THE MONETARY APPROACH TO THE BALANCE OF PAYMENTS

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affect the money supply are below the line. This balance is often referred to as the official settlements balance, and refers to official holdings of gold and foreign exchange, special drawing rights (SDRs), and changes in reserves at the International Monetary Fund. This allows us to concentrate on the monetary aspects of the balance of payments.

With fixed exchange rates, ^ E 5 0, and we have the monetary approach to the balance of payments. Recall that with the exchange rate change equal to zero, the monetary approach to the balance of payments (MABP) equation is given in Equation (14.9) . This equation indicates that the change in reserves is equal to the foreign inflation rate, plus the percentage growth of real income, minus the change in domestic credit. Therefore, with fixed exchange rates, an increase in domestic credit with constant prices and income (and thus constant money demand) will lead to a decrease in international reserves. This means that if the central bank expands domestic credit, creating an excess supply of money, reserves will flow out, or there will be a balance of payments deficit. Conversely, a decrease in domestic credit will lead to an excess demand for money, since money demand

is unchanged for a given ^ F P and ^ Y ; yet because D is falling, R will increase by the central bank buying up foreign currency injecting domestic currency,

to bring money supply equal to money demand. Given the framework just developed, we can now consider some of the implications and extensions of the monetary approach. First, the assumption of purchasing power parity implies that the central bank must make a policy choice between an exchange rate or a domestic price level. Since P 5 EP F , under fixed exchange rates, E is constant. Therefore,

maintaining the pegged value of E implies that the domestic price level will correspond to that of the rest of the world. This is the case in which people discuss imported inflation. If the foreign price level is increasing rapidly, then our price must follow to maintain the fixed E. On the other hand, with flexible rates E is free to vary to whatever level is necessary to clear the foreign exchange market, and so we can choose our domestic rate of inflation independent of the rest of the world. If we select a lower rate of inflation than foreigners do, then PPP suggests that our currency

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mechanism of adjustment to a change in the world economy like a change in the foreign price level. One view is that PPP holds strictly, even in the short run. In this case, a change in the foreign price induces an immediate change in the domestic price and a corresponding change in money demand or money supply. The other view is along the lines of the Hume quote cited previously. The idea here is that prices adjust slowly through the balance of payments effects on the money supply. Thus, if foreign prices rise relative to domestic prices, we tend to sell more to foreigners and run a larger balance of trade surplus. Since we gain international reserves from these goods sales, over time our money supply rises and our prices increase until PPP is restored.

The two approaches differ primarily with regard to timing. The first case assumes that PPP holds in the short run because international reserves flow quickly in response to new events and prices adjust quickly to new equilibrium levels. This fast adjustment is supposedly due to an emphasis on the role of financial assets being bought and sold, resulting in international capital flows. Since financial assets are easily bought and sold, it is easy to understand why many believe that PPP should hold in the short run (ignoring any relative price effects, which we are not discussing in this section). The second case also assumes that PPP holds, but only in the long run. This approach emphasizes the role of goods markets in international adjustment. Since goods prices are supposedly slow to adjust, short-run deviations from PPP will occur that give rise to the balance of trade effects previously discussed. The truth most likely lies between these two extremes. It is reasonable to expect goods prices to adjust slowly over time to changing economic conditions, so it may be reasonable to doubt that PPP holds well in the short run. On the other hand, PPP is not strictly dependent on goods markets. To ignore international capital flows is to miss the potential for a faster adjustment than is possible strictly through goods markets.

We can summarize the policy implications of the monetary approach to the balance of payments as follows:

1. Balance of payments disequilibria are essentially monetary phenomena.

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3. Balance of payments disequilibria can be handled with domestic monetary policy rather than with adjustments in the exchange rate. Devaluation of the currency exchange rate is a substitute for reducing the growth of domestic credit in that devaluation lowers the value of a country’s money relative to the rest of the world (conversely, an appre- ciation of the currency is a substitute for increasing domestic credit growth). Following any devaluation, if the underlying monetary cause of the devaluation is not corrected, then future devaluations will be required to offset the continued excess supply of the country’s money.

4. Domestic balance of payments will be improved by an increase in domestic income via an increase in money demand, if not offset by an increase in domestic credit.

THE MONETARY APPROACH TO THE BALANCE OF PAYMENTS