Balance-of-Payments and Exchange Rate Determination

Monetary and Portfolio Approaches

INTERNATIONAL MONETARY AND

FINANCIAL ECONOMICS

Third Edition

Joseph P. DanielsDavid D. VanHoose

Copyright © South-Western, a division of Thomson Learning. All rights reserved.

2

The Monetary Base

• A nation’s monetary base can be measured by viewing either the assets or liabilities of the central bank.

• The assets are domestic credit (DC) and foreign exchange reserves (FER).

• The liabilities are currency in circulation (C) and total reserves of member banks (TR).

3

Simplified Central Bank Balance Sheet

4

Money Stock

• There are a number of measures of a nation’s money stock (M).

• The narrowest measure is the sum of currency in circulation and the amount of transactions deposits (TD) in the banking system.

5

Money Multiplier

• Most nations require that a fraction of transactions deposits be held as reserves.

• The required fraction is determined by the reserve requirement (rr).

• This fraction determines the maximum change in the money stock that can result from a change in total reserves.

6

Money Multiplier

• Under the assumption that the monetary base is comprised of transactions deposits only, the multiplier is determined by the reserve requirement only.

• In this case, the money multiplier (m) is equal to 1 divided by the reserve requirement,

m = 1/rr.

7

Relating the Monetary Base and the Money Stock

• Under the assumptions above, we can write the money stock as the monetary base times the money multiplier.M = mMB = m(DC + FER) = m(C + TR).

• Focusing only on the asset measure of the monetary base, the change in the money stock is expressed as

M = m(DC + FER).

8

Foreign Exchange Interventions

• Leaning with the Wind: Central bank interventions to support of speed along the current trend in the market exchange value of its nation’s currency.

• Leaning against the Wind: Central bank interventions to halt or reverse the current trend in the market exchange value of its nation’s currency.

9

Example - BOJ Intervention

• Suppose the Bank of Japan (BOJ) intervenes to slow or halt an appreciation of the yen relative to the dollar by buying $1 million of US dollar reserves from a foreign exchange dealer at an exchange rate of 110 ¥/$.

• This action increases the foreign exchange reserves and total reserves component of the BOJ’s balance sheet.

• It also affects the foreign exchange reserves and total reserves component of the Fed’s balance sheet.

• We begin by illustrating the simplified balance sheets of both banks.

10

Simplified Balance Sheets of the Fed and the BOJ

The simplified balance sheets of the Federal Reserve and the Bank of Japan

express the monetary base as the sum of the central bank’s

domestic credit and foreign exchange

reserves, and as the sum of currency and

bank reserves.

11

The Effect of a Foreign Exchange Purchase on the BOJ’s Balance Sheet

When the BOJ purchases ¥110 million of foreign reserves ($1 million • 110 ¥/$), the

foreign exchange reserves component of

the monetary base rises. The BOJ pays the

foreign exchange dealer by applying a ¥110 million credit to the

reserves of the dealer’s bank.

12

BOJ Intervention

• Because the monetary base increased, so will the money stock.

• Suppose the money multiplier for Japan is 2.6. The change in the money stock is

M = m(DC + FER),

M = 2.6•(¥110 million) = ¥286 million.

13

The Effect of a Foreign Exchange Purchase by the BOJ on the Fed’s Balance Sheet

• When the BOJ purchases $1 million of dollar denominated bank deposits, it then presents the deposits to the Fed.

• The Fed assumes the liability and reduces the U.S. bank’s reserve account by $1 million. This, in turn, reduces domestic credit and the monetary base by $1 million.

14

Sterilization

• Note that the foreign exchange intervention indirectly resulted in an increase in the money stock.

• The BOJ can offset the impact of the foreign exchange intervention operation on the monetary base by “sterilizing” the operation.

• Sterilization entails an additional offsetting operation, such as an open-market operation so as to prevent the monetary base from changing.

15

Sterilization

• Because the foreign exchange reserves of the BOJ increased, the bank can undertake an open market sale of domestic assets, such as government securities, to offset it.

• Suppose the sale is exactly ¥110 million and that the BOJ debits the accounts of the banks that purchase the domestic assets.

• As a result, the monetary base is unchanged.

16

The Combined Effects of a Foreign Exchange Transaction and Sterilization

Assets Liabilities

DC C

FERTR

MBMB

+¥1 million+¥1 million

-¥1 million

-¥1 million

unchangedunchanged

When the BOJ purchases ¥110 million of foreign exchange reserves, the

foreign exchange reserves component rises. The BOJ

sterilizes the foreign exchange transaction through

an open-market sale of securities. This reduces the domestic credit component

of the monetary base.

17

The Monetary Approach to BOP Determination

• The Monetary Approach focuses on the quantity of money supplied and the quantity demanded.

• The monetary approach hypothesizes that BOP and exchange-rate movements result from differences between the quantity of money supplied and the quantity demanded.

18

Small Country Example

A small country is modeled as:

(1) Md = kPy

(2) M = m(DC + FER)

(3) P = SP*

and, in equilibrium,

(4) Md = M.

19

Small Country Model

• The official settlements balance consists mainly of changes in the central bank’s foreign exchange reserves. We will assume that the nation’s foreign exchange reserves are equivalent to its official settlements balance.

• Hence, (from Chapter 1) an increase in the foreign exchange reserves component of the monetary base is equivalent to a balance-of-payments deficit.

• Likewise, a decrease in the foreign exchange reserves component of the monetary base is equivalent to a balance-of-payments surplus.

20

Small Country Model

Substituting (4) and (3) into (1) yields

(5) M = kP*Sy.

Substituting (5) in (2), yields

(6) m(DC + FER) = kP*Sy.

21

Small Country Model: Fixed Exchange Rate Regime

• Under fixed exchange rates, the spot rate, S, is not allowed to vary.

• Foreign exchange reserves must vary to maintain the parity value of the spot rate.

• Hence, the BOP must adjust to any monetary disequilibrium.

22

Small Country Model

• Consider what happens if the central bank raises DC. The money stock exceeds money demand.

m(DC + FER) > kP*Sy

• There is pressure for the domestic currency to depreciate. The central bank must sell FER until M = Md.

m(DC + FER) = KP*Sy

23

Small Country Model

• There has been no net impact on the monetary base and the money stock as the change in FER offset the change in DC.

• A balance of payments deficit results, however, as foreign exchange reserves decrease (FER < 0).

24

Small Country Example:Flexible Exchange Rate Regime

• Under a flexible exchange rate regime, the FER component of the monetary base does not change.

• The spot exchange rate, S, will adjust to eliminate any monetary disequilibrium.

25

Small Country Model

• Consider the impact of an increase in DC.• Again the money stock will exceed money

demandm(DC + FER) > kP*Sy.

• The domestic currency must depreciate to balance money stock and money demand

m(DC + FER) = kP*Sy.

26

Small Country Model

• The monetary approach postulates that changes in a nation’s balance of payments or exchange rate are a monetary phenomenon.

• The small country illustrates the impact of changes in domestic credit, foreign price shocks, and changes in domestic real income.

27

The Portfolio Approach

• The portfolio approach expands the monetary approach by including other financial assets.

• The portfolio approach postulates that the exchange value is determined by the quantity of domestic money supplied and the quantity demanded and the quantity of domestic and foreign financial securities supplied and the quantities demanded.

28

The Portfolio Approach

• Assumes that individuals earn interest on the securities they hold, but not on money.

• Assumes that households have no incentive to hold the foreign currency.

• Hence, wealth (W), is distributed across money (M) holdings, domestic bonds (B), and foreign bonds (B*).

29

The Portfolio Approach

• A domestic household’s stock of wealth is valued in the domestic currency.

• Given a spot exchange rate, S, expressed as domestic currency units relative to foreign currency units, a wealth identity can be expressed as:

W M + B + SB*.

30

The Portfolio Approach

• The portfolio approach postulates that the value of a nation’s currency is determined by quantities of these assets supplied and the quantities demanded.

• In contrast to the monetary approach, other financial assets are as important as domestic money.

31

A Change in the Money Stock

• Suppose the domestic monetary authorities increase the monetary base through an open market purchase of domestic securities.

• As the domestic money supply increases, the domestic interest rate declines.

• With a lower interest rate, households are no longer satisfied with their portfolio allocation.

• The quantity of domestic bonds demanded falls and the quantity of domestic money and foreign bonds demanded rises..

32

Example - Continued

• Households shift out of domestic bonds.• They substitute into domestic money and foreign

bonds.• Because of the increase in the quantity of foreign

bonds demanded, the demand for foreign currency rises.

• All other things constant, the increased demand for the foreign currency causes the domestic currency to depreciate.

33

A Decrease in the Domestic Interest Rate

When the domestic interest declines, households buy more foreign bonds. As a result, their demand for the foreign currency rises. The increase in the demand for the foreign currency causes

the domestic currency to depreciate.

34

A Change in the Foreign Interest Rate

• Suppose the foreign interest rate increases.

• Because of the increase in the foreign interest rate, households desire to hold larger quantities of foreign bonds and smaller quantities of domestic money and domestic bonds.

• As households buy more foreign bonds, the demand for the foreign currency increase and the domestic currency depreciates.

35

A Change in the Foreign Interest Rate

When the foreign interest rate rises from R1

* to R2*,

households buy more foreign bonds. Households’

demand for the foreign currency rises, shown by a

rightward shift of the demand curve. As a result,

the domestic currency depreciates from S1 to S2.