THE MONETARY APPROACH Before turning to the model, we should consider some basic concepts and

assumptions. In principles of macroeconomics we learn that the Federal

The Monetary Approach 273

The domestic component of base money is called domestic credit, whereas the remainder is made up of international reserves (money items that can be used to settle international debts, primarily foreign exchange).

The international money flows that respond to excess demands or excess supplies of goods or financial assets at home affect base money and then the money supply. For instance, if a U.S. exporter receives payment in foreign currency, this payment will be presented to a U.S. commercial bank to be converted into dollars and deposited in the exporter’s account. If the commercial bank has no use for the foreign currency, the bank will exchange the foreign currency for dollars with the Federal Reserve (the Fed). The Fed creates new base money to buy the foreign currency by increasing the commercial bank’s reserve deposit with the Fed. Thus, the Fed is accumulating international reserves, and this reserve accumulation brings about an expansion of base money. In the case of an excess supply of money at home, either domestic credit falls to reduce base money, or international reserves will fall in order to lower base money to the desired level.

Now we are ready to construct a simple model of the monetary approach. The usual assumption is that we are analyzing the situation of a small, open economy. A country is defined as “small” when its activities cannot affect the international price of goods or the international interest rate. Openness implies that this country is an active participant in international economic transactions. We could classify nations according to their degree of openness, or the degree to which they depend on international transactions. The United States would be relatively closed, considering the size of the U.S. GDP relative to the value of international trade, whereas Belgium would be relatively open.

A strong assumption of the monetary approach is that there is

a stable demand for money. This means that the relationship among money demand, income, and prices does not change significantly over time. Without a stable demand for money, the monetary approach will not provide a useful framework for analysis. We can begin our model by writing the demand for money as

274 International Money and Finance

demand depends on prices and income.” The usual story is that the higher the income, the more money people will hold to buy more goods. The higher the price level, the more money is desired to buy any given quantity of goods. So, the demand for money should rise with an increase in either P or Y.

Letting M s stand for money supply, R for international reserves, and

D for domestic credit, we can write the money supply relationship as 1

ð14 :2Þ Letting P stand for the domestic price level, E for the domestic

M s 5R1D

currency price of foreign currency, and P F for the foreign price level, we can write the law of one price, defined in Chapter 7, as

ð14 :3Þ Finally, we need the assumption that equilibrium in the money market

P 5 EP F

holds so that money demand equals money supply, or

ð14 :4Þ The adjustment mechanism that ensures the equilibrium of Equation

M d 5M s

(14.4) will vary with the exchange rate regime. With fixed exchange rates, money supply adjusts to money demand through international flows of money via balance of payments imbalances. With flexible exchange rates, money demand will be adjusted to a money supply set by the central bank via exchange rate changes. In the case of a managed float, where theoretically we have floating exchange rates but the central banks intervene to keep exchange rates at desired levels, we have both international money flows and exchange rate changes. All three cases will

be analyzed subsequently. Now, we develop the model in a manner that will allow us to analyze the balance of payments and exchange rates in a monetary framework. We begin by substituting Equation (14.3) into Equation (14.1) .

M d 5 kEP F Y

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Finally, we want to discuss Equation (14.6) , money demand and money supply, in terms of percentage changes. Since k is a constant, the change is zero, and thus k drops out of the analysis and we are left with 2

E1^ F ^ P 1^ Y5^ R1^ D ð14 :7Þ where the hat (^) over a variable indicates percentage change.

Since the goal of this analysis is to be able to explain changes in the exchange rate or balance of payments, we should have ^ R and ^ E on the left-hand side of the equation. Rearranging Equation (14.7) in this manner gives

R2^ F ^ E5^ P 1^ Y2^ D ð14 :8Þ This indicates that the percentage change in reserves (the balance of

payments) minus the percentage change in exchange rates is equal to the foreign inflation rate plus the percentage growth in real income minus the percentage change in domestic credit.

With fixed exchange rates, ^ E 5 0, and we have the monetary approach to the balance of payments. With the exchange rate change equal to zero, the monetary approach Equation (14.8) simplifies to:

R5^ F ^ P 1^ Y2^ D ð14 :9Þ At the other extreme, a completely flexible exchange rate with no

central bank intervention results in a reserve flow ^ R equal zero, because there will not be any changes to reserves. In this case the general Equation (14.8) is now written for the monetary approach to the exchange rate as

2^ F E5^ P 1^ Y2^ D ð14 :10Þ

THE MONETARY APPROACH Before turning to the model, we should consider some basic concepts and