5 Questions To Help You Prepare For An Online Exam On Monetary Approach To The Balance Of Payments
Explain in detail the monetary approach to balance of payments and how it differs from the Keynesian balance of payments theory
Discuss the process of pegging and exchange rate in the UK.
Which is the most influential single contribution to the monetary approach?
Discuss the policy implications of flexible exchange rates
Figure 6.4 Exchange rate determination.
This model is extremely helpful in illustrating why the balance of payments is such a problem when the authorities are trying to peg the exchange rate in an over-valued position, such as at F. Here there is an even demand for dollars, which in this model is the same as a current account deficit, equal to 8-A. The only way that price F can be maintained is by the domestic authorities providing A dollars per period out of reserves by, in effect, buying back sterling of equivalent value Reserves are finite so this position is not sustainable indefinitely. A short-term is to borrow more reserves. A devaluation would involve changing the intervention price to E, but the conventional response in the 1950s and early 1960s was to depress domestic expenditures so that the D curve would be shifted to the left.
How is the monetary approach used to determine the demand of currencies derived from flow demands of goods?
The monetary approach is critical of treating exchange rates as solely determined by flow demand for currencies derived from flow demands for goods. Exchange rates are the relative price of two amounts of money, so conditions in money markets must have some part to play. In a world of mobile financial capital, the critical condition to be met is that all money stocks and financial asset stocks must be willingly held, at the margin. If there are excess money supplies or portfolio disequilibria, then financial capital will be flowing internationally and, in the absence of central bank intervention, exchange rates will be changing.
The principal difference between the fixed and floating exchange rate cases of the monetary approach is that, in the former, the price level was fixed to that of the rest of the world and the nominal money supply could change through induced reserve changes. In the latter there are no reserve changes and the nominal domestic money supply is fixed by the authorities. However, the real money supply is determined endogenously because domestic prices are no longer tied to foreign prices. Monetary expansion by the authorities now leads to downward pressure on the exchange rate and upward pressure on the domestic price level. The exchange rate measures the value of domestic money in terms of other money. The price level measures the value of domestic money in terms of goods. They are both indicators of the same thing declining value of the domestic money. Neither is the cause of inflation, and both are different aspects of the same inflation.
The monetary approach to the exchange rate does not claim that only monetary factors are important, but it does stress the importance of money markets in the short-run determination of exchange rates. This is because it may take a long time for price changes to influence goods markets, but the international 'wholesale' money markets are highly sensitive to minute interest differentials and expected exchange rate changes. If these markets anticipate an exchange rate change, as a result of some policy change. holders will tend to move immediately out of the currency which is expected to decline in value. Floating currencies do not move smoothly in line with inflation differentials. They adjust quickly to new information, but with a tendency to overshoot. The cause of overshooting will be discussed below.
Finally, it is important to avoid confusion about whether the monetary approach is a long-run or short-run theory. The fixed-rate case was criticized by some for only explaining the long-run situation, while the proponents of the floating case espouse it as providing the dominant short-run explanation of exchange rates. It would seem that the behavior of the authorities can change a model from the long run to the short run or vice versa. The answer to this paradox is very simple. In both cases, demand for money for transaction purposes for most individuals and non-financial firms can be out of equilibrium for long periods. International goods arbitrage is also slow so the 'law of one price' or purchasing power parity is at best long-run equilibrium conditions. However, interest arbitrage equilibrium conditions between financial firms such as international banks hold almost exactly even in the very short run. The monetary approach in both fixed and floating exchange rate cases is a theory of short-run international portfolio adjustments, i.e. capital flows. These markets adjust most quickly and can thus dominate exchange markets in the short run. They are thus vital components to the explanation of short-run exchange rate changes in one case and reserve changes in the other.