EC3067 International Finance The Monetary Approach The fundamental idea of the monetary approach is that the balance of payments is essentially a monetary phenomenon: Disequilibrium in BP reflects disequilibrium in the money market. A deficit in the BP is due to an excess of money supply in relation to money demand. If the change in reserves (dR) is positive then the CA and Capital account are in an overall deficit. This means that authorities bought home currency with foreign currency reserves, so reserves have fallen. BP = CA + K + dR = 0 Assumptions: Stable money demand function Vertical aggregate supply schedule Purchasing power parity (PPP) 2011/12 EC3067 International Finance

EC3067 International Finance Assumptions Stable money demand function Quantity theory of money is the basis for the money demand function: Where P is the domestic price level, y is real domestic income, and k measures the responses of money demand to changes in nominal income . Money demand function is the basis of the aggregate demand schedule: As k is fixed an increase in y requires a proportional fall in P. An increase in the money supply shifts the AD to the right, as at any given price level there is rise in real money balances (M/P) which leads to increased aggregate demand. 2011/12 EC3067 International Finance

EC3067 International Finance Assumptions Vertical aggregate supply schedule Labour market is sufficiently flexible that the economy is always at full employment. A rise in domestic price level does not lead to increase in output as wages adjust immediately so there is no advantage for producers to take on more labour. Therefore the aggregate supply schedule is vertical: AS shifts to the right with improvement in productivity due to technological progress, so that full employment is associated to a higher level of real output. 2011/12 EC3067 International Finance

EC3067 International Finance Assumptions Purchasing power parity Exchange rate adjusts to keep the following equation: The slope of the curve is P* and implies that a x% rise in the domestic price level requires a x% depreciation of the home currency (rise as S is defined as domestic currency per unit of foreign currency) 2011/12 EC3067 International Finance

EC3067 International Finance The monetary model Domestic money supply: Where D is domestic bond holdings and R is reserves of foreign currency. In difference form: dD represents change in money supply due to open-market operations (OMO): central bank buys/sells bonds held by privates dR represents changes due to foreign exchange operations (FXO): central bank buys/sells foreign currency assets held by privates 2011/12 EC3067 International Finance

Equilibrium of the model 2011/12 EC3067 International Finance

Effects of a devaluation Devaluation can only have an effect on the BP by influencing the demand for money in relation to the supply of money. Devaluation to S2 makes domestic goods more competitive → increase in the demand for domestic currency → money demand shifts to Md2 → money demand M2 exceeds supply M1 → to prevent appreciation authorities have to buy foreign currency → this increases reserves and expands domestic money supply → raises demand for domestically produced goods → aggregate demand shifts to AD2 and pushes prices up until PPP is restored at price P2. Money balances are at the equilibrium level (M1/P1 = M2/P2). In the long run the effect of an x% devaluation is an x% rise in domestic prices and an x% increase in domestic money stock. The surplus resulting from a devaluation is merely a transitory phenomenon. Exchange rate changes are incapable to cause lasting changes in the BP. 2011/12 EC3067 International Finance

Effects of a devaluation 2011/12 EC3067 International Finance

Monetary exchange rate equation The demand for money in the home and foreign economy are given by: The exchange rate is determined by PPP: In equilibrium money demand and supply are equal in each country. The relative money supply is: Using PPP and solving for S we get: An increase in the relative domestic money stock (income) will lead to depreciation (appreciation) of the home currency 2011/12 EC3067 International Finance

EC3067 International Finance Fixed exchange rates Money supply expansion (expansionary OMO) Central bank buys treasury bonds → increase in the supply of domestic currency → money supply shifts to Ms2 → residents have excess real money balances (M2/P1>M1/P1), money supply M2 exceeds money demand M1 → raises demand for domestically produced goods → aggregate demand shifts to AD2 and pushes prices up until price P2 → at prices P2 and fixed exchange rate S1 domestic economy is uncompetitive relative to PPP → deficit of BP → to prevent devaluation authorities buy domestic currency, so reserves fall to R2 → aggregate demand shifts back to AD1 → prices fall back to P1 → PPP is restored → money supply goes back to M1 Price level, output level and money stock return to their original levels. Deficit can become long lasting if: Authorities follow sterilization policies Surplus countries buy deficit’s country currency and hold it in their reserves 2011/12 EC3067 International Finance

EC3067 International Finance Fixed exchange rates 2011/12 EC3067 International Finance

EC3067 International Finance Fixed exchange rates Increase in Income Aggregate supply shifts to AS2 → increase in the demand of domestic currency → money demand shifts to Md2 → residents have excess real money balances (M2/P1>M1/P1), money demand M2 exceeds money supply M1 → reduces expenditure on both domestic and foreign goods, prices fall to P2 → at prices P2 and fixed exchange rate S1 domestic economy is in competitive advantage relative to PPP → surplus of BP → to prevent appreciation authorities buy foreign currency, so reserves rise to R2 → aggregate demand shifts to AD2 → prices rise back to P1 → PPP is restored → money supply goes to M2 Real money balances are greater (M2/P1>M1/P1). Increase in domestic income is offset by rise in domestic money supply. 2011/12 EC3067 International Finance

EC3067 International Finance Fixed exchange rates 2011/12 EC3067 International Finance

EC3067 International Finance Fixed exchange rates Increase in foreign prices Shift of PPP to PPP2 (at S1 a rise in foreign prices means that at the price level P1 the domestic economy is more competitive than PPP) → increased demand for domestic goods, BP surplus → money demand shifts to Md2 → to prevent appreciation authorities buy foreign currency, so reserves rise to R2 and money supply to M2→ aggregate demand shifts to AD2 → prices rise to P2 → PPP is restored By having fixed exchange rate the economy accepts that movements in domestic price levels will be affected by world prices: Country runs the risk of imported inflation. Country gives up monetary autonomy as it has to change its money supply in line with changes in foreign money supply. 2011/12 EC3067 International Finance

EC3067 International Finance Fixed exchange rates 2011/12 EC3067 International Finance

Floating exchange rates Under floating exchange rates there is no BP deficit or surplus as authorities do not intervene to buy or sell domestic currency, so there is no change in international reserves. Money supply expansion (expansionary OMO) Central bank buys treasury bonds → increase in the supply of domestic currency → money supply shifts to Ms2 → residents have excess real money balances (M2/P1>M1/P1), money supply M2 exceeds money demand M1 → raises demand for domestically produced goods → aggregate demand shifts to AD2 with demand y2 exceeding domestic output y1 → excess demand translates into increased expenditure in foreign goods leading to depreciation of exchange rate → price level rises → increase in money demand to Md2 → movement along AD2 until P2 is achieved. In the long run the effect of an x% increase in the money stock is an x% rise in domestic prices and an x% depreciation of exchange rate. 2011/12 EC3067 International Finance

Floating exchange rates 2011/12 EC3067 International Finance

Floating exchange rates Increase in Income Aggregate supply shifts to AS2 → increase in the demand of domestic currency and implies excess supply of goods (y2>y1) at P1 → downward pressure on domestic prices → prices fall to P2 → exchange rate appreciates to S2 to maintain PPP Real money balances are greater (M1/P2>M1/P1). Money demand does not shift because fall in domestic prices is offset by rise in transactions demand as income increased. The result is appreciation of exchange rate and fall in domestic prices, while money supply is unchanged. 2011/12 EC3067 International Finance

Floating exchange rates 2011/12 EC3067 International Finance

Floating exchange rates Increase in foreign prices Shift of PPP to PPP2 → competitive advantage is offset by appreciation of currency to S2 → PPP is restored With floating exchange rate the domestic price level, aggregate demand and output are unaffected by foreign price shocks. Country operates an independent monetary policy, avoiding imported inflation/deflation. The independence depends upon exchange rate adjusting in line with PPP. 2011/12 EC3067 International Finance

Floating exchange rates 2011/12 EC3067 International Finance

Implications of monetary approach The core of monetary approach is that the demand for money is a stable and predictable function of relatively few variables. In fixed exchange regime authorities loose control over domestic monetary policy. The only thing they can control is the composition of money base between domestic and foreign components. From the viewpoint of BP is irrelevant if the money supply is changed via OMO or FXO. Under floating exchange rate regime the country can exogenously determine its money supply because it is exchange rate not monetary changes that restore equilibrium. 2011/12 EC3067 International Finance

Criticisms of the monetary approach This model does not reflect the views of all monetarists. Some admit positively sloped aggregate supply function, therefore a money expansion might not be totally reflected in fall in reserves. The causation is an open issue: Are deficits caused by expenditure decisions or money demand changes? Assumption are empirically questioned particularly in the short-run: Money demand functions are unstable Economies are rarely at full-employment PPP is useless as guide to exchange rate movements. No attention is paid to the composition of deficits: any imbalance is a transitory feature representing a stock disequilibrium in the money market which is self-correcting. This ignores the problems of indebtedness due to current account deficits being financed by capital inflows. 2011/12 EC3067 International Finance

Preparing for coursework (Question from January 2008 exam) The extent to which a country’s current account balance responds to changes in the exchange rate depends on the responsiveness of imports and exports to changes in the exchange rate. Using the elasticity approach qualify the statement. Distinguish between long and short run expected results and provide possible explanations for such discrepancies. Lecture 3 and 4 The elasticity approach Effects of depreciation on current account The Marshall Learner condition The J-curve effect 2011/12 EC3067 International Finance

EC3067 International Finance Elasticity approach Elasticity approach provides an analysis of the effects of a devaluation (depreciation) of exchange rate on the current account balance. There are two effects of a devaluation of a country’s currency: Price effect: Exports become cheaper measured in foreign currency – contributes to worsening CA Volume effect: As exports become cheaper there should be an increase in the volume of exports – contributes to improving CA The net effect will depend on the dominating effect. 2011/12 EC3067 International Finance

EC3067 International Finance Elasticity approach The CA balance expressed in terms of the domestic currency is given by: Simplifying by setting the domestic (P) and foreign price (P*) levels to 1, we get: where S is the exchange rate (domestic currency units per unit of foreign currency). Taking differences and dividing by changes in the exchange rate we get: (1) 2011/12 EC3067 International Finance

EC3067 International Finance Elasticity approach Price elasticity of demand for exports ηx: is the percentage change in exports caused by a 1% change in the exchange rate. So we can write: Price elasticity of demand for imports ηm: is the percentage change in imports caused by a 1% change in the exchange rate. So we can write: Therefore we can substitute into (1) and get the Marshall-Lerner condition: Starting from a balanced CA, a devaluation will improve CA only if the sum of the elasticities is greater than 1. 2011/12 EC3067 International Finance

EC3067 International Finance Elasticity approach Original exchange rate is £0.5/$1. After devaluation is becomes £0.666/$1. 2011/12 EC3067 International Finance

EC3067 International Finance Elasticity approach Difference between short-run and long-run responses (the J-curve-effect). In the short run the volume effect is small, so devaluation can lead to deterioration of the CA, while in the long-run the Marshall-Lerner condition is generally met. Some explanations: Delayed consumer responses Delayed producer responses Imperfect competition 2011/12 EC3067 International Finance