LECTURE 9: The Monetary Approach to the Balance of Payments Sterilization definitions Price-specie flow mechanism Income-money flow mechanism Brief history of the Gold Standard Appendix: China sterilizes inflows, 2004-10 ITF-220 - Prof.J.Frankel

The Monetary Approach to the Balance of Payments (MABP) Defining assumption: Reserve flows are not sterilized. Another assumption sometimes associated with MABP: Goods prices are flexible => PPP holds. ITF-220 - Prof.J.Frankel

Definitions: Monetary Base: Liabilities of CB  assets held by CB MB  Res + NDA where Res ≡ International Reserves & NDA ≡ Net Domestic Assets Broad Money Supply (M1): Liabilities of entire banking system M1 = a multiple of MB <= fractional reserve banking Sterilization: Changes in reserves (i.e., BP) offset by NDA , D NDA = - DR, so MB unchanged. Non-sterilization: D MB = DR. ITF-220 - Prof.J.Frankel

David Hume’s Price Specie-Flow Mechanism Initially, Spain piles up gold, from the New World (mercantilism). But if England has a more productive economy (Industrial Revolution), its demand for money will be higher, in proportion to its higher GDP. If the economies are closed off, the disproportionately high money supply in Spain will drive up its price level. ITF-220 - Prof.J.Frankel

Hume’s Price Specie-Flow Mechanism continued If trade is open, then money flows to England (Spain runs a balance of payments deficit), until prices are equalized internationally. ITF-220 - Prof.J.Frankel

Mundell’s Income-Flow Mechanism MB↑ => M1 ↑ => (via i ↓ => I ↑) => A ↑ => Y ↑ But A ↑ => TB<0 => Res then falling gradually over time + nonsterilization MB falling over time A falling over time. In the long run, TB=0 and everything is back to where it was. ITF-220 - Prof.J.Frankel

Mundell’s Income-Flow Mechanism, continued A Monetary Expansion, and Its Aftermath LM IS NS-I´ LM´ TB Y + - NS-I As long as BP<0, reserves continue to flow out, i rises, and spending falls. In the long run BP=0; we are back where we were before the monetary expansion. ITF-220 - Prof.J.Frankel

Example: response to the 1994 tequila crisis LM´ IS M A Example: response to the 1994 tequila crisis Mexico sterilized reserve outflows in 1994. Stayed at point M, but ran out of reserves in December. . Y Argentina was on a currency board => no sterilization. In 1995 allowed reserve outflows to shrink the money supply, raise i, contract spending. Suffered recession, but equilibrated BP at point A. ITF-220 - Prof.J.Frankel

The Gold Standard Definition: Central banks peg the values of their currencies in terms of gold (and so in terms of each other). Pros and Cons Pro: prevents excess money creation and inflation. Cons: prevents response to cyclical fluctuations long-term drag on world economy, e.g., 1873-1896, no gold discoveries => prices fell 53% in US, 45% in UK. ITF-220 - Prof.J.Frankel

Capsule History of the Gold Standard 1844 – Britain adopts full gold standard. 1879 -- US restores gold convertibility. From 1880-1914, the world is on the gold standard. Idealized form: (1) nonsterilization, (2) flexible prices. 1925 -- ill-fated UK return to gold <= misplaced faith in flexible prices. 1944 -- Bretton Woods system, based on gold as the reserve asset. 1945-1971 -- de facto: based on $. 1958 -- Start of US BoP deficits. <= European growth > US growth Triffin dilemma: insufficient global liquidity vs. eventual loss of confidence in $ . Solutions: raise price of gold, or create SDRs. 1971 -- Nixon suspends convertibility & devalues. ITF-220 - Prof.J.Frankel

Appendix -- Example of sterilizing money inflows: China, 2004-08 & 2010 ITF-220 - Prof.J.Frankel

The Balance of Payments ≡ rate of change of foreign exchange reserves (largely $), rose rapidly in China from 2004 on, due to all 3 components: trade balance, Foreign Direct Investment & portfolio inflows Reserves Source: HKMA, Half-Yearly Monetary and Financial Stability Report, June 2008 12 ITF-220 - Prof.J.Frankel 12

FX reserves of the PBoC climbed higher than any central bank in history http://viableopposition.blogspot.com/2012/03/chinas-holdings-of-us-treasuries-what.html ITF-220 - Prof.J.Frankel

Sterilization of foreign reserves: People’s Bank of China sold sterilization bills, thereby taking RMB out of circulation. Data: CEIC Source: Zhang, 2011, Fig.4, p.45. ITF-220 - Prof.J.Frankel

In 2003-04, forex inflows accelerated rapidly In 2003-04, forex inflows accelerated rapidly. Initially, the PBoC had no trouble sterilizing the inflows. => The MB growth rate was kept down to the growth rate of the real economy (≈ 10%/year), so there was little inflationary pressure. ITF-220 - Prof.J.Frankel

In 2007-08 China had more trouble sterilizing the reserve inflow PBoC began to have to pay higher domestic interest rates and to receive lower interest rate on US T bills => “quasi-fiscal deficit” or “negative carry.” Inflation became a serious problem in 2007-08. Also a “bubble” in the Shanghai stock market. ITF-220 - Prof.J.Frankel

Money growth accelerated sharply, 2007-08 Sterilization faltered in 2007 & 2008 Growth of China’s monetary base & its components: Money growth accelerated sharply, 2007-08 Source: HKMA, Half-Yearly Monetary & Financial Stability Report, June 2008 ITF-220 - Prof.J.Frankel

China’s CPI accelerated in 2007-08 Inflation 1999 to 2008 Source: HKMA, Half-Yearly Monetary and Financial Stability Report, June 2008 ITF-220 - Prof.J.Frankel

Sterilization of foreign reserves: Decreases in PBoC’s domestic assets offset increases in foreign assets Source: Zhang, 2011, Fig.7, p.47. ITF-220 - Prof.J.Frankel

China’s inflation broke sharply in 2009, (<= big one-year loss of China’s exports due to global recession), But took off again in 2010-11. Inflation 2001 to 2011 ITF-220 - Prof.J.Frankel

Real Beijing land prices After the interruption of mid-2008 to mid-2009 overheating resumed: rapid rise of land prices in 2010 Real Beijing land prices ITF-220 - Prof.J.Frankel

When house prices rise relative even to rents, that suggests a bubble or easy money Scott Reeve blog ITF-220 - Prof.J.Frankel

China in 2010 resumed attempts to sterilize money inflows by raising banks’ reserve requirements -- to slow M1 growth even while MB is growing rapidly. ITF-220 - Prof.J.Frankel