Chapter 9

The Balance-of-Payments Adjustment (II)

The Monetary Approach

The monetary approach is different from the elasticity approach and absorption approach.

The monetary approach thinks the BOP is a monetary phenomenon. BOP disequilibrium results from disequilibrium in money market. That is, when money demand does not equal money supply, BOP will be imbalanced.

Cambridge equation is the quantity theory of money which is written as:

Md = k P y

Md: the money demand k: a constant which is based on the economic structure and monetary habits P: price level y: real domestic income (total output)

This equation tells us that people hold a fraction of their nominal incomes as money balances.

It also shows that money demand depends on price level and real income.

The money supply is composed of domestic credits and foreign exchange reserves.

Ms = m (D + R)

Ms: money supply m: the monetary multiplier D: domestic credits R: foreign exchange reserves

Open-market operation and foreign exchange transactions by the central bank change the money supply.

Money market equilibrium means the money demand equals the money supply:

Md = Ms = m (D + R)

Suppose m = 1, foreign exchange reserves are the difference of money demand and domestic credits:

R = Md – D

If money demand is greater than domestic credits, reserves increase and BOP has surplus. Otherwise, BOP runs deficit.

Monetarists thinks BOP consists of the current account, financial and capital account, and change in foreign exchange reserves.

BOP = CA + KA + dR

-dR = CA + KA

Monetary approach under fixed exchange rate system

BOP disequilibrium under fixed exchange rate system is automatically adjusted. If PPP holds, consider the equilibrium condition in money market:

k Sd/f Pf y = m (D + R)

Expansionary monetary policy increases domestic credits so that money supply exceeds money demand, BOP deteriorates.

k Sd/f Pf y < m (D + R )

To maintain the exchange rate, central bank sells foreign exchange for domestic currency. Part of the domestic credits are offset by the decrease in reserves.

Now BOP restores equilibrium.

k Sd/f Pf y = m (D + R )

Under the fixed rate system, domestic credit expansion results in BOP deficit; credit contraction leads to BOP surplus.

Now consider the change in money demand. If foreign price level or domestic real income increases, money demand exceeds money supply so that BOP runs surplus.

k Sd/f Pf y > m (D + R )

To prevent domestic currency revaluing, the central bank buys foreign exchanges, thus domestic credits increase until:

k Sd/f Pf y = m (D + R )

Monetary approach under floating exchange rate system

Under floating exchange rate system, the BOP is adjusted through the change in exchange rate.

For example, if domestic credits increase, money supply is greater than money demand. Domestic currency depreciates in the foreign exchange market.

k Sd/f Pf y = m (D + R )

Monetary approach in a two-country model For any country, money supply equals money

demand. That is:

Mds = kd Pd yd (8.1)

Mfs = kf Pf yf (8.2)

Now taking the ratio of the two equations,

(Mds / Mf

s) = (kd / kf)(Pd / Pf )(yd / yf)

(Pd / Pf ) = (Mds / Mf

s) (kf / kd) (yf / yd) (8.3)

Equation (8.3) states that the exchange rate between the two currency is determined by relative countries money supply, the constant k and total output.

Suppose the ratio (kf / kd) stays the same, the exchange rate rises by 1% for

1% rise in the domestic money supply Mds, or

1% drop in the foreign money supply Mfs, or

1% drop in domestic real GDP yd, or

1% rise in foreign GDP yf.

The Portfolio Balance Approach The portfolio balance approach considers not only

the money but domestic and foreign securities as well determine a country’s BOP or exchange rate.

Wealth identity

W ≡ M + Bd + Sd/f Bf w: wealth M: money (cash) Bd: domestic securities (bonds)

Sd/f: spot exchange rate Bf: foreign securities (bonds)

People’s wealth is composed of money, domestic and foreign securities. Domestic wealth will increase if domestic currency depreciates in the foreign exchange market.

The asset demand function The demand to hold money is negatively related to the domestic interest rate and the expected rate of return on foreign bonds.

Equilibrium in the capital market

S Bf B M

Se A

M Bf

B ie i

The effects of change in money supply S B M’ Bf

Se1

Se0

Bf’

M B’ i i1 i0

The effects of change in domestic bonds S B Bf M’ Se0

Se1

M Bf’

B’ i i0 i1

The effects of change in foreign bonds S B Bf

Se0 M’

Se1

M Bf’

B’ i i0

Sterilized or non-sterilized intervention in foreign exchange market Sterilized intervention means when the central

bank buys (sells) foreign exchanges in the foreign exchange market, it sells (buys) domestic bonds in the domestic capital market at the same time.

Sterilized intervention leaves domestic monetary base unchanged.

Non-sterilized intervention changes the domestic monetary base.

Some economists believe that sterilized intervention is ineffective.

For example, if PBOC expands money supply by ¥63 million, the excessive money supply leads RMB depreciate in the exchange market.

To defend the fixed parity, the PBOC must sell dollar and buy RMB. Suppose it has to sell $10 million, it buys back ¥63 million (assuming S¥/$ = 6.3).

The expansionary monetary policy is offset by the sterilized intervention.

Some economists believe intervention has immediate effect on the exchange rate, because the intervention delivers a signal to the market. This is the announcement effect or signaling effect of the intervention.

If central bank sells dollar in the market, market participants will reduce their holdings on the dollar. The dollar is thus expected to be depreciated in the future.