The Monetary Approach

The basic premise of the monetary approach is that any balance of payments disequilibrium or exchange rate movement is based on a monetary disequilibrium—that is, differences existing between the amount of money people wish to hold and the amount supplied by the monetary authorities. In simple terms, if people demand more money than is being supplied by the central bank, then the excess demand for money would

be satisfied by inflows of money from abroad or an appreciation of the currency. On the other hand, if the central bank (the Federal Reserve in the United States) is supplying more money than is demanded, the excess supply of money is eliminated by outflows of money to other countries or a depreciation of the currency. Thus the monetary approach emphasizes the determinants of money demand and money supply. The monetary approach can be analyzed separately for fixed and floating exchange rates. If the exchange rate is fixed, then the monetary approach pertains to the balance of payments. In such a case we call the approach the monetary approach to balance of payments (MABP). In contrast, if exchange rates are floating then the approach explains exchange rate movements and is called the monetary approach to exchange rates (MAER). Both approaches will

be discussed in this chapter. Prior to the monetary approach, it was common to emphasize international trade flows as primary determinants of exchange rates. The traditional approach emphasized the role of exchange rate changes in eliminating international trade imbalances. In this context we should expect countries with current trade surpluses to have appreciating currencies, while countries with trade deficits should have depreciating currencies. It is clear that the world does not work in the simple way just considered.

272 International Money and Finance

SPECIE-FLOW MECHANISM The monetary approach has a long and distinguished history, so the recent

popularity of the approach can be viewed as a rediscovery rather than

a modern innovation. In fact, the recent literature often makes use of a quote from Of the Balance of Trade, written by David Hume in 1752, to indicate the early understanding of the problem. Hume wrote:

Suppose four-fifths of all the money in Great Britain to be annihilated in one night, and the nation reduced to the same condition, with regard to specie, as in the reigns of the Harrys and Edwards, what would be the consequence? Must not the price of all labor and commodities sink in proportion, and everything be sold as cheap as they were in these ages? What nation could then dispute with us in any foreign market, or pretend to navigate or to sell manufactures at the same price, which to us would afford sufficient profit? In how little time, therefore, must this bring back the money which we had lost, and raise us to the level of all the neigh- boring nations? Where after we have arrived, we immediately lose the advantage of the cheapness of labor and commodities; and the farther flowing in of money is stopped by our fullness and repletion.

Hume’s analysis is a strict monetary approach to prices and the balance of payments. If England’s money stock suddenly was reduced by four- fifths, we know from principles of economics that the price level would fall dramatically. The falling price level would give England a price advantage over its foreign competitors, so that its exports would rise and its imports fall. As the foreign money (gold in Hume’s day) poured in, England’s money supply would rise and its price level would follow. This process continues until England’s prices reach the levels of its competitors, after which the system is back in equilibrium.

The Monetary Approach