The Monetary Approach to Balance of Payments Theory and
Exchange Rate Determination
The third stage in the development of orthodox monetarism came in the
1970s, with the incorporation of the monetary approach to balance of payments
theory and exchange rate determination into monetarist analysis. Until
the collapse of the Bretton Woods system of fixed exchange rates against the
United States dollar in 1971, the US economy could be treated as a reasonably
close approximation to a closed economy. The monetary approach was
particularly important in that it made monetarist analysis, which had been
implicitly developed in this closed economy context, relevant to open economies
such as the UK.
The monetary approach to the balance of payments under fixed
exchange rates
During the 1970s, a large number of different monetary models of the balance
of payments appeared in the literature. However, common to all monetary
models is the view that the balance of payments is essentially a monetary
phenomenon. As we will discuss, the approach concentrates primarily on the
money market in which the relationship between the stock demand for and
supply of money is regarded as the main determinant of balance of payments
flows. Furthermore, despite different specifications, in most of the monetary
models of the balance of payments four key assumptions are generally made.
First, the demand for money is a stable function of a limited number of
variables. Second, in the long run output and employment tend towards their
full employment or natural levels. Third, the authorities cannot sterilize or
neutralize the monetary impact of balance of payments deficits/surpluses on
the domestic money supply in the long run. Fourth, after due allowance for
tariffs and transport costs, arbitrage will ensure that the prices of similar
traded goods will tend to be equalized in the long run.
The most influential contributions to the development of the monetary
approach to balance of payments theory have been made by Johnson (1972a)
and Frenkel and Johnson (1976). Following Johnson (1972a) we now consider
a simple monetary model of the balance of payments for a small open
economy. Within this model it is assumed that: (i) real income is fixed at its
full employment or natural level; (ii) the law of one price holds in both
commodity and financial markets, and (iii) both the domestic price level and
interest rate are pegged to world levels.
The demand for real balances depends on real income and the rate of
interest.
Md = Pf (Y, r) (4.10)
The supply of money is equal to domestic credit (that is, money created
domestically) plus money associated with changes in international reserves.
Ms = D+ R (4.11)
In money market equilibrium, Md must be equal to Ms so that:
Md = D+ R (4.12)
or
R = Md − D (4.13)
Assuming the system is initially in equilibrium, we now examine the consequence
of a once-and-for-all increase in domestic credit (D) by the authorities.
Since the arguments in the demand for money function (equation 4.10) are all
exogenously given, the demand for money cannot adjust to the increase in
domestic credit. Individuals will get rid of their excess money balances by
buying foreign goods and securities, generating a balance of payments deficit.
Under a regime of fixed exchange rates, the authorities are committed to
sell foreign exchange for the home currency to cover a balance of payments
deficit, which results in a loss of international reserves (R). The loss of
international reserves would reverse the initial increase in the money supply,
owing to an increase in domestic credit, and the money supply would continue
to fall until the balance of payments deficit was eliminated. The system
will return to equilibrium when the money supply returns to its original level,
with the increase in domestic credit being matched by an equal reduction in
foreign exchange reserves (equation 4.11). In short, any discrepancy between
actual and desired money balances results in a balance of payments deficit/
surplus which in turn provides the mechanism whereby the discrepancy is
eliminated. In equilibrium actual and desired money balances are again in
balance and there will be no changes in international reserves; that is, the
balance of payments is self-correcting.
The analysis can also be conducted in dynamic terms. To illustrate the
predictions of the approach, we again simplify the analysis, this time by
assuming that the small open economy experiences continuous real income
growth while world (and hence domestic) prices and interest rates are constant.
In this case the balance of payments position would reflect the
relationship between the growth of money demand and the growth of domestic
credit. A country will experience a persistent balance of payments deficit,
and will in consequence be continually losing international reserves, whenever
domestic credit expansion is greater than the growth in the demand for
money balances (owing to real income growth). Clearly the level of foreign
exchange reserves provides a limit to the duration of time a country can
finance a persistent balance of payments deficit. Conversely a country will
experience a persistent balance of payments surplus whenever the authorities
fail to expand domestic credit in line with the growth in the demand for
money balances. While a country might aim to achieve a balance of payments
surplus in order to build up depleted international reserves in the short run, in
the long run it would be irrational for a country to pursue a policy of
achieving a continuous balance of payments surplus, thereby continually
acquiring international reserves.
The policy implications of the monetary approach under fixed
exchange rates
Automatic adjustment and the power of expenditure switching policies The
monetary approach predicts that there is an automatic adjustment mechanism
that operates, without discretionary government policy, to correct balance of
payments disequilibria. As we have discussed, any discrepancy between actual
and desired real balances results in balance of payments disequilibria as
people try to get rid of or acquire real money balances through international
markets for goods and securities. The adjustment process operates through
balance of payments flows and continues until the discrepancy between actual
and desired real money balances has been eliminated. Closely linked to
the belief in an automatic adjustment mechanism is the prediction that expenditure-
switching policies will only temporarily improve the balance of
payments if they induce an increase in the demand for money by raising
domestic prices. For example, devaluation would raise the domestic price
level, which would in turn reduce the level of real money balances below
their equilibrium level. Reference to equation (4.12) reveals that, assuming
there is no increase in domestic credit, the system will return to equilibrium
once the money supply has increased, through a balance of payments surplus
and an associated increase in the level of foreign exchange reserves, to meet
the increased demand for money.
The power of monetary policy From the above analysis it will be apparent
that, in the case of a small country maintaining a fixed exchange rate with the
rest of the world, the country’s money supply becomes an endogenous variable.
Ceteris paribus, a balance of payments deficit leads to a reduction in a country’s
foreign exchange reserves and the domestic money supply, and vice versa.
In other words, where the authorities are committed to buy and sell foreign
exchange for the home currency at a fixed price, changes in the money supply
can arise not only from domestic sources (that is, domestic credit) but also from
balance of payments intervention policy to maintain a fixed exchange rate.
Reference to equation (4.11) reveals that domestic monetary policy only determines
the division of the country’s money supply between domestic credit and
foreign exchange reserves, not the money supply itself. Ceteris paribus, any
increase in domestic credit will be matched by an equal reduction in foreign
exchange reserves, with no effect on the money supply. Monetary policy, in a
small open economy, is completely impotent to influence any variable, other
than foreign exchange reserves, in the long run. For an open economy operating
under fixed exchange rates, the rate of growth of the money supply (M˙ ) will
equal domestic credit expansion (D˙ ) plus the rate of change of foreign exchange
reserves (R˙ ), reflecting the balance of payments position. Domestic
monetary expansion will have no influence on the domestic rate of inflation,
interest rates or the rate of growth of output. Monetary expansion by a large
country relative to the rest of the world can, however, influence the rate of
world monetary expansion and world inflation.
Inflation as an international monetary phenomenon In a world of fixed
exchange rates, inflation is viewed as an international monetary phenomenon
which can be explained by an excess-demand expectations model. Excess
demand depends on world, rather than domestic, monetary expansion. An
increase in the world rate of monetary expansion (due to rapid monetary
expansion by either a large country or a number of small countries simultaneously)
would create excess demand and result in inflationary pressure
throughout the world economy. In this context it is interesting to note that
monetarists have argued that the acceleration of inflation that occurred in
Western economies in the late 1960s was primarily the consequence of an
increase in the rate of monetary expansion in the USA to finance increased
spending on the Vietnam War (see, for example, Johnson, 1972b; Laidler,
1976). Under the regime of fixed exchange rates that existed up to 1971, it is
claimed that the inflationary pressure initiated in the USA was transmitted to
other Western economies via changes in their domestic money supplies originating
from the US balance of payments deficit. In practice the USA
determined monetary conditions for the rest of the world. This situation
eventually proved unacceptable to other countries and helped lead to the
breakdown of the Bretton Woods system.
The monetary approach to exchange rate determination
The monetary approach to exchange rate determination is a direct application
of the monetary approach to the balance of payments to the case of flexible
exchange rates (see Frenkel and Johnson, 1978). Under a system of perfectly
flexible exchange rates, the exchange rate adjusts to clear the foreign exchange
market so that the balance of payments is always zero. In the absence
of balance of payments deficits/surpluses there are no international reserves
changes, so that domestic credit expansion is the only source of monetary
expansion. In contrast to a regime of fixed exchange rates where, ceteris
paribus, an increase in domestic credit leads to a balance of payments deficit
and a loss of international reserves, under flexible exchange rates it leads to a
depreciation in the nominal exchange rate and an increase in the domestic
price level. In the flexible exchange rate case of the monetary approach, ‘the
proximate determinants of exchange rates … are the demand for and supply
of various national monies’ (Mussa, 1976).
The monetary approach to exchange rate determination can be illustrated
using the simple monetary model first introduced in section 4.4.1. Assuming
the system is initially in equilibrium, we again examine the consequence of a
once-and-for-all increase in the domestic money supply (that is, domestic
credit) by the authorities which disturbs the initial money market equilibrium.
Reference to equation (4.10) reveals that, with real income fixed at its
full employment or natural level, and the domestic rate of interest pegged to
the world rate, the excess supply of money can only be eliminated by an
increase in the domestic price level. The discrepancy between actual and
desired money balances results in an increased demand for foreign goods and
securities and a corresponding excess supply of domestic currency on the
foreign exchange market, which causes the domestic currency to depreciate.
The depreciation in the domestic currency results in an increase in the domestic
price level, which in turn leads to an increased demand for money
balances, and money market equilibrium is restored when actual and desired
money balances are again in balance. In this simple monetary model, the
nominal exchange rate depreciates in proportion to the increase in the money
supply. In other words the exchange rate is determined by relative money
supplies. For example, in a two-country world, ceteris paribus there would be
no change in the (real) exchange rate if both countries increased their money
supplies together by the same amount.
The analysis can also be conducted in dynamic terms using slightly more
complicated monetary models which allow for differential real income growth
and differential inflation experience (due to different rates of monetary expansion).
These models predict that the rate of change of the exchange rate
depends on relative rates of monetary expansion and real income growth.
Two examples will suffice. First, ceteris paribus, if domestic real income
growth is lower than in the rest of the world, the exchange rate will depreciate,
and vice versa. Second, ceteris paribus, if the domestic rate of monetary
expansion is greater than in the rest of the world, the exchange rate will
depreciate, and vice versa. In other words the monetary approach predicts
that, ceteris paribus, a slowly growing country or a rapidly inflating country
will experience a depreciating exchange rate, and vice versa. The important
policy implication that derives from this approach is that exchange rate
flexibility is a necessary, but not a sufficient, condition for the control of the
domestic rate of inflation via control of the domestic rate of monetary expansion.
In the case of perfectly flexible exchange rates, the domestic rate of
inflation is held to be determined by the domestic rate of monetary expansion
relative to the domestic growth of real income.
Exchange Rate Determination
The third stage in the development of orthodox monetarism came in the
1970s, with the incorporation of the monetary approach to balance of payments
theory and exchange rate determination into monetarist analysis. Until
the collapse of the Bretton Woods system of fixed exchange rates against the
United States dollar in 1971, the US economy could be treated as a reasonably
close approximation to a closed economy. The monetary approach was
particularly important in that it made monetarist analysis, which had been
implicitly developed in this closed economy context, relevant to open economies
such as the UK.
The monetary approach to the balance of payments under fixed
exchange rates
During the 1970s, a large number of different monetary models of the balance
of payments appeared in the literature. However, common to all monetary
models is the view that the balance of payments is essentially a monetary
phenomenon. As we will discuss, the approach concentrates primarily on the
money market in which the relationship between the stock demand for and
supply of money is regarded as the main determinant of balance of payments
flows. Furthermore, despite different specifications, in most of the monetary
models of the balance of payments four key assumptions are generally made.
First, the demand for money is a stable function of a limited number of
variables. Second, in the long run output and employment tend towards their
full employment or natural levels. Third, the authorities cannot sterilize or
neutralize the monetary impact of balance of payments deficits/surpluses on
the domestic money supply in the long run. Fourth, after due allowance for
tariffs and transport costs, arbitrage will ensure that the prices of similar
traded goods will tend to be equalized in the long run.
The most influential contributions to the development of the monetary
approach to balance of payments theory have been made by Johnson (1972a)
and Frenkel and Johnson (1976). Following Johnson (1972a) we now consider
a simple monetary model of the balance of payments for a small open
economy. Within this model it is assumed that: (i) real income is fixed at its
full employment or natural level; (ii) the law of one price holds in both
commodity and financial markets, and (iii) both the domestic price level and
interest rate are pegged to world levels.
The demand for real balances depends on real income and the rate of
interest.
Md = Pf (Y, r) (4.10)
The supply of money is equal to domestic credit (that is, money created
domestically) plus money associated with changes in international reserves.
Ms = D+ R (4.11)
In money market equilibrium, Md must be equal to Ms so that:
Md = D+ R (4.12)
or
R = Md − D (4.13)
Assuming the system is initially in equilibrium, we now examine the consequence
of a once-and-for-all increase in domestic credit (D) by the authorities.
Since the arguments in the demand for money function (equation 4.10) are all
exogenously given, the demand for money cannot adjust to the increase in
domestic credit. Individuals will get rid of their excess money balances by
buying foreign goods and securities, generating a balance of payments deficit.
Under a regime of fixed exchange rates, the authorities are committed to
sell foreign exchange for the home currency to cover a balance of payments
deficit, which results in a loss of international reserves (R). The loss of
international reserves would reverse the initial increase in the money supply,
owing to an increase in domestic credit, and the money supply would continue
to fall until the balance of payments deficit was eliminated. The system
will return to equilibrium when the money supply returns to its original level,
with the increase in domestic credit being matched by an equal reduction in
foreign exchange reserves (equation 4.11). In short, any discrepancy between
actual and desired money balances results in a balance of payments deficit/
surplus which in turn provides the mechanism whereby the discrepancy is
eliminated. In equilibrium actual and desired money balances are again in
balance and there will be no changes in international reserves; that is, the
balance of payments is self-correcting.
The analysis can also be conducted in dynamic terms. To illustrate the
predictions of the approach, we again simplify the analysis, this time by
assuming that the small open economy experiences continuous real income
growth while world (and hence domestic) prices and interest rates are constant.
In this case the balance of payments position would reflect the
relationship between the growth of money demand and the growth of domestic
credit. A country will experience a persistent balance of payments deficit,
and will in consequence be continually losing international reserves, whenever
domestic credit expansion is greater than the growth in the demand for
money balances (owing to real income growth). Clearly the level of foreign
exchange reserves provides a limit to the duration of time a country can
finance a persistent balance of payments deficit. Conversely a country will
experience a persistent balance of payments surplus whenever the authorities
fail to expand domestic credit in line with the growth in the demand for
money balances. While a country might aim to achieve a balance of payments
surplus in order to build up depleted international reserves in the short run, in
the long run it would be irrational for a country to pursue a policy of
achieving a continuous balance of payments surplus, thereby continually
acquiring international reserves.
The policy implications of the monetary approach under fixed
exchange rates
Automatic adjustment and the power of expenditure switching policies The
monetary approach predicts that there is an automatic adjustment mechanism
that operates, without discretionary government policy, to correct balance of
payments disequilibria. As we have discussed, any discrepancy between actual
and desired real balances results in balance of payments disequilibria as
people try to get rid of or acquire real money balances through international
markets for goods and securities. The adjustment process operates through
balance of payments flows and continues until the discrepancy between actual
and desired real money balances has been eliminated. Closely linked to
the belief in an automatic adjustment mechanism is the prediction that expenditure-
switching policies will only temporarily improve the balance of
payments if they induce an increase in the demand for money by raising
domestic prices. For example, devaluation would raise the domestic price
level, which would in turn reduce the level of real money balances below
their equilibrium level. Reference to equation (4.12) reveals that, assuming
there is no increase in domestic credit, the system will return to equilibrium
once the money supply has increased, through a balance of payments surplus
and an associated increase in the level of foreign exchange reserves, to meet
the increased demand for money.
The power of monetary policy From the above analysis it will be apparent
that, in the case of a small country maintaining a fixed exchange rate with the
rest of the world, the country’s money supply becomes an endogenous variable.
Ceteris paribus, a balance of payments deficit leads to a reduction in a country’s
foreign exchange reserves and the domestic money supply, and vice versa.
In other words, where the authorities are committed to buy and sell foreign
exchange for the home currency at a fixed price, changes in the money supply
can arise not only from domestic sources (that is, domestic credit) but also from
balance of payments intervention policy to maintain a fixed exchange rate.
Reference to equation (4.11) reveals that domestic monetary policy only determines
the division of the country’s money supply between domestic credit and
foreign exchange reserves, not the money supply itself. Ceteris paribus, any
increase in domestic credit will be matched by an equal reduction in foreign
exchange reserves, with no effect on the money supply. Monetary policy, in a
small open economy, is completely impotent to influence any variable, other
than foreign exchange reserves, in the long run. For an open economy operating
under fixed exchange rates, the rate of growth of the money supply (M˙ ) will
equal domestic credit expansion (D˙ ) plus the rate of change of foreign exchange
reserves (R˙ ), reflecting the balance of payments position. Domestic
monetary expansion will have no influence on the domestic rate of inflation,
interest rates or the rate of growth of output. Monetary expansion by a large
country relative to the rest of the world can, however, influence the rate of
world monetary expansion and world inflation.
Inflation as an international monetary phenomenon In a world of fixed
exchange rates, inflation is viewed as an international monetary phenomenon
which can be explained by an excess-demand expectations model. Excess
demand depends on world, rather than domestic, monetary expansion. An
increase in the world rate of monetary expansion (due to rapid monetary
expansion by either a large country or a number of small countries simultaneously)
would create excess demand and result in inflationary pressure
throughout the world economy. In this context it is interesting to note that
monetarists have argued that the acceleration of inflation that occurred in
Western economies in the late 1960s was primarily the consequence of an
increase in the rate of monetary expansion in the USA to finance increased
spending on the Vietnam War (see, for example, Johnson, 1972b; Laidler,
1976). Under the regime of fixed exchange rates that existed up to 1971, it is
claimed that the inflationary pressure initiated in the USA was transmitted to
other Western economies via changes in their domestic money supplies originating
from the US balance of payments deficit. In practice the USA
determined monetary conditions for the rest of the world. This situation
eventually proved unacceptable to other countries and helped lead to the
breakdown of the Bretton Woods system.
The monetary approach to exchange rate determination
The monetary approach to exchange rate determination is a direct application
of the monetary approach to the balance of payments to the case of flexible
exchange rates (see Frenkel and Johnson, 1978). Under a system of perfectly
flexible exchange rates, the exchange rate adjusts to clear the foreign exchange
market so that the balance of payments is always zero. In the absence
of balance of payments deficits/surpluses there are no international reserves
changes, so that domestic credit expansion is the only source of monetary
expansion. In contrast to a regime of fixed exchange rates where, ceteris
paribus, an increase in domestic credit leads to a balance of payments deficit
and a loss of international reserves, under flexible exchange rates it leads to a
depreciation in the nominal exchange rate and an increase in the domestic
price level. In the flexible exchange rate case of the monetary approach, ‘the
proximate determinants of exchange rates … are the demand for and supply
of various national monies’ (Mussa, 1976).
The monetary approach to exchange rate determination can be illustrated
using the simple monetary model first introduced in section 4.4.1. Assuming
the system is initially in equilibrium, we again examine the consequence of a
once-and-for-all increase in the domestic money supply (that is, domestic
credit) by the authorities which disturbs the initial money market equilibrium.
Reference to equation (4.10) reveals that, with real income fixed at its
full employment or natural level, and the domestic rate of interest pegged to
the world rate, the excess supply of money can only be eliminated by an
increase in the domestic price level. The discrepancy between actual and
desired money balances results in an increased demand for foreign goods and
securities and a corresponding excess supply of domestic currency on the
foreign exchange market, which causes the domestic currency to depreciate.
The depreciation in the domestic currency results in an increase in the domestic
price level, which in turn leads to an increased demand for money
balances, and money market equilibrium is restored when actual and desired
money balances are again in balance. In this simple monetary model, the
nominal exchange rate depreciates in proportion to the increase in the money
supply. In other words the exchange rate is determined by relative money
supplies. For example, in a two-country world, ceteris paribus there would be
no change in the (real) exchange rate if both countries increased their money
supplies together by the same amount.
The analysis can also be conducted in dynamic terms using slightly more
complicated monetary models which allow for differential real income growth
and differential inflation experience (due to different rates of monetary expansion).
These models predict that the rate of change of the exchange rate
depends on relative rates of monetary expansion and real income growth.
Two examples will suffice. First, ceteris paribus, if domestic real income
growth is lower than in the rest of the world, the exchange rate will depreciate,
and vice versa. Second, ceteris paribus, if the domestic rate of monetary
expansion is greater than in the rest of the world, the exchange rate will
depreciate, and vice versa. In other words the monetary approach predicts
that, ceteris paribus, a slowly growing country or a rapidly inflating country
will experience a depreciating exchange rate, and vice versa. The important
policy implication that derives from this approach is that exchange rate
flexibility is a necessary, but not a sufficient, condition for the control of the
domestic rate of inflation via control of the domestic rate of monetary expansion.
In the case of perfectly flexible exchange rates, the domestic rate of
inflation is held to be determined by the domestic rate of monetary expansion
relative to the domestic growth of real income.
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