Bop and Monetary Policy

8/2/2019 Bop and Monetary Policy

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The Monetary Approach toThe Monetary Approach to

Balance-of-Payments andBalance-of-Payments and

Exchange-RateExchange-RateDeterminationDetermination


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Daniels and VanHoose Monetary Approach 2

Introduction

The Monetary Approach focuses on the

supply and demand of money and the

money supply process.

The monetary approach hypothesizes that

BOP and exchange-rate movements result

from changes in money supply and demand.


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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.


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Small Country Model

The balance of payments is defined as:

(5) CA + KA = FER.

For example, if FER< 0, then CA + KA < 0,

and the nation is running a balance of

payments deficit.


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Small Country Model

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

M = kP*Sy.

Sub in (2),(6) m(DC + FER) = kP*Sy.


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Small Country Model

Fixed Exchange Rate Regime

Under fixed exchange rates, the spot rate, S,

is not allowed to vary.

FER must vary to maintain the parity value

of the spot rate.

Hence, the BOP must adjust to any

monetary disequilibrium.


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Small Country Model

Consider what happens if the central bank

raises DC. Money supply exceeds money

demand.

m(DC+ FER) > kP*Sy

There is pressure for the domestic currency

to depreciate. The central bank must sellFER until M = Md.

m(DC+ FER) = KP*Sy


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Small Country Model

There has been no net impact on the

monetary base and money supply as the

change in FER offset the change in DC.

There results, however, a balance of

payments deficit as FER < 0.


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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.


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Small Country Model

Consider the impact of an increase in DC.

Again money supply will exceed money

demandm(DC+ FER) > kP*Sy.

Now the domestic currency must depreciate

to balance money supply and moneydemand

m(DC+ FER) = kP*Sy.


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Small Country Model

The monetary approach postulates that

changes in a nations balance of payments

or exchange rate are a monetaryphenomenon.

The small country illustrates the impact of

changes in domestic credit, foreign priceshocks, and changes in domestic real

income.


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The Portfolio Approach toThe Portfolio Approach to

Exchange-RateExchange-Rate

DeterminationDetermination


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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

quantities of domestic money and domesticand foreign financial securities demanded

and the quantities supplied.


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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*).


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A domestic households 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*.


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The portfolio approach postulates that the

value of a nations currency is determined

by quantities of these assets supplied andthe quantities demanded.

In contrast to the monetary approach, other

financial assets are as important as domesticmoney.


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An Example

Suppose the domestic monetary authorities increasethe monetary base through an open market

purchase of domestic securities.

As the domestic money supply increases, thedomestic interest rate falls.

With a lower interest, households are no longer

satisfied with their portfolio allocation. The demand for domestic bonds falls relative to

other financial assets.


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Example - Continued

Households shift out of domestic bonds.

They substitute into domestic money and foreign

bonds. Because of the increase in demand for foreignbonds, the demand for foreign currency rises.

All other things constant, the increased demand for

foreign currency causes the domestic currency todepreciate.


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Spot Exchange RateDomestic currency units/foreign currency units

Quantity of

foreign currency.

SFC

DFC

DFC

S1

S2

Q1 Q2

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Bop and Monetary Policy