economy, inducing domestic hoarding. Also raising the stock demand for money in the foreign economy and reducing foreign dishoarding below value associated with unchanged P. Adjustment in P ensures domestic hoarding = foreign dishoarding, H = −eH * maintaining world goods market equilibrium. The domestic economy experiences a BOP surplus while the foreign economy has a deficit. Foreign exchange market intervention leads to a redistribution of the world money supply from the foreign economy to the domestic economy. This redistribution, together with price adjustment ultimately restores long-run equilibrium.