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Book Name – Macroeconomics (HL Ahuja)
What’s Inside the Chapter? (After Subscription)
1. Introduction
2. Monetary Approach: Automatic Adjustments
3. Monetary Approach: Adjustment with a Fixed Exchange Rate
4. Evaluation
5. The Monetary Approach Under Flexible Exchange Rate
6. Adjustment with a Flexible Exchange Rate: Effect of a Monetary Expansion
7. Exchange Rate Over Shooting: Dornbusch Model
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The Monetary Approach to the Balance of Payments
Chapter – 34 A
Introduction
The monetary approach to balance of payments treats BoP disequilibrium as a purely monetary phenomenon; it argues that BoP imbalances reflect underlying monetary disequilibrium and can therefore be corrected through adjustments in the money stock.
According to this approach, disequilibrium in the balance of payments affects the demand for and supply of money, and in an open economy changes in foreign exchange reserves constitute an important source of expansion or contraction in money supply.
The basic monetary approach equation is:
\(\Delta M = \Delta D + \Delta R\)In this equation:
ΔM = change in money stock.
ΔD = change in domestic credit or domestic assets of the Central Bank.
ΔR = change in foreign exchange reserves.
Rearranging the equation gives:
\(\Delta R = \Delta M – \Delta D\)This shows that the change in the Central Bank’s foreign exchange reserves equals the change in the stock of high-powered money minus the change in domestic credit extended by the Central Bank.
A key implication is that ΔR (change in foreign exchange reserves) represents the balance of payments position of a country:
A decline in foreign exchange reserves indicates a BoP deficit.
An increase in foreign exchange reserves indicates a BoP surplus.
Under a fixed exchange rate system, a BoP deficit causes a fall in the Central Bank’s foreign exchange reserves, which leads to a contraction of money supply; conversely, a BoP surplus increases foreign exchange reserves and results in an expansion of money supply.
The monetary approach explains changes in the price level through the relationship between the demand for money and the supply of money, with foreign exchange reserves playing an important role in determining money supply.
The demand-for-money function is expressed as:
\(M_d\) = kPYWhere:
Md = demand for money balances.
k = proportion of nominal income people wish to hold as money.
P = price level.
Y = real national income.
Monetary equilibrium exists when money demand equals money supply:
\(M_d\) = \(M_S\)
or
kPY = \(M_S\)When money supply (MS) exceeds the demand for money (kPY), an excess supply of money emerges, which causes the price level to rise, assuming real national income (output) remains unchanged.