Balance Sheet Vs Current Account Deficit by yyp14196

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									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 publicliabilities |
• 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  bD  ci*  fY
• 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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