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# The Monetary Approach to Balance-of-Payments and Exchange-Rate Determination PowerPoint PPT Presentation

The Monetary Approach to Balance-of-Payments and Exchange-Rate Determination. Introduction. The Monetary Approach focuses on the supply and demand of money and the money supply process.

The Monetary Approach to Balance-of-Payments and Exchange-Rate Determination

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## The Monetary Approach to Balance-of-Payments and Exchange-Rate Determination

### 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.

Monetary Approach

### 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.

Monetary Approach

### 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.

Monetary Approach

### Small Country Model

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

M = kP*Sy.

Sub in (2),

(6)m(DC + FER) = kP*Sy.

Monetary Approach

### 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.

Monetary Approach

### 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 sell FER until M = Md.

m(DC + FER) = KP*Sy

Monetary Approach

### 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.

Monetary Approach

### 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.

Monetary Approach

### Small Country Model

• Consider the impact of an increase in DC.

• Again money supply will exceed money demand

m(DC + FER) > kP*Sy.

• Now the domestic currency must depreciate to balance money supply and money demand

m(DC + FER) = kP*Sy.

Monetary Approach

### Small Country Model

• The monetary approach postulates that changes in a nation’s balance of payments or exchange rate are a monetary phenomenon.

• The small country illustrates the impact of changes in domestic credit, foreign price shocks, and changes in domestic real income.

Monetary Approach

## The Portfolio Approach to Exchange-Rate Determination

### 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 domestic and foreign financial securities demanded and the quantities supplied.

Monetary Approach

### The Portfolio Approach

• 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*).

Monetary Approach

### The Portfolio Approach

• A domestic household’s 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*.

Monetary Approach

### The Portfolio Approach

• The portfolio approach postulates that the value of a nation’s currency is determined by quantities of these assets supplied and the quantities demanded.

• In contrast to the monetary approach, other financial assets are as important as domestic money.

Monetary Approach

### An Example

• Suppose the domestic monetary authorities increase the monetary base through an open market purchase of domestic securities.

• As the domestic money supply increases, the domestic 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.

Monetary Approach

### Example - Continued

• Households shift out of domestic bonds.

• They substitute into domestic money and foreign bonds.

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

• All other things constant, the increased demand for foreign currency causes the domestic currency to depreciate.

Monetary Approach

Spot Exchange Rate

Domestic currency units/foreign currency units

SFC

S2

S1

DFC’

DFC

Quantity of

foreign currency.

Q1

Q2

Monetary Approach