The Monetary and Portfolio Balance Approaches to External Balance Monetary Approach to the Balance of Payments • Emphasizes that the balance of payments are essentially a monetary phenomenon • Important issues are the supply and demand for money • Attention on category IV of the B of P, “Official Short-term capital Account” • B of P surplus = excess demand for a country’s money • B of P deficit = excess supply for a country’s money Supply of Money • Ms = a (BR+C) = a (DR+IR) • Ms = money supply • BR = reserves of commercial banks -- central | (depository institutions) bank | • C = currency held by the nonbank publicliabilities | • a = the money multiplier • DR = Domestic reserves Central bank • IR = international reserves assets Money Supply • Definitions: • M1 – currency held by nonbank public, traveller’s cheques and chequing accounts in financial institutions • M2 – M1 + savings and time deposits (except large time deposits of $100,000 or more • Money multiplier a – The process of multiple expansion of bank deposits, derives from the reserve ratio lending system – Example: a 10% reserve ratio leads to a money multiplier of 10 (simplistic calculation due to leakages from currency held, etc.) • Monetary base (BR+C) – Liabilities side of the balance sheet of the central bank – Includes currency issued, commercial bank deposits in central bank • Monetary base (DR+IR) – Asset side of the central bank balance sheet – Includes loans and security holdings by the central bank and international reserves (foreign exchange and foreign international assets The Demand for Money • This is the demand for currency or chequable deposits, not the demand for wealth • People either hold wealth in liquid form (money, etc.) or in a longer term asset (stocks and bonds, etc) • Demand for money sometimes broken into Transactions demand for money – demand for purchases, and payments Asset demand for money – demand for money as a way to hold wealth The Demand for Money ˙ L = f[Y,P,I,W,E(p),0) Y = level of real income in the economy P = price level i = interest rate W = level of real wealth ˙ E(p) = expected percentage change in the price level (inflation rate) O = all other variables that can influence the amount of money balances a country’s citizens wish to hold Demand for money • Signs of effects: • Y positive – the more real income there is in the economy the more people require cash balances and chequing deposits (reflects the transaction demand for money) • P positive – the higher is the price level in the economy the more people require cash balances and chequing deposits (reflects the transaction demand for money) Demand for Money • i negative – as the rate of return on alternative stores of wealth (bonds, etc.) increase, the demand for cash as a store of wealth decreases – (reflects the asset demand for money) • W positive – as the level of wealth rises, a person is expected to want to hold more assets of all types, including money • E(p) negative -- if people expect prices to rise, ˙ that means they expect the buying power of their cash to fall. They will switch assets out of money into an asset that will maintain its buying power (something that earns a return). Demand for Money • O don’t know – depends on things like the frequency of paycheques (the more frequently people are paid, the less cash they need to keep), • the availability and popularity of credit cards vs. cash cards (if all purchases on credit, may use less cash) • not significant for short time periods because they don’t vary that much Monetary Equilibrium and the BOP • The money market is in equilibrium when Ms=L • there is also a simple form of the money demand that is often used for this: • L = kPY so that in equilibrium Ms=kPY • P is the price level, Y is the level of income and, k is a constant embodying all other variables. • Note: k is inversely related to the speed with which money changes hands in the economy. • we refer mostly to this demand for money equation when analyzing the effects of changes in money supply and demand on the balance of payments. Monetary Approach and the BOP • Effects of an excess supply of money (fixed exchange rate): • Current Account: • people spend too much money on goods and services – this causes prices to rise – if economy is not at full employment, greater demand causes real income to increase (Y) – if part of real income is saved, W also rises – all of these increase the demand for imported goods, which would lead to a current account deficit Excess supply of money • Capital account (private) – excess cash leads to an increase in demand for other financial assets (i may fall), including foreign financial assets – this means capital will flow out of the country, leading to a BOP deficit • Category IV must be in a net credit position to finance the demand for foreign currency • Note: as Y,P,W increase and i falls, the demand for money increases, eliminating the excess supply of money Excess supply of money • Expectations: – If the excess supply of money is a result of long- standing central bank ineptitude, – and people expect the money supply to continue to expand, then – E(p) will be positive, it will have a negative effect on money demand, and this effect may swamp all others. ˙ – In this case, the problem may not be self-correcting, and the BOP deficit can grow until all reserves are wiped out. • Barring this problem, long-run excess supply or demand for money are self-correcting under fixed exchange rates Excess supply of Money – Flexible Rates • Monetary approach to the exchange rate • In this case there can be no BOP deficit or surplus • any movement away from demand=supply of currency leads directly to a change in the value of the currency • for this reason we talk about an incipient BOP surplus or deficit. This means there is a push in that direction which change the price of the currency Excess supply of money • the excess supply working through Y,P,W,i leads to an incipient BOP deficit and therefore a depreciation in the value of the currency, • changes in these variables will also lead to an increase in the demand for money, which should correct the excess supply problem • the increase in demand for money (from the above variables) needed to return to equilibrium will be higher if inflationary expectations decrease the demand for money (or offset some of the increase above) Two countries • Assume that there is purchasing price parity between the two countries, that is • PA=ePB , or e=PA/PB • where PA is the price level in country A and ditto for country B • We can use this and the equilibrium in the money market to derive the exchange rate as a function of the money supply and income Exchange rate • MsA=kAPAYA • MsB=kBPBYB e= kBYBMsA/kAYAMsB Derive this Exchange rate • MsA=kAPAYA • MsB=kBPBYB • MsA/MsB =kAPAYA/ kBPBYB • PA/PB =MsA/( kAYA ) /(MsB/kBYB) • e= kBYBMsA/kAYAMsB Effects of changes in the economy on the exchange rate • Using the equilibrium exchange rate: k BYB M sA e k AYA M sB • we can analyze the effect of an increase in velocity, income, price and/or money supply in either country on the exchange rate. • For example, if income rises in country A, the exchange rate decreases, meaning the country A currency appreciates!! (because there is an excess demand for money (and the money effect swamps the import effect)) Empirical work on the monetary Approach • Does this analysis hold in the real world? • Tests: • 1. Testing the monetary approach to the BOP with fixed exchange rates: Ujiie (1978) • Data – Japan 1959 to 1972 on BOP, change in domestic credit D , change in foreign interest rates i*, and change in income Y • performed linear regression analysis, to see the effects of the independent variables on BOP Empirical Tests • Regression: BOP a bD ci* fY • Expect: – b to be negative, (excess supply of money) – c to be positive, (excess supply of money overseas) – f to be positive, (excess demand for money) • Results: – b was negative – c,f were not significant • Summary: Money supply has expected effect, we are not sure of sign of other variables Empirical Tests with Ex. Rate • Frenkel (1978) using German data in the 1921 to .23 • Equation: log e a b log M s c log E ( p) • variables are as defined elsewhere in the chapter • the coefficients are elasticities (and if you took 18.253 you would know why) • Expected signs b positive, c positive • Both variables turned out as expected • b should in fact be close to 1 if the exchange rate moves proportionally to the money supply and it was 0.975. • So, monetary approach works during periods of hyperinflation. Empirical Tests with Ex. Rate • Problem with Frenkel’s test • during a period of hyperinflation, we would expect monetary phenomena to overpower all other effects. • The question must be, “Does the monetary approach give us information during somewhat normal periods of economic behaviour?” • Rudiger Dornbusch (who is one of the major names in international finance) decided to test this. Dornbusch test • Tested 5 countries (Canada, France, Japan, UK and US) against West Germany using 1973-79 data • Used difference in the logarithms of variables, so that we compare Y with Y* (log (Y/Y*)=logY-logY*) • Estimated: e a b(ms ms *) c( y y*) d (i i*) s f (i i*) L • where * refers to the foreign country, and all variables are in logs. • The subscripts S and L refer to short and long term interest rates. Dornbusch test • e is the number of the other currency required to purchase 1 mark. If e rises, the mark has appreciated. Germany is treated as the foreign country in these equations. • Expected signs: • b, d, and f should be positive. If the home money supply rises faster than foreign (Ger.) then the home currency should depreciate (e should rise), ditto for interest rates. • c should be negative. An exogenous increase in home income should cause an excess demand for money and an appreciation of the currency Dornbusch test • Results: – b was negative, but not significant – c negative, but also not significant – d and f were positive, but not significant • Note: PPP underlies these models • Tests of PPP show that relative PPP holds with countries’ currencies moving toward relative PPP at a rate of about 15 percent per year. Portfolio Balance Approach • Also called asset market approach • Models differ, but have common characteristics • 1. financial markets are integrated, people hold both home and foreign assets • 2. home and foreign assets are imperfect substitutes • 3. asset holders react to changes, and the portfolio shifts affect the BOP or exchange rate (as appropriate to exchange rate regime) • 4. rational expectations – individuals use all information available to form forecasts Portfolio Balance Approach • Types of assets in simple model: – money (L), – home bonds (Bd) , – foreign bonds (Bf) • Relationship between interest rates implied by imperfect substitution: • id = if + xa – RP • RP can be either positive (if foreign asset is riskier than home asset) or negative (if foreign asset is less risky than home asset) Asset demands: Money • The demand for money equation looks like: L = f(id , if , xa , Yd , Pd , Wd) • What are the signs of the effect of the six independent variables on the demand for money? Asset demands: Money • The demand for money equation looks like: -- -- -- + + + L = f(id , if , xa , Yd , Pd , Wd) • Or, money demand – increases with income, price and wealth, and – decreases with rises in home and foreign interest rates, and with an expected appreciation of the foreign currency Asset demand: Domestic bonds • The demand for domestic bonds looks like: Bd = h(id , if , xa , Yd , Pd , Wd) Signs on independent variables? Asset demand: Domestic bonds • The demand for bonds looks like: + -- -- -- -- + Bd = h(id , if , xa , Yd , Pd , Wd) • demand rises with home interest rate,but falls if foreign interest rate increases. • demand falls if the foreign currency is expected to appreciate, • demand also falls if home income or price rise (due to need for cash), but • rises if wealth increases. Asset demands: Foreign bonds • The demand for foreign bonds looks like: Bf = j(id , if , xa , Yd , Pd , Wd) Signs on independent variables? Asset demands: Foreign bonds • The demand for foreign bonds looks like: -- + + -- -- + Bf = j(id , if , xa , Yd , Pd , Wd) • foreign asset demand depends inversely on home interest rate, home income and home price level • foreign asset demand depends positively on the foreign interest rate, an expected appreciation of the foreign currency and wealth Asset demands • Comparing the three asset demands: -- -- -- + + + L = f(id , if , xa , Yd , Pd , Wd) + -- -- -- -- + Bd = h(id , if , xa , Yd , Pd , Wd) -- + + -- -- + Bf = j(id , if , xa , Yd , Pd , Wd) Portfolio Balance • The wealth of home country citizens must be held in one of the three assets. Wd = Ms + Bh + eBo Note: Bo is the amount of foreign bonds held by home country residents Bo = Bf in equilibrium • Therefore the financial market is in balance at home when all three asset markets are in equilibrium; • that is, the amount of assets held equals the amount of each asset desired. Portfolio Adjustments • Examine the effects of each of the following • sale of government securities • increase in expected inflation at home • increase in real income at home • purchase of government securities • decrease in expected inflation at home • decrease in real income at home. Sale of Govt securities on open market • securities are exchanged for cash – Ms falls – Bd increases, interest rate rises (PB falls) – rise in id causes a decrease in L and drop in eBf – both domestic and foreign asset holders buy more home country bonds and less foreign bonds – movement continues until all markets are in equilibrium – On the foreign exchange market: e falls (currency appreciates) and xa increases, even if the forward rate is constant doesn’t change. This means we return to equilibrium on the foreign exchange market with an appreciated currency di i xa RP f Rise in expected inflation at home • A rise in expected inflation will cause, as its first effect, a rise in xa. This implies: • L falls, because cash is expected to be worth less • Bd falls, as people expect the future return from domestic bonds to have a decreased value • Bf rises, as people choose to hold wealth in foreign assets. • e rises, because home citizens supply home currency to purchase foreign bonds • In general an expected depreciation can cause a depreciation: E (e) id i f ( 1) RP e An Increase in Real Income at Home • The first effects of a rise in Yd are L , Bh , eB f – People increase their money holdings by selling home and foreign bonds – The sale of foreign bonds leads to an improvement in the BOP, or an appreciation of the currency, both current and expected E (e) id i f ( 1) RP e Increase in home bond supply to buy physical assets • Bh increases causing its price to fall and therefore id to rise. – increase in id causes an increase in demand for Bd both at home and by foreigners – this would cause an appreciation of the currency – the increase in Bh to buy physical assets increases the home country’s wealth, leading to an increase by home country citizens in Bd , L and Bf , and a consequent depreciation of the currency – The overall effect on the exchange rate is uncertain, but it is likely to be an appreciation. Current account surplus = capital account deficit • The current acc. surplus (cap. acc. deficit) means that the home country is increasing its wealth via investment in foreign countries. • Again we have two possible effects on the currency – effect of increase in Wd – causes an increase in Bd , L and Bf , and a depreciation of the home currency – but increase in L could push up id – increase in Bd could push down id – since we don’t know direction of id (or if for that matter) we also can’t be sure of overall effect on currency Empirical work • Frankel 1984: Tested the effect of supply of home and foreign bonds, and home and foreign wealth on the exchange rate using 5 countries vs. the U.S.: e a bBh cB f gWh kW f • Expected signs • b negative, c positive, g positive and k negative • only Canada had the correct signs on all variable coefficients • Not sure whether problem was the theory, or foreign exchange market intervention by other countries Other Studies • Meese (1990) • tested predictive capacity of portfolio balance model vs. a random walk for the currency, random walk outperformed the model • Meese concluded “Economists do not yet understand the determinants of short- to medium- run movements in exchange rates.” • Other economists disagree, and the work continues. Exchange rate overshooting • Exchange Rate Overshooting occurs if: – when moving from one equilibrium to another, the exchange rate moves beyond the new equilibrium value, but then returns to it. • First model by Rudiger Dornbusch, but simplified here • (so this is NOT exactly the Dornbusch model) Assumptions for this model • country is small: therefore it cannot affect world prices or interest rates • there is perfect capital mobility and assets are perfect substitutes • therefore: id i f xa One Story: • Suppose the price level rises. P L • If money supply is fixed then id rises • An increase in id causes the exchange rate to appreciate. id i f xa and if is fixed • To restore asset market equilibrium, the exchange rate must appreciate high enough that investors expect it to depreciate. E (e) id i f ( 1) e Look at price and exchange rate reacting to money supply • First relationship: The exchange rate is negatively related to price, i.e., given a fixed money supply, a higher price is associated with a higher interest rate and a more valuable currency (lower exchange rate). A P • Graph A e Second relationship • The long-run PPP equilibrium dictates that an increase in the price level should lead to a depreciation in the value of the home currency. L P e Overshooting • Overshooting occurs because the exchange rate can adjust faster than prices to any external shock (say an increase in money supply P L A’ A e What’s going on? • An increase in Ms causes a surplus of money in the market. The surplus will eventually be absorbed, either because the exchange rate will depreciate (lower price, greater demand), or because the price level at home will rise, or both • The currency market can adjust faster than the price market, therefore, because Ms>L, and id falls, the currency value drops fast • It also drops so far that there is an expected appreciation in the currency as the prices start to adjust. • This means that we can see inflation and currency appreciation at the same time! Forward market equilibrium • If exchange markets are efficient, then efwd=E(e) • And so, an increase in the money supply, will cause both a decrease in id and an increase in efwd • .But this means: i i ( e fwd 1) d f • is out of equilibrium e e fwd id i f ( 1) • So, what happens is actually, e • the exchange rate depreciates so much right away that there is an expected appreciation.
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