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

Daniels and VanHooseMonetary Approach2 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.

The Monetary Base and the Money Stock

Daniels and VanHooseMonetary Approach4 The Monetary Base A nation’s monetary base can be measured by viewing either the assets or liabilities of the central bank. The assets are domestic credit (DC) and foreign exchange reserves (FER). The liabilities are currency in circulation (C) and total reserves of member banks (TR).

Daniels and VanHooseMonetary Approach5 Simplified Balance Sheet of the Central Bank AssetsLiabilities Domestic Credit (DC) Currency (C) Foreign Exchange Reserves (FER) Total Reserves (TR) Monetary Base (MB) Monetary Base (MB)

Daniels and VanHooseMonetary Approach6 Money Stock There are a number of measures of a nation’s money stock (M). The narrowest measure is the sum of currency in circulation and the amount of transactions deposits (TD) in the banking system.

Daniels and VanHooseMonetary Approach7 Money Multiplier Most nations require that a fraction of transactions deposits be held as reserves. The required fraction is determined by the reserve requirement (rr). This fraction determines the maximum change in the money stock that can result from a change in total reserves.

Daniels and VanHooseMonetary Approach8 Money Multiplier Under the assumption that the monetary base is comprised of transactions deposits only, the multiplier is determined by the reserve requirement only. In this case, the money multiplier (m) is equal to 1 divided by the reserve requirement, m = 1/rr.

Daniels and VanHooseMonetary Approach9 Relating the Monetary Base and the Money Stock Under the assumptions above, we can write the money stock as the monetary base times the money multiplier. M = m  MB = m(DC + FER) = m(C + TR). Focusing only on the asset measure of the monetary base, the change in the money stock is expressed as  M = m(  DC +  FER).

Daniels and VanHooseMonetary Approach10 Example - BOJ Intervention Suppose the Bank of Japan (BOJ) intervenes to strengthen the yen by selling ¥1 million of US dollar reserves to the private banking system. This action reduces the foreign exchange reserves and total reserves component of the BOJ’s balance sheet.

Daniels and VanHooseMonetary Approach11 BOJ Balance Sheet AssetsLiabilities DC C FER TR MB -¥1 million

Daniels and VanHooseMonetary Approach12 BOJ Intervention Because the monetary base declined, so will the money stock. Suppose the reserve requirement is 10 percent. The change in the money stock is  M = m(  DC +  FER),  M = (1/.10)(-¥1 million) = -¥10 million.

Daniels and VanHooseMonetary Approach13 Small Country Example A small country is modeled as: (1)M d = kPy (2)M = m(DC + FER) (3)P = SP * and, in equilibrium, (4)M d = M.

Daniels and VanHooseMonetary Approach14 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.

Daniels and VanHooseMonetary Approach15 Small Country Model (4) and (3) into (1) yields, M = kP * Sy. Sub in (2), (6)m(DC + FER) = kP * Sy.

Daniels and VanHooseMonetary Approach16 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.

Daniels and VanHooseMonetary Approach17 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 = M d. m(DC  + FER  ) = KP * Sy

Daniels and VanHooseMonetary Approach18 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.

Daniels and VanHooseMonetary Approach19 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.

Daniels and VanHooseMonetary Approach20 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.

Daniels and VanHooseMonetary Approach21 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.

The Portfolio Approach to Exchange-Rate Determination

Daniels and VanHooseMonetary Approach23 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.

Daniels and VanHooseMonetary Approach24 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*).

Daniels and VanHooseMonetary Approach25 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*.

Daniels and VanHooseMonetary Approach26 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.

Daniels and VanHooseMonetary Approach27 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.

Daniels and VanHooseMonetary Approach28 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.

Daniels and VanHooseMonetary Approach29 Spot Exchange Rate Domestic currency units/foreign currency units Quantity of foreign currency. S FC D FC D FC ’ S1S1 S2S2 Q1Q1 Q2Q2