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4.4.2 The policy implications of the monetary approach under fixed exchange rates

Automatic adjustment and the power of expenditure switching policies The

monetary approach predicts that there is an automatic adjustment mechanism

that operates, without discretionary government policy, to correct balance of

payments disequilibria. As we have discussed, any discrepancy between actual

and desired real balances results in balance of payments disequilibria as

people try to get rid of or acquire real money balances through international

markets for goods and securities. The adjustment process operates through

balance of payments flows and continues until the discrepancy between actual

and desired real money balances has been eliminated. Closely linked to

the belief in an automatic adjustment mechanism is the prediction that expenditure-

switching policies will only temporarily improve the balance of

payments if they induce an increase in the demand for money by raising

domestic prices. For example, devaluation would raise the domestic price

level, which would in turn reduce the level of real money balances below

their equilibrium level. Reference to equation (4.12) reveals that, assuming

there is no increase in domestic credit, the system will return to equilibrium

once the money supply has increased, through a balance of payments surplus

and an associated increase in the level of foreign exchange reserves, to meet

the increased demand for money.

The power of monetary policy From the above analysis it will be apparent

that, in the case of a small country maintaining a fixed exchange rate with the

rest of the world, the country’s money supply becomes an endogenous variable.

Ceteris paribus, a balance of payments deficit leads to a reduction in a country’s

foreign exchange reserves and the domestic money supply, and vice versa.

In other words, where the authorities are committed to buy and sell foreign

exchange for the home currency at a fixed price, changes in the money supply

can arise not only from domestic sources (that is, domestic credit) but also from

balance of payments intervention policy to maintain a fixed exchange rate.

Reference to equation (4.11) reveals that domestic monetary policy only determines

the division of the country’s money supply between domestic credit and

foreign exchange reserves, not the money supply itself. Ceteris paribus, any

increase in domestic credit will be matched by an equal reduction in foreign

exchange reserves, with no effect on the money supply. Monetary policy, in a

small open economy, is completely impotent to influence any variable, other

than foreign exchange reserves, in the long run. For an open economy operating

under fixed exchange rates, the rate of growth of the money supply (M˙ ) will

equal domestic credit expansion (D˙ ) plus the rate of change of foreign exchange

reserves (R˙ ), reflecting the balance of payments position. Domestic

monetary expansion will have no influence on the domestic rate of inflation,

interest rates or the rate of growth of output. Monetary expansion by a large

country relative to the rest of the world can, however, influence the rate of

world monetary expansion and world inflation.

The orthodox monetarist school 191

Inflation as an international monetary phenomenon In a world of fixed

exchange rates, inflation is viewed as an international monetary phenomenon

which can be explained by an excess-demand expectations model. Excess

demand depends on world, rather than domestic, monetary expansion. An

increase in the world rate of monetary expansion (due to rapid monetary

expansion by either a large country or a number of small countries simultaneously)

would create excess demand and result in inflationary pressure

throughout the world economy. In this context it is interesting to note that

monetarists have argued that the acceleration of inflation that occurred in

Western economies in the late 1960s was primarily the consequence of an

increase in the rate of monetary expansion in the USA to finance increased

spending on the Vietnam War (see, for example, Johnson, 1972b; Laidler,

1976). Under the regime of fixed exchange rates that existed up to 1971, it is

claimed that the inflationary pressure initiated in the USA was transmitted to

other Western economies via changes in their domestic money supplies originating

from the US balance of payments deficit. In practice the USA

determined monetary conditions for the rest of the world. This situation

eventually proved unacceptable to other countries and helped lead to the

breakdown of the Bretton Woods system.