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4.4.1 The monetary approach to the balance of payments under fixed exchange rates

During the 1970s, a large number of different monetary models of the balance

of payments appeared in the literature. However, common to all monetary

models is the view that the balance of payments is essentially a monetary

phenomenon. As we will discuss, the approach concentrates primarily on the

money market in which the relationship between the stock demand for and

supply of money is regarded as the main determinant of balance of payments

flows. Furthermore, despite different specifications, in most of the monetary

models of the balance of payments four key assumptions are generally made.

First, the demand for money is a stable function of a limited number of

variables. Second, in the long run output and employment tend towards their

full employment or natural levels. Third, the authorities cannot sterilize or

neutralize the monetary impact of balance of payments deficits/surpluses on

the domestic money supply in the long run. Fourth, after due allowance for

tariffs and transport costs, arbitrage will ensure that the prices of similar

traded goods will tend to be equalized in the long run.

The most influential contributions to the development of the monetary

approach to balance of payments theory have been made by Johnson (1972a)

and Frenkel and Johnson (1976). Following Johnson (1972a) we now consider

a simple monetary model of the balance of payments for a small open

economy. Within this model it is assumed that: (i) real income is fixed at its

full employment or natural level; (ii) the law of one price holds in both

commodity and financial markets, and (iii) both the domestic price level and

interest rate are pegged to world levels.

The demand for real balances depends on real income and the rate of


Md Pf (Y, r) (4.10)

The supply of money is equal to domestic credit (that is, money created

domestically) plus money associated with changes in international reserves.

Ms DR (4.11)

In money market equilibrium, Md must be equal to Ms so that:

Md DR (4.12)


R Md −D (4.13)

Assuming the system is initially in equilibrium, we now examine the consequence

of a once-and-for-all increase in domestic credit (D) by the authorities.

Since the arguments in the demand for money function (equation 4.10) are all

The orthodox monetarist school 189

exogenously given, the demand for money cannot adjust to the increase in

domestic credit. Individuals will get rid of their excess money balances by

buying foreign goods and securities, generating a balance of payments deficit.

Under a regime of fixed exchange rates, the authorities are committed to

sell foreign exchange for the home currency to cover a balance of payments

deficit, which results in a loss of international reserves (R). The loss of

international reserves would reverse the initial increase in the money supply,

owing to an increase in domestic credit, and the money supply would continue

to fall until the balance of payments deficit was eliminated. The system

will return to equilibrium when the money supply returns to its original level,

with the increase in domestic credit being matched by an equal reduction in

foreign exchange reserves (equation 4.11). In short, any discrepancy between

actual and desired money balances results in a balance of payments deficit/

surplus which in turn provides the mechanism whereby the discrepancy is

eliminated. In equilibrium actual and desired money balances are again in

balance and there will be no changes in international reserves; that is, the

balance of payments is self-correcting.

The analysis can also be conducted in dynamic terms. To illustrate the

predictions of the approach, we again simplify the analysis, this time by

assuming that the small open economy experiences continuous real income

growth while world (and hence domestic) prices and interest rates are constant.

In this case the balance of payments position would reflect the

relationship between the growth of money demand and the growth of domestic

credit. A country will experience a persistent balance of payments deficit,

and will in consequence be continually losing international reserves, whenever

domestic credit expansion is greater than the growth in the demand for

money balances (owing to real income growth). Clearly the level of foreign

exchange reserves provides a limit to the duration of time a country can

finance a persistent balance of payments deficit. Conversely a country will

experience a persistent balance of payments surplus whenever the authorities

fail to expand domestic credit in line with the growth in the demand for

money balances. While a country might aim to achieve a balance of payments

surplus in order to build up depleted international reserves in the short run, in

the long run it would be irrational for a country to pursue a policy of

achieving a continuous balance of payments surplus, thereby continually

acquiring international reserves.